MANAGER’S COMMENTS
SMALL CAP CORE GROWTH PORTFOLIO COMMENTARY
March 31, 2017
OVERVIEW
Strong movers in the technology, consumer-discretionary and health-care sectors
enabled Wasatch Small Cap Core Growth portfolios to produce gains during the
first quarter of 2017, outperforming the 2.47% return of the Russell 2000
Index.* The portfolios trailed the 5.35% return of the Russell 2000 Growth
Index.**
For much of the quarter, the rally ignited by the election of Donald Trump continued as investors focused on the benefits promised by his administration: less
regulation, lower taxes, increased infrastructure spending and revamped international trade agreements. That said, the specific winners and losers during the first
quarter were notably different from those of the previous quarter.
In the closing weeks of last year, investors keyed on value-oriented cyclical companies such as those in the energy and producer durables sectors—companies
that were perceived to be prime beneficiaries of the Trump administration’s
policies. These companies could be counted on to profit from increased
infrastructure spending and continued strengthening of the economy. Similarly,
financial-services companies did well during the fourth quarter of 2016, gaining
on the promise of lighter regulation and the likelihood that a higher interest-rate
environment would enable better returns on commercial loans, mortgages and
other types of consumer debt.
WASATCH ADVISORS – 3/31/2017
Overlooked during the fourth quarter of 2016 were many of the high-quality,
growth-oriented stocks that we favor. But this changed in 2017 as technology
companies that lagged during the opening months of the rally turned around in
the first quarter and posted significant gains. Our holdings in Zendesk, Inc.
(ZEN), a developer of systems for help desks, and Fortinet, Inc. (FTNT), a developer of network-security systems, both moved up sharply. We saw the same
behavior in the consumer-discretionary and health-care sectors, where two
of our biotechnology holdings, Seattle Genetics, Inc. (SGEN) and Sangamo
Therapeutics, Inc. (SGMO), rebounded from previous declines.
Although they were punished toward the end of last year for their expensive
valuations, we believe the fundamentals of these companies were solid and
remain so—with the companies’ growth potential intact in an economy that
continues to show signs of improvement. We were skeptical last year that the
selloffs in these stocks reflected any weakness in their businesses, believing
instead that the companies were simply left behind in the rush to join the Trumpdriven rally.
Our holdings in international companies were strong contributors during the
quarter. Of note was our exposure to India, both our single-largest allocation
outside the U.S. and the portfolios’ top-performing country during the quarter.
Major stock averages in India surged to record highs in March following the
landslide victory of Prime Minister Narendra Modi’s Bharatiya Janata Party in
elections to the state assembly of Uttar Pradesh, the country’s most-populous
MANAGER’S COMMENTS
province. The decisive victory left Mr. Modi unchallenged as a national leader and
boosted prospects for additional reforms aimed at furthering India’s growth and
development. The quarter’s strong showing also indicates that investors have
shunned any lingering effect from the Modi government’s demonetization program, implemented last November in an effort to curb graft and corruption.
Given that change in the landscape, we’re not surprised investors have begun to
rotate back toward growth stocks and away from value stocks. As we’ve consistently maintained, we think our high-quality, growth-oriented companies have
strong and sustainable fundamentals that will eventually be recognized in the
market.
NOTABLE MARKET TRENDS REVISITED
WHAT GOES UP MUST COME DOWN
In our commentary last quarter, we took a close look at investors’ rotation into
value-oriented stocks. As noted above, this rotation took a toll on our performance
during the fourth quarter of 2016, only to be partially reversed this year with
investors apparently rediscovering growth companies. In fact, investors favored
value stocks throughout most of 2016, as the Russell 2000 Value Index
outperformed the Russell 2000 Growth Index by about 20 percentage points.
During the first quarter of this year, the opposite was true, as growth stocks
outperformed by more than five percentage points. Given our focus on high-quality
growth companies, this was an encouraging development.
While the financial markets don’t precisely obey the laws of gravity, the phrase
“what goes up must come down” may also apply to cash movements into and out
of exchange-traded funds (ETFs) and index funds. Last quarter, we took note of
the rapid inflow of cash into certain sector ETFs, notably those perceived by
investors to be likely beneficiaries of President Trump’s economic policies.
Throughout much of last year, investors favored companies they thought would
receive a boost first from improvements in the economy and then, at the end of
the year, from President Trump’s policies. Despite the gains that value stocks
achieved, we didn’t see much in the companies’ fundamentals and in analysts’
projections to make us believe in the sustainability of the rally.
As the first quarter of this year came to a close, it became apparent we weren’t
alone in questioning whether the post-election rally would fade. With judicial
resistance to President Trump’s executive orders limiting entry into the U.S.,
confirmation that the Trump campaign is the subject of a counterintelligence
investigation, and the failed effort to repeal and replace the Affordable Care Act,
many investors have grown concerned that President Trump’s ability to fully enact
his economic agenda, including revamping the tax code and implementing largescale infrastructure projects, has been undermined.
WASATCH ADVISORS – 3/31/2017
The financial-services sector was particularly noteworthy, with November 2016
cash flows into the Financial Select Sector SPDR® Fund running in excess of $6
billion, nearly half the previous month’s total assets. Based on the outlook for
fewer financial regulations on the horizon, investors poured money into the
financial-services sector, pushing prices up sharply into early December.
Following a brief lull, prices of financials temporarily resumed their upward push.
But in mid-March, it seemed that gravity—or perhaps a change in the political
wind—began to take hold, and financials sold off. As we pointed out last quarter,
many of the stocks in ETFs have small market capitalizations and low trading
volumes under normal circumstances. We think the rapid and large inflows in
November may have overwhelmed normal liquidity dynamics, exerting strong
upward pressure on the underlying stocks. In March, we may have seen the early
signs of a reversal.
Our point all along has been that we think our relentless focus on high-quality
companies—as judged by factors such as return on equity, market share and
management talent—will over time receive due recognition in the market.
MANAGER’S COMMENTS
Gravity may have another role to play if interest rates continue to rise.
Conventional wisdom maintains that the prolonged zero-interest-rate environment
was largely responsible for pushing equity price-to-earnings multiples higher.
Unable to get a meaningful yield from fixed income, investors poured money into
stocks, ratcheting prices upward. Just consider, when was the last time you heard
someone say that valuations are inexpensive?
If relatively high valuations are partially the result of low interest rates, then one
would expect further rate increases to bring down valuations over time. With the
trailing 12-month price-to-earnings (P/E) multiple of the S&P 500® Index now at
about 21, well above the historical median of approximately 18 it would seem
reasonable to think lower stock multiples will result.
However, we’ve seen some research on the historical relationship between interest
rates (10-year Treasury yields) and stock multiples that offers the possibility of a
different conclusion. In fact, the research indicates that the present situation may
not be extreme—that the market may be only modestly overvalued following the
recent run-up. It’s even possible, according to the research, that the market has
underpriced stocks over the past few years and that multiples should have been
even higher.
While we’re not quite ready to agree that the market has underpriced stocks
overall, we’re also not so sure that interest rates will rise significantly over the
next few years—despite what many pundits are calling for. We believe there are
meaningful anti-inflationary forces in the world that could keep interest rates
lower than widely expected. If so, that could give renewed justification for higher
P/E multiples.
As usual, we’ll shy away from making our decisions based on macro predictions,
which are very difficult to get right. Instead, we’ll continue to do what we’ve
advocated all along: focus on the fundamentals of each company that we own or
that we’re considering for investment.
WASATCH ADVISORS – 3/31/2017
DETAILS OF THE QUARTER
We added a new company, WESCO International, Inc. (WCC), to the portfolios
during the first quarter. WESCO is a massive and broad-based distributor of
industrial and electrical products, supplying large-scale construction and infrastructure projects. The company’s business model is based on providing highquality products and generating fast inventory turns. Although the company’s
earnings have been down recently, WESCO has historically done better than the
typical industrial distributor. After monitoring the company for more than a
decade, we decided to take advantage of both its current low valuation and, in our
opinion, significant growth potential—as we’ve recently seen an increase in
requests for proposals from customers that are optimistic about new projects.
Global biotech company Seattle Genetics was the leading contributor to performance during the quarter as the stock rebounded from losses suffered in December.
The main news driving the performance of the stock was management’s
announcement of an agreement with Immunomedics** to gain exclusive worldwide rights to develop and sell sacituzumab govitecan, an antibody-drug conjugate
used to treat solid cancer tumors. However, not all of Immunomedics’ investors
are enamored of the deal. A battle to stop the agreement has ensued with one
beneficial owner of Immunomedics’ shares accusing the board of directors of
trying to give away the company’s crown jewel. We’re closely monitoring developments in the case. Separately, ADCETRIS®—which is Seattle Genetics’ drug to
treat Hodgkin lymphoma—has continued to experience strong growth.
Sangamo Therapeutics, a developer of gene-based therapies, also did well during
the first quarter. As was the case with Seattle Genetics, Sangamo’s stock price
rebounded after being beaten up—unfairly, in our opinion—during the previous
quarter.
India’s online travel agency MakeMyTrip Ltd. (MMYT) was another main contributor to the portfolios’ performance during the first quarter. MakeMyTrip is the
leading online travel agency (OTA) in India. The company’s focus on hotel
bookings and customized holiday packages—both of which command higher
MANAGER’S COMMENTS
margins than air ticketing—appears to be paying off. Gross margins at
MakeMyTrip widened to 48% in its most-recently reported quarter from 26% in
the same period last year. The company’s stock price has been volatile in recent
years, as intense competition negatively affected the profits of Indian OTAs.
Based on its recent merger with the ibibo Group, however, MakeMyTrip appears to
have emerged as the winner of that competition and is well-positioned in our view
to benefit from increased usage of online travel booking—which currently represents only about 20% of the massive $60 billion Indian travel market. In major
economies such as the U.S. and China, one or two OTAs have come to dominate
the market, and we believe MakeMyTrip is the preeminent OTA in India.
The leading detractor from the portfolios’ performance during the first quarter was
Ensign Group, Inc. (ENSG). The company operates facilities providing skilled
nursing and rehabilitative care services and offers home health and hospice
services in the U.S. Shares of Ensign declined after quarterly earnings missed
expectations and management lowered earnings guidance for 2017. While it
appeared that the earnings shortfall stemmed from a recent acquisition, investors
were also concerned that changes to government reimbursement rates may provide a headwind for the profitability of Ensign’s skilled nursing facilities. As an
investment team, we’re continuing to evaluate Ensign and we’re in the process of
finalizing our thoughts.
One theme we’ve been following in recent years is the steady improvement in
new-home construction since the last recession. Based on long-term averages
dating back to the 1950s, we believe there remains a deficit in the inventory of
new homes, particularly as younger Americans cease living with their parents and
form new households of their own.
Credit Acceptance Corp. (CACC), a provider of financing programs to automobile
dealers, was another detractor from performance during the quarter. Shares
dropped sharply when the Federal Trade Commission (FTC) disclosed it was
investigating the company’s use of ignition kill switches and GPS systems in debtcollection efforts. The FTC is concerned that the company may be employing
these technologies—used both for disabling and locating vehicles—to apply
undue pressure on borrowers. A sector-wide decline in financials, the result of
investors casting doubt on the continued strength of the post-election rally, only
exacerbated the fall in the stock price.
Installed Building Products, Inc. (IBP) fits neatly into that theme and was a
strong contributor during the first quarter. The company installs insulation, garage
doors, rain gutters, shower doors, closet shelving and mirrors during the construction of new homes. Through a combination of organic growth and sensible acquisitions that have broadened its footprint, Installed Building Products has logged
impressive growth with improving margins, and its stock price has followed.
Installed Building Products—together with Trex Co., Inc. (TREX), which manufactures non-wood decking products from waste wood fibers and reclaimed
polyethylene, and Pool Corp. (POOL), a provider of swimming-pool equipment,
parts and supplies—are three companies with solid fundamentals that have
benefited from healthy trends in the housing market. As the economy has
improved, homeowners have felt more comfortable investing in remodeling and
repairs. Additionally, with high rents continuing to make home ownership more
attractive, housing sales have continued to grow at a 10% clip, creating increased
demand for these companies’ products and services.
WASATCH ADVISORS – 3/31/2017
Shares of air carriers Spirit Airlines, Inc. (SAVE) and Allegiant Travel Co. (ALGT)
have continued to bounce around, ending the first quarter on the downside. The
stocks have been sensitive to several factors, including energy prices and larger
airlines’ occasional forays into the niche markets that Spirit and Allegiant serve.
During the first quarter, President Trump’s travel ban sent shockwaves throughout
the travel industry. Investors may also have been expressing concern that the
addition of capacity at larger airlines could have a negative effect on fares.
Regardless of the fluctuations in the stock prices, we continue to be impressed
that these air carriers have created successful, long-duration businesses by
serving value-conscious flyers.
MANAGER’S COMMENTS
OUTLOOK
With our large weighting in the health-care sector and the total collapse in March
of the effort to repeal and replace the Affordable Care Act, it’s fair to ask, “What
happens now?”
For the most part, given that we didn’t anticipate a major jolt from the anticipated
health-care legislation, we’re not predicting a significant upheaval in the market
now that the Trump administration is moving on to tackle other issues, potentially
tax reform and infrastructure.
In fact, we think that passage of the bill for the American Health Care Act—which
was ultimately pulled before a vote even took place—may have been more
troublesome than nothing at all. Had the bill passed, with up to 24 million people
losing insurance coverage over time, hospitals and many other health-care
providers would probably have suffered decreases in volumes, negatively affecting
their bottom lines.
As for our holdings specifically, we don’t see the legislation, or lack of it, as
having significant impacts. Our investments in the health-care sector are largely
concentrated in businesses whose fortunes depend more on company-specific
factors than on large-scale legislation.
We do see opportunities in some health-care-related businesses. For example, we
recently invested in Healthcare Services Group, Inc. (HCSG). Classified in the
producer durables sector, the company provides outsourcing of cleaning, laundry
and food services to nursing homes and senior facilities. We think it’s a solid
company, with a good business and stable demand. We bought it on its own
merits, with regard neither for the president’s policies nor for the prospects of the
American Health Care Act.
We take a similar approach with most of our investments. During the past several
months, the market has generally rallied on the hope that President Trump’s
agenda will accelerate economic growth. At the same time, there’s evidence that
WASATCH ADVISORS – 3/31/2017
regardless of what happens with the president’s agenda, the economy has been
doing better for quite some time. Macro indicators have continued to look
encouraging. Unemployment has been down, while jobs data and average hourly
earnings have been rising. Even inflation—for the time being—has been ticking
up. And the Institute for Supply Management’s manufacturing index showed
further expansion in March.
Having said all this, there’s a historical context to consider. Namely, with
disruptive political events—including the presidential impeachments in Brazil and
South Korea, the harsh political rhetoric regarding Mexico, the continuing
progression of Brexit, and the tumultuous debut of Donald Trump—dominating
news coverage during the quarter, many investors are considering whether or not
to maintain exposure to the financial markets.
When we look at the markets in the wake of these events, however, we see that
the actual performance has generally been strong—possibly to the contrary of
what we would have predicted ahead of time. In other words, even if we had had a
crystal ball we might not have been able to time the markets very well.
We think Warren Buffett had it right, opining in his 1994 Chairman’s Letter about
the Vietnam War, wage and price controls, oil shortages, the resignation of a
president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508
points, and Treasury yields fluctuating between 2.8% and 17.4%: “Imagine the
cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist,
but the friend of the fundamentalist.”
For our part, we intend to stay invested while maintaining our vigilance—focusing
on what we can control. That means searching for reasonably priced, high-quality
companies that can grow their revenues and earnings for long durations.
Thank you for the opportunity to manage your assets.
MANAGER’S COMMENTS
*The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index. The Russell 2000 is widely used in the industry to measure the performance of
small company stocks.
**The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.
You cannot invest directly in these or any indices.
Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. This is a presentation of Wasatch Advisors,
Inc. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. Frank Russell Company is not responsible for the
formatting or configuration of this material or for any inaccuracy in Wasatch Advisors, Inc.’s presentation thereof.
**As of March 31, 2017, the Wasatch Small Cap Core Growth portfolios were not invested in Immunomedics, Inc.
The Patient Protection and Affordable Care Act (PPACA), commonly called the Affordable Care Act (ACA) or “ObamaCare,” is a United States federal statute signed into law by President Barack Obama on
March 23, 2010.
The American Health Care Act is the Republican-sponsored bill intended to repeal and replace the Obama-era Affordable Care Act.
Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including
currencies, causing the British pound to fall to its lowest level in decades.
An Exchange-Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on a securities exchange. ETFs experience price changes
throughout the day as they are bought and sold.
The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return
performance.
Select Sector SPDRs, which include the Financial Select Sector SPDR Fund, are ETFs that divide the S&P 500 into 10 sector index funds that represent the S&P 500 as a whole. Each Select Sector SPDR
can be bought individually, providing exposure to a particular sector or industry group.
Valuation is the process of determining the current worth of an asset or company.
This commentary is intended to provide you with information about factors affecting the performance of Wasatch Small Cap Core Growth portfolios during the
quarter. References to individual companies should not be construed as recommendations to buy or sell shares in those companies. Wasatch analysts closely
monitor the companies held in Small Cap Core Growth portfolios. If a company’s underlying fundamentals or valuation measures change, Wasatch will reevaluate its
position and may sell part or all of its holdings.
Past performance is not indicative of future results.
WASATCH ADVISORS – 3/31/2017