Wasatch International Growth Fund Q2 2014 Commentary
The Wasatch International Growth (Trades, Portfolio) Fund returned 0.67% in the second quarter of 2014, underperforming the 3.64% return of the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index.
The world is showing uneven signs of economic recovery, with some positive advances being felt throughout many of the developed and emerging markets. Within this environment, the Fund’s relative performance was adversely affected largely by its investments in consumer-discretionary companies, many of which have not been the main beneficiaries of recent investor optimism. To a lesser, but still noticeable extent, it is apparent that much of the stock-market gains have come from cyclicals. And there’s been a lack of participation by some of the high-quality growth companies we prefer. We focus on companies that we believe have top-tier managements, strong business models, and leading market-share positions or innovative products or processes. Investors have also favored financials and industrials, areas where our stock selection has been strong, but where we are significantly underweighted.
Although our stocks generally underperformed for the second quarter and for the past 12 months, we’re optimistic going forward. In Europe, we’re seeing increased numbers of interesting companies, and more companies going public. Overall, the pace of economic recovery seems somewhat slower than in the U.S., but there are encouraging signs. The economy is relatively strong in the United Kingdom (U.K.), where the financial system is recovering along with the property market. European industrial activity has been mixed, with softness in France but increased activity in Spain and Portugal. In Spain, we’re even seeing initial-public offerings,†† which were almost nonexistent a year ago. While strong economic growth is far from pervasive throughout Europe, consumer-confidence levels are generally decent and overall stock valuations‡ are more attractive than in the U.S.
In Japan, our stocks did well for the second quarter, roughly keeping up with those in the benchmark. Similar to the U.S., valuations in Japan are somewhat expensive. But due to low interest rates and the strong growth of our companies, we’re willing to pay somewhat higher prices for the stocks. In addition, many of our Japanese companies operate globally, which expands their growth potential.
With the notable exception of uncertainty in China, emerging markets have continued to recover from their challenges last year. China’s economy is slowing down, and that negatively affected our return as all but one of our Chinese investments posted declines during the second quarter. Over the long run, however, we see benefits to more subdued growth—including better allocation of capital. In the meantime, we still believe there are good companies to be found.
India performed well during the quarter, and we expect that to continue as a result of the election of Narendra Modi as Prime Minister. Although Modi faces daunting problems, including corruption, high debt levels and inadequate infrastructure, it is already apparent that investors are optimistic that India’s new leadership can address these issues. As a result, we saw initial gains in cyclical stocks. And more recently, the Fund’s names, which we believe are higher quality, have also benefited. We expect this to continue as incomes rise and the middle class expands.
Details of the Quarter
The Fund is significantly overweight compared to the Index in the information-technology (IT) sector, where we’re finding attractive opportunities in both developed and emerging markets. At the end of the second quarter, the Fund’s overweight in information technology was close to 11 percentage points, which is much higher than in recent years.
Our research has led us to small IT companies that are attacking niche markets and finding ways to compete against larger competitors. We believe these companies possess world-class technologies and tend to provide first-tier products and services. Once their products are more fully recognized in the marketplace, the companies’ growth rates tend to be rapid. Examples held by the Fund include Criteo, Wirecard and Yoox.
Criteo S.A. (CRTO) is based in France and provides web-advertising services. The company closely integrates with its clients, allowing Criteo to track a user’s interaction on the client’s site. This enables highly targeted advertising with effective results. As its client base grows, Criteo’s buying power increases, which allows for better pricing. In addition, as the service runs, Criteo collects a wealth of data that’s used to improve targeted advertising. Companies like Expedia, Macy’s and eBay are clients.‡‡
Wirecard AG (XTER:WDI) is one of the largest payment gateways in Europe and a direct beneficiary of increased online spending. Based in Germany, Wirecard continues to expand the number of payment methods it accepts, which increases the difficulty for smaller players to compete.
Although classified as a consumer-discretionary company, Yoox S.p.A. (MIL:YOOX) uses advanced technology to provide an online platform for the sales of luxury goods. Clients include brands like Armani, Zegna, Dolce & Gabbana, and others.‡‡ Yoox, which is based in Italy, is in the process of expanding its technology to allow omni-channel shopping that will deepen the company’s ties with clients. The new omni-channel platform—which allows consumers to shop seamlessly from all available distribution channels, including mobile devices, Internet devices, computers, TV, radio, direct mail, catalogs and stores—adds an additional revenue stream to Yoox, and once adopted by clients will be difficult to drop, making the service fairly sticky.
We believe the democratization of technology has allowed innovative companies to prosper, despite being located in cities not traditionally associated with startups. For example, Yoox is based in Milan, Criteo in Paris, and Wirecard just outside of Munich. We also own several tech companies operating in London’s outskirts, which are becoming hotbeds of technology. The wide geographical dispersion of companies favors our investment process of on-the-ground research and extensive company visits. During the second quarter, three of our investment professionals periodically visited the European continent for research, while another three investment professionals were based in Europe for an extended period of time.
The Fund also had an average overweight versus the Index in energy of about three percentage points, and benefited as energy prices increased. Exploration & production (E&P) companies like Caracal Energy, Inc. (Canada) and Nostrum Oil & Gas L.P. (LSE:NOG)(Kazakhstan) posted gains, as did E&P support companies like ShawCor Ltd. (TSX:SCL)(Canada) and Schoeller-Bleckmann Oilfield Equipment AG (WBO:SBO)(Austria).
ShawCor (TSX:SCL) was the largest contributor to Fund performance during the quarter. The company is a world leader in advanced pipeline coatings, which are used in pipes that transport fuels, as well as in the E&P process. ShawCor benefits from the push toward offshore drilling, as well as from increased complexity in onshore-drilling processes. Schoeller-Bleckmann manufactures components for directional drilling, where the biggest applications are shale, deepwater and ultra deepwater. Directional drilling requires technically complex parts. Quality matters because part failures typically necessitate hours of work to fix and resume operations. Both companies are among the top players in their industries due to investments in research, development and processes.
Other leading contributors to Fund performance were Japanese consumer-staples manufacturers, Pigeon Corp (TSE:7956) and Calbee, Inc (TSE:2229). Both companies have strong consumer brands in Japan, have stable domestic revenues, and are expanding internationally.
Two of the largest detractors from Fund performance for the second quarter were U.K. consumer-discretionary companies ASOS plc and Rightmove plc. ASOS (LSE:ASC) is an online-only apparel store targeting 20-somethings with a catalog of 65,000 products. We believe non-capital-intensive businesses that do not have a brick-and-mortar presence have the potential to significantly disrupt traditional retail competitors. ASOS has performed strongly over time, averaging more than 50% revenue growth per year over the past three-, five- and 10-year periods. In the second quarter, the share price was hurt by aggressive sales promotions and weak currency translation, which led to a profit warning for the year and a compression of the stock’s price-to-earnings multiple.§ As long-term investors, we favor high-quality companies that have the ability to sustain long-duration growth. We’re watching ASOS closely, though we believe the recent problems are short-term in nature.
Rightmove (LSE:RMV) develops and operates a website that lists real-estate properties throughout Britain, similar to the multiple-listing service used by U.S. real-estate agents. The company’s stock price declined in the face of increasing competition and concern that the housing market may be cooling off. We continue to believe both ASOS and Rightmove have attractive long-term growth prospects.
SouFun Holdings Ltd. (SFUN) was another detractor from Fund performance in the period. The company operates an online-listing site for real estate in China. The online listing of properties is still in its infancy in China, as the industry is currently dominated by offline brokerage firms. SouFun is the best-known online broker, and the company recently lowered its pricing to increase competitiveness and grow the business. The price cut has hurt the company’s valuation, though we still see the online-listing business growing quickly, as consumers shift away from traditional offline competitors. (Current and future holdings are subject to risk.)
Our outlook for international small-cap companies is much-improved. The recovery in Europe is mixed, but there are pockets of decent growth around the world—particularly in emerging markets. This decent growth, in turn, is helping to jump-start companies that satisfy consumer and business demand in the countries that are progressing the fastest. Additionally, as currency and fixed-income markets have largely stabilized, cash flows have resumed into emerging-market countries.
While some trouble spots remain, there are exciting areas of opportunity for international investors. As noted above, we’ve found innovative IT and related companies in industries and geographic areas not normally associated with high-tech. We think innovation will play an increasingly important role, and not just in the information-technology sector. In energy and even in industrials, innovation will be a key to future growth.
Though we have yet to see a strong resurgence of capital expenditures and manufacturing in Europe, we think our investment in LPKF Laser & Electronics AG (XTER:LPK) is an example of a tech company that improves manufacturing. LPKF makes lasers used in the production of smart phones, iPads, automobiles and running shoes. Laser manufacturing is becoming an essential technique that will replace conventional tools in the production of miniature and highly complex products. While LPKF is based in Germany, a significant portion of the company’s sales are to manufacturers in Asia.
Although many of the investments in the Fund struggled during the second quarter and underperformed over the last year, we’re excited about the long-term potential of the companies we own. It’s not unusual in economic recoveries for higher-quality companies to lag at the outset. We’re optimistic, however, that at some point in the near future, the markets will once again favor our companies, which we think will have accelerated growth opportunities as the economic recoveries broaden in Europe, Japan and throughout Asia.
We thank shareholders for their support as always.
Roger Edgley and Linda Lasater
**The MSCI AC World Ex-U.S.A. Small Cap Index is an unmanaged index and includes reinvestment of all dividends of issuers located in countries throughout the world representing developed and emerging markets, excluding securities of U.S. issuers. This index is a free float-adjusted market capitalization index designed to measure the performance of small capitalization securities.
†The MSCI World Ex-U.S.A. Small Cap Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed markets, excluding the United States.
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The Wasatch International Growth (Trades, Portfolio) Fund’s investment objective is long-term growth of capital.
††An initial public offering (IPO) is a company’s first sale of stock to the public.
‡Valuation is the process of determining the current worth of an asset or company.
‡‡As of June 30, 2014, the Wasatch International Growth (Trades, Portfolio) Fund did not hold Expedia, Inc., Macy’s, Inc., eBay, Inc., Giorgio Armani S.p.A., Ermenegildo Zegna Holditalia S.p.A. or Dolce & Gabbana Srl.
§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.