Overview
In the third quarter, the Wasatch International Growth (Trades, Portfolio) Fund—Investor Class returned 5.29%. The Fund underperformed its benchmark, the MSCI AC World Ex-U.S.A Small Cap Index, which returned 7.91%%.
Global markets were volatile, but generally positive (in terms of local currencies), despite uncertainties such as the possible effect of the Brexit vote in the United Kingdom (U.K.). Central-bank policies around the world remained supportive, acknowledging that the global economic recovery remains fragile. Sustained accommodative monetary policies have distorted risk tolerance and appetite as investors search for yield. Emerging markets have stabilized underpinned by positive fund flows and compelling valuations. Cyclical sectors, including industrials, materials and financials, were the strongest performers in the MSCI AC World Ex-U.S.A. Small Cap Index.
Details of the quarter
During the quarter, a large part of the Fund’s underperformance of its benchmark was attributable to Japan as many of our holdings had a pullback in stock price performance. While the Fund’s weight in Japan was equal to that of the benchmark at 22% of the portfolio, our Japanese stocks declined, while those in the benchmark rose. The U.K. and Australia performed in-line with their benchmark counterparts, but our overweighted position in both of these countries supported the Fund’s relative performance. Since the beginning of this year, we have been increasing our weight in emerging markets given the relatively attractive valuations we have been seeing in our high-quality opportunity set. We were happy to see that India, our largest emerging-market weight, outperformed the benchmark. In Taiwan, the Fund’s weight was equal to that of the benchmark and our stocks significantly outperformed.
Domino’s Pizza Enterprises Ltd. (ASX:DPZ, Financial) (Australia) was once again our largest contributor. The company continued to execute well on the new regions acquired over the last two years. Innovation and technology are driving strong sales and efficiencies for Domino’s. Ennoconn Corp. (TPE:6414, Financial) (Taiwan), a designer and developer of industrial PCs and motherboards, was another strong performer. The company continues to disrupt the industry and take share with its strong cost advantage. It is also a beneficiary of secular trends including increased outsourcing and rising automation in industrial applications. Metro Bank plc (LSE:MTRO, Financial),a U.K. challenger bank that focuses on customer service, bounced back following Brexit woes as it continued to execute its long-term growth strategy. (A challenger bank is a relatively small retail bank set up with the intention of competing for business with large, long-established national banks. The British Bankers’ Association has urged ministers and regulators to boost competition by providing more support for “challenger banks.”) Vitasoy International Holdings Ltd., the leading maker of soybean drinks in Hong Kong and China, saw strong performance as the company continued to execute on its regional expansion strategy.
Detractors from the Fund’s results were mostly Japanese companies. Ain Holdings, Inc. (TSE:9627, Financial), a dispensing pharmacy in Japan, saw weaker-than-expected earnings from national health insurance drug price revisions and slower sales of a premium drug. Over the long term, we believe Japan’s pharmacy industry will consolidate as recruiting pharmacists and cost pressure challenge the industry. We believe Ain will be a beneficiary of this consolidation trend given the company’s scale, robust platform, and strong track record and experience in mergers and acquisitions. MonotaRO Co. Ltd. (TSE:3064, Financial), a leading online retailer of maintenance, repair and operation (MRO) supplies, saw disappointing results during the quarter. Japan’s MRO market is massive and we believe that MonotaRO will continue to take market share from its competitors as the company can offer a broader and deeper assortment of products at reasonable prices with high levels of service. Kakaku.com Ltd., the leading price-comparison website in Japan, also lagged as growth missed expectations. We see a lack of positive catalysts on the horizon and decided to exit the stock.
Chr. Hansen Holding A/S, a Danish company that develops and produces natural food ingredients, pharmaceuticals and biotech products, also detracted from the Fund’s performance as the company did not meet the expectations that management had raised earlier in the year.
One might wonder how we, as long-term investors, navigate uncertain economic times and volatile equity markets. A glimpse into our recent trip to Scandinavia helps to illustrate our process for finding high-quality companies that we believe will be able to grow from cycle to cycle.
We begin preparation for a trip by systematically screening the entire universe of companies with market capitalizations from $200 million to around $5 billion (USD). We use quantitative measures to look for companies that exhibit high-quality characteristics. We are attracted to companies with strong returns on capital that may indicate strong competitive advantages. A solid balance sheet shows that a company is likely to be resilient in various economic environments. Strong cash flows indicate a company’s ability to self-fund growth opportunities.
The economy of Scandinavia (Sweden, Denmark, Norway and Finland) is only 1/15 the size of the U.S. economy. Most people are surprised at the number of successful global companies from the region—IKEA, H&M, LEGO, KONE, Volvo and Ericsson to name just a few. Scandinavia is also considered one the most prolific technology hubs in Europe with companies like Skype, Spotify, King (Candy Crush), Rovio (Angry Birds) and Mojang (Minecraft) originating there.” ”
Various postulations exist as to why Scandinavia excels at producing good global brands and companies. Some say Scandinavian companies are good at building strong positions in global niches (Novo Nordisk,” ” LEGO and KONE). Others say that from the outset the companies are created with a global perspective (H&M and Ericsson). Furthermore, Scandinavian companies are well-known for their focus on great design, simplicity and reasonable pricing (IKEA, Volvo and Pandora” ” ). In the small-cap space, Scandinavian countries are very much like Australia. In both places, we have found great businesses where local or regional players can have dominant market shares in niche industries or areas. In Scandinavia, like Australia, once companies become market-share leaders in the region, they look to grow by expanding into nearby or adjacent geographies and beyond.
In Scandinavia, we have found several companies that are incredibly dynamic and entrepreneurial, tackling, embracing and reinventing challenges and trends and turning them into opportunities. Chr. Hansen from Denmark (mentioned earlier) helps food companies innovate and differentiate their products to accommodate changing tastes and tackle new markets. XXL ASA (OSL:XXL) from Norway provides the best value proposition in sports retailing. With a unique big box standard format and a relentless focus on costs, the company has been taking share from big incumbent players and mom-and-pop stores and even providing a more compelling value proposition than the pure online players.(Current and future holdings are subject to risk.)
Outlook
Our discipline of researching and buying the stocks of companies that we believe are high quality with long-duration growth potential at reasonable prices keeps us focused on the companies’ long-term opportunities and the ways they create value for their shareholders. While low-quality or value stocks can do well for short periods of time, companies with strong competitive positions, outstanding business models and good management teams—have the potential to outperform the market.
The small-cap universe is deep and broad and, while markets are uncertain and volatile, we are finding opportunities across all of our markets. We remain positive on emerging markets given relatively more attractive valuations and a rich set of companies we consider to be high quality, particularly in countries like India. Smaller countries like Australia, New Zealand and Sweden are punching above their weight in terms of the number of high-quality companies we have found. We still believe Japan is an extremely inefficient market. Due to improvements in corporate governance, more Japanese companies are meeting our high standards for quality. However, valuations and investors crowding into these high-quality companies have led us to be more cautious. In the U.K., we made minor adjustments to our positioning, favoring global companies that have the potential to grow regardless of Brexit, and that may even benefit from the weaker currency.
Thank you for the opportunity to manage your assets.
Sincerely,
Roger Edgley, Ken Applegate, Linda Lasater and Kabir Goyal
**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.
You cannot invest in these or any indices.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
CFA® is a trademark owned by CFA Institute.
The Wasatch International Growth (Trades, Portfolio) Fund’s investment objective is long-term growth of capital.
” ” As of September 30, 2016, the Wasatch International Growth (Trades, Portfolio) Fund was not invested in Inter IKEA Systems B.V., H&M Hennes & Mauritz AB, LEGO A/S, KONE Corp., Volvo AB, Telefonaktiebolaget LM Ericsson, Skype Global SARL, Spotify AB, King Digital Entertainment plc, Rovio Entertainment Oy, Mojang AB, Novo Nordisk A/S or Pandora A/S.
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.
Valuation is the process of determining the current worth of an asset or company.
Portfolio holdings are subject to change at any time. References to specific securities should not be construed as recommendations by the Fund or its Advisor. Current and future holdings are subject to risk.
Wasatch Funds are distributed by ALPS Distributors, Inc.
The MSCI World Ex U.S.A. Small Cap Index is an unmanaged index that measures the performance of stocks with market capitalizations between U.S. $200 million and $1.5 billion across 22 developed markets, excluding the United States. 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.
Portfolio holdings are subject to change at any time. References to specific securities should not be construed as recommendations by the Funds or their Advisor.
