Markets Generally Favored the Wasatch Approach During the Second Quarter
Our overall performance went from lackluster in the first quarter to excellent in the second, and individual stock selections—rather than broad themes—seemed to be the main reason. On an international basis, we see the U.K. as a “value market” with exciting small-cap growth opportunities.
In our previous Market Scout, we discussed how almost all of the Wasatch funds outperformed their benchmarks over the preceding five years. But during the first quarter of 2021, which is admittedly too short a period for properly evaluating returns, only two of the 18 funds outperformed their benchmarks.
What we saw during the second quarter, by contrast, was a sharp reversal in which 14 of the 18 funds outperformed their benchmarks. Again, while a quarter is too short for evaluating returns, we’d like to take this opportunity to describe conditions during the period and offer some longer-term insights.
GROWTH, VALUE, INTEREST RATES AND INFLATION
Broadly speaking, the Wasatch funds and strategies underperformed in the first quarter as growth-oriented stocks fell out of favor to some extent and value-oriented stocks became the market darlings. The conventional wisdom is that a disproportionate share of growth-company earnings will be generated far into the future. So in an environment of rising interest rates (which occurred during the first quarter), those future earnings are worth less in today’s dollars.
Value companies, on the other hand, tend to be more economically sensitive and are generally perceived as benefiting to a greater extent from rising interest rates, higher inflation and continued economic reopening. Banks, for example, can charge much higher rates on loans than they pay on deposits. And as the economy heats up, energy companies can raise prices faster than their costs increase.
There’s certainly some truth to the conventional wisdom described above, especially in the short run. But we believe the long-run circumstances in the economy stand a reasonable chance of favoring comparatively low interest rates and modest inflation. This is because technology, digitalization, e-commerce and other cost-saving developments are likely to keep prices down. We think the winners in such an environment will be less-capital-intensive companies that are able to dominate their industries with highly differentiated products, economies of scale and relatively low costs of goods sold. As a result, much of our research effort is focused on such businesses.
Having said that, there are a few reasons why we believe our companies can do well even if higher interest rates and inflation persist for a while. First, unlike some growth investors who own companies with low or nonexistent earnings, we generally like to own companies that have historically had high returns on capital. Second, some of our holdings consist of consumer-goods, retail, housing-related, industrial and hospitality/travel companies that should benefit from economic reopening. Third, because our companies are high-quality businesses offering differentiated products and services, they can generally pass rising costs on to customers.
WASATCH PERFORMANCE WAS MAINLY DRIVEN BY STOCK SELECTION IN THE SECOND QUARTER
If growth was relatively out of favor during the first quarter when the Wasatch funds and strategies generally underperformed their benchmarks, did growth come back into favor during the second quarter when the funds and strategies tended to outperform? Not exactly. For example, during the second quarter, the Russell 2000® Value Index rose 4.56%—which was somewhat greater than the 3.92% increase in the Russell 2000 Growth Index.
What about quality? Did the stocks of high-quality companies with strong returns on capital perform particularly well during the second quarter? Again, not exactly. We certainly think there were instances in which growth and quality were prized by investors, but we can’t say we saw major trends favoring these factors.
Instead, the Wasatch funds and strategies seemed to benefit mostly from favorable stock selection. Looking at sectors, countries and index deciles based on ROE (return on equity) versus the benchmarks, we see that our holdings generally rose more in aggregate than the benchmark positions. Although we don’t place much emphasis on just one quarter, we do consider ourselves to be stock pickers—rather than macro forecasters—and we expect our longer-term performance to be driven by stock selection too.
In terms of growth, value and quality, there are many different aspects of these broad generalizations. So we can’t just plug factors into a model for making investment decisions. Instead, we perform fundamental research into each company. This research is quantitative and qualitative, and is based on our extensive experience gained over more than 45 years as an investment firm.
As growth-oriented investors, we have a baseline of trying to find companies that we think can double their sales and earnings within about the next five years. But we’re not willing to pay an excessive price for this type of growth. So we have a value discipline as well. When it comes to quality, we like to see high returns on capital, strong management teams operating in expanding business segments, and durable competitive advantages based on innovative products and services.
THE UNITED KINGDOM: GROWTH, VALUE AND QUALITY
For international investors, we believe the United Kingdom is home to many companies that offer an especially attractive combination of growth, value and quality. Our assessment may surprise you. After all, the U.K. had to deal with issues surrounding Brexit for the past several years. And the country’s initial response to the coronavirus pandemic was inadequate.
From our perspective, we think Brexit and the pandemic will definitely have lasting repercussions. But these events didn’t change the fundamental attractiveness of great companies with strong management teams. In other words, these events created uncertainties that tested—rather than materially damaged—the competitive advantages of innovative British companies, which also benefit from some of the world’s top academic institutions.
Now that these uncertainties are lessening, we believe investors will increasingly recognize which companies are most underpriced and best-positioned to expand and take market share over the long term. This is why we consider the United Kingdom to be a “value market” with exciting small-cap growth opportunities.
The U.K. companies we like generally fall into the following categories:
- Strong cash-flow generators that are domestically focused for the most part
- Global businesses that were impacted due to their headquarters being located in Britain
- Serial acquirers
- Technology disruptors
The strong cash-flow generators usually deploy their cash in a balanced way—some cash reinvested into the business for growth, some paid out as dividends and some used for share buybacks. We consider these companies to be relatively inexpensive compared to the growth they experience, and they should benefit even more from an improved domestic economy. Examples of strong cash- flow generators include: (1) B&M European Value Retail, a discount retailer of general merchandise ranging from electronics to home goods; (2) Domino’s Pizza Group plc, which holds the exclusive master franchise to own and operate Domino’s Pizza stores in the U.K. and Ireland; (3) Howden Joinery Group, a designer, manufacturer and seller of fitted kitchens; and (4) Rightmove, which operates a website that lists properties across Britain and publishes a house-price index.
Even though some of our U.K. holdings are global businesses, they were impacted by the misperception that they were particularly vulnerable to Brexit-related woes. In reality, many global businesses have operations in multiple countries. But the misperception gave us the opportunity to build positions in these companies at attractive prices. Examples of global businesses include: (1) Abcam, a biotechnology company that offers antibodies, reagents and assay kits to carry out analyses; (2) Fevertree Drinks, which offers premium mixers for alcoholic beverages; and (3) Electrocomponents plc, a distributor of electronics and electrical, mechanical, automation, health and safety components.
The serial acquirers tend to operate globally and use most of their free cash flow to buy other companies. Our serial acquirers have a history of successful capital allocation and are attractively priced based on the synergies they achieve by combining companies in order to grow more quickly. Examples of serial acquirers include: (1) Diploma plc, whose subsidiaries manufacture and distribute building components, special seals, and an assortment of scientific and laboratory equipment and telecommunications products; and (2) Halma, which manufactures products that detect hazards and also protect assets and people in public and commercial buildings.
Based on the presence of advanced academic institutions and innovation in the United Kingdom, it’s no surprise that technology disruptors are prevalent in the business landscape. Such disruptors include: (1) AJ Bell, a provider of an investment platform that offers stockbroking, wealth management, custody, settlement and dealing services; and (2) Endava, which offers software engineering, cloud transformation, test automation, technology consulting and other related services.
POTENTIAL EFFECTS OF INTEREST RATES AND INFLATION ON EMERGING MARKETS
Interest rates and inflation are discussed above. But when it comes to emerging markets, there’s more to say. The sharp rise in long-term U.S. interest rates since August 2020 has evoked comparisons to the so-called “Taper Tantrum” of 2013. The term had been created to describe investors’ reaction to signals from the U.S. Federal Reserve (Fed) that it was preparing to wind down its quantitative-easing program by tapering purchases of fixed-income securities. In recent weeks, a pickup in inflation has sparked new fears that the Fed may be forced to hike its policy interest rate sooner than expected.
Higher interest rates in the U.S. impact developing nations largely through global currency markets. When yields on U.S. Treasury securities become more attractive, investments in emerging markets may be considered riskier by international investors. As these assets are sold and converted into U.S. dollars, local emerging-market currencies may come under pressure. The impact of capital flight from emerging markets is typically most acute in countries with large fiscal and current-account deficits, which need to be financed with substantial inflows of foreign capital.
During 2013, currency depreciation for some emerging markets raised the costs of imported oil and other raw materials—in addition to the prices of food products and consumer goods. As these higher costs rippled through emerging economies, central banks were forced to tighten monetary policy in order to fight inflation as well as defend their currencies. That, in turn, raised fears of tight monetary policy slowing economic growth, crimping tax receipts and widening fiscal deficits—leading to further currency depreciation, fresh rounds of capital flight and a vicious circle for financial assets.
For our part, however, we think comparisons to 2013 are premature and not generally applicable to all developing nations. Given lingering weakness in the U.S. labor market, the Fed has indicated no immediate plans to raise interest rates. Moreover, structural conditions in most emerging markets are much better today than they were eight years ago. For purposes of discussion, it’s useful to divide emerging markets into three broad groups.
Major exporters such as China, Korea and Taiwan run current-account surpluses that result in their accumulation of vast amounts of U.S. dollars. If necessary, central banks can sell some of these foreign-exchange reserves to purchase their own currencies. We don’t see a “Taper Tantrum” scenario as a serious threat for this group.
At the other end of the spectrum are countries such as Turkey, South Africa, Mexico and, to some extent, Brazil. Current-account deficits in these nations place them at greater risk of currency depreciation and subsequent inflation triggered by an exodus of foreign capital. This group could be expected to struggle if interest rates in the U.S. were to move significantly higher.
In between the other two groups are some increasingly stable countries such as India. In fact, India is moving closer to China, Korea and Taiwan in terms of current-account strength. Therefore, talk of India as one of the “Fragile Five” emerging markets has largely subsided since the term was coined during 2013, when inflation in the country was running around 10%. We credit much of this improvement to the Reserve Bank of India’s (RBI’s) flexible inflation targeting (FIT) framework and to the RBI’s steady accumulation of foreign-exchange reserves, which totaled $579 billion as of March 26. Furthermore, recent agricultural reforms have the potential to ease shortages of food staples that had fueled many of India’s previous battles with inflation.
Primarily among our U.S. holdings, and to a certain extent among our international names as well, we’ve sold some of our high-growth companies for which we believe stock prices have gotten ahead of fundamentals. But we still like a host of tech-related companies because technology can make businesses more efficient and better situated to raise prices in an inflationary environment. Our tech-related holdings are balanced at one end of the spectrum with less economically sensitive companies in areas like health care and at the other end of the spectrum with more economically sensitive companies that are likely to see significant rebounds in a post-Covid environment.
Among our investments in international developed markets, we’ve experienced a degree of underperformance relative to the benchmarks over the past year. There have been a few main reasons for this underperformance. First, our stocks performed exceptionally well on a relative basis early in the pandemic—and it’s therefore understandable that they’ve lagged as vaccine distribution has become increasingly prevalent. Second, Japan—our largest country weight—has seen lackluster returns as its response to Covid-19 went from exceptional to poor. Japan is finally playing catch-up in vaccinating its citizens, which should provide a tailwind for the economy and markets. Third, a number of companies that have generated strong earnings growth have been reinvesting back into their businesses for future growth opportunities. While this has weighed on short-term earnings and stock prices, we believe such corporate behavior is absolutely necessary for long-term success.
As for our emerging-market investments, it’s clear from the discussion above that interest rates, inflation and currency fluctuations are significant considerations. One of the ways we address these considerations is to apply a higher hurdle rate to investments in countries where the structural backdrop is less robust. Our goal in these situations is to find businesses that we believe will generate earnings growth sufficient to offset potential sources of weakness, while still providing attractive rates of return.
With sincere thanks for your continuing investment and for your trust,
RISKS AND DISCLOSURES
Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as currency fluctuations and political uncertainties, which are described in more detail in the prospectus. Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit wasatchglobal.com or call 800.551.1700. Please read the prospectus carefully before investing.
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
Wasatch Advisors, Inc., trading as Wasatch Global Investors ARBN 605 031 909, is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.
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. Current and future holdings are subject to risk.
As of March 31, 2021, the Wasatch Global Opportunities Fund had 2.0% of its net assets invested in Abcam plc, 1.2% in Fevertree Drinks plc, 1.4% in Electrocomponents plc, 1.5% in Diploma plc and 0.8% in Endava plc.
As of March 31, 2021, the Wasatch Global Select Fund had 3.1% of its net assets invested in Abcam plc.
As of March 31, 2021, the Wasatch International Growth Fund had 1.6% of its net assets invested in B&M European Value Retail S.A., 1.3% in Howden Joinery Group plc, 1.4% in Rightmove plc, 2.1%in Abcam plc, 1.8% in Fevertree Drinks plc, 2.3% in Electrocomponents plc, 1.9% in Diploma plc, 1.8% in Halma plc, 1.1% in AJ Bell plc and 1.2% in Endava plc.
As of March 31, 2021, the Wasatch International Select Fund had 3.4% of its net assets invested in Abcam plc, 2.6% in Fevertree Drinks plc and 3.8% in Halma plc.
As of March 31, 2021, the Wasatch Ultra Growth Fund had 1.2% of its net assets invested in Endava plc.
Domino’s Pizza Group plc was not held in the Wasatch funds as of March 31, 2021 but was purchased subsequently.
Wasatch Advisors, Inc., doing business as Wasatch Global Investors, is the investment advisor to Wasatch Funds.
Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI). ADI is not affiliated with Wasatch Global Investors.
CFA® is a trademark owned by the CFA Institute.
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.
The “cloud” is the internet. Cloud-computing is a model for delivering information-technology services in which resources are retrieved from the internet through web-based tools and applications, rather than from a direct connection to a server.
Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.
Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.
Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. 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 indexes.
The Wasatch strategies and funds have been developed solely by Wasatch Global Investors. The Wasatch strategies and funds are not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.
All rights in the Russell 2000 indexes vest in the relevant LSE Group company, which owns these indexes. Russell® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.
These indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in these indexes or (b) investment in or operation of the Wasatch strategies or funds or the suitability of these indexes for the purpose to which they are being put by Wasatch Global Investors.
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© 2021 Wasatch Global Investors. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS005432 10/30/2021