Question: How would you describe the current stock-market environment?
Jeff Cardon: In the years leading up to 2008, there was a tremendous run in the stock market, followed of course by the market crash and a deep recession. Today, most stock-market indices are above their pre-crash levels, and are making new highs. That’s the good news, but it’s also surprising to a lot of people, especially those who still are struggling financially or who still can’t find meaningful employment.
Several factors have been at work in the stock market’s recovery. First, when the market gets crushed like it did in 2008 and early 2009, classic buying opportunities are created. Companies get inexpensive; they fall to low multiples of their eventual earnings power and they set their stocks up for great future returns.
Second, the Federal Reserve’s quantitative easing (QE) has kept interest rates so low for so long. There’s been a perception among many investors that it will be difficult to get a decent return on money-market securities and bonds. So the stock market has widely been viewed as the best game in town. This environment has been especially favorable for small-cap growth stocks because, in a world without a lot of growth, companies that can grow north of 15% stand out.
Third, American corporations have some of the strongest balance sheets to be found anywhere in the world. Many municipalities, and certainly the federal government, are piling debt onto their balance sheets — which are already overburdened. Clearly, these entities are not operating responsibly. If you own stocks, you are investing in companies that are, on balance, acting rationally and making positive contributions to our economy. So from this perspective the stock market has been an excellent place to invest because corporations in America, and many around the world, have generally been good stewards of capital.
Question: Stocks have been doing well overall. What about small-cap stocks in particular?
JB Taylor: Small caps have consistently provided outsized returns for well over a decade. If you look at rolling one-year performance for every month since December of 1999, the Russell 2000® Index has returned better than the S&P 500® Index over 70% of the time. Total returns have been better in small caps, and especially off the market bottom of 2009.
Question: Is that because the earnings of small companies have generally grown faster than the earnings of large companies?
JB Taylor: Yes, over the long run certainly. One of the basic reasons to own small-cap companies is that their growth rates tend to be substantially higher, and that’s more the case today than it’s been for the last 15 to 20 years.
Jeff Cardon: I mentioned the effect a persistent policy of QE is having on stocks; this has perhaps been most visible since June of 2012. The Russell 2000 is up over 50% since then, mostly driven by lower-quality stocks, which is quite unusual this late in a market cycle. Typically, we see the lowest-quality companies do better right off a deep market bottom, but not several years into a recovery. We saw low quality perform well immediately off the bottom, but some of the best performers were the kinds of quality growth companies we focus on. More recently, we’ve seen a period of euphoria in which lower-quality, more speculative stocks have been the market leaders, although there has been a correction in some of these stocks during the last month or so.
JB Taylor: The mood of the market has definitely tilted back to risk-taking in lower-quality, more cyclical stocks. In addition, the valuations of higher-flying software and biotech stocks have been at nosebleed levels. Overall, the fundamentals of small-cap companies don’t really support what we’re seeing in the market. In 2013, the average company in the Russell 2000 grew its earnings around 8% on sales growth of 5.5%. But this was a deceleration from 2012. We haven’t seen a positive inflection point in the earnings growth of small-cap companies as a whole. This makes the recent market euphoria a little more difficult to understand.
Question: Does that mean it’s harder to find good small-cap investment ideas?
JB Taylor: The great thing about being small-cap investors is that we have literally thousands of companies to choose from as we sift for ideas. We only need 50 to 75 to fill a great portfolio. Our experience has been that we can find interesting money-making stocks in just about every type of market environment.
We’re focused on companies with the potential to grow their earnings at superior rates for long periods of time. For the most recent quarter, our companies posted year-over-year earnings growth of 15% and revenue growth of 15%. Like I said earlier, the average small-cap company is growing earnings closer to 8% and slowing down. If we consistently capture earnings growth that’s faster than the market average, we should do very well.
Jeff Cardon: As JB said, we target companies with earnings growth rates of 15% or better. We know that over time, if we own a basket of companies that can double earnings every five years or so, the power of compound growth provides a significant tailwind to our portfolio returns.
To test that point, we recently ran the aggregate sales and net-income numbers for companies that were in the Russell 2000 at the end of 2007, which was before the global financial crisis began. In the six years since then, those companies have grown their revenues by 18% total and net income by 15%. That’s cumulative, not annualized. By contrast, the Wasatch Small Cap Growth Fund’s companies from 2007 went on to grow their revenues by 100% and their net income by 150% over the same period.
So while money has recently poured into the stocks of lower-quality companies on the assumption that a much better economy, easy monetary policies and low interest rates would drive better results, we haven’t seen it in the fundamentals. The earnings growth rates are not that impressive for the overall small-cap market.
JB Taylor: But in momentum-oriented environments, it is not unusual for valuations to diverge from the fundamentals. We remain committed to our focus on quality growth, which we believe will be rewarded over the longer term.
Question: Hasn’t quantitative easing helped the economy?
JB TAYLOR: The question is, relative to what? Where would the economy be without quantitative easing? Because the global financial crisis was so severe, perhaps some quantitative easing was necessary at the outset. Now, five years later, the economy is still lagging dramatically relative to a typical recovery. Had a more normal interest-rate environment prevailed, where creditors could earn a reasonable return on their lending activities, perhaps overall economic growth would be even higher.
Those who follow our investment strategy closely know that the big-picture economic questions are not our areas of focus or expertise. Economic questions are far more complex than the questions we try to answer when we come to work every day: What are the best growth companies in America and around the globe? Which companies can grow fast regardless of the underlying economic backdrop? We obsess over these questions and think we do a really good job of finding and investing in the best growth companies in the world.
Jeff Cardon: One of our reasons for long-run optimism is that there’s an incredible amount of innovation happening in our country. The United States is still the world leader in producing transformative products and ideas. This amazing engine of innovation is what we’re trying to tap into.
For example, we’re seeing companies in the software industry harnessing business models that didn’t exist 10 years ago. Many of these Software-as-a-Service (SaaS) business models were just being developed before the market crashed in 2008. Today, they’re growing at phenomenal rates as they displace the old guard of client-server software solutions. Customers like these cloud-based solutions because they are cheaper, are easier to install and update, and they can harness the power of big data networks. As JB said, these dynamic companies have lofty valuations, something that we’re actively debating while constructing our portfolios.
We also own several companies in the biotech industry. This has been one of the hottest areas of the stock market, and another area of valuation concern. Still, the scientific exploration and the pace of discovery are phenomenal — at levels we’ve never seen before. This is the kind of environment — world-class innovation and accelerating scientific discovery — that provides long-run opportunities for small-cap investors.
Question: One of your SaaS companies, Ultimate Software Group, provides payroll and human-resources solutions via the cloud. What’s preventing more established companies from offering similar services?
Jeff Cardon: Ultimate Software competes against companies like ADP. About 70% of Ultimate’s customers were formerly with ADP. It’s the classic story of entrepreneurship, a small company bringing a new, innovative approach to market. How did Tesla come up with the best electric car when General Motors has been in the car business for over 100 years? In the 34 years I’ve been investing in small caps, it never ceases to amaze me how disruptive entrepreneurial companies can be to slow-moving incumbents.
Question: Can you provide an example of one of your biotech companies?
Jeff Cardon: Sure. Sangamo BioSciences has developed a tool for precisely editing DNA and is using this tool to reprogram or correct genetic errors in humans. The first clinical application is a treatment for AIDS patients. This treatment has the potential to be what’s called a “functional cure.” Today, most AIDS patients are on a lifetime regimen of multiple drugs that have harsh side effects. Sangamo’s process trains the immune system to be resistant to the virus, and several of Sangamo’s AIDS patients are off all HIV drugs with no signs of the disease. Sangamo’s tool is also being tested as a permanent treatment for many diseases caused by a single genetic mutation including (but not limited to) sickle-cell anemia, hemophilia and Huntington’s disease. These programs will begin clinical testing in 2014 and 2015.
Question: When looking at disruptive technologies and companies, how do you identify a quality company, particularly when earnings have not yet caught up with the sales trajectory?
Jeff Cardon: Using SaaS as an example, we know what’s happening because the companies are adding new customers and receiving high renewals from existing customers. With highly repetitive sales, the companies’ selling, general and administrative expenses will come down from about 20% to 8% over time. As that happens, these companies will become phenomenally profitable. Traditional software companies like Oracle are still running at operating margins north of 25% even as they are being disrupted by these new SaaS competitors.
Within the biotech industry, it’s tougher to define quality because most of the companies we are looking at don’t have products, so no revenues, no returns on capital, and no sustainable cash flows. In other words, all of the financial metrics that are important to us are absent in biotech. However, for the best biotech companies, the future opportunity to create wealth for shareholders is phenomenal. Any business model that can alleviate or diminish human suffering is something we’re very interested in, and clearly falls under our definition of a quality growth opportunity.
For biotech companies, we define quality in terms of the excellence of the underlying science and the size of the addressable market. The other very important standard of quality is the same for all our investments, and that is the superiority of the management team. We spend considerable time and effort getting to know the management teams of our portfolio companies, and biotech is no different. Management, culture and passion are incredibly important to successful small-cap investing.
Question: So you are finding some great companies, but valuation seems to be of concern. Is that correct?
JB Taylor: Broadly speaking, the small-cap market is expensive. One measure we look at is the percentage of companies in the Russell 2000 with multiple-of-sales ratios above 10 times, a valuation we’d generally consider extreme. There are more of those in the market today than at any time in the last 13 years. The number of companies trading at less than one times revenues is also hitting 13-year lows, which means there are fewer inexpensive companies out there.
So the market is more expensive and we have to accept that. The question is, what are the repercussions of having an expensive market? We can have an expensive market for quite a long time. It’s quite possible that the small-cap indices won’t post great absolute returns over the next several years. But if you look at the companies we hold, their earnings and growth rates are quite different from the small-cap market as a whole.
Jeff Cardon: There’s no question that valuation is our number one concern. Quality is less of a concern because we’re finding plenty of companies with attractive business models and high growth rates. We really like the companies in our portfolios. If we had no valuation constraints, this would be a very easy environment for investing because there is such an abundance of high-quality, innovative companies in America. We believe this truth is the secret of our economy’s long-run success, and that’s good news for the future since U.S. innovation and entrepreneurship are alive and well. We are in a unique position to observe this since we spend most of our time and effort hunting out these innovators and meeting with them at their offices. I believe there are more higher-quality disruptors today than when I started my career in 1980. The rate of change seems to be accelerating, which creates opportunity for the disruptors and, of course, risk for those being disrupted.
Question: How does this environment compare to the period leading up to the Internet bubble and crash?
Jeff Cardon: During the Internet bubble, money was pouring into companies that had no real products, sales or earnings. Most of those companies don’t exist anymore. Contrast those companies with NetSuite, which is signing up customers who are paying every month to have NetSuite run their enterprise resource planning systems in the cloud. NetSuite has real products and an attractive business model, and the company is creating a recurring revenue stream.
Compared to the Internet bubble, most of today’s business models are completely different. That’s why current valuations don’t represent a bubble, even though the companies are quite expensive. A classic bubble is defined by excessive speculation in unsound business models, which is not what we’re seeing today.
JB Taylor: That’s why we’re not panicked about the valuations among small caps. The market has rightly recognized and crowned some of the phenomenal growers in the investment universe. The difficulty at this point for some of these companies is that it may take them a few years to grow into their valuations. They’ll still be great companies generating tremendous profits in the future. But at some point, investors may prefer to pay lower earnings and revenue multiples for the stocks. So there may be some volatility ahead. It doesn’t mean the stocks will crash. During the dot-com euphoria, many stocks were poised to crash because
the underlying businesses weren’t creating value.
Question: Do you see opportunities in emerging markets?
Jeff Cardon: While I am optimistic regarding the U.S. and small American companies, I believe stock valuations are generally more attractive in emerging markets. But we do have currency, political, regulatory and other risks to consider in emerging markets. Emerging markets are much more vulnerable to the winds of change in the world. However, these winds of change also create opportunities. In India, for example, the long-term economic growth rate is 6% to 7%, versus 2% to 3% in the U.S. The higher growth rate is a huge tailwind for India, and the country’s rising middle class is a powerful demographic.
JB Taylor: Over the last five years, money flowed into emerging markets in a big way. Growth rates in those economies have been higher and the growth isn’t entirely dependent on the developed world. Consumers in emerging markets have increased their demand for local goods and services.
More recently, these markets have been hit with currency problems and more political instability. These issues have created some short-term volatility, but we believe the drivers for future growth are still intact.
Jeff Cardon: For investors with a time horizon of 10 years or longer, I think an emerging-markets allocation should be an important part of a portfolio. While investors may get nervous about periodic disturbances such as the current crisis in Ukraine, I think emerging markets are some of the best places to find quality growth companies selling at reasonable stock prices.
Question: Is the Wasatch investment process as applied by the international portfolio managers also focused on finding quality growth companies?
Jeff Cardon: Yes. The investment process is very similar. With our international companies, especially in emerging markets, the coverage by securities analysts can be sparser than for our U.S. companies. This low level of analyst coverage can mean that our emerging-markets companies are less efficiently priced, which often allows us to find even better buying opportunities. But it also means that we really have to do our homework because if we’re wrong about a company, the stock can get hit especially hard. So company visits are particularly important for our emerging-markets names.
Another important point is that the U.S. is like a tanker ship. The U.S. economy is not going to accelerate very quickly. While we can find fast-growing companies within the U.S., these companies are still operating within a slower-growth economy. Emerging markets, on the other hand, are like speedboats that can travel at a very high rate. When we find quality companies within emerging markets, the companies’ market-share gains can be further enhanced by the fast-growing economies in which the companies operate. We’re seeing this phenomenon in India, for example.
Thanks, Jeff and JB.
RISKS AND DISCLOSURES
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.
Investing in foreign securities, especially in 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 www.WasatchFunds.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.
The primary investment objective of the Wasatch Small Cap Growth Fund is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.
CFA® is a trademark owned by CFA Institute.
As of March 31, 2014, the Wasatch Small Cap Growth Fund had 0.8% of net assets invested in NetSuite, Inc., 1.2% of net assets invested in Sangamo BioSciences, Inc., and 2.8% of net assets invested in Ultimate Software Group, Inc. The Wasatch Small Cap Growth Fund was not invested in Automatic Data Processing, Inc. (ADP), Tesla Motors, Inc., General Motors Co. or Oracle Corp. Portfolio holdings are subject to risk and may 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.
DEFINITIONS
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.
Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.
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 S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance.
You cannot invest in these or any indices.
Valuation is the process of determining the current worth of an asset or company.
© 2014 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc.
WAS003451 Exp: 10/30/2014
