The $541 million Wasatch Core Growth fund stands out in this fund family because it prefers steady over spectacular growth. J.B. Taylor, the fund's longtime manager, looks for companies with earnings growth rates of 15% year in and year out, a fairly difficult hurdle for small companies to achieve. Those that do are standouts. "Core to us is a descriptive word," Taylor says. "It speaks to the quality and the consistency of the business models these companies have."
This fund's stocks tend to have the ability to hold up in a tough economy, a safeguard in high demand now. That strategy has also helped in the long term. In the three-year period that ended Aug. 28, Wasatch Core Growth was up 17.2% a year on an annualized basis, besting 78% of its small-cap growth peers, according to Morningstar. Over the previous five years, it was up 4.2% a year, in the top 27% of its category.
That's not to say that companies in Wasatch Core Growth never stumble. In some years, it's almost impossible to hit the 15% earnings growth rate, Taylor says. Nevertheless, the fund's holdings often perform better than their rivals. In 2009-10, the fund's stocks had flat earnings growth. Yet they still performed better than the average stocks in the Russell 2000, the fund's benchmark, which had major drops in growth. The fund's emphasis on both growth and value is largely responsible, Taylor says.
Having studied industrial engineering at Stanford, a major that was the closest he could find to an undergraduate business degree, Taylor uses a businessperson's analysis to ascertain a company's worth. He refuses to pay too much, even though some of the Steady Eddys can command premiums due to their consistency.
"That's part of the art of investing in this space," says Taylor, whose co-manager is Paul Lambert. "If you look at companies that we've held for eight to 10 years, you can see a one- or two-year period where they've underperformed and had P/Es below that of the market, but where the growth of the companies and consistency of that company was unchanged." The fund's average price-to-future-earnings ratio is 17.24, while the Russell 2000's is 17.78 and the small-cap growth category's is 19.82.
"Buying companies that have a P/E of 15 times, and not 25 or 30 times, keeps you from getting burned when several years of returns get eaten up by P/E compression," he says.
Earnings growth has returned to Wasatch Core Growth, but Taylor still faces headwinds. The most ominous is the broader economy, which has limped into an anemic recovery. That makes it difficult for the companies that Taylor favors to increase market share and drive profits.
But Taylor believes he and his team have a formula for finding the rare company that can. Businesses with strong competitive advantages have that. Those with ample cash and little debt do too, since they are self-sufficient in times when capital runs dry.
One example is Allegiant Travel, which operates the discount airline Allegiant Air. It's a rare airline that has no net debt on its balance sheet and high returns on capital. Allegiant's strategy is to operate routes to leisure destinations originating from small markets. "They have 170 routes that they fly," Taylor says. "But they only have direct competition on 10 or so of those."
Despite the weak economy, Allegiant shares rose 46.8% in the last year. Diluted earnings per share more than doubled in the second quarter from the year earlier, logging the 38th consecutive quarter of profits.
The stocks in the Core Growth portfolio are few, but Taylor believes that because of the distinct nature of small caps - these companies tend to focus on their core competencies and don't branch out into sideline businesses that might overlap with others - he can achieve portfolio diversity with the 55-odd names he holds.
The largest holding is Copart, which runs auctions of wrecked car parts. "If you get into an accident and the insurance company deems your car totaled, there's a 40% chance that the car will be handled by Copart," Taylor says.
Taylor likes the way Copart's management uses online auctions, a sort of eBay for car salvage. More important, Taylor believes Copart to be an all-season stock because it has growth strategies for both good times and bad. When the economy picks up, people drive more. As the number of miles increases, so do car wrecks. But when the economy dips, there's greater demand for used car parts as consumers choose to repair cars instead of buying new ones.