At the foot of the colossal Wasatch Mountains in Salt Lake City sits a fund company whose big idea is thinking small. Since 1975, Wasatch Advisors has been focused on small-cap stocks, believing that this corner of the investment universe offers pricing inefficiencies and enough periodic disruptions for a manager to find value.
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.
Over the last 12 months, Copart was up 28.9%. Diluted earnings per share clocked in at $1.04 for the nine months that ended on April 30, a 31.6% increase from the corresponding period a year earlier. The stock's P/E was 15.2 times future earnings.
AVOIDING BANKS, REITs
Wasatch has steered clear of banks and real estate investment trusts, believing those areas don't provide the high growth rates the fund seeks. "In financials, you can find companies with consistent earnings streams, but it's difficult to find companies with real competitive advantages," Taylor says. That hurt the fund's recent performance as financials have soared.
One exception is Higher One Holdings, which works with colleges and universities to distribute financial aid to students. The company, based in New Haven, Conn., provides students debit cards for their financial aid money, for which it charges a fee. "We were attracted to that company because of the recurring nature of the business and the high level of satisfaction that their customers have," Taylor says.
But the firm recently came under fire for overcharging students to use the debit cards. In August, Higher One settled with the Federal Deposit Insurance Corp. by paying $11 million in restitution and a $110,000 penalty. The stock dropped 24% over the last 12 months and earnings were off by 25% in the second quarter from the year prior. "We still like the company, and we like their competitive advantage," Taylor insists.
Of course, when you're keeping valuation in the back of your mind, the market doesn't always cooperate. But sometimes it does. Take the case of Herbalife, one of the fund's top 10 holdings. Wasatch began buying stock in the company, a purveyor of supplements and weight-loss products, in 2007 at around $20 a share when Herbalife made forays into emerging markets. Taylor and his colleagues liked the growth opportunity. But when the financial crisis hit, investors worried that exposure to those young economies would make companies vulnerable. The shares fell to $6 in March 2009. "That's when we bought the stock in a big way," he says.
Herbalife continued to grow and its stock reached $70 early this year. "As the stock got close to $70, we sold out completely," Taylor says. "We knew the company would continue to grow, but we thought the risk/reward wasn't as compelling as it had been."
This year, David Einhorn, the prominent hedge fund manager, asked several pointed questions on the company's conference call. Other investors began shorting the stock and it eventually fell to $42, before recovering. Guess who was buying then?
Ilana Polyak, a Financial Planning contributing writer in New York, has also written for The New York Times, Money and Kiplinger's.
Wasatch Core Growth Fund
Credentials: B.S. in industrial engineering, Stanford University
Experience: Portfolio manager, Wasatch Core Growth (2000-present); analyst, Wasatch Advisors (1996-2000)
Inception of fund:December 1986
AUM: $541 million
Three-year performance as of Aug. 28, 2012:17.2%
Five-year performance as of Aug. 28, 2012: .2%
Expense ratio: 1.22%
Front load: None
Minimum investment: $2,000
Alpha: 5.89% vs. Russell 2000