At Wasatch Global Investors, we got our start managing U.S.micro– andsmall–capstrategies. We’ve since expanded into international developed markets and emerging markets. Moreover, we’ve historically had quite a bit of success in these areas.
One of the interesting observations we’ve made over theyears—bothin the U.S. andinternationally—isthathigh–qualitycharacteristics often persist in companies even after they begin to move beyond the realm of small caps. In addition, due to somewhat inefficient pricing but still reasonable liquidity, we’ve found there are frequently good investment opportunities in these companies even to the point of reachingmid–capstatus.
To put ourin–depthknowledge to good use in companies that have moved beyond thesmall–caprealm into themid–caprange, we developed the Wasatch Select strategies for the advantages we believe are available to clients. OurGlobal Select strategyprimarily invests in U.S. and international mid caps. TheWasatch International Select strategyseeks mid caps outside of the U.S. with a focus on developed markets. And ourEmerging Markets Select strategy, as its name implies, mainly invests inmid–capcompanies in emerging markets. Since the Wasatch Emerging Markets Select strategy has been in existence for several years and is morewell–established, this white paper focuses mostly on our newer Global Select and International Select strategies. In the following discussion, we refer to“global mid caps,”which as mentioned above, include international as well as U.S.mid–capcompanies.
To begin to get an idea of why we find the universe ofglobal mid capsso attractive, considerFigure 1below. The bars on the left indicate the20–yearaverage annual total returns (based on quarterly observations) as ofDecember 31, 2019for the investment universe andmarket–capitalizationranges defined below. The bars on the right indicate calculations using companies in the first and second quintiles based on return on assets (ROA), which is an important measure of quality. As you can see,global mid caps(described in the next section) generated performance approaching that of smallcaps—butwith less risk. And thehigh–qualityoverlay based on ROA increased performance across all market capitalizations.
A UNIQUE INVESTMENT UNIVERSE: GLOBAL MID CAPS
In themarket–capitalizationrange between the higher end of small cap and the lower end of large cap, we categorize companies as“global mid caps.”As depicted inFigure 2 below,global mid capsinclude U.S. and international companies. Thus,global mid capsencompassnon–U.S. companies held in our International Select strategy as well as the U.S. and international companies held in our Global Select strategy. We believe theseglobal mid capsare at the intersection of inefficiency and liquidity onworld–widestockexchanges.
So, what do we mean by the higher end of small cap through the lower end of large cap? We define thisglobal mid caprange as companies with market capitalizations from $3 billion to $30billion—whichis a range not typically considered as a category by the investment community, but is where we tend to find some of the best opportunities from a risk/reward perspective.
HIGH QUALITY DEFINED
When investing in small caps, high quality is often defined as companies having excellent management, unique products or services, and significant headroom to gain market share. Unfortunately, many small companies are lesswell–capitalizedand are more vulnerable to competitive threats than largercompanies.
Global mid caps, on the other hand, often have some characteristics that are similar to smallcaps—butgenerally entail less risk. For example,Figure 3 below depicts sales growth for theone–yearperiod ended December 31, 2019 forglobal mid capsat11.5%, which was relatively close to 13.8% for small caps and considerably better than 7.8% for large/mega caps. Atthe same time, in terms of business sustainability,global mid capshad an average ROA as ofDecember 31, 2019 of4.2%, which was not far from the 5.9% for large/mega caps and much healthier than the 0.5% forsmall caps.
For the analyses of sales growth and ROA, the total universe is all companies in developed marketsworld–wide,including the United States.Global mid capsrange from $3 billion to $30 billion in market capitalization, and the universe is comprised of over 2,000 companies. Small caps are greater than $300 million and less than $3 billion, with the universe comprised of almost 5,000 companies. Large/mega caps are greater than $30 billion, and the universe is comprised of fewer than 400companies.
VOLATILITY: ANOTHER MEASURE OF RISK
While we consider the ongoing viability of a company’s business to be the primary measure of risk, many investors look at standard deviation as an indicator of volatility. On this basis,Figure 4 below shows thatglobal mid capshad an annualized standard deviation (based on daily observations) for the one year endedDecember 31, 2019 of 28.1%, which was significantly less than 37.5% for small caps and only somewhat higher than 22.7% forlarge/mega caps.
When combined in a portfolio, volatility drops even further. As you can see inFigure 5below, which was generated from quarterly observations over the 20 years endedDecember 31, 2019, a portfolio of about 30 stocks generally achieved a reasonably low standarddeviation—andmore stocks beyond that probably aren’t necessary to reduce risk. As expected, the lowest standard deviations were achieved by large/mega caps and the highest by small caps, withglobal mid capsrightin between.
Based on this research of volatility and our desire to invest in our most favored companies, theWasatch Global Select,Wasatch International Selectand Wasatch Emerging Markets Select strategies are generally invested in about 20 to 40mid–capstocks.
QUALITY AND PERFORMANCE TEND TO PERSIST
Now that we’ve established the likelihood ofglobal mid capshavinghigh–qualitycharacteristics, it’s important to show that these characteristics tend to persist over time and that they might have something to do with attractive performance in the stock market on an absolutebasis—notjust relative tovolatility.
As mentioned above, one of the most important indicators of quality is ROA.Figure 6 below depicts thefive–yearpersistence of ROA. Rollingfive–yearperiods with quarterly observations over the 20 years endedDecember 31, 2019were used in the analysis. Amongglobal mid caps,64.2% of the companies that started out in the top two quintiles based on ROA also ended the five years still in the top two quintiles. This is a strong indicator of staying power. By contrast, of the companies that did NOT start out in the top two quintiles based on ROA, only23.9%ended the five years having moved into the top twoquintiles.
As forstock–markettotal returns, of the entire performance generated byglobal mid capsfor the rollingfive–yearperiods,Figure 7 below illustrates that64.3%came from companies ending in the top two ROA quintiles and35.7%came from companies ending in the bottom three ROAquintiles.
What this means from aportfolio–managementstandpoint is that if we invest in companies that start in the top two ROA quintiles, there’s a strong likelihood these companies will maintain their ROA advantage. And that gives a portfolio of such companies a potential leg up in terms of performance on atotal–returnbasis (stock–pricechange plusdividends).
THE WASATCH APPROACH TOGLOBAL MID CAPS: CONCENTRATED—BUT STILL DIVERSIFIED—STRATEGIES OF HIGH-CONVICTION HOLDINGS
As described previously, we got our start at Wasatch Global Investors managingmicro– andsmall–capstrategies. When we found that quality and performance tend to persist over time, we identified a select, concentrated group of ourbest–in–classglobal companies that we knew extremely well and that we wanted to ownlonger—oftensignificantly past the point at which mostsmall–capportfolio managers are forced to selldue tomarket–capitalizationconstraints.
We determined there’s a deep and diverse pool of thesehigh–qualityglobal mid capsthat are generating good sales growth, that have solid ROAs and that have the potential to generate attractive total returns for their shareholders.
As discussed earlier, to capture the advantages of investing inmid capsfor Wasatch clients, we started threestrategies—Global Select, International Select and Emerging Markets Select. Each strategy holds about 20 to 40 outstanding companies that we think will grow faster and longer than generally anticipated and have the potential to become tomorrow’s large/mega–capleadersworld–wide. We like to say these are “growth” companies that are developing into truly “great”companies.
Figure 8below depicts the sameDecember 31, 2019one–yearcharacteristics as illustrated inFigure 3forglobal mid caps, small caps and large/mega caps. Also included inFigure 8are the characteristics for a representative Wasatch Global Select account. As you can see, the Wasatch Global Select strategy compares very well based on sales growth and looks extremely attractive based on ROA.
Moreover, compared to the large/mega–cap–dominatedMSCI ACWI (All Country World Index), the Wasatch Global Select strategy had athree–yearbeta as ofDecember 31, 2019of only 1.04. This is a welcome indication of more diversification and less risk than one might expect in a concentrated portfolio of dynamic,growth–orientedcompanies. For context, as ofDecember 31, 2019,the MSCI Index had a weighted average market capitalization of$165.3billion—whilethe Wasatch Global Select strategy was at$16.6 billion.
THE OPPORTUNITY SET SUMMARIZED
One reason we’re so excited aboutglobal mid capsis that the opportunity set is soexpansive—whichmakes it a good place to focus our investment research. As already discussed and as shown inFigure 9below, among developed marketsworld–wide, there are over 2,000global mid capsranging from $3 billion to $30 billion in market capitalization.
By comparison, there are almost 5,000 small caps above $300 million and less than $3 billion in market capitalization. However, we believe many of the small caps are unproven and/or are of lower quality. On the other end of the spectrum, there are fewer than 400 large/mega caps above $30 billion. These companies typically have what we consider to be inferior growth prospects relative to smaller companies and are more efficiently priced onworld–widestockexchanges.
Other attractive features of manyglobal mid capsare:
Proven business models and management teams
Companies in the “executing on a plan” phase, which tends to be alower–riskphase because business models and management teams have alreadybeen tested
Great corporate cultures
Exposure to diverse companies, industries, sectors and countries around the world
Headroom for ongoing, robust sales growth
Strong freecash flows
Somewhat inefficient equity pricing with significant opportunities to create alpha
Reasonable volatility in stocks
Ability to combineless–correlatedholdings to produce attractive risk/reward characteristics
Good diversification is achievable with a concentrated portfolio ofhigh–convictionnames
THE WASATCH ADVANTAGE
Having shown thatmid capscomprise a compelling pond to fish in and that our Wasatch Selectstrategies—Global Select, International Select and Emerging Markets Select—containwhat we think are some of the best companies around the world, it’s important for us to communicate why we at Wasatch Global Investors believe we’re sowell–suitedto investing in this area. The basic reason is that, asmicro– andsmall–capportfolio managers, we have a long history of following companies that go on to become the mid caps and large/mega caps of the future. Just as important, we have a sense of the type of companies that never make it to the big leagues.
At Wasatch, we travel the globe meeting with the management teams of more than a thousand companies every year. Over time, we’ve seen hundreds of companies that have been able to double in size again and again. We understand the types of business models, competitive advantages and management teams that make such growth possible. More specifically, we know many of the companies and their leaders firsthand, which could give us a sense of whether or not there are numerous good years of growth ahead. We also know why certain companies hit a wall in theirdevelopment—andwho or what was responsible for that failure.
Portfolio managers who specialize in large/mega caps, by comparison, are likely to have less experience withhigh–growthcompanies. For example, a large/mega–capmanager who’s analyzing amid–capcompany may be looking at the company for the first time. We, on the other hand, likely have followed that same company in real time through its earlydevelopment—andif not, we’ve undoubtedly followed similarcompanies.
So, while we may not have a competitive research advantage inmega–capcompanies that have been very big for many years, our dedicated, systematic investment process and our databases of proprietary research certainly give us an advantage in the realm of companies from thesmall–capstage all the way through the lower end of thelarge–capstage—andthat’s exactly the focus of theWasatch Global Select,Wasatch International SelectandWasatch Emerging Markets Selectstrategies.
PERFORMANCE OF WASATCH HOLDINGS
Although the Wasatch Emerging Markets Select strategy has been in existence since 2012, the Wasatch Global Select and Wasatch International Select strategies are relatively new. To get a sense of how Wasatch holdingsin generalhave performed, we looked at rollingthree–yearperiods with quarterly observations for the 20 years endedDecember 31, 2019. For this analysis, we included all stocks held by the Wasatch International Small Cap Growth, Wasatch Small Cap Core Growth and Wasatch Small Cap Growth strategies. The results are presented inFigure 10below.
WhatFigure 10shows is that when our holdings were below $3 billion in market capitalization, they generated athree–yearalpha of1.2%. When they were between $3 billion and $9 billion in market capitalization, they generated athree–yearalpha of2.8%. And when they were over $9 billion in market capitalization, they generated athree–yearalpha of3.1%. (Three–yearalphas are not annualized.)
In other words, our holdings actually produced more alpha as they rose in marketcapitalization—whichis another reason why we’re so excited about themid–capcompanies held in the Wasatch Selectstrategies.
Wasatch Global Investors is committed to finding themost–promisingcompanies in the world, wherever they may be. With over 40 years of experience as asmall–caporiented firm focused onhigh–quality,long–termgrowth, as well as a longstanding commitment to deep, thoughtful,in–houseresearch, we believe Wasatch is uniquely positioned to find companies with solid fundamentals before they appear on the radar of the broader investing world.
To this end, we think our Select strategies employ a strong approach for targeting new opportunities that arise from inefficiencies in today’s global equity markets.Figure 11below describes the three Wasatch Select strategies and their portfolio managers. TheWasatch Global Select, Wasatch International SelectandWasatch Emerging Markets Select strategiesmay be appropriate for investors seeking core exposure toworld–widemarkets or looking for a potentiallyhigh–alphacomplement to their existing investments.
ABOUT WASATCH GLOBAL INVESTORS
Wasatch Global Investors pursues a disciplined approach to investing, focused onbottom–up, fundamental analysis to develop a deep understanding of the investment potential of individual companies. In making investment decisions, our portfolio managers employ a uniquely collaborative process to leverage the knowledge and skill of the entire Wasatch research team.
Wasatch Global Investors is anemployee–ownedinvestment advisor founded in 1975 and headquartered in Salt Lake City, Utah. The firm had$20.8 billion in assets under management as of December 31, 2019. Wasatch Global Investors is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940.
RISKS AND DISCLOSURES
Investing in foreign securities, especially in emerging and frontier markets, entails special risks, such as currency fluctuations and political uncertainties, which are described in more detail in the prospectus. Investing in small and micro cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.
Diversification does not eliminate the risk of experiencing investment losses.
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 it carefully beforeinvesting.
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 Global Select and Wasatch International Select strategies are new and have a limited operating history.
ALPS Distributors, Inc. is not affiliated with Wasatch GlobalInvestors.
Alphais arisk–adjustedmeasure of theso–called“excess return” on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark index or “risk–free” investment. The difference between the fair and actually expected rates of return on a stock is called the stock’s alpha.
Betais a quantitative measure of the volatility of a given stock relative to the overall market. A beta above one is more volatile than the overall market, while a beta below one is less volatile.
Correlation, in the financial world, is a statistical measure of how asset classes, securities, markets, or countries move in relation toeach other.
Earnings growthis a measure of growth in a company’s net income over a specific period, often one year.
Free cash flowis a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. It is the cash a company generates after spending the money required to maintain or expand its asset base.
TheMSCI ACWI (All Country World Index)captures large and mid cap representation across 23developed–marketand 26emerging–marketcountries. With 2,853 constituents, the index covers approximately 85% of the global investable equity opportunity set. You cannot invest in this orany index.
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 indexes. 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)
Operating marginequals operating income divided by revenues, expressed as apercentage.
Return on assets (ROA)measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
Return on capitalis a measure of how effectively a company uses the money, owned or borrowed, that has been invested in itsoperations.
Sales growthis the increase in sales over a specified period of time, not necessarily one year.
Standard deviationis a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expectedvolatility.
Valuationis the process of determining the current worth of an assetor company.