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Fund Spy

This Small-Cap Pick Sparkles

Wasatch Core Growth has been upgraded to a Morningstar Analyst Rating of Gold.

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Morningstar recently upgraded the Morningstar Analyst Rating for Wasatch Core Growth to Gold from Silver. The Analyst Rating uses a five-tier scale of Gold, Silver, Bronze, Neutral, and Negative to express the Manager Research team's forward-looking views of a fund's ability to outpace its index and peer group over a full market cycle.

Analysts rate over 4,000 funds globally, representing $9 trillion in assets, and only 10% of rated funds in the U.S. receive an Analyst Rating of Gold. What follows is Morningstar's analysis of the fund, which is usually only available to Premium Members of and Morningstar's software for advisors and institutions: Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

One of the Best in Its Class
Wasatch Core Growth has proved a reliable outperformer, and there is reason to expect more of the same. Its Morningstar Analyst Rating merits an upgrade to Gold.

Lead manager J.B. Taylor--recently named CEO of Wasatch Advisors--has run the small-growth fund since the end of 2000, and comanager Paul Lambert has served since 2005. Wasatch's long-tenured, collaborative team backs them. The Wasatch brand of investing, which involves building compact portfolios of stocks with defensible economic advantages and consistent earnings growth across market cycles, has proved its worth over the long term here and at  Wasatch Small Cap Growth (WAAEX), now also led by Taylor. That fund is closed to new investors, and this one is expected to be when the strategy reaches about $2.5 billion.

This fund is more valuation-conscious than its sibling and is positioned as more of a core holding, but its average valuation measures are generally in line with the small-growth Morningstar Category average. However, the fund's quality metrics--such as return on assets--are usually stronger than peers', and risk-adjusted performance is its selling point. It has delivered competitive results within its category with a lower standard deviation than the norm and generally low Morningstar Risk ratings (which emphasize downside volatility). The fund was one of the best in the category and well in the black in 2011's tough market, for example, but lagged in 2013's speculative rally.

The fund hasn't always outperformed in down markets. Taylor and Lambert build a focused portfolio of 40-60 stocks, and the fund can look out of step at times, such as 2008. Bottom-up stock-picking drives portfolio construction, so assets can cluster in sectors where the managers find opportunities. At the end of 2014, the fund had large helpings of industrial and financial stocks relative to its small-growth peers and the Russell 2000 Growth Index and significant underweightings in healthcare and technology. This was not a setup for success in 2015, but strong stock-picking put the fund in the black and at the head of its class.

Process Pillar: Positive
Taylor and Lambert build a relatively compact portfolio of 40-60 stocks with strong management teams, defensible business models, and consistent earnings growth across economic cycles. Taylor and Lambert look for smaller companies growing by 15%-20% per year and pay attention to the price they pay. The managers and analysts model earnings, cash flow, and balance sheets for the next five years, then apply a reasonable price/earnings ratio to the stocks and pick the ones with the greatest upside. "Reasonable" can vary depending on the industry, and the managers will pay a premium for quality stocks. The portfolio's average valuation measures are generally in line with the small-growth category average, though often lower than those of its more-aggressive sibling Wasatch Small Cap Growth.

Because the managers let winners run and keep turnover well under the category average, the fund has an above-average mid-cap stake, with a smattering of large caps. It also has held up to 10% in foreign stocks (triple the category norm), and the stake has been distinguished by significant exposure to India, a Wasatch niche specialty. Wasatch portfolio managers and analysts work collaboratively; more than one investor at the shop evaluates each idea before it can make it into the portfolio. This Process warrants a Positive Pillar rating.

Bottom-up stock picks drive portfolio construction, and assets can cluster in certain sectors where the managers find opportunities. The fund has had large stakes relative to its small-growth peers in financials and industrial stocks, although the latter has decreased recently, and a significant underweighting in healthcare. Technology has been light in the past but is now near the category norm.

Cash was higher than normal at 8% at the end of 2015, but the managers are finding opportunities in 2016's volatile market. Taylor notes that technology services names have been slammed despite strong fundamentals, including software-as-a-service company Cornerstone OnDemand (CSOD), a top-10 pick added in 2014 for its strong revenue growth and a growing repeat-revenue stream. The fund remains heavy in financials, but some of that stake has shifted from Indian banks to U.S. banks with stable management and a good lending history.

Taylor notes that the core of the portfolio remains names such as salvaged-vehicle auctioneer Copart (CPRT), which dominates its niche; the fund has owned the stock for close to 20 years, and it has been one of the strongest performers over the past year. Overall, a preference for higher-quality stocks is evident: The average net margins and returns on assets and equity of the portfolio's typical holding are well above the category norm.

Performance Pillar: Positive
During Taylor's tenure, from the end of December 2000 through February 2016, this fund has gained an annualized 8.1%, well ahead of the small-growth category's 4.1% and the Russell 2000 Growth Index's 5.1%. (Founder Sam Stewart Jr. stepped off the fund in 2005, but Taylor has been day-to-day manager since 2000.) There was a subpar stretch from 2005-08, but the fund has been among the strongest in the category since. Its 2015 performance was noteworthy, with strong stock-picking across sectors leading to a 3.9% gain as its average peer was in the red.

This compact and distinctive portfolio is not without risks. The fund lost more than its peers in 2008, for example, when certain holdings proved more economically sensitive than expected. But during Taylor's tenure, the fund has captured 89% of the Russell 2000 Growth's upside return and only 77% its downside. The fund's Morningstar Risk ratings (which emphasize downside volatility) indicate that it has generally been among the least risky funds in the category. A quality bias has helped mitigate risk--though it will also mute performance in rallies such as 2013's, when speculative names led. During Taylor's tenure, the fund has almost kept pace with the 8.3% gain of the tough-to-beat S&P SmallCap 600 Growth Index, which includes only companies that have been profitable for at least four consecutive quarters.

People Pillar: Positive
Taylor joined Wasatch as an analyst in 1996, and took over in December 2000; he serves as lead manager and makes the final call on investment decisions. In February 2016, Taylor became CEO of Wasatch Advisors and took over as lead manager of Wasatch Small Cap Growth; these moves were part of a long-term succession plan for the firm. Lambert, an analyst at Wasatch since 2000, was named comanager here in January 2005. Taylor has spent his whole career at Wasatch; Lambert worked at Fidelity Investments for a year before joining the firm. Both Taylor and Lambert have more than $1 million invested in the fund. The fund earns a Positive for the People Pillar.

Taylor and Lambert are supported by a team of about 30 portfolio managers and analysts, most with long tenures at the firm. The team has been inculcated with the firm's style by founder Stewart and longtime portfolio manager and former Wasatch Advisors CEO Jeff Cardon. They work collaboratively: As a rule, Wasatch has more than one analyst or manager look at every investment idea. The firm has added managers with international stock-picking expertise, such as Roger Edgely, to support the firm's foreign funds and foreign weightings in some of its U.S. funds, including this one. Thor Kallerud joined as director of research in 2013 to help coordinate coverage and expand intern and hiring efforts.

Parent Pillar: Positive
Stewart founded Wasatch Advisors in 1975 as a domestic small-cap growth boutique. Small-growth remains its core strength, and its two oldest funds,  Wasatch Core Growth (WGROX) and Wasatch Small Cap Growth, are standouts. In February 2016, J.B. Taylor, already lead manager of Wasatch Core Growth, took over as lead of Wasatch Small Cap Growth and CEO of the firm. Former CEO Cardon, who had led Wasatch Small Cap Growth since its 1986 inception, remains a comanager and is on the firm's board.

The employee-owned firm branched into larger-cap, value, and international funds in the late 1990s and early 2000s. It bought 1st Source Funds, including large-value, long-short, and short-term bond funds, in 2008. Between 2007 and 2012, the firm launched five more international funds, including an India offering. Significant outflows lately bear watching, however.

These outflows have not affected the investment team, which is known for its collaborative effort. The shop has seen occasional departures, but overall manager retention has been high and the team has grown steadily to more than 30 members as of early 2016.

More than 90% of fund assets are in funds with manager investment of more than $1 million. The weak spot is above-average expenses overall, though that's partly because of the firm's laudable commitment to limiting the asset bases of its smaller-cap strategies.

Price Pillar: Neutral
This fund's expense ratio for retail shares is close to the median for no-load small-cap funds (though below the overall category average for small-growth funds, including all share classes). The institutional shares, which account for a small fraction of assets, have an above-average expense ratio relative to the subset. Overall, the fund earns a Neutral for the Price Pillar.

The fund's turnover is well below average for the small-growth category, though, which helps keep a lid on the fund's total cost of ownership. Its brokerage costs as a percentage of average net assets, which can be driven up by quick trading, are about one fourth the category average.

Laura Lallos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.