Wasatch Funds has a history of opening small and micro-cap funds, and then closing them to control asset levels. Of its family of 11 funds, only three are currently open to new investors. The latest release is the Wasatch Funds:Heritage Growth Fund (WAHGX), which differs from its siblings by focusing on mid- to large-cap companies with a market value of between $2.5 billion and $20 billion. The average market cap is about $10 billion.
Established in June 2004, the fund has been run since inception by Chris Bowen and Ryan Snow, previously senior analysts at Wasatch, utilizing the same philosophy and teamwork as the firm's small-cap vehicles. As of Sept. 30, 2005, the fund had already attracted $301.0 million in assets. Its expense ratio is a competitive 0.95%, compared with the mid-cap growth peer average of 1.62%. Because it is less than three years old, it is not yet ranked by Standard & Poor's.
For their portfolio, Bowen and Snow seek fast-growing firms that will double in size in five years, equating to a sustained compound annual growth rate of 15%. "But we don't pay any price for growth stocks," Snow stated. The team also keeps an eye on the rate of return on capital, management quality, and the ability to sustain a competitive advantage. "As we've studied the market, those are the things we've found in companies that have done well," Snow said. Other considerations are how the company finances its growth, how much excess cash flow it generates, and how that cash flow gets returned to shareholders.
The fund provides a new home to what the men call "Wasatch graduates" -- companies that have grown too large to be candidates for the firm's small-cap funds. Given the intermediate market cap range, the Russell 1000 Growth and Russell Mid Cap Growth Indexes are used as benchmarks.
As of Sept. 30, 2005, the fund's top holdings were Apollo Group`A` (APOL), 3.4%; Teva Pharmaceutical Industries Limited ADR (TEVA), 3.3%; Commerce Bancorp (CBH), 2.8%; North Fork Bancorp (NFB), 2.8%; and Bed Bath & Beyond (BBBY), 2.5%. Top sectors were consumer discretionary, 23.5%; health care, 21.2%; financial services, 19.3%; technology, 15.3%; and producer durables, 10.0%.
For each holding in the portfolio, Bowen and Snow produce a short "investment thesis" -- a one- to two-paragraph rationale for its inclusion. At the end of each quarter, they "freeze" the portfolio in order to calculate the weighted average earnings growth at that time. The co-managers also set 12-month earnings expectations for each stock to compare with the investment thesis over time.
If the company hits "a bump in the road" and earnings falter briefly or minimally, the co-managers aren't likely to sell it. But if the investment thesis gradually loses its validity, they will consider revising the thesis or selling the stock. Turnover in the portfolio, based on the previous 12 months, is 30% (excluding short-term securities).
Stocks in the portfolio are followed by Wasatch's 41-person research staff, which consists of Snow, Bowen, and its other portfolio managers, analysts, and assistants. "At Wasatch, everyone is an analyst, and we're all generalists," Bowen said. A research director makes sure that the same company isn't receiving duplicate coverage.
The fund's universe of stocks comprises those in the Russell 1000 Growth and Mid Cap Growth indexes that meet its market cap criteria. In addition to Wasatch graduates, the co-managers also look for "big gorilla" firms that "dominate the space" in an industry, such as Home Depot (HD) in the retail sector.
Like other growth-oriented Wasatch funds, the Heritage Growth Fund is expected to be heaviest in technology, health care, consumer discretionary, and finance. Underweight sectors tend to be energy, utilities, materials, and processing. "Historically, those tend to be slower growers," Bowen points out. "But we will look at those sectors," and occasionally invest in them, he added, citing Nextel Partners`A` (NXTP) as an example. The co-managers rely on fundamental research, not sector calls, to select individual companies.
The fund cannot invest more than 35% of assets in a single sector, or be more than 5% above the Russell Mid Cap Growth Index in a sector weighting, Snow noted. No upper limit is set on individual holdings. "Realistically, you'll see our largest holdings in the mid- to high single digits," Snow said.
With 78 stocks as of Sept. 30, Bowen said he would prefer to hold slightly fewer issues at higher percentages. "We are constantly looking for opportunities to take bigger bets," he said. Such bets would be placed on companies the team has a high degree of confidence in after following them for some time. "At this point, the market just isn't presenting us with great valuations," Bowen said. "So our list has tended to get a little longer."
At present, the area the fund is most overweight versus the mid-cap index is home building. Snow praised the large publicly held companies' competitive advantages through economies of scale, their ability to build quality homes faster than local builders, their geographic and demographic diversity, and their growing market shares, which he expects to continue to rise. He said he was unconcerned by an Oct. 4 New York Times report about large inside stock sales by executives and directors at the 10 largest U.S. home builders. "Most of these guys still have huge insider ownership," he said.
The fledgling fund has returned 16.0% for the one-year period ended Sept. 30, compared with 19.9% for the average mid-cap growth fund, and 12.3% for the S&P 500. Snow partly attributes the underperformance relative to mid-cap growth peers to the fund's underinvestment in energy. "Actually, our energy stock picks have done better than the [mid-cap] index," he said. "We just don't own enough of them" to outperform.
Another factor is the higher average market cap. The fund's weighted average market cap is on the high end of the mid-cap range, so it doesn't fully participate when the small caps are doing well, Snow said. "But when we're in between, doing better than the S&P and not quite as good as mid-caps, that's acceptable to us."
Although the co-managers say they have found attractive energy investments, they are skeptical about the sector's fortunes being so largely dependent on volatile commodity prices, preferring instead companies that, like any promising young graduate, can shape their own destinies.
Contact Bob Keane with questions or comments at: email@example.com.