Investing in technology and science requires a global outlook and preparedness to invest when others are avoiding the sector. Investors in this sector require deep knowledge of technology, demographics and business fundamentals. The last three years have not been kind to investors, yet there are signs of rebound and resurgence in certain areas. Every turn in the technology cycle brings a set of new winners and losers.

Q: Why do investors need global exposure in the Wasatch Global Science and Technology Fund?

A: Today technology and science development is knowledge intensive and no single country or region has a monopoly on knowledge development. The ideas can be turned into working technology and viable commercial products relatively quickly. Today inventors and developers have access to global capital and this in turn accelerates the time to market and generates significant first mover advantage to the pioneers in the field. Fund managers have to stay on their toes in this rapidly evolving marketplace. In the last ten years new technologies have emerged from Europe, Asia, and America, and technology development is likely to become more global as countries like China and India are integrated into the global economy.

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Q: How do you keep up with vast geography?

A: We are very quantitative in our approach. We are looking to invest in companies that are active in the American marketplace. We want to benefit from these companies’ expected rise in earnings and market penetration. We are concentrating on companies that are experiencing earnings growth and are trading on the American exchanges. We are comfortable investing in companies where we have greater access to investment information and management. While there are successful technology companies in many countries, we seek to invest in companies whose earnings are rapidly growing in the Americas.

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Q: Do you make a distinction between large- and small-cap companies when it comes to investing?

A: We like to detect the earnings growth while it is still in its early stage of the cycle. Historically we have invested in small and mid sized companies. Earnings for these companies are more manageable to understand and model, the business cycles are more straightforward to analyze and earnings are generally less affected by macro economic factors. The earnings growth rates that we are seeking are generally found in small and medium sized companies.

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Q: Technology earnings cycles can have wild swings, how do you cope with that?

A: We look at companies where we believe that we can reasonably model their earnings. Historically we have focused on smaller companies because of growth requirements. We believe that smaller companies tend to weather the downward cycle better than large cap companies, and their earnings tend to be less cyclical. Technology markets experience various cycles. For example, in the semiconductor business we look at earnings beyond the current down cycle and calculate normalized earnings and valuations. If the valuations meet our criteria, we keep the stock on our radar screen. For the deep cyclical stocks we look at the earnings power number, and eliminate peaks and valleys of the earnings cycle in our calculation. Reported earnings are based on the current operating margin and the normalized earnings are based on the earnings without the peaks and valleys. We use normalized earnings for the stock valuations.

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Q: What are your buy and sell disciplines?

A: We are looking to invest in companies that can grow earnings at a 20% rate or higher over the next three years. We are looking to invest in companies that are in the early stages of their earnings cycle. We generally do not like to invest in stocks that trade at PEG ratios of higher than one. The selected companies are grouped into three categories. Every stock is then assigned a target buy and sell price and a required rate of investment return. We do not have holding period targets. We sell a stock when it meets our price target, when the industry outlook is changed or when a company fails to meet our earnings target.

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Q: What are your views on company valuations?

A: Companies that meet our criteria at the quantitative and fundamental research level also have to meet our valuation criteria. We are willing to pay a reasonable multiple for the growth but we will not pay a substantial premium for a PEG ratio of one. For example, Amazon and eBay are category leaders in their fields but stock valuations of these companies do not meet our criteria. We would like to invest in these companies but only at a substantially lower valuation.

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Q: Do you buy stocks in the non-US markets?

A: We focus on ADRs trading in the US and we have the ability to buy stocks in various markets of the world. Seventy percent of the Fund’s investments trade on the US stock exchanges; five percent are invested in ADRs, and twenty-five percent trade on exchanges outside the US. We have a global research approach. The tech sector is global and tech development happens in various corners of the world. Taiwan, Japan, China, India, Korea and Europe are all parts of the world where we conduct research.

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Q: What is your research process?

A: We conduct research at the quantitative and fundamental levels. In our quantitative approach, we conduct a duPont analysis on each investment. We generate screens to analyze growth in revenue and earnings, earnings drivers, product market shares and qualitative factors. We also meet management and discuss business and industry dynamics. We generally put a higher reliance on the financial numbers for the US-based companies only because we have greater access to the management. Generally we have roughly 100 companies on our buy list and we invest in 70 companies. Currently, we have 114 companies in the portfolio.

"In the last ten years new technologies have emerged from Europe, Asia, and America, and technology development is likely to become more global as countries like China and India are integrated into the global economy."

Q: What themes do you like in the tech sector?

A: There are a few themes that we are tracking but wireless data, nation-wide broadband in the US and IT security spending are three of our favorites. Wireless tech and the wireless infrastructure spending are expanding. The demand for mobile computing at the business and individual levels is still in its infancy. The access to broadband in the US is lagging considerably to the access available in Japan, South Korea and a few other smaller nations. In our opinion, the investment in broadband connectivity will expand in the next three years. Home entertainment will also be a growth area in the US. In the next year several new manufacturing facilities in Taiwan, Korea and China will start manufacturing flat panel and LCD TVs with Internet connectivity. Broadband connectivity will also integrate Indian and Chinese skilled labor forces with those of advanced economies. Several back office functions in telemarketing, accounting, financial research and pharmaceutical research will continue to migrate to India, Ireland and Eastern Europe. Corporate tech spending should revive in the next two quarters in the US, and that will create demand for more productivity related equipment. However, it is still hard to gauge the depth and length of this cycle.

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Q: Can we discuss some of your top 10 holdings and how you discovered these investments?

A: We have a thematic approach to portfolio investing. If you look at the top 10 stocks, our selection is driven by product innovation cycles. While many technology companies rely on new products for revenue growth, the companies we invest in are not involved in frequent product launches. Product transitions are hard to manage and they can bring substantial volatility to a company’s earnings. We like to invest in companies that have stabilized earnings.

We divide the technology stocks into three categories based on expected rates of return. The first category of stocks is likely to benefit from the mega trends in the sector depicted by long product cycles, recurring revenue themes and expanding markets. Accredo Health and Cabot Microelectronics are examples of our holdings that fall into this category. Cabot sells consumables for the semiconductor industry and as the geometries for the ICs become smaller the need for Cabot’s chemicals increase.

The second category of stocks is likely to enjoy above market earnings and return on investment but their growth will also put a burden on them to add significant management infrastructure. Generally, these companies need to rapidly increase their staff to maintain their growth rate. For example, Wireless Facilities, Inc. provides consulting services and network design, and management services to wireless services providers. The business is people driven and business growth is dependent on the company’s ability to hire, train and retain skilled labor. Their business cycle is similar to the consulting business cycle.

The third category of stocks is likely to rise and fall with the industry cycle. These companies undergo a rapid, and at times extreme swing in the business cycle. Several factors outside the management control play a role in the company’s revenue and earnings. Management has to deal with several unknowns but the earnings could rise and fall in a few quarters. For example, Sanmina-SCI Corporation has gone through an extremely difficult phase in the last three years, however, when a business like this starts to increase capital spending, it is likely to experience a rapid rise in earnings.

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Q: The fund is named the Global Science and Technology Fund? Can we talk about the science in the Fund?

A: Investing in biotechnology is just as attractive to us as technology. Biotech companies will be rewarded for innovation as much as technology companies. The world’s population is aging and as new drugs are invented the markets for these products will only expand. We believe that genetic engineering and genome research are still in the early phase of their innovation cycles. Approximately thirty percent of the Fund’s holdings are in the science category.

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Q: The tech sector is known for its boom and bust, how do you minimize volatility in the Fund?

A: We watch the earnings of our portfolio companies and we closely monitor their PEG ratios and other metrics related to their valuations. The portfolio is currently diversified among more than 100 stocks. We think this approach helps us to mitigate valuation peaks and valleys. We do not make big bets and stay away from leveraging the portfolio into only a few stocks or sectors.