Flexible Income Fund

Equity markets continued their strong start to the year during the second quarter, primarily driven by strong corporate earnings growth. The Russell 3000 Index advanced 3.02% in the second quarter. As reported during the June 30 period, earnings from SP 500 Index companies were up 14% year-over-year in the first quarter, the strongest growth reading since 2011.

Broadly speaking, growth stocks continued their outperformance relative to value stocks, while cyclical stocks that rallied to end 2016 underperformed as investors continue to discount the likelihood of government infrastructure spending and comprehensive tax reform.

The yield on the U.S. 10-year Treasury ended the June 30 period at 2.298%, a decline from its recent high of 2.609% in March due in large part to weaker inflation readings. In contrast, the outlook for growth and interest rate expectations improved in much of the rest of the world, which has driven the trade weighted U.S. dollar down 5.6% year to date. Oil entered bear market territory, with crude prices declining 9% during the quarter in response to stronger than expected inventory levels and rising U.S. production.

As mentioned above investors continued to favor growth over value, and the Russell 3000 Growth Index climbed 4.65% during the period compared to the more modest gain of 1.29% for the Russell 3000 Value Index. By size, microcaps were the best performers with the Russell Microcap Index gaining 3.83%. Meanwhile the large cap Russell 1000 Index gained 3.06%, followed by the Russell Midcap Index at 2.70% and the Russell 2000 Index finishing with a gain of 2.46% during the period.

In general health care was the best performing sector as the chances for legislation to repeal or reform the Affordable Care Act appeared to diminish, and investors reacted by bidding up health care stocks. The technology sector was also a strong performer as the market continued to reward the strong earnings growth produced in this area. Conversely, energy was the worst performing sector driven by the decline in oil prices mentioned above.

The Buffalo Flexible Income Fund produced a return of 0.05% during the period and underperformed the S&P 500 Index return of 3.09% and the Bank of America Merrill Lynch High Yield Master II Index return of 2.14%. The equity portion of the portfolio declined 0.35% during the quarter compared to a gain of 3.09% for the S&P 500 Index.

Areas of the portfolio that led to the underperformance were energy and information technology. The underperformance in energy was primarily driven by sector allocation as the fund was significantly overweight the worst performing sector in the S&P 500 Index during the period. The underperformance in information technology was due to a sector allocation effect and security selection. The technology sector generated substantial positive returns for the index during the quarter and the fund failed to fully participate due to a significant underweight In the area.

As it relates to security selection among tech companies that are in the portfolio, IBM, Cisco, and Intel negatively impacted performance. IBM was negatively impacted by weak first quarter earnings reported during the period which was driven by gross margin pressure, as well as the public disclosure that one of its largest shareholders, Berkshire Hathaway, had reduced its stake in the company by 30%. Cisco was negatively impacted by a disappointing outlook driven by persistent weakness in its service provider business, competitive pressures in emerging markets, and weakness in some of its legacy products. Intel declined due to a weak outlook for its next quarter and softness in some end markets such as federal spending and traditional networking products.

The top contributors to the fund in the quarter were Boeing, Pitney Bowes, and Microsoft, while the top detractors in the quarter were IBM, ConocoPhillips, and General Electric. The equity portion of the portfolio ending the period as just over 80% of total fund assets, near the higher end of the expected range for common stock exposure.

The fixed income portion of the Buffalo Flexible Income Fund generated a return of 1.95% for the quarter which slightly underperformed the Bank of America Merrill Lynch High Yield Master II Index return of 2.14%. The primary reason the fund failed to keep full pace with the index was due to our performance results within information technology. Our technology performance was held back by the convertible bond position in Cornerstone onDemand which declined during the quarter. The company continues to face challenges and reported weaker than expected billings in the first quarter. The top contributors to the fund’s fixed income performance included Valeant, Lions Gate Entertainment, and Bankrate while the three top detractors were Medicines Company, Cornerstone onDemand, and Wildhorse Resource Development.

We believe the market could experience more volatility in the coming quarters as the Federal Reserve continues with its desire to normalize interest rates along with a focus on the likelihood of the Trump administration to enact infrastructure spending, deregulation, and corporate tax reform. Prospective tailwinds for the economy include further job growth, wage increases, lower tax rates, and simply more optimism from both businesses and consumers; all of which could lead to higher Gross Domestic Product (GDP) growth.

On the other hand, possible headwinds include potential strengthening of the U.S. dollar, further increases in interest rates, and stock price valuation metrics that are above historical market averages leading us to believe that the stock market may have a hard time achieving further multiple expansion. Despite the expectation of more volatility, we continue to focus on wide moat, large capitalization companies that are trading at reasonable valuations, in our view.

As always, the fund will continue to focus on competitively advantaged companies that can be purchased at a fair price, in our opinion. As the stock market has continued to climb, it is getting harder to find companies that fit our investment criteria, but we continue follow our process of finding new investment ideas and to be ready when market declines provide better opportunities. Within the fixed income portion of the fund, we continue to focus on higher quality, below investment grade credit securities. With credit yield spreads at cycle lows in our opinion, we are being selective and disciplined with purchases as we do not anticipate much price appreciation within fixed income markets, in general.