Small Cap Fund

(As of 12/31/18) — The 4th quarter of 2018 was a rough period for equity markets, with steep declines dragging full year returns into negative territory. The S&P 500 Index declined -13.52% during the quarter, driven by fears of tightening monetary policy, escalating trade tensions, slowing global economic growth, and margin pressure from higher labor and freight costs. Investors sought safety in government bonds, driving the yield on the 10-year Treasury down from 3.06% at the end of the 3rd quarter to 2.68% at the end of the 4th quarter.

In a reversal of the year-to-date trend, value outperformed growth in the period, as the Russell 3000 Value Index declined -12.24% compared to a -16.33% drop in the Russell 3000 Growth Index. Large companies held up better than smaller companies during the quarter, as the Russell 1000 Index fell -13.82%, the Russell Midcap Index was down -15.37%, and the small cap Russell 2000 Index was down -20.20%. The only sector to post a positive return in the 4th quarter was Utilities. Real Estate, Consumer Staples, and Health Care were down but outperformed the market. Energy was the worst performing sector, driven by steep declines in crude oil. Technology, Industrials, and Consumer Discretionary also underperformed the broad market.

(As of 12/31/18) — There were very few safe havens for small caps in the 4th quarter, as the asset class went from being a beneficiary of investor dollars due to having less international exposure during a period of trade wars… to the victim of a risk-off trade caused by all of the issues listed above. Furthermore, tax loss selling also forced some stocks to trade significantly lower during a period of low liquidity at year-end. Companies with higher debt levels and high growth stocks underperformed as one might expect, but surprisingly, lower valuation stocks did not outperform higher valuation stocks during the quarter.

The Buffalo Small Cap Fund declined -24.60% during the quarter versus the Morningstar U.S. Small Growth Index’s decline of -21.44%, and ended the year just about in line with the Index at -5.78% vs the Index at -5.67%. While the Fund outperformed in Energy, Technology and Industrials, relative weakness largely in Health Care, Financials, Consumer Discretionary, and Materials weighed on relative returns.

TOP CONTRIBUTORS
Air Transport Services Group (ATSG) provided the greatest contribution to the Fund, with the stock gaining 6% during the quarter. A provider of aircraft maintenance and support services and a beneficiary of the trend towards more e-commerce, ATSG had a late year move as Amazon inked a deal to lease 10 more planes from them, as Amazon continues to build out its own logistic capabilities for faster delivery to its customers.

TOP DETRACTORS
Ligand Pharmaceuticals was the largest detractor from performance during the quarter. The company had been a large outperformer earlier in the year, and its financials benefited from a couple of larger milestone and license payments that will cause a tougher comparison for 2019. Some bears on the stock have also been critical of the company’s pipeline of opportunities going forward. We continue to believe that the company’s monoclonal antibody discovery platform (OmniAb) is not being appropriately valued in the company’s share price.

Penn National Gaming also detracted from the Fund’s performance this quarter. We believe Penn was weak during the quarter due to increased debt levels brought about by their recent purchase of Pinnacle Entertainment and possibly some concern over whether the company would be able to achieve the synergies they expect from the acquisition. We remain bullish on the fundamentals for regional casinos and Penn in particular as industry consolidation has brought about very rational marketing spend. Higher interest rates will likely help the traditional gaming customer, and sports betting should increase traffic as it gets implemented over the next few years.

(As of 12/31/18) — While the quarter was a disappointment to an otherwise solid year, we remain very excited about the companies in the Fund’s portfolio. Valuations have become more attractive and sentiment around small caps has normalized. We believe the market has priced in a recession, and while we believe economic growth will slow in 2019, we do not believe we are headed for recession, unless the trade war and government shutdown last for an extended period of time or the U.S. Federal Reserve (Fed) gets too aggressive on interest rate hikes. We believe the Administration is sensitive to market movements and the risk declining markets can have on the overall economy, and would therefore prefer to make a deal with China. We also believe the Fed has suffered from poor communication about the likely path of future interest rate increases, but Chairman Powell is quickly learning from his mistakes. We have used this period of market weakness to take advantage of more attractive valuations in some existing positions and have started some new positions in stocks we missed at lower levels. We appreciate your continued confidence in us and look forward to hopefully better market conditions in 2019.