Small Cap 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 S&P 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 Small Cap Fund advanced 5.48% in the second quarter outperforming the Russell 2000 Growth Index return of 4.39%. Healthcare drove almost half of the benchmark’s return as investors gained more confidence that the Republican-led Congress would be unable to reach consensus on how to unwind and replace the Affordable Care Act. Technology was also a significant contributor to the index’s performance and most other sectors performed fairly well during the period. One outlier was energy which declined in conjunction with oil prices due, in part, to surplus of domestic inventories as mentioned in the capital market review above.

of these companies does not meet our investment criteria. As a result, outperforming in periods when the healthcare sector surges can be challenging. However, the portfolio’s relative performance in the healthcare sector this quarter was solid. The fund benefited from our position in Akorn which received a buyout offer from Fresenius and gained 38% in the quarter. The fund also experienced solid contributions from Exact Sciences, producer of the ColoGuard colorectal cancer screening test, Supernus Pharmaceuticals, a branded drug company with epilepsy products, and Catalent, a contract manufacturer for pharmaceutical companies.

The furniture and home goods retailer At Home Group was also a significant contributor to overall results for the quarter. The company went public in August 2016 with fairly weak demand for its shares. Since the IPO, the company has continually posted solid operating results and remained one of the best growth stories in retail with a differentiated, value-based offering that has experienced increasing interest from its core customer base.

To the downside the portfolio experience a few headwinds during the period and IMAX Corporation was the largest underperformer as a weak box office and concerns over shortening windows for feature films before going to video on demand weighed on the company’s estimates and its valuation multiple. We believe the company has an exceptional, differentiated brand and that the film slate for the rest of 2017 will improve against easier comparisons which should help the stock recover.

While the portfolio has performed well in the first half of the year valuations have also increased. However we are encouraged by what we are seeing in the economy and in the outlook for risk assets. Bonds remain an uncompetitive alternative and the Fed seems unwilling to take drastic measures on interest rates as inflation remains benign. While Trump’s success in approving his political agenda including significant tax reform remains a wildcard, investors are so far satisfied with the status quo and company executives are pleased with a more favorable regulatory environment. We continue to take action on those stocks with an unfavorable upside to downside trade-offs as we are actively trimming or selling investments that approach a full valuation by our analysis, and deploying capital into opportunities that we believe offer a better risk/reward profile.

Although the growth in the domestic economy has benefited small cap stocks, international economies seem to be improving and may present new investment opportunities which we are currently evaluating. As always, we appreciate your continued confidence in the fund and remain committed to pursuing investments that will potentially benefit the portfolio for years to come.