Small Cap Fund

Equity markets got off to a strong start in the first quarter of 2017, thanks to an improving economic outlook. In February, small business optimism, as measured by the National Federation of Independent Businesses, was at its highest level in 12 years. In addition, the University of Michigan’s March consumer confidence survey showed that consumers were more confident in the economy than they have been at any time since 2000. Against this backdrop, growth stocks outperformed value stocks, led by technology, health care, and consumer discretionary companies. The recent strength in infrastructure companies, banks, and high-tax-rate stocks stalled late in the quarter when, following Congress’s failure to agree on a health care reform bill, investors began to question the Trump administration’s ability to enact elements of its pro-growth agenda. Within commodities, the price of West Texas Intermediate (WTI) crude oil fell 6% during the quarter in response to better than expected U.S. oil inventories and production.

The Russell 3000 Index advanced 5.74% in the first quarter and larger cap stocks outperformed smaller cap stocks. The Russell 1000 Index returned 6.03%, followed by the Russell Mid Cap Index return of 5.15%, and the Russell 2000 Index result of 2.47%. The Russell Micro Cap Index advanced just 0.38% in the quarter. The Russell 3000 Growth Index outperformed the Russell 3000 Value Index by 5.64%. Technology was the best performing sector during the quarter while the energy sector was the worst performer, driven by the decline in crude oil.

The Buffalo Small Cap Fund rose 10.51% in the first quarter while the Russell 2000 Growth Index gained 5.35%. As we discussed in last quarter’s update, the market rotation into financials and cyclicals during the fourth quarter of 2016 started to fizzle in this first quarter of 2017 and the “Trump Trade” unwound. In the fourth quarter commentary, we remarked that the market may have gotten ahead of legislative reality, and the Trump administration’s inability to repeal and replace Obamacare showed definite proof that this was the case. In our view, the post–election reflation trade left a lot of high quality growth stocks trading at very attractive multiples and when the Trump Trade reversed this quarter, the market took notice of these growth stocks and bid them higher.

Our relative performance this period more than made up for relative underperformance late last year. One of the things we were most pleased with during the quarter was the breadth of outperformance; all sectors except for materials outperformed its respective benchmark sector. Outperformance was driven by stock selection while sector allocation effect was slightly negative. Technology and Industrials provided the greatest relative performance led by strength in software and commercial services, respectively. Despite a significant outperformance from biotechnology in the index during the quarter, the portfolio’s performance in healthcare was in line with the benchmark.

The fund ended the quarter with 73 stocks, slightly over the high end of our targeted range due to the addition of a few positions late in the quarter. We are now in the enviable position of having new stocks compete with existing ones to get in the portfolio which could further optimize the portfolio’s construction and ultimately improve performance. We have gradually increased the number of stocks over the last two years from 52 entering 2015, and believe the additional stocks should ultimately help reduce single security risk yet still allow an adequate level of weight for high conviction stocks.

Regarding drags on results, SPS Commerce was an underperformer this quarter. While e-commerce has historically been a tail-wind to this fairly predictable business selling supply chain software to wholesalers and retailers, some of SPS Commerce’s customers are now facing extreme disruption, including bankruptcy, which is delaying the sales cycle for their products and reducing their organic growth rate. The stock was sold during the period.

Regarding contributors to results, Exact Sciences was the best performing stock during the quarter. The company continued to gain payer, doctor and patient support for Cologuard, a commercialized alternative to colonoscopy for detecting colorectal cancer. Investors are now starting to give some attention to the company’s pipeline of screening tests in other areas of oncology like lung and breast cancer. Universal Display was another top performer for the period. The demand for the company’s intellectual property, materials and process know how used in the production of Organic Light Emitting Diodes (OLED) is increasing rapidly as Asian display manufacturers ramp capacity for OLED use in mobile handset displays.

The setup for 2017 appears to bode well for both accelerated economic growth and performance of U.S equities. The new administration’s focus on deregulation, infrastructure spend, and tax reform point to a more pro-growth, business-friendly environment. Factoring in higher interest rates, one can make a case for continued rotation out of fixed income into equities.

Investors are now keeping a close eye on Trump’s ability to pass meaningful tax reform, especially after promises of healthcare reform have so far fallen short. Inability to provide tax reform may cause market volatility though expectations for the timing of results are being actively managed by the new administration.

While we are pleased with the number of securities in the portfolio, we continue to look for additional ideas that could provide greater risk-adjusted returns. We have spent considerable time over the past few months looking at companies with a greater cyclical profile that could stand to benefit from factors like accelerating job growth, improved construction activity, and increased energy production. We would expect these companies to outperform in this environment of an elongated economic cycle. While we have added some new positions in these areas, we are remaining true to our process of identifying potential beneficiaries of long-term trends and implementing our valuation discipline. We continue to actively reduce stocks with disproportionate downside risk and those that have graduated well into being midcap stocks. We appreciate your continued support and confidence.