Small Cap Fund
Finding Premier Growth Companies
Portfolio Managers Jamie Cuellar and Bob Male discuss the foundation for the Buffalo Small Cap Fund investment strategy — finding companies that are rapidly growing and can benefit from long term trends.
“I think what really differentiates us is our process, where we combine the top-down work of looking at trends provided with the bottoms-up fundamental research we do on each company.”
~ Jamie Cuellar, CFA
Overall Morningstar Rating™ of BUFSX based on risk-adjusted returns among 574 Small Growth funds as of 2/29/20.
Fund Objective & Investment Strategy
The investment objective of the Buffalo Small Cap Fund is long-term growth of capital. The Fund normally invests at least 80% of its net assets in equity securities, consisting of domestic common stocks and preferred stocks, of small capitalization (“small-cap”) companies, that, at the time of purchase, have market capitalizations within the range of the Morningstar U.S. Small Growth Index.
The Fund managers seek to identify companies for the Small Cap Fund’s portfolio that are expected to experience growth based on the identification of long-term, measurable secular trends, and which, as a result, the managers believe may have potential revenue growth in excess of the gross domestic product growth rate.
Companies are screened using in-depth, in-house research to identify those which the managers believe have attractive valuation, strong management, conservative debt, free cash flow, scalable business models, and competitive advantages.
Bob Male, Portfolio Manager
Featured Articles & Reports
THE WALL STREET JOURNAL
November 4, 2019
|As of 2/29/20||3 MO||YTD||1 YR||3 YR||5 YR||10 YR||15 YR||20 YR||Since Inception|
|BUFFALO SMALL CAP FUND - Investor||-3.37||-5.34||7.85||13.97||9.50||11.09||8.52||9.82||11.53|
|BUFFALO SMALL CAP FUND - Institutional||-3.29||-5.27||8.07||14.16||9.67||11.26||8.69||9.99||11.70|
|Morningstar U.S. Small Growth Index||-5.78||-6.26||-0.10||9.94||7.73||12.66||8.74||3.90||5.92|
|Lipper Small Cap Growth Fund Index||-6.14||-7.24||1.53||11.23||8.31||12.15||8.12||4.24||6.86|
|Morningstar Small Growth Category||-5.38||-7.12||0.31||9.42||7.48||11.89||8.43||6.15||7.07|
|As of 12/31/19||3 MO||YTD||1 YR||3 YR||5 YR||10 YR||15 YR||20 YR||Since Inception|
|BUFFALO SMALL CAP FUND - Investor||12.99||40.97||40.97||19.06||11.36||11.89||8.67||11.50||11.91|
|BUFFALO SMALL CAP FUND - Institutional||12.98||41.17||41.17||19.24||11.53||12.06||8.83||11.67||12.07|
|Morningstar U.S. Small Growth Index||9.11||27.60||27.60||14.21||10.26||13.42||8.99||5.73||6.28|
|Lipper Small Cap Growth Fund Index||8.35||30.25||30.25||16.01||10.80||12.89||8.51||5.91||7.26|
|Morningstar Small Growth Category||9.41||27.66||27.66||13.49||9.61||12.21||7.94||7.23||7.49|
3 Year Risk Metrics
|BUFSX vs Morningstar U.S. Small Growth Index (As of 12/31/19)|
Hypothetical Growth of $10,000
|(As of 12/31/19)|| |
|# of Holdings||76|
|Median Market Cap||$2.36 B|
|Weighted Average Market Cap||$3.11 B|
|3-Yr Annualized Turnover Ratio||48.21%|
|% of Holdings with Free Cash Flow||56.58%|
|% of Holdings with No Net Debt||50.00%|
Top 10 Holdings
|Name of Holding||Ticker||Sector||% of Net|
|Monolithic Power Systems||MPWR||Technology||1.97%|
|TOP 10 HOLDINGS TOTAL||22.27%|
CAPITAL MARKET OVERVIEW
(As of 12/31/19) — The combination of a U.S. Federal Reserve (Fed) interest rate cut, an improving economic outlook, and easing trade tensions, sent equity markets sharply higher in the 4th quarter. The S&P 500 Index advanced 9.10% during the period, which brought the full-year (2019) gain to 31.49%. The Fed cut interest rates three times in 2019, erasing the brief yield curve inversion and assuaging fears of a recession. The economy continued to add new jobs at a strong pace and unemployment declined to 3.5%. Consumer spending remained healthy, and there is optimism for better business investment following the announced “phase one” trade deal with China.
Similar to the S&P 500 Index, the broad-based Russell 3000 Index returned 9.04% during the quarter. Growth outperformed value, as the Russell 3000 Growth Index returned 10.62% compared to a return of 7.41% for the Russell 3000 Value Index. Smaller companies outperformed larger companies, as one would expect in a “risk-on” period. The Russell Microcap Index surged 13.45% and the Russell 2000 Index advanced 9.94%. Large company benchmarks such as the Russell 1000 Index advanced 9.04% while the Russell Midcap Index produced a return of 7.06%. Technology and Health Care were the best performing sectors in the quarter, while more defensive areas of the market lagged such as Real Estate and Utilities. Higher long-term interest rates weighed on high-quality bond proxies – the safe haven 10-year U.S. Treasury Bond produced a return of -1.74% during the quarter.
(As of 12/31/19) — The Buffalo Small Cap Fund produced a return of 12.99% during the quarter, outperforming the Morningstar U.S. Small Growth Index, which gained 9.11% during the same timeframe. Stock selection in Information Technology and Consumer Discretionary were key drivers of relative outperformance. Results were offset, in part, by weakness in the Real Estate and Telecom sectors.
For full year 2019, the Fund returned 40.97%, outperforming the Index return of 27.60% by over 13%. Calendar year outperformance was broad-based, driven by strong stock selection in Information Technology, Health Care, and Industrials. Results were slightly offset by weakness in Consumer Discretionary and Real Estate.
During quarter, the sectors contributing the most to the Index’s return were Health Care, Technology, and Consumer Discretionary. Health Care was particularly strong after experiencing weakness in the September quarter. The rebound in Health Care was driven by several factors including significant merger and acquisition (M&A) activity, which included six small- and mid-sized biotechnology companies during the quarter that lifted valuation multiples across the sector. Additionally, moderate Democrats, who are perceived to be friendlier to health care stocks, regained the polling lead over more progressive candidates in the Democratic primary, which reduced investor concern over pharmaceutical pricing pressure.
eHealth was the Fund’s top contributor, with the stock increasing by 44% for the quarter. The company provides an online exchange where individuals and small businesses purchase health insurance. Strong performance has been driven by improved productivity from its sales force, solid enrollment growth in all segments, and optimism that recent investments will help sustain growth into the future. We remain optimistic about the long-term outlook for the stock as the company pursues the fast-growing Medicare-related health insurance market.
CyrusOne was the largest detractor to results during the quarter. The data center operator has reported consistently-strong operating performance, and its shares were bid up heavily in the September quarter on anticipation that it would be acquired. The stock sold off in October when company management reported they are not currently pursuing a sale and subsequently the potential “M&A premium” was let out of the share price.
(As of 12/31/19) — Looking forward, we remain optimistic about the environment for small cap growth stocks in 2020. While absolute performance was strong in 2019, the small cap asset class lagged behind large caps overall. The S&P 500 Index returned 31.49% in 2019, which outperformed the Morningstar U.S. Small Growth Index return of 27.60% by nearly 4%. Although earnings of small cap stocks are poised to grow at a faster rate than large caps in 2020, we believe small caps are trading at relatively-favorable valuation when compared to large caps. This disparity could be a source of outperformance for the small cap asset class if valuations revert to more normalized levels.
In terms of portfolio positioning, Technology and Health Care are the two largest sectors in the Fund. Within Technology, component companies appear poised for accelerated growth out of an inventory correction, and many service and software companies are benefiting from digital transformations of corporate customers and a shift away from legacy, on-premise solutions to cloud-first providers. In the Health Care sector, we are positive on diagnostic companies due to more accurate tests and screens from newer, less-invasive technologies. We also favor suppliers into pharma and biotech companies as the research and development spending environment from these companies remains strong. Suppliers typically have less binary-event risk and better near-term revenue and cash flow characteristics than their customers, a risk-reward trade-off we prefer.
In spite of the overall optimistic tone in the marketplace, we recognize several factors that could drive volatility and downside risk. A policy misstep by the Fed or from key political figures are leading concerns. In 2019, the Fed’s pivot on monetary policy demonstrated willingness by our nation’s central bank to be flexible and “data-dependent” by cutting rates three times when there were signs of slowing economic activity.
While trade dynamics seem to change on a daily basis, the rhetoric has died down considerably, and the U.S. and China appear set to ink a phase one agreement. With the presidential election less than a year away, we think it is unlikely President Trump re-escalates the trade war again before November. We believe that we are likely in the later innings of an abnormal economic cycle that has produced below-trend growth and a longer expansionary phase compared to historical averages. Signals that this economic expansionary period is slowing or ending would likely lead to significant market volatility. Furthermore, after the strong returns of 2019, many small caps are now trading at high absolute valuations as we enter 2020. These elevated valuations could serve to enhance small cap volatility as these factors play out.
Within this context, we have been managing the Fund actively, seeking to deploy capital into stocks that we believe have the most favorable risk/reward trade-offs. The Fund finished the year with 76 holdings (excluding cash), up from 73 at the end of the 3rd quarter. We continue to identify investment opportunities in smaller companies with strong secular growth opportunities that, in our opinion, could benefit from long-term trends trading at attractive valuations. As always, we appreciate your continued support and confidence in our investment capabilities over the long haul.
We get to know the companies we invest in and learn how they run their business.
Top-Down & Bottom-Up
We identify Top-Down broad, secular growth trends and search for companies from the Bottom-Up.
We construct our portfolios based on our own proprietary investment strategy.
Sticking to our disciplined investment strategy ensures we maintain a consistent, balanced approach.
The Morningstar Rating™ for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating™ for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating™ metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
In each Morningstar Category, the 10% of funds with the lowest measured risk are described as Low Risk, the next 22.5% Below Average, the middle 35% Average, the next 22.5% Above Average, and the top 10% High. Morningstar Risk is measured for up to three time periods (three, five, and 10 years). These separate measures are then weighted and averaged to produce an overall measure for the fund. Funds with less than three years of performance history are not rated. ©2020 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. The Morningstar Style Box™ reveals a fund’s investment strategy by showing its investment style and market capitalization based on the fund’s portfolio holdings.
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