It’s fair to wonder how much more outperformance we can expect from small-cap stocks, considering how well they have been performing in 2018. But there are always areas of innovation and demand that can make you money. Jamie Cuellar, the manager of the Buffalo Small-Cap Fund (BUFSX), discussed two trends and three companies poised to take advantage of them.
First, here’s a comparison of the 2018 performance of the Russell 2000 Index (.RUT) the S&P Small-Cap 600 (.SML) and the large-cap S&P 500 (.SPX):
Both small-cap indexes have more than doubled the performance of the S&P 500 this year. So what does this mean? It certainly means an endless array of sensational headlines, some of which warn that the fast ride for small-cap stocks cannot last, in part, because domestic small-cap companies are expected to see larger benefits this year from the federal tax cut and rising dollar than larger companies.
But for long-term investors it may not be such a surprise to see small-caps outperforming. Here’s the same chart, but for 10 years:
That’s an impressive track record, showing how important it is to have exposure to small-cap stocks, as well as the large-caps that dominate the headlines.
Kornitzer Capital Management of Mission, Kansas, manages about $7 billion in client assets and is the subadviser for Buffalo Funds. Cuellar has managed the Buffalo Small-Cap Fund (BUFSX) since January 2015.
Cuellar’s style is to identify companies with potential for “good revenue growth, with good pricing power and margins” for investments of three to five years. In an interview on July 13, he said the fund’s typical annual turnover of about 40% is low compared with a typical 100% turnover for actively managed small-cap funds.
The two trends he focused on during the interview were increasing demand for:
- SaaS computing (software as a service)
- Communications bandwidth
The SaaS trend has been important for large-cap companies, including Microsoft (MSFT) with its cloud services and the migration of Microsoft Office to a subscription model. Other prime examples in the large-cap world include Salesforce.com (CRM) and Workday (WDAY).
The long-term SaaS trend has lowered risk for many software companies because under the old licensing model, “if you missed a sale, it had a devastating effect on the business model,” Cuellar said.
With this year’s strong performance, he said he had trimmed many positions in software companies, but here are two stocks of SaaS companies he believes are still trading at attractive valuations:
Pros Holdings (PRO) makes price-optimization software and has “more recently made the transition” from the old licensing model to SaaS, according to Cuellar. The transition to a subscription model can be a rocky one, as investors may not appreciate the (hopefully temporary) disruption to sales figures in companies’ quarterly earnings reports.
But for Pros Holdings, the transition is nearly complete and “they are expanding the market,” as they bring in new customers who were unable to afford the old licenses, Cuellar said.
“Price optimization is getting a lot more important,” especially in the retail and travel industries, he added.
“This group is typically valued on revenue. This one we have at about six times forward revenue, against eight or nine times for the group,” Cuellar said.
Twilio (TWLO) actually straddles both trends — providing application programming interfaces (API) that allow companies to communicate with customers through their own systems. Twilio is typically paid based on usage, with fees charged per text or minute of voice communication. “They are the largest network out there for this,” Cuellar said.
Small caps for market shifts
One major stumbling block for the company was the loss of Uber as a customer, because Uber was able to take its API development in-house. But Cuellar expects sales growth to improve this year and also believes estimates for Twilio are too low.
“Twilio also has new products coming, including a customizable call center called Flex and another that helps customers connect to the internet of things,” which refers to the trend for nearly any appliance or device in the home to be connected to the internet, he said.
“Twilio is trading at seven times my revenue estimate for 2019, while [rapidly growing SaaS companies] trade upwards of 10 times,” he added
When discussing the demand for increased communications bandwidth, Cuellar focused on the rollout of 5G service, which will begin with large carriers connecting fiber-optic cable to cell towers for high-speed wireless service to homes and business in areas that don’t currently have cable or high-speed fiber-optic services available.
A company that is taking advantage of the trend toward outsourcing construction for communications, pipeline and power transmission construction is MasTec (MTZ).
“All parts of the company are doing well,” Cuellar said. AT&T (T) and Comcast (CMCSA) are among MasTec’s largest customers.
“Valuation on this one is pretty reasonable. It generally trades 18 to 19 times forward earnings, but is currently trading around 13 times,” he said.
Morningstar rates the Buffalo Small-Cap Fund (BUFSX) three stars out of five. The fund has one share class with total annual expenses of 1.02%, which Morningstar considers “below average” for its small growth category.
The fund’s performance (after expenses) has been much better than its Morningstar category, its benchmark, the Russell 2000 Index and the S&P 600 Small-Cap Index this year and in 2017. It has beaten its category and the Russell 2000 for most longer periods but has trailed the S&P 600 Small-Cap Index for all of the longer periods.
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