How a small-cap fund manager is handling a ruthless period in the stock market

  • By Sarah Max,
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The past few months have been ruthless for small-company investors, with the benchmark Russell 2000 (.RUT) now down more than 13% over that period. It’s a far cry from earlier this year when investors viewed small companies as havens from tariffs and big beneficiaries of tax cuts.

“We’ve gone from being the darlings to [the victims of] a risk-off market,” where small-cap stocks are particularly vulnerable, says Jamie Cuellar, co-manager of the $473 million Buffalo Small Cap fund (BUFSX).

While the market has punished small companies indiscriminately, Cuellar and the rest of the small-cap team at Kornitzer Capital Management—the firm behind Buffalo Funds—are staying focused on what’s down the road. The companies they like are the beneficiaries of long-term trends, such as cost-containment in health care and software as a service (known in the industry as SaaS), that should ultimately transcend market wobbles. “If anything, you’ve just got some better valuations for ideas you may have missed out on in the first place or something you’re really excited about,” says Cuellar, 49.

Trend-spotting has long been the basis of investment decisions for the 20-year-old Buffalo Small Cap fund (BUFSX), but like the companies it follows, it has seen its own inflections. One such change came in late 2014, when Cuellar came in to help turn around the small-cap strategy. Buffalo Small Cap (BUFSX) has outrun the Russell 2000 by an average of two percentage points a year over the past decade. But a couple of bad years—2010 and 2014—put it in the bottom half of its peer group for that period.

To avoid big swings that can be a drag on performance, Cuellar and his co-managers, Robert Male and Alexander Hancock, revisited the fund’s valuation discipline. While many small-cap investors don’t worry about high multiples, which often reflect rapid growth, they instituted a plan to trim high-priced winners to dampen risk and make way for new ideas. They also increased the portfolio from what had been about 50 holdings to its recent roster of nearly 75, and made a conscious decision to shop in a wider selection of sectors.

The fund made a gradual recovery and in 2017 returned 27%, finishing well in the top quartile. The past few weeks have been challenging, but Buffalo Small Cap (BUFSX) is still up more than 5% for the year, ahead of the majority of its peers.

Born and raised in Texas, Cuellar graduated from college in the early 1990s when the job market was slim and took a call-center job at Fidelity Investments. That sparked his interest in asset management, and within a year he was in business school and studying for the chartered financial analyst, or CFA, designation. After working as an analyst for a registered investment advisor, Cuellar learned the ropes of small-cap management at PineBridge Investments in Dallas. After the firm was sold to a private-equity firm that scrapped its mutual fund business, Cuellar took a two-year detour into wealth management. Working directly with clients “was a reminder of why you’re doing this in the first place,” says Cuellar, who hung pictures painted by a former client in his office.

Even so, when Kornitzer offered him an opportunity to get back into small-cap management, Cuellar left his beloved Lone Star State and moved north to Kansas.

Mission, Kan., population 9,400, is a long way from Wall Street. Even so, the firm gets more than its share of companies coming to town, thanks in part to its proximity to goliaths Waddell & Reed (WDR) and American Century. The companies that Kornitzer and team look at more closely are grounded in at least one of 26 secular trends, some broad and some niche, and exhibit traits of what the fund calls premier companies: strong management, growing margins, healthy balance sheets, positive cash flow, and significant competitive advantages.

While the Kornitzer small-cap team will occasionally buy on the initial public offering, it will in many cases wait for what is often an inevitable pullback in valuations. Twilio (TWLO) followed a similar script. The company makes it easy for developers to integrate communication, such as phone calls or text messages, into their own apps or websites. It went public in June 2016, and Buffalo owned a small position but sold as the stock price more than quadrupled. “The stock traded at almost 20 times revenue, which is insane,” he says.

Later that year, shares fell back to earth and the fund got back in. Then in 2017, Uber, its largest customer, said it would gradually reduce its use of Twilio, sinking shares again. Buffalo bought more. The stock has since recovered to $76 and is adding new products and new customers. “It’s a developer-first model, so they don’t have to have a massive sales force” trying to land major deals, says Cuellar, who estimates that Twilio’s revenue could more than double by 2020.

Health savings accounts, or HSAs, don’t scream growth, but assets in these plans recently hit $51 billion and are starting to pile up as a result of the shift to high-deductible plans, an aging population, and increasing awareness of the tax benefits of HSAs. HealthEquity (HQY), which is a custodian for assets deposited directly and through other financial institutions, is well positioned to benefit from growing adoption and balances.

The Kornitzer team built its position when the stock was trading at $15 to $20 a share in early 2016, weighed down by concerns over how the Affordable Care Act’s “Cadillac Tax” would affect the popularity of HSAs. “HSAs actually have bipartisan support for being a great way to lower the cost of health care by putting more responsibility in the hands of the consumers,” he says. Meanwhile, HealthEquity is taking market share and growing its top-line revenue more than 20% a year. The stock was recently at $77.

PROS Holdings (PRO) is a longtime leader in price-optimization software, such as for airfare, but its shares have seen wild swings over the past few years as it transitions from traditional perpetual licensing to a SaaS model. The latter makes it easier to attract new customers because the initial cost is lower and implementation is easier. The catch: “Most investors just don’t want anything to do with a company while going through this process,” says Cuellar, explaining that it is difficult to forecast earnings as a company moves from one model to another.

The fund saw the potential and bought the stock this spring around $30 a share—or five times forward revenue, about half the multiple of high-growth SaaS companies. While transition is never easy—as Cuellar knows—PROS is in the final leg of its makeover, with more than 80% of its revenue now recurring. Meanwhile, price optimization has expanded well beyond travel and is used in commodities, health care, technology components, and even retail.

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