The managers of Buffalo Mid Cap see technological innovations and growth among emerging-markets consumers as influencers of industry activity for an extended time.
Kent Gasaway, Robert Male, and Grant P. Sarris, co-portfolio managers of Buffalo Mid Cap BUFMX, recently answered our questions on prominent investing themes found in today's market along with the main advantages and disadvantages of employing this type of strategy. They also provide their outlook for the energy sector and the market for high-end consumer firms such as Whole Food Market WFM, Abercrombie & Fitch ANF, and Polo Ralph Lauren RL.
1. The fund is driven by a theme-based investing process. What are the biggest themes you are seeing in the marketplace today? What's the biggest theme you've missed?
We believe that beginning our research process by identifying long-term trends allows us to eliminate short-term speculation from our decision-making on industries and companies. We are long-term investors, looking at a three- to five-year growth horizon for our holdings. By identifying trends that should influence or benefit certain industries over an extended period of time, we hope to capture growth related to those trends.
Powerful trends we are seeing today include movement by U.S companies to sell to the growing middle class in emerging markets. Although domestic growth has slowed since the recession, growth in many emerging economies, such as China and Brazil, has remained strong. Many U.S. companies are looking to replace or supplement growth at home with this growing international market. We believe that companies will continue to adapt their business models to capture growth potential wherever it exists throughout the globe.
We are also seeing numerous technology trends such as software as a service, cloud computing, and the proliferation of smart mobile devices such as Apple's AAPL iPad and Google's GOOG Android devices. Businesses and individuals today are becoming more accustomed to information delivered quickly, right to their fingertips. Demand continues to increase for devices and services that deliver, store, and process information quickly, to any location. We believe innovation will continue to drive technology markets as the consumer's appetite seems unquenchable.
Typically, these technology names tend to be fairly pricey, so we have had limited exposure to the mobile-device market. However, we have found some other good opportunities. For example, we recently added Equinix EQIX to the fund when it came within our valuation range. This company, which fits the cloud computing trend, builds data centers for co-locating information. More companies are moving toward off-site data storage, yet they need to remain interconnected. Equinix provides that capability. We think it has substantial growth potential.
2. What would you say are the main setbacks and opportunities of this type of strategy?
The main benefit of the trend-based strategy is that it affords us the ability and confidence to invest for the next three to five years and not be scared off by extreme volatility or the macroeconomic outlook in the short period. The trends we use are all well-documented with measurable data and statistics. We have a great deal of conviction that these trends are real and sustainable. With that as our investing foundation, we are able to ignore short-term volatility. We maintain our focus on the trends and ensure that the companies we place in the portfolio have a direct correlation to the trends.
The main setback we would associate with this type of trend-based investing is that we might sometimes miss opportunities to participate in certain sectors that can have significant short-term outperformance, such as commodities, deep cyclicals, and banks. We know that from time to time there will be outperformance of this type, and it may temporarily cause our fund to underperform our benchmark, the Russell Midcap Growth Index. What we have also learned, though, is that the converse is true. When these commodities or cyclical stocks are hit, our fund has typically been buffered and fared better than the benchmark. Over time, we believe that avoiding this type of volatility is best for our investors, and our track record tends to support that belief.
3. How do you decide when it is time to sell a stock or that a theme is not going to play out as expected?
The buying and selling of stocks is as strong a discipline for us as is trend analysis. Valuation is our main guide to selling a stock. We will never chase a stock simply because of its movement or returns. If it doesn't fit our valuation model, we simply watch it and wait. Patience is part of our investment philosophy, not only in terms of holding stocks, but in timing our buys, as well. Once we identify a company that we believe has good long-term growth potential, if we feel it is priced too high, we will wait for the price to drop as a result some economic anomaly or market underappreciation. We purchase stocks only when their price meets our valuation guidelines, and we sell stocks when they reach what we have determined to be their peak value.
Over time, there have been few instances of our trends not playing out, but they certainly can be interrupted by severe macro events. The bigger risk for us is not picking the right companies to benefit from certain trends. This is where our research plays such a vital role. We are constantly looking for companies that both benefit from our established trends and meet our strict criteria for business models.
4. The fund does not have any investments in the energy sectors. Why are you steering clear?
We do not avoid all energy, only those whose fortunes are strongly correlated to a commodity price. We do not feel anyone can consistently forecast the price of oil. Furthermore, the organic unit growth is low for most oil and gas companies, and the industry is very capital-intensive. We like business models that are more predictable, have higher unit growth, and have low capital intensity.
But that does not mean we avoid energy altogether. We have had some real success with companies that benefit from the energy industry without depending directly on the price of oil. We tend to prefer companies that support the development of clean energy or innovative ways to find, extract, and/or process energy.
5. You own a few upscale consumer stocks, such as Whole Foods, Abercrombie & Fitch, and Polo Ralph Lauren. Do you think the high-end consumer will be able to keep spending, or do you think there will be another retrenchment?
Most of our mid-cap consumer stocks have grown very fast internationality and have strong global brands. In the last several quarters, we have seen this growth continuing, even as domestic growth has slowed. We believe this will continue as the middle class in emerging markets continues to flex its muscle.
The few exceptions to this scenario are those whose growth runways are still very long in the United States, such as Whole Foods, Chipotle Mexican Grill CMG, and Life Time Fitness LTM. Short of another financial crisis, we do feel the high-end consumer will hold up better.
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Mutual fund investing involves risk. Principal loss is possible. The Buffalo Mid Cap Fund invests in small and mid cap companies which involve additional risks such as limited liquidity and greater volatility than large cap companies. Diversification does not assure a profit or protect against a loss in a declining market.
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The Russell Midcap Growth Index® measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. It is not possible to invest directly in an index.
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|Top Ten Holdings (as of 3/31/2011) *|
|Abercrombie & Fitch||
|Whole Foods Market||
* Top 10 holdings for the quarter are not disclosed until 60 days after quarter end. Those listed are for the previous quarter.