Small has been big in U.S. equities in this year’s early going. The returns on the universe of small-capitalization stocks were roughly twice that of mid-caps and three times greater than large caps through mid-February. That momentum carried over from 2020, when small caps essentially outperformed the other two cap sizes by a factor of two. It had been a mixed bag for small company stocks in the handful of years before that, but the Covid-19 pandemic and its aftermath have lit a fire under these names during the past year.

“What’s getting people excited about them now is that they outperform as we come out of weak economic periods after a recession or after a downtick in the market,” says Jamie Cuellar, portfolio manager of the Buffalo Small Cap Fund.

As we all know, the pandemic’s swift, devastating rise in early 2020 caused a dramatic and stunning plummet in both economic activity and equity prices in the first quarter. Since then, U.S. stocks have staged an extraordinary rebound while the economy has seen a slower, more gradual return to normalcy. While many investors fret that stocks have come too far too fast, the measured economic recovery leaves room for further economic growth. And that potentially bodes well for small companies.

“Usually, small caps have very high operating leverage relative to larger caps, so when you see an acceleration in the economy it’s generally a time that they outperform,” Cuellar says. “I think more people are willing to step out on the risk curve given that interest rates are low and the economy is improving, and some people are rotating into small caps because of that.”

The Buffalo Small Cap Fund, which Cuellar manages along with two other portfolio managers, Bob Male and Alex Hancock, has been a prime beneficiary of that trend. Last year it zoomed 66.4%, which was nearly 32 percentage points greater than its bogey, the Russell 2000 Growth Total Return Index. This year through February 12, it was up 19%, or 2.6 percentage points more than its bogey.

The fund aims to invest in small-cap growth stocks the managers believe are premier companies benefiting from long-term trends and trading at good valuations. Cuellar says he and his team look at a number of attributes that define a “premier” company. That includes solid revenue growth, along with a solid management team that can articulate its vision and has the ability to execute on that vision.

“We like companies with really high margins, and who can hopefully expand on those,” he explains. “And we like companies with scalable business models and competitive advantages versus their peers.”

Growth Vs. Value
In both the small-cap space and U.S. equities in general, growth stocks have significantly outperformed value stocks in recent years. One reason is that value investors tend to gravitate toward the energy and financials sectors, and both have faced stiff headwinds.

“The low rate environment and poor net interest margins for banks, coupled with the Fed saying it will keep rates low going forward, makes it hard for banks to make money,” Cuellar says. “And energy has been hit by a slower economy and the ESG movement, which impacts fossil fuels. We tend to traffic more in the growth cyclical names.”

One such holding is Kornit Digital Ltd., an Israeli maker of printing solutions for the fashion, apparel and home decor segments of the printed textile industry.

“It’s part of the transition from analog to digital, and the move to e-commerce has caused an acceleration in their business,” Cuellar says. “It falls within the machinery industry area within the industrials sector.”

The industrials sector represented 16% of the Buffalo Small Cap Fund’s portfolio as of year-end 2020, making it the fourth-largest sector weight after information technology, health care and consumer discretionary. Cuellar stresses that his fund takes a bottom-up investing approach.

“Stock selection drives the performance of this fund, not sector allocation or anything like that,” he says. The goal, he adds, is finding good companies at good valuations that really haven’t been discovered by the market yet.

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