Q: Would you provide an overview of the fund?

The fund can best be described as a select fund, not too concentrated that the risk is high, but not too broad that it looks like an index fund. We are located in Kansas, far from Wall Street and all the latest investment fads, so we are committed to maintaining our independence and focus. 

I joined the firm in 2003 as a healthcare analyst, and in 2007 I became one of three managers on the portfolio team. Since July 2012, I have been the sole portfolio manager of the Buffalo Large Cap Fund. The performance on the fund has improved in the past three years.

Q: What are the underlying principles of your investment philosophy?

First of all, we buy high-quality companies at reasonable valuations. We are driven by research and valuation and look for ideas that we can hold long term. We believe that opportunities and efficiencies are created because of short-term uncertainties, and we seek to use these short-term inefficiencies as buying opportunities to create long-term growth. 

We are focused on high-quality companies that are leaders in their market with limited competition. I prefer to own companies that solve a problem, that add value to their customer rather than just selling a product. Costco Wholesale Corp is a company that delivers profound value to the consumer. Another good example is Whole Foods Market Inc, which has done an excellent job of raising our awareness of healthy eating.

Growth is another important part of our set of criteria, and companies must have a growth opportunity in North America.

Finally, valuation is critical. Each security must offer a good return on invested capital.

Q: What is your investment strategy and process?

We have a top-down approach with 26 identified trends called Buffalo secular trends, which are measurable, long-term growth trends. Companies that are beneficiaries of these trends should grow well in excess of gross domestic product (GDP) over the three to five year time horizon. Essentially, our investment universe is made up of the companies that meet those 26 trends. Any of the trends can evolve to the point that they no longer are relevant, but for the most part there is little turnover in our trends.

We do a lot of work in terms of bottom-up analysis. I spend 95% of my time researching companies and trying to understand their business and management. We look for a sustainable growth on the revenue line, efficiency and optimization of margins, particularly gross margins that can be reinvested in sales and research and development. Also, we focus on companies that are stewards of shareholder value. 

The next step in our process is valuation. Here, we build discounted cash flow models on companies to determine their intrinsic value. Not only do I consider this metric both in bear or bull case scenarios but I also seek to buy at a discount. We are not momentum investors. 

Sometimes a stock is mispriced based on our proprietary model, or it could be that we disagree with the Street consensus model; both of these factors can create a buying opportunity. In assessing the valuation we determine, based on the model, the upside and downside on the security. We strive to buy companies that trade with the upside twice the downside. Taken together, these factors form the investment thesis for the stock.

The weighting of any security in the portfolio is determined by valuation; the lower the valuation the higher the weighting, conviction, or the potential to achieve the upside, and finally familiarity with the company. Management teams where we have a shorter history of following typically get a lower weighting. 

The net result of this process is a portfolio that delivers solid returns and has low turnover with less risk. By focusing on high quality companies that are beneficiaries of the Buffalo secular growth trends and enforcing valuation discipline on the buy and sell decision, we create a win-win situation. In a bull market we should outperform due to superior stock selection and in a bear market we should outperform given the focus on high quality companies and managements, as well as valuation. 

Q: What is your definition of high quality and growth?

For me, owning a name is not simply a trade but an act of becoming an owner of a company. Apart from investing to make money, I am also investing in this business because I believe in it.

In my view, high quality refers to a company that has a solution to a problem and faces limited competition. In other words, the company emerges as the leader who claims their share in that market. Such companies are also good stewards of shareholder value, which translates into making the right decisions about what to invest in and when to return capital to shareholders. They have a culture that inspires their employees and nurtures their human capital.

Typically, the gross margins of these companies are going to be higher than their competitors because they are more efficient and more likely to be reinvesting in R&D, sales and marketing—something that will eventually drive them to faster growth than their competitors.

Q: How does your research process work?

The first step of our research process is to identify the trends. We uncover these trends by paying attention to the world around us. Once a trend is identified, we assess whether it is sustainable, measurable and growing. 

Next we look for companies that are beneficiaries of the trends. This list is our investment universe. Using our trends, we have essentially narrowed the large set of publicly traded companies to a smaller set of growth companies that are benefiting from a growth trend and should have the wind at their back. 

From this growth universe we do significant bottom-up analysis to determine the companies that we believe are positioned to lead. We meet with management teams, research the product or service, grind through financial statements, and build financial models. We favor companies that have a recurring revenue stream, as these models are more sustainable. 

Finally, we assess valuation. The analyst inputs the financial projections into the Buffalo proprietary five-factor model. The factors are attributes of the company and include growth opportunity, margins, capital intensity, sustainability and management quality. By ranking these factors, we determine the appropriate multiple for the stock relative to our investment universe. Using this model, we clearly delineate the upside and the downside on the security. 

Q: What is the market cap range that you adhere to in your selection?

At least 80% of investments in the fund must be in holdings in excess of $10 billion in market cap. Although we own large-cap companies like Apple Inc and Google Inc, approximately 60% of the portfolio is invested in companies with market cap below $50 billion. Additionally, we have about 11% of the fund invested in companies with market cap below $10 billion.

Q: Could you share an example to highlight your research process?

I think Boeing Company is a great example of the kind of company we are looking for. It is one of our highest weightings in the portfolio, and we have owned it since 2009. The company is a duopoly and has a backlog that extends for six to seven years.  
Boeing is definitely solving a problem in terms of delivering more fuel efficient airplanes to its customers. The company has invested significantly in R&D and is going to reap the benefits of that through improved cash generation going forward. Boeing has returned capital to its shareholders; those returns are sustainable and the company has limited competition, standing out as a leader in the marketplace. It also a strong management team, who are stewards of shareholder value.

Q: Would you quote another example?

Entering 2015, one of our largest holdings in the fund was a healthcare name, Hospira, Inc., a provider of injectable drugs. Healthcare is a market that has been growing quite well. The trends in the sector are extremely favorable and I aim to optimize the portfolio to take advantage of that tailwind.

One of the current trends in healthcare is costs containment. As a result of the Affordable Care Act, more people have access to insurance coverage and consume preventive healthcare. Consequently, healthcare expenditures in this country will likely accelerate. With healthcare expenditure growing faster than GDP, the result is that healthcare is becoming a greater percentage of our economy. Over the long term this trend is detrimental to the U.S. economy and we, therefore, have to do a better job of controlling costs. 

The good news is that we see ample opportunity to control healthcare costs. 

One way is to use generic drugs. When small molecule brand drugs go off patent, copycats can enter the market. These copycat or generic drugs can be switched at the pharmacy and they typically range from 50% to 10% of the price of the brand drug. Delivering lower cost drugs to patients significantly reduces healthcare costs. Over the long term this generic switching system for small molecule drugs has reduced U.S. healthcare expenditure by hundreds of millions of dollars. Hospira is the largest small molecule injectable generic drug company in the U.S. and should benefit from this trend.

Over the past few decades more and more large molecule, or biologic, branded drugs have been approved in the U.S. This country is at the forefront of establishing a pathway to bring copycat biologic drugs to the market once the branded biologic drug goes off patent. It is estimated that globally there are $60 to $80 billion of branded biologic drugs that will come off patent between now and 2020. 

Hospira is a trailblazer with two copycat or follow-on biologics pending with the U.S. FDA and three approved and marketed in Europe. We believe that Hospira’s follow-on biologic portfolio will drive growth well into the future. 

We were not the only ones to see Hospira’s potential. In February 2015, Pfizer announced plans to acquire the company for $90 per share in cash, over a 30% premium.

Q: How do you look at valuation?

In looking at valuation, I take the financial projections as inputs to our five-factor proprietary model. 

The five factors include the management quality, growth opportunity, margins, sustainability, and capital intensity required for that business. Based on where the company in question ranks relative to our investment universe, we establish an appropriate EBITDA multiple for the stock. Taking into consideration how the company should perform in good times and in bad times, we calculate the upside and downside on the stock. 

I also consider the amount of cash the business generates. I prefer businesses that have a free cash flow yield in excess of 5% which is an attractive return in the context of a U.S. ten year treasury yield of about 2%.

Q: How do you construct your portfolio and how important is diversification?

In terms of diversification and portfolio construction, the most important thing is that we do not manage to the benchmark but to the opportunities we see in the world, while also trying to control risk. Our investors should expect active management, not management to a benchmark. 

The portfolio is diversified across various sectors, industries, and our 26 trends, I make sure that the fund is not too invested in one particular trend, but rather has representation across many of our trends.

Q: How do you decide on position sizes?

Presently, the fund has about 45 holdings, with a typical range across the business cycle of 30-45 securities. A position size could be anywhere from 1% to 4% depending on valuation, my conviction level, and my familiarity with the company. We tend to add to positions as they approach the downside and trim positions as the near the upside.

Q: What constitutes your sell discipline?

I prefer to hold names for a long time, but when my investment thesis is violated I sell the name. Discovery Communications, Inc. is a name that I recently owned and ended up selling because I became concerned that the value of their content was going to be less meaningful in a world where individuals could purchase content over the top. 

At other times I may sell based on valuation. For instance, Biomarin Pharmaceutical Inc. is a company that we sold recently. Biomarin is an innovative biopharmaceutical company with a wonderful franchise in rare diseases. The management team did an excellent job launching their most recent product to treat a severe rare disease.

The company also made good progress on advancing and expanding its pipeline over the past twelve to eighteen months. But with the stock appreciating 100% in a year, the downside became significant. Even though I think Biomarin is a great company, it was no longer a good stock, in my opinion, and we exited the holding due to valuation.

Typically the number of names in the portfolio grows as we go through the economic cycle. When in a bear market we concentrate the portfolio at the bottom. That is, we allocate capital to our highest conviction name at the bottom. As the cycle progresses and valuations increase, so does risk. Therefore, we increase our diversification by expanding the number of stocks in the portfolio as the cycle matures.

Q: How do you define risk? How do you measure and control it?

As an active manager focused on a bottom-up approach, I cannot make a case that we do a lot of top-down analysis of risk. My goal is to outperform in a down market and some of the things that help control risk are focusing on valuation of companies, the sell and buy discipline, growing the number of names and thereby increasing the diversification as the market goes up, and limiting the weighting of any particular stock to less than 5% of the fund.

Over the past three years I have lowered the risk rating in the fund based on a third-party measure. By focusing on the risk of each company, on diversification, on valuation and on high-quality companies with good management teams that are stewards of shareholder value, one can certainly construct a portfolio with less risk.