Micro Cap Fund

Manager Commentary as of 12/31/10

After a summer slowdown markets were reignited in the second half of 2010. In the fourth quarter, the confirmation of additional stimulus through quantitative easing (QE2), lower tax rates, and November elections which handed control of the House to the Republicans spurred renewed optimism in the U.S. economic recovery. Smaller companies continued to be the market leaders as the Russell Micro Cap Growth Index was up for the quarter nearly double the S&P 500 Index.

In the fourth quarter, the Buffalo Micro Cap Fund showed good absolute returns, but underperformed the benchmark Russell Micro Cap Growth Index. The Fund returned 14.69% compared to 21.17% for the Index. For calendar year 2010, the Fund returned 26.86% compared to 28.89% for the Index.

Data represented reflects past performance and is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original value. Current performance may be lower or higher than the performance quoted. Performance current to the most recent quarter end may be obtained by clicking here. Performance current to the most recent month end may be obtained by clicking here.

Underperformance in the quarter is due largely to stock selection in the Information Technology and Health Care sectors. The Fund was also overweight in cash, averaging 7.30% which resulted in a drag on performance. Across all cap sizes, pro-cyclicals Energy and Materials were the stand-out performers for the fourth quarter. As the Buffalo Funds typically avoid cyclicals and commodities, we are underweight in these sectors and relative performance reflects this weighting.

Top contributors for the quarter were Chart Industries in Industrials, SodaStream International in Consumer Staples, and MarketAxess in Financials. Laggards in the quarter, in addition to cash, included Coldwater Creek and Deltek. The market punished Deltek, a maker of enterprise resource planning software, for not showing growth quickly enough in a rapidly rebounding equity market. Micro cap companies, which are usually focused on one niche business, are particularly sensitive to this type of growth expectation because they do not have diversified operations that can support weakness in one area.

After the fourth quarter "market melt-up," it would not be surprising to see the market grow into the recently elevated expectations. As a potential offset to this observation is that cash balances on company balance sheets remain at all-time highs and continue to grow. As confidence builds, businesses will not hesitate to put that cash to work in hiring, capital investment, or acquisitions. The Buffalo Funds investment strategy leads us to invest in firms with attractive structural growth profiles, which may help supplement the growth of larger firms. Merger and acquisition activity combined with stimulus-induced growth should provide a nice tailwind in the short-term, but fiscal imbalances at home and abroad, and inflationary pressures will need to be addressed at some point in the future. The Fund continues to use a disciplined valuation approach to stock selection and we remain committed to our long-term, trend-based investment philosophy.

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