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It’s a good feeling as an investor to know where your money is going and why. It’s nice to have the hard numbers to back up an investment strategy. In that sense, the management team running the Buffalo Small Cap fund at Kornitzer Capital Management has succeeded with flying colors.

The management team, based in Mission, Kansas, and led by Kent Gasaway and co-managed by Robert Male and Tom Laming, backs up its reasons for investing in certain sectors with clear and compelling logic.

Relying on an economic outlook spanning a three-to-five-year period, finding appealing valuations, and studying changing demographic figures, the Buffalo Small Cap fund is trotting along this year with an impressive 21.26% return as of July 31, according to Morningstar.

While it is no secret that many mutual funds have headed nowhere but south over the last year and a half with still no end in sight, the Buffalo Small Cap fund ranks high among its small-cap peers, boasting a 32.07% three-year annualized return through July 31, 2001, and an appealing 31% turnover ratio.

This fund has actually benefited from a sputtering economy. The two main reasons, both demographics-based: the increased popularity of post-secondary education, and the aging population of the United States.

Gasaway provides some unassailable facts to back up his investments in education. “The children of the baby boomers are reaching college age. There will be more kids in the next 10 years going to college. That’s going to drive enrollment growth. Also, it’s a great area to own in tough economic times. When people get laid off, many times they change industries, and a lot of the time that entails going back to school.”

Along with education, this fund has profited from solid research that led the managers right to the graying of America. Once they realized that the 55-64-year-old age group was the fastest growing age group in the country, the next step was to investigate industries where people from this group were already putting their money. That led them to leisure and gaming, which currently make up 14% of this fund’s portfolio and include such holdings as the riverboat casino company Argosy Gaming and Harrah’s.

“People in this age group generally have a lot of free time, and a lot of discretionary income. They travel frequently and go to casinos a lot. We particularly like the riverboat part of the gaming sector because there are no new licenses being let out to speak of. We know who the winners are,” says Gasaway.

Here’s what else the managers had to say about their still-young, still-manageable fund.

The three of you met at Waddell & Reed. Can you talk about your experiences there and how you all eventually ended up at Kornitzer Capital Management? Gasaway: I was at Waddell for 10 years. It was a great place to learn the business as an analyst. After a while, I determined I wanted to join more of an entrepreneurial, smaller shop where I could have a bigger impact. I was the first person to leave Waddell, and I joined Kornitzer in 1991. Soon after, I convinced Tom [Laming] to join. The people at Waddell weren’t really happy about that. But over time wounds have healed, and we are all good friends now. Some years after that we convinced Bob Male, who used to work with us at Waddell and had spent five years at USAA, to come aboard at Kornitzer. Once he decided to come on we had the whole team back together again. John Kornitzer founded this company in 1989, starting it in the basement of his house. We have grown tremendously in the last few years and now we have just under a dozen investment professionals in the firm.

Describe the team management process of the Buffalo Small Cap fund. Who does what? Gasaway: For each of the funds there’s a lead manager. The lead sets the weightings and charts the course of the fund. Each of us has their area of expertise and we rely on each other heavily in those areas for picking stocks. My area is services, which includes industries such as education and gaming. I cover a lot of areas that have been de-emphasized recently. I also manage a high-yield bond fund, so my industries are cyclical and pertain more to the bond investing side.

Laming: In our firm we realized we weren’t going to win a game of having the most feet on the Street. We have always held the view that the way we would do the best job is to take a longer-term view: Everyone is so focused on the next quarter, but the short term is less visible. For instance, I can guarantee it will be sunnier next year [than this year] in Kansas City by taking a long-term view of history. In the same sense, I can guarantee there will be greater cellular demand next year. What we try to do is to identify areas that we are almost 100% sure about for the next three to five years. From a demand standpoint, we are very confident that healthcare demand, based on the growth of certain age groups, will increase. The 45-55-year-old age group will grow dramatically. We’ll make an investment based on that. We know what they buy. They buy cruises, high-end furniture, and healthcare, to name a few. I don’t know the direction over the next month. Leave that up to another analyst. I have absolute confidence over the next five years of where this is headed.

Male: My areas of coverage include telecom services, financial services–brokerages, banks, and money managers–retail, and some of the leisure areas such as Brunswick boats and Coachman RVs.

Gasaway: What we try to do is continuously look for new trends and new companies that fit existing trends. For the most part this is a great market for us. We have positive cash flow in our fund, and it’s a difficult market environment. There are a lot of companies that if they miss the quarter by a penny or two the stock blows up and we love that. We sit back and pick targets on different companies and where we’d like to buy them and increasingly those targets are being met. This year has been driven by certain segments. We are now reloading the portfolio in new areas with new companies that we have high confidence are going to give us the firepower for next year. They may not perform this year, but we are buying them cheap enough now in preparation for when the economy turns and people get more optimistic. Growth-type cyclical names are going to perform great next year. Whether that’s technology, retail, or certain consumer cyclicals, we have high confidence that that’s the direction things are going.

Division I: NEXT Financial Group
NEXT was founded by a group of reps who had worked for Advantage Capital in Houston. As President Jeff Auld tells it, these reps had been with the company for years, and several of them had followed their fathers’ footsteps to Advantage. In other words, this was a stable group not prone to company-hopping.

But the atmosphere at the company had changed to the point that the group was no longer happy. They began to look around for another B/D and visited several firms, and held some serious discussions. In the end, the group decided that the only way they would be satisfied with the level of control and service at their broker/dealer was to start their own. So they did.

“The firm was incorporated in 1998,” says Auld, “but it was early 1999 when NASD approved NEXT as a broker/dealer.” There were a couple of dozen in the group that originally left Advantage, he says, and by the end of 1999 there were 78 at NEXT. That number nearly doubled by the end of 2000, and another 50 reps signed on in the first half of this year alone.

Auld himself was a retail broker, a registered rep with Edward Jones in Iowa. He left that behind to help start a firm called First Bankers Securities Corp., which offered brokerage services in banks. Auld headed one firm after another, with success, but when his position at Magna Banks in St. Louis was consolidated due to a merger, he found himself on the move again. “I was introduced by a mutual friend to Gordon D’Angelo [one of the firm's founders],” Auld remembers. “He described the firm, and it sounded very interesting, but I was reluctant to move my family again.” He wasn’t anxious, either, to hear another presentation. “I’d made dozens, if not hundreds, of these presentations,” Auld says, “and they all pretty much seemed to be the same. [They were] suits, successful in their business, but [they] didn’t know anything about my business.” Still, he went to Houston, where he spent four hours talking to the board at NEXT. “They were all men in this business,” he recalls. “They spent a few hours a month doing board business, but all do this [brokerage work]. About my age, some had been in business longer than I had. I left the meeting knowing that I wanted to work for them.”–Marlene Y. Satter

Do you consider yourself a growth or blend fund? Gasaway: We think the majority of the time we’ll be classified as a blend fund, but we are growth managers. We think all of our companies, because of their long-term trends, are growth stocks. They are just not necessarily value growth stocks. We’re a growth manager, but we just won’t overpay.

Male: Besides, if you look at how value versus growth is defined, it’s more like expensive versus inexpensive. Basically the universe, say the S&P 500, is taken and chopped in half based on book value.

Morningstar has you classified as a medium growth fund in their style box. Do you agree with this? Gasaway: That will be changing. With the new rules put out by the SEC regarding if you have “small cap” in your name, it looks like the direction things are going you have to have companies with caps of $2 billion or less. The fund has grown quite a bit recently. All new purchases have been of companies of $2 billion or less. Our average market cap has been falling. That Morningstar categorization was not because we bought mid-cap stocks. Our stocks had gone up a lot. We had a lot of them go up into that mid-cap category. Now that the fund has grown, we haven’t added to those areas. We are moving toward the SEC’s 80% requirement that is going to be in place as of July 2002; 80% of our stocks will have to be small cap. We define that as $2 billion or less and we feel that will be the industry standard.

So at what point do you sell a holding? Gasaway: We are out to be a very tax-efficient fund. Just because something grows over $2 billion, that doesn’t mean we sell. We won’t add to them anymore, and if they get too big, then we will trim.

How big is too big? Gasaway: Historically anything that has gotten over $10 billion we’ve sold. If it gets close to that we start to look at it very closely. Right now we don’t have anything close to that. The majority of our holdings are in the $3 or $4 billion or less range.

You currently have 59 holdings. Does that fluctuate very much? Gasaway: We’ve generally been between 55 and 60. We like to keep things in a position where our holdings are meaningful, yet prudent. We are prudently diversified, but we are not going to have 500 names where no one name can make a difference in the fund. That doesn’t make any sense at all.

What makes the post-secondary technical institutes like ITT and the University of Phoenix good buys? Gasaway: I don’t think they’re giveaways anymore; I think they’re fairly priced now. We are not adding to them anymore. They have generally doubled or tripled in price. What attracted us to the group starting two years ago was, number one, demographics. When economic times are tough enrollment actually increases to the upside and that’s what we are seeing now. When everyone had jobs a couple of years ago and dot-coms were hiring left and right, the argument was that the education stocks were dead money and you didn’t want to invest in them because people didn’t need to go back to school and jobs were plentiful. So they were traded at very low valuations, and that’s when we bought them up. But now, although they are not ridiculously overpriced, valuations have gone up a lot.

What attracted you to a company like FirstService, who provides property management and other services mainly to retirement communities? Gasaway: We own a larger version, although it is performing badly, called ServiceMaster. Part of our theme with demographics is that as you get older, things around the house that you used to do on your own, you don’t do them anymore. You hire someone else to do it. In the large cap area we latched on to ServiceMaster. Management hasn’t executed very well in its case, however. The way we found FirstService is we were looking for a smaller-cap version of ServiceMaster. Management at FirstService has done a phenomenal job. They are seeing no impact of a slowing economy. Their market is growing. Again, it’s mostly demographics.

Are there any current trends you are excited about? Laming: One area that we have been focused on but that we’re waiting for a better valuation in is the contract manufacturing and outsourcing of electronics areas. Companies like Selectron for the manufacturing of cell phones for various companies.

Your fund has put up such impressive returns since its inception. What is one area that has been bad? Laming: Technology has been the weakest area. The collapse of the Internet bubble hurt everyone in one way or another. An interesting byproduct of the collapse has been the expansion of other stocks as the dot-com threat has lifted. A good example of this is furniture and interiors manufacturer Ethan Allen. This is a stock that was getting weaker and weaker as companies like were supposedly getting stronger and stronger. It was a sign of the times and filed for an IPO in January 2000. Internet stocks then peaked in March 2000. Ethan Allen had been pretty weak this whole time. As the Internet bubble burst, however, then pulled its IPO and filed for bankruptcy. Now Ethan Allen is strong.

Who is the ideal investor for this fund? Gasaway: It is for someone who is looking for a pure small-cap play. We are not going to skew from that and start buying large-cap companies. It’s for someone looking for consistency and long-term results. It’s for an investor that pays attention to valuation and wants a pure no-load fund.

Have recent cuts in interest rates affected your fund in any way? Gasaway: I think some of our growth cyclical holdings are certain to act a little better.

Male: At the same time that we were dropping weightings in technology we were increasing financial. Financials have benefited from lower interest rates. Historically when the Fed has lowered rates the market eventually has gone up.

Gasaway: The small-cap market has benefited. It’s harder for bigger companies to grow. Nimble, smaller companies that have their niches can still find some growth in a slow-growth economy. That seems to be what investors are thinking right now. And they had underperformed for so long. It’s about time.


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