Deep Dive: ‘We find innovation all over the place,’ says fund manager who’s beaten the S&P 500

“The good thing about our process is we have already thought about the worst of times,” he said in an interview April 21.

“We want to identify long-term trends, make sure our companies can benefit from those trends, and manage to the trends, rather than to a benchmark,” said Carlsen, who started in the investment industry as an analyst in 1992.

We have compared the fund to two index benchmarks, and you can see its outperformance below.

Buffalo Funds is based in Mission, Kan., and has $3.5 billion in assets under management. Carlsen has been a portfolio manager of the Buffalo Discovery Fund since January 2004 and is now its sole manager.

Carlsen described a three-step investing process.

1. He and colleagues identify long-term innovative trends “that the market accepts,” and then pinpoint “market disrupters,” which are companies with growing market shares within those innovative industries.

“We look for trends up and to the right, rather than cyclical or mature companies,” he said.

2. Carlsen and his team use fundamental analysis to screen for companies with high profit margins, “scalable business models” and “balance sheets that can fund growth in good times and bad and a strong management team that can transform that secular opportunity into value for the shareholder.”

3. The fund picks investments based on stock selection. Carlsen and his team will look out five to seven years and establish best-case and worst-case scenarios with price-target ranges. “Best/worst provides a band of price targets that we think are possible. The band should be moving up and to the right, and the downside should too,” he said.

Here are seven examples of stocks held by the fund that Carlsen discussed:

Take-Two and Activision

Carlsen called Take-Two Interactive Software TTWO, -1.47% and Activision Blizzard ATVI, -0.34% “beneficiaries” of this year’s stay-at-home and social-distancing behavior meant to curb the spread of COVID-19. Shares of Take-Two have returned 4% this year, while Activision is up 13.5%. The broad indexes are down significantly, as you can see in the table below.

“They should put up good numbers this year. Even though we have had demand destruction elsewhere, this is an area where demand can hold up,” he said, adding that there is a longer-term “tailwind” for both video-game developers because of the coming upgrade cycle for Microsoft’s MSFT, -0.09% Xbox and Sony’s SNE, +0.47% PlayStation.

Chewy

Chewy CHWY, -1.08% is known for providing excellent customer service and has “less than a 10% share of total pet spending, expected to be $85 billion in 2020,” according to Carlsen. The online-pet-food service, which provides all sorts of other pet supplies, is an obvious beneficiary of the COVID-19 lockdown. The stock is up 55% this year.

“Total pet spending grows by 4% to 5% each year. The primary driver is people are pampering their pets more than ever. Chewy is a very strong disrupter” to capture a significant portion of the move to online spending, Carlsen said.

SBA Communications

SBA Communications SBAC, +0.71% owns wireless towers and leases space on them to multiple tenants using various technologies.

“Every time you make the tower more dense, in terms of customers, it becomes more profitable. Capex and maintenance cost for a tower are very low,” Carlsen said.

“It is a defensive business model, because customers sign long-term contracts. The contracts include annual price increase escalators,” he added.

One short-term disadvantage is the recently completed merger of T-Mobile US TMUS, +0.73% with Sprint. That means eventually less revenue on towers that had rented space to both companies. Then again, SBAC’s stock is up 27% this year.

The 5G network rollout is another long-term driver for the stock, Carlsen said.

DexCom

DexCom DXCM, +1.22% makes continuous glucose-monitoring systems for diabetes patients.

“The advantage DexCom has is their accuracy is better than their competition. On the glucose monitoring side, they are the absolute leader,” Carlsen said.

The stock is up 47% this year, so Carlsen has trimmed his position. “The long-term potential is exceptional, but we think the current price reflects that. So we would buy on a dip,” he said.

Equifax

Here’s a chart showing the five-year total return for Equifax EFX, +0.64% :

FactSet

You can see the dramatic decline resulting from the customer data security breach disclosed in September 2017. This year the stock is down 5%. The COVID-19 shutdown has led to a decline in consumer-credit applications.

Carlsen stressed that Equifiax has been “transitioning to more of a data-analytics provider” from its traditional credit-reporting business. The company collects data directly from various entities, including banks and utility companies, allowing it to build a very accurate set of information about a person’s credit history, income, assets, bill-paying habits and even their employment status.

Equifax “differentiates itself by the quality of the data they collect. This verified data is worth more than competitors’ data,” Carlsen said.

Following a difficult period of elevated legal costs and efforts to rebuild its brand, Carlsen believes the worst is behind Equifax. Now during the coronavirus crisis there is “a demand void,” he said, but he believes the company ”is set to do very well when the economy recovers.”

Ecolab

Shares of Ecolab ECL, +1.52% are down 8% this year, but as a maker of hygienic-water-purification equipment used in various industries, it is a “good ESG” play for the long term, according to Carlsen. (ESG stands for environmental, social and governance.)

Ecolab also makes the supplies used by its cleaning equipment, which means an annuity stream from most customers.

“They have 10% of a $130 billion global marketplace. They are also known for a world-class sales force,” Carlsen said.

This year represents a challenge because so many of Ecolab’s customers in the hospitality and restaurant businesses have been shuttered. However, there is a long-term opportunity, as these and other industries focus even more on hygiene after the coronavirus restrictions are lifted.

“A lot of people think innovation is science, technology and health care, but we find it all over the place. This is an example of a materials company that is innovative and rewarding shareholders,” Carlsen said.

Outperformance

During 2020, the fund has held up well, with a 9.9% decline (after expenses) through April 23, compared with a 16.3% decline for the S&P 400 Mid Cap Index MID, +1.69% and a 12.8% drop for the S&P 500 SPX, +1.08%. Here are longer-term performance figures through April 23:

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