Undiscovered Quality in Small and Mid Caps
Author: Ticker Magazine
Last Update: Feb 26, 12:11 PM EST
|Volatility does not necessarily mean risk, and one does not need to invest in every sector to be successful, according to Craig D. Hodges, portfolio manager and co-founder of Hodges Funds. Relying on its own extensive research to find opportunities ahead of Wall Street, the fund aims to invest in industries with superior tendencies, such as high barriers to entry, or in companies with superior products or services that the market has not yet accounted for.
ĎThe one thing we donít do is filter stocks. We donít run screens. Some of our greatest stocks would not have looked good screening for undervalued ideas at the time when we came across these ideas.Ē
Q: What is the history of the fund? How has it developed through the years?
I founded Hodges Capital Management with my father in 1989. The firm is based in Dallas, Texas. In the early 1990s, after we started our business, our clients were clamoring for mutual funds. We started our first fund, the Hodges Fund, on October 9, 1992. The original concept was a multi-cap, go anywhere fund. In the first ten years of its existence, that fund did really well, but never received much traction. However, in the period between 2003 and 2008, the fund grew dramatically to $850 million.
During those five years, the small-cap portion of the Hodges Fund compounded about 36%. We felt that with our process and style of investing, a small-cap fund would do well. As a result, we started the Hodges Small Cap Fund with $3 million of investor capital in 2007. Between 2009 and 2015, the fund grew noticeably and reached $2.3 billion in assets. For the 10 year life of the Hodges Small Cap Fund, it ranks in the top 7% verses our peers.
We had a tremendous year in 2016 and the Hodges Fund was up about 40%, compared to a gain of about 12% for the broader market averages.
Q: What core beliefs guide your investment philosophy?
The investment philosophy of the fund is to own companies that we feel have the best management teams in the best areas of the marketplace, or companies with a superior product or service that the market has not discovered yet. The basic tenet of our fund is we do our own independent research and do not rely on Wall Street research.
Q: How do you translate that philosophy into an investment strategy and process?
The one thing we donít do is filter. We donít run screens. Some of our greatest stocks would not look good on screens at the time we came across these ideas.
We look for ideas anywhere and everywhere. For example, I recently went to the ICR Conference in Orlando and the CES trade show in Las Vegas looking for ideas and opportunities, which arenít necessarily absorbed by the marketplace.
We read a variety of industry publications and look for things that are out of the ordinary. We subscribe to papers like Investorís Business Daily, which has a lot of good information on emerging and new companies. We meet at least eight to ten companies in our offices in Dallas every week.
We also do some technical analysis to see if there are any patterns that are telling of changing fortunes of a company. Also, our portfolio management team stays busy hunting down information, turning over stones where most investors donít go.
We have 6 analysts and 3 Portfolio Managers that all look for ideas. We meet three times a week and everyone shares information. Each year we make about 2600 company touches over more than 800 companies. We also talk to their competitors, customers, and suppliers; doing all sorts of channel checking. So the entire team is charged with getting as much information as possible and being as knowledgeable about these companies as humanely possible.
We are not necessarily traders, but if we buy a stock and it appreciates quickly, we are not afraid to sell it when it is ahead of itself.
Q: Could you illustrate your process with some specific examples of investments?
One of our largest holdings is a company called Texas Pacific Land Trust (TPL). It was created 130 years ago in the wake of the Texas and Pacific Railway bankruptcy.
The company is a gradual self-liquidating trust, which generates cash flow via periodic land sales and oil royalties from owned land in Texas. TPL owns around 900,000 acres in 20 counties in West Texas, most of the acreage is in the Permian Basin where all the big fracking and oil fields are.
When we first started buying over 25 years ago, 4% to 5% of the shares were retired every year by land sales. That money goes into buying back its shares, so the company will always have a shrinking share base. However, we knew that over five and 10 years land would get more and more valuable. Over the years, land sales have peaked and paused, but in the last 5 years, due to fracking, the land value has gone up quite a bit. The stock made a move from about $20 to $550 per share.
Every year we go to each county and get the records of land sales to estimate the average for that countyís land sales. Then we assess how many acres the company has in that county and what that land is worth. We process a lot of statistical information on the land and its worth.
TPL is the largest position in our small-cap fund. We bought the stock when it was $82 and today trades over $500, so we have made tremendous gains. But I still think the stock has significant upside, because more and more people want to drill the land. TPL also receives royalties and grazing rights. A new catalyst could be the water business, because fracking requires a lot of water and it has become a bigger and bigger issue. With that much land, TPL has tremendous opportunities in the water business.
This is a stock with no analyst coverage and not many shareholders. I think that one of the reasons behind the huge growth in the stock price is that many people now see the potential for a royalty play.
Q: When you select the stocks, do you set price targets? What is your sell discipline?
No, we donít. For example, when I first got into business co-managing this fund with my father, one of the stocks I bought was Apple, Inc. The stock went from $40 to $95 (pre-split) over three months and I sold it at $95. I was able to repurchase the stock in the $120 range after it came out with the iPhone and, obviously, it has gone up tremendously since then.
We always need to update our information and know the evolving story. If we buy something and the situation deteriorates and changes the original thesis, it is better to get out of the stock quickly and to put that capital into something with better prospects. We wouldnít want to be stuck in a dead stock, waiting for a turnaround.
The key is to always be on top of new information. If a stock goes up significantly in a short period, and there is no reason for additional upside, we would trim that position. If it pulls back, we would buy more. Thatís why we do so many company meetings, read all the news and research, and rely on our investment process. We need all the information that we can get.
Q: Could you give us another example from a different industry?