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
Encore Wire Corporation, based in McKinney, Texas, is in the copper wiring business. It has lost a lot of competitors, and once the building boom continues, its earnings should accelerate tremendously. It is a well-run company with hardly any analyst coverage. It does a great job of cutting costs every year, has limited competition, and should have significant pricing power going forward.
A similar company is Eagle Materials, a producer of building materials based in Dallas, Texas. Cement represents more than half of its business. It has also lost many competitors, while the cement business has very high barriers to entry. The company has a great management team.
Their gypsum wallboard business has not always been very strong, but it makes up 40% to 45% of their business. There has been some oversupply of gypsum wallboard for a while, but hurricane events created real demand in that area. Once the gypsum wallboard makers get to about 85% capacity, pricing power really kicks in. With all the demand and rebuilding in these areas, we have confidence that the wallboard pricing is going up and Eagle Materials will benefit dramatically from the trend.
Q: What would be the reason behind the boom in the cement business?
There has been substantial commercial construction in Texas, especially in North Texas. There are many prospects for infrastructure rebuilding. In many areas, there is deterioration in airports, bridges, and roads, so the building companies will benefit from that. When demand comes back, weíll see earnings come up dramatically. In addition, these types of companies will benefit from tax cuts, because most of them are full taxpayers. Thatís another real stream of future earnings.
A key aspect of the cement business is that it has one of the highest barriers to entry. There are many regulations for building a cement plant and it takes years to get all the permits. It would take another five years to build the plant, which is quite expensive. So, there has been consolidation in industry and fewer players. Martin Marietta bought Texas Industries several years ago, for example.
Q: What are the main issues in the wallboard business?
During the last building boom, the wallboard produced was in terrible shape, with mold and other issues, so now there are many restrictions and regulations. An important aspect is that wallboard is so heavy, that we can only economically move it about 300 miles. If it moves more than that, some of it is lost, because it breaks easily. So, there are circumstances that really prevent a lot of competition in this business.
Q: What drives your portfolio construction process?
The Hodges Fund has less than 40 stocks in the portfolio. The Hodges Small Cap Fund has between 50 and 55 stocks. Typically, our largest position is about 5% of the portfolio. Our average sector weighting would be about 7%, but we donít mind having larger sector exposure.
We do not need to be in every industry or to be represented across all the different categories. We like to find a handful of industries with superior tendencies, such as high barriers to entry. We aim to overweight the most dynamic industries or the ones, for which we have high confidence in their pricing power or lack of competition.
Q: How do you define and manage risk?
We believe that there is a difference between risk and volatility. Typically, the stocks that perform best in an 18-month period are also the most volatile. Most of the stocks that have led the market are quite volatile, because they are perceived in different ways and there are many buyers and sellers.
So, we believe that volatility doesnít necessarily make a stock risky and volatility doesnít scare us. If the fundamentals are solid and we have a model where revenues and profits can grow, we would embrace that situation.
We pay a lot of attention to what we own, what the earnings prospects and the growth rates are. We need to be aware of any changes in these prospects and we discount that into our modeling. We like to buy high-quality companies that have value. In the individual stock selection process, we select stocks that are inexpensive and have significantly higher upside potential than downside risk.
Q: How long do you hold stocks on average?
We typically look for about an 18-month horizon. The intention is to own something for that 18-month cycle, where we can have several quarters for our thesis to play out. In the example of TPL, we have owned the stock since the inception of the small-cap fund.
But we have had higher turnover turned it over in the last couple of years, because the market dictated that we go where value is, or where we feel like underpriced stocks or disconnects exist in the marketplace.
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