Mike Santoli: Craig Hodges is cofounder and CEO of Hodges Capital Management, an investment advisory firm managing about $2 billion for investors. He's been serving as the chairman and portfolio manager of the firm since 1999 focusing on equity selection and investment strategy. Craig is also a member of CNBC Pro's portfolio competition where he's up six percent so far this year. He joins us now to discuss his investment approach, market outlook, and favorite stocks for the rest of the year. Craig, thank you very much for being here, appreciate it.
Craig Hodges: Great to be with you Mike.
Mike Santoli: So, you focus, your firm focuses largely on small and mid cap stocks. Talk a little bit about your approach to navigating your way through what a literally thousands of small and mid cap stocks in the US and also where that sector, if you wanna call it a sector, is positioned right now.
Craig Hodges: Yeah. To me it's the most inefficient part of the market and there's not all that much analyst coverage on the lower ends so that's where you sometimes find your undiscovered, or your opportunities. At Hodges Capital we have seven analysts, three portfolio managers and we make about 3000 company touches a year. We just focus on stocks, that's it. We wanna know as much about US stocks, hopefully, than anybody out there and that's what we spend all of our time doing. And it's information, just get as much information, good and bad as you can.
Mike Santoli: So when you say it's the more, "inefficient part of the market," you kinda touched on this, that it's essentially where fewer investors and analysts focused on these stocks. Many of them are not in the large indexes, necessarily, so therefore there's opportunity for stocks to get mis-priced relative to the fundamentals.
Craig Hodges: Correct. And the other thing that's happened is when, kinda the market making went away and now that we have so much computer trading you can get some wild fluctuations 'cause the markets aren't very deep and that's where you get your opportunities.
Mike Santoli: Interesting.
Craig Hodges: But, you know, just because a stock isn't widely followed doesn't make it a good buy. But when you find a stock that does not have much analyst coverage and they're doing well and doing the right things, you know, that's when our ears perk up.
Mike Santoli: You mentioned 3000 company touches so that's essentially what? You listen to a conference call? You visit with management? How does it work?
Craig Hodges: Correct. You know we keep track of who talks to how many companies on a weekly basis and we wanna get as much information as, you know, we're talking about conference calls, company visits. We have a lot come through Dallas. We probably have eight companies come through a week that we talk to and – when a company's there we wanna know who their best competitor is, who their worst competitor is, who's doing it right, who isn't. So there's a real process that we've developed over the last 50 years of asking the things that get us a knowledgeable about the industry as we can.
Mike Santoli: Yeah, and, you know, just on that general thought of doing the company by company work and operating in a part of the market that's not necessarily as saturated with coverage, there's been this trend really going in the other direction of money going toward index strategy. So basically passively owning the index, typically the larger cap indexes, but all of them. And that is seen as the most efficient way to do it right? You just get low cost exposure to the market. What are the implications of that for your approach?
Craig Hodges: You're exactly right. The ETF business has grown 30 percent for the last decade plus, it's a behemoth out there. But now you have extremely correlated market. People are just basically buying indexes, buying the market. And there's a lot of inefficient priced stocks out there. Not all companies are good, not all are bad but they traded at like a 90 percent correlation so it's our job to find those inefficiencies and to pick the stocks that we think can trade below their intrinsic value or whatever the case maybe. You know, look for those opportunities.
Mike Santoli: And, you know, there's sort of two schools of thought as to the indexing wave. Whether it's in fact made it easier to find those inefficiently priced stocks and then, of course, hope that they get back to something like fair value or whether or not in fact it's just kind of taking the weaker active managers out of the market and leaving it just a tougher market to beat in general.
Craig Hodges: And it is a dilemma. Like, for example, we're underperforming right now a little bit and in the small cap space and that's strictly because there's a fight to quality, utilities, and telco, and consumer staples. That's not what we're looking to do, we're not gonna buy a 30 times earnings utility and a growth account. And so, you have those periods but with the proliferation of everyone just hitting a button and buying, just basically the market, there will be opportunities and that's what our job is. To find those opportunities and focus on them.
Mike Santoli: Now of course the smaller stocks try to bear the brunt of the market turmoil going back, starting about a year ago. In fact really by the indexes the small caps had their own bear market, right? I mean, they really did at those lows in the winter they were down more that 20 percent on the rest of 2000, have clawed their way back and played some catchup. But where do you think we are in the sort of market cycle with large relative to small or small caps relative to the economic cycle.
Craig Hodges: I don't know exactly where we are small caps. I do believe, even though I'm not a large cap manager, I think large caps are really well placed. You've had seven years of money coming out of US stocks into bonds, that will be a disaster at some point. Where does that money go once it does come out? Where, you know the TINA, an acronym –
Mike Santoli: There is no alternative.
Craig Hodges: Right, there is no alternative. The alternative is blue chip dividend paying companies, the most conservative out there. I think you'll see probably five years of multiple expansion but that will trickle down to small caps. And, you know, we feel like that there's always, no matter what's going on in the market, there's always opportunities in small and mid-caps.
Mike Santoli: So, you mentioned that you're not particularly interested in those supposedly safer, stable, expensive, stocks that just give you some income like utilities right now. What are areas where you are finding the opportunities?
Craig Hodges: Yeah there's a lot of stocks that are trading below their replacement cost. You know, interesting things has happened in the market the past couple years. We've seen energy come down and it's, there's no question why energy stocks should get cut in half when oil gets cut in half but there's been a lot of companies that aren't energy stocks that have traded like energy stocks. Like Texas banks, you're talking about like some Texas hotels. Things that are treated like an energy company even like a United Rentals that rents, you know, 20 percent of their business rents to the oil business, that stock's been cut in half. And so that's where the opportunities is, and the opportunities are, you don't even need oil to go back for those things to work. If oil would just stay here people would see those businesses are not oil companies and we're not gonna see $20 oil for the next 10 years.
Mike Santoli: Has the market by now somewhat figured that out? In other words with oil trading in the mid 40s at the moment, nobody really talking about $20 oil again, has the pricing kinda bounced back to say ok they're stable?
Craig Hodges: Somewhat but they're still some tremendous opportunity. There's a lot of, and I keep going back to Texas where we are based, but there's a lot of these Texas banks are still trading half. And, you know, their loan portfolio's are tiny, you know, maybe five percent in most cases. But they're traded like it's the 80s and we're gonna see disasters coming. Like La Quinta that was a $25 stock is about an $11 stock, trading below its replacement cost. The perception is it's a Texas play, 25 percent of their hotels are Texas. So there's a lot of those type of things that still have not recovered, I still think there's a lot of opportunities in this.
Mike Santoli: Now, one of the funds you mentioned is Hodges fund, up about 26 percent this year, but you know of course would've had a tough time, just out of the gate starting the year. Also your portfolio, as everybody, had some trouble finding buys that worked in the first part of this year. Just as a general matter, for an investor, how do you know, when you see the market go against you like that, how do you know whether your thesis is wrong or you wanna buy more or you wanna cut your loses? How do you navigate all that?
Craig Hodges: You know that's the beauty of owning individual stocks as opposed to owning the market or owning an index. In an index you own expensive stocks and cheap stocks but you own the market. When you own individual companies, you know a lot of stocks traded below their intrinsic value, if you shut down the business, sold the assets it would go up. So that gives me a lot of comfort. Knowing that a lot of these names that were, in the first six weeks, the craziest six weeks I've ever had in the business meaning nothing made sense. You saw things that just did – but when you know the companies, know what's going on – I'll give you another great example, you saw maybe what happened with the prison stocks this week?
Mike Santoli: Yeah.
Craig Hodges: We followed those companies for over 25 years. We know them very very well, when we saw the release that it was probably only 10-11 percent of their business that would eventually be affected they were cut in half.
Mike Santoli: Right. So this is the Justice Department saying perhaps they were going to stop using these privately run prisons for certain federal inmates.
Craig Hodges: Yeah. Well they cut those stocks in half that day basically. And we knew that this was not good but it was trading way below, way over done and so we were able to buy a lot of stock and the only reason we were able to do that is 'cause we know that company. We've know it for – Corrections Corp and Geogroup, we've known them for a long time and we know what that – and you have a comfort going in buying and knowing that assets and knowing the intrinsic value of the names.
Mike Santoli: Do you have a particular base case in terms of, let's say what the US economy's looking like and what kinda trajectory we're on when you do do the company analysis as well?
Craig Hodges: Not typically. We don't hold ourselves out as being, you know, very wise or incredibly astute at predicting the market or predicting the economy or even interest rates or all that. We really just focus on companies and if we're right on our thesis with the companies it really shouldn't matter what, you know, the short term fluctuations in the market are. The best scenario for us is kinda where we are now which is a slow growth environment because stock pickers buy name should be able to do well in a slow growth where everything is barely moving. You can put in the stocks that are doing above ordinary that have better management, that have better rates of return, have better, you know, ways to return on investment capital and such.
Mike Santoli: Yeah. I guess even for the managers who are not top down, who don't start with a broad expectation about the economy if you talk to that many companies you must just kinda filter up from there just how things are feeling and looking, right? The part of sectors that seem like oh you know what, things might be coming back or they might be heading into a little bit of a downturn.
Craig Hodges: Yeah, you do. You get a sense and there's been times when the pessimism has been palpable out there. And managements were saying, "It's not bad. It's not great but it's not bad." So you get a sense and I kinda get a sense that's where we are. I mean we're talking one of the most unloved stock markets ever. I mean investor participation is terrible, you've have seven years of money coming out of stocks but yet we're hitting new highs, what does that tell you? It tells you that things are probably better than they're perceived, not booming, not great, but, you know, there's opportunities.
Mike Santoli: It seems like, besides just a general skepticism toward that market there are a lot of these industries that seem to be undergoing, I mean there always are but maybe now more than often may be the case, some kind of structural change. Where it seems like, "Yeah, that might be a cheap stock." And it's a retailer for example but that's just something that's challenge for the long term et cetera.
Craig Hodges: Yeah.
Mike Santoli: Are those areas where you've plucked out value? I mean I know you have only JCPenny for example.
Craig Hodges: Yeah, yeah. To me that's the best looking situation I see out there right now is JCPenny's. It's perceived that it's being eaten up by Amazon and that the mall is dead and that sort of thing, and there's some truth to that. But their turnaround doesn't involve any sort of increase in market share or increase in people going back to the malls, it's the low hanging fruit, the restructuring, the getting the things that they messed up for that last four years right. And you see very simple ways for them to get, you know, they'll earn a billion dollars in ebita and probably earn, within a couple years, $2 a share. The stock at $10, to me is about as easy of thing as I see out there. Now, you do have to fight the prevailing winds of, you know, everything's changing out there but you try to identify what areas that Amazon may not destroy, you know what I'm saying?
Mike Santoli: Sure.
Craig Hodges: People will still try on clothes, people will still go do things but, you know, they wanna touch an appliance or whatever it'd be. So, it's a moving target as you'd say.
Mike Santoli: Sure. So you deal with, obviously your end clients are retail investors generally or individuals?
Craig Hodges: Yeah, and advisors mostly.
Mike Santoli: And advisors as well. What's your sense of them? You talk about how, you know, it's not a very loved market, there's not a lot of public participation, does it seems like that's something that might change? I mean, what would it take if we already got seven years and record highs in the market are they just gonna sit this who cycle out?
Craig Hodges: I think the only thing enforcing it's the wrong decision. That will change when the market is good and they feel like they need to be in the market, but that's the wrong move. Now is when things are cheap and I hear people say we're in a bubble. Man, I don't know of a bubble that money has been going out of for seven years where – there are parts of the market that are expensive, don't get me wrong but, there are a lot of parts of it that are inexpensive.
Mike Santoli: Yeah. That's been the kind of really cautionary word for a while now is that, ok sure interest rates are low and there's a lot of liquidity and at least we have slow positive growth but stocks are expensive. Right, I mean, I think that's a standard thought. Do you think that's just a distortion of the indexes?
Craig Hodges: I do, I believe it's a distortion of the indexes. I keep harping on the exact same things but, you know, in our portfolios we have a PE of about 15 times earnings where the Russell 2000 is about an 18. Our growth plate is much faster than the Russell so we're paying less and getting more. So if you do the individual stock selection you can put together a portfolio that's inexpensive that is growing, but you just can't buy everything.
Mike Santoli: And where does it shake out in terms of, for example, where you're tilted in sectors within your portfolio?
Craig Hodges: We've overweighted what I would consider sectors that have high barriers to entry. The big mistakes I've made in my career are getting in hot areas that are easy to duplicate, you know, where a lot of competition will come in. But things like cement companies, steel companies, you can't build any of those type plans if you wanted to at this point in time. Corrugated paper, even the airline business now has a high barrier of entry because in order to compete you have to have the fuel efficient planes that are 30 percent more efficient than the old planes. So we're attracted to those industries and I think that time will, 'cause of pricing power, time will show well on those industries so we overweight those.
Mike Santoli: Gotcha. Ok, so it's not necessarily, you know, kinda a specific industry sector focus it's just the kinds of businesses that seem to be in those areas?
Craig Hodges: Yea, yes. Exactly right.
Mike Santoli: What could, I guess, kinda knock things off course? If you're looking at the standard risk factors in the companies you own, is it interest rate risk, is it policy, trade policy, the election? Anything that seems like you're constantly coming back that says, you know, we have to worry about that?
Craig Hodges: Yeah. Unfortunately, I'd love to be able to bury my sand and say, "We can just buy companies and hold on them, the good ones." But, you saw the first six weeks and the fact that China can influence our markets so dramatically, you know, we are a little bit hostage to that. So, you know, that's one thing and then of course there's always terrorism and that stuff to worry about and that sort of thing, But we are the best looking house on an ugly block and I do think that capitalism still works and that eventually dollars find the best use of capital, I believe it's here. So I think those things take care of themselves eventually. But I tell anybody that's getting in the market, be prepared for ten percent sell offs. First of all they're good for you, they get all the weak holders out but that's just the world we live in. I don't see a scenario of a big 50 percent like we saw in '08 or that sort of thing, I don't think those things are on the table.
Mike Santoli: Does it feel to you for any reason that we're on the verge of one of the ten percent drops or is it just one of those things that can hit at any time?
Craig Hodges: Yeah, it can hit at any time. I was pretty optimistic at the first of the year and those first six weeks were the craziest thing I've ever seen. I mean it looked like there was no floor in stocks. Luckily we bought a lot of those things 'cause we knew that the values there. People think the election, I think the election actually will be a positive either way it goes. We've had a, not to be political, but we've had a very anti-business atmosphere for a long time, not just eight years but for a long time. It's been harder and harder to do business and I think that people are seeing now that that's only hurting us and that there's some changes there. So I actually think that the market will like both candidates.
Mike Santoli: Two issues that, in terms of kinda corporate matters that come up a lot in this entire cycle really is, buybacks, stock buybacks. Companies essentially using either their cash flow or borrowing some money, buying back stock ____ numbers and also returning cash to shareholders. You know, it's a feature of all bull markets, right, I mean especially that last couple. Yet it sort of seems somehow suspect to a lot of folks. What's your stance on it as a use of capital or as a part of a corporate finance, I guess, policy?
Craig Hodges: I've always been a fan of it. And I know people bash it because they think it's artificially propping up stocks. I don't agree at all. What a management team is supposed to be doing is, "Where is the best use of capital? Should I build more restaurants or are we kinda saturated there? Should we be buying back the stock?" A great example was we owned a good stake in Cracker Barrel which basically retired about half their stock. That's been a phenomenal stock. They haven't killed it necessarily on a same store sales basis, they've done well but the fact that they're retired so much stock, their earnings have gone up. That's real, that's not fake. And so it basically comes down, are you gonna give the money back to shareholders or are is it not best in shareholders hands? Is it best buying new things or buying back stock? So it's a personal decision but I think there's limits, there are some companies that do it too much.
Mike Santoli: Sure. I mean, yeah so an example, let's just say Cracker Barrel. If they buy back a lot of stock and retire a lot of stock, reduce the share count, those holders who have held on just own a proportionally bigger piece of a decent business.
Craig Hodges: That's right, that's exactly right.
Mike Santoli: And are there companies that you own or look at and say, "Oh I really wish that they would invest more, they should have a lower threshold for what it would take to – "
Craig Hodges: Yeah, yeah. Not to give you a specific name but I think one of the problems with large caps is that they have not been investing in their future, they've been buying back stocks. But I guess they think that's the best use of the capital. That's debatable but that is a big talking point for small caps. If you have not invested in growth for the last five years, and you're a big company, how do you get growth? You've gotta go acquire smaller names that can give you growth and that's one reason that we do like the small caps.
Mike Santoli: Yeah, they typically do act as a pretty good play on the that consolidation effect as well. As you've been in the business a while, you've interacted with a lot of investors, what are some of the common mistakes or blind spots that you find the average investor has? Just things to keep in mind sort of as a check on yourself?
Craig Hodges: Yeah. You know, I think that getting in the hot areas is kind of what's hot now, I think that's always been a mistake. You know, if you watch what funds do, funds always bring out new funds of hot areas and those typically is the total wrong thing to do. I think you need to find – if I can say one thing to an investor to look at when they're buying stocks, look at the barriers of entry. If it is easy to duplicate you need to rent that stock not own it. If it's very hard to replace that business then that's a good long term investment if they're using the capital right. So, you know, stay away from hot trends, buy good solid companies with good balance sheets and good management teams. And management teams that own the shares themselves not just, you know, they're working and making a nice payment and they're playing defense trying not to lose their job we want guys that are trying to make wealth with their ownerships of the stocks.
Mike Santoli: You talk about the hot areas, you know, one of the interesting things is to see the way the ETF industry tries to seize on the next thing. Let's say, year and a half ago it was all about, well the dollar's gonna go through the roof so let's come out with currency hedged stock ETFs. One of them that I remember from early this year was basically, it's the stocks in the index except for energy.
Craig Hodges: Yep, if you could carve out one.
Mike Santoli: Right. So there's always one thing to worry about and it seems like maybe they make it almost too easy to say, "Oh look, this is a can't lose."
Craig Hodges: And it's interesting that you bring up ETFs. One of our favorite ideas in the small cap area right now is WisdomTree. They're the largest independent out there and the stocks come from the 20s to around 10 and they've lost a lot of assets because of those very hedged country, Japan and Europe.
Mike Santoli: Yeah, that's right.
Craig Hodges: But that's a good business and somebody will, I think, eventually buy them and so even though we're active managers I do recognize the fact that the ETF business is most likely here to stay and WisdomTree is a good acquisition candidate.
Mike Santoli: Right so basically, you have your established players in the industry look at ETFs being the one area of growth or one of the few and you might as well get somebody with scale.
Craig Hodges: Yes, correct.
Mike Santoli: How do you think your industry is gonna hold up? I mean, is it just a, kind of a cyclical thing where people don't really want as many actively managed funds and people are kind of –
Craig Hodges: I think for the time being, but money goes to where money's being made. And our industry, the active industry, will only do well if we outperform and people gravitate to that. That's the bottom line. So if we continue to underperform it's gonna be hard. But, 30 years I've done this, I've seen it come and go. And we've had, like I've mentioned, we've had just incredible stock liquidations. I mean stocks are not loved by people. People just, they'd rather buy a fund or, you know, millennials hardly even buy stocks at all.
Mike Santoli: Sure.
Craig Hodges: There will be a, the pendulum at some point will swing the other way. I don't know when but money will go to where it's used best.
Mike Santoli: And do you think that small caps as a category, do you kind of pitch it as a diversifier or as kind of, you know, for certain parts of the cycle it works for certain investors it works?
Craig Hodges: It's a part of an investment process. You know, you don't want all your money just in small caps, especially if you're worried about short term performance, or if you're older. If you're a younger person I could see why you'd wanna do the most active part of the market which is small caps. But, you know, I think there will always be opportunities in small caps and, like I mentioned, I think large caps are gonna do fantastic, I think you'll see multiple expansion for the next five years of those but I still see tremendous opportunities in small caps.
Mike Santoli: Right, I mean, it's hardly a zero sum game right. I mean usually in most cycles they both can do ok.
Craig Hodges: I can't imagine what we'd do, it's become less and less prevalent. There's less and less people doing what we do which is picking individual companies. That's become less and less prevalent but I think there'll always be a spot there.
Mike Santoli: And, you know, one aspect of that general phenomenon? Fewer IPOs and in fact fewer stocks in general right?
Craig Hodges: That's true.
Mike Santoli: I mean a lot fewer stocks on the market right now than there were 10-15 years ago.
Craig Hodges: Very, very true. And that's an issue. There is a pool of money out there by mandate needs to be invested for a rate of return and luckily it's found a home in kind of the bond fund and bond area but at some point it's gonna need to find a new home and, where does it go? I mean there's not a lot of alternatives and capitalism and buying US companies, I think, will always be in vogue and there's opportunities there.
Mike Santoli: Maybe it'll come back in fashion. All right Craig, thank you very much. Appreciate it.
Craig Hodges: Thank you Mike, enjoyed it.
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EBITA is an acronym for earnings before interest, taxes and amortization. To calculate a company's EBITA, start with its earnings before tax (EBT), which can be found on the income statement, and add interest and amortization expenses back in. EBITA is a variation of the more commonly used EBITDA, which deducts depreciation expenses. Both are used to gauge a company's operating profitability, that is, the earnings it generates in the normal course of doing business, ignoring capital expenditures and financing costs. Both measures are sometimes considered indications of cash flow.
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