“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
– Albert Einstein
Relative returns for the Hodges Funds were mixed in the recent quarter, as the rally in U.S. stocks continued in 3Q17. Despite the constant uncertainty surrounding the actions associated with much of the policy rhetoric coming out of Washington D.C., we have been encouraged with the fundamental outlook and regulatory environment for most domestic businesses. As the prospects for continued earnings improvement over the next twelve months appear likely for many of the companies in our portfolios, we see value and growth opportunities in many of the cyclical areas of the market such as financials, consumer discretionary, technology, and industrials, whose earnings had been stagnant in previous years due to sluggish growth in the U.S. economy. By contrast, we see less long-term opportunities in utilities, telecom, and consumer staples which have benefited the most from low interest rates and a flight to “safety” in recent years.
Returns (% Retail Class) as of 09/30/2017
|3Q2017||1 YR*||3 YR*||5 YR*||10 YR*||SI*||Inception*||Gross||Net|
|Small Cap Fund (HDPSX)||4.97||9.85||2.02||10.48||--||9.17||12/18/07||1.28||--|
|Russell 2000 Total Return||5.67||20.74||12.18||13.79||--||8.73|
|Hodges Fund (HDPMX)||5.35||12.29||6.28||16.98||5.40||10.21||10/09/92||1.30**||1.18**|
|S&P 500 Total Return||4.48||18.61||10.81||14.22||7.44||9.79|
|Blue Chip Equity Fund (HDPBX)||5.95||21.63||6.34||13.18||--||11.27||09/10/09||1.45**||1.30**|
|Russell 1000 Total Return||4.48||18.54||10.63||14.27||--||14.00|
|Pure Contrarian Fund (HDPCX)||1.92||-0.93||-0.47||7.11||--||7.50||09/10/09||2.26**||1.41**|
|S&P 500 Total Return||4.48||18.61||10.81||14.22||--||13.93|
|Small-Mid Cap Fund (HDSMX)||4.49||14.18||5.41||--||--||6.89||12/26/13||1.85**||1.41**|
|Russell 2500 Total Return||4.74||17.79||10.60||--||--||8.56|
|Small Intrinsic Value Fund (HDSVX)||7.28||19.29||9.96||--||--||9.30||12/26/13||1.40**||1.30**|
|Russell 2000 Value Total Return||5.11||20.55||12.12||--||--||8.18|
* Average Annualized
**The Advisor has contractually agreed to reduce its fees and/or pay Fund expenses until at least July 31, 2018.
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling 866-811-0224. The funds impose a 1.00% redemption fee on shares held for thirty days or less. Performance data quoted does not reflect the redemption fee. If reflected, total returns would be reduced.
In general, we have been encouraged with the broad improvement in corporate earnings this year, which has been largely driven by revenue growth and operating leverage instead of the cost cutting of recent years. Although the upward move in the market indexes has recently been driven by a broader group of stocks, we believe this is an ideal time to scrutinize the fundamentals of individual companies in each portfolio. Although not true for every company, we see further opportunities for earnings improvement as input costs stabilize and consumption improves. Furthermore, the potential for corporate tax reform could provide an added tailwind for corporate earnings. While we believe the market has not priced in the benefits of proposed changes in corporate taxes, we do believe such reform would increase capital investment in businesses of all sizes, but would especially benefit smaller U.S. companies which typically carry the greatest tax burden. Moreover, we are not attempting to market-time interest rates, currency fluctuations, or commodity prices. As always, we are making a conscious effort to remain objective and open-minded in our buy and sell decisions, while continuously looking for new opportunities around every corner. Although many areas of the U.S. equity market appear fairly valued, we believe that there are still opportunities to invest in great businesses that are trading at bargain prices in segments of the market that are out of favor or simply misunderstood by Wall Street.
Despite new all-time highs in the recent quarter, we view the investing landscape for U.S. equity valuations as still in check with the S&P 500 Index trading at 17.7X forward earnings estimates according to FactSet. The inverse of this multiple is an earnings yield around 5.65%, compared to the 10-year treasury yield of 2.33% at quarter end. We believe this risk premium indicates that the potential reward for holding stocks still outweighs the underlying potential downside risk.
The research team at Hodges Capital Management has continued to rigorously gather and analyze firsthand information from a broad scope of publicly traded companies, which has resulted in a few worthwhile observations. First, most management teams seem optimistic regarding the prospects for demand growth, pricing power, margin improvement and earnings growth compared to a year ago. Second, corporate balance sheets remained generally in good shape, allowing many companies to reinvest in capital projects, make strategic acquisitions, buy back shares, and historically pay dividends. While we invest in individual companies, not stock markets, we can’t help but point out that most individual and institutional investors still remain underweight small cap equities following a prolonged period of outflows from actively managed domestic equity funds. In the past five years, there has also been a meaningful rotation from active to passive investing in U.S. stocks. In many cases, passive exchange traded funds (ETFs) offer investors the obvious advantages of low fees, tax efficiencies, and intraday liquidity. However, we believe the large scale increase in passive investing has had a structural impact on the capital markets by interrupting the natural price discovery of individual stocks and creating trading inefficiencies in smaller, less known stocks. While this can be frustrating at times, it is in our opinion that such inefficiencies create opportunities for active managers to take advantages of mispriced stocks.
While the final quarter of 2017 will likely not be without its unique challenges, we remain constructive on the investing landscape over the next twelve months despite that fact that the market, as measured by the S&P 500, has not seen a correction of more than 5% in over a year. In most cases, we would view two or three corrections of more than 5% as normal within any given year and view such pull backs as a healthy mechanism for keeping stock market valuations in check throughout a typical bull market. In the midst of such corrections, we have historically found bargains in well-run businesses that may become oversold during periods of volatility. Although the macro conditions that impact the daily fluctuations in stock prices can seem overwhelming at times, we always fall back to the simple idea that stock prices over the long run are not a function of news headlines or political rhetoric, but instead are determined by future earnings and cash flows of each underlying business. In conclusion, we see this as a good time for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.
Hodges Small Cap Fund (HDPSX)
During the third quarter of 2017, the Hodges Small Cap Fund experienced a gain of 4.97% versus a gain of 5.67% for the Russell 2000 Index. While the fundamental philosophy, portfolio managers, and core investment disciplines have not changed since the Fund’s inception, underperformance in the recent quarter reflected a lack of exposure to many areas of the market that experienced the greatest momentum. The Fund has been underweight many of the stocks with higher price/earnings multiples in healthcare and technology. As the strong have seemed to get stronger throughout this year, we have resisted chasing after small cap momentum stocks that appear expensive relative to their underlying fundamentals and instead have focused on areas that we see the best long-term prospects for future earnings and cash flow.
Despite disappointing lagging performance this year we believe the Hodges Small Cap Fund remains well diversified across industrials, transportation, financial services, technology, and consumer-related names that we expect could contribute to the Fund's long-term performance. The Fund has recently taken profits in several stocks that appeared fairly valued, and established several new positions that we view as having an attractive risk/reward profile. The total number of stocks held in the Fund at the end of the quarter was 56 compared to 66 at the beginning of this year. Top ten holdings at quarter-end represented 33.59% of the Fund's holdings and included Texas Pacific Land Trust (TPL), Eagle Materials (EXP), U.S. Steel (X), Encore Wire Corporation (WIRE), Hilltop Holdings (HTH), Tower Semiconductor (TSEM), Legacy Texas Financial Group (LTXB), RSP Permian (RSPP), KapStone Paper & Packaging (KS), and Air Transport Services Group (ATSG).
It is our belief that the nature of small cap investing can provide opportunities for active portfolio management in just about any type of market. That being said, we view the current environment as an especially advantageous period for active stock picking within the small cap segment of the market. However, small caps (as measured by the Russell 2000 Index) outperformed the broader market (as measured by the S&P 500 Index) in the recent quarter, experiencing gains of 5.67% and 4.48% respectively. Moreover, we expect small cap investing to require a greater degree of individual stock selection and are now focusing on a number of areas within the small cap universe that, in many cases, are underfollowed or ignored by larger institutional investors. In the current environment, we expect merger activity to pick up as larger companies seek to grow by acquiring smaller businesses that can complement or expand their addressable markets. In our opinion, small caps may also be in the best position to benefit from corporate tax reform as they tend to have more simplistic capital structures and exposure to the domestic economy. For the most part, we expect these factors to support valuation multiples for small cap stocks.
As of 09/30/2017
Hodges Small Cap Fund vs Russell 2000
Hodges Fund (HDPMX)
The Hodges Fund's third quarter return amounted to a gain of 5.35% compared to a gain of 4.48% for the S&P 500 Index. Positive relative performance in the recent quarter was attributed to stock selection in several of the Fund’s top holdings. Despite the uncertainty surrounding many economically sensitive areas of the market, we believe several of the Fund’s energy, technology, and consumer discretionary stocks hold the potential for upside over the next twelve to eighteen months.
The Hodges Fund remains focused on investments where we have the highest conviction. The number of positions held in the Fund at the end of the recent quarter was 42, which was down from 62 positions at the beginning of the year. During the recent quarter, we took profits in a few stocks that appeared to offer less additional upside potential relative to their downside risk, increased the size of several positions in which we remain convicted, and entered into several new positions. For example, the Hodges Fund sold its remaining position in Amplify Snack Brands (BETR) and exited its stake in Timken Steel (TMST), while adding to or entering into new positions such as Builders FirstSource (BLDR), which is a leading distributor of building materials, and Integrated Device Technology (IDTI), a small cap producer of analog semiconductors. The top ten holdings at the end of the quarter included Texas Pacific Land Trust (TPL), American Airlines Group (AAL), Gogo (GOGO), Southwest Airlines (LUV), Facebook, Inc. (FB), Nutanix, Inc. (NTNX), Eagle Materials, Inc. (EXP), Encore Wire Corporation (WIRE), Builders FirstSource, Inc. (BLDR), and Ring Energy, Inc. (REI), which represented 40.86% of the Fund's holdings.
As of 09/30/2017
Hodges Fund vs S&P 500
Hodges Blue Chip Equity Income Fund (HDPBX)
The Hodges Blue Chip Equity Income Fund experienced a gain of 5.95% in the third quarter of 2017 compared to a gain of 4.48% for the Russell 1000 Index. Solid performance relative to the benchmark reflected strength in a couple of the Fund’s larger holdings, Boeing (BA) and AbbVie (ABBV). Looking ahead, we seek to find plenty of attractive high quality blue-chip stocks that offer upside potential in addition to dividend income as stable corporate profits support the ability of companies to pay out dividends. The Blue Chip Equity Income portfolio remains well diversified in companies that we believe can generate above average income and total returns on a risk adjusted basis. The top ten holdings at the end of the quarter represented 46.53% of the Fund’s assets and included The Home Depot, Inc. (HD), Microsoft Corporation (MSFT), Facebook (FB), Apple (AAPL), Johnson & Johnson (JNJ), Boeing Company (BA), Citigroup, Inc. (C), Delta Airlines (DAL), Union Pacific Corporation (UNP), and Visa, Inc. (V).
As of 09/30/2017
Hodges Blue Chip Equity Income Fund vs Russell 1000
Hodges Pure Contrarian Fund (HDPCX)
Although the Pure Contrarian Fund stood out as our best performing fund last year by generating a return of 70.51%, the Fund underperformed in the recent quarter experiencing a gain of 1.92% versus a 4.48% gain for the S&P 500 Index. Lagging relative performance in the most recent quarter was largely attributed to a pullback in some of the airlines in the portfolio, which we continue to view as compelling long-term opportunities.
Although timing a recovery in contrarian stocks can be tricky over short periods of time, we believe this strategy could be rewarding over a long investment horizon. We also expect this strategy to be less correlated with the broader market due to the general nature of contrarian investing. During the recent quarter, we continued to position the Fund in out-of-favor investment opportunities that we believe offer the best upside potential relative to their underlying risk. The top 10 stocks in the Fund at the end of the quarter represented 49.04% of the Fund's holdings. These stocks included Mesabi Trust (MSB), Comstock Resources (CRK), Cleveland-Cliffs, Inc. (CLF), Gogo, Inc. (GOGO), Ring Energy, Inc. (REI), American Eagle Outfitters, Inc. (AEO), Spirit Airlines, Inc. (SAVE), Gilead Sciences, Inc. (GILD), Dixie Group, Inc. (DXYN), and Chico’s FAS, Inc. (CHS).
As of 09/30/2017
Hodges Pure Contrarian Fund vs S&P 500
The returns shown for HDPCX were achieved during a period of generally rising market values.
Hodges Small-Mid Cap Fund (HDSMX)
For the third quarter of 2017, the Hodges Small-Mid Cap Fund experienced a gain of 4.49% compared to a gain of 4.74% for the Russell 2500 Index. The Fund’s unfavorable relative performance was attributed to weakness in two stocks that declined by more than 30% in the recent quarter that included movie theater chain, AMC Entertainment Holding (AMC), and a frac sand provider tied to oil and gas production, Fairmount Santrol Holdings (FMSA). The top ten holdings at the end of the quarter represented 43.74% of the Fund's holdings and included Veritex Holdings (VBTX), Select Energy Services, Inc. (WTTR), Norwegian Cruise Line (NCLH), Conn’s Inc. (CONN), D.R. Horton, Inc. (DHI), WPX Energy, Inc. (WPX), Affiliated Managers Group, Inc. (AMG), Pilgrim’s Pride Corporation (PPC), Bioverativ, Inc. (BIVV), and Eagle Materials, Inc. (EXP).
As of 09/30/2017
Hodges Small-Mid Fund vs. Russell 2500
Hodges Small Intrinsic Value Fund (HDSVX)
The Hodges Small Intrinsic Value Fund experienced a gain of 7.28% in the September quarter compared to a gain of 5.11% for its benchmark, the Russell 2000 Value Index. Although the Fund’s performance in the recent quarter was ahead of the benchmark, value stocks in general have trailed growth stocks recently on a relative basis. Furthermore we would like to highlight that the outperformance in the recent quarter saw no benefit from the effects of sector allocation and had all of its outperformance attributed to individual stock selection. The top ten holdings at the end of the quarter represented 30.74% of the Fund's holdings and included Triumph Bancorp (TBK), TriState Capital Holdings, Inc. (TSC), Dycom Industries, Inc. (DY), Farmer Bros. Co. (FARM), Veritex Holdings, Inc. (VBTX), Tower Semiconductor Ltd. (TSEM), Emergent BioSolutions, Inc. (EBS), Integrated Device Technology, Inc. (IDTI), Westwood Holdings Group, Inc. (WHG), and KapStone Paper and Packaging (KS).
As of 09/30/2017
Hodges Small Intrinsic Value Fund vs Russell 2000 Value
In conclusion, we remain encouraged by the long-term investment opportunities surrounding the Hodges Mutual Funds. By offering six distinct mutual fund strategies that cover most major segments of the domestic equity market, we have the opportunity to serve the diverse needs of most financial advisors and individual investors. Our entire investment team of portfolio managers, analysts, and traders are rigorously studying companies, meeting with management teams, observing trends, and attempting to navigate today's volatile financial markets. Feel free to contact us directly if we can address any specific questions.
The above discussion is based on the opinions of Eric Marshall, CFA, and is subject to change. It is not intended to be a forecast of future events, a guarantee of future results, and is not a recommendation to buy or sell any security. Portfolio composition and company ownership in the Hodges Funds are subject to daily change
The fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Hodges Funds, and it may be obtained by calling 866-811-0224, or visiting www.hodgesmutualfunds.com. Read it carefully before investing.
Mutual fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater for investments in emerging markets. Options and future contracts have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. These risks may be greater than risks associated with more traditional investments. Short sales of securities involve the risk that losses may exceed the original amount invested. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Investments in small and medium capitalization companies involve additional risks such as limited liquidity and greater volatility. Funds that are non-diversified are more exposed to individual stock volatility than a diversified fund. Investments in companies that demonstrate special situations or turnarounds, meaning companies that have experienced significant business problems but are believed to have favorable prospects for recovery, involve greater risk.
Value investing carries the risk that the market will not recognize a security’s inherent value for a long time, or that a stock judged to be undervalued may actually be appropriately priced or overvalued.
Diversification does not assure a profit or protect against a loss in a declining market.
Active investing has higher management fees because of the manager’s increased level of involvement while passive investing has lower management and operating fees. Investing in both actively and passively managed mutual funds involves risk and principal loss is possible. Both actively and passively managed mutual funds generally have daily liquidity. There are no guarantees regarding the performance of actively and passively managed mutual funds. Actively managed mutual funds may have higher portfolio turnover than passively managed funds. Excessive turnover can limit returns and can incur capital gains.
Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.
Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The S&P 500 Index is a broad based unmanaged index of 500 stocks that is widely recognized as representative of the equity market in general. The Russell 1000 Index is a subset of the Russell 3000 Index and consists of the 1,000 largest companies comprising over 90% of the total market capitalization of all listed stocks. The Russell 2000 Index consists of the smallest 2,000 companies in a group of 3,000 U.S. companies in the Russell 3000 Index, as ranked by market capitalization. The Russell 2500 Index consists of the smallest 2,500 companies in a group of 3,000 U.S. companies in the Russell 3000 Index, as ranked by market capitalization. The Russell 3000 Index is a stock index consisting of the 3000 largest publically listed companies, representing about 98% of the total capitalization of the entire U.S. stock market. You cannot invest directly in an index. The Russell 2000 Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Value Index is constructed to provide a comprehensive and unbiased barometer for the small-cap value segment. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set and that the represented companies continue to reflect value characteristics. It is not possible to invest directly in an index.
Cash Flow: A revenue or expense stream that changes a cash account over a given period.
Price/earnings: The most common measure of how expensive a stock is.
Earnings Growth is not a measure of the Fund’s future performance.
Forward Earnings Yield: The same earnings per share for the projected 12-month period divided by the current market price per share.
Hodges Capital Management is the Advisor to the Hodges Funds.
Hodges Funds are distributed by Quasar Distributors LLC.