October 13, 2022
Manager’s Commentary - Third Quarter 2022 Review

“The key to making money in stocks is not to get scared out of them.” -Peter Lynch

U.S. stocks experienced a dramatic sell-off that accelerated in the final weeks of the third Quarter of 2022, as global economic uncertainty arose from inflationary pressures and the Fed hiked interest rates at the fastest pace in forty years. As a result, PE multiples in the recent quarter further contracted to adjust to the reality of higher interest rates and slower earnings growth. The S&P 500 Index posted a loss of 4.88% in the third quarter, resulting in a year-to-date decline of 23.87%. While the recent turbulence in financial markets has been unsettling, three of the four Hodges Mutual Funds have maintained positive year-to-date returns relative to their respective benchmarks as of September 30, 2022. While our portfolios remain laser-focused on fundamental investing and individual stock selection, there were few places to hide in the recent quarter as just about every asset class saw the effects of a broad repricing of most risk assets.         

As we size up the third-quarter turmoil in financial markets, investors face a wall of uncertainty regarding the trajectory of interest rates and the prospects for changing economic conditions in 2023. Further uncertainty exists from geopolitical unrest, the reliability of global supply chains, and the upcoming midterm elections. In our opinion, the year-to-date sell-off has priced a slowdown in the global economy next year and an appropriate contraction in PE multiples relative to current interest rates. According to the most recent data published by FactSet, the S&P 500 is trading at approximately 15.4X forward earnings estimates compared to 21.2X at the beginning of the year and the five-year average of 18.6X. Although PE multiples have contracted, the inverse of the S&P 500 quarter-end PE multiple reflected an earnings yield of 6.49%, which was still well above the 10-year Treasury yield of 3.83% at quarter-end. The big macro questions are now; how much will the global economy slow next year, and to what degree will it drag on corporate earnings and cash flow? Recent discussions that our investment team has had with public company management teams over the past months suggest earnings for most have held up in the September quarter but visibility over the next couple of quarters is mixed and less certain. However, not every economic slowdown looks the same, and not every business will be affected the same by potential macro headwinds. In this environment, we believe active portfolio management becomes essential to navigate quickly changing business conditions across many sectors. Furthermore, prevailing inflation, a slowdown in the economy, and higher interest rates favored stocks with solid balance sheets whose underlying assets can produce stable cash flow and earnings. Although the market is pricing in a more challenging macro environment for earnings in the balance of the year, we still see a favorable risk/reward in stocks that have the staying power to deal with volatile commodity prices and curtailed discretionary spending. Challenging macro conditions and the recent sell-off in stock prices will likely result in new sector leadership in the months ahead. With this in mind, the Hodges Capital Management investment team has positioned our portfolios to benefit from shifting economic trends and secular and structural changes across different industries. 

We spend little time predicting short-term fluctuations in interest rates, foreign currencies, or commodity prices. However, we pay close attention to how prices and, more importantly, the pricing power that our portfolio companies exhibit within the goods and services they produce. For many businesses, inflation and a slowdown in demand could adversely impact profit margins and revenues in the months ahead. Companies that exhibit pricing power and a low threat from substitute products can often pass on higher costs and see profit margins benefit from an inflationary environment. As a result, we are overweighting our portfolios with growth and value stocks that we believe can create shareholder value despite challenging macro conditions.

As we enter the year's final quarter, we are reminded of an old Peter Lynch quote; “The key to making money in stocks is not to get scared out of them.” As we attempt to capitalize on the recent sell-off, there is no shortage of scary prevailing macro headlines and economic uncertainty. What we know for sure is what we do not know. We do not know the day that the bear market will bottom, the peak level of interest rates, or the severity of an economic slowdown. We do know that investor sentiment turned negative at the end of the September quarter, and the P/E multiples for the Russell 2000 and S&P 500 have contracted year-to-date by 36% and 29%, respectively. Specific sectors of U.S. stocks, such as housing, transportation, retail, semiconductors, and other cyclicals, appear to have priced in a meaningful slowdown in the months ahead. The lack of capital flows into equities, and overall cash levels indicates that investors are defensively positioning portfolios, which is part of the bottoming process for any bear market. The big question in the coming months is: What will investors be willing to pay for future earnings in a rising interest rate environment, and what earnings expectations are priced into individual stock prices? We believe the PE multiple for the broader market has adjusted appropriately to the current interest rate environment. However, this is not true for every stock, as we see the potential to unlock value for many under-the-radar companies in our portfolios.

During this arduous sell-off, the investment team at Hodges Capital is rigorously looking for bargains in businesses that we believe are well-run and control their destiny by relying on ingenuity and well-calculated business decisions rather than day-to-day momentum in the stock market. Investors in the Hodges Funds can be assured that we are not changing our core investment discipline, designed to seek out quality companies running great businesses with excellent management teams trading at reasonable prices. Furthermore, we see this as an ideal environment for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.

Returns (% Retail Class) as of 9/30/2022

Hodges Small Cap Fund (HDPSX) 

The return for the Hodges Small Cap Fund amounted to a loss of 1.98% in 3Q22 compared to a loss of 2.19% for the Russell 2000 Index. As of September 30, 2022, the Fund's year-to-date return amounted to a loss of 22.08% compared to a loss of 25.10% for the Russell 2000 Index during the same period.   Although small-caps have been underperforming large-cap stocks this year, we view the current risk-reward for holding quality small-cap stocks as attractive. While small-cap stocks tend to experience greater volatility during a period of market turmoil, we expect this segment to generate above-average relative risk-adjusted returns over the long term. 

The Hodges Small Cap Fund remains well diversified across industrials, transportation, financial services, technology, and consumer-related names, which we expect to contribute to the Fund's long-term performance. The Fund recently took profits in several stocks that appeared overvalued relative to their underlying fundamentals and established several new positions with an attractive risk/reward profile. The total number of stocks held in the Fund increased from 48 to 50 during the recent quarter. The top ten holdings amounted to 39.11% of the Fund's holdings and included SM Energy Company (SM), Matador Resources Company (MTDR), Texas Pacific Land Corporation (TPL), Commercial Metals Company (CMC), Eagle Materials Inc. (EXP), Texas Roadhouse Inc. (TXRH), Vista Outdoor Inc. (VSTO), Diodes Inc. (DIOD), Hilltop Holdings Inc. (HTH), and Taylor Morrison Home Corp. (TMHC).

Hodges Fund (HDPMX)

The Hodges Fund's third-quarter 2022 return amounted to a gain of 0.12% compared to a loss of 4.88% for the S&P 500 Index. Furthermore, the Fund's total year-to-date return as of September 30, 2022, amounted to a loss of 30.88%, compared to a loss of 23.87% for the S&P 500 Index. In the recent quarter, improved relative performance was attributed to a handful of consumer discretionary and energy stocks that held up well in the recent quarter. The Hodges Fund’s turnover has recently picked up to take advantage of volatile market conditions. We have upgraded many portfolio holdings into stocks that we believe offer above-average returns relative to their downside risks over the next twelve to eighteen months.

While we are disappointed with the Fund's most recent performance, the Hodges Fund's portfolio managers remain laser-focused on investments where we have the highest conviction based on fundamentals and relative valuations.    The number of positions held in the Fund at the end of the recent quarter decreased from 36 to 35 positions at the beginning of the quarter. On September 30, 2022, the top ten holdings represented 51.02% of the Fund's holdings. They included Texas Pacific Land Corporation (TPL), Matador Resources Company (MTDR), Chesapeake Energy Corporation (CHK), ON Semiconductor Corporation (ON), Uber Technologies Inc. (UBER), Encore Wire Corp. (WIRE), Topgolf Callaway Brands Corp. (MODG), Cleveland-Cliffs Inc. (CLF), CyberArk Software Ltd. (CYBR), and Commercial Metals Company (CMC).

Hodges Small Intrinsic Value Fund (HDSVX) 

The Hodges Small Intrinsic Value Fund experienced a loss of 4.9% in the third quarter of 2022 compared to a loss of 4.61% for its benchmark, the Russell 2000 Value Index. The return for the first nine months of 2022 amounted to a loss of 15.61% compared to a loss of 21.12% return for the Russell 2000 Value Index. The Fund's solid relative performance over the quarter was attributed to several of the Fund's energy and industrial stocks. The Fund had a total of 42 positions at September 30, 2022. The top holdings represented 35.62% of the Fund's holdings and included Texas Capital Bancshares, Inc. (TCBI), Chesapeake Energy Corporation (CHK), Chord Energy Corp (CHRD), Eagle Materials Inc (EXP), Stratus Properties Inc. (STRS), Legato Merger Corp. (LGTO), HighPeak Energy Inc. (HPK), Builders FirstSource, Inc. (BLDR), and Vista Outdoor Inc (VSTO).

Hodges Blue Chip Equity Income Fund (HDPBX)

The Hodges Blue Chip Equity Income Fund was down 4.71% in the September quarter of 2022 compared to a loss of 4.61% for the Russell 1000 Index. The Fund experienced a negative return of 20.63% compared to a loss of 24.59% for the Russell 1000 Index for the nine months ending September 30, 2022. Positive relative performance in the recent quarter was attributed to stock selection among a handful of the energy and technology names. Although large-cap stocks have held up better than small and mid-cap stocks during the recent sell-off, we see the current investing landscape as offering plenty of attractive, high-quality dividend-paying stocks with solid upside potential. We expect underleveraged balance sheets and corporate profits across most blue-chip stocks to support stable dividends over the next several years. The Blue Chip Equity Income Fund remains well-diversified in companies that we believe can generate above-average income and total returns on a risk-adjusted basis. The Fund had a total of 29 positions at September 30, 2022. The top ten holdings at the end of the quarter represented 51.46% of the Fund's holdings and included Microsoft Corporation (MSFT), Apple Inc. (AAPL), Exxon Mobil Corporation (XOM), Deere & Company (DE), Amazon.com, Inc. (AMZN), PepsiCo Inc. (PEP), Costco Wholesale Corporation (COST), Texas Instruments Incorporated (TXN), Johnson & Johnson (JNJ), and Home Depot Inc (HD). 

We believe the Blue Chip Equity Income Fund offers long-term investors an attractive total return in higher quality dividend-paying stocks.   When interest rates rise, many investors seek the logic of increasing their exposure to bonds over stocks. We believe this approach can be misguided, as dividend growth can be a better way to potentially hedge the purchasing power of income from inflation over long periods.

In conclusion, we remain optimistic regarding the long-term investment opportunities surrounding the Hodges Mutual Funds. By offering four distinct mutual fund strategies covering most segments of the domestic equity market, we can serve most financial advisors’ and individual investors' diverse needs. Our entire investment team is rigorously studying companies, meeting with management teams, observing trends, and navigating today's ever-changing 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 statutory and summary 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 be appropriately priced or overvalued.

Diversification does not assure a profit or protect against a loss in a declining market.

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 publicly 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.

Cash Flow: A revenue or expense stream that changes a cash account over a given period.

Price/earnings (P/E): The most common measure of how expensive a stock is. 

Earnings Growth is not a measure of the Fund’s future performance.

Hodges Capital Management is the Advisor to the Hodges Funds.

Hodges Funds are distributed by Quasar Distributors LLC.