This week's sell-off
This week’s sell-off in U.S. stocks has reset investor sentiment, as macroeconomic factors and interest rate worries dominate the financial news ahead of third-quarter earnings season.
A lot of attention has been given to the relative underperformance in small caps, with the Russell 2000 giving back all of its outperformance and now lagging the S&P 500 on a year-to-date basis.
Although this weakness has been fairly broad-based across sectors, this correction has especially taken a toll on technology, healthcare, and many economically sensitive industrials. It is also worth noting that value has significantly trailed growth over the past several years and that, over the long-term, value stocks have tended to outperform after growth stocks undergo a period of selling that changes investors risk tolerance.
Like most periods of volatility and uncertainty, we are looking for opportunities during the current sell-off based on our own proprietary valuation work on the earnings power of individual companies throughout a business cycle. Furthermore, we are not ignoring the macro conditions that could develop into earnings head winds such as inflationary cost pressures, the impact of higher interest rates, and a lack of clarity on certain aspects of international trade.
We do think it is important to recognize that not all small caps will be impacted by higher borrowing costs and international trade and as a result we are focusing on well-managed companies that have solid balance sheets, and the ability to pass on inflationary cost pressures. In addition, we believe the long-term benefit from corporate tax cuts and repatriations could provide further stimulus to earnings in the year ahead.
According to data provided by Strategas Research, U.S. companies are estimated to have already repatriated roughly $500 billion of cash and will see another $80 billion from corporate tax cuts. With stock buy backs expected to be up $125 billion this year, we think it is reasonable that a significant portion of the remaining 82% of this cash may be used to pay down debt, shore up pension plans, as well as increase capital expenditures that have the potential to ultimately drive productivity and provide future earnings growth.
At Hodges Capital, we always fall back to the old-fashioned idea that regardless of what is in fashion in the short term, the long-term performance of stock prices is determined by the future earnings and cash flows of each underlying business.
In conclusion, we see the next few months as an ideal environment for active portfolio managers to carefully select individual stocks that have the potential to generate long-term value for shareholders.
Eric J. Marshall, CFA
Hodges Capital Management
2905 Maple Avenue | Dallas, TX 75201
The above discussion is based on the opinions of Eric Marshall, CFA, as of 10/11/2018and 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.
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.
The fund invests in smaller companies, which involves additional risks such as limited liquidity and greater volatility. The fund invests in foreign securities which involves greater volatility and political, economic and currency risks and differences in accounting methods. These risks increase for emerging markets. Earnings growth is not representative of the fund's future performance.
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 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. One cannot invest directly in an index.
Cash Flow: A revenue or expense stream that changes a cash account over a given period.