Q: What is the history of the fund? How has it developed through the years?
I founded Hodges Capital Management with my father in 1989. The firm is based in Dallas, Texas. In the early 1990s, after we started our business, our clients were clamoring for mutual funds. We started our first fund, the Hodges Fund, on October 9, 1992. The original concept was a multi-cap, go anywhere fund. In the first ten years of its existence, that fund did really well, but never received much traction. However, in the period between 2003 and 2008, the fund grew dramatically to $850 million.
During those five years, the small-cap portion of the Hodges Fund compounded about 36%. We felt that with our process and style of investing, a small-cap fund would do well. As a result, we started the Hodges Small Cap Fund with $3 million of investor capital in 2007. Between 2009 and 2015, the fund grew noticeably and reached $2.3 billion in assets. For the 10 year life of the Hodges Small Cap Fund, it ranks in the top 7% verses our peers.
We had a tremendous year in 2016 and the Hodges Fund was up about 40%, compared to a gain of about 12% for the broader market averages.
Q: What core beliefs guide your investment philosophy?
The investment philosophy of the fund is to own companies that we feel have the best management teams in the best areas of the marketplace, or companies with a superior product or service that the market has not discovered yet. The basic tenet of our fund is we do our own independent research and do not rely on Wall Street research.
Q: How do you translate that philosophy into an investment strategy and process?
The one thing we don’t do is filter. We don’t run screens. Some of our greatest stocks would not look good on screens at the time we came across these ideas.
We look for ideas anywhere and everywhere. For example, I recently went to the ICR Conference in Orlando and the CES trade show in Las Vegas looking for ideas and opportunities, which aren’t necessarily absorbed by the marketplace.
We read a variety of industry publications and look for things that are out of the ordinary. We subscribe to papers like Investor’s Business Daily, which has a lot of good information on emerging and new companies. We meet at least eight to ten companies in our offices in Dallas every week.
We also do some technical analysis to see if there are any patterns that are telling of changing fortunes of a company. Also, our portfolio management team stays busy hunting down information, turning over stones where most investors don’t go.
We have 6 analysts and 3 Portfolio Managers that all look for ideas. We meet three times a week and everyone shares information. Each year we make about 2600 company touches over more than 800 companies. We also talk to their competitors, customers, and suppliers; doing all sorts of channel checking. So the entire team is charged with getting as much information as possible and being as knowledgeable about these companies as humanely possible.
We are not necessarily traders, but if we buy a stock and it appreciates quickly, we are not afraid to sell it when it is ahead of itself.
Q: Could you illustrate your process with some specific examples of investments?
One of our largest holdings is a company called Texas Pacific Land Trust (TPL). It was created 130 years ago in the wake of the Texas and Pacific Railway bankruptcy.
The company is a gradual self-liquidating trust, which generates cash flow via periodic land sales and oil royalties from owned land in Texas. TPL owns around 900,000 acres in 20 counties in West Texas, most of the acreage is in the Permian Basin where all the big fracking and oil fields are.
When we first started buying over 25 years ago, 4% to 5% of the shares were retired every year by land sales. That money goes into buying back its shares, so the company will always have a shrinking share base. However, we knew that over five and 10 years land would get more and more valuable. Over the years, land sales have peaked and paused, but in the last 5 years, due to fracking, the land value has gone up quite a bit. The stock made a move from about $20 to $550 per share.
Every year we go to each county and get the records of land sales to estimate the average for that county’s land sales. Then we assess how many acres the company has in that county and what that land is worth. We process a lot of statistical information on the land and its worth.
TPL is the largest position in our small-cap fund. We bought the stock when it was $82 and today trades over $500, so we have made tremendous gains. But I still think the stock has significant upside, because more and more people want to drill the land. TPL also receives royalties and grazing rights. A new catalyst could be the water business, because fracking requires a lot of water and it has become a bigger and bigger issue. With that much land, TPL has tremendous opportunities in the water business.
This is a stock with no analyst coverage and not many shareholders. I think that one of the reasons behind the huge growth in the stock price is that many people now see the potential for a royalty play.
Q: When you select the stocks, do you set price targets? What is your sell discipline?
No, we don’t. For example, when I first got into business co-managing this fund with my father, one of the stocks I bought was Apple, Inc. The stock went from $40 to $95 (pre-split) over three months and I sold it at $95. I was able to repurchase the stock in the $120 range after it came out with the iPhone and, obviously, it has gone up tremendously since then.
We always need to update our information and know the evolving story. If we buy something and the situation deteriorates and changes the original thesis, it is better to get out of the stock quickly and to put that capital into something with better prospects. We wouldn’t want to be stuck in a dead stock, waiting for a turnaround.
The key is to always be on top of new information. If a stock goes up significantly in a short period, and there is no reason for additional upside, we would trim that position. If it pulls back, we would buy more. That’s why we do so many company meetings, read all the news and research, and rely on our investment process. We need all the information that we can get.
Q: Could you give us another example from a different industry?
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, we’ll see earnings come up dramatically. In addition, these types of companies will benefit from tax cuts, because most of them are full taxpayers. That’s 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 don’t 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 doesn’t necessarily make a stock risky and volatility doesn’t 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.
