August 29, 2011

Don’t Give Up on Small-Cap Stocks: Don Hodges

Hodges Capital to host 13 hand-picked U.S. companies at Wednesday investment forum

Fund managers who bet on small U.S. business are having a tough time of it these days.

Take Don Hodges, whose Dallas-based firm, Hodges Capital, runs five mutual funds. Four of those funds—focused on the multi-cap, equity income, blue chip and contrarian asset classes—have taken the same bumpy ride that most stocks have taken this summer. (Indeed, Minyanville.com CEO Todd Harrison’s back-of-the-envelope math shows that the Dow Jones industrial average endured more than 10,000 points of intraday swings in the month of August alone.)

Don Hodges, Hodges Capital

But like the rest of the small-cap class, his fifth fund, the Hodges Small Cap (HDPSX) fund has experienced an even wilder summer ride. Hodges (left) has no intention of giving up on HDPSX, though. In fact, he believes the fund, which numbers many U.S.-headquartered companies among its holdings, is in a great position for buying opportunities right now.

Morningstar data show that a $10,000 investment in Hodges Small Cap averaged yields of more than 10% in the spring of 2011, rising as high as $11,263. But by June, that same investment was lurching around, reaching highs above $14,850 and a low of  $9,299. Worse, after the Standard & Poor’s credit downgrade of U.S. debt on Aug. 5, a $10,000 investment in HDPSX plummeted to a value as low as $8,224.

Considering that the fund also got slammed in 2008, just a year after its startup, Hodges is philosophical about the rollercoaster performance that is the small-cap stock market.

“We try to separate volatility from risk,” Hodges told AdvisorOne over a pre-hurricane lunch last Thursday at Delmonico’s restaurant, just steps from the New York Stock Exchange. “The best-performing stocks are volatile.”

Every year, Hodges Capital hosts an investment forum to introduce investors to a small group of favored companies. This year’s forum, scheduled for Wednesday, features former New York City Mayor Rudy Giuliani as keynote speaker along with 13 hand-picked presenting companies, all based in the United States, including agricultural equipment maker Alamo Group Inc., Devon Energy Corp. and Sally Beauty Holdings Inc.

A 50-plus-year market veteran (the grandfather of six began his investment career with Merrill Lynch, Pierce, Fenner and Smith in Oklahoma City in 1960), Hodges noted that he has witnessed recessions time and time again. And he has seen money come and go on Wall Street.

That said, he acknowledged that the small-cap space is an especially volatile one: Over the last three months, the Morningstar Small Cap index has fallen from a high of 5,449 to a low of 4,129, or nearly 25%.

So is that kind of loss worth the investment in stocks? According to investment strategist Ben Warwick of Aspen Partners, stocks are, over the long run, one of the best investments for protecting investors from inflation. “They are liquid, well regulated, and can provide important

dividend income,” Warwick wrote in a recent column for AdvisorOne that explains his firm’s stock positions. “Clients would be hard pressed to meet their investment objectives without owning some stocks.”

Warwick is underweight on small caps, however. “Typically,” he writes, “small cap stocks tend to outperform large caps as rates head lower. But in our view, this additional return is not worth the much larger amount of volatility that small caps typically generate.”

Hodges, on the other hand, is still a believer in small-cap stocks and the companies behind them.

“The biggest hope we get for the U.S. economy is from talking to companies,” Hodges said. “Our big passion is companies, not what gold or the dollar are going to do.”

Hodges Capital comprises five fund co-managers, including Hodges and his son, Craig. Don’s name is listed as an HDPSX co-manager, but he credits his son as well as Eric Marshall and Gary Bradshaw for active management of the small-cap fund.

Don Hodges credits mutual fund pioneer John Templeton, with whom he worked earlier in his career, as a stock-picking mentor. Established in 1954, the Templeton Growth Fund was known for buying low and selling high. Each $10,000 invested in the fund’s Class A shares at its inception would have grown to $2 million by 1992, when Templeton sold his family of funds to the Franklin Group.

Today, Hodges advises clients who can’t take stock market volatility of the sort seen this summer to think about moving at least some of their money into a more sheltered place. But for those with an appetite for risk, there’s plenty of opportunity, he said.

Hodges Capital’s five analysts keep a database of more than 2,000 company contacts, and they spend a lot of time talking to them. Right now, Hodges sees a shortage of inventory at a variety of firms in all sectors, including railroad manufacturers, cement companies and hydraulic equipment makers. And compared to the period just before the recession hit, he said, companies are well-positioned for growth.

“In 2008, everybody was over-leveraged,” Hodges said. “Now a lot of companies have no debt on their books. There was a shortage of cash back then, and this time it’s different. They’re in good shape financially, which is a safety factor for the whole economy.”

Stocks are now trading at their lowest price-to-earnings multiples in years, at approximately 12 to 13 times versus the historical average of 14 to 15 times, Hodges said. And that, he asserted, means opportunity in small-cap stocks.

“You won’t hear it on CNBC, but this is the time to buy stocks,” he said. Quoting Shelby Davis, once named “America’s most reliable fund manager” by Money magazine, Hodges added: “You make your money in a bear market. You just don’t know it at the time.”

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