Top manager Hodges on small caps, JC Penney

Published Tue, Sep 20 201611:27 AM EDTUpdated Thu, Sep 22 201611:53 AM EDT

Craig Hodges, CEO of Hodges Capital Management, a small-stock specialist with $2 billion under management, sat down with CNBC's Mike Santoli for an in-depth conversation on why it may make sense for the average investor to add exposure to small- and mid-cap stocks. "It is the most inefficient part of the market," said Hodges, in regard to small- and mid-cap companies. Those inefficiencies translate to opportunities, said the money manager, whose fund, the Hodges Retail fund , is up 22 percent this year, making it No. 1 in its category, according to Morningstar. The fund has a five-year annual return of 17 percent, seventh best in its category, according to the fund-tracking site. In this exclusive interview, Hodges shares his investment thesis behind the stock picks for CNBC PRO's "Platinum Portfolio" competition, including his bullish stance on shares of JCPenney , which have rallied more than 40 percent this year. Other topics include: Investing in index ETFs versus individual stocks. What to look for when selecting small-cap equities. Some of his favorite industries for the months ahead. How to navigate market volatility. The most common mistake average investors make and how to avoid it. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service, so there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Craig Hodges is co-founder and CEO of Hodges Capital Management, an investment advisory firm managing about $2 billion for investors. He's been serving as the chairman and portfolio manager of the firm since 1999, focusing on equity selection and investment strategy. Craig is also a member of CNBC Pro's Platinum Portfolio Competition where he's up 6% so far this year. He joins us now to discuss his investment approach, market outlook and favorite stocks for the rest of the year. Craig, thank you very much for being here. Appreciate it. CRAIG HODGES: Great to be with you, Mike. MIKE SANTOLI: So your firm focus is larger in the small to mid-cap stocks. Talk a little bit about your approach to navigating your way through what are literally thousands of small and mid-cap stocks in the U.S. and also where that sector (if you want to call it a sector) is positioned right now. CRAIG HODGES: Yeah. To me it's the most inefficient part of the market and there's not all that much analyst coverage on the lower ends. And so that's where you sometimes fine your undiscovered or your opportunities. At Hodges Capital we have seven analysts, three portfolio managers and we make about 3,000 company touches a year. We just focus on stocks, that's it. We want to know as much about U.S. stocks, hopefully than anybody out there. And that's what we spend all of our time doing. And it's information: Just get as much information, good and bad, as you can. MIKE SANTOLI: When you say it's the more inefficient part of the market (you kind of touched on this) that it's essentially where there are fewer investors and analysts focused on these stocks, many of them are not in the large indexes necessarily. Therefore, there's an opportunity for the stocks to get mispriced relative to the fundamentals? CRAIG HODGES: Correct. And the other thing that's happened is when the market making went away, and now that we have so much computer trading, you can get some wild fluctuations because the markets aren't very deep. And that's where you get your opportunities. MIKE SANTOLI: Interesting. CRAIG HODGES: But just because a stock isn't widely followed doesn't make it a good buy. But when you find a stock that does not have much analyst coverage, and they're doing well and doing the right things, that's when our ears perk up. MIKE SANTOLI: You mentioned 3,000 company touches. So that's essentially, what, you listen to a conference call, you visit with management? How does it work? CRAIG HODGES: Correct. We keep track of who talks to how many companies on a weekly basis. And we're talking about conference calls, company visits. We have a lot come through Dallas, we probably have eight companies come through a week that we talk to. And when a company is there we want to know who their best competitor is, who their worst competitor is, who's doing it right, who isn't. So there's a real process that we've developed over the last 50 years of asking the things that get us as knowledgeable about the industry as we can. MIKE SANTOLI: And just on that general thought of doing the company-by-company work and operating in a part of the market that's not necessarily as saturated which coverage, there's been this trend going in the other direction of money going toward index strategy. Basically passively owning the index, typically the larger cap indexes but all of them, and that is seen as the most efficient way to do it, right? CRAIG HODGES: Correct. MIKE SANTOLI: You just get low-cost exposure to the market. What are the implications of that for your approach? CRAIG HODGES: You're exactly right. And the ETF business has grown 30% for the last decade plus. It's a behemoth out there. But now you have extremely correlated market, people are just basically buying indexes, buying the market. And there's a lot of inefficient price stocks out there. Not all companies are good, not all are bad. But they trade at a 90% correlation so it's our job to find those inefficiencies and to pick the stocks that we think can trade below their intrinsic value or whatever the case may be, look for those opportunities. MIKE SANTOLI: And there's two schools of thought as to the indexing wave, whether it's made it easier to find those inefficiently priced stocks and then of course hope that they get back to something like fair value, or whether it's taking the weaker active managers out of the market, and leaving it a tougher market to beat in general. CRAIG HODGES: It is a dilemma. For example, we're underperforming right now a little bit in the small cap space, and that's strictly because there's a (UNINTEL) to quality, utilities, and telco and consumer staples. That's not what we're looking to do. We're not going to buy a 30 times earnings utility and a growth account. You have those periods, but with the proliferation of everyone hitting a button and buying it, just basically the market, there will be opportunities. And that's what our job is, to define those opportunities and focus on them. MIKE SANTOLI: Now of course, the smaller stocks bore the brunt of the turmoil going back starting about a year ago. In fact, by the indexes had their own bear market, right? They really did. At those lows in the winter they were down more than 20% on the rest of 2000, have clawed their way back and played some catchup. But where do you think we are in the market cycle "Well, with large road it's a small," or small caps relative to the economic cycle? CRAIG HODGES: I don't know exactly where we are small caps. I do believe, even though I'm not a large cap manager, I think large caps are really well-placed. You've had seven years of money coming out of U.S. stocks into bonds. That will be a disaster at some point. Where does that money go once it does come out? The TINA, an acronym. MIKE SANTOLI: "There is no alternative." CRAIG HODGES: Right, "there is no alternative." The alternative is blue chip dividend paying companies, the most conservative out there. I think you'll see probably five years of multiple expansion but that will trickle down to small caps. And we feel like no matter what's going on in the market there's always opportunities in small and mid-caps. MIKE SANTOLI: So you mention that you're not particularly interested in those supposedly safe or stable, expensive stocks that just give you some income like utilities right now. What are areas where you are finding the opportunities? CRAIG HODGES: There's a lot of stocks that are trading below their replacement cost. And an interesting thing just happened in the market the last couple of years. We've seen energy come down and there's no question why energy stocks should get cut in half when oil gets cut in half. But there's been a lot of companies that aren't energy stocks that have traded like energy stocks: Texas banks, you're talking about some Texas hotels. Things that are treated like an energy company, even United Rentals, that 20% of their business rents to the oil business. That stock has been cut in half. That's where the opportunities are. And the opportunities are you don't even need oil to go back for those things to work. If oil would just stay here people would see those businesses are not oil companies and we're not going to see $20 oil for the next ten years. MIKE SANTOLI: Has the market by now somewhat figured that out? In other words, with oil trading in the mid-40s at the moment nobody really talking about $20 oil again. Has bounced back to say, "Okay, they're stable?" CRAIG HODGES: Somewhat. But there's still some tremendous opportunity. And I keep going back to Texas where we are based, but a lot of these Texas banks are still trading half and their loan portfolios are tiny, maybe 5% in most cases. But they're traded like it's the '80s and we're going see disasters coming, like La Quinta that was a $25 stock is about an $11 stock, trading below its replacement cost. The perception is it's a Texas play; 25% of their hotels of Texas. There's a lot of those type of things that still have not recovered and I still think there's a lot of opportunities in this. MIKE SANTOLI: One of the funds you managed, Hodges Fund, up about 26% this year. But would've had a tough just out of the gate starting the year. Your portfolio, everybody had some trouble finding buys that worked in the first part of this year. Just as a general matter for an investor, when you see the market go at you like that how do you know whether your thesis is wrong or you want to buy more, or you want to cut your losses? How do you navigate all that? CRAIG HODGES: That's the beauty of owning individuals stocks as opposed to owning the market or owning an index. In an index you own expensive stocks and cheap stocks, but you own the market. A lot of these stocks traded below their intrinsic value. If you shut down the business, sold the assets it would go up. So that gives me a lot of comfort knowing that a lot of these names, that in the first six weeks are the craziest six weeks I've ever had in the business. Meaning, nothing made sense. But when you know the companies, I'll give you another great example. You saw maybe what happened with the prison stocks this week? We followed those companies for over 25 years. We know them very, very, well. When we saw the release that was probably only 10%, 11% of their business that would eventually be affected, they were cut in half. MIKE SANTOLI: Right, so this was the justice department saying perhaps they were going to stop using these privately run prisons for certain federal inmates? CRAIG HODGES: Well, they cut those stocks in half that day basically. And we knew that this was not good, but it was trading way below, way overdone and so we were able to buy a lot of stock. And the only reason we were able to do that is because we know that company, Corrections Corp and GEO Group, we've known them for a long time. And you have a comfort going in buying, knowing what you're buying, and knowing the assets and knowing the intrinsic value of the names. MIKE SANTOLI: Do you have a particular base case in terms of, let's say, what the U.S. economy is looking like and what kind of trajectory we're on when you do the company analysis as well? CRAIG HODGES: Not typically. We don't hold ourselves out as being very wise or incredibly astute at predicting the market or predicting the economy, or even interest rates. We really just focus on companies. And if we're right on our thesis with the companies it really shouldn't matter what the short term fluctuations in the market are. The best scenario for us is kind of where we are now, which is a slow growth environment, because stock pickers by name should be able to do well in a slow growth where everything's barely moving. You can put in the stocks that are doing above ordinary, that have better management, that have better rates of return, have better return on investment capital and such. MIKE SANTOLI: I guess even for those managers who are not top-down, who don't start with a broad expectation about the economy, if you're talking to that many companies you must kind of filter up from there just how things are feeling and looking. CRAIG HODGES: Right. And you MIKE SANTOLI: Sectors that seem like, "You know what? Things might be coming back or They might be heading into a little bit of a downturn." CRAIG HODGES: You do, you get a sense. And there's been times when the pessimism has been palpable out there and managements were saying, "It's not bad, it's not bad. It's not great; it's not bad." And I kind of get a sense that's where we are. We're talking one of the most unloved stock markets ever. Investor participation is terrible; you've had seven years of money coming out of stocks. But yet we're hitting new highs, what does that tell you? I think that tells you that things are probably better than they're perceived. Not booming, not great. But there's opportunities. MIKE SANTOLI: It seems like besides just a general skepticism toward the market, there are a lot of these industries that seem to be undergoing (there always are, but now maybe more than often has been the case) at least some kind of structural change where it seems like, "Oh yeah, that looks like a cheap stock." If it's a retailer, for example, but that's just something that's challenge for the long term, et cetera. Are those areas where you've plucked that value? I know that you have owned JC Penney, for example. CRAIG HODGES: To me that's the best-looking situation I see out there right now, is JC Penney's. It's perceived that it's being eaten up by Amazon and that the mall is dead and that sort of thing, and there's some truth to that. But their turnaround doesn't involve any sort of increase in market share or increase in people going back to the malls. It's the low-hanging fruit, the restructuring, the getting the things that they messed up for the last for year's right. But you see very simple ways for them earn $1 billion in EBITDA, and probably earn within a couple years $2 a share. The stock at $10 to me is about as easy of a thing as I see out there. Now, you do have to fight the prevailing winds of, "Everything's changing out there." But you try to identify what areas that Amazon may not destroy, if you know what I'm saying. People will still go try on clothes, people will still go do things. But they want to touch an appliance, or what it is. But it's a moving target, as you say. MIKE SANTOLI: Obviously your end clients are retail investors generally or individuals? CRAIG HODGES: And advisors. Mostly advisors. MIKE SANTOLI: And advisors as well. You talk about how it's not a very loved market, there's not a lot of public participation. Does it seem like that's something that might change? What would it take if we already got seven years and record highs in the market, are they just going to sit this whole cycle out? CRAIG HODGES: Unfortunately it's the wrong decision, but that will change when the market is good and they feel like they need to be in the market. But that's the wrong move. Now is when things are cheap and I hear people say we're in a bubble. Man, I don't know of a bubble that money has been going out of for seven years. There are parts of the market that are expensive, don't get me wrong. But there are a lot of parts that are inexpensive. MIKE SANTOLI: That's been the cautionary word for a while now, is that, "Okay, sure. Interest rates are low and there lots of liquidity, and at least we have slow positive growth. But stocks are expensive." Right, I think that's a standard thought. Do you think that's just a distortion of the indexes? CRAIG HODGES: I do. I believe it's a distortion of the indexes. And I hate to keep harping on the exact same things, but in our portfolios we have a PE of about 15 times earnings, where the Russell 2000 is about an 18. Our growth rate is much faster than the Russell so we're paying less and getting more. If you do the individual stock selectin you can put together a portfolio that's inexpensive that is growing, but you just can't buy everything. MIKE SANTOLI: And where does it shake out in terms of, for example, where you're tilted in sectors within your portfolio? CRAIG HODGES: We've overweighed what I would consider sectors that have high barriers to entry. The big mistakes I've made in my career are getting in hot areas that are easy to duplicate, where a lot of competition will come in. But things like cement companies, steel companies, you can't build any of those type plants if you wanted to at this point in time. Corrugated paper, even the airline business has now a high barrier of entry. Because in order to compete you have to have the fuel efficient planes that are 30% more efficient than the old planes. So we're attracted to those industries and I think that because of pricing power, time will show well on this industries, so we overweight those. MIKE SANTOLI: Got you. So it's not necessarily a specific industry sector focus, it's just the kinds of businesses that seem to be in those areas? CRAIG HODGES: Exactly right. MIKE SANTOLI: What could knock things off course? If you're looking at the standard risk factors in the companies you own, is it interest rate risk, is it trade policy, the election? Anything that seems like you're constantly coming back to that says, "We have to worry about that." CRAIG HODGES: I'd love to be able to just bury my sand and say we can just buy companies and hold onto the good ones. But you saw the first six weeks and the fact that China can influence our markets so dramatically. We are a little bit hostage to that, so that's one thing. And then there's always terrorism stuff to worry about and that sort of thing. But we are the best-looking house on an ugly block and I do think that capitalism still works, and that eventually dollars find the best use of capital. I believe it's here, and so I think those things take care of themselves eventually. But I tell anybody that's getting in the market, "Be prepared for 10% selloffs." First of all, they're good for you, they get all the weak holders out. But that's just the world we live in. I don't see a scenario of a big 50%, like we saw in '08 or that sort of thing. I don't think those things are on the table. MIKE SANTOLI: Does it feel to you for any reason that we're on the verge of one of those 10% jobs or is it just one of those things that can hit anytime? CRAIG HODGES: It can hit anytime. I was pretty optimistic at the first of the year, and that first six weeks were the craziest thing I've ever seen. It looked like there was no floor in stocks, and luckily we bought a lot of those things because we knew that value was there. I think the election actually will be a positive either way it goes. Not to be political, but we've had a very anti-business atmosphere for a long time. Not just eight years, but for a long time it's been harder and harder to do business. And I think that people are seeing now that that's only hurting us and that there's some changes there. So I actually think that the market will like both candidates. MIKE SANTOLI: Two issues in terms of corporate matters that come up a lot in this entire cycle, is stock buybacks, companies essentially using it as a cash flow or borrowing some money, buying back stock, meet (?) their numbers and also return cash to shareholders. It's a feature of voluble markets, right, especially the last couple. But yet, it sort of seems somehow suspect to a lot of folks. What's your stance on it as a use of capital or as a part of a corporate finance policy? CRAIG HODGES: I've always been a fan of it. And I know people bash it because they think it's artificially propping up stocks. I don't agree at all. What a management team is supposed to be doing is, "Where is the best use of capital? Should I build more restaurants or are we kind of saturated there? Should we be buying back the stock?" a great example was we owned a good stake in Cracker Barrel which basically retired about half their stock. That's been a phenomenal stock. They haven't killed it necessarily on a same-store sales basis; they've done well. But the fact that they've retired so much stock, their earnings have gone up. That's real, that's not fake. And so it basically comes down to, "Are you going to give the money back to shareholders or it not best in shareholders' hands? Is it best for us to be buying new things or buying back stock?" And so it's a personal decision but I think there's limits. There are some companies that do it too much, (UNINTEL PHRASE). MIKE SANTOLI: Sure. So an example, let's just say like Cracker Barrel, if they buy back a lot of stock and retire a lot of stock, reduce the share count, those holders who have held on just own a proportionally bigger piece of a decent business? CRAIG HODGES: That's right. That's exactly right. MIKE SANTOLI: And are there companies that you own or would look at where you say, "You know what? I really wish that they would invest more. They should have a lower threshold for what it would take to--?" CRAIG HODGES: Not to give you a specific name, but I think one of the problems with large caps is they have not been investing in their future. They've been buying back stock, but I guess they think that's the best use of the capital. That's debatable. But that is a big talking point for small caps. If you have not invested in growth for the last five years and you're a big company, how do you get growth? You have to go acquire smaller names that can give you growth, and that's one reason we do like the small caps. MIKE SANTOLI: Yeah, they typically do act as a pretty good play on that consolidation effect as well. As you've been in the business a while, you've interacted with a lot of investors, what are some of the common mistakes or blind spots that you find the average investor has? So just things to keep in mind sort of as a check on yourself? CRAIG HODGES: I think getting in the hot areas or going with what's hot now, I think that's always been a mistake. If you watch what funds do, funds always bring out new funds of hot areas, which is typically is the total wrong thing to do. If I could say one thing to an investor to look at when they're buying stocks, look at the barriers of entry. If it is easy to duplicate you need to rent that stock, not own it. If it's very hard to replace that business then that's a good long term investment if they're using the capital right. So stay away from hot trends, buy good, solid companies with good balance sheets, good management teams. And management teams that own the shares themselves, not just they're working and making a nice payment, and they're playing defense, trying not to lose their job. We want guys that are trying to make wealth with their ownerships of the stock. MIKE SANTOLI You're talking about the hot areas, one of the interesting things is to see the way the ETF industry tries to seize on the next thing. Let's say a year and a half ago it was all about, "Well, the dollar is going to go through the roof so let's come out with currency hedged stock, ETFs." One of them that I remember from early this year was basically the stocks in the index except for energy, right? (CRAIG HODGES: MIKE SANTOLI: So there's always one thing to worry about and it seems like maybe they make it almost too easy to say, "Oh look, this is a can't lose." CRAIG HODGES: And it's interesting that you bring up ETFs. One of our favorite ideas in the small cap area right now is Wisdom Tree. They're the largest independent out there and the stocks come from the 20s down to around ten, and they've lost a lot of assets because of those very hedged countries, Japan and Europe. MIKE SANTOLI: Hedged, right. CRAIG HODGES: But that's a good business and somebody will, I think, eventually buy them. And so even though we're active managers I do recognize the fact that the ETF business is most likely here to stay, and Wisdom Tree is a good acquisition (UNINTEL). MIKE SANTOLI: So basically you have your established players in the industry look at ETFs being one area of growth, or one of the few, and you might as well get somebody with scale? CRAIG HODGES: Exactly right. MIKE SANTOLI: How do you think your industry is going to hold up? Is it just a cyclical thing where people don't really want as many actively managed funds and people are kind of--? CRAIG HODGES: I think for the time being. But money goes to where money is being made. And the active industry will only do well if we outperform and people gravitate to that. That's the bottom line. So if we continue to underperform it's going to be hard. But in the 30 years I've done this I've seen it come and go. And like I've mentioned, we've had just incredible stock liquidations. Stocks are not loved by people. People would rather buy a fund. Millennials hardly even buy stocks at all. The pendulum at some point will swing the other way. I don't know when but money will go to where it's used best. MIKE SANTOLI: And small caps as a category, do you kind of pitch it as a diversifier, or for certain parts of the cycle it works, for certain investors it works? CRAIG HODGES: It's a part of an investment process. You don't want all your money just in small caps, especially if you're worried about short term performance or if you're older. If you're a younger person I can see why you would want to do the most active part of the market, which is small caps. But I think there will always be opportunities in small caps. And like I mentioned, large caps, I think you'll see multiple expansions for the next five years of those. But I still see tremendous opportunities in small caps. MIKE SANTOLI: It's hardly a zero sum game, right? Usually in most cycles they both can do okay. CRAIG HODGES: What we do, it's become less and less prevalent. There's less people doing what we do, which is picking individual companies. That's become less and less prevalent, but I think there will always be a spot there. MIKE SANTOLI: One aspect of that or outgrowth of that general phenomenon is fewer IPOs, and in fact fewer stocks in general, right? CRAIG HODGES: That's true. MIKE SANTOLI: There's a lot fewer stocks on the market right now than there were ten, 15 years ago. CRAIG HODGES: That's very, very true. And that's an issue. There is a pool of money, by mandate needs to be invested for a rate of return. And luckily it's found a home in the bond fund and bond area, but at some point it's going to need to find a new home and where does it go? There's not a lot of alternatives. And capitalism and buying U.S. companies I think will always be in vogue, and there's opportunities there. MIKE SANTOLI: Maybe it'll come back in fashion. All right, Craig. Thank you very much, I appreciate it. CRAIG HODGES: Thank you, Mike. I enjoyed it. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. * * *END OF TRANSCRIPT* * *

"It is the most inefficient part of the market," said Hodges, in regard to small- and mid-cap companies. Those inefficiencies translate to opportunities, said the money manager, whose fund, the Hodges Retail fund, is up 22 percent this year, making it No. 1 in its category, according to Morningstar. The fund has a five-year annual return of 17 percent, seventh best in its category, according to the fund-tracking site.

In this exclusive interview, Hodges shares his investment thesis behind the stock picks for CNBC PRO's "Platinum Portfolio" competition, including his bullish stance on shares of JCPenney, which have rallied more than 40 percent this year. Other topics include:

Investing in index ETFs versus individual stocks.
What to look for when selecting small-cap equities.
Some of his favorite industries for the months ahead.
How to navigate market volatility.
The most common mistake average investors make and how to avoid it.

PRO subscribers can also read the entire transcript of the exclusive interview below.