Quarterly Investment Guide

Nation's top fund managers reaping millions by avoiding the Dow

Bryan Borzykowski, special to CNBC.com
What's working in small caps

With the Dow Jones Industrial Average flirting with 20,000 and up nearly 15 percent since January, those who invested in the index at the beginning of the year certainly did well. They didn't do as well as the country's best-performing managers, though, who handily beat the U.S. benchmark this year.

According to Morningstar, Craig Hodges, CEO of Hodges Capital Management, is the best-performing non-sector U.S.-focused fund manager in 2016, with his Hodges Pure Contrarian Fund returning 77 percent year-to-date. How did he do it?

Not by investing in DJIA-listed companies, but rather, by choosing beaten-down small-cap value stocks.

At the end of last year and during January's market correction, Hodges began buying into metals and resources stocks, which had been out of favor for years. He bought steelmaker United States Steel when it was trading at about $7 and purchased iron-ore producer Cliffs Natural Resources when it was trading at around $3 in March. The stocks are now trading at $36 and $9, respectively.

He also purchased Bank of America when it was around $13 — it's now at $22 — and some private prison companies, which tanked after the Department of Justice said it wanted to stop using them. Post-Trump, though, those stocks have rebounded.

While Hodges' portfolio, which holds about 36 names, is spread across several sectors, every company has one thing in common: It was once an unloved business, ignored by investors. In fact, the top eight best-performing funds of the year are all value funds. "These are throw-the-baby-out-with-the-bathwater type of things," said Hodges. "They were so bad the previous year."

Chasing cheap cash-flow multiples

Scott Barbee, manager of the Aegis Value Fund, the second best-performing U.S. equity fund this year, with a 70 percent year-to-date return, also bought down-in-the-dumps stocks in January, only to see them rise significantly over the course of the year.

He focused on the commodity sector, buying several energy, metals and mining stocks at dirt-cheap prices. For instance, he bought Coeur Mining, Alamos Gold and Guyana Goldfields at low single-digit prices. While he has paired down some of his positions, these stocks are up 265 percent, 80 percent and 56 percent year-to-date, respectively.

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To Barbee, the best buys are the ones trading at well below book value compared to the broader market. Currently, the S&P 500 is trading at 280 percent of book value; his portfolio is trading under 70 percent of book value. The metal stocks, in particular, got so cheap that the only direction left for it to go was up.

"These equities were trading at very cheap cash flow multiples, even with the fact that precious metals had declined," he said. "They were significantly underperforming the metal. We didn't think they would drop further."

Value in small caps

The top-performing funds share another characteristic: They're all small cap–focused. These companies tend to be more volatile — they can dramatically outperform one year and fall hard the next — but they can also be good value buys. There's more to choose from, and some aren't followed closely by analysts, which tends to lead to mispricing, said Barbee. "You can pick up good bargains," he said.

While it might be tempting to chase the Dow Jones higher, the best-performing managers aren't worried about beating a benchmark. Burak Alici manages the Morgan Stanley Institutional Global Discovery Fund. It's the best-performing world stock fund, with a 34 percent year-to-date return, and he said he "doesn't care about the indexes."

He's also a value manager, focusing on high-quality but also unpopular businesses. He then hangs on until the stock price rises. "We invest with the mind-set of a business owner and not merely as a stock operator," he said. "We put our money in few businesses we know well and monitor them carefully, and we invest patiently."

What's ahead for 2017

It will be difficult for these managers to top this year's performance, but they're going to try.

Miners are still on Barbee's radar. While he sold out of several of his positions this year, with gold prices falling by 10 percent since Trump's election, some of the stocks he had purchased look attractive again.

He also thinks companies that benefit from rising inflation will do well in 2017. That includes gold miners, but also his largest holding is in Alliance One International, a North Carolina-based company that processes and sells leaf tobacco. It lost $35 million in profits in 2015 due to a major rainfall in Brazil wiping out its crops, but with weather remaining calm this year, and hopefully next, earning should continue to rise, he said.

More from Quarterly Investment Guide:
As Dow nears 20,000, these sectors can take it higher
Dow nearing 20,000, but there are still deals for value investors
Dow 20k a difficult target but we'll get there: Expert

Hodges is bullish on the market in general, but he does think it will sell off at some point and that the Dow hitting 20,000 could cause investors to sell. When it does pull back, he's going to buy. He's got his eye on infrastructure stocks — he thinks Trump's infrastructure plans could boost cement, steel, road-building and construction companies — and he also thinks financials will improve as rates rise next year. "You'll see them start doing a lot better," he said. "It's almost a whole new game."

These managers are no doubt thrilled with how their funds performed this year, but Hodges does say that it will be hard to repeat. However, he's still searching for opportunities, and he said that despite record-breaking markets and higher valuations on many stocks, he's still finding undervalued buys that could hit big in the future.

"There's always things going on," he said. "You might have to be patient, but buy something cheaply, at below replacement cost and you'll be rewarded."

By Bryan Borzykowski, special to CNBC.com