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2 Small Caps With Strong Potential
04/10/2012 7:00 am EST
Small-cap manager Craig Hodges explains his company’s strategy for evaluating holdings during market downturns. He also tells Kate Stalter about two little-known stocks that he expects so show big gains going forward.
Craig, I wanted to start out with some current events. This week, as we’re speaking, the market appears to be consolidating in recent sessions. Is that action that should worry investors, or do you see it as just a normal pullback after a healthy run-up?
Craig Hodges: I see it as a normal pullback. Actually, I see it as a very healthy thing for the market. Last year was filled with a lot of volatility, a lot of big down days—three in a row, that sort of thing—and this year we haven’t seen much of that since the markets started surging in October.
I think in 2012, we only had one or two days where the markets been down 100 points. And every time there is a sell-off, you see pretty good buying come in and absorb it and take the market right back up.
So, I think there are a lot of people that have missed this latest rally that are looking for an entry point, and so I view a 3% to 5% correction in the market as a healthy event. And I think there’s so much money on the sidelines that it’ll be absorbed pretty quickly.
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Kate Stalter: Do you, as a fund manager, go in there at these pullbacks to support an existing position or get some more shares?
Craig Hodges: We do at some point. We look at every one of our holdings, and really are laser focused on what’s going on individually in that company.
I a stock starts to pull back, we will double check, check out and see what-all is going on in the company, see if we can find out if there’s a reason for the weakness. And if the thesis stays intact, we will use weakness to add to our position. We definitely use that strategy, that sort of thing.
There are occasions where something will change, or maybe your original thesis may be changing, and if that’s the case, that’ll raise a red flag. And we’ll assess it and maybe get out of a position if that’s the case.
Kate Stalter: Let’s talk specifically, then, about the space you’re in, the small-cap space. It’s an area that I follow closely, and I know that these stocks can often experience greater volatility than the broader market. How do you as a manager deal with that volatility?
Craig Hodges: Since we do it every day, it really doesn’t affect us like it does individual investors. Individual investors tend to get pretty upset when a stock they own will drop 10% or even 15%. But as a manager, that volatility sometimes can be an advantage.
Another thing: A lot of times, the best companies are the most volatile. So the ones that aren’t doing all that well, there’s not a whole lot happening at the company…those stocks don’t seem to do much. So, by nature, your best, fastest-growing companies are going to be the most volatile. So, we take that into account.
And we have a very long-term view at Hodges Capital. Like you stated, we use the volatility to take advantage of getting some better pricing, as far as our cost basis goes.
Kate Stalter: Craig, can you share a little bit about some of the positions you have right now, and maybe even talk both fundamentals and technicals, if you’re able to?
Craig Hodges: We’re bottom-up stock pickers, and so we really look for companies that may be bucking the trend even if the economy—we’re in a slow-growth environment—there are still a lot of small-cap stocks that are doing extremely well. So, you’ll see a lot of consumer discretionary stocks in our portfolios, kind of niche companies that are bucking the trend.
We also are real favorable on the energy space, and see a lot of opportunities there. There are a lot of industrial-type companies, small industrial companies that are doing well.
One company that I’m real excited about, it’s the most unique unusual company in the 27 years that I’ve been doing this, that we’ve ever come across. It’s a company called Texas Pacific Land Trust (TPL), and it’s just about one of the oldest companies on the New York Stock Exchange.
It’s a self-liquidating trust. The railroads, in the early 1900s, a lot of those went out of business. They set up this trust, and it’s a self-liquidating trust. And what is it? They own about 1 million acres of land in West Texas, a little under 1 million acres of land.
So, with just under 10 million shares outstanding, each share represents about one-tenth of an acre. And this land is being used for a lot of different purposes. This is rural land out in West Texas, but there’s a lot of drilling going on in this area, and that’s making this land a lot more valuable.
We’ve done a lot of surveys on the company, gone to a lot of the local county tax records, and figured out what the land is worth in that are—just from land sales—and we estimate the land to be worth in excess of probably $55 a share. And if you tack on the oil and gas royalties that they’re receiving, that puts another probably $20 per share on the stock, which puts it in the $70s.
The stock trades around $48, but the interesting thing: They only have seven employees, and their only business is selling land and collecting these royalties, and with that money, they buy back stocks.
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So, there is a shrinking base of outstanding shares, and so it’s a tremendous way over an extended period of time to pass on wealth. But as more and more drilling is being done in this Wolfcamp area in West Texas, which they own a lot of acres in, you’re seeing a lot of activity in this. We think this stock is very, very undervalued.
Kate Stalter: And they’re using share buybacks rather than dividends, or in addition to?
Craig Hodges: Yes. They have paid some special dividends. In the past I think they had a big sale, like a $20 million sale of land, and they did pay a special dividend on that. But their only business is buying back the shares of the stock.
Like I said, they have seven employees, they don’t have any really costs or anything, and so what you end up having—the shareholders today and the shareholders in five years—there’s going to be a lot less shares outstanding in five years, as they continue to buy back shares.
So, long-term shareholders should be rewarded, I think pretty handsomely. But it’s one of the most unique companies I’ve ever come across. And it looks like it’s got a tremendous amount of value, especially if you’re looking long-term and have a little longer time horizon.
But even on a short-term basis, from our valuation of what the land is selling for now, it’s easy math. Because one share is one-tenth of an acre, so at $48, they’re saying each acre is worth $480, and it’s going for much, much higher than that. Plus, you add on the oil revenues and that puts a lot of value into the company. So, it’s a great looking value situation.
Kate Stalter: We’ve got a couple more minutes here, Craig. Can you briefly tell us about perhaps one other name that maybe a lot of folks are not familiar with?
Craig Hodges: Probably our favorite energy name is Atwood Oceanics (ATW), and Atwood is into deep-water drilling. They have rigs for deep-water drilling.
The deep-water drilling area of the energy business, we feel at Hodges Capital, that has the most long-term promise. They have very high barriers of entry in that deep-water business. To build a half-a-billion-dollar rig, there’s not a lot of people flying to get in that business, plus the fact that it takes five to seven years to build those rigs.
But the day rates in the deep-water business are going to get higher and higher, and a lot of that money goes to the bottom line. Atwood has about nine or ten rigs and they’ll probably earn $4 a share this year and over $5 next, and the stock trades around $43. So, it trades less than ten times earnings.
We think there’s going to be a deep-water rig shortage in 2013. So, there’s some real potential for those earnings to go up. And like I said, when the day rates go up like they’re going to, there’s not added cost for that. So all that will go to the bottom line. So, we think there’s a real nice move.
Plus, Atwood, we think there’s a high degree, a chance that it’ll be acquired by somebody at some point. So, Atwood Oceanics would be another one we like quite a bit.
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