Boxes, Boats & Bulbs

03/09/2016 10:00 am EST

Focus: STOCKS

Eric Marshall -- portfolio manager of the Hodges Small Cap Fund -- discusses his investment strategy, the long-term benefits of small caps, and a trio of favorite stocks – a container board firm, a play on boats and fitness centers, and a leading edge company in LED lighting.

Steve Halpern:  Our guest today is Eric Marshall portfolio manager of the Hodges Small Cap Fund (HDPSX).  How are you doing today Eric?

Eric Marshall:  I’m doing great.  It’s great to be with you.

Steve Halpern:  Now can you tell our listeners a little about the Hodges Small-Cap Fund and help describe its underlying investment strategy?

Eric Marshall:  The Hodges Small Cap Fund is really focused on bottoms-up stock picking.  We like to think of ourselves as private equity investors in the public market, so we’re going out.  

We’re not trying to predict what the market’s going to do or try to predict the macro trends and the interest rates, commodities, or currencies.  

Instead, we’re really laser focused on what’s going on in the individual businesses that we invest in and we go out and do a lot of deep dive bottoms-up research as part of that process.

Steve Halpern:  Now small caps are appropriate for almost anybody’s portfolio at least in terms of diversification, so would you recommend a small cap holding for most investors?

Eric Marshall:  For most investors that have a long-term investment horizon, I think that is the case.  Small caps do tend to be a little more volatile and they carry with them more risk because of that volatility, but over time they also tend to outperform the broader market.

So having at least a small portion of your portfolio in small cap stocks -- if you’re looking out over a three to five year time period -- that really is the area of the market that you have the highest return potential.

Steve Halpern:  Now, many people have looked at the recent market sell off as a reason to panic.  On the other hand though you’ve looked at it as an opportunity and suggest that active managers should be taking advantage of the current negative sentiment.  Could you expand on that view?

Eric Marshall:  Yeah, we think that these type of markets -- when you have a bear market like we’ve had here over the last few months, that’s really an opportunity -- and that’s where you make most of your money it just isn’t any fun at the time while you’re going through it - but we see today very negative sentiment out there.

And we think the perception is far worse than the reality that we see going on in some of these businesses when we look at the fundamental earnings power in cash flow abilities of the companies that we’re holding in the small cap fund.

Steve Halpern:  Now you also point to weakness and energy as a supply driven problem and expect that it will take time to correct.  However, you also note that there are parts of the US Economy that are benefiting from this situation.  Could you explain that?

Eric Marshall:  That’s correct.  There are -- if you think about the US -- we consume about twice as much energy than we produce.  Before the shale boom we produced about a quarter of what we consume.  

Now we consume about twice what we actually produce and so as energy prices come down there is a longer-term net benefit for the US economy, the European economy, and the Japanese economy -- which are all net importers of energy.

And over time that should be positive for things like some of the transports, trucking, airline stocks should do well because of this, and also certain facets of the consumer economy should do well as consumers have more money in their pocket because of the energy savings at the gas pump and in other areas.

Steve Halpern:  Now let’s walk through a couple of investment ideas of yours to help better explain to our listeners the underlying strategy of your fund and one idea you like is International Paper (IP).  What’s the story here?

Eric Marshall:  Yeah, this is a stock that’s not a small cap stock.  We actually own it in our multi-cap portfolio, but we like what’s going on in this industry.  

Container board -- which is basically cardboard -- this industry has gone through a decade long consolidation where you’ve gone from 10 players down to three players that control about 70% of the market.

And with that it’s taken a business that’s been very cyclical in the past and it’s created a lot of discipline around how the product is priced, how capacity utilization is managed, and we think international paper is positioned to do very well over the next few years.

The stock trades about 10 times the earnings, and has just under a 4.5% dividend yield and we see them doing very well throughout the business cycle, but think that that’s a stock that’s very much misunderstood out there and has some very high quality earnings power.

Steve Halpern:  Now you also like Brunswick Corp. (BC).  What’s the situation with Brunswick?

Eric Marshall:  Yeah, this is a recent small cap addition to the Hodges Small Cap Fund and they are a leading boat manufacturer.  They also own Mercury Motors.  

In addition to that, they have a commercial exercise equipment manufacturing business and what we like about Brunswick is we see secular growth opportunities ahead of them that aren’t necessarily tied to what’s going on in the economy.  

There is a major upgrade cycle in the boat business. Boats last on average about 15 years.  There hasn’t been a replacement cycle in the last 15 years, so they’re starting to see something very similar to what the auto industry went through three or four years ago and there’s been a lot of capacity taken out of the market.  

There are fewer boat manufacturers than there were before the 2008-2009 recession, and we see them very well positioned to take advantage of some very strong demand going forward, plus lower fuel prices should increase the amount of time people spend on boats and help spur on that upgrade cycle.  

In the case of exercise equipment, if you look at fitness clubs and the trend towards health clubs, that equipment lasts about half as long as a boat, about seven years, and there’s also a major upgrade cycle going on in that business.

So this is a company that we think stands to see very nice earnings growth over the next couple of years regardless of what happens with interest rates, currency rates, or oil prices.

Steve:  An in fact it seems like this company might benefit from the comments you made earlier regarding strength in the US consumer sector as a result of lower oil prices long term.

Eric Marshall:  We think so.

Steve Halpern:  Now let’s look at Cree (CREE) which I believe is a manufacturer of lighting equipment.  Could you discuss that idea?

Eric Marshall:  Yeah, if you look at Cree this is a company that has been through a turnaround over the last couple of years and we think it’s become timely.  

Recent addition stock that we’ve added to the small-cap fund just this year, and Cree has basically two businesses.  One is actually making LED light diodes.  

The other part is the commercial and light bulb business where they actually make light bulbs and commercial lighting.  What we like about this business, there is a secular trend towards LED lightning.  The lighting business has been growing at 20% a year over the last few years.  

The LED diode business is very much a commodity business.  There was over excess capacity added in China years ago that was subsidized and as the market has continued to grow at this healthy double-digit growth rates we finally have started to see that market stabilize and we think that Cree has above-average growth trajectory for it.  

It competes against people like Phillips and GE in this space, but they have some of the leading edge lighting products out there.  There’s a major replacement cycle going on for commercial and industrial lighting.  

There’s huge cost savings for those that consume this lighting to go ahead and replace iridescent lighting with LED lighting and that’s something that we think is going to continue and the best is still yet to come for that replacement cycle.  

Over the next four to five years we think Cree has a very attractive outlook and we wouldn’t even be surprised if one of the larger industrial manufacturing companies like a Honeywell or someone like that would come in and decide to get into this business and acquire Cree in order to go head to head with some of the larger conglomerates out there that are really taking advantage of this growth opportunity.

Steve Halpern:  Again, our guest is Eric Marshall, portfolio manager of the top-rated Hodges Small Cap Fund.  Thank you so much for your time today.

Eric Marshall:  Thank you.

Learn More About Hodges Small Cap Fund...

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