Guest: Craig Hodges, Hodges Capital Management CEO, Hodges Fund Portfolio Manager
–We are positioning our portfolios to benefit from broader economic growth and earnings improvement across a wide number of sectors.
–We believe an improved outlook for earnings in 2018 should be supported by a more business-friendly tax and regulatory environment.
–As the prospects for significant earnings improvement in 2018 appears likely for many U.S. companies, we see compelling investment opportunities in many of the cyclical areas of the market, such as financials, consumer discretionary, technology, and industrials, which have the most earnings upside in the current environment.
–Despite the market’s rally in 2017, we still find U.S. equity valuations reasonable with the S&P 500 trading at 17X forward earnings estimates according to FactSet.
–Most management teams seem more confident regarding the prospects for demand growth, pricing power, potential margin improvement and earnings growth in the next year compares to a year ago.
–For some companies, we still think consensus earnings estimates are too low for 2018 and 2019 given recent tax reform. Tariff negotiations will continue to generate volatility. We believe the end game will be an improved landscape for US companies (i.e. steel).
Why Small Caps
- Has underperformed the last few years
- Biggest beneficiary of tax cuts
- Biggest beneficiary of decreased regulations
- More attractive as M&A targets
- Repatriation a catalyst for small caps
- Don’t have tariff issues like larger multinationals
- Decreased supply of investable companies
o There has been a meaningful decline in the number of listed stocks in the U.S. as fewer smaller companies are going public while merger activity reduces the number of publicly traded companies. According to a recent Global Financial Strategies Report published by Credit Suisse, the number of U.S. listed companies has decreased by roughly 50% from 1996 through 2016 as the number of delisted stocks outstripped the number of new listings by 3,650 companies.
- This is likely the function of the cost and regulatory environment outweighing the need for smaller companies to access the public markets in a low interest rate environment.
- As a result, the supply of small publicly traded stocks has fallen, while the surviving publicly traded companies on average tend to be more established and profitable businesses that are more capable of paying out dividends and returning cash to shareholders through share buybacks.
- What matters most to equity valuations in the long-run is future earnings and cash flow, which we see as improving for many small cap domestic companies. Generally speaking, street earnings estimates are too low for 2018 and 2019 given recent tax reform.
- Return (possible) of active management
Commercial Metals Co. (CMC) – As the leading low-cost manufacturer of rebar in North America, we see CMC as well positioned in 2018 to benefit from improved trade policies in Washington that should make domestic producers more competitive. CMC’s move over the past year to eliminate non-core business units and focus on the core manufacturing, fabrication, and recycling of steel will improve its return on capital. We believe this will also make the company more attractive to institutional investors and a possible acquisition candidate.
- Best positioned company we know of to benefit from infrastructure spending
- Transformational acquisition (GERDAU) that will give them a 50% share of domestic rebar market
- Earnings potential goes from $2.00 to over $3.00 per share
- Stock relatively unknown with limited analyst coverage
International Paper (IP)
International Paper (IP) is a leading global producer of renewable fiber-based packaging, pulp and paper products with manufacturing operations in North America, Latin America, Europe, North Africa and Russia.
- Corrugated packaging products that protect and promote goods, and enable world-wide commerce; pulp for diapers, tissue and other personal hygiene products that promote health and wellness, and papers that facilitate education and communication
- International Paper has accumulated what is arguably the most well-invested and modern group of assets in the North American containerboard, white paper and pulp industries
- Stock down 20% from February highs
- Corrugated paper industry has high barriers to entry
- Top 3 companies control 75% of market share
Airlines: American Airlines – We believe that airlines are still under-owned and as the market rotates out of expensive momentum stocks, we believe airlines will be viewed less as cyclicals and gain more of a market multiple. American Airlines would be our favorite pick at this point. American traded as high as $59 on January 16th, and is now trading around $43 (down 40%). EPS guidance has recently come down because of higher fuel costs. We believe this will be offset with higher traffic and ticket prices. The US airline industry has right-sized itself and has become profitable on a much more reliable basis. This industry is quietly transforming and returning cash to shareholders. Also believe there is a Buffet bid in airlines.
Disclosure: I personally own all these stocks directly or indirectly through our mutual funds. The firm owns all these stocks directly or indirectly through our mutual funds. No investment banking relationships.