The fourth quarter was a mixed bag for U.S. stocks, resulting in an advance of 2.41% in the S&P 500 Index and more modest gains for small caps. The S&P 500 finished the year with a 2.6% drop from Christmas to year's end, which marked the worst final week of any year since 1952. Despite the year-end sell-off, the S&P 500 Index posted a total return of 25.02% in 2024. For the second year in a row, robust gains for the S&P 500 were supported by a handful of the largest market cap stocks, with the equally weighted S&P 500 returning a loss of 1.92% in the recent quarter to reflect a gain of only 12.79% in 2024. Moreover, the top 10 stocks with the largest market capitalization represented 40.2% of the total S&P 500 capitalization at year-end, up from 16% five years ago and roughly 25% at the peak of the 2000 dotcom bubble (data from RBC Capital Markets). Small caps, measured by the Russell 2000, increased 0.33% in 4Q 2024, finishing the year at 11.54%.

The base case for a soft economic landing took shape in 2024, resulting in a GDP increase of 2.8%, supported by a resilient labor market and healthy consumer spending. Inflationary pressures moderated, resulting in three interest rate cuts by the Federal Reserve totaling 100 basis points last year. However, the Fed has recently signaled that its battle against inflation may not be over by suggesting a slower pace of future rate cuts. In response, cyclical, financial, and material stocks saw aggressive profit-taking during the year's final quarter as long-term interest rates increased and P/E multiples contracted. According to the FactSet consensus estimates, S&P 500 earnings are expected to show positive year-over-year gains in 4Q 2024 of +11.9% from improving margins for many companies that previously struggled to pass on higher costs a year ago. If these expectations are met during the upcoming earnings season, it will represent the highest year-over-year growth rate since 4Q 2021. According to FactSet data, the 12-month forward P/E multiple for the S&P 500 was 21.4X at the end of December, flat from the end of September and above the 5-year average of 19.7X. The inverse of the current S&P 500 P/E multiple is a forward earnings yield of 4.67%, just above the 10-year Treasury yield of 4.58% at year-end. It is worth acknowledging that the S&P 500 is now more expensive relative to the yield on the 10-year Treasury than it was at the beginning of October, as the earnings yield for stocks remained unchanged and the bond yield increased 0.85%.

Our recent discussions with public company management teams after the U.S. elections have become noticeably more optimistic as many corporate decision-makers anticipate a more favorable regulatory environment, lower taxes, and greater fiscal discipline regarding government deficits. A tick down in the December unemployment rate to 4.1%, accompanied by higher wages in December, appears supportive of consumer spending despite a lower savings rate and rising credit card balances over the past year. According to data from the Federal Reserve, the wealth effect of a rising stock market in 2024 is also a positive for consumption as household ownership of equities in the U.S. reached its highest record ever at 28.9%. Furthermore, supply chains appear stable for most industries, and input costs have continued to moderate, while the secondary impact of wage increases keeps inflation above the Fed's 2% target. Demand related to infrastructure spending, AI data centers, energy projects, and the reshoring of manufacturing are areas that remain healthy and appear poised to grow in 2025. The housing market is slower than a year ago due to higher financing costs and affordability. Mortgage applications have declined in recent months as a higher yield for the 10-year Treasury has pushed 30-year mortgage rates higher, climbing to nearly 7% to start the new year (6.93% as of 1-9-25, according to Freddie Mac). As equity investors, we find ourselves in a dynamic business environment where active portfolio management becomes essential to navigate quickly changing business conditions across many sectors and position portfolios to potentially benefit from shifting trends and structural changes across different industries.

Our outlook for 2025 presents a mix of optimism and caution as we weigh the risks and rewards of each stock in our portfolios. We are encouraged by the anticipated policy measures under a new presidential administration, which could boost corporate earnings and drive new investment growth over the next several years. However, one of the biggest concerns for the stock market in 2025 is a reacceleration of inflation, which could pressure the P/E multiples of growth stocks and keep interest rates higher for longer. What we know for sure is what we do not know. We do not know what actions the Fed may take to curtail a resurgence in inflation, or the exact structure and timing of new economic actions promised by the incoming Administration. What we do know is that change is inevitable. As a result, we would not be surprised to see volatility manifest around structural changes in the U.S. economic landscape in the months ahead. While short-term market volatility can sometimes seem overwhelming, we expect the next few months to create opportunities for active portfolio managers pursuing mispriced stocks. As a result, our investment team is laser-focused on the fundamentals of individual stock selection and the prospects for future earnings power. Furthermore, we would not be surprised to see new leadership emerge within the market or at least a broader number of stocks participating in any upside from earnings growth over the next twelve months.

In summary, our focus is not on predicting short-term changes in interest rates, foreign currencies, or commodity prices. Instead, we prioritize identifying prevailing trends and, more importantly, evaluating the earning potential of our portfolio companies within their respective industries. At Hodges Capital, our investment team is dedicated to uncovering opportunities in companies that are well-managed and guided by strategic innovation and sound business decisions rather than reacting to daily market fluctuations. We want to assure Hodges Funds investors that our fundamental investment philosophy remains steadfast. As we enter 2025, we view this environment as an ideal opportunity for our portfolio managers to carefully select stocks we believe will deliver enduring value for our shareholders. Your trust is invaluable to us, and we remain committed to disciplined investment practices.

The return for the Hodges Small Cap Fund amounted to a gain of 2.91% in the fourth quarter of 2024, compared to an increase of 0.33% for the Russell 2000 Index. The Small Cap Fund's total return for 2024 amounted to a gain of 20.18% compared to 11.54% for the Russell 2000 Index. Although small-cap stocks have now underperformed large-cap stocks for the better part of the past decade, we still consider the current risk/reward for holding quality small-cap stocks as attractive. While small-cap stocks tend to experience greater volatility during market turmoil, we expect this segment to generate above-average relative risk-adjusted returns over the long term. Furthermore, many small-cap companies are uniquely positioned to benefit from deregulation, a pick-up in M&A activity, AI productivity enhancements, and the reshoring of manufacturing activity in the year ahead.

The Hodges Small Cap Fund remains well diversified across industrials, transportation, technology, and consumer-related names, which we expect to contribute to the Fund's long-term performance. The Fund recently took profits in several stocks that appeared overvalued relative to their underlying fundamentals and established new positions with an attractive risk/reward profile. The Fund had a total of 50 positions on December 31, 2024. The top ten holdings amounted to 34.93% of the Fund's holdings and included Matador Resources (MTDR), Texas Pacific Land Corp (TPL), On Holding Ltd (ONON), Eagle Materials Inc (EXP), Taylor Morrison Home Corp (TMHC), SunOpta Inc. (STKL), Academy Sports & Outdoors (ASO), Prosperity Bancshares (PB), Clear Secure (YOU), and Greenbrier Companies (GBX).

The Hodges Fund's fourth quarter 2024 return amounted to a gain of 6.71% compared to 2.41% for the S&P 500 Index. The annual return for the 2024 calendar year amounted to 16.87% compared to a 25.02% return for the S&P 500 Index. Although the Fund demonstrated strong relative performance in the year's final quarter, underperformance over the past twelve months has been attributed to the portfolio's underweight exposure to the seven most extensive momentum stocks in the S&P 500. That said, the Fund generated solid performance relative to the S&P 500 on an equally weighted basis, up 12.79% in 2024. The Hodges Fund's turnover was average in the recent quarter as we have carefully updated the portfolio holdings, moving into stocks that offer above-average returns relative to their downside risks over the next twelve to eighteen months.

The Hodges Fund's portfolio managers remain focused on investments where we have the highest conviction based on fundamentals and relative valuations. The number of positions held in the Fund at the end of the recent quarter was 40. On December 31, 2024, the top ten holdings represented 42.19% of the Fund's holdings. They included Matador Resources Co (MTDR), Texas Pacific Land Corp (TPL), Uber Technologies (UBER), SharkNinja, Inc. (SN), DraftKings Inc (DKNG), On Holding (ONON), First American Treasury Obligations Fund (FXFXX), Wynn Resorts (WYNN), Nvidia Corp (NVDA) and Expand Energy Corporation (EXE).

The Hodges Small Intrinsic Value Fund experienced a loss of 2.40% in the fourth quarter of 2024 compared to a loss of 1.06% for its benchmark, the Russell 2000 Value Index. The Small Intrinsic Value Fund's calendar 2024 return amounted to a gain of 1.49%, compared to 8.05% for the Russell 2000 Index during the same period. The Fund's recent underperformance relative to the benchmark was impacted by weakness in a handful of consumer discretionary and construction-related stocks that experienced above-average tax loss selling in the final month of the quarter. The number of positions held in the Fund at the end of the recent quarter was 47. On December 31, 2024, the top holdings represented 35.34% of the Fund's holdings. They included SunOpta (STKL), Triumph Financial (TFIN), Texas Capital Bancshares (TCBI), Banc of California (BANC), Eagle Materials Inc (EXP), Home Bancshares (HOMB), Academy Sports & Outdoors (ASO), Greenbrier Companies (GBX), Gulfport Energy Corporation (GPOR), and Shoe Carnival Inc (SCVL).

In conclusion, we remain optimistic regarding the long-term investment opportunities surrounding the Hodges Mutual Funds. By offering four distinct mutual fund strategies covering most segments of the domestic equity market, we can serve most financial advisors and individual investors' diverse needs. Moreover, our entire investment team is highly committed to rigorously studying companies, meeting with management teams, and observing trends to navigate today's ever-changing financial markets. Feel free to contact us directly if we can address any specific questions.

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