“When looking at buying a company, focus on what the business is worth, not the stock price.” – Warren Buffett
Much like the first, the second quarter of 2023 proved positive for U.S. stocks as market sentiment seemed to change daily around inflation concerns and prevailing economic activity. The S&P 500 rallied 8.7%, and the NASDAQ-100 Composite was up 12.8% in the recent quarter to reflect year-to-date returns of 16.9% and 31.7%, respectively. Year-to-date strength in the broader market indexes has primarily resulted from momentum in a concentrated number of mega-cap growth stocks, with seven stocks in the S&P 500 contributing more than two-thirds of the year-to-date return. As a result, the S&P 500 on an equally weighted basis was up only 7.03% year-to-date for the period ending June 30, 2023. As measured by the Russell 2000, small-caps rose 5.21% in the quarter, lagging due to their cyclical sensitivity and exposure to regional banks. Value stocks have underperformed growth this year as economic uncertainty and tighter credit conditions have weighed on sectors more sensitive to the business cycle. We are pleased to report that all four Hodges Mutual Funds generated positive one-year returns relative to their benchmarks as of June 30. Positive relative performance in our fund strategies was attributed largely to individual stock selection, which we attribute to our steadfast focus on companies with sound business fundamentals and reasonable valuations.
It's been well over a year since the Fed started its aggressive tightening cycle, which has led to a highly anticipated recession that has been slow to materialize. However, there is still ample uncertainty regarding the trajectory of interest rates and the prospects for challenging economic conditions in the back half of the year. We believe it is worth noting that the 16.9% rally in the S&P 500 in the first half of the year has been entirely driven by multiple expansion and not earnings growth, which is contrary to conventional wisdom that stagnate earnings growth combined with higher interest rates should cause PE multiples for stocks to contract. According to the most recent data published by FactSet, the S&P 500 traded at approximately 18.9X forward earnings estimates at the end of the recent quarter compared to 17.8X at the beginning of the second quarter and a 5-year average of 18.6X. The inverse of the current S&P 500 PE multiple reflects an earnings yield of 5.29%, which has moved closer during the recent quarter to the 10-year Treasury yield of 3.81%. However, it is essential to consider that the higher PE multiple for the S&P 500 has been fueled mainly by the information technology sector and those top seven stocks that contributed more than two-thirds of the market's return this year. Under the surface, the average stock in the S&P is trading closer to 17.0X forward earnings, which is below the 5-year average and more consistent with prevailing interest rates and expectations for earnings growth next year.
The most important factors for individual stock selection in today’s environment are balance sheet risk to rising rates, future earnings trajectory, and cash flow. We would point out that many businesses have spent the last six months cutting costs, scrutinizing capital expenditures, tightening supply chains, and cautiously managing inventories in anticipation of a slowdown. However, the inevitable contraction in bank lending and tighter credit conditions will be challenging for businesses and industries dependent on easy access to low-cost credit. This sometimes creates opportunities for companies with conservative balance sheets, low-cost operations, and ample liquidity to potentially weather a downturn.
Our investment team's recent discussions with public company management teams over the past few months suggest that labor costs have been stabilizing, and many other input costs have also been moderated in recent months. Although the U.S. economy remains near full employment, consumer spending has flattened this year and appears challenged as excess savings built up during the pandemic are no longer a tailwind. The housing market has slowed due to higher mortgage rates, but new residential construction has stabilized due to a lack of existing homes for sale in many regions. Although discretionary consumer demand is more challenging, certain areas, such as travel and hospitality, remain robust this year. Furthermore, we believe many facets of manufacturing are experiencing a renaissance due to onshoring and nearshoring supply chains and increased infrastructure-related spending. It is also important to note that not every economic slowdown looks the same, and not every business will be affected the same by potential macro headwinds. In this environment, active portfolio management becomes essential to navigate quickly changing business conditions across many sectors. Furthermore, an economic slowdown and tighter credit conditions favor stocks with solid balance sheets whose underlying assets have shown to produce stable cash flow and earnings. With this in mind, the Hodges Capital Management investment team has positioned our portfolios to potentially benefit from shifting economic trends and secular and structural changes across different industries.
As we look at the balance of 2023, our portfolios remain laser-focused on fundamental investing and individual stock selection. Our investing approach involves spending little time predicting short-term fluctuations in interest rates, foreign currencies, or commodity prices. Instead, we pay close attention to how prices and, more importantly, the pricing power that our portfolio companies exhibit within the goods and services they produce. For many businesses, tighter credit conditions and a slowdown in demand could adversely impact profit margins and revenues in the months ahead. As a result, the investment team at Hodges Capital is rigorously looking for bargains in businesses that we believe are well-run and control their destiny by relying on ingenuity and well-calculated business decisions rather than day-to-day momentum in the economy or stock market. Despite challenging macro conditions, we are overweighting our portfolios with growth and value stocks that can create shareholder value.
During this time of ambiguity, investors in the Hodges Funds can be assured that we are not changing our core investment discipline, designed to seek out quality companies running great businesses with excellent management teams trading at reasonable prices. Furthermore, we see this as an ideal environment for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. The current performance of the Funds may be lower or higher than the performance quoted. Performance data current to the most recent month-end may be obtained by calling 866-811-0224. The Funds impose a 1.00% redemption fee on shares held for thirty days or less (60 days or less for Institutional Class shares). Performance data quoted does not reflect the redemption fee. If reflected, total returns would be reduced. Performance reflected is net of all other fees and expenses.
The return for the Hodges Small Cap Fund amounted to a gain of 6.84% in the second quarter of 2023, compared to an increase of 5.21% for the Russell 2000 Index. The Small Cap Fund's year-to-date performance as of June 30, 2023, amounted to a gain of 11.99% compared to 8.09% for the Russell 2000 Index during the same period. The Small Cap Fund's one-year performance on June 30, 2023, amounted to a gain of 22.98% compared to 12.31% for the Russell 2000 Index during the same period. Although small-caps have underperformed large-cap stocks this year, we view the current risk-reward for holding quality small-cap stocks as attractive. While small-cap stocks tend to experience greater volatility during a period of market turmoil, we expect this segment to generate above-average relative risk-adjusted returns over the long term.
The Hodges Small Cap Fund remains well diversified across industrials, transportation, healthcare, 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 49 positions at June 30, 2023. The top ten
holdings amounted to 35.43% of the Fund's holdings and included Eagle Materials Inc (EXP), Matador Resources (MTDR), SM Energy Co (SM), Taylor Morrison Home Corp (TMHC), Encore Wire Corp (WIRE), Cleveland-Cliffs Inc (CLF), On Holding (ONON), Hilltop Holdings Inc (HTH), Kimball Electronics Inc (KE), and Inmode Ltd (INMD).liffs Inc (CLF), Vista Outdoor (VSTO), Hilltop Holdings Inc (HTH), and Encore Wire Corp (WIRE).
The Hodges Fund's second quarter of 2023 return amounted to a gain of 6.15% compared to an increase of 8.74% for the S&P 500 Index. The year-to-date return amounted to 14.22% compared to a 16.89% return for the S&P 500 Index. The one-year return for the period ending June 20, 2023, amounted to a gain of 29.39% compared to an increase of 19.59% for the S&P 500 Index. Although the portfolio has been underweight among the seven largest momentum stocks in the S&P 500, positive performance over the past twelve months has been attributed to a handful of industrial, healthcare, and technology stocks. The Hodges Fund’s turnover was again elevated in the recent quarter to take advantage of volatile market conditions. We have upgraded many portfolio holdings into stocks that we believe offer above-average returns relative to their downside risks over the next twelve to eighteen months.
The Hodges Fund's portfolio managers remain laser-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 43. On June 30, 2023, the top ten holdings represented 46.28% of the Fund's holdings. They included Uber Technologies (UBER), Matador Resources Co (MTDR), Encore Wire Corp (WIRE), On Semiconductor (ON), Cleveland-Cliffs Inc (CLF), Chesapeake Energy Corp (CHK), Charles Schwab Corp (SCHW), Eagle Materials Inc (EXP), Norwegian Cruise Line Holdings Ltd (NCLH) and On Holding (ONON).
The Hodges Small Intrinsic Value Fund experienced a gain of 5.12% in the second quarter of 2023 compared to a gain of 3.18% for its benchmark, the Russell 2000 Value Index. The Fund’s year-to-date and twelve-month returns amounted to 9.56% and 11.32%, respectively, compared to 2.50% and 6.01% for the Russell 2000 Value Index. The Fund's solid relative performance over the past year was attributed to several of the Fund's material, consumer staples, and industrial stocks. The number of positions in the Fund increased to 49 from 46 during the recent quarter. The top 10 holdings, excluding cash, represented 36.18% of the Fund's holdings and included Eagle Materials Inc (EXP), Taylor Morrison Home Corp (TMHC), Triumph Financial Inc (TFIN), Chord Energy Corp (CHRD), Brunswick Corp (BC), Kimball Electronics Inc (KE), Aviat Networks (AVNW), Vista Outdoor Inc (VSTO), Home Bancshares Inc (HOMB), and Diodes (DIOD).
The Hodges Blue Chip Equity Income Fund was up 7.03% in the second quarter of 2023, compared to a gain of 8.58% for its benchmark, the Russell 1000 Index. The Fund experienced a year-to-date return of 14.21% compared to 16.68% for the Russell 1000 Index. The return for the twelve months ending June 30, 2023, amounted to 21.35% compared to a gain of 19.36% for the Russell 1000 Index. Laging relative performance in the recent quarter was attributed to sector allocation among energy and technology. However, the current investing landscape offers attractive, high-quality dividend-paying stocks with solid upside potential. We expect underleveraged balance sheets and corporate profits across most blue-chip stocks to support stable dividends over the next several years. The Blue Chip Equity Income Fund remains well-diversified in companies that we believe can generate above-average income and total returns on a risk-adjusted basis. The number of positions held in the Fund at the end of the recent quarter was 29. The top ten holdings at the end of the quarter represented 51.10% of the Fund's holdings and included Apple Inc (AAPL), Microsoft Corp (MSFT), Nvidia (NVDA), Deere & Co (DE), Exxon Mobil Corp (XOM), Tesla (TSLA), Novo Nordisk (NVO), PepsiCo Inc (PEP), Texas Instruments Inc (TXN), and Costco Wholesale (COST).
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. Our entire investment team is rigorously studying companies, meeting with management teams, observing trends, and navigating today's ever-changing financial markets. Feel free to contact us directly if we can address any specific questions.
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The above discussion is based on the opinions of Eric Marshall, CFA, and is subject to change. It is not intended to be a forecast of future events, a guarantee of future results, and is not a recommendation to buy or sell any security. Portfolio composition and company ownership in the Hodges Funds are subject to daily change.
The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the Hodges Funds, and it may be obtained by calling 866-811-0224, or visiting www.hodgesmutualfunds.com. Read it carefully before investing.
Mutual fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater for investments in emerging markets. Options and future contracts have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. These risks may be greater than risks associated with more traditional investments. Short sales of securities involve the risk that losses may exceed the original amount invested. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Investments in small and medium capitalization companies involve additional risks such as limited liquidity and greater volatility. Funds that are non-diversified are more exposed to individual stock volatility than a diversified fund. Investments in companies that demonstrate special situations or turnarounds, meaning companies that have experienced significant business problems but are believed to have favorable prospects for recovery, involve greater risk.
Value investing carries the risk that the market will not recognize a security’s inherent value for a long time, or that a stock judged to be undervalued may be appropriately priced or overvalued.
Diversification does not assure a profit or protect against a loss in a declining market.
Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.
Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The S&P 500 Index is a broad-based unmanaged index of 500 stocks that is widely recognized as representative of the equity market in general. The Russell 1000 Index is a subset of the Russell 3000 Index and consists of the 1,000 largest companies comprising over 90% of the total market capitalization of all listed stocks. The Russell 2000 Index consists of the smallest 2,000 companies in a group of 3,000 U.S. companies in the Russell 3000 Index, as ranked by market capitalization. The Russell 2500 Index consists of the smallest 2,500 companies in a group of 3,000 U.S. companies in the Russell 3000 Index, as ranked by market capitalization. The Russell 3000 Index is a stock index consisting of the 3000 largest publicly listed companies, representing about 98% of the total capitalization of the entire U.S. stock market. The Russell 2000 Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Value Index is constructed to provide a comprehensive and unbiased barometer for the small-cap value segment. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set and that the represented companies continue to reflect value characteristics. The NASDAQ Composite Index is an index of more than 3,000 common equities listed on the NASDAQ stock market. You cannot invest directly into an index.
Cash Flow: A revenue or expense stream that changes a cash account over a given period.
Price/earnings (P/E): The most common measure of how expensive a stock is.
Earnings Growth is not a measure of the Fund’s future performance.
Hodges Capital Management is the Advisor to the Hodges Funds.
Hodges Funds are distributed by Quasar Distributors LLC.