The 2Q24 proved to be another quarter of “haves and have-nots” for U.S. stocks, with the S&P 500 Index posting gains of 4.3% in the quarter and 15.3% year-to-date. Robust gains for the S&P 500 were powered by a 37.0% advance for the seven largest stocks in the Index and a stunning 149.5% return for AI chip producer Nvidia (NVDA). However, most stocks have experienced a much more muted performance this year, with the equally weighted S&P 500 returning roughly 5.1% year-to-date and approximately three out of five stocks in the Index experiencing a negative year-to-date return. The market has also remained divided among market cap size, with the small caps, as measured by the Russell 2000, down 3.3% in 2Q24 to finish the first half of the year up only 1.7%.

The broadening of capital flows into sectors outside of mega-cap technology experienced in the first quarter of this year reversed course in the second quarter to favor a narrow band of technology companies expected to benefit from the prolific growth in artificial intelligence investments. Uncertainty around possible rate cuts and the prospects for a soft economic landing weighed on cyclical stocks in the later part of 2Q24, resulting in underperformance in the energy, industrial, consumer discretionary, and materials sectors. Furthermore, PE multiples remain highly bifurcated between growth and value stocks. According to FactSet data, the 12-month forward PE multiple for the S&P 500 was 21.2X at the end of June, expanding from 20.5X at the end of March to well above the 10-year average of 17.1X. The inverse of the current S&P 500 PE multiple is an earnings yield of 4.72%, slightly above the 10-year treasury yield of 4.42% at the end of the recent quarter. It is worth acknowledging that the S&P 500 is more expensive today relative to the yield on the 10-year treasury than it was at the beginning of the year.

For the balance of 2024, our investment team is laser-focused on the fundamentals of individual stock selection and the prospects for earnings power in the year's second half. While many economic pundits have predicted a U.S. recession for the past couple of years, a decline in real GDP for two consecutive quarters has not materialized. However, we have observed that specific sectors, such as financials, energy, and industrials, have already experienced an earnings recession or at least a significant contraction in profit margins over the past 18 months. Moreover, inflation appears to be moderating compared to this time a year ago, albeit at a slower pace than some predicted. Given the prospects for a more normalizing environment for inflation, we would not be surprised to see new leadership emerge within the domestic market or at least a broader number of stocks participating in any upside from earnings growth over the next twelve months.

We believe this is an ideal time to focus on quality stocks at a fair price rather than growth at any price. In our view, quality is not always measured by market capitalization or reflected in market sentiment. We define quality as well- managed companies with structural competitive advantages stemming from a differentiated niche, proprietary technology, or unique barriers to entry. Other key factors include conservative balance sheets, low-cost operations, and ample liquidity to weather downturns and, in many cases, to take market share from weaker competitors.

Our recent discussions with public company management teams over the past few months have become more mixed as some businesses tied to consumer discretionary spending have become more cautious in recent months. Although the U.S. economy remains near full employment, consumer spending appears more erratic this year as low savings rates and higher credit card balances curtail discretionary consumption of some goods and services. On the positive side, supply chains appear stable for most industries, and input costs have continued to moderate. Demand related to infrastructure spending, renewable energy projects, and the reshoring of manufacturing remains healthy. The housing market is slower than a year ago due to higher financing costs and affordability but is holding up better than feared in many regions due to a lack of existing homes for sale. As equity investors, we find ourselves in a 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.

The return for the Hodges Small Cap Fund amounted to a loss of 3.48% in the second quarter of 2024, compared to a decrease of 3.28% for the Russell 2000 Index. The Small Cap Fund's year-to-date performance as of June 30, 2024, amounted to a gain of 7.28% compared to 1.73% for the Russell 2000 Index during the same period. The Small Cap Fund's one-year performance amounted to a gain of 10.03% compared to an increase of 10.06% for the Russell 2000 Index during the same period. 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 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.

We believe 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 51 positions on June 30, 2024. The top ten holdings amounted to 34.07% of the Fund's holdings and included Matador Resources (MTDR), Texas Pacific Land Corp (TPL), Eagle Materials Inc (EXP), Taylor Morrison Home Corp (TMHC), Halozyme Therapeutics (HALO), Norwegian Cruise Line Holdings (NCLH), Shoe Carnival Inc (SCVL), Cleveland-Cliffs Inc (CLF), Topgolf Callaway Brands (MODG) and Permian Resources (PR).

The Hodges Fund's second quarter 2024 return amounted to a loss of 4.61% compared to a gain of 4.28% for the S&P 500 Index. The year-to-date return amounted to 5.58% compared to a 15.29% return for the S&P 500 Index. The fund's one-year performance amounted to a 19.98% gain as of June 30, 2024, compared to a 24.56% gain for the S&P 500 Index during the same period. Over the past twelve months, underperformance was attributed to the portfolio’s underweight exposure to the seven largest momentum stocks in the S&P 500 during the most recent quarter. The Hodges Fund’s turnover was average in the recent quarter as we have carefully updated the portfolio holdings, moving 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 focused on investments where we seek 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 42. On June 30, 2024, the top ten holdings represented 44.09% of the Fund's holdings. They included Matador Resources Co (MTDR), Uber Technologies (UBER), Texas Pacific Land Corp (TPL), DraftKings Inc (DKNG), Freeport McMoran Inc (FCX), Norwegian Cruise Line Holdings (NCLH), Nvidia Corp (NVDA), Airbnb (ABNB), On Holding (ONON), and Wynn Resorts (WYNN).

The Hodges Small Intrinsic Value Fund experienced a loss of 6.76% in the second quarter of 2024 compared to a decrease of 3.64 % for its benchmark, the Russell 2000 Value Index. The Small Intrinsic Value Fund's year-to-date performance as of June 30, 2024, amounted to a loss of 1.47% compared to a loss of 0.85% 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 materials stocks that fell out of favor in the final month of the quarter. It is also worth noting that many of the stocks that underperformed in the June quarter were among the holdings that contributed to the strategy's positive relative performance in the previous quarter. The number of positions held in the Fund decreased by three, resulting in 47 holdings at the end of the recent quarter. On June 30, 2024, the top holdings represented 30.90% of the Fund's holdings. They included Eagle Materials Inc (EXP), Shoe Carnival Inc (SCVL), Triumph Financial (TFIN), Halozyme Therapeutics (HALO), Banc of California (BANC), Aviat Networks (AVNW), Ethan Allen Interiors Inc (ETD), SunOpta (STKL), Texas Capital Bancshares (TCBI), and Tower Semiconductor (TSEM).

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 navigate today's ever-changing financial markets. Feel free to contact us directly if we can address any specific questions.