Hodges: Small-Cap Guru Shares His Top Stock Picks

Eric Marshall, CFA, co-manager of the Dallas-based Hodges Small Cap Fund (HDPSX), has a bottom-up stock picking strategy that's put his firm on the map of top performers. We spoke with Marshall to get the scoop on his top stock picks.

"Our philosophy is that stocks have prices, but businesses have values. We don't worry about foreign exchange and commodities or Greece and Spanish bond yields, we just invest in companies that are investing in business."

The firm's five analysts go out and study companies full time. "We talk to vendors, suppliers, competitors, and industry participants to size up the risk reward of the investment. We talk to management and focus on buying at a good price." When asked if his stock picking strategy has any constraints based on ratios, dividend yields, or historical performance, he replied that his firm avoids the hard-and-fast rules and screens. "Sometimes the best investments are not the most obvious."

The benefits of small caps
For active investors, small caps operate in a less efficient area of the market. If the names are less followed, information may not be fully digested in the stock price, so if you spend time doing homework, you can really find some great bargains. "In a slow growth environment, it's often that you can still find positive price growth with small caps," adds Marshall.

In general, smaller businesses are less affected by global events than big name firms. "It doesn't matter what happens to EU bond rates overnight, they're just focused on growing their own business."

Industry favorites
Hodges currently favors energy, consumer discretionary, technology, and financial sectors, and airline, media and agriculture industries. Favorites include Belo Corp, Eagle Materials, FelCor Lodging Trust, and Faro Technologies.

Hodges is also adding smaller financial stocks like Texas Capital and Viewpoint, which it had avoided in the past four years. Marshall explains how the banks have better capital structures and more transparency than they used to, giving investors a great opportunity to capitalize on healthier banks. He also believes companies with niche technology for smaller hospitals, such as Computer Programs and Systems, are well positioned.

Let's talk specifics
The Manitowoc Company
(NYS: MTW) , market cap $1.66 billion, specializes in construction cranes and food processing equipment, two completely uncorrelated products. The share price is currently near $12.5, "but we see a lot of value coming back in the next few years -- to high teens, low $20s."

Texas Pacific Land Trust (NYS: TPL) is one of the oldest traded companies on NYSE and created out of old Texas Pacific railroad in 1880 when it went bankrupt after the civil war. Today the firm passively sells off their millions of acres, receives gas royalties, pays dividends and buys back stocks. "It's not really exciting, but there is a lot of value." Today it is trading at $60, they have a 10th acre per share of land, the equivalent of buying land at $600/per acre -- quite a bargain. And their claim to oil and gas fields and hard assets in the form of land should increase their value through inflation over time. As Marshall puts it, "we're buying land well under what we think is the fair market value."

Shoe Carnival (NAS: SCVL) is a niche retailer in the family shoe channel. "They have a little over 300 stores and [are] growing the store base by 10% year. And we think they can grow their revenues faster than that. It's probably a good acquisition candidate for larger retailers like DSW that want to go after that family shoe space."

This brings up another good point about small caps: You often see smaller companies get bought out by larger companies to subsidize lack of organic growth in slower environments, when revenues aren't growing that fast. "They kind of leverage fixed costs, and we saw some of this activity pick up this summer. It should continue to end of year, which bodes well for a lot of small-cap companies."

Belo Corp. (NYS: BLC) owns TV stations in various major metropolitan areas. The field has been depressed in past years but stands to do well. Among other means of benefiting include a recovery in car sales, which represent 20%-25% of local advertising. "They will get aggressive with advertising soon, plus a very heated election season is coming, so these local stations are benefiting form money spent on political advertising." says Marshall. "It can probably do very well and bring in over $1 earnings per share [current EPS at $0.8]."

Cirrus Logic (NAS: CRUS) had a big run providing audio chips for the iPhone and iPad. "With the iPhone 5 coming out we believe they stand to gain market share and their revenue per unit for the iPad and iPhone we think is going to be on the rise. That will help grow the top line of the company. We started buying around $12-$13 areas, and we still like it long term."

Recent trades
Most recent purchase: Hodges recently added to their position in Primoris Services Corporation, a contract infrastructure firm "that could have some upside. There's heavy insider ownership and high earnings power."

Hodges recently sold off their position in the premium mattress manufacturer Tempur-Pedic International. "We've owned it since '09, and we bought in $20s, sold in $70s and $50s, and it's trading down in $30s today. The reason we sold that stock [is] because we [saw] pricing power deteriorate."

He explains: The premium mattress business held up in recession. It gained market share even in a different market environment. But Sealy, Serta, and other competitors have spent years trying to get into that premium business, and they finally made it. As a result, Tempur-Pedic has had to do more promoting, which they never had to do before, and offer discounts, which put pressure on their margins.

Words of wisdom
Don't try to outsmart yourself, and with all the volatility in the market these days, you are at risk if you're trying to beat the market. If you're jumping in and out, you're being risky, but if you try to get in when you think shares are mispriced, that strategy is an investor's best friend.

Remember that owning part of a company is the best way to accumulate wealth over time.

Business section: Investing ideas
Looking to emulate Hodge's Small Cap Fund's strategy and find other small-cap names where long-term growth opportunity abounds?

We list the fund's top 10 holdings below. List Average 1-Year Return: 67%. (Click here to access free, interactive tools to analyze these ideas.)

Compare 1-year returns:

  1. Texas Pacific Land Trust

  2. Smart Balance

  3. US Airways Group

  4. Encore Wire Corp.

  5. Cirrus Logic

  6. Atwood Oceanics

  7. Coinstar

  8. Westport Innovations

  9. Group 1 Automotive

  10. Cinemark Holdings

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.

Kapitall's Rebecca Lipman owns shares of Shoe Carnival andTexas Pacific Land Trust.

The article Hodges: Small-Cap Guru Shares His Top Stock Picks originally appeared on Fool.com.

The Motley Fool owns shares of Westport Innovations and Atwood Oceanics. Motley Fool newsletter services have recommended buying shares of Westport Innovations and Atwood Oceanics. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.