Small Caps With Pricing Power In Niche Markets

Eric J. Marshall, CFA, President, Portfolio Manager Director of Research, Hodges Capital Management

Eric Marshall:  At the Hodges Small Cap Fund we undertake an investing strategy that is focused on individual company selection.  We spend a lot of time doing bottom-up research on individual companies.  We think of ourselves as private equity investors in the public markets.

Because we invest in individual companies and not in markets, we don’t spend a lot of time worrying about what the yield curve is going to look like six months from now or, for instance, what will happen with currency rates or Spanish bond yields.  We remain focused on what is going on in the individual businesses that we invest in.  We look for businesses where we can make money and then make individual stock selections within those areas.

In the Hodges Small Cap Fund we’ve done very well executing this strategy over the last few years.  And we think now is a unique time to be an active manager — especially in the small cap space where there are so many inefficiencies in the market.

One factor is that fewer funds are focusing on these unloved companies.  This results in less sell-side firm published research because Regional brokerage firms do not want to write research on the less liquid small cap stocks.

Wally Forbes:  Do you have a general time horizon in mind when you’re making decisions on buying or selling?

Marshall:  We think of ourselves as long-term investors.  When we build an investment thesis we typically build it around a 12- to 18-month time horizon where we see some kind of catalyst to unlock the value over that timeframe.

Some of the biggest money that we have made in stocks has been in the third or fourth year that we have owned them.  And there are several key holdings in the Hodges Small Cap Fund that we have owned for four or five years.

Forbes:  That gives a very helpful perspective to people who are going to be reading this to get a sense of how you’re going about the selection process.

Marshall:  One key aspect we look for in companies is high barriers to entry that have relatively good pricing power.  We like to find companies that have identified an underserved or niche market that has the ability to raise prices and have margins that are attractive or expanding.  Typically when you find industries or businesses that have pricing power and margin expansion, you not only get good earnings growth — you also get some multiple expansion as well.

Forbes:  Sounds like a good opportunity if you can put all those factors together.

Marshall:  Absolutely.  Let’s discuss a couple of examples of companies that we like right now.  One of the themes that we see is a big trend towards moving crude oil by rail.  You’ve heard a lot of the railroads talk about this.

As such, one of the holdings that we have in the Hodges Small Cap Fund is a company called Trinity Industries (NYSE: TRN).  It is one of the leading manufacturers of rail cars.  They make a large number of tanker cars, which they sell to operators.  They have a leasing group that leases these cars, as well.

They have seen a record backlog over the past year.  Business has come back very nicely off the lows of the recession.  There are some headwinds out there from coal and agriculture with the drought.  They haven’t been making as many coal- and hopper-related cars, but the demand for tankers has been great.

Forbes:  Why has the trend gone to rail cars as opposed to pipelines?

Marshall:  In the long-term, pipelines will move the oil.  But because domestic oil production is being found in several new shale plays where oil was not previously found, there is no existing infrastructure to move the oil from production areas to the refineries.  In some cases it could take up to 10 years to build those pipelines; get the regulatory approval, engineering, and the funding to build them.  In the meantime, even some of the pipeline companies, like Kinder Morgan Kinder Morgan, the largest pipeline company in theUnited States, are buying rail cars from Trinity.