No one can blame small-cap investors for feeling a bit disappointed in 2014. After several years of beating large-cap stocks, the Russell 2000—a small, popular small-cap benchmark—rose about one-third as much as the S&P 500 index.

But Eric Marshall, who manages the $1.9 billion Hodges Small Cap Fund, believes 2015 “is setting up to be a good year for actively picking stocks in the small-cap space.” And despite last year’s disappointing performance, he cited a number of reasons small-cap investors shouldn’t pare back allocations to the asset class.

For one thing, the dollar is strong. A stronger dollar can hurt large U.S. companies that do a lot of business overseas, since profits from weaker currencies translate into fewer dollars back home. Smaller companies don’t face currency or geopolitical issues to the same extent, since most of their business is done in the U.S.

It’s often possible to find smaller companies that do pretty much the same thing larger ones do yet have little or no international exposure. One such company in the Hodges Small Cap Fund is KapStone Paper and Packaging. Headquartered in Northbrook, Ill., this company manufactures and sells most of its products in the U.S. By contrast, multi-billion-dollar paper manufacturer International Paper derives a substantial portion of its revenue from overseas. Both stocks trade at similar price-earnings multiples.

“In the small-cap universe, it’s possible to find secular growth opportunities even in mature businesses,” he says. “The cardboard box business isn’t considered a growth industry, but it’s possible to find a smaller cardboard box maker that’s growing rapidly.”

Valuations are also a good reason to stay with small caps. While the Russell 2000 Index still has a higher price-earnings ratio than the S&P 500, the gap between the two has narrowed since last year. And Marshall thinks the valuation premium for small stocks is still warranted because they have a better potential for earnings growth and lower exposure to geographic risk than large companies. Also, while small-cap biotech and some other sectors may have high PE multiples, Marshall says small companies in the financial, industrial and materials sectors are trading at more reasonable multiples than their large-cap counterparts.

Some small-cap stocks are more reasonably valued than large-cap stocks in similar sectors and have a better shot at growth. Last year, the Hodges Small Cap Fund initiated a position in Horizon Pharma, a company with a $1.8 billion market capitalization that produces drugs to treat arthritis and inflammatory diseases. Marshall believes Horizon, which realized earnings per share of $0.80 in 2014, will grow earnings to $1 per share in 2015 and $1.35 in 2016.

“At a time when most biotechs are losing money, Horizon is enjoying strong cash flow and earnings growth,” he says. “It also has a growth component from an established base of drugs and drugs in development. We think it could be an acquisition target down the road.”

Meanwhile, the wide dispersion of valuations among small-cap stocks fosters a good environment for active stock picking. The popularity of passive index mutual funds and ETFs, many of them covering large-cap territory, have made it more difficult to find bargains in that space. Because small caps have less skin in the indexing game and are less followed by institutional investors and analysts, it’s easier to find pricing inefficiencies among them.

Small caps will also likely become acquisition targets because their more reasonable valuations make them attractive for large companies trying to buy growth. “Larger companies have been using excess cash to improve balance sheets rather than make capital expenditures,” Marshall says.

Long-Term Returns
Some attribute last year’s dull small-cap performance to stubbornly low interest rates, which make dividend-paying blue chips more attractive than bonds or small companies that pay small or no dividends. Marshall sees valuations as the main culprit. “At the beginning of 2014, small-cap companies were trading at considerable premiums to large companies,” he says. “So for many large caps, 2014 was a catch-up year.” The performance was also typical of economic recovery cycles in which small companies make their strongest surge in the early stages, he adds.

Despite last year’s dull showing, small-cap stocks, while more volatile than large caps, have also delivered more robust returns over long-term periods. The same holds true of the fund. From its inception in 2007 through the end of last year, it realized an average annualized return of 12.3%, outpacing the 8.4% of its Russell 2000 benchmark.

The road hasn’t always been smooth, though, for either small-cap stocks or the fund. In 2008, the fund’s first full year of operation, it plummeted 40.6% amid the financial crisis. But over the next two years, it bounced back 104%. By the end of 2014, the fund ranked in the top 20% of its Lipper small-cap peer group for one-year returns, in the top 4% for three-year returns and in the top 1% for five-year total returns.
While the fund’s 6.05% total return for 2014 beat its benchmark’s by over one percentage point, the fund inched up only 1.64% in the fourth quarter, while the benchmark rose 9.73%. The firm’s latest shareholder report attributes the poorer performance in that quarter to significant declines in the fund’s energy and industrial stocks. In response, the fund pared back some of its energy holdings but stuck with its most “high conviction” names, which Marshall felt would be in the best position to benefit from any eventual increase in energy prices.

Marshall says lower energy prices have created buying opportunities among a variety of companies. “With lower gas prices, consumers have more money to spend, so businesses tied to consumer demand are seeing a tailwind. Airlines and other companies where input costs for fuel or chemicals have been reduced also stand to benefit.”

Some stocks have been hurt by lower energy prices even though they aren’t directly tied to energy. Fund holding LegacyTexas Financial Group (LTXB), the holding company for Legacy Texas Bank, is a regional bank with 48 branches in the north Texas area. Although the stock fell last year amid concerns that plummeting energy prices would affect its loan portfolio, the bank has minimal exposure to energy-related loans, says Marshall. According to its Nasdaq quote page, Legacy sells at 14.6 times forward one-year earnings and has a market capitalization of $920 million. It has an active share-buyback program, and the stock has a dividend yield of 2.3%.

Another victim of the oil price drop, Eagle Materials, is a leading U.S. manufacturer and distributor of building materials, including cement, gypsum wallboard, recycled paperboard and concrete. It also produces sand used by the fracking industry, known as “frack sand.” The Hodges Small Cap Fund initiated a position in this company in 2014, when the stock dropped because of investor concerns about the impact lower oil prices would have on the frack sand business. Marshall believes investors aren’t giving enough credit to other parts of the business tied to construction, such as wallboard and cement. “Basically, we are buying the wallboard business and getting the energy-related business for free,” he says.

Shoe Carnival, a retailer and longtime holding of the Hodges Small Cap Fund, falls into the category of consumer stocks that stand to benefit from the extra spending money lower gas prices have put in consumers’ pockets. Based in Evansville, Ind., the chain of 376 shoe stores has $900 million in annual sales and a market capitalization of about $500 million. It has funded most of its growth from internal cash flow.

“Shoe Carnival caters to lower-end consumers, which are a niche market that has been largely ignored by others,” says Marshall. “It has a low price-earnings ratio relative to its growth rate, lots of cash flow and no debt. And it would be a good acquisition for a larger retailer seeking exposure in the family shoe channel.”

Another holding, Lithia Motors, is an auto retailer with 129 dealerships and a $2.3 billion market capitalization. According to Marshall, the company is “positioned to benefit from being in the early stage of a four- to five-year upside cycle for vehicle sales.” The stock also trades at a modest 15 times estimated 2015 earnings.

The assets under management of the Hodges Small Cap Fund stand at $1.9 billion. To help keep the fund nimble and avoid the liquidity issues that arise when a big fund trades in smaller, thinly traded companies, Marshall says the fund will consider closing to new investors once assets reach the $2 billion mark. If that happens, investors can turn to two smaller, newer funds that Marshall manages: the Hodges Small Intrinsic Value Fund (HDSVX) and the Hodges Small-Mid Cap Fund (HDSMX).