Hodges fund invests wherever the father-and-son managers find opportunity. By Steven Goldberg, Contributing Columnist October 23, 2006 Twenty years ago, many mutual funds were generalists. They didn't specialize in one corner of the market or another. When the managers thought large companies would do well, they bought more large caps. When they thought small-company stocks were attractive, they bulked up on those. Few funds still try to cover all the bases. Dallas-based Hodges Fund (symbol HDPMX) is one that does -- and does so exceedingly well. Don Hodges, 72, has been investing for a living since 1960. He launched the fund in 1992, and his son, Craig, 43, signed on as co-manager in 1999. "We float to where we think the action is going to be," Craig says. "We're not into styleboxes, and we are not in a stylebox. We only have one fund and we'll probably only have one fund." The fund is managed essentially the same way the firm manages private accounts. The fund holds about $500 million, and the firm manages another $500 million in private money. That's a good size for an all-cap management firm. It's profitable enough to retain four analysts, but small enough to invest in stocks of many smaller companies. Hodges fund returned an annualized 12% over the past ten years through October 20. On average, that's three percentage points per year better than the return of Standard Poor's 500-stock index. But whether the SP 500 is the best benchmark for judging this fund is problematic because Hodges doesn't just invest in large-company stocks. Before you jump in, be aware that this fund has offered investors a hairy ride at times. It plunged 59% during the 2000-02 bear market -- 12 percentage points more than the SP 500 sank. Although Hodges aims to appeal to all investors, it tilts toward growth stocks most of the time. Stocks they like Until the past few weeks, Hodges was bullish on large caps, putting 55% of assets in those stocks. "We're starting to see more value in small caps and mid caps," Craig says. "We're probably trending towards one-third each in small caps, mid caps and large caps, but it might take us three months to get there." Craig says he and his father make their decisions on how to allocate money based on the fundamentals of the stocks they're examining -- not on economic predictions. The most important thing they look for in a company is earnings growth. They like to see companies whose earnings should grow faster than the stock's price-earnings ratio -- that is, they're looking for a price-earnings-to-growth-rate (PEG) ratio of less than one. Next, they look for growing profit margins. "If companies can raise prices, it leads to margin expansion, which leads to higher P/Es," Craig says. They also favor companies with strong balance sheets. The managers tend to put a good portion of the fund's money into four or five industries that look attractive. Currently, they're bullish on basic industries, construction, railroads, deepwater oil-and-gas drillers, as well as cement and steel. "Those are the areas where we see pricing power," says Craig. Trinity Industries (TRN) is a favorite stock. The firm makes and leases railcars, which are in heavy demand, and is in several other fast-growing businesses. Hodges also likes Southwest Airlines (LUV), the discount airline. Craig thinks it will profit from lower jet fuel costs. Cisco Systems (CSCO) is another favorite. Craig sees the networking giant benefiting from the continued expansion of video over the Internet. This longtime laggard "is extremely well positioned," he says. One more pick: Sterling Construction (STRL). A new federal highway bill will put $15 billion into Texas highways. "Sterling is a pure play on Texas highway construction," Craig says. "They're in the sweet spot." Yet few analysts cover Sterling, which is a major player in transportation and water infrastructure. He estimates that the company will earn $1.40 per share next year and will increase earnings 20% annually in the coming five years. Hodges Fund reflects the personalities and values of the father-and-son team that run it. The fund doesn't own tobacco, alcohol or gambling stocks. "We want to own products that we can be proud of," Craig says. Steven Goldberg is a freelance writer and former senior associate editor of Kiplinger's Personal Finance magazine.