From Contrarian Fund Manager Don Hodges

Early in 2009, Don Hodges made a big bet on pens. Two of his mutual funds bought several hundred thousand shares of A.T. Cross, maker of the ­famous Cross fountain pens and other writing instruments, when the stock was trading for less than $2 per share and when few investors and analysts thought that there was much of a ­future for a pen company in the digital age. The stock has since soared past $21 per share, handing the Hodges funds a huge profit. Hodges likes to go against the Wall Street tide and invest in out-of-favor stocks. He has been doing it for more than 50 years. And the strategies he uses in picking his contrarian stocks hold important lessons for all ­investors. Bottom Line/Personal asked Hodges, whose Hodges Fund gained 54% in 2013 as of early December,* to share his stock-picking insights and his current favorites…

UNLOVED BARGAINS

In A.T. Cross, which changed its name to Costa Inc. last year, I saw a well-run company that dominated its niche and had a customer base as fanatically loyal as Apple’s. The stock was an unloved bargain, and even though last year’s stock market gains have left most stocks pricey, it still is possible to find such bargains. You have to wait for a stock or segment of the market to become dirt cheap because it’s been dumped by investors and ignored or criticized by Wall Street analysts. Then search for positive signs that have been overlooked. One of the great advantages of betting on the comeback of a deeply out-of-favor stock is that the company doesn’t have to deliver spectacular ­financial results to see its stock price rise substantially. Even a marginal improvement can surprise skeptical investors, beat analyst expectations and attract a flood of money. I often start by looking for stocks that have dropped 50% or more below their historic highs. They sometimes are so disparaged that the perceived risks can be much greater than the reality. For example, the newspaper industry faces many challenges in the Internet era as its main sources of revenue-—advertising and paid subscribers—shrink. But investors have priced many print-media companies as though they were near bankruptcy. I was able to buy A.H. Belo (AHC), the parent company of The Dallas Morning News, for as little as $1.20 per share over the past few years because investors disregarded the company’s strengths. Those include a solid balance sheet, valuable real estate assets in Dallas and a devoted readership in what is essentially a one-­newspaper town. The share price has topped $7.

Buffer Stock Risks

While I like to challenge conventional wisdom, the stock market isn’t always wrong about punishing poorly performing companies. Buying cheap stocks can be risky because they may continue to drop, so I look for one or more of the following elements in a company to buffer my risk…

  • Savvy management
  • Low debt
  • Steady dividend
  • High barriers that discourage competitors from entering the business
  • A catalyst that can turn the tide of investor sentiment and hike the share price in the next 18 months.

For instance, in early 2013, Boeing’s newly introduced 787 ­Dreamliner planes were grounded after battery problems caused fire and smoke in several of the aircraft. We held on to our Boeing shares—and even added to them when the stock was trading below $100—convinced that the company would solve the problems and continue to thrive. On a single day recently, Boeing, which already had a $415 billion backlog of orders, won $100 billion in additional orders from various ­Persian Gulf airlines. And the stock was recently trading at more than $130 per share.

FAVORITE CONTRARIAN PICKS NOW

Recently, we have been buying stocks in businesses as diverse as copper mining…deepwater-drilling rigs…and old-fashioned cafeteria-style restaurants.

  • BP (BP). Some investors shun this oil giant as a matter of principle because of its role in the massive 2010 oil spill in the Gulf of Mexico. Many also are wary of the tens of billions of dollars in possible additional fines that the company still may face. But the stock, which has lost 22% of the value it had before the disaster, is very attractive to contrarians.
  • Why I’m buying: The new management values safe practices and ethics. The former CEO was replaced by Bob Dudley, who headed BP’s Gulf Coast Restoration Organization, responsible for the cleanup in the Gulf of ­Mexico. Also, the company is shareholder-­friendly. Recently, it boosted its dividend by 6% and announced a $10 billion share-repurchase program. BP’s balance sheet remains strong, thanks to the sale of nearly $40 billion in assets to cover current and future liabilities from the oil spill. And BP has high levels of proven reserves and now owns a lucrative 18.5% share of Rosneft, Russia’s state-owned oil company. Recent share price: $46.57.

  • TSMPlantTaiwan Semiconductor Manufacturing (TSM) makes the electronic chips in the circuits that run computer tablets, smartphones and other devices for tech companies that don’t have the expensive facilities to do it themselves. Although the company controls 50% of this market globally, investors have fled from its stock as the growth in overall demand for mobile phones has slowed, hurting chip production. The stock was up just 4% in 2013, far behind the S&P 500’s gains.
  • Why I’m buying: Semiconductors are a cyclical sector that faces volatile ups and downs. I think the industry is poised for a turnaround as the need for entry-level smartphones in emerging markets accelerates. The company, which has about $5 billion in cash, recently pulled off a coup. It beat out its main competitor, Samsung, by signing a three-year deal to produce chips for Apple. Recent share price: $17.37.

  • Freeport-McMoRan Copper & Gold (FCX) is the world’s largest publicly traded copper miner. Its stock has lost nearly half its value since 2011 amid an ugly bear market for commodities and slackening demand from China, which accounts for 40% of global copper consumption. Investors fear that the infrastructure boom in China, which depends on copper for electrical wiring in everything from houses to trains, is over and that copper prices, which quadrupled over the past decade, will sink.
  • Why I’m buying: The company is priced as if it will be in a down cycle for copper permanently. In fact, long-term copper demand is continuing to outstrip supply, and the company can remain solidly profitable even if the Chinese economy never returns to double-digit annual percentage growth. Major new markets for copper have arisen. For instance, hybrid vehicles use about twice as much copper as ordinary cars. In the meantime, Freeport-McMoRan stock recently yielded 3.6%, and the company’s new mines in the Democratic Republic of Congo will enable production growth in the future. Recent share price: $34.89.

  • Luby’s (LUB). In an age of organic ingredients and “fast-casual” chains such as Chipotle Mexican Grill, investors have overlooked this old-fashioned, cafeteria-style Texas chain that serves gravy-smothered chicken-fried steak and pot pie. Even though Luby’s stock price has gained nearly 7% a year over the past five years, it trails the restaurant category’s average annual gains by 16 percentage points.
  • Why I’m buying: I’ve had great ­success with other unsexy restaurant chains that had sound business fundamentals and the potential for significant expansion, such as Cracker Barrel Old Country Store (up 71% in 2013) and Pizza Inn Holdings (up 145%). Luby’s has great management, its profits have been rising strongly, and it owns most of the real estate locations where it operates. Recent share price: $7.45.

  • Transocean Ltd. (RIG). The stock of this leading provider of deepwater-drilling rigs for oil companies was recently trading at nearly 50% below its five-year high. Headlines have scared off investors because tepid global growth has kept down demand for oil, plus Transocean’s legal trouble pertaining to the 2010 Gulf of Mexico oil spill could wind up costing the company several billion dollars in financial ­settlements.
  • Why I’m buying: With a $28 billion backlog of orders, Transocean has more than ample cash flow to withstand legal damages and still pay a significant dividend, recently yielding 4.3%. The company has few competitors in major deepwater basins such as the West African coast and the Gulf of Mexico, where the biggest oil deposits and the greatest expansion of drilling will occur in the next decade. Recent share price: $49.25.