Stocks to Watch: Rails and Oil Drillers

Hodges Fund comanager would take a flier on airlines, too.

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From his Dallas office, Craig Hodges comanages the Hodges Fund and Hodges Small Cap Fund, two portfolios currently stuffed with energy and railroad shares. With markets in turmoil, he's betting those sectors can continue their gains while he eyes all sorts of unloved small-company stocks to snap up when markets start to improve. He spoke with U.S. News about his strategy and offered up some ideas for the rest of the year. Excerpts:

What's the environment like for small caps right now?

It's hit or miss. The problem with small caps is they're extremely volatile because the markets aren't very deep. If it's not a loved or closely followed company, it can go into a free fall if there's not somebody there to support the price. That's a negative, but it also creates opportunities. If we're doing our homework and really get to know the companies, there are some inefficiencies in the market. Is it tougher to spot those types of companies given the volatility of these markets?

We have more stocks on our radar screen that we're excited about than ever before. The problem is you have to sit and wait and be extremely patient. There's one stock, A.T. Cross , that makes the Cross pens, who've bought a couple fast-growing sunglasses companies. It's a great-looking situation, but there's no analyst coverage at all, and you'll go through long periods where there's not much buying interest. But we feel the market will eventually clue into how well they're doing. There are situations out there like that. We see a lot of them, but I don't know how timely they all are. A quick look at the Hodges Fund shows a lot of energy and transport holdings. What's the strategy so far this year?

There's two markets out there right now, kind of the haves and the have nots. If you're tied to the consumer at all or to financials, it's really tough on you. The environment is about as tough for retailing as anything I've ever seen. At the same time, there's a whole section of the economy that's booming: energy, construction, equipment, cement, steel, railroads. They're having some of the best success we've ever had. Tell me about railroad stocks. When did you get in, and when does the cycle stop?

We got into rail very early. We started buying Burlington in July of '04 around $30. [Shares are near $100 today.] We saw what was going on with imports from China, and it just so happened that at that time the coal business got extremely strong, and then trucking got weak, and that translated to a boom for rails. Then ethanol and the grain business [picked up], and rail had a rebirth with limited competition. As long as we have high energy prices, the rails are going to be extremely attractive. They have such a cost advantage over every other form of transport. Warren Buffett sees them as a cycle that's going to last an extremely long time, and we do as well. How do you play energy?

Our favorite ideas in energy are the deep-water drillers. They have the most pricing power. There's limited competition there, and day rates and new contracts are setting all-time highs. Now that governments are buying oil for strategic reasons rather than just oil companies, it's created a new level of enthusiasm. If you found a bunch of oil right now, you probably couldn't get a deep-water rig for three years. So who do you buy?

We like Transocean, Diamond Offshore, and Atwood Oceanics, which is a smaller-cap name. Even though those stocks have made big moves, they trade at about eight times [projected] earnings. Then we play the service companies. As a small-cap play, we like Bristow Group. It's a helicopter contract company that sends helicopters to and from offshore platforms. That's another business that has tremendous pricing power and limited competition. You can't get many big helicopters because the government is using most of them. Energy is usually cyclical. How to you decide when to exit?

The main thing we look for is to see if these industries start to lose pricing power. If contract prices come down, it means an excess of rigs. But we think we're a long way from that in many of these industries.