Secrets of high returns

(Fortune Magazine) -- There's a lot working against investors right now. Despite the recent declines, stocks still aren't all that cheap, and the economic picture is hazy. But even in the best of times, trying to predict the market's direction is a terrible idea, says Craig Hodges, who manages the Hodges fund (HDPMX) in Dallas with his dad, Don Hodges; he'd rather focus on the strengths and weaknesses of individual companies.

And the father-son team has done a good job: The fund, now with assets of $650 million, has a five-year annualized return of 18.8 percent, according to Morningstar, vs. 5.7 percent for the S&P 500. Hodges talked with Fortune's Katie Benner about where his go-anywhere, buy-anything strategy is leading him today.

Your fund's guidelines allow you to buy all types and sizes of stocks. How do you handle that freedom?

We typically divide the fund into thirds, with a third of our stocks including companies like Exxon Mobil (Charts) and Johnson & Johnson (Charts) that provide stability and some growth. Another third would go to overlooked values that have hardly any analyst coverage or that have done so poorly that everyone has given up on them. For example, we bought GM (Charts) below $20 and sold it at $30. Another third would be in supergrowth companies like Apple (Charts) and Google (Charts).

But we don't always stick to this. In 2003 we were up 80 percent, mainly because 60 to 70 percent of the portfolio was in small caps. Small caps were obliterated in 2002, so we thought they would come back. We slipped back to a more balanced portfolio in 2004, and now we're overweight large cap.

What's your strategy now that it looks as if we might be in for a choppy 2007?

We're a big proponent of pricing power. What allows a company to maintain or even increase its prices is a lack of competition, high barriers to entry and good demand. PC makers can never have pricing power because there's too much competition. Instead, we focus on businesses like railroads and steel, where there used to be a ton of competitors and now there are just three or four.

Where's the pricing power today?

Right now we like deepwater drillers, oil services, cement, steel and construction equipment companies. It takes more drilling to get the same amount of oil out of the ground, and there's a limited supply of deepwater rigs. They take five years to build and cost about $500 million, so there won't be a flood of these products on the market.

I like Transocean (Charts) and Atwood Oceanics (Charts). Transocean will probably earn about $7.25 this year and over $11 next year. Atwood's earnings should go from $4.30 in 2007 to $8.50 in 2008. Halliburton (Charts) gets a bad rap because of its association with the Vice President and the war in Iraq, but it's one of the few companies that can do what it does. Linn Energy (Charts) is an oil and gas company that's acquiring gas drillers and will increase its dividend from $2.28 to $2.60. It's trading at $32 but should be a $40 stock.

Anything outside the energy sector?

Caterpillar (Charts) is a great buy in the large-cap arena. It's trading at 11 times earnings but will earn $5.50 this year and $6.25 next year. Earnings have doubled over the past three years, and they're cutting costs, expanding into China and India, and building plants all over the world. There has been some negative news about the company, but we think they're getting their ducks in a row.

Our favorite small-cap stock is a bit riskier, because no one really looks at it. Wireless Ronin Technologies (Charts) makes digital signs on liquid-crystal displays and delivers the content over a wireless network. It's a fast-growing business, and the company, which is just now becoming profitable, will be one of the big players in this industry.

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