How to Invest in the Best Texas Stocks

Dan Caplinger, The Motley Fool

Texas isn't the biggest state in the U.S., but it has a unique combination of people, natural resources, and attitude that make it a place millions call home and millions more visit. It's also a great place to find a surprisingly wide array of investment opportunities, and investing in Texas stocks can be quite lucrative.

To get investment exposure to the best Texas stocks, you'll want to put together your own portfolio. That might seem unexpected, as Texas has a strong enough reputation to have inspired at least some investment professionals to make a go at offering ready-made investment vehicles featuring Texas-based companies. Yet as you'll see below, those efforts to make it easy for investors to pick companies with links to Texas haven't gone as well as hoped, and that makes it critical to have a good strategy for putting together your own ideal portfolio of stocks that call the Lone Star State home. We'll provide you with that kind of strategy below, but first, let's look at some of the alternative ways to invest in Texas stocks that haven't panned out.

Where are all the good Texas funds?

Given the interest that investors have in exchange-traded funds (ETF) that let you drill down on particular segments of the stock market, it's surprising that you can't simply go out and buy shares of a Texas-focused ETF. It would be relatively simple to put together an index that includes companies with certain relationships with Texas and then build an ETF to track that index.

Texas flag flying in front of the Austin skyline.

Image source: Getty Images.

That's exactly what OOK Advisors did back in 2009, launching its Texas Exchange-Traded Fund. The financial company had opened a similar ETF based on Oklahoma stocks shortly before launching the Texas ETF, with the same general idea. The fund had a simple investment objective: match the performance of a market-capitalization-weighted index of stocks whose headquarters were located in the Lone Star State.

Choosing Texas-headquartered companies led to a huge allocation to the energy sector. At its launch, the Texas ETF had more than 60% of its assets invested in oil and gas, with the next highest weighting coming in at less than 10% for technology stocks. Yet the fund never really gained popularity among investors, and the fund provider decided to close down both of its state-specific ETFs just a year after their initial launches.

A more recent traditional mutual fund focusing on Texas stocks has had a longer history, although it hasn't been much more successful. The Texas Fund, offered through Monteagle Funds, aims to invest the bulk of its assets in companies headquartered in Texas, incorporated under Texas law, or that got at least half their revenue or profit from goods, services, or investments connected to Texas. The fund holds more than 100 stocks that meet those criteria, and although it does have a slight overweight to the energy sector, the 15% allocation there is far less out of line with the overall stock market than its ETF peer's portfolio was. Unfortunately, the fund's five-year performance numbers have been negative even in a big bull market, and so it's no big surprise that the fund has only $10.5 million in assets under management and such a high expense ratio of 1.62% that the Texas Fund just isn't a viable option for investors looking to make money on Texas companies.

5 principles for picking a top portfolio of Texas stocks

Without any good options for farming out the job of selecting the best Texas stocks for your investment portfolio, it's up to you to go through all the companies that call Texas home to find the ones that are most likely to produce top returns, valuable investment income, or whatever other goals you have for your portfolio. That can sound intimidating to many investors, especially those who are used to relying on mutual funds and ETFs to do their stock-picking work for them. But it doesn't have to be scary, and it actually gives you a lot more flexibility to tailor a combination of Texas stocks that fits best with your other investments and will help you meet your specific investing objectives. 

Before you even think about what your Texas stock portfolio might look like, it's useful to make sure you know what you mean by a "Texas stock" in the first place. Some investors look at Texas stocks as being any company with a headquarters inside the Lone Star State -- even if it does most of its business outside its borders. Stock screening tools often give you the chance to search for companies based on their HQ location. Other investors are fine with companies that have headquarters outside Texas as long as they do a lot of business inside the state. For example, oil giant Chevron (NYSE: CVX) has a headquarters in California, but its purchase of Beaumont's Texaco nearly 20 years ago gave it a huge presence in the Texas market.

Below, we'll go through five basic core principles that you can use to put together a good Texas stock portfolio. Some of these principles are useful for coming up with any portfolio of stocks that targets a particular portion of the market, but a couple of them are specifically designed with Texas investments in mind.

1. Figure out how many stocks you want to follow

The first step in putting together a strong Texas stock portfolio is deciding just how big you want that portfolio to be. The ideal portfolio size will vary from person to person, but there are some general guidelines you should follow in making your own personal decision.

One consideration that's especially important has to do with how much of your money you want to dedicate to Texas stocks. If you have most of your money invested in a broader set of investments and just want to take a small portion of your investment capital to concentrate on opportunities in Texas, then it's not as important for you to have a diversified portfolio. Picking as few as one or two Texas-based companies could give you the spice to your investments that you're looking for, and you'll still have the rest of your outside investments to protect you if something goes wrong with the Texas stocks you pick.

If you want to invest most of your available money in Texas, however, then it's more important to take a prudent approach in building a diversified portfolio. Yet some people make the mistake of thinking that they have to buy dozens of stocks in order to get the diversification they need. In the process, they set themselves up for being overwhelmed with the sheer number of different businesses they have to follow, and it becomes impossible to do a good job of tracking all of their stocks and keeping up with how each one is doing individually.

Many successful investors find that tracking somewhere between eight and 12 stocks is a good middle-ground between having too few stocks to get diversified exposure and having too many to be able to keep on top of from a fundamental standpoint. Given the breadth of the Texas economy, it's easy to find a dozen or so stocks that can cover all the bases that are important to you. If you'd prefer to concentrate on a smaller number of top opportunities, then aiming for eight rather than 12 can give you a better reward if a couple of your picks end up doing especially well without leaving you overexposed if some of your choices perform poorly.

2. Decide what allocations to various sectors and industries you want

Once you've decided how many stocks you're comfortable having in your portfolio and following as their businesses develop, the next step is choosing how much of your money you want to allocate to particular industry groups and sectors of the economy. Like choosing the number of stocks, the best answer depends on the overall purpose of your Texas portfolio. If you have outside investments beyond the money you're investing in Texas stocks, then concentrating in a particular sector (energy or healthcare, for example) is a much more viable option. If you intend to put all of your investments in Texas-based companies, though, you'll want to consider more strongly putting together a portfolio of stocks in different industries.

Four oil pumps under an orange sky on a sunny day.

Image source: Getty Images.

Probably the most common idea that investors who are interested in Texas have is to load up on energy companies. Within the Lone Star State, the impact of the oil and gas industry is huge. During the 1970s and 1980s, the state's economy was heavily dependent on oil and gas development. That worked well during the oil boom, but it also left the state vulnerable when that boom ended and was followed by a prolonged period of painfully low prices for energy products.

It was that experience that led to a concerted effort in Texas to diversify its economy to protect it against the volatility of the energy markets. Moreover, as primary sources of energy products got depleted, forward-thinking planners realized that a more sustainable model for economic development was crucial in order to give the state something to build on once oil and gas reserves had been completely used up.

The result was a dramatic uptick in other areas of the economy. The state's business-friendly tax structure helped to entice technology companies to set up shop, with the state's capital of Austin becoming an important hub for tech upstarts to draw from the graduate pool of some of the state's most influential colleges and universities. Dell Technologies (NYSE: DELL) came to prominence in the Austin market, and now, giants like Apple and Facebook have a presence in the Texas capital, also referred to as Silicon Hills. The healthcare industry also rose in importance, as top institutions like the MD Anderson Cancer Center in Houston gained national prominence for its oncological work, and upstart private innovators like Irving-based Reata Pharmaceuticals (NASDAQ: RETA) built up their businesses. Given the location of Texas at the entry point to the fast-growing Latin American economy, trade, commerce, and logistics became valuable businesses for the state as well.

Interestingly, it was a renaissance in the energy industry that has returned Texas to the national spotlight most recently. Advances in technology have allowed oil and gas companies to revisit assets that they'd previously thought had nothing more to produce, and key shale plays like the Eagle Ford geological formation have taken advantage of techniques that weren't available to first-generation exploration and production companies. Now, there are a wide range of companies that cater to the energy industry once again, and growth opportunities in the sector abound.

The takeaway for investors considering Texas stocks is that there's now a surprisingly wide array of companies from which those who are interested in the Lone Star State can choose. If you want to track the same sector allocations as the broader U.S. market, then you can do so without feeling as though you have to settle for second-tier companies in certain industries. It's likely that Texas stock portfolios will be at least somewhat more energy-heavy than a typical portfolio, if only because those who are interested in Texas are often drawn to the opportunities in oil and gas. Which way you go depends on where you see the greatest chance of long-term profits and how important diversification is for your overall investment objectives.

3. Find a balance between huge multinational corporations and smaller up-and-coming businesses

In addition to allocating across various sectors, investors need to decide how they want to spread out their investment capital across companies of different sizes. In general, the companies with the largest revenue will have businesses that are mature and well established, and the stock market will reward those companies with higher stock prices that translate into a larger total value for the company -- also known as market capitalization. Although the best mega-cap stocks still have sizable growth opportunities, it takes a lot more in absolute growth to move the needle in a relative way. That makes large-cap stocks -- often defined as companies valued at $10 billion or more -- useful for those seeking securities, but it can be harder for aggressive investors seeking to maximize capital appreciation to find suitable companies that fit the bill.

By contrast, smaller companies are typically a lot riskier but have dramatically more potential for long-term growth. In many sectors, you can find small companies that aren't yet profitable and are still trying to build up a sustainable level of revenue on a regular basis. If you can separate the wheat from the chaff and find the small companies that are destined to become the leaders of the future, then getting in on the ground floor can produce life-changing results for your investment portfolio. However, it's tough to identify those winners without the benefit of hindsight, and so those who invest in small-cap stocks have to accept the fact that they'll inevitably make some choices that don't pan out at all and lead to substantial losses in their portfolios.

To understand better exactly what this can look like, consider a few Texas companies that might be good prospects for a Lone Star portfolio. Two of the biggest companies with headquarters in Texas are ExxonMobil (NYSE: XOM) and AT&T (NYSE: T). Both of them have long histories of successful business and are leaders in their fields. Both have generated good long-term returns for their shareholders, and they make sizable payments of income on a regular basis to investors in the form of dividends that have grown over time. Both companies have reasonable opportunities for future growth, but their size makes it difficult for them to pursue new business niches as nimbly as smaller companies could. As a result, most investors see these stocks as solid choices that even the most conservative of investors can be comfortable owning.

On the other hand, LGI Homes (NASDAQ: LGIH) has a market cap that's less than 1% what ExxonMobil and AT&T sport, but the homebuilder has been able to put up much more impressive growth numbers. The company saw its stock nearly quadruple between 2014 and mid-2019, as total revenue soared almost tenfold in the five-year period that ended at the beginning of 2019. An emphasis on starter homes has matched up well with the current demand trends among a rising demographic of millennial shoppers, and LGI has been smart about pursuing its most lucrative business opportunities. If the housing market turns downward, then the risk for LGI is significant, but the potential reward is worth it for those willing to accept that risk.

For different investors, the best mix of big and small companies will depend on factors like overall risk tolerance, the need for current investment income, and the time horizon involved. For most people, though, having at least some exposure to both big and small companies will provide a good balance that can lead to better overall returns.

4. Look at what each company's doing both inside and outside Texas

Investing in companies that are based in Texas doesn't necessarily mean that the most important exposure that you'll have will be to the Texas economy. Many of the top companies based in the state have corporate operations that span the entire globe. Others will have limited markets that, in some cases, will be entirely within the boundaries of the Lone Star State and will therefore be more reliant on the health of the Texas economy.

As an example, let's look again at AT&T. In some ways, it's entirely an accident of geography that AT&T ended up being based in Texas, because it was the regional Bell telephone company that covered the Texas market that ended up purchasing the long-distance carrier and adopting the AT&T name. Texas has a huge population and is therefore an important source of revenue for the wireless carrier, but AT&T has nationwide scope and isn't reliant on Texas for the majority of its sales.

Meanwhile, Texas Capital Bancshares (NASDAQ: TCBI) is a good example of a smaller company that's much more dependent on the health of the state's economy. The Dallas-based financial institution doesn't exclusively do business in Texas, but it does have major locations in key Texas cities like Houston, Austin, San Antonio, and Fort Worth as well as its home city. The independent bank prides itself on serving mid-market commercial businesses and Texas entrepreneurs, and it provides substantial financing for Texas-based projects like energy development, commercial and residential construction, and mortgage finance. The bank holding company faces many of the same challenges that its peers across the country have to deal with, and macroeconomic issues like the direction of interest rates and the general creditworthiness of the overall population definitely affect Texas Capital just as much as they do other banking institutions. However, if something happens that dramatically affects the health of its Texas-based customers to a greater extent than other regions of the country see, then Texas Capital does bear the risk of having a more difficult time in overcoming those obstacles and finding ways to keep growing.

The specific objective you have for your stock portfolio will guide you in choosing whether you're most comfortable having more of one of those types than the other. But, in general, a balanced mix often makes sense for typical investors.

5. Invest in what you love about the state

Finally, many successful investors discover that when they find businesses that they can connect with on a personal level, it's much easier to have confidence in their business models. That doesn't mean that you should let your emotions get the better of you, unreasonably expecting that a Texas-based company will be able to beat out rivals from outside the Lone Star State based simply on their location.

For me, my love of Tex-Mex food led me to make an investment in restaurant chain Chuy's Holdings (NASDAQ: CHUY). This small Austin-based company served markets solely within the boundaries of Texas for the first several decades of its existence, but more recently, it decided to carry its affordable yet delicious wares outside the Lone Star State. Chuy's now has almost 100 locations as far away as Denver, Chicago, Baltimore, and Miami, and although I still live several hundred miles away from the nearest location, I still have hope that one day I'll be able to visit a nearby Chuy's as often as I did when I was in law school in Austin.

Burrito with rice and salsa.

Image source: Chuy's Holdings.

Texas has enough different industries that finding something that connects with you isn't difficult. Every aspect of the energy business, from production and drilling to transportation and pipeline building to refining and marketing gasoline and other energy products, is available for investors, and you can either buy a stock like ExxonMobil that offers all of those aspects in a single investment or pick smaller companies that focus on one particular area. Tourism is a major industry, and companies like theme park operator Six Flags Entertainment (NYSE: SIX) -- headquartered in the Dallas-Fort Worth area city of Grand Prairie -- profit from its visitors both from within Texas and from elsewhere. The financial, transportation, and technological infrastructure needed to power the local economy offers numerous opportunities for investors interested in those areas, ranging from banking institutions like Texas Capital and high-tech businesses like chipmaker Cirrus Logic (NASDAQ: CRUS) to airlines like Southwest Airlines (NYSE: LUV) and American Airlines Group (NASDAQ: AAL). If you're already familiar with the products and services that the Texas-based companies you know and love offer, then it makes it that much easier to motivate yourself to find out more about their business operations and make an informed decision about whether you should invest your hard-earned money in those companies. 

Find the right Texas stocks for you

So much success in investing comes from being comfortable with the investments you make and understanding what goes into the companies you choose being successful over the long run. The opportunity to buy shares of well-known, respected Texas companies can be a great way to focus your attention on investments that already have meaning for you. By following the simple principles above, you can put together a portfolio of stocks that will have good prospects to deliver long-term growth to help you reach your financial goals.

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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Dan Caplinger owns shares of Apple and Chuy's Holdings. The Motley Fool owns shares of and recommends Apple, Chuy's Holdings, Facebook, and Southwest Airlines. The Motley Fool owns shares of LGI Homes and has the following options: short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool recommends Cirrus Logic. The Motley Fool has a disclosure policy.