From the June 2002 issue of Investment Advisor • Subscribe!

June 1, 2002

The Numbers Game

Neil Hennessy sticks to his formula, come hell or high water, and gets results

The theory has been developed, the calculations have been figured, and the percentages distributed. Now only time will tell if the expected results are achieved. Does this sound like a weird science experiment? Well, not exactly. We're talking about investment strategies, not chemical compounds. But for Neil Hennessy, fund manager and president of Hennessy Funds Inc., a little of this and a little of that in the right proportions is how he achieves his returns.

As portfolio manager of Hennessy's Balanced, Leveraged Dogs, Cornerstone Value, and Cornerstone Growth funds, Hennessy runs the gamut when it comes to conservative to mildly aggressive investing styles. But is his methodology really that different from that of other investment managers? One critical difference between Hennessy and other managers is that a computer picks his stocks. He keeps it "highly disciplined and non-emotional," and everyone gets the same story.

Price-to-sales ratios are the foundation of Hennessy's method, which he calls strategy indexing. He favors high sales and strong momentum. Cornerstone Growth (given the highest rating by both Morningstar and S&P) owns only 50 stocks and holds them for one year. Once the stocks are selected, they are not eliminated if they no longer fit the bill. What's more, they are not looked at again until the annual rebalance. This leads to sector inconsistencies, rotating companies, and avoidance of the investment trend du jour.

We recently spoke to Hennessy by telephone at his Novato, California, headquarters to discover the magic behind the math. His response, "What you see is what you get."

You've been quoted many times as saying your funds are highly disciplined and non-emotional. How is that different from other fund managers? Our funds are driven by formulas, so there are no secrets. If an investment advisor is basing his suggestions on our funds, he can be sure we are not going to change our investment philosophy. The same goes for the individual investor. Our formulas are solid and they aren't going to change from person to person.

Some of the best money mangers got caught up in the euphoria of dot-com mania, and we didn't. We stuck to our guns, as painful as it was. People were telling me that we didn't know what we were doing, but we did not waver. And now, three of our four funds have been profitable every year [Leveraged Dogs was only down 0.25% last year]. Our models wouldn't allow any technology stocks [during the tech boom], but now we are at about 7.4% in technology.

How has the fund changed from when you started until now? It hasn't changed. The formula is still the same. But to understand why it hasn't changed, you have to understand the formula. We always screen approximately 9,700 different companies, and the first step from there is that we make sure the market capitalization is above $172 million. The reason for the $172 million is we don't want to get into micro-caps. We want to make sure that the companies are big enough, but still have strong momentum potential. In fact, when we rebalanced the portfolio last year, the average market cap was about $950 million.

Our second step, and one of the most important steps, is to evaluate the price-to-sales ratio. At the time we buy it has to be 1.5 or less. In other words, we are not going to pay more than $1.50 for $1 in sales. Let's say you have a very good large company; if you bought it at $14 today, you are still paying $6 for $1 in revenue. But when the stock was $70 you were paying $20 to $30 for $1 in sales. I am a patient individual, but I am not going to wait 30 years to break even. So this is why we don't pay more than $1.50 for $1 in sales.

The third step is to make sure the earnings are higher than the previous year, meaning money is continuously streaming to the bottom line. The final step is reviewing the relative strength of the stock over 3-, 6-, and 12-month periods. We then select the top 50 stocks that have the best relative liquidity strength. What we combine is value and momentum. If a company, regardless of how good it is, doesn't fit our criteria, we don't buy it. We've sort of stayed out of everybody's way by keeping that philosophy.

How did you come up with this formula? This approach is nearly the opposite of the traditional fund manager. James O'Shaughnessy, the fund's founder, created the formula and stuck to it. When I purchased the management contracts from Jim in 2000, I took over the philosophy, kept the formula, and incorporated some of my own experience.

Were you using any sort of formula before you purchased this one? When we purchased the value fund and the growth fund, we didn't use this technique. In our original two funds, we were utilizing the "dogs of the Dow" investment theory. Dogs of the Dow is a strategy consisting of the 10 stocks with the highest dividend yield among the 30 blue-chip companies that comprise the Dow Jones Industrial Average. As the price of the stock goes down, the yield goes up, even if the amount of the dividend is the same. Stocks with a relatively high dividend yield are often considered to be out of favor in the marketplace. Dogs of the Dow calls for the investing of equal dollar amounts in the 10 highest-dividend-yielding Dow Jones stocks, and holding them for one year. After one year, the stocks are readjusted to maintain the top 10 highest-dividend- yielding Dow Jones stocks.

This process identifies potential values by investing in established companies whose prices look to be undervalued. We started with this philosophy in our two original funds, and then when we added to them, we combined this thought process with the Hennessy formula. I'd been running money individually like that in the past, but it became too costly. I realized that if I put it into a mutual fund format, I would be able to lower the cost. And with the rebalancing, you can reinvest your dividends through capital gains, whereas you couldn't do that in individual portfolios.

Was there ever any discussion to change the formula once you purchased the contracts? Absolutely not. If we wanted to change the formula, we would have to go through a shareholder vote, and I can guarantee no one would vote to change it. This is what we mean by "what you see is what you get." This, by the way, is how I think people will want to see their money invested in the future.

Let me give you an idea of what I mean. From the end of 1999 to the beginning of 2000, technology was booming and people started to see their 401(k)s go to 201(k)s and then slump to 101(k)s. This was a result of investment managers getting caught up in the height of technology. So, although they had a great purchasing track record and knew how to run the money, they got caught up. I think the shoot-from-the-hip days are over, and people want to know how their money is being managed. A set formula or something like it is the answer they are looking for.

S&P categorizes you as a small-cap growth fund. Do you agree? Yes, essentially what we try to do at the beginning of the year is buy small caps, and by the end of the year we would like to see them become mid caps. But sometimes this changes. If no new small caps come into our portfolio, then they don't come into it. A company has to meet our stringent requirements; otherwise it doesn't come in.

Do you maintain the same number of stocks every year? Every year we have 50 stocks in multiple sectors. And after our annual reorganization we invest 2% into each company.

If there is no quality control, or no eliminating of stocks before the end of the year, what happens if the equity no longer fits the formula? Everything stays in for the year; this is what highly disciplined, non-emotional means. Although one holding might go down, another one will make up for it. For example, NVR, a homebuilder and mortgage broker, was purchased when the price-to-sales ratio was 0.59 and the market cap was $1.4 billion. Now the price to sales is smaller and the market cap is $2.7 billion. If you compare that to Rex Stores Corp., another stock we purchased at 0.48 that is now down to 0.44, you can see NVR more than outperformed it. So by leaving them all in for the year, one thing makes up for the other and then we rebalance.

You have done so well over the last few years when so many have done so poorly. What do you think is next for the economy and what kinds of companies will do well? I can't tell what companies are going to do in the next couple of years, but I can tell you technology isn't coming back anytime soon. History teaches us a lesson. In August of 1982, the technology market really took off, and when it died in December, it didn't come back until December of 1994. So in 1999 and 2000, when tech companies and dot-coms took off, I knew it wouldn't last very long.

Have any sectors done particularly well in your fund? The homebuilding sector. To be honest, people thought I was a genius last year because of our interest in this sector. People kept asking me how I knew to buy the homebuilders. And I told them it is very simple: That sector had low price of sales, a better earnings reputation, momentum was up, and the relevance rate was good. They fit the bill, so we put them in the portfolio.

Has your formula ever been wrong? No, that's what I mean by saying it's non-emotional. I think the mistakes that investors made in 2000 and 2001 were emotional mistakes, and you don't make financial decisions on emotion. It is no different than the real world. If emotion gets into a conversation, nothing is going to get done. We base our decisions on value in relation to momentum.

Then would you consider yourself a bull or a bear? That is totally irrelevant, but I suppose we are always a bull. You have to be if you are going to buy stocks. But no matter what kind of market you have, if you have value, you will do well over time. Our philosophy is not what you make on the upside, it's what you don't lose on the downside.

So are you playing not to lose? No, you can't outsmart something that doesn't have a brain. The market doesn't have a brain. We keep things real simple and over time the numbers tell the story.

The fund appears to be pretty conservative. Who's your ideal investor? It has to be someone who's willing to wait three to five years. It's a conservative fund, but an aggressive fund, all wrapped in one. It moves around and sector distributions change. So if you've had a double bypass, then maybe you shouldn't buy it.

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