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.