Neil Hennessy relies on quantitative yardsticks to produce big gains.
Some would call it skilled stock picking, while
others may say it's a way to ride cyclically hot sectors of the market.
Whatever label one applies to his methodology, the returns generated by
Neil Hennessy's uncomplicated quantitative approach to investing have
recently trounced those of many actively managed funds that rely on
more complex, fundamentals-driven investment techniques.
Once a year, the 50-year-old founder and manager of Hennessy Advisors uses a variety of back-tested quantitative screens to filter out the companies that he and his team believe have the most favorable characteristics for a particular portfolio. He buys those stocks, and waits patiently. About a year later, he runs the screens again and constructs a new portfolio for his firm's half-dozen mutual funds.
The approach, he says, takes the hand wringing and guesswork out of investing. "When emotion enters a conversation, things often get ugly," he says. "The same is true of investment decisions. We have a formula that is easy to understand, and it does not change." He retools the portfolio once a year because "you need to give stocks at least a year to work out." He doesn't announce the exact rebalancing dates, which differ from fund to fund, because he doesn't want outside speculators to try to profit from changes to the portfolio.
Hennessy implements the strategy through six mutual funds. Hennessy Cornerstone Growth, the largest at $1 billion in assets, is a small-cap offering that focuses on companies with at least $134 million in market capitalization that have the highest one-year price appreciation as of the date of purchase, a price-to-sales ratio below 1.5, annual earnings higher than in the previous year and positive relative strength over the past three- and six-month periods.
The fund has beaten its Morningstar category average in six of the last eight years. A newer fund, Hennessy Cornerstone Growth Series II, uses the same criteria as its older sibling but has a different rebalancing date and different stocks. The $260 million fund was created in July from the acquisition by Hennessy Advisors of the former Henlopen Fund.
Three other funds, while also formulaic, take a very different approach and have had more subdued returns recently. Approximately twice a month, the Hennessy Total Return Fund buys the ten stocks that meet the criteria of highest dividend yield in the Dow Jones Industrial Average, an approach known as "Dogs of the Dow." The fund buys the stocks with 75% of its investable cash, and invests the remaining 25% in U.S. Treasury securities with a remaining maturity of one year. Each new individual portfolio is then reevaluated after one year. The Hennessy Balanced Fund combines Dogs of the Dow stocks with short-term Treasury bills.
The high-yield strategy worked well a few years ago but has sputtered over the last three years, with blow-ups in component stocks like GM and Merck. "It's tough when you have 10 stocks and one or two of them take a hit," says Hennessy, who nonetheless notes that the fund has a good long-term track record and believes its approach is "still valid."
Hennessy Cornerstone Value takes a modified
high-dividend approach by investing in 50 stocks that meet criteria
such as dividend yield, market capitalization and cash flow. The fund's
portfolio is rebalanced once a year. Like its growth fund siblings,
Cornerstone Value uses price-to-sales as a valuation measure, because
its manager believes sales are more difficult to manipulate on a
financial statement than earnings.
Construction Stocks Dominate
The best-performing fund of late has been the $153 million Hennessy Focus 30 Fund, a two-and one-half year old mid-cap offering that emerged as a top performer in 2005. It was up 32.7% in 2005, beating the average mid-cap blend fund by nearly 25% over the period.
To qualify for inclusion in the fund, a stock must have a price of at least $5 a share, and the company must have a market capitalization of between $1 billion and $10 billion. Aside from those criteria, its quantitative screening resembles that of the firm's two other growth funds. It holds 30 stocks, each accounting for an initial position of 3.33% of the fund's $125 million in assets.
The composition of the fund can change dramatically from year to year, In 2004, it was heavily invested in the energy sector at a time just before oil prices began to take off. Those stocks vanished from the fund after a rebalance in the fall of 2005, and construction and engineering firms have replaced energy as the dominant sector. The recent hurricanes, says Hennessy, have created a tailwind for some of the stocks.
Holdings in the sector include Shaw Group, an engineering and construction firm whose stock more than doubled over the one-year period ending December 1. It sells at more than 100 times earnings, but has a price-to-sales ratio of just 0.72. Revenue at holding CB Richard Ellis Group, the world's largest commercial real estate firm, shot up 29% in the third quarter of 2005 over the year-ago period, reflecting strong leasing and investment sales activity in the Americas, Europe and Asia Pacific.
Express Scripts, one of the fund's largest positions, is a pharmacy benefit management firm that tries to reduce drug costs through consolidation of pharmaceutical buyers to extract discounts, tiered co-payment schedules and other cost-cutting measures. At a recent price of $86 a share, it has a price-earnings ratio of 35 and a price-to-sales ratio of .81.
High price-to-sales ratios have virtually eliminated technology stocks from the portfolio. "With a company like Google, you're paying $21 for every $1 of sales, which is way above our threshold," says Hennessy. "Besides, there is nothing going on right now that would change the face of the industry to the extent that the Internet did."
The screens the fund uses don't discriminate between traditional measures of value and growth. Some stocks sport price-earnings ratios in the low single digits, while others
sell at more than 100 times earnings. A common thread among stocks in the portfolio is their strong recent
performance, a result of the price momentum screen. Several holdings had year-to-date returns of more than 100% at the end of November, and most had risen 30% or more during the 11-month period.
While Morningstar analyst Gareth Lyons acknowledges the strong performance of Hennessy's growth funds, he has reservations about its manager's methodology for picking stocks. Screens that favor companies with low price-to-sales ratios and strong price momentum have "caused the fund
to highlight strong-performing firms operating in high-sales and low-margin businesses, meaning the portfolio hews toward whatever sector is cyclically hot," he says.
Hennessy disputes that observation. He points out price momentum is only one component of the quantitative process, which is layered with value screens. And the fund screens don't always yield stocks in sectors that are considered "hot." In 1999, for example, Cornerstone Growth had 25% of its assets in the technology stocks. But as 2000 began, the fund had almost no assets in the sector, which tanked sharply later in the year.
Expanding Through Acquisition
The strategy of Focus 30 and its sibling funds is patterned after the work of noted quantitative investor James O'Shaughnessy, who sold his Cornerstone Growth and Cornerstone Value Funds to Hennessy in 2000. In the mid-1990s, O'Shaughnessy downplayed the importance of price-earnings ratios and advocated a price-to-sales investments strategy in his book, What Works on Wall Street.
The sale came 11 years after Hennessy had left his life as a former broker, branch manager, and divisional sales manager for Paine Webber and Hambrecht & Quist. He founded Hennessy Advisors in 1989 with "no assets and no clients."
In 1996, he started the Hennessy Balanced Fund and in 1998, the Hennessy Total Return Fund. But the small funds struggled, and finances grew tight. "My kids learned what 800 numbers are for," quips Hennessy, referring to the toll-free digits that collection firms leave in messages.
The tide began to turn in 2000, when Hennessy used a $2.6 million bank loan to buy the O'Shaughnessy funds, which had about $200 million in assets. At the time, he says, he had $1,347 in the bank. Acting as his own underwriter, he took the company public in 2002, using investments from 400 friends and family members. He used the money to acquire additional mutual funds, including the Sym Select Growth Fund in 2003, Lindner Funds in 2004 and the Henlopen fund in 2005. Today, Hennessy Advisors manages $1.9 billion in assets and has some 107,000 shareholders.
As the year begins, Hennessy is optimistic about prospects for both his firm and the stock market. "Consumer confidence is high, interest rates are in check and companies are very lean, which means that incremental increases in revenue will flow to the bottom line," he says. "I believe the year will end with the Dow over 12,000."