MW This fund's winning formula is diversified from your heavily weighted index fund
By Philip van Doorn
The Hennessy Cornerstone Mid Cap 30 Fund is highly rated and follows a fascinating stock selection methodology
With so much coverage of Nvidia and other large tech-oriented companies that sit atop the S&P 500, and the incredible popularity of exchange-traded funds that track the U.S. benchmark index, you may already be aware of how concentrated that pool of 500 stocks really is. But it never hurts to be reminded of the importance of real diversification in an investment portfolio.
The $1.1 billion Hennessy Cornerstone Mid Cap 30 Fund has followed a formula-based strategy that has worked out well over the past 20 years. Hennessey Funds of Novato, Calif., has about $4 billion in assets under management. The firm was founded in 1989 by Neil Hennessy, who co-manages the Cornerstone Mid Cap 30 Fund with Ryan Kelley and Josh Wein.
By definition, the fund is diversified from the S&P 500 SPX, because when the portfolio is reconstituted annually, the fund managers begin with companies with market capitalizations between $1 billion and $10 billion. The fund's formula hasn't changed over the years, but the stock market has grown enough that this range puts this fund pretty much in the small-cap category. But Kelley said it was "still part of the midcap universe" when he and Wein discussed the strategy during an interview with MarketWatch.
Before spelling out the fund's formula, here are numbers to remind you that your S&P 500 SPX index fund might be less diversified than you realized. The top 10 holdings of the S&P 500 ETF Trust SPY - the $535 billion ETF that has been tracking the index for decades by holding all of its components with the same weighting of the index - made up 37.4% of the portfolio as of Friday:
Meta Platforms Inc. Class A Ticker SPY portfolio weight Microsoft Corp. MSFT 7.2% Nvidia Corp. NVDA 7.1% Apple Inc. AAPL 6.7% Amazon.com Inc. AMZN 3.7% Meta Platforms Inc Class A META 2.4% Alphabet Inc. Class A GOOGL 2.3% Alphabet Inc. Class C GOOG 1.9% Broadcom Inc. AVGO 1.7% Berkshire Hathaway Inc. Class B BRK.B 1.6% Eli Lilly and Co. LLY 1.5% JPMorgan Chase & Co. JPM 1.2% Source: State Street Corp.
This list includes 11 stocks for 10 companies - two common share classes of Alphabet Inc. $(GOOGL)$ $(GOOG)$ are in the index and in SPY. Even if you hold no individual stocks, you have made quite a commitment to Microsoft Corp. $(MSFT)$, Nvidia Corp. $(NVDA)$ and Apple Inc. $(AAPL)$ if you hold shares of the typical U.S. index fund. This weighting to market capitalization has worked out very well over recent years. But it can also lead to difficult periods, as it did during 2022 when SPY fell 18.1%.
Stock selection methodology
The managers of the Hennessy Cornerstone Mid Cap 30 Fund go through this process every year, some time after Sept. 30, to establish the fund's equal-weighted portfolio of 30 stocks that will not be changed over the following 12 months:
Starting with what Kelley called a "giant funnel," the managers narrowed the list of all publicly traded companies on U.S. exchanges to those with market caps between $1 billion and $10 billion.The list is then pared to companies trading at price-to-sales ratios below 1.5 times. For reference, the S&P 500 trades at a forward price/sales ratio of 2.8. The list is narrowed further to companies whose profits have increased over the past year from a year earlier.The last step is to screen the remaining companies for price momentum - only those whose prices have increased over the previous three months and six months are included.
This typically leaves a list of about 100 stocks. "Then we rank them by highest one-year price performance, and the top names go into the portfolio," Kelley said. The fund is then equally weighted to the top 30 companies in this final ranking.
That's it.
Kelley said the price/sales ratio is not widely used, but that the 1.5 limit during the annual selection process adds a value component to temper the price momentum focus. In other words, the stock market has a way of identifying recovering or improving companies before the good news is reflected in profit numbers. The standard price-to-earnings ratio is meaningless if a company has not returned to (or achieved initial) profitability, or if it is only marginally profitable while otherwise improving.
Wein said the process "favors low-margin companies because of the price-to-sales threshold."
"It can favor industrials," he added, including those building "factories, bridges and tunnels," with limited competition.
The approach can favor a company such as Emcor Group Inc. $(EME)$, which is one of only three held by the fund that had been in the previous year's portfolio. Emcor is a commercial construction company that also provides facilities services. The stock has returned 75% this year, following a 46% return in 2023.
Now take a look at the fund's top 10 holdings as of March 31, keeping in mind that these weightings reflected price appreciation since the fund was reconstituted last year to an equally weighted 30 companies, and that the portfolio is likely to change completely in October:
Company Ticker SPY portfolio weight as of March 31 2024 total return through June 14 Forward price/ sales Gap Inc. GPS 6.4% 21% 0.6 Abercrombie & Fitch Co. Class A ANF 5.4% 111% 2.0 Modine Manufacturing Co. MOD 5.1% 55% 1.9 Comfort Systems USA Inc. FIX 4.6% 53% 1.6 Emcor Group Inc. EME 4.1% 75% 1.2 XPO Inc. XPO 3.9% 18% 1.4 Sprouts Farmers Market Inc. SFM 3.7% 57% 1.0 Sterling Infrastructure Inc. STRL 3.7% 32% 1.6 Parsons Corp. PSN 3.7% 22% 1.2 Guess Inc. GES 3.6% 2% 0.4 Sources: Hennessy Funds, FactSet
The table includes forward price-to-sales ratios, which are Friday's prices divided by consensus estimates for sales per share over the next 12 months, among analysts polled by FactSet.
Abercrombie & Fitch & Co. $(ANF)$ stands out, with shares more than doubling this year. But the price/sales ratio is now 2, which means the company is unlikely to make the cut when the fund's portfolio is reconstituted in October. Kelley said the stock was trading at a price/sales ratio of only about 0.7 when it was added to the portfolio last year. "We let our winners run," he said - at least until the fund's next annual cycle begins.
From Kelley's comments, you might expect that the fund managers don't know or care about the underlying reasons for the performance of the stocks they hold in this portfolio. But Kelley said that in the world of fashion, "everything old comes back," and that he had been told that styles popular during the 1990s were coming back, which favored Abercrombie. He also said that "in general," holiday season was better" for retailers.
Gap Inc. $(GPS)$ was the fund's second-largest holding at the end of March. The stock has been performing well, with positive coverage of Gap CEO Richard Dickson's eforts to spice-up the company's brands. Dickson took over the top spot at Gap in August.
Wein added that within the retail space and in other industries, there tend to be "old names that have been forgotten and there is no premium placed on them." And performance for these cheaply priced stocks can shift "the minute there is a good quarter or a good comp comes out." The "comp" refers to the typical year-over-year financial performance comparisons covered in the financial media when companies announce their quarterly results.
"A lot of these companies are the opposite of priced-to-perfection" when the fund goes through its annual stock selection process, Kelley said. "They are priced for deep value."
Over time, the value approach can lead to moves into or out of entire sectors. "Energy is a great example," he said."
"Three years ago, energy went from 3% to 30% in one rebalance," when crude oil was trading around $60 a barrel, he said. "Then, post-COVID, oil almost went to $120. We did not add oil because we were super smart, but because [related stocks] traded at the right valuation. Now we are down to a small allocation to energy," he said.
Performance
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June 17, 2024 10:46 ET (14:46 GMT)
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