MW This stock-market strategy combines value, quality and momentum for stellar performance
By Philip van Doorn
The Hennessy Cornerstone Mid Cap 30 Fund has an unusual approach for setting its portfolio of stocks once a year and letting it ride
Hennessy Funds uses a formula-based approach to set its Cornerstone Mid Cap 30 Fund annually. The strategy has done well over the long term.
The managers of the Hennessy Cornerstone Mid Cap 30 Fund take a unique approach to setting up the fund's portfolio annually and letting it run for the following 12 months. This has led to excellent long-term returns relative to peers. And with its focus on smaller companies, it offers investors an easy way to diversify from the S&P 500.
Hennessy Funds is based in Novato, Calif., and manages about $4.3 billion in client assets.
Ryan Kelley, Hennessy's chief investment officer, discussed how the fund's most recent reconstitution in October highlighted companies that benefit from the build-out of infrastructure to support the development of artificial-intelligence technology. These include Sanmina $(SANM)$, which makes server racks and other equipment deployed in data centers while providing equipment to industrial, medical and defense-related industries. Another example is Dycom Industries $(DY)$, which supplies fiber-optic cable.
Speaking with MarketWatch, Kelley said that although the fund's stock selection methodology doesn't identify industry trends, "it can capture that type of company because the process focuses on momentum."
Kelley co-manages the Hennessy Cornerstone Mid Cap 30 Fund with Josh Wein and Neil Hennessy, who founded the firm in 1989.
The fund has two share classes. The investor share class HFMDX has a minimum of $2,500 for regular accounts and $250 for individual retirement accounts. The institutional share class HIMDX has lower expenses with a minimum of $250,000 for regular accounts. The institutional shares are available with no minimum within corporate-sponsored retirement plans, and may be available with lower minimums through investment advisers. The share classes' expenses and performance records are shown below.
Both of the Hennessy Cornerstone Mid Cap 30 Fund's share classes are rated five stars (the highest rating) within Morningstar's "Small Blend" fund category.
The $1.2 billion fund uses a unique methodology, with only some modifications, since it was established in 2003. The fund's portfolio is reconstituted annually and not changed until the following year. Hennessy doesn't disclose precisely when it will next reconstitute the portfolio, but it happens every year on or after Sept. 1.
To set the portfolio, the managers of the fund begin with a list of all stocks listed on U.S. exchanges with market capitalizations ranging from $2 billion to $25 billion. This was increased from the former market-cap range of $1 billion to $10 billion in September.
Then the list is narrowed down to stocks meeting the following criteria:
-- Trailing price/sales ratio below 1.5. This is a stock's closing price divided by the company's sales per share over the previous 12 months. For reference, weighted trailing price/sales ratios are 3.4 for the S&P 500 SPX and 1.5 for the S&P Mid Cap 400 Index MID, according to FactSet.
-- Annual earnings higher than the previous year
-- Increasing share prices for the past three and six months
This process usually produces a list of about 100 stocks, which the Hennessy team ranks by 12-month price appreciation. The top 30 stocks are then equally weighted for the renewed portfolio.
According to Kelley, the requirement for a trailing price/sales ratio below 1.5 is "pretty restrictive," and if applied to the S&P 500 would remove about two-thirds of the stocks.
"There are not a whole lot of companies that fit the bill. You might wind up with some boring companies. But some of these companies are backbones of industry," he said.
When the portfolio was reconstituted in October, about a third was invested in industrial companies, and about 25% of the fund was invested in companies in the consumer-discretionary sector, according to Kelley.
"It is typical for the fund to have more than 50% in the two sectors," he said.
Top holdings
Since the Hennessy Cornerstone Mid Cap 30 Fund was reconstituted in October, with its holdings weighted equally at that time, a recent list of its top holdings will reflect price increases since then. But it may still be of interest. Most of the stocks' trailing price/sales ratios are still low.
Here are the top 10 holdings of the fund as of Jan. 31, with current trailing price/sales ratios:
Company % of portfolio Trailing price/ salesIndustry C.H. Robinson Worldwide Inc. 4.8% 1.3Air freight/ Couriers ViaSat Inc. 4.6% 1.3Telecommunications equipment EchoStar Corp. 4.6% 2.2Specialty telecommunications Dycom Industries Inc. 4.5% 2.2Engineering and construction MasTec Inc. 4.2% 1.5Engineering and construction Primoris Services Corp. 4.0% 1.1Engineering and construction Sanmina Corp. 3.7% 0.8Electronic production equipment Wayfair Inc. 3.7% 0.9Specialty stores Macy's Inc. 3.6% 0.3Department stores StoneX Group Inc. 3.6% 1.5Investment banks/ brokers Sources: Hennessy Funds, FactSet
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Read: Tomi Kilgore's detailed guide to the information available on the MarketWatch quote page
Capital gains
With a good long-term performance record and what is likely to be full turnover of the portfolio once a year, investors might be concerned that the Hennessy Cornerstone Mid Cap 30 Fund will distribute capital gains.
For a traditional open-ended mutual fund, such as this one, a booked gain is distributed to its shareholders. This means if you are invested in the fund, you will receive the capital gain and may take the cash or reinvest it in the fund's shares. Either way, unless the shares are held within a tax-deferred retirement account, you will have to pay capital-gains taxes.
Kelley said that he and his co-managers take tax implications into account each year when the portfolio is reset. During a year of strong performance, the fund will be reconstituted after 365 days have passed so that more of the distributed capital gains will be long-term gains, which may be taxed at a lower rate than an investor's short-term gains.
If capital losses - or a low level of short-term gains - are embedded in the portfolio, Kelley and his co-managers may choose to reconstitute the fund earlier than the year from the previous reset time.
For investors who have been in a mutual fund for many years, a change in strategy can cause a fund to book what is effectively many years of gains all at once. This can be particularly painful come tax time. So one might see this fund's annual turnover as an easier course, as an investor will bear smaller annual tax burdens.
Kelley said that Hennesy's methodology has kept capital gains to "a fairly small percentage of overall total return."
When asked where an exchange-traded-fund structure might be something to consider, since ETFs have tax advantages that reduce or eliminate the distribution of capital gains to shareholders, Kelley said that converting the fund to an ETF wasn't likely because so many of its investors were direct customers of Hennessy. These investors might not have brokerage accounts, which they would need to hold shares of an ETF, he said.
Fund performance
The Hennessy Cornerstone Mid Cap 30 Fund's Investor share class has an expense ratio of 1.33%, which translates to annual expenses of $133 for a $10,000 investment. For the institutional share class, the expense ratio is 0.95%, translating to annual fees of $95 for a $10,000 investment.
The fund's performance benchmark is the Russell Midcap Index RMCC, so the third item on the performance table is the iShares Russell Mid-Cap ETF IWR, which is the largest fund tracking the index.
LSEG lists 34 funds as peers of the Hennessy Cornerstone Mid Cap 30 Fund also benchmarked to the Russell Midcap Index. The top five actively managed performers among these peers over the past 10 years, through January, round out the list.
All return figures on the table are net of expenses and all run through Jan. 31. They also exclude any sales charges. The Hennessy Cornerstone Mid Cap 30 Fund has no sales charges.
Fund 1 year 3-year avg. 5-year avg. 10-year avg. Net expense ratio Hennessy Cornerstone Mid Cap 30 Fund - Investor 2.6% 20.2% 17.6% 13.8% 1.330% Hennessy Cornerstone Mid Cap 30 Fund - Institutional 3.0% 20.6% 18.0% 14.2% 0.950% iShares Russell Mid-Cap ETF 9.2% 12.3% 9.2% 11.9% 0.180% Carillon Scout Mid Cap Fund - Class I 14.1% 16.1% 9.9% 13.1% 0.950% Madison Mid Cap Fund - Class Y 1.1% 11.1% 10.7% 12.1% 0.910% Touchstone Mid Cap Fund - Class Y 4.1% 10.5% 7.8% 12.1% 0.900% Virtus KAR Mid-Cap Core Fund - Class I 0.4% 7.7% 6.8% 12.1% 0.950%
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