Hennessy: Cornerstone Buys

03/14/2016 10:00 am EST

Focus: STOCKS

Portfolio manager Brian Peery discusses the strict, time-test formula used to select stocks for his Hennessy Cornerstone Midcap 30 Fund. In addition, he walks us through a trio of his holdings – an airline, an auto dealership and a turnaround in retailing.

Steve Halpern:  Our special guest today is Brian Peery, portfolio manager of the highly regarded Hennessy Cornerstone Midcap 30 Fund (HFMDX).  How are you doing today Brian?

Brian Peery:  Great.  Thank you.  Thanks for having me on today.

Steve Halpern:  Could you tell our listeners a little about the Hennessy Cornerstone Fund and the underlying investment strategy?

Brian Peery:  Absolutely.  The Hennessy Cornerstone Midcap 30 Fund uses a formula that marries value with momentum so it’s really seeking stocks that have a growth that and a reasonable price strategy. 

Our process for stock selection follows a strict adherence to a time-tested formula where we utilized companies that have market capitalization between $1 billion and $10 billion and they have to be domestic stock so no ADRs.  This market cap spread allows us for the inclusion of some broad range midcap companies.

The next thing we look for in our metrics is the stock has to have a price to sales ratio below 1.5 and this is essentially our value metric and helps us uncover relative bargains. 

We use 1.5 as our price to sales which will get you roughly half the market place so if it has a price to sales of 1.5 we exclude it from potential inclusion within the portfolio.

The next thing we’re looking for in the companies is they have to have annual earnings higher than the previous year. 

We’re not looking for quarter-to-quarter changes, we’re really looking for the long-term trends of the company and are they able to contribute revenue growth and have it fall down to the bottom line in terms of higher earnings and really the benefit of the shareholder. 

The next thing we look for is positive stock price appreciation or relative strength over a three-, six-, and 12-month period and it has to be positive in all of those periods and what we do is we rank them based on their 12-month price appreciation and we allocate 3.3% of this portfolio to the top 30 names that meet all of our criteria.

We’re not trying to pick which ones in the top 30 we really favor.  We give an equal allocation to each, hold it for approximately a year, and at the end of that year we go back and rebalance the fund. 

Any stocks that continue to meet our criteria we will hold and pare back to their original 3.3% rating.  Any stocks that no longer meet our criteria get sold and replaced with new stocks that do.

Steve Halpern:  Let’s turn for a minute towards the market environment and you note that there’s a lot of things in the current environment that have you concerned.  Can you walk us through some of the potential headwinds that are worrying you?

Brian Peery:  Certainly.  Right now there’s a healthy amount of uncertainty within the market and that’s led in turn to the volatility and pronounced swings we’ve seen so far this year. 

There is always going to be some headline risk for geopolitical instability and there’s obviously a lot of news going on surrounding oil prices and the ups and downs in that market.  I think the commodity prices have basically moved in tandem and have caused some real pain in the material segment as well.

When we see what the remainder uncertainty that we’re looking at is Federal Reserve rates.  What’s the timing increases?  Are there going to be more this year or is going to be deferred until next year?  What are corporate profits looking like? 

It looks in the last couple quarters like they’ve been slowing or even decreasing so there’s some concern there.  We’ve seen that revenue growth is basically anemic, if you can get to 3%, but we’d like to see it get back to that double digit of 10% above for the companies that we’re looking at.

Obviously with the political elections around the corner we’ve got election fears of what’s going to happen, who’s going to be a beneficial candidate for the markets and who’s not going to be so we are climbing that proverbial wall of worry. 

There are enough headwinds out there that any news can be positive or negative.  We see plus or minus 1% on the indices almost every day so we are seeing a lot of uncertainty and that’s kind of adding to this volatility.

Steve Halpern:  On the other hand, you emphasized that if the investor’s time horizon is long-term that the risk/reward at these levels could be enticing.  Could you expand on the factors that would support your longer-term optimism?

Brian Peery:  Sure.  I think that we’ve seen a pullback in the markets and with that we’ve got some really great valuations.  If you take a look back to the June of 2015 highs that we saw in the Russell indices, we had a pullback of roughly 25% from those levels, which is an indicative of a bear market. 

We’ve since bounced back up a little, but we’re still seeing a trend of really good valuations out there and I think that while we are indeed seeing slow growth, it’s going to be slow and steady growth. 

We’re not really looking for a recession at this point.  We think the labor market is getting better, initial jobless claims have been steadily trending lower with that pulling the US underemployment rate down.

The question remains the consumer and they’ve been extremely frugal with their money up to this point and they’ve been paying down debts and saving some money so we’re looking for is the consumer who’s going to kind of take that money that they’ve built up over the last couple years and really deploy it towards some durable goods.

And that leads us to believe that we’re more bullish on some of the more cyclical segments in the market like consumer discretionary stocks.

And we additionally think there are some great opportunities within the industrial space, but again you really have to take a long-term perspective and kind of take out the day-to-day fluctuations and realize that you’re investing for the long term.

Steve Halpern:  Let’s discuss a few long-term that are representative of the holdings in the Hennessy Cornerstone Midcap 30.  At first you point to JetBlue (JBLU).  What’s the attraction there?

Brian Peery:  Well, we think JetBlue is really in an exceptional position to capitalize on the lower fuel costs and the benefit of being a low-cost carrier.  They’ve got a really competitive cost structure, which is essential to their success. 

They continue to build a profitable and defensible network.  They’ve now introduced their mid-service.  They’re expanding it and I think that that’s going to actually have more consumers looking to them as an option against some of the larger carriers. 

I’d actually use the recent weakness in the stock as a great entry point again if you’re looking at the stock for a longer term.

Steve Halpern:  You also highlight a company that may not be well known to many investors, Lithia Motors (LAD).  What does this company do and what are your thoughts on its outlook?

Brian Peery:  Lithia sells both net worth and used cards primarily in the western US.  They’re operating in 12 states, about 108 dealerships or so. 

They continue to grow their operations through expansion and acquisitions and I think that the acquisitions are really the enticing part of this because the US auto dealership industry is so fragmented that it really gives Lithia a look at potentially 2,600 creative acquisition candidates that they can use to continue to leverage their operating efficiencies and that should drive earnings for quite some time. 

The free cash flow growth and strong balance sheet is going to give them the capital to do both internal and external investments and I think that they’re in great shape for the long haul and it’s a company that we continue to be buying.

Steve Halpern:  Finally, you see potential in JC Penney (JCP), a retailer that’s certainly been in the headlines having had some troubles in recent years.  What do you see looking ahead?

Brian Peery:  JCP is exactly the type of company that we think will do well in the face of lower oil prices and how consumers are spending right now. 

Management is really running this business efficiently and the financials have approved alongside their consumer image.  With the expansion of Sephora stores within JCP and jewelry segment doing really well we think that the sales trends will continue through the remainder of the year.

JCP has continued to focus once again on being a branded value play for men’s, women’s, and children’s clothing and we think that they’re doing a great job in earning back their customers. 

It’s really going to be interesting to see if the company can get some traction in the appliance segment and if they can they may put a real dent in Sears’ business model and I think that that would be a real opportunity for them to grow faster even than the forecast out there for it.

Steve Halpern:  Again, our guest is Brian Peery of the Hennessy Cornerstone Midcap 30 Fund.  I really appreciate your time today.  Thanks.

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