Sally Beauty, Lithia: Hennessy Buys, Holds A Year


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Hennessy Cornerstone Growth Fund picks its holdings just once a year, so the managers know they better get it right.

They do that by choosing 50 stocks that have the wherewithal to perform well the whole year.

Research has shown Hennessy that if you get that right, the frenetic trading that's done by most other managers isn't needed.

Cornerstone Growth was the top small-cap blend portfolio so far this year going into Monday. Its 29.32% gain is nearly triple its peer group's 10.79%. It more than doubled the S&P 500's 14.47% advance.

In an industry filled with managers who trade -- sometimes frenetically -- daily, weekly and monthly, managers Neil Hennessy and Brian Peery stand in contrast to their peers. They decide once a year what to hold, then buy those 50 names from October through February. They don't trade any more until it's time for them to replenish their portfolio a year later.

Hennessy, who is 56 years old and chief investment officer of Hennessy Advisors, and Peery, 44, talked shop from their offices north of San Francisco.

IBD: This is a fund that Mr. Spock, the highly logical character in the "Star Trek" series, would have loved.

Hennessy: This is a quantitative fund rather than qualitative. Qualitative lets managers' emotions drive the stock-buying decision-making process. Do they like a company's management? Do they like the economy? We don't let emotions dictate how we accumulate positions. That's the secret behind our sauce.

IBD: You buy during a single period of the year. What do you do with inflows the rest of the year?

Hennessy: We start by putting 2% into each of 50 companies. The rest of the year, we allocate inflows based on a holding's weight. If a stock is 3% of our portfolio, for instance, it gets 3% of inflows. We do the same for redemptions.

IBD: What are some of your buy criteria?

Hennessy: We start with a universe of about 10,000 companies. The first thing we do is make sure a company's market cap is at least $125 million, so we don't get caught in microcaps.

Second, we make sure its price-to-sales ratio is 1.5 or less, so we don't pay more than $1.50 for every $1 of revenue.

Third, we make sure earnings are higher than the previous year on a rolling 12-month basis.

The companies that come through those filters go through additional screens. One is that we look for relative strength over three to six months. That's essentially price momentum.

Then we pick the 50 companies with the best relative strength over 12 months. Essentially, we use GARP (growth at a reasonable price) by using price-to-sales, then add in momentum.

IBD: What's unique about your tack?

Hennessy: Most managers have some formula like that. But then they put in qualitative overlays. We're strictly quant.

IBD: But not all of your funds are run this way, right?

Hennessy: We have six quant funds that have a buying (window) like this one.

We just acquired FBR funds, adding another 10 funds to our lineup. Three are quant, the rest actively run. And we have funds managed by subadvisers. The ones that are subadvised can buy and sell whenever they want. It's all explained on our Website.

IBD: So in Cornerstone Growth, you are not making bets based on any macro trends?

Hennessy: Look at today's portfolio. Consumer discretionary and consumer staples are about 55% of the portfolio. The portfolio is saying ...we are in a slow growth economy and people are trying to get more for fewer dollars. We're inDollar General ( DG ),Ross Stores ( ROST ),Domino's Pizza ( DPZ ),Tractor Supply ( TSCO ) .

IBD: But doesn't Tractor Supply cater to affluent weekend farmers?

Hennessy: When the economy slows, you might have to cut your gardener, who brings his lawn mower. So you buy a lawn mower, do your own lawn, and you get satisfaction out of it too. That satisfaction keeps you from going back in the opposite direction even once the economy improves.

IBD: Sally Beauty ( SBH ) is fighting back from a rough patch. What's the appeal?

Hennessy: It met our criteria last year. Even today, you're looking at a 1.2 price-to-sales ratio. Here's a company earning about $1.30 a share, and doesn't pay dividends.

Until we get clarity from Washington on health care, taxes, regulations, companies won't hire, but they keep making money. They can do five things with it: initiate a dividend, raise a dividend, make buybacks, put the money into internal infrastructure or make acquisitions. All of those are good for companies but not good for (lowering) unemployment.

So when we look at Sally Beauty, we see a company that could initiate a dividend.

IBD: Not that you assessed that when you bought. You bought because it came through your screens.

Peery: Right. It's one of several companies in the portfolio that are doing well on top-line sales growth and beating GDP numbers pretty handily. We use rolling 12-month looks at earnings per share on a quarter-to-quarter basis, so we see how they grow earnings.

IBD: Why are many of your holdings not household names?

Hennessy: I've been in this business 33 years. Every time I rebalance, I go, "I never heard of this or that!" With our emphasis on value, you find that most value plays are overlooked because they are not sexy stories.

You go toPool Corp. (POOL) for chlorine. How sexy is that?Papa John's (PZZA) is pizza.W.R. Grace (GRA) is can coatings. Not sexy. But that's what the portfolio picks up.

IBD: Is Papa John's a play on today's consumer cost-cutting?

Hennessy: Right. In a slow economy, people don't have a lot of money. Dad wants to take the family out, but he can't afford something fancy. So he goes to Papa John's, rents a movie, gives the family a change of pace without spending too much.

This is one of those companies that makes a lot of money but isn't spending a lot because it doesn't have the clarity it wants from Washington. Yet it could initiate a dividend at some point. And at some point when the economy gets better, it will grow faster.

IBD: Explain why W.R. Grace works for you.

Hennessy: They're very large, but not well understood. Most people have a product from them in their house. They make sealants for cans, food cans. In a tough economy, people might cut back from fresh vegetables to canned. Without Grace's coating, your veggies will taste like they came from a can. Their coatings are in soda, beer, vegetables. They do other things too, but sealants are a tremendous business for them.

IBD: What makes American Vanguard, another non-household name, tick?

Hennessy: Today, their price-to-sales ratio is 2.9, so they would not fit into the portfolio going forward. But just because something rises past 1.5, we don't sell until it's time to rebalance. This stock had a good run. It doesn't mean their run is over. They just won't fit into our new portfolio when we rebalance.

IBD: Cambrex (CBM), which makes pharmaceutical ingredients, was up roughly 100% for the year in mid-October. What is its recent pullback about?

Peery: Its price-to-sales is 1.3. The recent downtrend is because people are getting nervous, coming into earnings season. It still meets our criteria. If you look at it over the longer term, the stock has done exceptionally well.

IBD: Arctic Cat (ACAT) also nearly doubled before downtrending. Is this maker of all-terrain vehicles showing sensitivity to a soft economy?

Peery: On price, you'd pay 80 cents for $1 of revenue. That's within our limit. But based on momentum, this would not make it into the portfolio now. Still, typically their Q2 and Q3 earnings are their best of the year, so you may be seeing some seasonality.

IBD: LeapFrog Enterprises (LF) has pulled back and is trading below 10. They're in educational entertainment for kids. Are they another victim of investor worries about slow economic growth?

Hennessy: Its price-to-sales ratio is within our realm at 1.2. They (expect to) earn 68 to 70 cents per share (in 2012 compared to 30 cents per share in 2011). They don't pay a dividend. So there are a lot of things that could go right for them. But this is Brian's.

IBD: Brian, what can you add?

Peery: They've done exceptionally well with execution. It's a company that people kind of know. But everyone has taken a myopic view and is looking at earnings on too-short of a basis. Everyone is acting like a trader. We're investors. We don't worry about quarter-to-quarter numbers.

IBD: Lithia Motors, which runs car dealerships and sells parts in rural areas, has bounced back from an Oct. 25 sell-off, right after reporting earnings per share rose 48% after rising 41% the prior quarter. It was its highest quarterly EPS ever.

Hennessy: Auto sales have picked up. People feel more comfortable buying a car. In the go-go days of 2007-08, car sales went through the roof, hitting 16 million. Now they're just 11 million. And people are shedding leverage. So they want less expensive cars.

IBD: Why did the stock hiccup?

Peery: It was due to their 2013 guidance, with Q1 earnings roughly in line with Q4's. The 2013 projections were for roughly 5% to 10% increase. So some analysts may have had higher growth targets than what Lithia announced.

IBD: Do you make your buys and sells all at once or throughout the October-February period?

Hennessy: We buy and sell over time, but it doesn't take the entire period to complete the rebalance.

IBD: What do you do the rest of the year when you're not rebalancing?

Hennessy: We constantly monitor and document corporate data on each stock we hold.

IBD: Do you have any re-do rules that let you bail out of a stock in, say, midyear if a disaster destroys it before it's time to rebalance?

Hennessy: If a restatement has been made to the data that were used to select a stock, our team determines if the restated data would have met our screening criteria. If not, then the stock would be replaced with the next stock in line. But we've never needed to replace a stock that way.

IBD: Any other exceptions?

Hennessy: We would sell a company as soon as it files for bankruptcy protection.

IBD: What are the risks with this portfolio? Lagging the S&P 500 in the past six years has played havoc with your average annual returns for three, five and 10 years.

Hennessy: We don't expect our portfolios to outperform in every single time period. Rather, our formulas were developed to maximize long-term risk-adjusted returns, and we are proud of our longstanding performance record.

IBD: Neil, who was your mentor?

Hennessy: My father. That's who taught me how to invest. He died in 1974, when I was a senior in high school. He was a position broker who bought equity for clients.

IBD: Did your dad teach you to buy and reshuffle just once a year?

Hennessy: No, he taught me about investing by taking all of my paper route money and (money from) other jobs and investing it in mutual funds. I got very little to spend, but it turned out for the best.

IBD: I'm sure you were thrilled!

Hennessy: Actually, it taught me a lot. This business is in my blood. (My career) would not have been possible had my dad not sensed that this business was for me. Making money for others is very gratifying to say the least!

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Mutual Funds
Referenced Stocks: DG , DPZ , ROST , SBH , TSCO

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