Top-Notch Investor's Bets On Likely Trump-Era Stock Leaders

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Think you've got the post-election stock-market winners' sorted out? Well, have you considered consumer discretionary or companies likely to gain an edge as new tax rules are applied? Award-winner Hennessy Focus Fund ( HFCSX ) sees stocks like CarMax ( KMX ), Charles Schwab ( SCHW ), 21st Century Fox ( FOXA ) and Alphabet ( GOOGL ) doing well as a Trump administration ushers in corporate tax cuts and interest-rate hikes.

Schwab and Fox also stand to benefit from demographic trends and the rising prospects of media-content winners.

And despite issues weighing on Alphabet, Macauley expects the internet giant to nearly double earnings in the next five years.

The $2.4 billion Hennessy Focus Fund ( HFCSX ) is a Best Mutual Funds 2016 Awards winner . To learn more about its managers' visions of likely stock-market leaders in the months and years ahead, IBD turned to Brian Macauley, one of the fund's three managers. Macauley, who is 42 years old, shared insights on those and other stocks he thinks will do well as corporate America adapts to life under new political leadership. He spoke from his office in Arlington, Va.

IBD: Your fund's low turnover rate makes it look static. But the fund is flexible in other ways. Is that its real secret sauce?

Macauley: Right, we don't manage to a style box or by market-capitalization size.

This is a go-anywhere portfolio with an emphasis on finding long-term compounders - businesses with the competitive position, growth, and management to create outsized value over an extended period of time. We most often find business with these characteristics in the mid cap space, but sometimes small- or large-cap companies will fit our model.

We try to build a portfolio with attractive expected returns and low risk of loss. We do not want artificial capitalization limitations or style boxes to constrain us.

IBD: You recently told me your usual turnover rate is slightly higher. Why is that?

Macauley: On average our turnover is about 15%. This past year is one of the lower years. The reason is that in general we've not had a lot of market volatility, so we haven't seen a lot of mispricing to take advantage of.

IBD: Whether 4% or 15%, this fund differs from its Hennessy stablemates, which rebalance just once a year, right?

Macauley: We buy and sell when it is appropriate in the marketplace. We have a very different approach from our stablemates.

IBD: Your turnover rate is a fraction of the 66% pace for U.S diversified stock mutual funds on average, according to Morningstar Inc.

Macauley: Right.

IBD: Tell me more about the traits you seek in stocks.

Macauley: We're looking for businesses with a wide competitive moat, durable competitive advantages that can earn outsized returns on capital even if competitors come into their market. We look for businesses that have a different mousetrap that can gain a lot of market share over time, or that have a secular tailwind that benefits them or their whole industry.

We look for high quality management that thinks and acts like long-term owners. We look for a low risk of catastrophic outcome. We try to stay away from situations where there's rapidly changing technology or a fad or a fashion risk.

And we try to meld growth with valuation. We will pay for quality, but we want to make sure we get in at a discount. Warren Buffett says that a lot of accounting vagaries obscure the true economics of a business. We try to look through vagaries and understand a business's true economics.

IBD: I know this is unlikely, but has the fund done anything to take advantage of the Trump election?

Macauley: We don't make directional bets based on individual economic influences. We had a number of REITs and yield-sensitive positions do poorly (amid election results), but those have been offset by strength in our more consumer discretionary and yield beneficiary names.

Names that benefited were CarMax, Charles Schwab and Encore Capital Group (ECPG).

CarMax is the largest used-car retailer in the U.S. It has a differentiated consumer proposition - it is a no-haggle-on-price dealer. And it offers a wide selection of late-model used cars, making them easy to use to purchase a car.

IBD'S TAKE:To get a handle on whether no-haggle pricing helps car-sellers like CarMax , read this IBD report.

They've grown to 170 stores and should be able to about double their store base as they march across the U.S. in the next 10 to 12 years.

They get two benefits from the Trump election. One, if there are tax cuts, then consumers will have more discretionary dollars in their pockets. Second, they are a purely U.S. company that pays a high tax rate. To any extent that corporate tax rates change, they could see a cut.

Schwab is a broker and custodian of investor assets, serving individuals, wealth planners and registered investment advisors. They benefit from brokers leaving wirehouses like ( Bank of America (BAC)-owned) Merrill Lynch and becoming fee-only advisors. Schwab provides the enabling technology for advisors to do that. Also, as baby boomers retire and roll their 401(k) balances into IRAs and look for financial advice, Schwab is a solution for them.

And Schwab holds a lot of cash from clients. They can lend that out and buy securities with it. As rates rise, they earn more from that.

IBD'S TAKE : Schwab is the No. 1 stock in IBD's Finance-Investment Bank/Bankers industry group due to key growth metrics. It has a top-notch IBD Composite Rating. Consulting IBD's Stock Checkup is a quick way to get a handle on the traits of a stock like this.

Encore Capital Group purchases charged-off credit-card receivables. Encore is a specialist in trying to get people to pay what they owe on those credit-card debts. Regulatory burden has compressed this industry to essentially two competitors that control 90% of the industry. It's difficult for new players to come back in. And it takes a large operation to collect debt efficiently.

A softer regulatory environment should allow the supply of debt to come to market more quickly.

IBD: Does Alphabet's recent softness reflect investors' fear that a Trump presidency will bring trade wars and an economic slump?

Macauley: Our thesis is that between growth in online advertising and improved monetization of mobile search and growth at YouTube, that Google (Alphabet) should nearly double their earnings over the next five years. From the current valuation, that's a reasonable opportunity given the high quality business we believe Google is.

Their competitive moat is not technology so much as it is users' habits. So there's a low risk of Google being leapfrogged.

The election has done three things: One, it has caused scrutiny of low corporate tax rates. We think Google's taxes are not so low, but there still could be some increased tax burden. Second, if there is a trade war, Google and other large technology companies are high-profile places that other countries can retaliate against. Finally, there is the obtuse risk that these technology companies were biased in their presentations of (political) information during the campaign. They may receive more scrutiny from the new administration because of that.

IBD: What's driving accelerating earnings per share growth at American Woodmark (AMWD), a kitchen cabinet maker?

Macauley: About half of their business is driven by new home construction, which is still climbing out of a depression. We have a long way to go to get to long-term historical norms, so that cyclical uplift is a tailwind.

Another thing: during this housing recession they had net cash that they used to improve their service levels and gain market share.

After partnering with Home Depot (HD), then Lowe's (LOW), then large home builders in the 1980s, in the last few years they finally had the bandwidth to service the small kitchen-bath market.

And they've culled out a lot of lower margin customers in the last few years, filling their capacity with higher-profit customers. So they will have much higher operating margins going forward.

And they benefit from the election. Some of their competitors import products. Woodmark pays a full tax rate, so if corporate taxes go down they benefit. And if people have more discretionary income due to tax cuts, they're more likely to buy a home or remodel.

IBD:Marlin Business Services (MRLN), which provides leasing for small-ticket equipment leasing, has trended higher in recent weeks. Any election cause and effect?

Macauley: They are simply very good at underwriting those leases. They work with people leasing copying machines, equipment for dentists' offices, restaurant equipment. Because of the regulatory environment, regular banks have pulled back from this space. Even where banks compete, it can take weeks to get a loan from banks, but just hours from Marlin. And Marlin is working to bring this to other (business areas). That provides a good forward outlook.

IBD: Why do you like 21st Century Fox among media companies?

Macauley: The media world is separating into winners and losers, and 21st Century Fox will be a winner. They have must-have content. And they are included in all important over-the-top solutions like Hulu , Google Unplugged , Dish Network (DISH).

IBD: Does "over-the-top" mean independent from a cable provider?

Macauley: Yes. All you need is an internet solution. It's a more efficient means of distribution. People who want to cut the cord with their cable provider are likely to end up with a noncable solution that includes Fox content. And over-the-top is attractive to advertisers because ads can be targeted and lower advertisers' cost per thousand of reaching viewers.

In addition, Fox owns 30% of Hulu, which we think will be successful.

IBD: Insurance seems staid. What's the appeal of Aon (AON)?

Macauley: This is a company that should be relatively a-cyclical, with a low teens growth profile.

They are one of only three providers with a global insurance footprint, so there aren't many other places you can go for global coverage. And with their size, they collect a tremendous amount of data. They create information solutions that are valuable to clients and insurance companies, which enables them to grow market share. And they are available at a fairly attractive price - about 15 times forward earnings.

IBD:American Tower (AMT) pulled back after the election. Do you still like it?

Macauley: The stock has come under pressure as almost all REITs have because interest rates have risen and there's some expectation they might continue to rise, which would make (some) REITs worth less.

In addition, there's concern that the new administration would be more amenable to a merger between Sprint (S) and T-Mobile (TMUS). Obama was strongly against the merger. If two large tenants merge, it would reduce revenue growth at American Tower for some period.

Despite the risk, with its growth profile this is one of our four best ideas, which is why on one of our largest positions we (recently) could buy it cheaper than it was just days earlier.

IBD: Why has O'Reilly Automotive (ORLY) rallied in recent weeks?

Macauley: O'Reilly is the best in their industry at getting parts to customers quickly. They've set up a distribution network that's more robust than anyone else's. And in this business, especially on the commercial side, a mechanic needs same-day parts so he can fix a car and return it to a customer in the afternoon. O'Reilly is in the best position to do that.

They have 4,500 stores today. They'll have 6,500 or 7,000 stores in the U.S. over the next 10 years.

They pay a full tax rate, so any tax cut should benefit them. As for possible new tariffs, they do import parts from Asia, but all of their competitors do as well. And any increase in tariffs will be passed on to their end customers.

IBD:Mistras Group (MG) gapped down 13% on Oct. 7, a day after reporting a 4% decline in first-quarter EPS growth and a downward revision for the fiscal year. It has rallied since then. Do you still like the stock?

Macauley: If you run an oil refinery, let's say, you deal with a very corrosive product. Mistras inspects plants to make sure it does not blow up. They are the leader in nondestructive testing for oil and gas and other infrastructure assets, like aerospace and bridges.

Our thesis is that they can hold their market position and improve margins by applying some better-business practices being brought to them by the CFO they hired a few years ago. The business will be valuable to a private equity or strategic buyers. We think somebody else will own it after (current management) fixes the operations.

IBD: Since you don't trade a lot, how do you spend your days?

Macauley: We spend time monitoring businesses we own and industry developments. We have a watch list of 75 companies that represent our next-best ideas, and we always try to stay on top of that. It's a continual process of looking for ideas that are superior to what we already own.

IBD: How do you and your co-managers divide portfolio responsibilities? Is each of you responsible for certain sectors, for example?

Macauley: We're all equally responsible for names in the portfolio. Our voting on trades is one-third, one-third, one-third, majority rules. Day to day, we have a primary analyst in charge of each name. I'm the primary on CarMax, for example. My partners know my primary businesses well, but not in quite as much detail as I do.

IBD: Financials are the fund's largest sector, with a 29% weighting as of Sept. 30. Why is that?

Macauley: There is an important distinction for us. We're really invested in specialty companies. We do not tend to own traditional depository banks or commodity financials. Markel (MKL) is our largest. It's a specialty insurer. It's also our oldest holding. The records don't still exist, but I believe it's been in the fund since the fund opened in 1997.

Brookfield Asset Management (BAM) (the fund owns A shares traded on the Toronto Stock Exchange) is an alternative asset manager. It invests in assets other than stocks and bonds. It owns office buildings, toll roads, retail real estate, hydroelectric plants, electrical transmission lines. They are infrastructure related assets.

IBD: You had a 15% cash weighting as of Sept. 30, well above the industry average. Is that much cash normal?

Macauley: We've averaged about 8% over the past seven years. We've had a lot of inflows. We're patient about deploying new capital.

IBD: How long does it normally take you to build a full position in a stock?

Macauley: Every situation is different. It may take two weeks on average.

About The Fund

As a winner in the IBD Best Mutual Funds 2016 Awards, it outperformed the S&P 500 over the one-, three-, five- and 10-year periods ended Dec. 31. Only 9% of U.S. diversified stock funds met that standard.

Managers Brian Macauley, David Rainey and Ira Rothberg have been at the helm since 2009.

Hennessy Focus is up 6% this year, in line with its midcap growth peers but trailing the S&P 500. Among the fund's top-performing holdings this year are Marlin business Services, Aon and IBD 50 and Big Cap 20 member Charles Schwab.

The fund's assets were focused on just 21 names as of Sept. 30, with about 40% of assets alloted to the top biggest holdings. The fund has an expense ratio of 1.46%, considered high vs. the fund comparison group tracked by Morningstar Inc.


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

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

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