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Advisor select

Mark DeVaul is a Portfolio Manager of the equity portion of the Hennessy Equity and Income Fund and is a member of The London Company’s investment committee. Mark began w +

Gary Could is a Portfolio Manager of the fixed income portion of the Hennessy Equity and Income Fund and is a Senior Vice President and Portfolio Manager of Financial Counselor +

Hennessy Equity and Income Fund
HEIFX (Inv Shares)
HEIIX (Inst Shares)
Fund Family
Hennessy Funds
Fund Advisor
Hennessy Advisors, Inc.
Sub Advisor
The London Company of Virginia, LLC
Financial Counselors, Inc.

7250 Redwood Boulevard, Suite 200
Novato, CA 94945

T: 800-966-4354

Seeking Lower Volatility Through a Better Upside/Downside Ratio
Hennessy Equity and Income Fund
Jul 13, 2017

Q: What is the history and mission of the fund?

The Hennessy Equity and Income Fund was launched on September 24, 2001, and in 2007, when our firms were brought in as its two subadvisors, Mark and I became co-portfolio managers. 

Our goal is to offer an S&P 500 Index experience to investors – capturing what the S&P 500 can do on the upside – while preserving the fund’s value and offering potential downside protection during rough patches. Over the last 10 years, the fund has captured 84% of the market return as measured by the S&P 500 Index with 41% less volatility, as measured by standard deviation. Currently, assets under management are approximately $300 million.

The fund’s goal is to capture most of the market upside as measured by the S&P 500 Index and limit the downside. Over the last 10 years, the fund has captured 84% of the market return with 41% less volatility.

We independently manage two asset classes as separate sleeves in the fund: equities and fixed-income securities. Sixty percent of the fund’s assets are in high-quality, dividend-paying stocks, and 40% are allocated to fixed-income investments including high-quality domestic corporate, agency, and government bonds. Together, these sleeves have provided a balanced portfolio with broad market exposure with relatively low volatility.

The equity portion of the fund is managed by Mark and the team at The London Company, which is located in Richmond, Virginia, while the fixed-income sleeve is managed by my firm, Financial Counselors, Inc., which is headquartered in Kansas City, Missouri.

Q: What core beliefs guide your investment philosophy?

On the equity side, our investment philosophy stems from a belief that the market does not efficiently assess risk and reward. Also, we believe protecting the downside is just as important as selecting good investments. To do this, our investment thesis is built around balance sheet strength, which we believe can cushion against unforeseen downside. 

Taking advantage of timing is also important to our philosophy. Our aim is to buy good businesses with sustainably high return on capital and own them for a long time. On average, the holding period for an equity is four to five years.

For the fixed-income sleeve of the fund, one core belief is that the corporate bond market should outperform U.S. Treasuries and U.S. agencies’ bonds over a full market cycle; historically this has been the case. However, managing through that cycle is challenging. 

Security selection has been the largest component of alpha of our active management strategy. This performance is driven by not only allocating to appropriate securities, but also by avoiding a bond or an industry that might be troubled. Because attempting to protect the downside is crucial to our process, if there are concerns about a particular bond, we act quickly. 

Q: How would you describe your investment process?

Our process on the equity side stems from our philosophical belief regarding market inefficiencies. Much of what we do is built around the goal of risk control, downside protection, and trying to eliminate the left-tail risk in each holding. 

Quantitatively, we look for companies that have generated high return on capital and trade at attractive valuations. We identify competitive advantages and potential drivers of return – whether strength of brand, a distribution system, or the industry structure – then determine whether we believe that is sustainable.

Next, a great amount of time is dedicated to balance sheets, because analyzing balance sheet strength and return on capital are so important to us. Through a process called balance sheet optimization, we build our investment thesis and avoid speculation on future earnings’ growth.

When we look at businesses that have generated high return on capital, we evaluate how leveraging the balance sheet might help the company lower its cost of capital. Our scenario analysis shows us the impact of increasing leverage to four times interest coverage, and also tells us how much cash the company management could return to shareholders if it chose to do so. 

Because the cost of debt typically is much lower than the cost of equity, in doing such transactions we could lower a company’s overall cost of capital – which is the metric we use to determine the intrinsic value of a firm. But importantly, we are just discounting the current cash flow of the business. 

Again, we want to find good businesses that we believe are trading at significant discounts to intrinsic value, without having to assume much growth, and then build our thesis around the financial flexibility that management has with the strength of their balance sheets.

Also, we review management’s long-term incentives and look for companies with a strong history of returning capital to shareholders through dividends or that repurchase shares at attractive prices. We avoid those that make excessive acquisitions. 

The names we would consider purchasing for the fund are those that pull all these things together, and then are trading at what we believe is a 30% to 40% discount to intrinsic value.

Ultimately, we think and invest like business owners and take a longer-term approach. Meaningful weights are allocated only to our high conviction ideas, and the portfolio’s turnover is generally between 20% and 25%. 

Q: How do you go about constructing the fixed-income sleeve?

Duration positioning is important to us; because we are incrementalists, we won’t swing from 20% long to 20% short. To optimize the portfolio’s duration positioning, we consider a number of factors, including the momentum in the economy, inflation outlook, Fed policy, and global macro conditions. Our duration policy also affects our view of the yield curve.

In the fixed-income sleeve, more than 75% of holdings are in higher-yielding, investment-grade corporate bonds. For example, we bought Rio Tinto plc over BHP Billiton Limited, even though Rio Tinto was a slightly lower rated credit comparatively, because we thought its relative debt dynamics were better than BHP’s. This turned out to be correct: we bought Rio Tinto when its 10-year credit spreads were out over 2%, and they have since narrowed to inside of 1% and performed better than BHP’s comparative debt issue.

The debt-to-market-cap ratio is used as a key metric for non-financial entities. Our experience tells us the lower the debt to market cap, the lower the risk of a widening credit spread.

Because we prefer not to take any added balance sheet risk, we are skeptical of companies where short interest exceeds 5% of the float. Instead, our investments focus on strong companies in out-of-favor cyclical industries where investors are not betting heavily on a share price decline. 

  • Inception: June 3, 1997
  • AUM: $277 million

Event risk, especially mergers or leveraged buy outs (LBOs), is another concern. Sometimes a high-quality bond can be turned into junk credit to finance the purchase – and bondholders like us suffer. 

For example, we had a smaller holding in EMC Corporation bonds. The company had zero net debt and the bond was A rated. However, when Dell Inc., the PC maker, acquired EMC in an LBO, it resulted in lowering the EMC credit to junk status. Even with our solid issue selection process, a buyout of a company can change our thesis and hurt the bond’s relative performance.

As a result, we try to avoid companies with an enterprise value of $20 billion or less, merely because they can be more easily leveraged and taken private. Because event risk is the bane of our existence, requiring an enterprise value above a certain threshold reduces the likelihood that someone can raise enough debt to acquire it.

Q: What part of fixed income do you focus on?

Typically, 90% of our fixed-income holdings are investment-grade bonds rated A and BBB. The other 10% can include high-yield bonds and other securities like preferred stocks, commercial and mortgage REITs, business development companies, and bank loans.

With investment-grade corporate bonds, we are far more concerned about ratings downgrades than upgrades because downgrades have a larger negative impact on individual bond performance.

Q: Can you give examples of your research process?

Apple Inc., the popular mobile and computing device maker, illustrates our research process well. The company has about $250 billion in cash and investments, and roughly $100 billion in debt. 

Last year, the stock started popping on our screen after a prolonged correction, which occurred largely due to concerns about the release of the upcoming version of the iPhone. We believed these concerns were overdone; Apple has a strong history of product innovation, and most importantly, its balance sheet was so strong that it could limit any downside. 

When we ran our balance sheet optimization model, we assumed Apple rightsized its capital structure a bit and took on more debt, but did not assume any type of growth in free cash flow. The resulting intrinsic value estimate suggested $200 a share, and at the time, the stock was trading at a 40% plus discount to that price. 

That type of opportunity is rare in this market environment. Apple still generates $60 billion or so in annual operating cash flow and has paid a dividend of about 1.7%. Moreover, management incentives are tied to total shareholder return, which we find attractive. Over time, we believe the yield could improve and that a significant amount of capital could be used for share repurchase. 

Q: Do you set any price targets for holdings in the fund?

Because we often hold on to an investment when its return on capital seems sustainable and its valuation isn’t egregious, we don’t have target prices per se. However, our balance sheet optimization model does estimate intrinsic value, which is updated at least quarterly as new information comes out. 

However, we also recognize that good businesses exist that have the ability to compound significant returns over time. We like to take a longer-term approach and buy meaningful positions, before leaving them alone unless a major change occurs. It is important to avoid the temptation of selling immediately once we get a 30% or 40% gain. 

When our winners are doing well and their businesses are generating strong fundamentals, we are reluctant to sell. The fund has held on to several names for this reason – for example, Visa Inc. and Apple – and we anticipate owning them for another five years, or perhaps even longer. 

Q: What is your fixed-income security due diligence process?

The investment-grade corporate bond space where we invest is well covered by several ratings agencies. Although we don’t internally rate bonds, we have strong opinions about the underlying issuers. 

Bringing an equity market investing approach to our bond investments is important, because a deep decline in its stock price would clearly impact a company’s credit spread negatively. Inherently, when we like a corporate bond implicitly, we look at the underlying equity price and anticipate it will continue to do well. Also, with all else being equal, as a stock price goes up, we expect a narrowing credit spread.

To cite an example, the insurance sector is facing several issues including a tough regulatory environment and a very low rate of return on their investment portfolios. Although insurance underwriting is a tough business, we find insurance brokers attractive. 

Recently, Willis Towers Watson merged to create a larger insurance brokerage and risk management firm, Willis Towers Watson PLC. Compared to traditional insurers like Prudential Financial Inc. and MetLife Inc., the newly merged company had a wider credit spread on its 10-year bond. We believed the risk of owning a brokerage firm like Willis Towers Watson was lower; additionally, after doing a thorough analysis of industry sectors and subsectors, we estimated the bond would likely have better credit performance than a typical P&C or Life Insurance underwriting company. 

Q: How do you construct your portfolio?

On the equity side, our number of holdings typically ranges from 25 to 35 stocks. We remain fairly benchmark agnostic.

Individual security selection dictates the portfolio’s sector weights. In terms of sector limitations, normally we won’t be more than two times the weight of any benchmark sector greater than 10%. So, if technology is 12%, we wouldn’t be more than 24%. 

For the fixed-income side, the portfolio generally holds 75 to 80 securities chosen from an extremely large universe. The benchmark for this sleeve is the Bloomberg Barclays US Intermediate Government/Credit Index, which spans over 5,000 investment-grade securities including utilities, industrials, finance, Treasuries, and agencies.

To attempt to lower credit risk and dampen volatility, we tend to invest in credits issued by larger companies and diversify among several names. Our investment approach is flexible and applies our best investment ideas based on relative values, and we do not make big bets on any single issuer or bond. 

Q: What is your definition of risk? How do you control it?

For us, risk is permanent loss of capital, so we focus on left-tail risk for every name. We seek companies with sustainable competitive advantages, then to attempt to limit the downside, we look further to identify those with a strong balance sheet. For each holding, there are also additional steps taken which have the potential to limit potential downside even more. 

Our risk-management process is all bottom-up and uses conservative assumptions when calculating the intrinsic value of a security. Moreover, our balance sheet optimization model recognizes each position will be a meaningful one.

On the fixed-income side of the portfolio, we are aware that we live in a world of asymmetrical return – which means that in the best-case scenario, we get paid the coupon and our principal returned, but if things go wrong, we could lose a portion of our invested principal. 

Controlling risk, in our opinion, is about continuously monitoring the creditworthiness of the bonds we own, and a large part of that requires simply watching what’s going on with the underlying equity. It would not be positive for credit performance if a stock price dropped 20% or 30%, so we always pay attention to the companies and industries we own on both the debt and equity sides of the ledger

Finally, our incremental approach attempts to limit losses and risks. Because market conditions or circumstances around a particular issue can change overnight, we limit exposures and spread holdings across several names.