Neil Hennessy – The Opportunities in Mid-Cap and Japanese Stocks

We’ve had to think outside the box. Just like the RIA community, when you are small you have ask, “How do we distinguish ourselves from others?” At the start, we didn’t have the money to employ wholesalers, so our feeling was if we hired a PR firm to wholesale us to the media, and they wrote an article about one of our funds, it was like a third-party endorsement. Over the years we’ve continued to utilize PR, which has resulted in the Hennessy name appearing on national TV, radio or in print media on average every two-three days. We don’t advertise. We don’t offer institutional accounts, and we don’t offer SMA’s or individual accounts. Our sole focus is on the clients of our 14 mutual funds.

Eight of our 14 funds are quantitatively managed, so clients know exactly how their money is being managed. We offer two financial funds managed in-house, run by Dave Ellison, the most tenured portfolio manager in the sector. We manage two of the highest performing Japan funds, sub-advised by SPARX Asset Management Co. Ltd., located in Tokyo. Broad Run is the sub-advisor of our Focus Fund, while The London Company and Financial Counselors, Inc. together sub-advise our Equity and Income Fund.

What is your outlook for the economy and the how is that translated into your view of where markets are headed, particularly the U.S. equity market?

My message to the advisor community it is that they should be making outgoing phone calls to their clients to prepare them for a market correction. The headlines every day are that “the market is overvalued” or “It’s been up for nine years. It’s going to come down.” But corporate profits and cash flows are at all-time highs. Businesses survived a very difficult eight-year regulatory environment, and they are doing well. Any tax relief will be beneficial for all.

The mutual fund industry as a whole is facing a big headwind, which is the flight to passive away from active investing. Now if you think about the psychology of the investor, all they hear is that the Dow Jones Industrial Average is up. They think to themselves, “I’m making money.” The next day the Dow Jones is up, “I’m making money.”

If investors are in an index fund or ETF, and the market goes down for three, four, five days, then investors realize they are losing money and tend to sell out.

Here is the interesting point. Investors will want to get out of the market and they will call their advisors. As an advisor, you don’t want that call. You want to make the outgoing one.

Go back to 2010. There have been 14 times that the market has corrected between 5% and 10%. The average duration from peak-to-trough was 16 days, and the snapback was half that time, approximately. You had no time to get out and get back in. There were four times when the market corrected between 10% and 20% since 2010, 15.75% being the greatest correction, and that was in 2011. On average, that took 50 trading days, and it snapped back almost twice as quickly. So you had no time to get out.

This will happen again. The last time we saw the peak-to-trough cycle was February 2016. But when you look at what’s happened over the last two years, passive investing has garnered almost all the incoming money.

Here’s the problem: Passive investors all own the same companies in the same percentage and they can’t use limit orders. When the selling begins, they’ve got to sell at market. When you sell at market, selling begets more selling. If the market corrects 3,500 points, that’s a 15% correction. That would bring the Dow Jones PE down to 16. People would be buying in at 16- or 17-times earnings, and it’s only at 19 now, so it’s not overvalued.

This market reminds me of 1982 to 2000 when it was up each and every year with the exception of 1990, when it was down one half of 1%, and that included the crash of 1987. In 1987, the market lost 25% in one day. That bull market also included the late 1980s and early 1990s, when 837 savings and loans and banks failed. The real estate market collapsed. History tends to repeat itself. We will have a correction. That is why it’s important that advisors make the outgoing phone call to clients to prepare them for this. You just don’t want to come in after the fact and play defense.

What do you think has driven the flow of money from active to passive strategies?

We’ve seen this movie before, so you don’t need to wait around for the credits. The headlines are all about fees. This is the Vanguard story and the SEC story under Mary Jo White, that the best thing for shareholders is “low fees”.

But that’s not true. The best thing for the shareholder is making money net of fees. The DOL ruling came – and it doesn’t matter if it’s negated – and put everybody on notice. Why would you use the Hennessy Cornerstone Mid Cap 30 Fund at 1.2% versus Vanguard at four basis points? That has driven a lot of money to passive, yet investors aren’t looking for the best performing funds, just the cheapest.

If it’s a combination of fees and regulation, what will it take to reverse the flow of money from active to passive? Will it take a market correction, or is it going to take something else?

The impetus will be a market correction. Active managers have outperformed passive in bear markets. In an index fund you are selling at market. But value-based, active managers will be very selective about what they buy or sell.

I’ll just use our company as an example. We are a publicly traded company under the symbol HNNA. We were included in the Russell 2000 index. We have only 7.7 million shares outstanding. But when we were added to the index and then subsequently removed, the indexes owned 445,000 shares of our thinly traded stock, and they had to sell at market. That is what’s going to happen. There’s no thinking behind it.

But the value manager who would have bought those 445,000 shares at that lower valuation is where active management can really outperform passive.

Do you think there will be a consolidation or shakeout among active managers when there is the next big correction?

The current environment is making it very tough for mutual funds to grow organically. You are either going to acquire to grow or be acquired. A lot of managers are bringing down fees. It’s crazy because people misunderstand the fee structure. The manager only gets paid his management fee. The rest of the fee is made up of the expenses of running the funds, such as legal, accounting, etc. If the advisor wants to eat all those expenses, God bless them. We don’t.

You are a publicly traded firm. John Bogle at Vanguard has been critical of the model of publicly owned mutual funds. The problem, as he put it, is having to serve two masters. You have a board that has a fiduciary responsibility to its shareholders to maximize profits for the fund company. But you are also trying to maximize outcomes for your investors and those interests aren’t aligned. How do you view that issue when managing your firm and your investments?

Jack built a good firm, and it’s a mutual fund firm. That means the shareholders and investors are one and the same. It was a great model and it has worked. But he’s been able over the years to sell that fact that “cheap” is the best thing for the investor.

If you match up the funds of the good actively managed managers, like ourselves, you will see that our returns net of fees perform better than a lot of Vanguard’s funds.

If you look at T. Rowe Price, Franklin Templeton or Hennessy, you see that we are very, very transparent. You know what we get paid. You know what the executives of those firms get paid. You know what my expenses are. You know everything about my company.

Why isn’t Vanguard that transparent with its members? You cannot find out what its CEO makes. You cannot find out what people are making over there.

They built a wonderful company. Vanguard’s new chairman is supposed to be a wonderful person. But at the end of the day, as a publicly traded company we are as transparent as you can get, and the regulatory environment is just getting worse. A new rule is going to come out next year for a publicly traded company to disclose how much the chairman of the board and president get paid compared to the average worker. Will Vanguard participate with this new regulation?

Let’s talk about some of your funds. Some of them use the “Dogs of the Dow” approach to investing, which is essentially investing in high-dividend stocks. What are some of the strategies that are particularly appealing to advisors?

The Dogs of the Dow is a concept that is very easy to understand, and advisors can buy those stocks themselves should they want. We just make it easier by buying the 10 highest yielding Dow Jones stocks in an equal-dollar amount.

One of our top picks for advisors is our Cornerstone Mid Cap 30 Fund (HFMDX). I love the mid cap arena.

That’s one of the funds that you manage personally or co-manage.

Right. It’s quantitatively managed, so I’ll give you the formula. It’s on the website and in the prospectus. We are looking for companies with a market cap between $1 and $10 billion. We want to make sure that the price to sales ratio is below 1.5, so we are not going to pay more than a $1.50 for a dollar in revenues. We make sure that the earnings are higher than the previous year. The companies that are still standing out of the 10,000 that we screen, we make sure that they have positive relative strength for a three- and six-month period. From there, we buy the 30 companies in equal-dollar amounts that have the best relative strength, or price appreciation, over the previous 12 months. We hold those for a year and then rebalance the portfolio.

The track record has been phenomenal. It’s only had one down year since inception in 2003, and that was in 2008 when, going into September 2008, it was up over 9% and then the market dropped and it got crushed along with everything else.

I like mid caps for a number of reasons. Companies that have a market cap of $1 to $10 billion are big enough to withstand an economic calamity. They are also big enough to make an acquisition that would be accretive. They are also big enough to be acquired to be accretive to the acquirer. So it’s a very attractive market. In the 38 years I’ve been in business I’ve always been invested in mid caps.

The second investment area I’d look at is Japan. I acquired two Japan funds in September 2009 and people thought I was crazy. Why Japan?

The whole story about Japan is that it is changing structurally. When you look at our Japan funds, which have outperformed many other Japan funds, you see they are up over 25% and almost 40% year to date alone.

It’s a very compelling investment story and I will just give you one example, which is tourism. In 2009, there were six million visitors to Japan. For a Chinese citizen to visit, you had to prove that you made $37,000 a year, and you had to travel in a group of four with a Japanese guide. The Japanese government then significantly relaxed those requirements, and by June 2010, visitors needed to prove income of only $3,000 a year to visit Japan, , which opened up Japan as a tourist destination to the 350 million middle-class people in China who are just a three-hour flight away. This year they have had over 20 million visitors. They were trying to get to 20 million by 2020. Last year they had 18.5 million. We haven’t seen anything yet, because they have the Summer Olympics in 2020. The world is going to see how beautiful Japan is, how nice the people are, how good the food is and that there is virtually no crime whatsoever.

Japan had been in a deflationary spiral for nearly two decade, but structurally the country is changing. On average, every man, child and woman in Japan has $187,000 of cash. Forget about their investments. It’s in cash, or in bank notes. During that deflationary period, why would someone buy something today when it is going to cost less tomorrow? Following the implementation of Abenomics, Japan is inching toward the government target of 2% inflation. And the Yen is at far more attractive levels.

Japan is a great story, and Japanese companies are making so much money. If the yen holds at current levels, earnings will get better and better through 2020, and beyond

The other topic I wanted to ask you about is the intersection between Wall Street and Washington, and how do you see the political environment playing out for investors? From an advisor’s perspective, what should they tune out and what should they care about?

Advisors should tune out everything until it becomes law. The market was down yesterday because some Republican senator came out and said they weren’t going to vote for the tax bill. It’s up today because somebody else said they would. Don’t listen to the noise; just let it go. Once the rules are set, then we’ll know how to play.

They are not making the smartest decisions in Washington, but hopefully they will get it right at some point in time. But I never let it bother me, because I can’t do anything about it.

But I do believe that corporate taxes will come down. If they do come down to 20%, corporations are going to make a lot more money. Who benefits from that?

The shareholders?

The middle-class. If corporate profits move higher, the stock market will move higher. If the stock market moves higher, then retirement funds, the biggest asset for the middle-class in America, are going to get bigger. It benefits them. The rich, the wealthy, corporations, they are not going to rely on an IRA or a defined-pension plan. But if the market goes higher, maybe we can at the same time get some of these unfunded pension liabilities down to a reasonable level.

A corporate tax break, as much as people will complain that it’s on the back of individuals, is going to benefit the middle class. It is not being sold that way, but that is the truth of the matter.

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Are you confident you will outperform your benchmarks this year?

I’ve never believed that success comes from beating indexes. If you look at one-, three-, five- or 10-year periods, we have been very fortunate and have made our shareholders money. Maybe we didn’t beat an index. But my philosophy has always been, it’s about making the shareholders money. If a shareholder redeems because we didn’t make them enough money, fine. I don’t want them to leave because I beat an index and have them say, “Hey, you beat the index but lost 25% of my money.”

The main thing is making the client money, not worrying about the indexes, and making sure that shareholders understand the products that they are invested in. Once they understand one product, they will have a lot more faith in you as an investment advisor.

Just get out in front of the next market correction. If I’m wrong on that, so what? The client made more money. It’s a win-win situation for advisors.

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