Lipper Leaders Spotlight—Hennessy Fund Focuses on Value, Benchmark Differentiation to Consistently Outperform its Peers

The Lipper Small-Cap Core Funds classification is defined as funds that by portfolio practice, invest at least 75% of their equity assets in companies with market capitalizations (on a three-year weighted basis) below Lipper’s USDE small-cap ceiling, according to Lipper methodology. These funds have more latitude in the companies in which they invest. These funds typically have average characteristics compared to the S&P SmallCap 600 Index.

The Lipper Leaders Rating System is a toolkit that helps guide investors and their advisors in selecting funds that suit individual investment styles and goals. According to Refinitiv Lipper, “Each fund is ranked against its peers based on the metric used (such as its flagship risk-adjusted return measure, Consistent Return, Total Return, or Expense), and the highest 20% of funds in each peer group are named Lipper Leaders, the next 20% receive a rating of 4, the middle 20% are rated 3, the next 20% are rated 2, and the lowest 20% are rated 1.”

Using Lipper Leader metrics for the month ended March 31, 2023, one of the best Small-Cap Core Funds is the Hennessy Cornerstone Mid Cap 30 Fund, Institutional (HIMDX). The fund has a Lipper Leaders rating of 5 for the three-year and five-year Consistent Return and Total Return ratings, and it has beaten its benchmark—the Russell MidCap Index—over the one-, three-, five-, and 10-year periods to March 31, and since inception in 2003. HIMDX won a 2023 Refinitiv Lipper Fund Award for Consistent Return. We spoke with fund manager and Hennessy Funds CIO Ryan Kelley to examine the strategies he uses to manage the fund, and his team’s outlook on small-cap funds in general.

Benchmark differentiation and a fundamental, consistent approach

Kelley said Hennessy has been running the fund for almost 20 years and he and his team have vast experience managing Small-Cap Core Funds. The team focuses on value investing and the mean price-to-earnings ratio of its investments is nine times earnings. Kelley said he also focuses on revenue and sales, and considers sales to be a more “pure” number than revenue.

“One of our investment criteria is to look at stocks between $1 billion and $10 billion. Over time—the small- and mid-cap space—mid caps outperform large and small over a decade,” Kelley said. “We also like that these companies in general are big enough to have proven track records, longer earnings tracks, and yet they are small enough that they can grow a lot. On top of that, mid caps are usually big enough to move the needle if a larger cap buys them.”

Additionally, HIMDX’s holdings differ considerably from the fund’s benchmark, which while causing more volatility at times offers more potential upside for investors, according to Kelley.

“When you have a concentrated portfolio of just 30 stocks it can move differently than the benchmark. That has helped us to have solid outperformance over periods,” Kelley said. “We are looking at stocks that have both value and momentum, and then we pick the 30 best stocks. We are not traders—we rebalance the fund only once a year (generally in the Fall). That way we let momentum and certain stories play out. At minimum, each stock will be in the portfolio for at least a year.”

Kelley said that in the last rebalance, seven stocks remained from the previous rebalancing and 23 holdings were new. Overall, each stock adds up to 3.3% of HIMDX’s holdings.

HIMDX’s management team takes a formula-based approach based on fundamental quantitative investing. The idea, Kelley said, is that you are looking at the fundamentals of companies and let those drive the investment formula. “This formula is based on consistent backtesting over decades. It eliminates the emotional part of investing. It is also very transparent,” he said. “You look at the fact sheet and it tells you exactly the type of stock we’re looking for—growth and earnings, stocks with positive price appreciation over the past three and six months. These criteria will give us about 200 stocks and then we buy to the top 30.”

Managing risk by focusing on value

Kelley said his fund’s best defense against risk is focusing on value. “We would rather do less well in a hyper upmarket and protect on the downside. We do that by adhering strictly to our value metric, which is price to sales below 1.5 times, and that is basically our biggest mitigation factor.” At times the fund will be really underweight in one sector and really overweight in another. The fund’s management team let the stock selection itself drive performance. “At times a subset or sector can show detrimental returns, but if we stick to our value bent those are usually fairly limited,” Kelley said. “Our three-year downside capture is below 50% and the five-year number is 90%. When the market dropped during the pandemic, we only experienced about 50% of that drop.”

Kelley said that mid caps overperform large caps with less volatility. In this particular space over the last few years, mid caps, small caps, and large caps have all been about even in terms of performance, according to Kelley. The last year in particular the mid caps did outperform the large caps by a little bit, but it was a pretty dismal year for most stocks. “If there’s any concern right on the horizon, a lot of the small-cap financials are under a lot of pressure. We’re keeping an eye on that,” Kelley said.

Diversification in a volatile market

“You really want to have diversification across asset classes and really make sure you are good on the asset allocation point of view. I like funds having higher active share and differentiation among sectors,” Kelley said. “When it comes to risk, this fund protects on the downside. This can really augment the portfolio over the long term.”

Active share is the calculation of this fund versus the Russell MidCap, Kelley said. It compares HIMDX’s holdings and its weightings versus the benchmark’s holdings and benchmark’s weights. “An active share of anything below 60% shows you don’t have a lot of differentiation between yourself and the benchmark,” Kelley said. HIMDX’s differentiation is 99%. “It means we are really differentiated from our benchmark,” he said.

High inflation is causing mergers and acquisitions to be less of a factor in the market. This is causing interest rates to rise and companies to assess internally what is going on, Kelley said. “If we stick to some strict value in this uncertain market, that will perform better as we see more disruption until we get more clarity on when the Fed stops raising interest rates and more comfort in what the financial system is doing.”

Kelley said that, overall, he believes HIMDX’s key to its success is its downside protection, differentiation from its benchmark, and its focus on value and momentum. “Stocks have momentum, and the performance is usually a mix of being overweight in certain sectors and picking some good stocks within those sectors,” he said. “It’s about how we allocate and select the sectors. Our return is driven by not only sectors we’re in, but what stocks we’re buying in those sectors.”