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Seeking Lower Volatility Through a Better Upside/Downside Ratio
Hennessy Equity and Income Fund
Interview with: Mark DeVaul, Gary Cloud

Author: Ticker Magazine
Last Update: Jul 13, 1:18 PM ET
Combining stocks and bonds offers investors the potential to capture most of the upside while limiting the downside of volatile stock markets. Mark DeVaul and Gary Cloud, portfolio managers of the Hennessy Equity and Income Fund, focus on investing in quality dividend-paying stocks and investment-grade corporate bonds with the objective to generate alpha along with the benefit of downside protection.

“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.”
Q: What is the history and mission of the fund?

A: 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.

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?

A: 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?

A: 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?

A: 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.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc