Investing in Financials with the Goal of Downside Protection
Hennessy Large Cap Financial Fund
Dave Ellison, Ryan Kelley
Author: Ticker Magazine
Last Update: Mar 09, 10:45 AM EST
|As a result of the 2008 financial crisis, investors are still cautious about banking stocks. However, for Dave Ellison and Ryan Kelley, co-managers of the Hennessy Large Cap Financial Fund, the financial world provides plenty of opportunities. Running a concentrated portfolio, they focus on choosing the companies with the right business models, repeatable earnings, and management teams with the ability to withstand the storms in the credit and interest rate cycles.
ďThe financial industry isnít one that can significantly transform itself. This is a commodity industry thatís been around for 1,000 years; it has seen the ups and downs of cycles and is very much tied to an Apple or a Facebook. They piggyback and prosper from those innovations.Ē
Q: What is the history and mission of the fund? How does it differ from its peers?
The Hennessy Large Cap Financial Fund was started in 1997. The mission of the fund is to run a diversified, large-cap, financial services portfolio. It is a performance-driven fund.
One of our main differentiators is that we have stayed more concentrated in large-cap banks, despite having investments in other financial companies. We donít try to replicate an index. Instead, we try to find the best companies that we believe will bring solid returns to the shareholders.
Q: What are the benefits of investing in such a fund?
Our goal has been to protect the downside when times are difficult and to provide investors with a measured and thoughtful group of companies that we believe will do well in the good times.
The hallmark of a good economy comes from the banking system. We had huge problems from the credit side in 2008-2009, but afterwards we have come a long way in creating much stronger balance sheets, system controls, and safety. So, we can evaluate the companies from a pure price-to-earnings and fundamental basis and not worry too much about asset quality at this point.
Q: What core beliefs drive your investment philosophy?
We believe that four major factors drive the performance of companies - the credit cycle, the interest rate cycle, the regulatory cycle and the accounting cycle. We focus mostly on the credit cycle, because it is the most important driver.
Next we look at earnings, as we acknowledge that the sustainability and the repeatability of these earnings are important for a company to withstand the storms of credit, interest rate, regulatory and accounting changes.
Q: Would you explain your view on analyzing the credit cycle?
Between 2008 and 2011 we went through a significant credit cycle, where home prices dropped, defaults increased, and foreclosures were too common. That is a bad thing for the banks, because they own mortgages. If they have to write the assets off, that creates losses, higher provisions and expenses.
So we look for changes in underwriting that may lead to rising default rates and the costs associated with these defaults. Thatís why we follow the companies with attention to detail and talk to them quarterly. We look at 400 to 500 companies every quarter to get an update of whatís happening in the marketplace in terms of the pricing and underwriting standards. Thatís, obviously, a big driver for these companies and we saw that in the last down cycle.
For instance, back in 2015, oil prices dropped quickly. In the third and fourth quarters of 2015 there was a lot of scrutiny on banks, especially the large banks, to figure out how exposed they were to the oil industry. Huge banking losses were expected if oil companies, drillers, and exploration & production players went bankrupt. However, the reality was that many banks had little to no exposure. JPMorgan, for instance, had loan exposure of 1% to that type of lending.
At the end of the day, losses were minimal over the next four quarters, but in some cases stocks dropped 50 percent. The recovery in those stock prices has been pretty phenomenal for the last two years. Thatís a specific case, where we had to pay attention to what the companies were showing and saying, not to what the market was doing or believing.
Q: How does your philosophy translate into the investment process?
Every earnings season we look at 400 to 500 financial companies and focus on those with a market capitalization of more than $3 billion. Historically, we have invested only in U.S. companies and have not invested in foreign banks or financial companies.
We focus on growth in book value, because it is a critical way to measure financial companies. The banking business runs on the balance sheet and if the balance sheet isnít getting better, then we are not getting anywhere. Then we look at price-to-book and price-to-earnings ratios. We are valuation oriented and we donít want to buy the highest-priced stocks in the market.
The next step is looking for four types of criteria. First, we look for repeatable earnings, because they are a sign of well-run companies. Second, we look for companies with management changes, because when a poorly run company gets a new manager, there is the potential for a turnaround and repeatable earnings.
Third, we focus on companies in which thereís been a difficult credit environment, and that either brings a new management or attention to detail in credit. Historically, credit has been the biggest driver in terms of earnings and stock prices, both on the upside and the downside.
The fourth type is the transformative merger or acquisition, where a company doubles in size and gets scope, market control and the ability to have repeatable earnings over time.
Overall, our process is driven by stock selection. There is a macro overlay as well, which is more related to the types of companies we might be invested in. Although the fund is primarily focused on large banks, we do invest in other financials based on macro trends. For instance, right now we have about a quarter of the portfolio in companies like MasterCard, Visa, and PayPal, which are not traditional banks.
Changing the portfolio in terms of composition and types of holdings is always a conscious decision. Because of the move in rates and the regulatory recalibration after the 2008 cycle, the way we invested in financial stocks has now changed. The ability to grow loans or make a margin has been diminished. So, we needed to move the portfolio towards new types of repeatable businesses that wouldnít be impinged by rates or regulatory overlays. We had to adjust a lot of our thinking because of the post-2008 regulatory and accounting changes.
Q: Could you highlight your investment process with some examples?
Weíve added or increased our exposure to names like Visa and MasterCard, because these are quasi-monopolies that are not sensitive to the credit cycle or regulatory changes. Weíve increased our exposure with the assumption that if there is a significant move up in interest rates, changes in the yield curve, or a significant regulatory change, they will be less affected and, therefore, their repeatable business model will remain intact.
We look for businesses that are able to sustain a level of consistent profitability and these businesses should be in the right market or mindset. Although the regulatory cycle has been very harsh, there has been a regulatory moat put around larger banks, so we have kept them in the portfolio.
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