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Opinion: ‘Keep it simple’ helps this stock-fund manager trounce the market

Here’s a valuable tip on how to beat the market: Keep it simple. This seems like dumb guidance in an investing world filled with erudite portfolio managers who try to dazzle investors with complex strategies as part of their marketing.

But here’s proof that simple is better. The Hennessy Cornerstone Mid Cap 30 Fund HFMDX — which has a strategy so simple that even I can follow it — has topped its fund category and index by eight percentage points annualized over the past three and five years, according to Morningstar Direct. It also outperforms nicely over 10 years — by four percentage points annualized. 

That’s remarkable in a world where most mutual-fund and hedge-fund managers consistently lag the market year in and year out — including many of the ones with the most complicated strategies. 

To get these returns, Hennessy portfolio manager Ryan Kelley uses a basic seven-part screen. He focuses on midcaps, tossing out anything with a price-to-sales ratio above 1.5, and targets names with earnings and price momentum. He eliminates non-U.S. stocks and stocks under $5 a share because they can be less liquid. He ranks what’s left by stock performance and keeps the top 30. Then he lets the portfolio ride for a year and rebalances again every October. 

The gating factors in the screen are based on back testing that found what works over the course of a market cycle. “The process is like a giant funnel,” Kelley says. “We look for reasonably valued companies with growth in earnings that have turned off the bottom. We have been running it the exact same way since day one.” 

In a recent interview, Kelley explained the five core investing lessons in his strategy that we can all use. 

1. Go with the flow

Legendary investors like Martin Zweig stand out for performance by using a momentum strategy — which basically says whatever is working will continue to work. In short, momentum begets momentum. “Don’t fight the tape,” was how Zweig put it. 

Kelley captures momentum in three ways. First, his screen looks for positive stock-price momentum over past three to six months. “We don’t want to buy stocks that are still falling because it is hard to identify stocks right before they turn,” Kelley says.

He then captures price momentum again with the last step of his process. It ranks finalists by one-year stock-price performance, and goes with the top names. “We are OK with missing the first part of a move up because usually positive price movements last longer than six months.” Six months to one-year price momentum has the most predictive value. 

He also finds momentum by singling out companies where earnings are improving, or losses narrowing. “This is important because if they are growing earnings, they are doing something right,” Kelley says. 

2. Let your winners run

A lot of investors spend far too much time thinking about how to tweak their portfolios every week based on headlines and perceived trends. A common mistake is to take profits too early. “The tendency after a 100% move is to say ‘This has been a great holding and I am out,’” Kelley says. He avoids this by rebalancing only once a year. That helps him let portfolio winners run — in part by taking the emotion (greed) out of investing. 

3. Favor value

Kelley’s price-to-sales cap of 1.5 is Draconian. It means his fund won’t be invested now in popular “Magnificent Seven” stocks. But there’s upside in this. “Value allows you to sleep better at night because there is less volatility,” says Kelley. And you might not be missing out on much, depending on when you get in and out. Kelley points out the Magnificent Seven had a great 2023, but were down 42% in 2022. If you put the two years together, they were up just 8%. 

The hard cutoff of 1.5 times sales brings another advantage. It gives Kelley’s portfolio a contrarian bent by populating his portfolio with stocks in sectors that are unloved by the crowd. The system finds sectors that are out of favor that have started to turn and still have long runway because of favorable changes in the economy or the sector, says Kelley. 

He goes with price to sales as opposed to p/e or price to book, because revenue is least likely to be messed with by accounting adjustments — another good lesson from his system.

As of the end of 2023, the Cornerstone MidCap portfolio was overweight consumer discretionary (20% of holdings), energy (22%) and industrials (35%). 

In consumer discretionary, as of the most recent reporting date, the fund owned Gap
GPS,
-0.11%
and Abercrombie & Fitch
ANF,
+0.43%,
which are already up a lot since his screen found them back in October. It also owns Guess
GES,
+2.63%
and Cinemark Holdings
CNK,
-1.37%.
 

In energy the portfolio included Par Pacific Holdings
PARR,
+1.58%,
California Resources
CRC,
+1.88%,
PBF Energy
PBF,
+1.70%,
Liberty Energy
LBRT,
-0.64%,
Consol Energy
CEIX,
+4.44%
) and Plains GP Holdings
PAGP,
+1.48%.
  

Among industrials, it owned Flowserve
FLS,
+1.75%,
Emcor Group
EME,
-0.16%,
MSC Industrial Direct
MSM,
+0.46%,
Fluor
FLR,
-0.84%,
Applied Industrial Technologies
AIT,
-0.41%,
Parsons
PSN,
-0.60%
and Oshkosh
OSK,
+0.76%.
 

4. Go with midcaps

This means companies with market valuation of $1 billion to $10 billion. Smaller companies like these are likely to be misunderstood because they have less (or no) analyst coverage. But if you go too small, you increase volatility. That can make you do dumb things by stirring up emotions. Midcaps are also more likely to perform well. “Over the last 20 years midcaps have outperformed large-caps and small-caps 60% of the time,” Kelley says. 

5. Stay optimistic

Over the years I’ve noticed that people in the market with the best records are often optimistic — like Warren Buffett, or Ed Yardeni of Yardeni Research. “People accuse me of being a permabull, and I say ‘thank you very much,’” Yardeni quips. He’s referring to the fact that over time, the U.S. stock market tends to go up. 

Kelley attributes his fund’s outperformance in part to his own optimistic outlook. The key here is that if you are optimistic, you are more likely to stay invested and not bail out near market bottoms when sentiment is dire — a common mistake. 

“Investing is not about timing and getting in and out of the market at the right time,” says Kelley. “Because inevitably you will be wrong on one of those big up days.” 

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned META, GOOGL, AAPL, MSFT and NVDA. Brush has suggested META, GOOGL, AAPL, MSFT, NVDA, GPS, ANF and PAGP in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks

Also read: This fund manager stopped worrying about economics. Now he is outperforming the stock market.

More: Is Meta Platforms now a value stock?

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