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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.”
Event risk, especially mergers or leveraged buy outs (LBOs), is another concern. Sometimes a high-quality bond can be turned into junk credit to finance the purchase – and bondholders like us suffer.

For example, we had a smaller holding in EMC Corporation bonds. The company had zero net debt and the bond was A rated. However, when Dell Inc., the PC maker, acquired EMC in an LBO, it resulted in lowering the EMC credit to junk status. Even with our solid issue selection process, a buyout of a company can change our thesis and hurt the bond’s relative performance.

As a result, we try to avoid companies with an enterprise value of $20 billion or less, merely because they can be more easily leveraged and taken private. Because event risk is the bane of our existence, requiring an enterprise value above a certain threshold reduces the likelihood that someone can raise enough debt to acquire it.

Q: What part of fixed income do you focus on?

A: Typically, 90% of our fixed-income holdings are investment-grade bonds rated A and BBB. The other 10% can include high-yield bonds and other securities like preferred stocks, commercial and mortgage REITs, business development companies, and bank loans.

With investment-grade corporate bonds, we are far more concerned about ratings downgrades than upgrades because downgrades have a larger negative impact on individual bond performance.

Q: Can you give examples of your research process?

A: Apple Inc., the popular mobile and computing device maker, illustrates our research process well. The company has about $250 billion in cash and investments, and roughly $100 billion in debt.

Last year, the stock started popping on our screen after a prolonged correction, which occurred largely due to concerns about the release of the upcoming version of the iPhone. We believed these concerns were overdone; Apple has a strong history of product innovation, and most importantly, its balance sheet was so strong that it could limit any downside.

When we ran our balance sheet optimization model, we assumed Apple rightsized its capital structure a bit and took on more debt, but did not assume any type of growth in free cash flow. The resulting intrinsic value estimate suggested $200 a share, and at the time, the stock was trading at a 40% plus discount to that price.

That type of opportunity is rare in this market environment. Apple still generates $60 billion or so in annual operating cash flow and has paid a dividend of about 1.7%. Moreover, management incentives are tied to total shareholder return, which we find attractive. Over time, we believe the yield could improve and that a significant amount of capital could be used for share repurchase.

Q: Do you set any price targets for holdings in the fund?

A: Because we often hold on to an investment when its return on capital seems sustainable and its valuation isn’t egregious, we don’t have target prices per se. However, our balance sheet optimization model does estimate intrinsic value, which is updated at least quarterly as new information comes out.

However, we also recognize that good businesses exist that have the ability to compound significant returns over time. We like to take a longer-term approach and buy meaningful positions, before leaving them alone unless a major change occurs. It is important to avoid the temptation of selling immediately once we get a 30% or 40% gain.

When our winners are doing well and their businesses are generating strong fundamentals, we are reluctant to sell. The fund has held on to several names for this reason – for example, Visa Inc. and Apple – and we anticipate owning them for another five years, or perhaps even longer.

Q: What is your fixed-income security due diligence process?

A: The investment-grade corporate bond space where we invest is well covered by several ratings agencies. Although we don’t internally rate bonds, we have strong opinions about the underlying issuers.

Bringing an equity market investing approach to our bond investments is important, because a deep decline in its stock price would clearly impact a company’s credit spread negatively. Inherently, when we like a corporate bond implicitly, we look at the underlying equity price and anticipate it will continue to do well. Also, with all else being equal, as a stock price goes up, we expect a narrowing credit spread.

To cite an example, the insurance sector is facing several issues including a tough regulatory environment and a very low rate of return on their investment portfolios. Although insurance underwriting is a tough business, we find insurance brokers attractive.

Recently, Willis Towers Watson merged to create a larger insurance brokerage and risk management firm, Willis Towers Watson PLC. Compared to traditional insurers like Prudential Financial Inc. and MetLife Inc., the newly merged company had a wider credit spread on its 10-year bond. We believed the risk of owning a brokerage firm like Willis Towers Watson was lower; additionally, after doing a thorough analysis of industry sectors and subsectors, we estimated the bond would likely have better credit performance than a typical P&C or Life Insurance underwriting company.

Q: How do you construct your portfolio?

A: On the equity side, our number of holdings typically ranges from 25 to 35 stocks. We remain fairly benchmark agnostic.

Individual security selection dictates the portfolio’s sector weights. In terms of sector limitations, normally we won’t be more than two times the weight of any benchmark sector greater than 10%. So, if technology is 12%, we wouldn’t be more than 24%.

For the fixed-income side, the portfolio generally holds 75 to 80 securities chosen from an extremely large universe. The benchmark for this sleeve is the Bloomberg Barclays US Intermediate Government/Credit Index, which spans over 5,000 investment-grade securities including utilities, industrials, finance, Treasuries, and agencies.

To attempt to lower credit risk and dampen volatility, we tend to invest in credits issued by larger companies and diversify among several names. Our investment approach is flexible and applies our best investment ideas based on relative values, and we do not make big bets on any single issuer or bond.

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