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Investing in Financials with the Goal of Downside Protection
Hennessy Large Cap Financial Fund
Interview with: 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
We recognize that the industry has changed significantly in the last decade and is in tremendous flux. Companies like Square, Lending Club, Alipay and Apple Pay are coming into the industry and disrupting it around the edges. Then, there are the crypto currencies. Combined with the Fed rate policy, there is an impact on the supply and demand of credit in the marketplace. There are international influences as well, so we are constantly looking at the competitive landscape, and we try to stay away from potential problems.

With the significant disrupters around the edge, we have to be mindful of how business models are changing. The bigger companies have the flexibility, the earnings, and the ability to get through these challenges and reinvent themselves or become part of the new regime. Now we are in an environment where rates arenít rising anymore, so leverage isnít as valuable, and we had to recalibrate.

Many of the companies have been in the fund for a long time, but we re-examine them every quarter when we look at their earnings. Every quarter we decide if we want to keep them. Thatís part of our process - going through every name every quarter and looking at the fundamentals.

Q: Would you give us an example from the banking industry and your research process?

A: Weíll look at Bank of America this quarter to see if there is any loan or deposit growth and to compare it with the industry. Next, weíll look at growth in tangible book value and the asset quality, both in new and old loans, as well as how well reserved the bank is in absorbing any losses.

Then we look at revenue and expenses, or how efficient the company is versus its peers. Different types of banks have different business models and varying degrees of the efficiency ratios and we look closely at that. Bank of America has been trying to rationalize its businesses, to cut costs where possible. Through the financial crisis there were many changes in the business and some aspects donít make sense any more. We like that the bank is doing a good job of controlling expenses.

We also examine the deposit and loan mix, because it dictates the margins going forward. A company with 100% in fixed-rate 30-year mortgages will not do well as rates rise, but a company with more variable rate mortgages, will ratchet up in such an environment. Thatís something we consider.

Once we review all these fundamentals, we focus on valuation. Bank of America is now trading at 11-12 times next yearís earnings and, historically, thatís very cheap relative to peers.

Overall, we think the industry moves together more than in previous years, because the level of rates and oversight has pushed everybody into the same types of products. So, we want to own companies with management teams that provide repeatable earnings and who can best deal with changes in operating conditions.

In essence, we are buying management teams with the assumption that we are going to hold these companies for a fairly long period of time. We have owned Berkshire Hathaway, Inc. for a while, as it fits the criterion of good management thatís going to make better than average decisions over a period of time.

We also take into account valuation and changes in the fundamental outlook of the industry. Then we try to select the best managements in the industry. Thatís why we look at all the companies every quarter and closely follow whatís happening.

We believe that knowing whatís happening in the entire industry gives us an advantage over most people on Wall Street, because typical analysts on Wall Street follow 15 or 25 companies, not 300 or 500 like we do.

The 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.

Itís very hard to outperform in this industry, and thatís why protecting the performance is so important, especially when conditions get rough. Now we are entering a period, when it is more about rates, not that much about credit. With rates moving up, the price of bonds is falling, and we must be mindful of that.

Q: Are you skeptical about regulations in the banking industry?

A: Itís an industry that has been affected by lack of regulation. Thatís one of the reasons behind the current valuations. There is still concern that even with all the regulations, the companies may not be always acting in appropriate ways.

We very much support many of the regulations that have been put in place. Thanks to increased regulations, asset quality has improved immensely from10 years ago. In the last two years weíve had the lowest levels of net charge-offs in 25 or more years. We have seen the benefits of regulation, and that helped investors become more confident about the banks in terms of underwriting standards. The large-cap banks are taking the biggest cost related to the changes.

On the flip side and not credit-related, it is disheartening to see growth in fake customer accounts, but I am hopeful that we wonít see additional abuses. Overall, we believe that the current regulatory structure is good for banks and good for the long-term health of the economy.

Q: What is your portfolio construction process?

A: Right now we have 26 names in the portfolio and, typically, we hold between 20 or 30 names. These are stocks that we feel are the better companies in the industry, or the ones that offer opportunity during the credit cycle, the interest rate cycle, the regulatory cycle or the accounting cycle.

We run a concentrated portfolio, and we donít worry about the indexes. We keep the individual position sizes no higher than 5% or 6%. We never have a position thatís 10% of the portfolio, because when a stock reaches 6% or 7%, we would sell or trim down the position.

Q: What are the other components of your buy-and-sell discipline?

A: We are not driven by hard price targets because, over time, that would make us too rigid. We could miss opportunities if we get rid of stocks too quickly. It takes a few months to buy a stock, and when we sell, we do it in increments. We are long-term investors, with the expectation to hold a stock for many years. In some cases, we may get in and out in half a year if conditions change and the underlying story doesnít make sense any more.

Q: How do you define and manage risk?

A: Credit is the biggest risk that we focus on all the time. It doesnít change that dramatically, but the idea is to be mindful of the trends in the industry, and this is an industry thatís tied to the macro economy with respect to loan growth, rates and credit.

Business model risk is also important. Although banks are in the business of lending and getting deposits, the models can vary dramatically in sources of income and the volatility of those sources. We tend to eliminate companies if their business model has inherent volatility, even if valuations are good. Also, we prefer not to focus on companies that rely solely on Wall Street for funding purposes.

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