Staying Disciplined, Finding Opportunity

Dear Hennessy Funds Shareholder:

As we enter 2026, I wanted to share some of our views on the market and what may lie ahead.

Markets have been on a tear, with the S&P 500® Index delivering double-digit gains in 2023, 2024, and 2025. These past few years are a reminder that discipline and “time in the market” has mattered far more than trying to time every twist and turn.

In 2025, fundamentals held up better than many expected. Earnings are notably strong, with S&P 500 net profit margins above 13% in the third quarter of 2025, an eye-catching record. The Federal Reserve commenced rate cuts in September, with potentially two to three more cuts in 2026. While inflation persists and signs of weakness are appearing in the job market, the economy continues to grow, with GDP growth forecasts at about 2% for the next few years.

Importantly, one economic tailwind is the significant amount of capital that could be deployed to drive efficiencies, enter new markets, and enhance growth prospects. S&P 500 companies have roughly $6.9 trillion in cash on their balance sheets while private equity firms have roughly $2.5 trillion in “dry powder.”

Much of the market’s strength in 2025 has been buoyed by large-cap technology companies and artificial intelligence (AI), and this dynamic may extend into the coming years. In 2025, almost 40% of the S&P 500’s total return was attributable to the Magnificent Seven (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla). With the AI arms race now in full force, investors, companies, and government entities are accelerating investment in AI. In fact, large-cap tech companies may issue approximately $500 billion in corporate bonds over the next five years to fund capital expenditures for AI infrastructure, highlighting the scale of the opportunity and the intensity of the buildout.

No doubt we are in the midst of an AI super-cycle of investment, which could lead to over-investment and lower returns as companies strive to be first. We would caution against over-concentration in the largest AI companies and encourage broader opportunities across the market. In our view, some of the more compelling opportunities are in small- and mid-cap stocks, energy and utilities, financials, and Japanese equities, areas where we believe fundamentals and valuations offer a favorable setup for long-term investors.

• U.S. Small- and Mid-Cap Companies. We believe AI adoption in smaller companies could have an outsized impact on their operating margins, as meaningful cost efficiencies can be realized. In addition, rate cuts in 2026 should benefit small and mid-cap stocks. Small and mid-cap companies rely more on bank loans and short-term financing, so lower rates could translate into lower debt servicing costs. Perhaps more importantly, as rates decrease, investors’ appetite for risk may increase due to the declining benefits of investing in short-term fixed income. Lastly, mid-cap stocks, as measured by the Russell Midcap® Index, have lagged their larger peers as defined by the S&P 500® Index, by a large margin when looking at 1-, 5- and 10-year returns. As a result, mid-caps look attractively valued with the Russell Midcap Index trading at 17.7x 2026 estimated earnings compared to the S&P 500’s 22.2x as of December 2025.

• Energy and Utilities. The rapid pace of AI infrastructure buildout is driving significant growth in electric power demand, prompting both utilities and hyperscaler companies to add significant power generating capacity, much of which is utilizing natural gas as a fuel source. We see the capital investment opportunity associated with natural gas infrastructure expansion as a key source of sector cash generation and ultimately enhanced shareholder return, a clear positive for equity investors.

• Financials. As we enter 2026, lending conditions have improved, supported by a steeper yield curve where long-term rates are higher than short-term rates. Loan demand remains healthy, and credit has been stable with no material signs of stress. At the same time, a more constructive regulatory backdrop is facilitating increased merger and acquisition (M&A) activity. We expect bank earnings to rise in 2026, with a favorable setup that should support continued growth into 2027. Overall, we believe the banking sector is increasingly positioned as a potential “safe haven” for investors, with reasonable valuations, manageable competitive threats, straightforward business models, and highly transparent financial reporting.

• International. As we begin 2026, Japan stands at an inflection point. Structural reforms, accommodative monetary conditions, and a reform-minded government under Prime Minister Sanae Takaichi set the stage for a compelling investment environment in 2026 and beyond. We believe Japan’s equity market offers unique opportunities driven by governance improvements, productivity gains, and a continued shift from deflation to mild inflation. Governance remains a central theme as Japan is implementing meaningful changes to improve capital efficiency and enhance corporate value. Prime Minister Takaichi’s administration remains committed to growth-oriented fiscal policies, while the Bank of Japan cautiously normalizes rates without undermining liquidity. Inbound tourism is forecast to exceed 40 million visitors in 2025, contributing over 1% of GDP growth and bolstering domestic demand. We believe 2026 is poised to be a year of structural resilience and incremental reform for Japan. While risks remain, Japan’s evolving market dynamics should make it a compelling allocation for long-term oriented portfolios.

At Hennessy Funds, we focus on building high-conviction portfolios through time-tested investment approaches led by long-tenured management teams. We invest with optimism, yet protecting capital matters. In fact, we would rather participate less in strong, positive markets than expose shareholders to outsized losses in down markets.

We appreciate your continued trust and interest in the Hennessy Funds, and we are grateful you have chosen to include our Funds as part of your diversified portfolio. If you have any questions, or would like to speak with us directly, please don’t hesitate to call us at (800) 966-4354.

Best regards,

Ryan C. Kelley, CFA
Chief Investment Officer and Portfolio Manager