Equity & Income Fund Investment Strategy

Portfolio Managers Mark DeVaul and Gary Cloud discuss the investment strategy of this 60% / 40% balanced fund. They discuss key selection criteria for both equity and fixed income securities.

January 2018

  • Mark E. DeVaul
    Mark E. DeVaul, CFA, CPA
    Portfolio Manager
  • Gary B. Cloud
    Gary B. Cloud, CFA
    Portfolio Manager
 

Mark DeVaul: The Hennessy Equity and Income Fund is a balanced fund, invested in high-quality equity and fixed income securities. Our focus is downside risk mitigation, and the goal is to generate market level rates of return over a full market cycle with significantly less volatility.

Gary Cloud: The Hennessy Equity and Income fixed income portion is 40% of high-quality investment grade bonds. They compliment the long-term capital gain potential from the 60% on the equity side. And, we're trying to capture the right part of the yield curve, the right amount of credit risk, over many market cycles with fixed income securities.

Balance Sheet Optimization Model

Mark DeVaul: Balance sheet optimization for us is a way to determine the intrinsic value for each company, but by focusing on the balance sheet strength and not our ability to forecast future earnings. So it starts with our universe of high return on capital companies that are generating ample cash flow, and in many cases are under-leveraged and could benefit by changing their capital structure, taking on a little bit of debt, low-cost debt, buying back their higher cost equity. In effect, lowering their weighted average cost of capital. We then use that newly derived weighted average cost of capital to discount the current free cash flow of the business, but importantly, don't assume much growth, don't assume any margin improvement, to derive what we think the company is worth, and attempt to buy it at discount to that value.

Key Stock Selection Criteria

Some of the key characteristics we seek in any holding in a fund first starts with sustainably high returns on capital, so driven by some competitive advantage that others have not been able to duplicate. It could be brand strength, distribution strength, cost advantages, industry structure, oligopolies, duopolies, those are the types of things we look for.

Also, balance sheet flexibility, so significant cash flow generation, strong balance sheets. Insider activity, making sure insiders are on your side, so executives and board members buying with their own money, not selling. Then finally, looking at the history of capital allocation. What has the company done with their cash and their balance sheet over time? Looking for companies with a good track record of returning that cash to shareholders through dividends and share repurchase at attractive prices.

Duration and Maturity Management

Gary Cloud: So a good way to think about the bond portion of this Fund is to think of about a four-year maturity because that's the average maturity of the bonds in the portfolio. Also, consider maybe about a 10-year maximum maturity. And then through a cycle, what we're going to do is try to find the best part of the yield curve, the most attractive credits that make sense, and following Federal Reserve policy and inflation, make the best judgment that we can.

Key Stock Selection Criteria

Gary Cloud: So the fixed income portion of the Fund is really geared towards investment grade bonds, and that includes U.S. Treasuries and agencies, all AAA, as well as investment grade bonds, BBB or higher. We tend to specialize in individual issue selection on the credit side. Because you can pick up spreads of 100 to 120 basis points, 1.2% above Treasuries, we tend to focus on those through an entire cycle, and so that selection process with our team is what we feel is our hallmark in representing the fund.