The Return of Market Volatility Offers Opportunity

Hennessy Focus Fund Portfolio Managers discuss the return of market volatility, describe the investment case for two holdings, and share their investment philosophy.

May 2018

 

May 2018

  • David Rainey
    David Rainey, CFA
    Co-Portfolio Manager
  • Brian Macauley
    Brian Macauley, CFA
    Co-Portfolio Manager
  • Ira Rothberg
    Ira Rothberg, CFA
    Co-Portfolio Manager

In the first quarter of 2018, investors experienced a significant increase in volatility. What are your thoughts on the return of volatility, and your outlook for the market?

Volatility has indeed returned to U.S. equity markets. The S&P 500 Index made a daily move of more than +/- 2% six times in the first quarter of the year after experiencing no such moves in 2017. We believe concern over tighter monetary policy and higher trade tariffs were the central issues behind the increased volatility in the first quarter.

Nevertheless, we remain cautiously optimistic about the economy and the markets. We believe the severity of the 2008/2009 financial crisis and the slow pace of the recovery mean that this expansion will last longer than typical expansions. Tax cuts are helping to boost spending and investment, consumer and business confidence is rising and corporate earnings are being revised upward.

The U.S. equity market is trading at about 17x forward twelve-month consensus earnings - a slight premium to the long-term historical average. With an expectation that corporate earnings will continue to benefit from the effects of tax reform and deregulation over the intermediate term, we believe that the valuation of the U.S. equity market is reasonable, particularly in relation to other major asset classes.

Periods of volatility can offer opportunities to active portfolio managers. Would you provide an example of how you were able to add to one of your “best ideas” in the first quarter?

Yes. As one example, we found an opportunity in the first quarter to add to our position in American Woodmark, which the Fund has owned for nearly 15 years. American Woodmark Corp. manufactures kitchen cabinets for national homebuilders and home improvement centers, such as Home Depot Inc. and Lowe’s Companies, Inc., and is the market leader at the mid-level price point.

At the end of last year, the company acquired RSI Home Products, Inc., a cabinet manufacturer that is the market leader at the entry-level price point. Not only is this a very attractive financial transaction, but it is also a great strategic fit.

We believe American Woodmark will be successful cross-selling RSI product into its existing homebuilder relationships, helping American Woodmark grow its earnings significantly over the next few years.

We believe the U.S. homebuilding industry has a favorable outlook, and we believe American Woodmark will continue to be a beneficiary of positive trends in the homebuilding industry. Housing starts remain well below what is needed to satisfy population growth, with approximately 850,000 single family houses built over the last year compared to a 60-year average of approximately 1.1-1.2 million per year.

How might American Tower benefit from the move to 5G wireless service?

The build-out of four new national 5G wireless networks in the U.S. will likely require wireless carriers to add more equipment at existing tower sites as well as provision equipment at new sites to provide the capacity and speed customers expect from next-generation services. This will lead to carriers needing to lease more space on cell towers, leading to higher rental income for American Tower Corp., the Fund’s largest holding. Additionally, with more computing power moving to the edge of the network, cell tower operators may be able to provide new services to customers over the
coming years.

We believe the build-out of small cells in urban areas to support the 5G network will not compete directly with American Tower’s business which is focused on macro-towers located in mostly suburban and rural areas.

How would you describe your high conviction investment strategy?

The Hennessy Focus Fund is a highly concentrated, best ideas portfolio. We generally have 20 to 30 holdings, weighted by our level of conviction, with 60-80% of assets in our top 10 holdings. As of the end of June 2018, the Fund had 18 positions, with over 79% of assets in the top 10 holdings.

Over the years, we have developed a rigorous, in-depth fundamental research process geared to uncovering exceptional investment opportunities that we have the confidence to hold for the long term.

As a result of this philosophy, the Fund typically has a very low turnover and only needs to make a handful of new investments each year. This, in turn, allows us to be patient and very selective about new investments and to give the companies we invest in the time to execute their long-range business plans.