Long-term Holdings Driving Shareholder Value

The Hennessy Focus Fund Managers discuss their investment process, describe share buyback programs among portfolio companies, and share their insights on a few of the Fund’s largest holdings.

November 2019

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

Would you describe your investment process and discuss market conditions where the Fund tends to perform well?

As the Fund’s portfolio managers, we view ourselves as long-term owners of the companies in the portfolio. We take a bottom-up approach, and we analyze businesses for their potential over the next 3-, 5-, and 10-year periods. We employ independent, fundamental research to choose companies we believe are high quality, trading at reasonable prices, have large growth opportunities, and are run by excellent management teams.

While it is our goal to provide outperformance over market cycles, we have found that during periods of market and economic distress, the Fund’s holdings tend to endure adversity better than cyclical or lower-quality companies. Our holdings generally have stronger balance sheets, which enable them to take advantage of competitors’ financial weaknesses by growing market share during economic downturns. We focus on management teams that are prudent when it comes to the use of debt and companies that generally have lower than industry-level leverage. While we are not forecasting a downturn on the horizon, historically, the Fund has generally achieved better relative results during periods of weaker overall market performance.

Would you please comment on share buyback programs at companies within the portfolio?

Of our current 17 holdings, over half have announced and implemented a share buyback program. Importantly, we look for businesses that can compound capital at a mid-teens rate or better over a long period of time. Generally, these “compounders” have a high revenue growth rate and produce a significant amount of free cash flow, which they then deploy opportunistically on organic growth, acquisitions, or a share repurchase program.

A number of our portfolio companies have created shareholder value by buying their shares at a discount to their assessment of intrinsic value. As an example, O’Reilly Automotive, Inc., created significant value since it began its share buyback program in 2011. Its share count was about 140 million in December 2010 with a stock price of around $60 per share. In October 2019, the company had 76 million shares outstanding and the stock traded at approximately $440 per share.

Can you discuss CarMax’s move into the online car-buying channel?

As the largest used-car retailer in the U.S., CarMax currently has about 3-4% market share in the late-model, used car market. To grow market share, the company continues to open new stores and is implementing capability to allow customers to purchase cars online.

We believe anywhere from 10% to 25% of the population could be interested in buying a car online. While CarMax has dozens of local brick-and-mortar competitors in any market, we believe only a handful of companies will be able to successfully compete in the online used car market long term. We believe CarMax will be one of the winning online companies, with the potential to increase its
competitive differentiation and significantly boost its market share over time.

CarMax’s first rollout of this new online capability was in Atlanta, Georgia in the fourth quarter of 2018, and early results have been promising. Since the launch, Atlanta’s comparable same store sales rate has experienced a double-digit increase compared to a 5% rate for the overall company. We anticipate that a majority of CarMax locations will add online capabilities in 2020, with almost all stores having online channel capability in 2021.

Charles Schwab recently announced an end to commissions on stock trades. How might that affect their business in the short and long term?

We believe ending stock trade commissions was a strategic decision for Charles Schwab to improve its competitive position in the financial services industry. Zero commissions will likely have a negative short-term impact, decreasing Schwab’s revenues by approximately 4% and profits by 8%. However, we believe it should only take Schwab two to three quarters to regain the lost revenue and return to today’s profitability.

After Schwab’s announcement, many of its competitors have followed suit and eliminated commissions, which will more substantially impact their profits than Schwab’s. For example, zero commissions could reduce E*Trade’s bottom line by approximately 20-25% and Ameritrade’s profitability could fall even more, by approximately 30-35%.

Although Schwab’s stock price fell after the change was announced, we believe this move makes good, long-term strategic sense. In addition to damaging current competitors’ profitability, the loss of trading commissions will hinder the value proposition for many start-up trading and investment advice platforms while accelerating the growth of Schwab’s collection of assets.