This Stock Fund Is Trouncing the Market—and Trading Just Once a Year

In a stock market where returns have been increasingly driven by the biggest, flashiest stocks, one fund has beaten the market by going in the opposite direction.

For the past two decades, Hennessy Cornerstone Mid Cap 30 Fund HFMDX has posted returns far outpacing the stock market with an unconventional approach. It’s one that combines a strict, quantitative screen with trading just once a year.

Even just this year, the $1 billion fund is up 21% for the year to date, compared with 2.2% for its category, small-value funds, and 10.5% for the overall stock market as measured by the Morningstar US Market Index.

Not only does Hennessy Cornerstone Mid Cap steadfastly stick with winners or losers for a year, the fund has delivered big returns to investors by employing a value tilt in its investing process and primarily investing in small company stocks. Those two factors—value and smaller stocks—have been a combination that has produced lousy returns for years.

Under the hood are stocks that rarely make big headlines but share low price/sales ratios. Its largest two holdings are clothing retailers, the Gap GPS and Abercrombie & Fitch ANF, followed by companies in the decidedly not-flashy industry of heating, ventilation, and air-conditioning systems, such as Comfort Systems USA FIX.

However, Hennessy’s process can lead it to find stocks that turn out to be red-hot and then ride them. The fund bought Super Micro Computer SMCI in October 2022, and investors were able to benefit from the stock’s 400% gain.

With this process, the $1 billion Hennessy Cornerstone Mid Cap 30 Fund has beaten its benchmark, the Russell Midcap Index, over one-, three-, five-, and 10-year trailing periods. It ranks in the top percentile of funds in its Morningstar Category over all those periods. It has also beaten the S&P 500 over the 20 years since its inception in September 2003, with its investor share class returning 12.3% annually compared with 10.5% for the S&P 500 over that period.

Most equity funds fail to beat their passive counterparts over the long term. In the Cornerstone fund’s own US small-value category, only 24% outperformed comparable index funds net of fees over the 20 years ended June 30, 2023, according to Morningstar’s Active/Passive Barometer.

Hennessy Cornerstone Mid Cap has managed to outperform the market despite having an expense ratio of 1.34%, which Morningstar classifies as “high.”

Avoiding Value Traps

Fund managers Ryan Kelley, L. Joshua Wein, and Neil Hennessy look for investments among US stocks with market capitalizations between $1 billion and $10 billion, then screen for names with a price/sales ratio below 1.5.

To avoid so-called value traps—stocks that look cheap but essentially should be because their fundamentals are worsening—the team then screens for companies with an annual earnings growth of any level and whose stock price has risen over the past three- and six-month periods. The team is generally left with roughly 100 stocks, from which it chooses the 30 with the highest 12-month trailing price increase, and it invests 1/30th of the fund in each.

Once the portfolio is set, each of the 30 stocks is left in place to grow or shrink as part of the portfolio, with no rebalancing until the next year’s complete redo of the portfolio, which takes place in October. “We continue to let it run. We don’t cut back in the position. Except for cash flows coming in and out, we’re not trading anything until the next rebalance the next year,” says Kelley.

In most cases, this process leads to a nearly complete revamp of the portfolio. In the most recent turn of the portfolio last October, energy firms PBF Energy PBF and Plains GP PAGP, as well as building management and construction firm Emcor Group EME, were the only companies that carried over from the previous year.

The fund has used the same method since the fund’s inception. Kelley emphasized that the process “has not changed, and we’re very transparent about this. You can look back at the original annual report in 2004, and it will say the same thing.”

Hennessy Cornerstone Mid Cap 30 Fund Top Five Holdings

Allowing Winners to Ride—for a Year

Kelley pointed to Abercrombie & Fitch, the fund’s second-largest holding, at 5.4% of its portfolio as of the end of March, as a reflection of how the process can find out-of-favor stocks.

The team explains how Abercrombie benefited from three factors. The first is that the most recent rally in stocks was broader than those in the past five years, which had buoyed large-cap tech stocks but left other companies, like Abercrombie, behind. The second is that consumer spending held up better than expected over the past year, which is especially important for retailers like Abercrombie. Finally, holiday sales are especially important for retailers, and Abercrombie and other retailers had “a really excellent holiday season,” says Kelley.

“So you put that all together, and it just made for almost a perfect storm of a few different things happening at once,” Kelley says. “Both overall market-related, overall consumer-related, and that specifically for Abercrombie & Fitch, and that now moved up from the 0.7 price/sales, and we bought it at that. It’s now 1.6.”

Abercrombie is up 156% since the end of October.

Kelley and Wein also point to a pick from last year: Super Micro Computers, a firm that manufactures computer servers. It delivered 2.9 percentage points out of the fund’s 46% one-year trailing return, according to Morningstar Direct. The stock was sold during the fund’s most recent annual turnover last October, having returned 402% over the previous year.

The two managers point to their willingness to trust the process as to why they were able to garner such high returns from the stock. “Super Micro Computers was up a couple hundred percent at one point. A lot of people would say ‘we had a good run, let’s get rid of it and reallocate,’ and we don’t do that. You know, and we stay out of our own way,” Wein says.

Price/Sales Is the Key

While the growth and momentum metrics their process uses only require a stock to produce a positive number, their value metric is much more specific, requiring a price/sales ratio of 1.5 or below. Kelley and Wein say that while they look at other metrics, they are fundamentally a value fund, with the other factors mostly there to screen out value traps.

Kelley says, “We always want to try to focus on the price/sales first, because that’s the most restrictive. And that’s the thing that allows our portfolio to be so differentiated from others out there. We’ve spent a lot of time talking about how different the fund is, and I think the price/sales is what really makes it happen that way.”

The managers focus on price/sales, rather than the more common price/earnings, because they think it can better reflect how a company is doing as a business.

“Sales is at the top of the income statement. It’s the purest of all the numbers. While there can be a few things that can be adjusted, for the most part, $1 of sales is $1 of sales, so when you see it increasing, that’s pretty indicative of what’s going on at the company,” says Wein. “A lot of what is happening as you go down the income statement is up to the company’s accounting methodologies.”

They also think that price/sales can show which companies have durable competitive advantages. They cite their second-biggest holding, Emcor Group, as an example. Emcor, which makes up 4.1% of the fund’s portfolio, installs and services various building systems like electrical wiring and HVAC. Wein says, “We own at least two or three HVAC, which is fairly boring, but no one’s looking to get into that business. With the huge installed base of customers Emcor has, there aren’t venture capitalists funding competitors to Emcor in the same way they are funding competitors to the Nvidias of the world.”

Emcor is up 92.4% since the end of October, contributing 3.9 percentage points to the fund’s one-year return, the most of any stock during that period.

The strict selection by price/sales does often limit what kinds of companies the fund can invest in. This tends to mean that the fund is often disproportionately invested in industrials, as well as consumer staples, but tends to have lower allocations in financials or utilities, Wein says.