How a midcap fund uses this simple long-term strategy to outperform the market

Published Sat, Sep 10 20229:11 AM EDT

Sometimes keeping it simple and consistent is a strategy that can pay off compared with overthinking the market. For Hennessy Fund Cornerstone Mid Cap 30 (HFMDX) fund, relying on price to sales and a nearly two-decades long formula since its 2003 inception has enabled the fund to outperform the market even amid this year's market shakeup. "We're not stock pickers," says Ryan Kelley, chief investment officer and portfolio manager. "We don't go out and say we think you guys should buy this or sell this. This is just what we own and it's what's worked for us." Even with the S & P 500 down 15% this year, and the Russell Midcap index off by more than 12%, thanks to an aggressive Federal Reserve and slowing economy, shares of the mid-cap fund have risen almost 3% year to date, including reinvested dividends. Last year the fund surged 27.2%. Not only has HFMDX outperformed this year but it's also done the same over the last three, ranking in the top 1% percentile, according to Morningstar, with a 10-year trailing return of roughly 10.7%. The fund's expense ratio stands at 1.36%. How it works The fund includes 30 common stocks with market capitalizations between $1 billion and $10 billion. To find those, Kelley uses the "Mid Cap 30 Formula," which searches for companies expected to grow annual earnings over the previous year and have seen positive stock price growth in the previous three- and six-month periods. Most importantly, the fund limits itself to stocks with a price-to-sales ratio below 1.5 times, meaning investors pay no more than a $1.50 for every dollar of revenue the company brings in. "We think price to sales is one of the most pure numbers," Kelley says, adding that the metric offers the clearest view of a company's potential value. "There's much less manipulation you can do on the revenue side versus when you get down to EPS, there's a lot of moving parts in between." The focus on midcap stems from data indicating less volatility than small caps and in-line performance to large caps over a 10-year rolling period, Kelley explains. He tends to rebalance once a year between September and November when about two-thirds of the portfolio turns over. It's a value approach that's led the fund to strong pockets of the market, including energy, at the right time, and even before the sector took off in the wake of the war in Ukraine. In the months since, the fund's been adding to its stake in the sector using this strategy, investing in oil refineries and under-the-radar companies such as HF Sinclair and Antero Resources — its largest holding. The formula also steered Hennessy toward steel and metal manufacturer Commercial Metals . BJ's Wholesale is another key holding that meets the fund's criteria. Hennessy first bought shares of the company about three years ago and has slowly built its stake over the past 12 months, bringing the total position to roughly 4.4% of the portfolio, according to FactSet data. Shares of BJ's are up more than 18% this year, with the stock hitting an all-time high earlier this month. Kelley says the stock has benefited from sales at its gas stations and should continue performing well as consumers trade down in the face of inflation. Despite a long-term shift from coal, Peabody Energy is another name Kelley added to in recent months, bringing the position to roughly 6.3% today from 2.8% about a year ago, according to FactSet data. Peabody has soared 132% this year. To be sure, outperformance isn't a sure thing, especially if mega cap stocks once again take over market leadership after taking a breather this year amid rising interest rates. "We are longer-term investors," Kelley said. "We want to provide participation on the upside when we can but also because we're looking at pretty strict valuation metrics we're trying to protect the downside so we don't want our investors to lose as much when the market's going down."