Score One for the Machines

Call Neil Hennessy a mutual fund collector. No, not someone who buys any fund on a hot streak and ends up owning 20 or 30 (or more) funds. Hennessy buys entire funds from their management companies, slaps his name on them and installs his own numbers-based stock-picking strategies.

The creation of Hennessy's six-fund empire is interesting, but it's the performance of two of his funds that captures our attention. Hennessy Cornerstone Growth (symbol HFCGX; 800-966-4354) is based on the pioneering research of James O'Shaughnessy, author of What Works on Wall Street, from whom Hennessy acquired the fund in late 2000. It gained an annualized 18% over the past five years to February 1. By contrast, Standard Poor's 500-stock index returned nothing. Focus 30 (HFTFX), a 30-stock fund Hennessy acquired in 2003 from Sym Financial, gained 14% in 2004 and a resounding 49% over the past year to February 1. It was the top performer among all diversified U.S. stock funds during the 12-month period.

Simple screens

Hennessy's systems are remarkably simple. For Cornerstone Growth (and Cornerstone Growth II, a former Henlopen fund acquired last year), Hennessy uses a computer to screen 9,700 stocks with market values of at least $134 million. Next, he identifies companies with higher earnings than the previous year's and stocks with price-to-sales ratios of 1.5 or less.

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Then the computer identifies the 50 stocks with the best relative strength over the previous three, six and 12 months (relative strength measures performance versus the overall market). Hennessy buys equal amounts of those 50 and holds them for one year, starting sometime in the fall (he won't say exactly when). He repeats the process a year later. (Cornerstone II [HENLX] makes its switch in the summer, which results in different holdings.)

The process, Hennessy says, eliminates emotion from stock selection. By using a system that includes both value and growth criteria, he adds, he's able to capture the best of both. "Value managers scour the earth to find undiscovered companies, and they invest before everyone else does," says Hennessy, 50. The relative strength screen, he says, enables him to discover cheap stocks that some investors find attractive but that most momentum investors and the general public haven't discovered yet.

Misgivings

One problem with Hennessy's system, notes fund researcher Morningstar, is that it tends to unearth companies that generate high sales but not necessarily high profits. That leads to big holdings in economically cyclical companies that happen to be hot at the moment. Hennessy says that because the system requires him to revisit every company annually, he's often out of a stock before it starts to cool.

The Hennessy funds levy no sales charges, and expenses, though not dirt-cheap, are below average (1.25% for Cornerstone Growth and 1.45% for Focus 30). In short, although we would not make either fund the cornerstone of a portfolio, you might consider investing a small amount in them and hope that machine continues to triumph over man.