Simple Formulas for Success

You almost do have to be a rocket scientist to decipher the formulas employed in computer-driven mutual funds. In their mission to identify the most promising stocks, many quantitative-based funds use complex software programs that average investors -- and even professionals -- may find baffling. Some quant managers, such as John Montgomery of the Bridgeway funds, consider the formulas intellectual property and divulge few details about how they work.

Neil Hennessy takes the opposite approach. He gives up just about every detail of the stock-picking process used for his six Hennessy funds. As it turns out, the recipes are remarkably simple. "Our philosophy is to use models that could be understood by your average investor," says Hennessy, 51. "What we do, individuals could do themselves -- we just make it more cost-effective."

At Hennessy's Novato, Cal., office, you won't find any research analysts. That's because he doesn't need to know anything about the companies he invests in. "A lot of stocks make it into our funds that I've never heard of in my life," says Hennessy, a former stockbroker who opened this firm in 1989. In 1996, he started his first fund, Hennessy Balanced (symbol HBFBX). Since then, he's built a small empire by acquiring other funds, branding them with his name and installing his own quantitative strategy. Today, his funds contain $2 billion in assets.

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One of Hennessy's best performers is Cornerstone Growth (HFCGX). The fund is based on the research of James O'Shaughnessy, author of What Works on Wall Street, from whom Hennessy acquired the fund in late 2000. Over the past five years through February 28, Cornerstone Growth gained an annualized 14%. It has lost money in only one year, 2002, when it dropped 5%.

For Cornerstone Growth, Hennessy first screens for companies with market values of at least $175 million. Next, he identifies companies with annual earnings that are higher than the previous year's. Finally, he screens for price-to-sales ratios of 1.5 or less. "We will not pay more than $1.50 for $1 in sales," he says. Hennessy then purchases equal dollar amounts of the 50 qualifiers with the best relative strength over the past three, six and 12 months (relative strength measures performance versus the overall market).

This formula, Hennessy says, eliminates emotion from the stock-picking process. It uses criteria that captures both growth- and value-oriented companies, and pinpoints cheap stocks that most investors haven't discovered yet.

Hennessy prefers to use price-to-sales ratios in his screens because, he says, sales are less subject to accounting manipulation than earnings (the price-to-sales ratio is essentially a company's stock-market value divided by revenues over the past 12 months). By focusing on sales rather than profits, the Hennessy funds often overload on economically sensitive companies that are in the sweet spot of the cycle.

But Hennessy says he's often out of a stock before it starts to cool because he rebalances each fund annually. Cornerstone rebalances in the winter (he won't say exactly when.) Its younger sibling, Cornerstone II (HENLX), uses the same process but makes its stock switches in the summer. The different rebalancing tends to minimize overlap between the two portfolios.

In recent years, Hennessy's best performer has been Focus 30 (HFTFX), a 30-stock fund he acquired from Sym Financial in 2003. The fund, which focuses on midsize companies, has been the top-performing mid-cap fund over the past three years, with a 19% annualized return. Focus 30 uses a screening process similar to that of Cornerstone Growth, except that it hunts for companies with market capitalizations between $1 and $10 billion, eliminates foreign companies, and holds only 30 stocks.

The other funds in Hennessy's stable are Cornerstone Value (HFCVX), which screens for large, undervalued companies that pay generous dividends; and Total Return (HDOGX), which invests 25% in U.S. Treasuries and 75% in the ten highest-yielding stocks in the Dow Jones Industrial Average (known as the "Dogs of the Dow" strategy). Hennessy says he's interested in expanding his empire by buying more funds. The next, he says, will likely be a large-company growth fund.

The funds' annual expenses range from 1.15% for the Cornerstone Value fund to 1.34% for the Balanced fund. Cornerstone Growth and Cornerstone Growth II charge 1.21% and 1.25%, respectively. These fees are below average for small-company focused funds, though they're far from rock-bottom.