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Emotion, Curse of the Investing Class

Sticking with a disciplined strategy and keeping emotions out of investing decisions are the keys to successful returns over time, argues Neil Hennessy, president of the Hennessy Funds. The portfolio manager also pays close attention to historical trends, and based on the market's behavior after past military conflicts, prices are bound to head higher, he says.

Hennessy selects the 50 stocks for Hennessy Cornerstone Growth Fund (HFCGX) and Hennessy Cornerstone Value Fund (HFCVX) using a series of quantitative screens. His mantra is clearly giving investors something to cheer about. Hennessy Cornerstone Growth has gained an average of 8.6% annually over the last three years through July 31, vs. a decline of 10.2% for the broad Standard & Poor's 500-stock index. In the last 12 months through July, the portfolio jumped 21.7%, beating the average small-cap growth fund and the broader market.

Hennessy's other funds -- Hennessy Balanced (HBFBX) and Hennessy Total Return (HDOGX) -- are based on variations of the "Dogs of the Dow" investment theory, which involves owning the highest-yielding stocks in the Dow Jones Industrial average for one year. Karyn McCormack of BW Online recently spoke with Hennessy about his investing philosophy and strategy. Edited excerpts from their conversation follow:

Q: The stock market has really come a long way since March. Do you think that it can continue going up?

A: Very much so. Everything we do at Hennessy Funds is time-tested. We allow history to be our guide, and what's interesting about this market is that if you go back and you look at World War II, and then you look at the Korean War, the Vietnam conflict, then Gulf I, and then Gulf II...there are so many similarities.

Number One is the market normally loses approximately 15% of its value when the conflict begins, so the market will come back. During the conflict, it will come back to even. It will actually end up finishing in positive territory at the end of the conflict, and then the market grows approximately 11% a year until the next conflict.

When we started to amass troops in December of 2002 on the Iraq situation, the market fell 15% from then until Mar. 11, [when it] turned around. And then what happened? The market now has picked up all the ground it lost, and more. The conflict is pretty much over, and I think what you're going to end up seeing is that the markets normalize around 11% a year. And this is just looking back at history. History tends to repeat itself.

The interesting part about investors is they don't look at history as their guide. They always think something is different. And that's what happened in the dot-com bubble: "It was different! It was a "new economy!"

Q: A lot of investors, from what I understand, have made huge shifts in allocation -- especially to bonds. Now the bond market has had a big selloff.

A: First of all, let me state I am not an economist, I'm not an analyst. What we try and do is look at things in a logical way at Hennessy Funds. We're quantitative, we're highly disciplined, and we're non-emotional. In what happened on Wall Street, interest rates came to a 45-year low. The market was annihilated, and what were the two hottest products on the Street? Closed-end leveraged bond funds and hedge funds.

I'm no genius. So let's see if I got this straight: You're buying bonds at their historical lows -- 45-year low yields -- and you're leveraging them. What's going to happen when rates go back up, which they have? The retail investor is going to get crushed. You can see this coming.

The retail investor then gets into hedge funds at the bottom of the market. They're going to get crushed again. If you just sit back, buy quality, and have a discipline and you're not emotional, you'll make money over time.

Q: Your Hennessy Cornerstone Growth Fund is top-rated by both BusinessWeek, which has an A rating, and Standard & Poor's (5 Stars). What's your strategy and why has it worked so well?

A: Well, the strategy is very simple. There are very few moving parts. Actually, our formula is in the prospectus and cannot be changed without a shareholders' vote. First, we screen approximately 9,700 different companies. Our first screen is to make sure that the market capitalization is at least $172 million. The companies that pass that screen should then have a price-to-sales ratio of 1.5 or less. In other words, we're not going to pay more than $1.50 for a dollar in sales.

The third screen is to make sure that the earnings are higher than the previous year, so that we know that money is falling to the bottom line. In the fourth and final screen, we buy the 50 companies with the best relative strength over 3-, 6-, and 12-month periods.

So we take value at a reasonable price, which is the price-to-sales, and add momentum, which is the relative strength. The key to our success is in discipline. It's in nonemotion. And that's no different than the real world. If emotion enters a conversation, most likely that's not going to be a fun conversation. If emotion enters your investment decisions, you're most likely going to be very upset at the results also.

Q: Tell us about some of your top holdings.

A: Our prospectus in our semiannual report has all of our positions, because we rebalance them once a year. So everybody knows what our positions are. We can rebalance them any time between November and February. You might ask, why is there such a wide window? The reason is there's no style drift and there's no quarterly window dressing. If somebody knew my rebalance date, they could go out and run my own screens and front-run my shareholders.

Let me give you a couple of stocks that are in our top 10 holdings that a lot of people don't hear about. One is Select Comfort (SCSS), the mattress manufacturer. When we bought that at the beginning of the year, we paid approximately 1 on a price-to-sales [ratio]. Today, it trades at a price-to-sales of 1.81. So, under today's guidelines, if we were to rebalance today, it would not make it in because the stock price has gone up and the price-to-sales is over 1.5.

Another one would be Pacific Sunwear (PSUN). These are companies that most people don't follow or understand. And this is just casual apparel -- there's no real genius behind it. But when we bought it on a price-to-sales we paid 1.21. On a price-to-sales today, it trades at 1.61.

Something that most people see but never realize is a public company is J.B. Hunt (JBHT), the transportation company. You see their trucks all over the road. When we bought that, the price-to-sales was 0.52. And today it trades at 0.78.

What the formula does in a quantitative basis is pick up companies that people normally don't know. And that's why we're small-cap, and hopefully by the end of the year, we're mid-cap.... The growth fund is up 25.7% this year [through Aug. 18].

We stick to our discipline. What you see is what you get, and our philosophy -- being in the business 24 years -- is it's not what you make on the upside, it's what you don't lose on the downside. The only down year we've had since inception in '96, with the growth fund, was last year, when it was down 4.96%.

Q: What about the Cornerstone Value Fund -- do you approach it in a different valuation sense?

A: Cornerstone Value Fund is a different formula. The last leg of that formula is buying the 50 companies with the highest dividend yields. I'll give you an interesting statistic: When we rebalanced this portfolio this year, 24 out of the 50 stocks that we bought paid some sort of dividend, which told me that the undervalued part of the market is dividend-paying companies. And it worked.

Q: Are we seeing more companies paying dividends after the change in the tax code?

A: You're going to see a lot more companies pay dividends. There are two philosophies out there. One philosophy is, if you have nothing better to do with your corporate money than pay dividends, shut your doors and go home because you're not a growth company anymore.

The second philosophy, which is my philosophy: If I invest in something, I want to get a return on my money. Nobody goes and buys a rental home and then just lets somebody live in it free and hope for the appreciation. Just using common sense, if you're getting money back, two things happen. Number one, it means that the company financially is in good shape because you can't cash checks without the money in the bank.

And the second thing is, you lower your risk and your volatility by having dividends. That doesn't mean that they're not growth companies. Microsoft (MSFT) is still a growth company. The dividends are going to help propel this market a whole heckuvalot higher.

Q: You were one of the first money managers to use the "Dogs of the Dow" theory in a fund. Tell me about the two funds -- where it applies and how that works.

A: Yes, the Hennessy Balanced Fund and the Hennessy Total Return. There are 30 Dow Jones industrial stocks. You buy the 10 highest-yielding Dow Jones stocks in equal dollar amounts. You hold them for one year, and on the anniversary date or thereabouts, you adjust to then the 10 highest-yielding Dow Jones stocks in equal dollars amounts, hold for a year, so on and so forth.

Now if you've done that since '73, you would have averaged an approximately 17.5% average return. Just for your information, if you want to check, you can go to the site. The 10 highest yielding Dow Jones stocks now are Eastman Kodak (EK), Altria Group (MO), General Motors (GM), SBC Communications (SBC), JP Morgan (JPM), AT&T (T), DuPont (DD), Caterpillar (CAT), Merck (MRK), and Exxon Mobil (XOM).

What's interesting about this is if you buy those 10 highest-yielding Dow Jones stocks today, you're going to get a 4.3% yield, vs. a 10-year U.S. government Treasury at 4.5%. Yet, you're going to be taxed at 15% on the dividends, which is the same as long-term capital gains. And you have to ask yourself logically, if I buy these 10 stocks and I held onto them for 10 years, would I have more money in 10 years than I would with a 10-year Treasury? You're getting the same rate of return from the dividends as you would from the interest payment -- and you get growth to boot. And these companies all have products. They have customers. They have revenues. They have earnings. They pay dividends. That's why it works.

Q: And what's the difference between those two funds?

A: In the Balanced Fund, it is truly a balanced fund. Half the money is in one-year U.S. government Treasuries, and the other 50% of the money is in the Dogs of the Dow. So you're essentially having short-term government paper in having the Dogs of the Dow.

The Total Return acts and looks as if 75% of the money is in the Dogs of the Dow and 25% is in one-year Treasuries, and that's as close as you're going to get to a pure Dogs of the Dow open-ended mutual fund because of the rules and regulations. But once again, there is no style drift. There is no quarterly window dressing. What you see is what you get.

Q: What advice would you give investors?

A: I think the first thing people have to do is understand how the money is being managed.... And [don't just follow] the crowd. You follow the crowd, at some point in time some car is going to come through the intersection and hit you.

I think if they can look at their portfolio and say, "Where are we and what are we trying to do?" and understand what they're doing, then they won't be so emotional. Everybody is very emotional about money. That's human nature. But you can't be emotional about investing. You just can't.

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