Midcap stocks are often the forgotten stepchild of the equities market, as focus centers on the excitement of large-cap and small-cap stocks.
But good opportunities are available in the midcap world, says Ryan Kelley, co-manager of Hennessy Cornerstone Mid Cap 30 Fund (HFMDX) .
The fund, with $1.1 billion of assets, generated annualized returns of 50% for the past 12 months, 19% for three years, 22% for five years and 12% for 10 years.
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That easily surpassed the Russell MidCap Index for all those periods and beat the S&P 500 for all but the 10-year category.
Mid-capitalization stocks are often cheaper than large-cap. They have been around long enough to have a track record but still have room to grow, Kelley said.
The Hennessy Cornerstone uses a formula of basic indicators to choose its 30 stocks. It has a bottom-up selection style, which has led it to a concentration in industrial stocks, consumer discretionary and energy stocks.
Here’s what Kelley had to say in an interview with TheStreet.com.
TheStreet.com: What’s your investment philosophy?
Kelley: We use a quantitative formula. We want to take emotion away from investing. We try to combine value, momentum and growth of earnings to find the 30 best stocks.
We filter for companies with market capitalization of $1 billion to $10 billion, with price-to-sales ratios below 1.5, with the most recent annual earnings higher than the previous year and with a rising share price in the last three and six months.
Ryan Kelley, co-manager, Hennessy Cornerstone Mid Cap 30 Fund
Hennessy Funds (TheStreet)
That leaves about 100 stocks, and the fund chooses the 30 with the highest gain over the past year. The fund rebalances its holdings yearly. And after the rebalancing, each stock has an equal weight in the fund of 3.3%.
We hold winners and losers at least until the next annual rebalancing date.
Why Hennessy’s Kelley likes midcaps
TheStreet.com: What’s the attraction of midcap stocks?
Kelley: Midcaps generally have lower valuations than the overall market. That’s certainly the case now, when the S&P 500 has a price-to-earnings ratio of 24, compared to 16-17 for the S&P MidCap 400.
Midcap companies have been around long enough to have a good track record, but there is still a lot of runway for growth. They are big enough to be acquired, too.
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TheStreet.com: Why do you hold only 30 stocks?
Kelley: We don’t want to mute outperformance by owning too many stocks. We aren’t interested in following a benchmark. We would rather concentrate, protecting our ability to differentiate ourselves from the rest of the pack.
Our risk mitigation is that our companies’ valuations already are low – at less than 1.5 times sales. Only one-third of the overall stock market has valuations that low.
Knowing that our stocks have momentum and low valuations, we can sleep at night. We’re not diversified: you would need 100 stocks for that. But we still have risk mitigation.
Focus on industrials, consumer discretionary, energy
TheStreet.com: Are there any industries you particularly like?
Kelley: We’re bottom-up stock pickers. But we will end up with concentration in some industries. Now, there are three industries that account for over 70% of our holdings: industrials, consumer discretionary and energy.
Those have typically been a large part of the fund over time. It’s often companies people haven’t heard of, maybe boring names.
Holdings include lower-margin businesses: manufacturing and construction companies, HVAC (heat, ventilation and air conditioning) companies, auto companies, grocery stores.
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They are the nuts and bolts of the economy. These stocks can have nice runs if you buy at the right price.
As for energy, no one cared about the industry when oil was trading $40-$50 per barrel. Companies had low valuations, but there was nothing wrong with them. A lot of energy companies came into the fund. Then oil prices soared, and the stocks had huge outperformance.
Last fall, the fund purchased three apparel retailers — Abercrombie & Fitch (ANF) , Gap (GPS) and Guess (GES) . [All three have achieved sizable gains since then.] The holiday season was really good for them. People realized apparel retailers aren’t dead. It’s the kind of turnaround we can capture.
TheStreet.com: Are there industries where companies don’t fit your investment criteria?
Kelley: Yes, we almost never invest in utilities, health care or finance. It’s not that we don’t like them; it’s just because of our process.
Three of the fund’s top stock picks
TheStreet.com: Can you discuss three of your top stocks?
Kelley:
1. Gap, which I mentioned above. It was trading at a low valuation of 0.3 times sales when we added it last fall. It appears there’s a return to brick-and-mortar. Gap is building online as well to keep things relevant.
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2. Emcor (EME) , an electrical and mechanical construction company, including data centers. It was trading at 0.8 times sales when we rebalanced last fall. We bought it in fall 2022.
Emcor benefits from the onshoring of manufacturing. Onshoring consists of U.S. companies taking their manufacturing back from overseas. That’s reenergizing construction of manufacturing facilities.
3. Plains GP Holdings (PAGP) , a limited partnership midstream pipeline company. They own and operate a lot of gas and oil pipelines throughout the U.S.
Recent levels of gas production and consumption are at record highs, despite the emphasis on renewables. Plains also pays a nice dividend [6.85%], though that’s not what we’re going after in the fund.
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