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Values in Consumer Staple Retailers

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. We're reporting from the 2010 Morningstar Investment Conference. And I am here with Frank Ingarra. He is a Manager in the Hennessy Focus 30 Fund. These are quantitative – it's a quantitative fund. He is here to tell us a little bit about what the models are saying today and what they've been telling them over the last couple of years. Frank, thanks for joining me.

Frank Ingarra: Thank you for having me.

Stipp: The first question for you and I think it's interesting to look at the market through a lens of a very – a process that's set out and isn't changing all the time. Just to see what kind of differences did you see and what the models were giving you in 2008 to 2009, a period of a lot of volatility in the market?

Ingarra: Correct. So, initially, in 2008, the beginning part of 2008, we rebalanced this strategy in the fall. So in the beginning part of 2008, we had a good amount of energy stocks and that held us up very well compared to the market. One stock particularly was Alpha Natural Resources that got bought out, that totally helped the fund outperform.

And when we did that rebalance and we got a good amount of consumer discretionary names, that right when the market downturn you would have thought was crazy, but it was kind of the more for less theme where consumers were overextended. They saw – they buy a couple of things, but they looked for value and what they were spending their money for. And that theme also went into our rebalance in the fall of '09 and is driving us currently the more for less theme there.

Stipp: So what is specifically about the consumer discretionary stocks? So these were the stocks that were purchased then in 2009?

Ingarra: Yeah. They were – that theme came in, in the fall of 2008 to drive us for 2009 and it also stayed in for the rebalance in the end of 2009 to drive us for 2010. So there are stocks in there, and particularly like a Ross Stores currently, they are providing a lot of lower end consumers. People are no longer maybe going to a Bloomingdale's or a higher end shop. They are looking to trade down to get more value for their money.

Another one is the Dollar Tree. Again, they run it pretty lean. They offer a lot of staples and other lower end items for people, but they also could benefit if the market turns up a little bit of how they've set out their offerings to clients. And another one, pretty good staple is the Carter's. You have a baby, you still need to buy clothes. They have pretty good price points. They have price points all over the place. So they are starting to take market share and do pretty well as well.

Stipp: And so is there a valuation component when these stocks came up at the time that they came up, so what's specifically about the model caused these to come on the radar?

Ingarra: Yeah, we like to use sales, price-to-sales ratios instead of a price-to-earnings. You know, earnings, everyday people get a W2 and it's their best legally to take as many deductions to pay as little to the government as possible. Well, companies do the same thing. We think sales is a truer number and we use 1.5 as our cut off. So we'll never pay more than $1.50 for $1 in sales. That keeps us to get reasonably valued stocks. And then we have a good amount of growth characteristics. We combine with that earnings momentum and stock price momentum and those combinations have proved well over the life of the fund and strategy.

Stipp: A question for you on earnings specifically, a lot of folks have said we could be in for an environment, where earnings may be lower than they have been in the past. And maybe we got spoiled through the 2000s with earnings that were helped driven by leverage and a lot of other factors that maybe aren't going to be there for a while. When you are looking ahead and how the models might be working, what's your thought on if there is a lower earnings environment, what kind of names do you think might be coming up and how might the models be affected…?

Ingarra: You know what I think is interesting is a lot of people use P/E. So I think that's going to affect a lot of people are using models or select stocks based on P/E. I think they are going to have depressed values there. What we look for is earnings momentum. So, basically, we want the Company to start earning a little bit more or their sales are going to the right place, their bottom line. So we think it's not really going to affect our model or change the makeup. It's going to just be very interesting to see the dynamics of stock price and earnings momentum with that valuation component what that's going to bring.

I imagine if we did it today, would price still be pretty weighted in consumer discretionary. Though they are starting to underperform in the short run, they still have pretty good long-term momentum factors. It will be interesting to see what happens. Maybe more industrials will come in or something like that, but you know, that would be a time of our selection in the fall.

Stipp: Sure. And a question for you on that point and sort of a broader question, and you rebalancing in the fall. Now, we've had seen a lot of volatility over the downturn. Do you think that there is any question of how often the portfolio should be rebalanced just because things seem to be changing, at least in investors' minds things seem to be changing so quickly? And I guess the broader question for you then is, did you learn anything through the downturn and through all that quick volatility that caused you to rethink the models or tweak the models or change them in anyway?

Ingarra: You know we are big believers that when emotion – if we're just talking and emotion get involved in our conversion, you're going to have a problem. There is going to be a fight or something like that. We think that carries through to investment themes and strategies.

That if you start getting emotional or you think the market is different this time, you're going to start tweaking your formula and miss out on the bigger picture. You see that a lot with lot of active money managers. They change their knitting and what they are known for instead of going for – they are trying to keep up with the market to keep that performance. They are not sticking to their knitting and they end up getting hurt in the long run.

So we don't change our strategy simply because we know there is going to short-term periods of underperformance because maybe our factors are not the most prevalent or the most loved right now, but we build on models to succeed over the long periods of time. And we find through all of our research and through the live data that that's the better way to be is to be disciplined not emotional and stick with our strategy.

Stipp: Frank, thanks so much for joining me today.

Ingarra: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.