Q:  What are the key elements of your investment philosophy? A : The fund is team managed, and utilizes a quantitative, non-emotional stock selection formula. The fund is managed with strict discipline, and we never stray from our proven formulas. We manage money by a mathematical formula, so we never deviate from our style and we never let emotions get involved in the process. We are bound by the prospectus to adhere to our strategy, and the portfolio doesn’t change because of the market volatility or the hot new trend. That discipline has been crucial to our success. We believe that in any strategy, investors need to know how their money is managed. One of our primary differences is that we offer full disclosure and transparency to our shareholders, unlike some money managers who hide behind the word ‘proprietary.’ There is no secrecy involved in our process, and we fully disclose our formulas, holdings and performance. We keep private the exact rebalance dates in order to protect the shareholders from front-running. Q:  How do you select the stocks for the Hennessy Focus 30 Fund? A : We start with the Compustat database, which contains extensive data on over 10,000 different companies. Since we focus entirely on domestic equities, we remove the ADRs. Then we choose the companies with market capitalization in the range of $1 to $10 billion. In other words, we invest in domestic mid-cap companies. The companies we invest in have a priceto- sales ratio of below 1.5. This is our value criteria, and the companies that pass have strong revenue to support their stock price. The second requirement is earnings momentum, or growth in annual earnings, versus the previous year. That means that the growth of the company is transferred to the shareholders. The next criterion is relative strength. We look for companies with positive three- and six-month stock price appreciation. From that universe, we take the 30 stocks with the highest one-year price appreciation, that pass our liquidity screens, and we invest equal dollar amounts in each of them. We refresh the portfolio once a year, so our buy and hold period is approximately one year. We tend to have almost 100% stock turnover every year. If a stock is doing really well, it’s no longer cheap. And if a stock isn’t doing well, it doesn’t have the earnings and stock price momentum behind it. The key to our success has been this disciplined and non-emotional approach, even in difficult markets. We don’t fall in love with management teams, but we fall in love with price-to-sales ratios, earnings momentum, and stock price appreciation. Those are the most important elements of the process. Q:  How often do you change or adjust your model? A : We rebalance our fund annually in the fall of each year. It is important to note that we have built a model that works very well over long periods of time and we don’t make frequent adjustments. It may underperform in a week, a month, or a year, but we have developed it to work well over a long time. The combination of factors and the discipline is important in that respect. We wouldn’t buy a company with growing earnings, great relative strength, and a priceto- sales ratio of 1.51, because we stick exactly to our formula. At the same time, such a company will probably attract the attention of an active manager, even if it is a bit outside of his parameters. But we have often seen how managers get a bit outside of their style and get punished. For example, back in 1999, all the large-cap value funds had many growth stocks, and when the trend changed, many of those funds were hammered. Sticking to your strategy is the key. Q:  Do you have different requirements for different sectors such as retail, manufacturing, or finance, where the price-to-sales ratios may have different meanings? A : We don’t have an industry-by-industry approach and we don’t change the priceto- sales ratio to make everything fit. It is the combination of factors, not just the price-tosales ratio, that accounts for the success of the Focus 30 portfolio. So, we’re not concerned whether we have a coal stock or a retailer; the model tends to bring the best of the breed. Our approach is to let the companies come to us. Last fall, for example, this strategy moved us totally out of financials and heavily into industrials and materials, which is one of the reasons that the portfolio performed so well. This fall, the formula added in a number of Financials, increased our exposure to Consumer Discretionary stocks and almost totally moved us out of Material stocks. We never have more than 25% in one sub-industry, but we never adjust the model to allow more retail stocks or more tech stocks. Q:  What’s your approach towards research? A : Unlike many fund managers, we don’t employ an army of research analysts. After running the screens in our database, our model selects 400 to 500 stocks that we rank by 12-month stock price appreciation. Then, our research is to verify the data with numerous data sources. We use databases from different vendors to make sure that there are no outliers or discrepancies. Also, we remove stocks in potential mergers because, typically, the price appreciation is only due to the merger announcement. Overall, we go through the data, scrub, and analyze it, to make sure that it is correct. Then we take the 30 best stocks, based on the 12-month stock price appreciation, that pass our liquidity screens. We invest equal dollar amounts in each stock. That makes our research process very different from that of most funds. We don’t meet management teams and we don’t pour over annual reports. We don’t allow ourselves to become emotional about a company’s story, or fall in love with their management. We only care whether the factors that we use are correct, because those factors are a very good predictive measure over long periods of time. Q:  Could you give us some stock-specific examples of successful and unsuccessful picks? A : One of the stocks that we bought last fall was Alpha Natural Resources. It had a low price-to-sales ratio, great earnings momentum, and great price appreciation. That stock gained 200% from the purchase price; it started at 3.3% of the portfolio and grew to represent more than 12% of the portfolio at the time of the most recent rebalance. The stock did not remain in the portfolio this fall because its price-to-sales ratio was well over our threshold of 1.5. A stock that did not perform well in last year’s portfolio was Oshkosh Truck. It fell to 1% of the portfolio, after signaling the economic slowdown in europe a couple of months ago. But for every stock that doesn’t do well, we have two or three that do, like Alpha Natural Resource, AK Steel, Schnitzer Steel, or Flowserve, each of which performed very well in last year’s portfolio. It is the combination of factors that results in a diverse portfolio that does well together. Q:  Would you sell a stock when its price-to-sales ratio exceeds the 1.5 level? In general, what would trigger a sell decision? A : No. For instance, we did not sell Alpha Natural Resources because its price-tosales ratio went above 1.5; it got sold once we rebalanced this fall. Outside of the normal buying and selling for on-going purchases and redemptions, there are only three reasons for us to sell a stock outside of the rebalance window. Q:  What’s the rationale behind keeping Alpha Natural Resources, even its price-to-sales ratio jumps to 2 in less than six months? A : We have evaluated many different periods before we decided that one year is the optimal rebalance time. That period gives the stocks enough time to run and do well, and even to recover if they have an early downward pop. The one-year time period keeps us from being emotional and from excessive trading, which would increase costs and reduce alpha. It maximizes the performance. If we sold Alpha Natural Resources when its price-to-sales ratio broke the level of 1.5, we would have missed the remaining performance. More importantly, selling and replacing it early would take us away from our core annual rebalance strategy. This strategy is also important for risk control because the annual rebalance allows us to refresh the portfolio and not get overweight in any one position. Q:  What other portfolio construction rules do you have? How important is diversification? A : If we have too much concentration in one sub-industry, over 25%, we would skip the lowest stock on the list and select the next one. Diversification is important to us, and even when we have a large investment in industrials and materials, it is split in many different sub-industries, such as coal, gas, pipes, and specialty chemicals. For us, the diversification comes at the more granular level. Once the formula has been run and stocks have been identified, we try to interpret what the model is telling us. It is the model that picks our concentration, such as the lean towards industrials and materials and away from financials last year, which was a very beneficial distribution. Of course, we had a few retail stocks, some aerospace and defense stocks, an IT services company, really a bit of everything. Typically, the result is a diversified portfolio, although at the sector level it always looks very concentrated. Q:  What is the performance benchmark for this fund? A : The proper benchmark should be the S&P 400 because of our focus on mid-cap names, but the fund can be also compared to the Russell 2000 Small Cap Index. Our fund fits right in the middle between the two, because the market cap range of $1 and $10 billion is at the top part of the small cap area, as well as in the mid-cap area. We chose the S&P 400 for simplicity, but the more sophisticated investors should look at the combination of those two benchmarks. Q:  What is your view on risk control? A : The inherent risk in this type of strategy is incorrect data, so we go to pain-staking lengths to verify all the key data items used in the model. If data inconsistency is an issue that we can’t resolve, we move to the next stock on the list. Our analysis shows that you don’t necessarily have to pick the top 30 names to do well over time. The important part is to stay within the top deciles. Liquidity is another risk control check, although it is not a big problem in the mid-cap area. Initially, we never overweight a company and we would never invest more than 3.3% in the stock. That minimizes the stock-specific risk. But the most important risk control is the strict discipline regarding the price we pay for a stock, combined with the annual rebalancing that protects the portfolio. We have found that most stocks that do phenomenally well, run for about 18 months. We may leave a bit on the table, but we get out before performance turns. The fact that we aim to capture 12 months of the potential 18-month run provides downside protection. We don’t need to get greedy. At the end of the day, once we purchase the portfolio, we manage it in a consistent, disciplined and repeatable manner. We guard against allowing emotion to creep into our management process, which we believe is the reason that most investors fail.