Welcome to the 9th episode of the AMM Dividend Growth Podcast. I’m Glenn Busch, a portfolio manager with American Money Management. In this podcast I discuss a current position held within our Dividend Growth strategy and I do portfolio updates if we sell anything or any major changes occur to an investment thesis. Now with this episode, I’m going to try something new. I think it’ll help highlight our research and investment process.
This episode is about a dividend stock I would avoid.
But before I get into the stock, we have to do the disclaimer.
The stock is Hennessy Advisors and the ticker is HNNA.
H for harry, N for Nancy, N for Nancy, A for alpha.
Before I tell you why I would avoid it. Let’s go through what makes it an attractive dividend growth stock.
Over the last five years they have grown their dividend at a compound annual growth rate of 36%.
Its current dividend yield is 4.97%.
And it trades at a PE ratio of 7.21 and a free cash flow yield over 16%.
This is all very attractive so why would I say avoid it?
The first issue is it is really small. Its current market cap is 77m. Because of its size it is less liquid. Lately its daily average trade volume is 10,934 shares. Because of its size larger firms don’t want to own it or can’t because of their mandates. Less demand is partly a reason for the lower multiple.
If you’re a buy and hold investor this probably isn’t much of an issue for you, if you think the company will be around for a long time. So this leads into my big issue, Hennessy’s business.
Hennessy Advisors is an asset manager that manages mutual funds. The mutual fund business is facing serious headwinds and is what I would describe as a melting ice cube.
The first mutual fund was created in 1924 but it wasn’t until the 80s and 90s that mutual funds really took off. With the rise of defined contribution plans like 401Ks
It is during this time we see the rise of the star stock picker like Peter Lynch, John Neff, and David Dreman.
These guy had great performance which helped draw in assets but it’s the old cliché Mutual Funds are sold not bought. It was the army of brokers and advisors touting the fund performance that sold these funds to their clients. They were the distribution channel to the retail client and they earned sales loads and commission trailers for their efforts.
But eventually everyone woke up to the high fees and the immense drag it had on portfolio performance. And advisors before they cut their fees looked to where they could add the most value and cut out as much fees as possible. Advisors added financial planning and shifted assets towards low cost ETFs to reduce the total fees in client accounts.
Money has been pouring out of Mutual Funds and into low cost ETFs. The estimate is total ETF assets will surpass Mutual Fund assets in 2024.
This is not to say that a niche product mutual fund that solves a specific problem for portfolios can’t be successful. They can and I’ve seen quite a few raise significant amounts of money in recent years. It’s just a much tougher environment.
Now if you’re large cap value fund or a large cap growth fund charging 1.5% or more then you really have a sales problem.
Hennessy Advisors has 15 mutual funds. The largest is the Hennessy Focus Fund with 1.9 billion dollars and a 1.48% expense ratio.
Let’s say the average advisor charges 1% of AUM and they use an equity fund with a 1.5% expense ratio. Then they have a 2.5% drag on equity performance. Contrast that with say the SDPR Strategic Factors ETFs, ticker QUS, which is a quality and value factor ETF that has an expense ratio of 0.15%.
Which would you choose?
The Hennessy Focus Fund has had a great year so far. As I record this episode the fund is up 36% year to date while QUS is up 29.15%.
I didn’t go through the performance of all 15 funds but despite great returns in its flagship fund, .3 billion dollars in net AUM has left Hennessy.
Revenue is down 22% year over year and net income is down 31.4% year over year after adding back last year’s tax adjustment.
When we first started our dividend growth portfolio our focus was to invest in companies with a good track record of paying and growing their dividend, that are also high quality companies that we define by high returns on invested capital or high returns on equity, and that are trading at a discount to our estimate of fair value.
Over time we’ve added a couple more qualification. One is a long runway for growth. This doesn’t mean high growth. We just want to be comfortable that there is some form of a secular growth trend for the company. The second qualification is a company that is increasing its competitive advantage.
Paul Black from WCM Investment management sums up this thought perfectly in the podcast interview he did with Ted Seides on Capital Allocators.
“focus on a company where there is a strong likelihood of growing its competitive advantage over the next 5, 10, 15 years. If you get that right, any valuation work you do is going to look ludicrously cheap 5 and 10 years out”.
The mutual fund business model is not experiencing long–term secular growth and mutual fund only asset managers are not growing their competitive advantage.
Right now ETFs are in a secular growth trend and they are taking market share away from mutual funds every day.
Now ETFs could hit their own disruption. As software gets better and cheaper, with trading costs at zero, and now the trading of fractional shares, then self-indexing could come after equity ETFs. This will also be another headwind for mutual funds.
Could a market downturn cause assets to flow back into actively managed mutual funds? Yeah of course but I don’t think enough money would flow back in to reverse this trend. Plus, once the market recovers and after a year or two of good market returns, the flow of money out of mutual funds and into ETFs will pick up steam again.
In the short-run, Hennessy Advisors could be a good investment, it’s cheap, and it’s returning a bunch of cash to shareholders. And management is trying to increase how much cash it gives back to shareholders in the short-run. Like Howard Marks says anything is a triple A security at the right price. Again, we want to own a position for the next 5, 10, 15+ years. Given the long-terms secular headwinds facing mutual fund companies, I can’t see Hennessy Advisors growing its competitive advantage or being a long-term dividend growth company. At some point the declining AUM and lost profits can’t support future dividend growth.
Using a very basic model. If AUM continues to decline by 20% each year and keeping their margin profile the same. Which it won’t. As assets decline fixed costs eat up a larger percentage of revenue. But for this simple model let’s keep margins consistent. At 20% the current dollar amount paid out in dividends would exceed net income by 2024.
With a 10% decline per year it would take until 2026. This is assuming the dividends paid out remains the same throughout the years too.
Obviously the slower the decline the longer it will take. The thing going for management is assets in mutual funds are relatively sticky. It’s the old status quo bias. People don’t really do anything unless forced to act. It’ll be tough to gain new assets but the decline could slow over time as the stickiest assets remain.
Take a look at the Hussman Strategic Growth Fund. At its peak I think it had around 1 billion dollars. Even after losing money over the last 1, 3, 5, 10 years and down 18 per cent YTD. Wow! What amazing growth. But after a decade of negative returns the fund still has 200 million in assets.
I hope this episode give you more of an idea about our research and investment process. If you enjoyed this podcast please leave a rating and review in your favorite podcast player to help others find it. If you’re an individual investor or a financial advisor that uses separately managed accounts and you like to learn more about the AMM Dividend Growth Strategy, please give me a call at 888-999-1395. And please subscribe to our email newsletter using the link in the description to get notified when we release a new dividend letter, YouTube video, or a podcast episode.
Until next time.