October 9, 2012 / 9:01 PM / 5 years ago

Inside the year's best performing small-cap fund

NEW YORK (Reuters) - Forget counting the number of cars in a parking lot.

Brian Peery, a co-manager of the $262 million Hennessy Cornerstone Growth Fund, has delivered the best year to date performance among small-cap funds by eschewing the traditional metrics investors sometimes use - such as how many cars are in the lot or big orders to suppliers - to determine what a company will be worth.

Instead, Peery replaces the 50 companies in his fund once a year with a new group that can pass his four-part screen.

"We don't kick the tires. You kick enough tires and you end up hurting your feet. We look at underlying fundamentals and follow a strict adherence to formulas," he said.

Such a focus on fundamentals alone has fallen out of favor with many investors lately as the stock market swung widely on news from Europe or the latest employment numbers. Yet Peery's rigid approach has helped his fund return 28.8 percent through the end of September, the best showing among the 466 small-cap funds tracked by Lipper, a Thomson Reuters company. Over the same period, the average small cap fund returned 12.4 percent, according to Lipper.

Among the fund's current holdings: A mix of household brands such as Foot Locker Inc and Elizabeth Arden Inc and more-obscure companies such as Arctic Cat Inc and Neenah Paper Inc.

Perry's strategy is relatively simple, but comes with the risk that it may not be able to respond quickly to events. Once a year, his team sorts through 10,000 public companies, looking for firms with market caps greater than $175 million, price to sales ratios below 1.5, positive year over year earnings and stock appreciation over three, six, and 12-month periods.

Peery likes price to sales over other market metrics because it lessens the chance a company can take accounting steps to disguise its true performance, he said.

"The sales figure is harder to manipulate unless you're cooking the books," he said.

The team then ranks the stocks based on 12-month appreciation and allocates two percent of the fund's assets to the top 50 companies. With exceptions generally only in the case of mergers and acquisition deals, Peery holds onto each stock for a full year and then rebalances again using the same screen. Any stocks that meet the screen a second time stay in the fund.

It is an approach that can lead to unfamiliar places.

"We have 4 stocks now that, prior to their selection, I had never heard of them and I've been doing this for 20 years," he said.

A case in point: Tractor Supply Co, which operates 1,085 retail stores selling things such as livestock feed and ranch equipment. Its shares are up 46 percent this year, partly because of a 18 percent jump in earnings in its second quarter after opening 51 new stores in the first half of 2012.

Another obscure pick, American Vanguard Corp, is the fund's best performer, with a 166 percent jump this year. The company manufacturers chemicals used for pest control on crops such as corn and cotton insecticides. It saw its earnings per share jump 41 percent in the second quarter.

When constructing his portfolios, Peery's goal is to identify companies that are growing sales at a reasonable price. But the fund's once-a-year construction has left it vulnerable when the market swings in an unexpected direction.

In March 2009 for instance, Peery had large positions in stable materials and consumer discretionary companies at the time when the post-financial crisis started roaring. Riskier, lower-quality companies jumped the most, leaving Peery's fund behind. That year, his fund's 10.2 percent return lagged his category by 21.5 percentage points, according to Morningstar.

Another year of sub-category performance in 2010 helped push the fund into a negative 5.9 percent annualized return over the last five years, putting it in the bottom 2 percent of comparable funds, according to Morningstar.

For his part, Peery said his fund is going to underperform during volatile market periods.

"We'd rather have a client leave us for not making enough money than trying to explain these wild swings," he said.

His outlook for the market - and fund - is now brighter.

"In markets where you've got people really focused on growth, but also looking for the price of it, I think the fund will do exceptionally well," he added.

The Hennessy Cornerstone Growth fund charges $1.33 per $100 invested, a fee level that Morningstar classifies as "above average."

First time investors must invest a minimum of $2,500.

Reporting By David Randall.; Editing by Jennifer Merritt and Andre Grenon

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