Separating Sentiment from Fundamentals to Find Exceptional Opportunities

What are the earnings growth rates and valuations for the Hennessy Focus Fund compared to the Russell 3000® Index?

As of June 30, 2022, we believe the Fund is trading at 14.4x our estimate of 2022 operating earnings, which is a 13% discount to the Russell 3000® Index’s 16.5x estimate. With respect to 2023 estimated operating earnings, the Fund is trading at 12.8x compared to 15.1x for the Index—about 15% lower.

In terms of earnings growth, we believe the Fund will grow cash earnings by 14.3% from 2022 to 2023 whereas the Russell 3000 is estimated to grow its earnings at 9.1%.

With the Fund trading about 15% lower than the Index and an earnings per share growth rate 55% faster than the Index, we believe the portfolio offers high-quality, faster growing companies at an attractive price.

How has your watchlist changed due to the market volatility?

With high-quality assets available at lower prices, as long-term, value-aware investors, we have been very active looking for opportunities. We have focused our attention on areas that have experienced the most market pain, such as tech-enabled growth businesses we have long admired. We added about six technology companies that are leaders in their industries and fit many of our investment criteria to the watchlist in 2022. 

However, we conclude these stocks still need a meaningful price correction to be investable with a margin of safety. To justify their current prices, these companies require aggressive growth and margin assumptions, while ignoring their high stock compensation.   

Would you please discuss new holding Shenandoah Telecommunications?  

Shenandoah Telecom, a/k/a “Shentel,” provides telecommunications services to rural areas in Virginia, West Virginia, Maryland, and Kentucky. With a unique geographic footprint including low population density, mountains, valleys, and forests, Shentel commands a desirable position in the broadband communications industry.

Shentel has two core assets: 

1. An established cable broadband business.

Recently large cable networks have been facing increased competition from fiber overbuilders and fixed wireless. Yet, we think Shentel will face minor incremental encroachment in the next decade due to its unique geography and operations. In addition, with just 52% household penetration with its cable broadband product, we believe they can slowly displace DSL ‘s 30% share, leaving room for Shentel to continue to grow cable broadband subscriber counts.

We view Shentel’s cable business as a well-protected cash cow that should grow revenue organically in the low- to mid-single digits with gradual margin expansion, while providing cash flow and the operations backbone to propel Shentel’s emerging fiber business to success.

2. An emerging fiber broadband business. 

Shentel is targeting new fiber builds in markets served today by only one broadband provider, the legacy cable network that enjoys a monopoly position, high prices, and high market share (75-85%). When Shentel arrives with fiber it can offer faster speeds, higher reliability, and a lower price point. Combined with local customer service (call centers based in western Virginia), Shentel provides an attractive customer value proposition. With its long history of intelligent network expansion, its established cable footprint, and deep local relationships, Shentel is well positioned to execute on its fiber overbuilding plan in adjacent markets.

At current prices, we believe the market is assigning very little value to Shentel’s fiber build strategy. If we assign a market multiple to their cell tower business and value Shentel’s fiber build to date at cost, we believe the market is valuing Shentel’s cable business at ~9x EBITDA, which is a two-turn discount to its closest peer, Cable One. In addition, we expect Shentel to compound consolidated EBITDA at  ~17-18% per annum through 2026 driven by a successful fiber rollout.

With continued high levels of inflation, would you please discuss American Woodmark’s pricing power to pass increased costs to the consumer?

The kitchen cabinet manufacturer has experienced significant cost increases in wood inputs, such as wood and particle board plus challenges sourcing key components from overseas. The company has also seen wage inflation in its workforce. We believe the company has the pricing power to offset these increased costs albeit with a 3-12 month lag. American Woodmark has had multi-decade success in being able to pass through higher costs. Adding to our conviction is the fact that the cabinet industry is facing capacity constraints with solid demand from new home construction and remodeling activity. 

The company has implemented several rounds of pricing increases in the past year and a half. These price increases were to recoup known costs at that time, yet costs have continued to rise. We believe the company is at an inflection point where labor and materials cost inflation has started to slow, which should benefit the company going forward. Our thesis on the company remains intact, and the stock is undervalued in our view, trading at 7x our estimate of next 12-month earnings.

What should investors consider in today’s volatile market?

It’s important to consider where the market is on the fear and greed pendulum, and where it is trading relative to long-term valuation metrics. During the 13 years of the bull market, the risk pendulum had swung full range from fear to greed. For half a generation, risk seeking had been rewarded, and prudence was often penalized. We began calling out the excesses in the fourth quarter of 2020. In the first half of this year, some of the excesses in the hottest sectors were wrung out. Technology stocks and early stage growth companies were particularly hard hit. 

While we still find it hard to find value in these particularly speculative areas, we are becoming increasingly constructive on our opportunity set. We see good value in our existing portfolio (trading at ~14x our next 12 months earnings estimates – the lowest multiple we have seen since 2011) and are finding many watchlist names and new businesses worthy of study for potential investment. We believe that the valuations of many of our portfolio companies are already discounting a severe recession that is far from certain to occur.

We believe the potential for sustained inflation poses a serious risk to purchasing power for assets held in cash and fixed income. With this backdrop we particularly like our portfolio of what we believe to be high quality, well run, growing businesses, owned at reasonable valuations based upon demonstrated earnings and cash flow.