There’s money to be made as consumers trade down to discount stores and pizza dinners, says mid-cap fund manager Brian Peery. He also tells MoneyShow.com about the impact of dividends, and about some key fundamental metrics he uses to select stocks.

Kate Stalter: We’re talking about the Hennessey Focus 30 Fund (HFTFX) today with co-portfolio manager Brian Peery.

Brian, this is a growth fund, which as the name suggests consists of 30 investments. So can you give us a little background about the fund’s objectives and your investment requirements?

Brian Peery: Absolutely. What we do at Hennessey Funds is we employ a consistent—and what we think is a repeatable—investment process.

The way we do that is we use time-tested quantitative methods. This fund in particular uses price-to-sales ratio, earnings growth, and stock price appreciation to select its stocks.

We basically take all 13,000 publicly traded companies and we sift through them. Within that, we’re looking for companies in this fund with a market capitalization between $1 billion and $10 billion, so we’re looking for true mid-cap stocks. We also remove any foreign stocks or ADRs, which are simply foreign stocks traded on a US exchange.

The next criteria we look for is a price-to-sales ratio below 1.5. What that essentially means is that we won’t pay more than $1.50 for $1 in sales.

The next criteria we look at: We want to make sure that the annual earnings of that company are higher than the previous year, so what we’re seeing is that the companies are actually making more money and that earnings are actually being transferred to the shareholders.

Then we look at the relative strength or the price appreciation of the stock over three different periods—so we’re looking over a three-month period, six months, and 12 months. They have to be positive in the three- and six-month periods. If they’re not, we won’t put those in the portfolio.

After that process, we’ll rank them on that 12-month appreciation and we’ll select the 30 stocks with the highest relative strength over that period. We equally allocate to every single one of those stocks, so we’re not trying to say one stock is going to outperform another.

We have 30 positions in the fund, and we’ll hold those for roughly a year. At the end of that year, we’ll go back, we’ll revisit our criteria. If they continue to meet the criteria in the portfolio, we’ll pare them back to their 3.3% weighting, so we’ll take some of the money off the table. If they no longer meet our criteria, we’ll replace it with ones that did.

Kate Stalter: So, you’re always invested in 30 stocks, regardless of the market conditions?

Brian Peery: Correct. The only time that we wouldn’t be invested in 30 stocks is in the case if we had a takeover of an individual security. What we would do is, we would take the cash that’s distributed from that and redeploy among the existing 29.

So, we always maintain less than a 5% cash position, because our sentiment is: We’re not getting paid to manage cash; we’re getting paid to buy equities.

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Kate Stalter: I’m looking at some of the holdings here on your Web page, and there are some interesting names, where investors might be familiar with the brand, but not necessarily the stock. Tell us about a few of these.

Brian Peery: We recently rebalanced our portfolio, and we tend to see trends that kind of lead into the next year. So it’s really interesting for us to go back and look at these.

One of the trends that we saw: We had a fairly large position in consumer-discretionary stocks, and we continue to own those. But we’re seeing, and we have seen over the last year, those stocks tend to be really the lower end of the retail market.

So, what we’re seeing from consumers is that trade-down, looking for value in certain products. In that line, we own Family Dollar Stores (FDO) and we own Ross Stores (ROST). We think the consumer is going to continue to spend, but they’re really going to be seeking out that value proposition.

Another key driver in our rebalance that we saw is a shift towards utilities. Prior to the third quarter, we had zero utilities in the fund. We now have nine. So, what we’re really seeing is that volatility that’s been in the marketplace is actually transferring over to the retail investors now. What that means is they’re starting to look at recurring repeatable revenue streams and consistency.

So, I think the economy is in good shape, and what’s going to happen is people are shifting into these utilities because they know that people are not going to stop heating their house, they’re not going to stop switching on their lights. They pay good dividend streams, so they’re actually getting some income off of it, but they’re taking away some of that volatility within their portfolio.

Within the consumer-staples space, they tend to be kind of the low-end names that we own in there as well, stuff like Domino’s Pizza (DPZ) and Dr Pepper Snapple (DPS). People aren’t going to stop buying a pizza. If they want to feel good about going out to dinner, they might order Domino’s and some Dr Pepper, and that’s basically what we’re looking at. It’s that middle-income consumer that we’re looking towards to trading down to the value products.

Kate Stalter: One thing I wanted to follow up, Brian. When you were talking about the utilities, and I’m sure this could apply to other sectors as well: Do dividends factor into your model at all?

Brian Peery: You know, it’s interesting. It doesn’t factor into this particular model. But we’ve seen a kind of resurgence within that dividend space. Prior to the third quarter, I’d say about 25% to 30% of our companies paid dividends. Now, it’s upwards of 87%.

What we’re seeing is that all of these companies are sitting on a lot of cash. When you look at the economy as a whole, it is growing very slowly, but the corporate earnings are up at all-time records. There’s no real way for them to deploy that capital. So they’re instituting dividends, they’re raising their dividends, and they’re doing some M&A to be accretive to the bottom line.

So, I think that a dividend going forward is actually a great way for the investors to play this market space, because frankly the ten-year and the 30-year bonds are really not giving you any kind of a yield, while you can see something like the utilities, in this particular case, are yielding over 4% in our portfolio. So you really get the underlying capital appreciation of the stock, plus you’re getting a better income stream—nearly double that of the ten-year US Treasury.

Kate Stalter: That kind of segues into the last question I had for you today. What is the best way for retail investors, people who are trying to manage their own portfolios—or even working with an advisor—what’s the best way to navigate these challenging markets?

Brian Peery: You know, I think the best way to look at it is really take a long-term approach to things, and really focus on the companies as opposed to the economy.

It’s a difficult thing to do when we’re bombarded by the media and the stock market, and the gyrations in it every day. But I think if you really take a long-term approach, and say I want to buy a quality company at a reasonable price that I know is going to be around in two, three, five, ten years, and you hold on to those.

The days of buy-and-hold are not done; you just have to be selective in what you’re looking at and say, “OK, how do I mitigate that volatility in that portfolio, and how do I really invest for the long-term?”

I think that’s kind of where investors are starting to look right now, and I think it’s a key driver going forward.

Kate Stalter: So, kind of tune out some of the noise that we might be hearing on a regular basis?

Brian Peery: And it’s tough to do. Doesn’t matter if you get in an elevator or you turn on a radio, everybody’s talking about the European Union or real-estate prices. There’s a lot of negative sentiment out there.

But, when we look at the markets as a whole, whether you’re looking at price-to-cash, price-to-book, price-to-sales, price-to-earnings, all of these are telling us that this is a great opportunity for those who have the kind of intestinal fortitude to stand into this market and buy some stocks.