John hadwen has a straightforward method of picking stocks in the financial services sector.

Financial services companies are focused on growing their assets, whether they are mutual funds, mortgages, credit cards or brokerage assets under administration, and then try to maximize profits on those assets.

“My strategy is to find the companies that are able to produce stable profit margins and grow their assets at attractive rates — say, 8%, or more — over the long term,” says Hadwen, 36, a portfolio manager at Toronto-based Goodman & Co. Investment Counsel.

Hadwen oversees the $228.8- million Dynamic Focus + Wealth Management Fund, which invests in companies involved in financial asset management, spread across banks, life insurers, brokerage companies and investment-management firms.

But Hadwen is particularly fond of investment-management firms. “It is the easiest group to figure out what it will earn on its assets,” he says. “It generates very strong free cash flow. It’s my favourite group in Canada because the firms have an opportunity to increase profit margins by 50%.”

By converting to income trusts, which receive favourable tax treatment, mutual fund firms can boost their share prices. Toronto-based CI Financial Inc. did just that on June 30. Its share price began to move up long before the actual conversion, rising to a current price of about $29 from $20 a year ago.

As a consequence, 23% of the Dynamic fund is invested in Canadian fund companies that potentially could convert to income trusts, such as Saxon Financial Inc., AGF Management Ltd. , both of Toronto, and Winnipeg-based IGM Financial Inc.

Saxon Financial is a favourite, comprising 6% of fund assets, largely because of its rapid growth. In Hadwen’s view, the stock also looks very much as CI Financial looked a year ago before it converted to an income trust. Saxon is trading at 18 times after-tax earnings.

“But it can go to 18 times pre-tax earnings,” says Hadwen, adding that the firm’s revenue is up 35% year-over-year. “That’s cheap, relative to its growth rate of about 15%. So, Saxon should trade at a premium to CI, which is growing much slower.”

Overall, Hadwen is bullish on mutual funds because, in his estimation, the sector is trading on a free cash-flow yield of 6%. (He prefers this measure to price-to-earnings multiples because he says it gives a better measure of a firm’s earning power.)

“Given their long-term asset growth potential of 8%, I find that attractive,” he says. “Plus, there’s the potential of converting to an income trust structure. This is where the easy money can be made.”

This approach has driven the Dynamic fund’s top-quartile performance in the financial services category for the past five-, three- and two-year periods. For the five years ended July 31, the fund averaged 8.7%, compared with the median fund re-turn of 4.7%. Over three years, it averaged 15.1%, vs the median fund’s return of 11.7%. In the past 12 months, it slipped into the third quartile, returning 12% vs 13.8%.

The fund’s relatively weak performance compared with its peers in the past year is attributable to top holdings, such as TD Bank Financial Group, remaining flat. Yet Hadwen is decidedly bullish about his fund’s prospects.

“My stocks have a lot more upside than downside, so I have less cash today than over the past couple of years. Six months ago, my average return was about 10%. Now, most of my stocks are 30% under-valued,” he says, noting free cash-flow yields are also high. Indeed, he took advantage of market weakness in the spring and added to existing positions in Royal Bank of Canada and Bank of Nova Scotia.

Hadwen admits the inversion of the yield curve in the U.S. and deterioration in the credit cycle have put pressure on banks’ earnings in the U.S. “There are legitimate concerns out there, but they are priced into the stocks,” he says, noting stocks such as Citigroup Inc. are trading at 10 times 2007 earnings. “And, if the Federal Reserve Board is done, things will get better.”

In terms of potential asset growth at banks, Hadwen notes that mortgage lending has been strong and commercial lending has started to pick up. “Asset growth is very good at the moment. We’re expecting 10% growth for the next year,” says Hadwen, who resists being labelled either a value or a growth investor.

@page_break@He uses a proprietary model to assess about 100 banks around the world. About 40% of the fund is invested in banks, of which 23% are Canadian. Moreover, Hadwen takes a concentrated approach — the fund has only 28 names.

The fund belongs to a small category made up of 12 funds (which often come in several versions) that focus on investing in financial services companies. These are split between Canadian funds and global products. The Dynamic fund straddles the fence: it has 55% Canadian assets and 43% foreign stocks (and 2% cash). About one-third of its foreign exposure is hedged back into Canadian dollars.

One of the largest international holdings is Kookmin Bank, a dominant retail bank in South Korea. Hadwen acquired the stock (as an American depositary receipt) about two-and-a-half years ago, when share prices were depressed and many South Korean banks were under pressure from high loan losses in their credit card operations.

“It traded at a low valuation, relative to tangible assets. But it had potential for lots of improvement in profitability as it sorted out its credit problems,” says Hadwen, who measured the downside risk against upside potential by studying other South Korean macroeconomic trends. Acquired at about US$36, it is now US$80. Given the bank’s profitability and growth in assets, the stock could reach US$100 in 12 months, he says.

As a rule, Hadwen is a long-term investor and keeps turnover at about 30% a year. But he will sell stocks when they become excessively valued or when he needs cash to buy something that is undervalued. This year, for instance, he sold Amvescap PLC (which controls AIM Fund Management Inc. of Toronto).

“For years, it has been trading at about 50% of what I thought it was worth,” he says, adding that the stock ran up last spring to within 10% of its value.

After taking some profits, he invested in Britain-based HSBC Holdings PLC. According to his valuation model, it rates as an “average” bank. But he thinks it will generate above-average growth because it can allocate capital across 100 countries: “It has all these options for investing, which enhances long-term potential.”

Hadwen is not keen on life insurers, which account for only 12% of the fund. What’s more, he has no exposure to property and casualty firms because it is difficult to estimate their profit margins over the long term. He says life insurers are “complex business structures, so my comfort level in estimating earnings is lower. They seem like great businesses, but I can’t say with conviction what their earnings will be five years out.”

A native of Brighton, Ont., Hadwen has first-hand knowledge of the financial services industry. After he graduated from Trent University in 1993 with an honours bachelor of administrative studies, Hadwen landed a position in customer service at Mackenzie Financial Corp. Then he moved into mutual fund accounting, and later shifted to money market trading. In 1998, he joined Infinity Mutual Funds, a unit of now-defunct Fortune Financial Corp.

“The fund industry is a great business. Its profitability is a well-kept secret,” he says. “In my long-term models, I price in declining margins because there will be pressure on fees. But it will be gradual.”

Hadwen analysed financial services companies on the team that ran Infinity Wealth Management Fund. “When I went to Infinity, they told me, ‘You know all about fund companies, so why not cover financials?’ I did all right and stuck to it,” he says.

In 1999, he moved to Dynamic when it acquired the Infinity group of funds. He has been lead manager his fund since 2000.

Analysts have mixed opinions of the fund. “On a stand-alone basis, it looks like a good fund,” says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “But should you buy a financially focused fund? I am not sure if there is a great deal of value in that.”

The fund has a wealth-management “tilt” and some names, such as Kookmin Bank, that are atypical, Hallett adds: “But if you’re investing in Canadian, U.S. and overseas stocks, the indices have decent weights in financials. So, the issue is: how do you use this fund? That’s where I have difficulty with it.”

Gordon Pape, publisher of the Toronto-based Internet Wealth Builder, is more favourably disposed: “When you look at the holdings, you can see it is blue-chip stuff.” He gives the fund a solid rating.

However, Pape cautions advisors to ensure it is suitable for clients. “Advisors should be aware of the total financials services exposure in clients’ portfolios,” he says. “If you have a diversified equity fund, you may think twice before owning a financial services fund.” IE