John Arnold, portfolio manager and head of AGF International Investors Inc. in Dublin, likes to touch and feel what he’s investing in.

If it’s a retail food chain, he’ll go to an outlet, make a purchase and return periodically during the day to calculate the traffic. Once, he took his wife to Spain to visit a fried-chicken outlet, which a fast-food pizza company had opened, to test the concept. In that case, he didn’t invest in the company.

Arnold is a deep-value investor on the hunt for undervalued companies for the five funds he manages for Toronto-based AGF Funds Inc. — AGF European Equity Class, AGF Global Perspective, AGF Global Value, AGF International Stock, AGF World Balanced — as well as La Capitale Global Balanced, sponsored by Quebec-based La Capitale Ins and Financial Services, and United International Equity Value Pool sponsored by United Financial Corp. in Toronto.

He uses what he calls the “30/30/30 rule” — only considering stocks that have a price/earnings ratio at least 30% less than the market average, a dividend yield that’s 30% more than the average and a share price that is 30% below its 18-month peak.

Arnold then examines the companies that qualify under this rule in more detail, to see why they are so undervalued and to determine whether they have the right strategy and management in place to turn performance around.

At this stage, industry or sector themes can come into play. For example, the transformation of retail European banks into financial supermarkets has provided great growth opportunities and resulted in handsome returns for the funds Arnold manages. These financial supermarkets offer one-stop shopping that’s much more comprehensive than anything offered in Canada. Customers can address all their needs at a teller’s wicket, including purchasing life and property and casualty insurance as well as wealth-management products.

Interviewing managers of companies in which he is planning to invest is also an important part of Arnold’s process. Over the years, he has built relationships that give him access to senior managers. On a recent visit to Axa S.A. in Paris, for example, he spent an hour with Axa’s CFO in the morning and an hour with its CEO in the late afternoon. This kind of in-depth discussion with company executives is a key competitive advantage for Arnold.

Arnold is also disciplined on the sell side. He begins to unload stocks once their P/Es and dividend yields reach average levels.

Brian O’Neill, senior fund analyst at Toronto-based Morningstar Canada says Arnold’s approach has generally served investors well. So does Dan Hallet, president of Windsor, Ont.-based Dan Hallett & Associates Ltd.

Hallett is impressed with Arnold’s extensive qualitative research, calling the approach “investing at the ground level.” He adds: “He really hits the road and gets in front of senior management.”

But O’Neill is concerned about AGF European Equity’s 60.7% weighting in financial services. He considers this risky and emphasizes that this is a fund for clients with a long time horizon, given the volatility inherent in an investment style that often results in high exposure to a single sector.

Indeed, the heavy exposure to financial services stocks has hurt the fund’s performance, as the global credit crunch sent financial services stock prices plummeting. And while this approach to investing has worked well for Arnold, with the funds he manages delivering above-average returns most years, it has produced losses for the funds since May 2007.

AGF European Equity, for example, had second-quartile performance in 2004 and first-quartile performance in the other six years between 2000 and 2006. But in the 12 months ended July 31, the fund was down 24.7%, whereas the median for the European mutual funds category was 17%. That has pulled down the fund’s average annual compound return for three years to 2.2%, vs a median of 3.1. The average annual return for five years is 7%, vs the median 7.4% return; but the 10-year average annual return was 4.6%, well above the 0.1% median.

Arnold’s funds don’t do well when sector dynamics are driving stock markets, as has been the case with energy stocks in the past year and technology stocks in 1999-2000. Over the past year, he has had little energy exposure. In 1999 and 2000, he had no exposure to technology, after selling his tech holdings in August 1998. As a result, his funds were generally fourth quartile during those periods.

@page_break@Arnold believes the pendulum is about to swing and may already be swinging back to a value market, driven mainly by the performance of individual companies. “It will certainly happen within three months,” he says, “and may indeed have started.”

Oil prices have already come down and Arnold expects further declines. Indeed, he thinks that US$35 a barrel is a logical equilibrium price, given supply and demand fundamentals. He notes that only a few years ago, people talked about US$35 as a reasonable price. But he doesn’t anticipate it will fall that low in the near future.

At the same time, there are signs of recovery among financial services stocks. Arnold believes these stocks would have recovered in the spring but for several banks doing rights issues to raise money to repair their balance sheets, with hedge funds responding by short-selling. With no more rights issues likely in the near term, he expects stock prices to rise.

Many financial services companies have continued to post good financial results and raise dividends, Arnold notes. In the year ended June 30, 35 of the 51 companies Arnold holds in various funds raised their dividends, six held them at the same level and only 10 cut dividends. Those that raised dividends include Paris-based BNP Paribas S.A., up 8%; Munich-based Allianz AG, up 45%; and Bilbao, Spain-based Banco Bilbao Vizcaya Argentaria S.A., up 15%.

This means share prices should go up significantly when investors lose their fear of the financial services sector. That fear is fed by “bad news” stories in the media; as there are fewer and fewer stories, investors should gain confidence. Once this happens, Arnold believes, his funds will jump into the first quartile.

One holding whose shares have increased recently is London-based Royal & Sun Alliance Insurance Group PLC. Its share price closed at £1.44 on Aug. 21, vs £1.16 on July 15. The company announced a 23% increase in net income in the six months ended June 30 over the first half of 2007.

Pharmaceuticals is another sector that Arnold feels has been oversold recently, amid the following concerns: patent expiries; increased market share for generic drugs; little product in pipelines; a U.S. Federal Drug Authority that’s afraid of making decisions; and the possibility of the Democrats, who dislike Big Pharma, winning the election.

But, Arnold says, the pharma companies do have patents, make huge profits and have the potential to increase earnings by controlling costs. He holds Paris-based Sanofi-Aventis S.A. and London-based GlaxoSmithKline PLC. Both have fewer significant patent expiries and more product in their pipelines than most of their peers.

As a value investor, Arnold doesn’t have many resources holdings because the price of the underlying commodity tends to drive share prices. But he does have some. These include integrated oil company Royal Dutch Shell PLC, headquartered in the Hague, Netherlands. Integrateds have many businesses and their results are less affected by oil and gas prices. Their earnings are strong when prices are high, but when prices come down, they make money in their refining and petrochemical operations. Even with oil prices high, Royal Dutch is not trading at a high multiple — a P/E of 7.6 recently — and qualifies as a value investment.

Besides financial services, AGF European Equity had 13.7% of its assets in health care as of June 30, 7.3% in consumer discretionary, 6.3% in telecommunications, 6% in energy, 3.1% in materials, 2.4% in industrials, 0.2% in utilities and 0.1% in information technology.

Arnold is an Englishman, born in Plymouth in 1947 and educated at Portsmouth Polytechnic. He took a course related to stock markets in high school that got him regularly reading business sections of newspapers. But his interest in university was marketing. The eight job offers he received after graduating all required spending two years in London. So, he decided, if he were in London, he might as well get a job in financial services. He took the job that paid the most, becoming a trainee analyst at National Provident Institution. The rest is history.

He became British equity manager at NPI in 1973 and, in 1982, investment director of Crown Financial Management Ltd., a subsidiary of then Toronto-based Crown Life Insurance Co. He joined AGF in 1993 and moved to Dublin.

Arnold has built up AGF International Advisors for parent AGF Management Ltd.; it now manages $15 billion in assets for both AGF Funds and institutional clients in Europe. The institutional side of the business took off in 2004 when clients realized that AGF European Equity was second-best over three years and fourth-best over five years among a wide range of European funds.

All the institutional business is European equity but the firm hopes to do some global-equity money-management in the future.

For his part, Hallett commends the firm stand that Arnold takes on investments: “It’s not often that his funds closely resemble the index that they are tracking.” IE