It isn't easy running a mutual fund that focuses on financial stocks – at least, not if you want to stand out from the crowd. Canada's Big Banks form the backbone of the sector, and they tend to trade as a uniform bloc, making stock selection look like a futile exercise if you're trying to beat your peers.
But that's why Aegon Capital Management Inc.'s Trans IMS Canadian Financial Services fund stands out. The fund has trounced its peers in the short term and the longer term, consistently creating the sort of returns that suggest the financial sector is actually a good place for stock pickers to ply their craft.
“It has been noted by many investors and market observers that the banks do tend to trade as a group, so it can be challenging in the short term to differentiate among them,” said Crystal Maloney, senior analyst and portfolio manager.
“But over the longer-term, their strategies do differ,” she added, leaving plenty of opportunity for a fund manager to add value.
According to Lipper Inc., the fund has declined just 3.4 per cent over the past three years -- a period that straddles the financial crisis -- versus a far-sharper 11.8 per cent decline among its peers. And over the past five years, the fund is up 0.6 per cent, versus a 6 per cent decline among its peers.
This outperformance is due to a few factors. For starters, the fund has a very concentrated portfolio, currently holding a mere 13 stocks, which makes each stock pick tremendously important. This compares to an average portfolio of 39 stocks among the fund's peers.
And while many financial funds look abroad for holdings in an effort to goose returns with better growth profiles, the Trans IMS fund sticks close to home with an all-Canadian roster – a strategy that certainly paid off during the recent financial turbulence, when Canadian financials stood out with their rock-solid dividends and balance sheets.
As well, the fund isn't afraid to look beyond the usual suspects and invest in mortgage lenders, asset managers and stock exchanges – and with considerable success. Over the past five years, these other financials have averaged about 30 per cent of the fund's holdings, yet have generated about half of the fund's returns.
However, there's no getting away from the Big Banks. And Ms. Maloney -- who cut her teeth in the industry working with mentors like the well-respected BMO Nesbitt Burns Inc. analysts Hugh Brown, Ian de Verteuil and John Reucassel – has her favourites: Toronto-Dominion Bank TD-T and Royal Bank of Canada RY-T. They form the fund's top two holdings.
Both banks, she believes, have the best expected earnings growth, reasonable valuations and the strongest franchises in Canadian retail banking.
For TD, which is her top pick, she sees earnings growth of 12 per cent in 2011, which is above the group average of about 10 per cent growth. And while it dominates the service and convenience space in Canada, she also likes the bank's leverage to the U.S. market.
“Through the acquisitions that they've done, they've established a very sold footprint there,” Ms. Maloney said. “They're in 10 of the 15 wealthiest states, and they also have opportunities to grow through TD Ameritrade.”
In the case of Royal Bank, it has set ambitious targets for becoming a more efficient organization, driving down its expenses as a percentage of revenue to become more productive, which should drive the bank's retail earnings higher. The international division has been struggling, but things are starting to look up.
That's right, she didn't mention the importance of dividends here, despite some encouraging signs that the long drought on dividend increases is nearing an end, now that National Bank of Canada raised its quarterly payout.
“I don't think now is the time to load up on banks because of dividend increases,” Ms. Maloney said. “There certainly is a potential for some increases, but it wouldn't be large,” noting that payout ratios are likely to come down in the new regulatory environment. And besides, dividend yields are already very attractive, especially when compared to bond yields.
“We're focussing more on the growth in earnings,” she said. “We think that's what's going to drive valuation more than the growth in dividends.”
