Beyond mainstream: Dynamic Financial Services Fund

11-05-2019
Beyond mainstream: Dynamic Financial Services Fund

Searching for quality at a reasonable price

 

Financial companies have long been a staple of most Canadians’ portfolios, providing relatively steady returns compared with more volatile sectors such as resources or precious metals. Indeed, Financial Services Equity funds as a group have generated 3-, 5- and 10-year average annual compounded returns through Sept. 30, 2019 of 8.7%, 7.3%, and 7.4% respectively, placing them consistently among the 10 best-performing of 50-plus fund categories.

With interest rates now falling again in the U.S. and global economic growth reportedly on the wane, however, lenders’ margins are starting to be squeezed. For the one-year period ended Sept. 30, 2019, that category average fell to a mere 1.9% – 31st in the rankings. Despite the downturn, though, the Fundata FundGrade A+® Award-winning Dynamic Financial Services Fund continues to lead the category in performance (1-, 3-, 5-, and 10-year returns of 6.4%, 14.8%, 11.5%, 10.0% respectively) as a result of its focus on alternate asset managers both in Canada and abroad.

“We’re not value or growth investors; we look for quality at reasonable price,” says portfolio manager Yassen Dimitrov at 1832 Asset Management LP in Toronto. “The financial services universe in Canada is not very broad, so 50% of our assets are invested here, and 50% are in U.S. or global markets. Having that [global exposure] is helpful.”

Of course, investing 50% in Canadian financial services inevitably means owning some big bank shares, and indeed, three of the fund’s top four holdings are banks (Bank of Nova Scotia, Toronto-Dominion Bank, and Bank of Montreal). But Dimitrov cites Toronto-based Brookfield Asset Management Inc. (the fund’s fifth-largest holding) as an example of the type of alternates they seek in order to bolster overall returns.

“There are two things happening when it comes to Brookfield,” says Dimitrov. “Firstly, we have ultra-low interest rates globally – they’re actually negative in Europe and Japan – so traditional lenders can no longer generate sufficient returns ... compared to fixed income yields. Investors looking for higher returns must turn to private capital.”

Secondly, Dimitrov points to the trend towards industry consolidation, which has resulted in strong returns for companies that are able to develop sufficient scale to appeal to institutional investors. “Brookfield is riding double trends – increased allocations to alternate financials, and increased concentration. They’re in the mid-teens for cash flow growth, with strong growth in partnerships and third-party [arrangements]. And they’re trading at an attractive valuation – 14 times earnings to forward operating cash flow.”

Similarly in foreign markets, Dimitrov’s focus is elsewhere than on the mainstream. “In the U.S. and global markets we are focusing on financial technology rather than banks or other lenders – for example Visa, Mastercard, SNC and TransUnion. These companies are stable, with faster growth than the banks.”

The fund’s top foreign name and third-largest holding, however, is Air Lease Corp. of Los Angeles, CA, a company engaged in purchasing commercial aircraft and leasing them to airlines. “This is a best-in-class airplane lessor that has delivered a 15% compound growth rate with remarkable consistency, yet they’re trading at seven times forward earnings,” says Dimitrov. “That is extreme value.”

The key to the company’s consistent success in a highly cyclical industry, according to Dimitrov, is its focus on new aircraft. “That’s important – their fleet is very young, they run leases for seven or eight years, and at the end of the leases they sell and buy new planes,” he explains. “In weak markets, airlines tend to park their older planes and keep flying the newer ones – they’re more cost efficient and more attractive to customers. Newer planes are less sensitive to downward pressure on residual values.

“The planes are all bought on long-lead orders, so they get the best available discounts, which increases their yields,” Dimitrov adds. “On top of that, they have the lowest funding costs for the industry,” says Dimitrov. “And finally, double-digit asset growth is built into their forward books, and 100% of their bookings are already placed, so we expect they will continue to deliver double-digit earnings growth.”

Olev Edur is an experienced financial and business journalist and a frequent contributor to the Fund Library.

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