Quick Take: Investing in service industries yields competitive returns with less volatility than other industries, says John Heffern, lead manager of Delaware Group: American Services/A (DASAX). Heffern follows this strategy by focusing on companies with growth rates of 10% to 25% annually.

Looking for moderately growing companies has led Heffern to financial, consumer, and business services sectors. He particularly likes financial services because companies there tend to be durable and able to benefit from technology.

Though Heffern highlights a growth strategy for the fund, Standard & Poor’s will be reclassifying it as a mid-cap blend portfolio because of its sizable stake in financial services, a predominantly value sector. The fund would retain its 5-Star rank regardless of its classification.

The Delaware fund’s results show it has been able to generate competitive returns with moderate volatility whether classified as growth or blend. The portfolio’s standard deviation (17.78) is lower than the average for mid-cap blend funds (19.08), and the average for mid-cap growth funds (23.62).

For the three years through last year, the fund rose an average annualized 15.4%, versus 4.1% for mid-cap blend funds, and a loss of 7.9% for mid-cap growth funds. Heffern credits his results to his moderate growth strategy and to avoiding “fiascoes.”

The Full Interview:

S&P: What are the benefits of investing in service industries?

HEFFERN: We started the fund because we felt service industries provided low beta, high alpha investments. There’s been a major shift toward services throughout the U.S. economy. We’ve found opportunities in financial, consumer, and business services, but not technology hardware or health care because those sectors have above-average volatility. We’re aiming for an investment vehicle that is more risk adverse, but has competitive returns over the long run.

We look for moderate rates of growth, ranging from 10% to 25% annually. Rather than hyper-growth companies, or slow growth companies, we look for companies in the middle with improving margins and strong management teams. We like companies that are not overly mature.

S&P: Why do you like the financial services sector?

HEFFERN: Financial services companies tend to be durable and able to benefit from technology. The business models of financial services generally hold up, and the companies can grow more slowly than some sectors, but they grow in a sustainable manner. These stocks have also been market leaders for extended periods of time.

S&P: Are you planning to reduce your financial services exposure if interest rates rise in the future, as many expect?

HEFFERN: We anticipate reducing our financial holdings, although we are positioned for rising interest rates. We don’t own large consumer banks, and our bank holdings are likely to benefit from higher rates because their asset management fees are likely to move up with higher interest rates.

S&P: Do you think the ongoing mutual-fund scandals will have a significant impact on the financial services industry?

HEFFERN: Mutual fund flows have held up, and the industry is likely to benefit as people increasingly save for retirement. In our culture, people want to do better than the other guy, which is a good environment for investment management.

S&P: Why do you like the consumer services sector?

HEFFERN: We’ve found stocks with good margins and sustainable growth rates.

S&P: When would you sell a holding?

HEFFERN: If our expectations for revenues and margins aren’t met, we’ll consider selling. We’re also sensitive to valuations, so we have target prices. We won’t sell knee jerk, but we focus on where a company is in terms of its margins and industry.

S&P: Why has the fund’s performance been solid for the past three years?

HEFFERN: We’re willing to accept moderate rates of growth, and don’t follow fads. We look for companies with 10% to 15% operating growth, not 50% growth rates. We also tend to avoid fiascoes.

S&P: What are your largest holdings?

HEFFERN: They include Comcast`A`Spl(non-vtg) (CMCSK), MBNA Corp. (KRB), AmeriTrade Holding (AMTD), Cendant Corp. (CD), and Eaton Vance (EV).

S&P: Have there been any changes in your largest holdings in the past few months?

HEFFERN: We don’t own McDonald`s Corp. (MCD) anymore. One or two better opportunities came along, so selling McDonald’s was like sharpening the blade.

S&P: What have you purchased recently?

HEFFERN: We recently bought eSpeed Inc. `A` (ESPD), which provides electronic trading of Treasury securities. Although eSpeed was hurt by the events of September 11, it has since developed new products, and Treasury issuance is picking up.

– Bill Gerdes