If you buy into my fund and it fails, you won’t pay me a penny, says Gary Channon.
I first met Gary Channon at the London Value Investor conference in 2013. A late train meant that I only managed a ten-minute chat with him. But I remember one thing he told me very clearly: value investing is all about arbitraging “the difference between perception and reality”. Other people see something as bad news. You figure that underneath the noise there is a strong business. You buy it cheap. You make lots of money. Easy – or rather, Channon makes it look fairly easy. He has been running the Phoenix UK Fund since its launch in 1998. His average annualised net return of just under 10% (a total of 413%) over that period compares to the FTSE All Share’s 4.3% (112.2%). Not bad going.
Right business, right boss, right price
So how does he do it? Find the right business with the right management, then wait for the right price, he says. What’s the right management? One good enough “not to mess up” a great business. But also one whose interests are aligned with those of outside investors. They need to be long-term founders or owners, or at least have an incentive to act that way, so that they invest capital for the long term. What’s the right business? Channon wants to see high returns on capital and some predictability of cash generation – this usually comes from a consumer franchise or set of brands with pricing power, or some kind of oligopolistic market position.
The other ingredient is “transparency”: Channon looks at all businesses through the eyes of their customers – if he can’t do that, he doesn’t buy. That, he says, is “our real risk management”. As a result, Channon can’t ever buy Rolls-Royce, say: it’s too hard to pretend you are in the market for a jet engine when you aren’t, so you can’t look at the firm from any viewpoint other than that of the management. The same goes for many “business-to-business” firms. So Phoenix ends up more heavily invested in consumer-facing firms.
That doesn’t worry Channon. While businesses are “quite rational in their spending… individuals are much more emotional”. When the “purchase decision” has human behaviour baked into it, you often get much better returns. “So I don’t think we miss much.”
I’m not keen on being reminded about my irrational purchases, so we move on. What’s the right price for a good company with competent management? Channon has to be as sure as he can be that he will get his investors’ money back (he holds just 17 stocks – he can’t afford any “zeros”). So the debt and pension liabilities must be covered by the business’s assets. He won’t look at very cyclical stocks and he wants to pay no more than half of what he considers the business to be worth on a discounted cash-flow basis.
Does he specifically look for very low-debt businesses? Not necessarily, but “the debt shouldn’t imperil the business… some businesses with small amounts of debt are imperilled and others can take decent amounts of debt and not be imperilled, and sometimes there’s an illusion that things look imperilled – such as with house builders a few years ago”.
The return of the house builders
That brings us to the sector that got me interested in Phoenix six years ago. In 2008, no one would touch house builders – except Channon. He bought Barratt Homes at the bottom. It looked “horrific” – it came into the credit crunch with £1.2bn in debt. But it was spending £1bn a year on land. Once that stopped, Barratt generated huge amounts of cash. Its £1bn of work in progress was also soon to turn into cash. Channon went mystery shopping and found Barratt was selling 200 houses a week: “the money was coming in”.
He still holds Barratt and Bellway too. Both are working in an undersupplied market – the overhang of new houses in the UK was gone by the end of 2008. So if “you build the houses, you can sell them”. The government is also helping by supporting first-time buyers and easing the planning rules. And there isn’t much competition: the crisis wiped out more of the small and medium-sized builders, who find it tough to compete on scale anyway.
We move on to the concentration in the portfolio – the top five usually makes up over half of it. Barratt is the biggest holding, followed by Lloyds, Card Protection Plan (CCP), JD Wetherspoon and Sports Direct. CCP is re-emerging from a credit-card insurance mis-selling scandal and is reinventing itself with new protection products and an airport lounge access business. Phoenix’s help in recapitalising it means it now has a 40% stake and a nominated director on the board.
JD Wetherspoon fits the consumer brand bill, and Sports Direct – which the fund has held since 2007 – is a “fantastic retailer” led by a “brilliant team”. The market hated the stock in 2007 when Channon bought in at around £1. It was loved up to £8, then hated again as it fell by 60%, where Channon is buying today. All that, despite it being “the same business all the way through”. It isn’t the prettiest business, says Channon, but “a lot of our investments are like that. When we make them, they look ugly, but… when you dig… deeper, they’re not as ugly as they seem.”
One big mistake
I am keen to talk about Channon’s new investment trust. But first, he insists on telling me about one of his failures, for balance. It was HBOS – which has now turned into his Lloyds holding. He would, he says, have been better off never investing in banks at all. But “we’re drawn to industries where the Competition Commission has… found that competition doesn’t work properly and the operators therefore earn excess returns… UK retail banking’s one of those”.
Surely that’s a risk factor – if the Commission isn’t happy, new regulation is a given. It is, says Channon. But in banking, all the evidence suggests that regulation won’t change anything: we just don’t like shifting bank accounts, so we don’t. Convinced by that and by the fact that “mortgage lending in the UK has never had a loss-making year”, he “invested in HBOS way too early”. The lesson? Sometimes perception can change reality. At HBOS “there was a perception that there was an issue, and that mortgages were part of the issue… that became self-fulfilling”.
Is this the ideal charging structure?
That discussed, we move on to the new investment trust. Phoenix has taken over the management of a particularly awful investment trust – Aurora – and plans to run it as it does its offshore fund, replicating (as closely as it can) the existing Phoenix fund. The trust is tiny (assets under management are just £17m), but I suspect it won’t stay that way for long. There is a plan to raise £50m in a share issue that, given Channon’s record and his charging structure, might attract quite a few MoneyWeek investors. Has someone finally produced a charging structure I approve of? Maybe.
Channon plans to charge no administration or basic management fee of any kind. Instead, there will only be a performance fee – one third of the outperformance (over the FTSE) is to be paid to the managers in shares in the trust – with a three-year clawback period if any of that performance is given back. The result? Channon can only make money if he does well on a rolling, long-term basis.
This is interesting. Investment trusts are reasonably expensive to run (although presumably regulatory costs and so on are borne by the trust separately). So if he doesn’t cover his own costs, he will be losing money in every year that he doesn’t outperform. This addresses the “heads you win, tails I lose” nature of most fund management charges. The system is still relative – Channon gets paid if he beats a falling market, so his investors could lose money and still pay a performance fee.
But as he says, that might not matter to them – if the FTSE falls 15% and their fund falls only 5%, then perhaps paying a bit extra to Phoenix will be by the by – particularly if you outperform in most other years too. Anyone can deliver returns over a year, he says: “it’s random”. But over three years it isn’t. So if your stockpicker isn’t performing on a three-year basis, you’re probably overpaying. You won’t be overpaying Channon if he doesn’t deliver. You won’t be paying him at all, which is exactly as it should be.
Who is Gary Channon?
Gary Channon started his career in 1987 on the fixed income trading desk at Nikko Securities Europe. He moved on to join Goldman Sachs in 1989, where he traded global equity derivatives. He left in 1992 to head up Nomura’s equity and equity derivatives trading unit. In 1998, Channon left Nomura to co-found Phoenix Asset Management, where he is now the chief investment officer. He has managed the Phoenix UK fund since its launch in May that same year.
The fund’s investment philosophy – “long-term, value-based and focused” – is “strongly inspired by” US investor Warren Buffett and also Phil Fisher (the author of the 1958 investment bible Common Stocks and Uncommon Profits). Channon typically holds a small number of shares, mostly UK-listed, chosen for their long-term potential. He particularly focuses on areas where he believes the market has made flawed assumptions about a business model or level of potential returns.