When breaking the rules pays off

Domiciled in the Bahamas, Phoenix UK is not a typical retail fund. It has just 16 stocks, with the top five making up 60% of the fund’s worth, but this strategy seems to be working just fine

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The Phoenix UK fund, managed by Garry Channon, is a true mould breaker. It goes against almost every convention that other fund managers conform to and raises serious questions about investment management rules imposed by regulators.

Let’s start with the portfolio. It’s shocking. It has just 16 stocks, one of them is nearly a quarter of the entire fund’s worth, and cash is currently equivalent to 18 per cent of the fund. That’s lots of rules broken straight away, as well as much of the philosophy of diversification that underpins standard retail funds.

But from the moment, Channon, a graduate of Goldman Sachs and Nomura, founded Phoenix in 1998, he was determined to run a fund that would make money rather than live by convention. “The regulations said you couldn’t have more than 10 per cent in any one stock. In other words, they make you sell your winners. All I was interested in was picking winners, finding great businesses, buying at the right price and holding on to them forever.”

This didn’t quite fit the regulatory environment in the UK, so Channon opted to domicile the fund in the Bahamas, where he had more freedom and manoeuvrability. But given the prevailing antipathy against tax havens, and post-crisis concerns about light-touch regulation, was that such a good idea?

“The Bahamas are a proper jurisdiction. Think of them as the Channel Islands for Americans. There is not the opacity of the Cayman Islands, and there are lots of real banks, not nameplates, and real people doing business there. We did not do it for the tax angle, and we have been granted distributor status in the UK by HMRC.”

It does mean that Phoenix UK is not a typical retail fund. It has a minimum investment of £100,000 and most of its investors are pension funds, endowments, family offices and rich individuals. And quite a bit of the money in the fund is Channon’s own, plus some from his small band of colleagues, adding up to £18m.

But let’s get back to that portfolio. Most managers think a fund of 50 stocks is concentrated. Channon’s not only has just 16 stocks, he proudly tells you that his top five make up 60 per cent of the fund.

“It’s where we learn from Warren Buffet. Have just a few eggs in your basket, and watch them very closely.” Above all, he wants a company to have a consistent high return on capital, of at least 15 per cent a year, and to do so over a long period of time.

The golden egg is Barratt Developments. You know, the one that went from a net profit of more than £300m in 2007 to a net loss of more than £400m just two years later, and whose share price collapsed from £13 to 50p. Today it’s back above £3.

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Channon owns block after block of Barratts. At one point, in 2008, he was the single largest shareholder in the company, with 12 per cent of all its stock, and even after trimming the position, the housebuilder is 23 per cent of the fund. But how the hell does the Barratts rollercoaster sit with the stock picking philosophy of steady, consistent 15 per centa year return on capital?

Firstly, let’s make clear Channon didn’t hold it throughout. He sold out at £6, and no doubt groaned as it doubled in price over the next year or so. But he started buying back as it collapsed, paying from 60p a share to get back in.

What people don’t understand about Barratts, says Channon, is that it if you analyse it from a current cost accounting basis, the profit it makes from each plot is incredibly consistent. What changes is the price of land. When the housing market is rising, it looks like Barratts profit is expanding, but if you look at the replacement cost of land, the picture is less exciting.

“Barratts was profitable all through the cycle. If you look at the individual home level, profit was very stable. We held it from 1998 to 2006. We sold because even though house prices were going up, land prices were going up much faster. When land prices fell, we bought back in.

Barratts is also typical of the incredible scrutiny that Channon brings to his stocks. He or his team visit almost every development site, analyse every property sale, watch them build, and ‘mystery shop’ as new estates go up. He reckons if Barratts accounting system went down, “they could call us for the figures”.

Barratts core model will earn 15 per cent on capital over the cycle. “They are in an incredibly sweet spot at the moment. We are building only two-thirds of what is needed to meet demand, while there is reduced competition from other housebuilders, particularly the small ones, who can’t access bank funding.”

It’s not all Barratts, of course. The other top five positions are Sports Direct, Lloyds, Bellway and Tesco. “People talk about Sainsbury’s gaining market share, but Tesco wipe the floor with Sainsbury’s on margin and returns on capital.”

But it all comes down to performance. Does what Channon says translate into real returns? Unfortunately you can’t look up this Bahamas fund on the usual data platforms. He lost 40 per cent in 2008, when the market was down 30 per cent. But he clawed back 60 per cent in 2009, double the gain of the FTSE.

Overall, since opening in 1998, annualised returns have been 12.6 per cent (to May 2013) compared with 4.8 per cent from the FTSE All-Share. Two years after launching, Channon closed the fund to new investors, but now it’s open again, although for how long we don’t know. It’s tempting.

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Patrick Collinson is the Guardian’s personal finance editor