Aurora (ARR ) fund manager Gary Channon talks about the rare trade he made in inflation options last year, hedging his £140m UK equities trust against the impact of rising inflation. In this 20-minute interview recorded in May, Channon, founder and chief investment officer of Phoenix Asset Management Partners in west London, discusses:

• How Warren Buffett and Phil Fisher inspired him to take a focused, contrarian, research-intensive approach to picking stocks;
• The well-timed inflation hedge he successfully bought last year to offset falls in interest rate sensitive stocks. It shot up in value and provided cash to buy stocks such as white good retailer AO World (AO);
• His faith in Frasers Group (FRAS) – Aurora’s biggest holding at 21% of assets – under the leadership of Mike Ashley and his son-in-law Michael Murray;
• His determination never to sell funeral provider Dignity Group (DTY) where he was temporarily chief executive;
• The Castelnau Group (CGL ) he set up last year to hold a portfolio of special situation stocks, including Dignity, stamp dealer Stanley Gibbons and model toy maker Hornby;
• The unusual pay structure in which Phoenix receives no annual management fee from Aurora but receives a performance fee of a third in any outperformance over the FTSE All-Share.

Can’t watch now? Read the transcript! 

Gavin Lumsden: Hello, I’m at the Frostrow Company’s conference in the City of London and with me is Gary Channon of Phoenix Asset Management Partners and we’re going to talk about the Aurora Investment Trust, which invests in the UK. Gary, good to see you. Could you tell us, briefly, about your approach because it’s a bit distinctive?

Gary Channon: Yes, I suppose it is. The inspiration was originally Buffett, but I would say our style is more Phil Fisher [US investor and author of ‘Common Stocks and Uncommon Profits’], which is very focused. 15 holdings, but the top five being 50% to 60% of the portfolio, doing all the heavy lifting. Very, very long-term. Not afraid of volatility that comes with that. Really, very business-like. So, most of our time is spent monitoring our companies and that’s the Phil Fisher bit. Really getting stuff about going out in the field, mystery shopping.

GL: You do a lot of detailed, on-the-ground research into your companies?

GC: Yes. We invest in businesses where you can-, we don’t rely upon the management to tell us how they’re doing. We want to see how our assumptions about how they’re going to do in the competitive landscape is something we can monitor ourselves. So, whether it’s mystery-shopping retailers or whether it’s checking airline prices for how airlines are competing against each other and looking at where the new routes are opening. So that’s what we do. We put ourselves in the shoes of customers and see how the world is changing for customers, to see whether that is aligned with how we value the business.

GL: Talking of customers. Obviously, inflation is the big subject for investors and the wider public at the moment. You successfully used an inflation hedge last year to protect the portfolio, can you tell us what you did and how you’re protecting the portfolio at the moment?

GC: We very rarely do that. In our 24 years, we’ve only twice done something macro. Where we’ve got something that we worry about could do a lot of damage, but nobody else is worrying about it, you can buy cheap insurance. So, we were worried about all the extra stimulus around Covid and that focus on a health thing was distorting the signals about, if you increase money supply that much without increasing the supply of goods, might be an inflation risk. Then suddenly, rates might have to go up.

So, we bought, effectively, out-of-the-money options on what the interest rate will be in September this year and I have to say at that time when we bought them at the beginning of last year, the assumption would be that rates were still close to zero. So, you could buy the one percents for virtually nothing. So, one or two cents the options were priced at. So, we put 1% of the portfolio into those and now, they’re assuming 2% rates.

GL: So, they’ve shot up in value.

GC: They went up 20-fold.

GL: Is that the protection that it affords because they go up in value, therefore, you’re making money on something, even if other holdings are maybe doing less well because of inflationary fears?

GC: Yes. Some of our holdings at higher interest rates-, we have a holding in a bank, we have housebuilders. The intrinsic values of those may be affected. Higher rates may lower the price of houses and therefore, it will do some damage to the portfolio. So, we’ve sold the hedge because it’s already been discounted now in the market now there’s an assumption rates will go up a lot. We’ve sold it, we’ve taken that money off the table. So, we have cash and then, we’ve been investing the cash. So, in some respects, we’ve covered what might have been the damage. In fact, it’s outperformed with that performance of that hedge.

GL: How much cash did that generate for you to invest?

GC: It would have been 17%. It went from 1% to 17% in the portfolio.

GL: That’s a remarkable return.

GC: Yes. Also, the thing we really feared hasn’t yet fully manifested itself. So, what will do real damage is, is it sustainable inflation? Will it go into wage inflation? That’s what I worry about as well. That it was a tight labour market, that you were doing this at a time when there was a tight labour market. So, if it spirals into wage inflation, then that will do some damage. The other thing we do is have holdings that have pricing power. So, we have businesses that have some control over their economics.

GL: That’s more conventional stock picking.

GC: Yes. So, we have that and then taking that cash and then buying the businesses that have been very depressed. There’s a lot of good value around at the moment. So, we both get some protection as things fall, but then by deploying the cash, we can get another return on that hedge.

GL: Can you say which-, did you make any new additions to the portfolio into new stocks or was it adding to existing?

GC: I’m not allowed to say anything that’s not there. So, we’ve got AO Group, AO World (AO). So that’s a new addition and we’ve disclosed that we’ve got 3% of that and we’ve disclosed that we’ve got a material holding. Once we went above 5% of the company, we’ve had to disclose that. So that’s a holding and it’s caught up in that whole-, you know, the technology bubble imploding.

GL: There’ve been concerns about its expansion in Germany in the past as well, but your belief in the company is based on.

GC: One of the things about getting involved directly in businesses, you get more of an appreciation of good managements. I think that is an extraordinarily well-managed business. Constantly making small gains of improvements. Out of nothing, they’ve bought the leading position in online. You get a lot of brought-forward demand as a result of the pandemic, but when you’re in white goods, that doesn’t immediately show up. That lifetime value of the customer. You don’t just buy another washing machine tomorrow, but a lot of people that have never heard of AO have been exposed to them now and they have extraordinarily good-, so have gone through all of that and still be five-star customer reviews.

You see so many other businesses dealing with the bottlenecks of sudden jumps in demand, having all sorts of customer service issues, AO’s come out the other side still with its customers raving against it. So, it’s added this whole bank of new customers who’ve come in the last couple of years. People are comparing results to last year, well clearly, we’re not locked down anymore and that brought forward isn’t there. We look at 2019 and business is 15% up on 2019. So, we think there’s going to be a big space for online in the market. They’re in electrical goods and that’s the market leader and it’s got the best management team. Whatever they do in Germany, because he’s got his own money, we trust him to do the smart thing. If it’s the right thing to stay in, do it, but it won’t be some sort of strategy thing, it will be the smart thing for shareholders. So, you can write off Germany and make the investment, just based on the UK.

GL: Interesting. Another business that you’ve considered to be very well run is Frasers Group (FRAS). It’s the biggest position at 19% at the end of April, I believe. So, I was just wondering, how’s that been affected by inflation?

GC: I mean, Frasers now got-, is very complicated. When you’ve got elements of it, it’s still the old discount Sports Direct, then you’ve got the elevated Sports Direct. Brand businesses are different and Flannels is luxury brands. Frasers is-, there’s been a lot of turmoil in retail. That creates winners and losers. A company like Frasers, very, very agile with no set strategy agenda. Just trying to find new ways of doing. So that’s why I say about Mike and his team there, finding Flannels. For every Flannels he found, there will be three or four that never worked out, but they didn’t lose any money on that. Whereas Flannels was extraordinarily well-placed. Luxury is very different. People don’t think of pricing and luxury in the same way that they do at discount.

So, he’s got the discount side. So, people are more price sensitive, then you’ll see that side benefit. When people shop, they seem to save money elsewhere in order to buy something luxury. Discounting luxury is incongruous. It’s not luxury if it’s cheap. So, it has its own natural pricing power. You can see that. Those guys have passed on their price rises and people are taking them.

GL: Mike Ashley’s son-in-law is Michael Murray. He’s taking over this year. Has that happened already?  Have you got confidence in his abilities as well?

GC: Yes. Mike wouldn’t be putting him in that position unless he thought he could do the job and he’s given him a real tough test, I think so far, in terms of how he’s evaluating him. Then he’s given him a real big stretch target, in terms of what he gets paid, but he’s got to deliver a performance that will have the shares trading at £15. They’re just playing to their strengths, I think. That team of Mike and Mike. I think we would have a concern if Mike was retiring, leaving, but I don’t think that’s what’s happened. I think that’s a very, very good team. In terms of going into luxury and elevation, Mike Murray gets that. That’s all come from Mike Murray. Working with the brands, building that-, Mike still has a reputation from the brands as being a discounter.

There’s still fear that he just wants their stuff so he can discount and put his own stuff next. Mike Murray’s built a really good reputation with the brands. So, I think that works and it’s on merit and we can watch it. It’s something you can see every day. You can visit the Flannels. You can see how they’re doing and he’s producing wonderful results. So yes, we think that’s a very well-run business.

GL: Sounds like he’s the future. So, another business in the portfolio, where you have bigger concerns is Dignity (DTY), where you’ve actually spent some time as the chief executive. Clearly, you’re an engaged investor, but do you regret how much time you’ve had to put into turning round or sorting out Dignity?

GC: I regret the years beforehand, of faffing, trying to influence things from the outside and trying to put people on the board.

GL: You’re a longstanding investor in the company.

GC: Yes, and also, I should say Dignity is in that group that you talked about at the beginning. This is us taking-, as we’ve gone along, we formed a view that we might be able to take some of our learnings and apply them to actual improving businesses. We’ve got four businesses. We put them in a vehicle called Castelnau (CGL ) which we’ve listed, which is owned within Aurora, but this is us trying to create great businesses out of existing businesses. Started with those four companies. A year ago, three of those were loss-making, now none of them are loss-making, but the biggest one is Dignity and the future will be the judge of my tenure, but I suppose, I’ve been able to use that time to get the wrong people out, put the right people in. The right strategy and create the foundation.

GL: There’s a new chief executive, I was just reading.

GC: Kate’s [Kate Davidson] just about to replace me and she’s going to be brilliant. She’ll be a better CEO than me and I will help in all the ways that I can help. I’m still doing work on the capital structure piece. There’re still some unfinished pieces but Dignity is one of the holdings that we call permanent, we’d never sell it. So, when you think about owning something for ten or 20 or 30 years, it’s worth it. I won’t do the CEO job again. I learnt a lot by doing it, but I like doing the analysing, backing good people and perhaps, connecting good people. Got a lot out of that, but it’s not for me. It’s an extraordinary measure because we were in there trying to help the company and we discovered something we didn’t like, and we couldn’t persuade the board to stop doing it. So, I didn’t think I could ask something else to go in and do that.

GL: What was it you discovered you didn’t like?

GC: Funeral plans were being sold by third parties in a way that wasn’t consistent with good values. That industry is now being regulated and we can see that these people were not people that Dignity should have been dealing with and when we took it to the board, they wouldn’t act on it. Because we’d uncovered it, we felt we were there in an uncomfortable position. So, I resigned, called the AGM. I did go to the board and said we need for you to stop doing it or you need to change people. When they wouldn’t do that, we went into the public domain. I didn’t think I could ask someone else to be my proxy and do it, I’d got fed up of proxies by then. I thought I’d just go in and do it myself and that’s what’s happened, and we stopped dealing with those people straightaway.

That role’s changed and a year on, we’re coming into FCA [Financial Conduct Authority] regulations, some of these funeral plan companies are going bust and Dignity is actually stepping in and we’re helping. Safe Hands, you may have read about it. It’s gone into administration. It wouldn’t have been able to carry out funerals. We, at Dignity, are doing those funerals. Initially for nothing, to make sure there wasn’t any harm. So, I don’t regret it and I hope that the work I’ve done will have been a grounding of foundation for future value. I’ve turned Dignity on to a different path. I’ve taken all those things I’ve learnt from watching, from good people. We’ve taken all those ideas and we’ve tried to embed them into Dignity. What we’ve learnt with some of the other businesses we’re involved in as well.

GL: This Castelnau is a separate investment company listed on the stock exchange and Aurora has got a stake in it. So, you’re saying Castelnau is a place where you can turnaround special situations. Is another advantage from Aurora’s point of view, if Aurora wants to disengage from those companies, it’s easier to sell a stake in Castelnau that it might be to get out of those individual situations?

GC: What will happen-, as we started to do this and got more involved, we started something outside of the group and then realising, we can then maybe apply it to some of the holdings. It then becomes messy. Is all this time worthwhile? Is this the right thing to be doing? Putting it into a company that’s detachable, like you said. So, one of the benefits, therefore, of having it separate is if we decided that we’re not good at it and we should be doing it, then you could just sell the holding. They’re separate. Also, are we adding any value? Well, how’s Castelnau doing? We’ve got some way of how seeing it. It’s now very clean, so you’re right. They’re separate, they make it very clear. If somebody was wanting to just invest in that, well then, they can just directly invest in that. If the Aurora board decided that it wasn’t for them, then we could sell those shares.

GL: Is it accurate to describe you as a deep value investor?

GC: Sometimes, but people think that’s like a vulture thing. So, we do a lot of work. We’ve had companies we’ve spent ten years doing the DD [due diligence] and the work on them. So, in that sense, we’re deep homework investors. I think the way that markets are, they favour the prepared mind and the disciplined process. So, we do a lot, a lot of work on companies and then don’t invest. We wait for the price. We queue up things that we would like to own, but when we buy, we want to buy very cheap. We want to buy half price. If it goes wrong, we want our money back. That’s quite a low level for what we want is a very good business you can own forever. So, the value in that sense might be deep value, but I think people tend to associate it with bad companies and break up. We want to own something that’s a great company you can own for 20 years, you never have to touch again, but we want to pay a price that’s very attractive from a value perspective.

GL: Looking at the performance since you took over at the start of 2016, I think that’s the turning point up to the end of April, up 60%, which looks very good against rivals and it’s ahead of the UK stock market. I just wonder, could we have expected Aurora to have done even better since this big rotation from growth to value?

GC: It’s the same portfolio that’s in the [Phoenix] UK fund. If you look at our 24 years, there’s times when things get very cheap and there are times when they’re less cheap. We always own cheap. We’re in one of those moments. If you look at what’s in the portfolio, housebuilders and airlines, they’re very, very depressed. So that’s what I would say. Our current estimate of the upside is 110%. So, we measure this upside to intrinsic every quarter and have been doing it for 24 years. When it’s been that high in the past, over the three years after that, there’s never been a period where we lost money and the average return is 55% to 60%. So, we’re in one of those pockets at the moment, where it’s very, very cheap. It’s underperformed this year, but then the index is very dominated by energy and we don’t have any energy or commodities and stuff.

So, I don’t look too much for those growth-value cycles because I think our companies are all growth. We never would invest in a company we thought was not growing. I view this as one of those buying windows where the portfolio gets depressed, keeps getting depressed. The stuff we own keeps going down and it goes down. That just stores up-, the elastic starts to stretch. We’re at one of those points and we’ll reap those rewards in two to three years.

GL: If you do get close to that intrinsic value, clearly investors will do well. So will you. I just want to turn to the subject of performance fees because unusually as a fund manager, you don’t charge an annual management fee, you get remunerated, paid purely by a performance fee, which you believe aligns you with shareholders. Basically, you get one-third of any growth in the asset value, is that not right, how does it work?

GC: No. It’s just the outperformance. So, if I’m an investor and I’m putting it in equities, I could go into an index fund and what we get paid is if we do better than the index fund. So, if we do better than the index, one-third of that we get paid in the equity. So, if the equity is trading at a discount, we add that and for three years it’s not ours. So, if any of that slips away, then we don’t get it. So, it’s only for genuine alpha. So, for the average fund manager who performs in line with the index, it’s a zero fee. If we outperform by 3%, which I think would probably put you into the top 1% of fund managers, we get paid 1%, which I think would make it a modest fee. Our track record has generally been about 7%, our 24-year record. So that means we’ll get 2%, but it means investors will get 5% of outperformance.

So, I view that as like no fee because you’ve got the index plus and you’ve got to think about the net return you got, not how much fees are. We want to earn big fees, but for having done a really good job and protect people from the fluctuations. I think that four-year period does protect people from a bumper year, where it all goes back in the following year. So, we shouldn’t be able to do well and investors not do well. We don’t have that fee structure in the main fund, but we do have high fees if we do well in our-.

GL: The main fund you refer to is Phoenix UK. It’s an offshore fund so most people watching this probably couldn’t access it.

GL: That’s why we were asked to do something that retail investors-, Aurora was our way of taking our Phoenix strategy, making it available for retail investors. Because of the nature of our bumpiness, we’re not suited to most fund structures. When I deal with investors in the UK, I can try and put you off. I spend most of my time trying to put people off because what I don’t want to do is, when we have a 40% drawdown, you reach for the redemption button because that’s terrible for both of us. So, I have to make sure that you’re not that person. Now, once we get some sort of public market thing, if you don’t control who invests-, the beauty of the investment trust is that kind of a reaction just goes into a secondary market.

We get to do the smart thing for the long-term, but trying to explain to people, it will be bumpy. It will be bumpy. In those 24 years, all of our big drawdowns, all the 25%-plus drawdowns have all reversed within a year. It would always have been a dumb thing to redeem after we had a drawdown and the investment trust means we will get judged on our track record on the other side of that. If ultimately, we’re not doing the job, then the board can fire us, but Aurora is the public version, accessible version of the Phoenix strategy.

GL: Gary, thanks for clarifying the point about the performance fee and putting me right. Thanks very much, giving some overview and an explanation of what Aurora does a little bit different from everybody else and let’s see if you’ll get the upside you’re talking about. It will be very interesting to watch as things unfold. In the meantime, thank you.

GC: Gavin, thank you very much.