An oft-repeated piece of investment wisdom is “don’t try to catch a falling knife”. A stock that experiences a double-digit correction in a short period of time is often falling for good reason, and if the momentum is moving strongly downward, it is likely to continue plummeting after you buy in. Moreover, bad news is rarely an orphan, and whenever a company announces a profit warning, for example, it is often the first of many.
However, Gary Channon, manager of the Aurora Investment Trust, takes a different view. He looks for great businesses that demonstrate a high return on equity, pricing power and a strong management team – a strategy that is similar to the one used by Berkshire Hathaway chairman Warren Buffett.
The problem is that, because everyone would ideally like to own these companies, their advantages are reflected in high valuations, so once the manager has identified a business with these attributes, he will wait – sometimes for years – until they become cheaper.
Often this will only happen if a piece of bad news breaks about the company, its sector or the economy – and this is where he goes against the grain.
“Imagine we've got two stocks that halve and halve again. If you invest with us, you're familiar with this story,” Channon quipped.
“But one of them bounces back and gets to where it started. And the second one just keeps halving, halving and halving to oblivion.
“If we've got a portfolio of £1m and we put £50,000 in after every time a stock halves, and max out at three lots over a set period, what happens is you're doubling up: it starts with 100,000 shares, then it's 200,000 and then it's 400,000.
“You've put £150,000 in, which is worth £87,500 after three investments. But then if it works, it's off to the races and you have £700,000. The one that doesn’t work goes down to almost nothing”
Many fund managers have said that being willing to admit you are wrong and cut your losses early is a vital part of investing.
For example, Simon Edelsten, co-manager of the Mid Wynd International Investment Trust, said that if a stock falls to your target price even though nothing fundamental has changed, then you should buy in. However, if it has undergone a crisis or there has been a sharp change in the economic environment, you should start your analysis again and work out a new target price.
“The same goes for shares you already hold that may have fallen sharply,” he said. “The knee-jerk reaction is to say: ‘I decided this share was worth holding and now it’s a lot cheaper, so I should buy more.’ Unfortunately, a more hard-nosed view of the situation says: ‘I was wrong to hold these shares at the higher price, so I now need to rework my analysis from scratch.’”
Yet Channon said: “I would like to think the way our framework is set up eliminates psychological bias. Stick to doing the rational thing: you've just bought in, something's gone wrong, but it's gone wrong with the right processes, so you should carry on investing.”
Data from FE Analytics shows the Aurora Investment Trust has made 52% since Channon took charge in January 2016, compared with gains of 62.5% from the FTSE All Share and 36.7% from the IT UK All Companies sector.
Performance of trust vs sector and index under manager
Source: FE Analytics
Since Channon started Phoenix in 1998, it has made a total of 88 investments, of which 78% by number and 88% by value have paid off. This should have equated to a compound return of much higher than the 11.5% achieved by Channon’s Phoenix UK fund (available to professional investors only). The manager put this down to a flaw in his process, one that differentiates him from other Buffett acolytes: a failure to run his winners.
“After the first 10 years, we analysed our record and saw it would have been better to have done nothing than what we did,” he explained. “We could have had nine years off and made 15% compound returns. We made less than that.”
Channon said the problem was his inclination to sell companies when they reached a price that he felt exceeded their intrinsic value. The problem is that great businesses tend to surprise to the upside.
“That means extraordinary managers, and our process underestimated the value of management,” he continued.
“Now we go back to the actual manager and tell them our thought process, because with a couple of the mistakes we made, they would have explained the flaws in our thinking.”
Channon’s process doesn’t always work. He bought HBOS in the credit crunch, saying a reluctance among customers to switch banks meant there wasn’t proper competition, allowing the major players in the sector to maintain a high return on equity.
The manager felt worries about the bank’s mortgage book had opened a buying opportunity, but while he was right about that part of the business, he missed a much bigger problem.
“It's a bit like the magician's trick,” he explained. “We were looking where everybody was looking, at the mortgage book, but we missed the fact that on the corporate side, it had been doing lax lending.
“We could have found that, but we didn't look there. And that book on its own completely destroyed the value of HBOS.”
Channon still owns what is left of HBOS via Lloyds, saying that although he quickly realised he had made a mistake, he still felt the shares were well undervalued, meaning the smart thing to do was to hold on to them.
“I woke up loads of mornings in the credit crunch thinking my life would be so much better if we weren’t in banks,” he added. “But we use that knowledge and make a judgement based about what we expect in the future, and that's why we still have it in the portfolio.”