Francis Chou is one guru that many investors will never come across. I first learned of Mr. Chou in 2002 at which time he was managing under $20 million. Though his track record even then was outstanding.
His business has grown considerably since then, but he still remains off the radar, which he probably likes. Mr. Chou is a classic value manager, usually running with a portfolio loaded with companies that are out of favor with the market.
Over the last 15 years the Chou Associates fund has had a 13.6% annualized return vs. 6.8% for the S&P 500.
I first learned about Credit Default Swaps reading the 2006 Chou Annual Report. Francis was looking at purchasing what he thought was extraordinarily cheap protection against financial companies. Unfortunately for Chou, unit holders getting approval to buy such securities for a mutual fund was not a fast process and the market turned before Chou could get in.
His words of wisdom, 2010 style, are below:
After unprecedented interventions by governments around the world, the Fund continued to benefit from the recovery of the global equity and fixed income markets that began in March 2009.
Positive contributors to the Fund’s performance were International Coal Group (ICG), King Pharmaceuticals (KG), Watson Pharmaceuticals (WPI), Valeant Pharmaceuticals (VRX), Overstock.com (OSTK), PrimusTelecommunications (PMUG) and debt securities of Abitibi-Consolidated (ABY). Securities that declined the most in 2010 include Media General (MEG), Sears Holdings (SHLD), Sanofi-Aventis (SNY), and debt securities of Level Communications (LVLT).
We believe that equities and debt securities, both investment and non-investment grade, are now close to fully priced.
In equities, we believe the financial, retail and pharmaceutical sectors are undervalued. We favor a basket approach versus concentrating on one or two stocks in those sectors.
Debt Securities Can Be As Volatile As Equities
Many have the misconception that debt securities—whether investment grade or non-investment grade—do not fluctuate as much as equities. The following table shows that is not the case.
Link to table:
As you can see, debt securities, whether investment grade or non-investment grade, can be as volatile as equities. Yet this is where opportunity lies for investors who understand the recovery value of bonds. Namely, bonds can provide a higher margin of safety without sacrificing equity-like returns. However, if your valuations are wrong, the punishment can be as severe as it can be with equities.
In cases where we were uncertain about the investment merits of buying a company’s common shares, we had no hesitation buying its undervalued debt securities if it met our criteria, particularly if the debt security was selling at a price that gave us at least 10% yield to maturity (YTM). This 10% return may not sound like much until you remember that equities, on average, have generated long-term returns of around 8%-9%.
Investing in Debt Securities
In aggregate, over the years, our returns for the family of Chou Funds from investment-grade and non-investment-grade debt securities have been satisfactory.
While the following focuses on our experience with non-investment grade debt securities, it largely applies to investment-grade securities as well.
When we look at what happened in 2008, we learn that a number of investment-grade securities were quickly downgraded to non-investment grade. We also learn that investors cannot rely on rating agencies for guidance, even for investment grade securities. Rather, that investors must do their own due diligence and rely on their own experience and judgment.
Many investors fear touching non-investment-grade debt securities, anticipating that such companies may soon need financing or refinancing. These investors especially fear that troubled companies may not be able to refinance their debt, or if the companies restructure their debts, they risk losing some or all of their investment.
While we agree that investing in non-investment-grade securities can be tricky, we have not shied away from them when we believe their prices provide us with an attractive return and adequate margin of safety. Although we have made our share of mistakes, over the long-term, we have been pleased with our results.
I would like to share with you what has worked for us and the pitfalls we try to avoid.
Before we invest in troubled companies we always ask questions and base our decisions on some of the criteria outlined below. Listing all the criteria is impossible, but these are the main ones we look for:
1) Where does the debt security we are considering rank in the company’s capital structure? And what would the company be worth if it had to liquidate?
We start by setting a desired target rate of return, and then try to buy the most senior security in the capital structure that meets the return target. We know that in a restructuring, it’s a dog-eat-dog world, and senior holders will show no mercy to investors holding lower ranked securities.
Experience proves it is prudent to give up some return by buying senior debt versus taking a chance on more junior securities, even though they have the potential to earn a much higher return.
For example, imagine two scenarios. Scenario one offers the prospect of recovering 50 cents on the dollar for a junior security trading at 25 cents on the dollar. Scenario two offer the possibility of recovering 100 cents on the dollar for a senior security that is trading at 80 cents and that is backed up by 200 cents of collateral. The wise course, in our view, is to invest in the second scenario and not succumb to the temptation of the first, as we believe maximizing the margin of safety on the principal invested is just as important for debt securities as for equity securities.
2) How competent is management?
Assessing the competence of management is as critical when buying debt securities as it is when buying equities. In the financial crisis of 2008, when money was tight, many companies faced liquidity issues. When companies need financing or refinancing, they are in a bind and require strong, competent managers who can run the operation while navigating the restructuring process.
As a result, we seek management teams that are passionate about their work and own enough equity in their company to care deeply about its future. We are not interested in companies with managers who are just doing their job, collecting their salaries, stock options and other perks.
And we are especially averse to CEOs who view their companies as a job for fear they’ll do a job on investors, that is, deliver "just over breakeven" (job) profits. We are always on the look-out for competent CEOs and management teams who think and act like owners. One of the best times to invest in a debt issue is when a company is facing a short-term liquidity issue rather than an operational issue.
3) Is the underlying business strong and able to generate consistent free cash flow?
The economics of a business are important. Ultimately, a company has to repay or restructure its debt. In either scenario, having a strong underlying business that can generate strong cash flow can be vital.
Strong cash flows make it easier for companies to repay or refinance debt, or sell assets at higher valuations. One must beware when buying into an industry with excess capacity, since overcapacity is normally equated with negative or below-average return on capital.
4) What do the bank and bond covenants look like? Is there a cash flow sweep recapture?
In some instances, debt comes with a cash flow sweep, which means that free cash flow left after all the needs of operations have been met can be used to buy back debt at par from debt holders. This cash flow sweep could be monthly, quarterly or yearly. For example, R.H. Donnelly’s bank debt has a quarterly cash flow sweep and is trading at 77 cents. However, every quarter, whatever free cash flow that is left is used to buy back the bank debt at 100 cents.
5) What does the company's balance sheet look like and what is its liquidity position? Will it need to raise additional capital?
It is important to understand the liquidity position of the company and know if it has adequate resources to pay interest on current debts and any debts that may be maturing. If the company has to raise capital to meet its financing and operational needs, oftentimes this capital is very expensive and diluting to existing bondholders.
6) If the company goes through a restructuring, will it cause permanent damage to the business by diminishing the value of the brand or by alienating customers?
If the company decides to restructure, it has implications not only for the company and its employees but also for its customers. It is critical to understand the impact on customers and if they will continue to do business with the company or move to a competitor instead. If it is the latter, it will result in diminished revenues and possibly negative cash flows.
One of our best deals involved Brick Ltd. (BRKQF), a retailer of largely lower-end household furniture, mattresses, appliances and home electronics, which we purchased for the Chou RRSP Fund. We attended a meeting during which an executive succinctly described the reasons for their operational problem thus: "We tried to go to the middle of the road, and the oncoming traffic killed us."
Brick Ltd. had a financing/liquidity issue in 2009, and in May of that year, succeeded in raising $120 million to recapitalize their balance sheet, pay off senior notes and partially repay their Operating Credit Facility. We were already impressed with the company and were further impressed when the founder of the company said he was willing to invest $10 million on the same terms as the other debenture holders. The Debt Unit consisted of $1,000 principal amount 12% senior secured debentures maturing in five years, and 1,000 Class A Trust Unit purchase warrants.
Each warrant entitled the holder to purchase one Class A Trust Unit for a strike price of $1.00, which was very close to the stock’s trading price.
Under the able stewardship of Mr. Bill Gregson, Brick continues to make a remarkable turnaround. A $1,000 investment is now worth $2,925, not counting the 12% coupon that we have been clipping all along.
Uneasiness With the Government Policies
We went through a traumatic financial crisis in 2008 and 2009, and you can argue that under exceptional circumstances, the government can, maybe should, intervene in the economy, as the U.S. Federal Reserve did with massive quantitative easing starting in 2008.
As we all know, governments everywhere have intervened in securities markets for decades by artificially lowering interest rates during declines and artificially supporting prices. That said, I’m always uneasy when this happens, primarily because such interventions skew the markets and make it difficult for investors to determine the soundness of a business and its prospects for future success.
In addition, government intervention puts investors in the dilemma of having to factor in how much quantitative easing the Fed will apply and for how long. For example, when analyzing some of our fixed income investments in 2008, we assumed the Fed would likely continue providing enough liquidity to keep financial institutions afloat. As a result, we bought Wells Fargo 7.7%, 2049, and Goldman Sachs 5.793%, 2043 for the Chou Bond Fund and paid $36.75 and $43.25, respectively.
Interestingly both companies’ debts were rated investment grade. By December 31, 2010, they were trading for $103.75 and $85.35, respectively. We predicated our investment on the Fed providing the liquidity financial companies needed to stay solvent.
It was okay in 2008 when we were facing a one-of-a-kind financial crisis, but continuing with that policy is unwise. We believe it is preferable that the Fed has soundly-based economic and monetary policies rather than have it open the tap at every hint of a slowdown. Let the market do its job!