No college degree. No connection. No formal education in finance or business. Living at a place far from Wall Street. Just one assistant in the office. But still achieved an amazing long-term track record and manages more than $1 billion. No, we are not talking about Walter Schloss.
We are talking about Francis Chou!
Francis Chou does have a lot in common with Walter Schloss, besides no college degree and no connections. They both learned value investing from Ben Graham. Except that Walter Schloss took value investing class directly from Ben Graham, and worked for Ben Graham at his firm. Francis Chou learned investing by just reading Graham’s books.
Francis Chou’s experience is an amazing success story of value investing. He came to Canada in 1976 at age 20 with $200 in his pocket. Without a college degree, he could only work on blue collar jobs. Finally he landed a job at Bell Canada as a telephone repairman. Somehow he was introduced to the books of Benjamin Graham. As written by Warren Buffett in his famous article, The Superinvestors of Graham-and-Doddsville, “It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn't take at all.” The idea apparently took Francis Chou immediately.
In 1981, together with six of his fellow telephone repairmen, Francis Chou started an investment club with $51,000. He left Bell Canada in 1984 and became a retail analyst at GW Asset Management, where he met Prem Watsa, the great future Fairfax CEO. He turned the investment club into Chou Associates Fund in 1986.
The rest is history. If you had invested $10,000 in 1986, when Chou Associate Fund started to operate, that $10,000 would be worth $136,916 as of Dec. 31, 2010. During the 24 years of the fund’s history, he had only five down years. Over the past 15 years, Chou Associate Fund average gained 13.6%, while the S&P 500 gained just 6.8% a year.
When asked about what the most important things are for him in investing, he said: “Buy bargains. Get the returns slowly. Think independently. Don’t be afraid of what other people are saying.”
This is exactly what he has done. In the 1990s, during the height of the tech bubble, Francis Chou wrote to his shareholders that he had “no concrete idea of where to proceed from here.” He said the market at that time was a fool’s game where investors were buying stocks trading at 100 times revenues in the hope of being able to to sell them for 200 times revenues a week later. His fund was down in 1999.
As the stock market made its first crash from 2000 through 2002, Chou Associate Fund gained 71%. By 2006, his fund gained 160% while the broad market just barely broke even from its high at the beginning of 2000. Everything was looking great to investors, and they started to push Dow to new highs. Francis is worried again. He wrote at the beginning of 2007: “We continue to have problems finding compelling bargains in the marketplace. Not only are the P/E ratios and price-to-book values still high, and dividend yields low, relative to historic valuations, the number of companies that are underpriced is at an all time low. We would caution all investors that their chances of a large permanent loss of capital are high if they invest in today’s market leaders at current prices.”
Chou Fund lost 10% in Canadian dollars in 2007 mainly due to the appreciation of Canadian dollar, but was about even with the market. His worst year ever was 2008, as with many other value investors. In Canadian dollars his fund lost 29%, and in US dollars 42.6%. The fund underperformed the S&P 500 by 6.7%.
As with many other value investors, he bought too early and underestimated the magnitude of the financial crisis. But he strongly disagreed with the comments that the financial crisis were caused by market-to-market accounting. He wrote: “The financial mess was caused by misguided policies and actions on the part of some companies and would have occurred regardless of whether this accounting rule was in place or not. As investors, we prefer transparency and clarity and unless these rules exist, companies will not disclose what the assets are currently worth in the market. Obviously, when there are extenuating circumstances like the period we are in now, good and toxic assets may be priced at unduly low prices.”
But now the good news is, this might be the best time to buy stocks, he wrote at the beginning of 2009: “The good news is, if one wants to look at the current situation in a contrarian manner, most of the bad news is already reflected in the stock prices. We don't know whether the stock market has hit bottom yet but we suspect that when we look back at the current environment 10 years from now, we will classify this as one of the best periods for buying stock and debt securities.”
And he did! He bought stocks aggressively and brought the fund’s cash level from more than 34% in December 2007 to just under 5%. His fund gained 51% in 2009, and another 25.5% in 2010.
What is he thinking now? He wrote in his latest shareholder letter: “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.”
GuruFocus had the opportunity to talk to Francis Chou lately. The following discussions are from the combination of his comments during the conversation and his shareholder letters.
As of March 31, 2011, AbitibiBowater is the largest holding for Francis Chou, accounting for almost 16% of the portfolio. But he did not buy the stock. He received his shares from debt conversion. He said that he bought the AbitibiBowater senior debt at 29 to 30 cents on a dollar, which was then converted as a full dollar into the stock.
To him AbitibiBowater is still undervalued. The stock is traded between $19 - $20 and the book value is around $40.
Normally he does not like the business AbitibiBowater is in. But the debt was cheap and the risk was small.
AbitibiBowater is also the largest holding of Prem Watsa. He keeps adding to the position. Prem Watsa received most of his AbitibiBowater shares from the debt conversion, too. Considering the close connection between Prem Watsa and Francis Chou, it is not surprising that they share the same idea.
Francis Chou wrote a detailed piece in his latest shareholder report on how to invest in debt securities. We strongly recommend you to read it.
You will be amazed by his knowledge. How can one believe that he had only a high school education?
Watson Pharmaceuticals Inc. (WPI)
Francis Chou bought Watson Pharmaceuticals Inc. in the fourth quarter of 2007, when many pharmaceutical companies are traded at 7 - 8 times free cash flow. His cost is around $29 a share. The stock is now traded at $69. He has more than doubled his money with this position, and has been selling. He thinks that the stock is now fair valued.
GuruFocus ranks WPI a predictability of 3-star. With this business predictability we are able to estimate its fair value with the DCF Calculator, which does find that the stock price is close to its fair value.
Bank of America Warrants (NYSE:BAC.WS.A)
Instead of investing in Bank of America directly, Francis Chou invests in Bank of America Warrants. He calls this “an interesting way to invest in banks.” The warrants’ expiration date is Jan. 16, 2019, with the strike price of $13.3. He wrote:
One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank's stock at a specific price.
When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.
So, what is so unique about these stock warrants?
1) They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
2) The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don't see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class 'A' warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
3) Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
4) The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
5) Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company's future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.
Francis Chou owns 4.2 million units of the Bank of America Warrants. It is also in the portfolio of hedge fund giant John Paulson. The cost of both of them is above $7 a unit. The recent price decline of Bank of America stock has brought down the warrants to $4.8. This is exactly what he wrote, “Too bad we had to go through so much turmoil to get there.”
Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)
As Berkshire Hathaway stock makes new lows, we asked his opinion on the company. He said: “It is a cheap stock. It will do well if you buy at these prices. You can sleep well with it.”
Francis Chou owns 190 A shares; it is about 5.9% of his portfolio.
At the end of the conversation, GuruFocus asked whether he ever goes out of his circle of competence. He said, “Yes, many times. But every time I was hurt, big time!”
A lesson that all of us should remember.