Francis Chou's Semi-Annual Letter
Dear Unitholders of Chou Associates Fund,
The net asset value ("NAVPU" or "NAV") of a Series A unit of Chou Associates Fund at June 30, 2012 was $74.75 compared to $65.94 at December 31, 2011, an increase of 13.4%, while the S&P 500 Total Return Index returned 9.7% in Canadian dollars. In $US, a Series A unit of Chou Associates Fund returned 13.2% while the S&P 500 Total Return Index returned 9.5%.
The table shows our 1 year, 3 year, 5 year, 10 year and 15 year annual compound rates of return.
Rates of return are historical total returns that include changes in unit prices, and assume the reinvestment of all distributions. These annual compounded returns do not take into account any sales charges, redemption fees, other optional expenses or income taxes that you have to pay and that could reduce these returns. The returns are not guaranteed. The Fund’s past performance does not necessarily indicate future performance. The table is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of the mutual funds or returns on the mutual funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing.
Factors Influencing the First Six Months Results
World markets remained volatile during the first half of 2012 due to the three-year-old-and-counting Eurozone crisis, the slowdown in the Chinese economy and the anemic recovery in the U.S. While a late June rally kept the U.S. economy intact, a slowdown in its previously robust corporate earnings growth, weak economic data at home, waning U.S. manufacturing and international trade activity in and with China, India and other developing countries, added to investors’ concerns. With so much uncertainty, investors have become exceptionally risk averse and drawn to “safe choices”, such as 10-year U.S. Treasury Bonds. Positive contributors to the Fund’s performance were equity securities of Watson Pharmaceuticals, Sears Holdings, Sprint Nextel, The Gap and Class A warrants of Bank of America. Securities that declined the most in the first half of 2012 were equity securities of Overstock.com, RadioShack Corporation and the debt securities of Level 3 Communications.
In equities, we believe the financial and retail sectors are undervalued and have invested in them using a basket approach rather than concentrating on one or two stocks in either sector.
Investing in U.S. Financial Institutions
Following up on a past letter, we continue to believe U.S. financial institutions are very cheap and TARP warrants associated with these companies are an attractive way to invest in them. Depending on the price, TARP warrants have several characteristics that make them appealing long-term investments. Specifically, they are long dated, with most expiring around 2018-2019. This time frame of six-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. In addition, we believe the strike price will be adjusted downward for any quarterly dividend that exceeds a set price. This is rarely seen in a stock warrant. 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.
Bank TARP warrants are complex, with terms and conditions that are unique to each bank. Thus we encourage you to research them for yourself and draw your own conclusions. The legalese is quite intimidating but there is some help on the way. Some banks have started to pay dividends that exceed a set price, and we are starting to see how anti-dilution clauses that were added to protect TARP warrant holders apply with regard to:
1) The adjustment of the strike price.
2) The adjustment to the number of shares you can purchase for each warrant you hold.
It’s been over three years since the European crisis began and we’re still unable to predict what will happen to the Euro and the 17 Eurozone countries that have adopted the Euro as their national currency. While most believe that to solve its problems the Eurozone must undergo deep structural reform, to date no one has devised a solution that all 17 disparate Eurozone nations can agree on. If the ramifications of Euro crisis on the world economy weren’t so serious, we could all get a good laugh at the comical way the Eurozone club was set up and how that has played out. Nigel Farage, leader of the UK Independent Party, captured the humor in a speech he gave in June 2012. “I remember being here ten years ago, hearing the launch of the Lisbon Agenda. We were told that with the Euro, by 2010 we would have full employment and indeed that Europe would be the competitive and dynamic powerhouse of the world. By any objective criteria the Euro has failed, and in fact there is a looming, impending disaster.
You know, this deal makes things worse not better. A hundred billion [Euro] is put up for the Spanish banking system, and 20 per cent of that money has to come from Italy. And under the deal the Italians have to lend to the Spanish banks at 3 per cent but to get that money they have to borrow on the markets at 7 per cent. It's genius isn't it. It really is brilliant.” The problem centers on the fact that by adopting the Euro, countries could control their domestic fiscal policies, but not their monetary policies.
As a result, when the Great Recession struck and countries worldwide faced huge debts, these countries did not have the monetary tools to mitigate their problems. Under this scenario, troubled countries had to rely on other Euro countries for help, many of which had their own fiscal problems, and voters with little sympathy for indebted nations.
Another element that cannot be denied is the cultural diversity of Eurozone nations and their unique attitudes about the role of government and taxation. Whenever I think of the Euro crisis, it reminds me of two strangers travelling on a long distance train in Europe. A Greek man and a German woman who never met before, find themselves on the upper and lower berth of a long distance train.
At 2 am, the Greek man leans over saying, “Madam, sorry to bother you. Would you be kind enough to give me a second blanket from the side table? It's awfully cold.”
“I have a better idea,” she replied. “Just for tonight, why don't we pretend that we are married?”
“Great idea Madam,” he replied with excitement.
“Good,” she says. “THEN GET UP AND GET IT YOURSELF.”
At the end of the day, each country, whether it’s in or out of the Eurozone, has to solve its own problems.
Floating an Investment Idea
When the investors are optimistic of the future, it is hard to find bargains in the market. But introduce some fear and uncertainty and you will find a plethora of bargains. The Eurozone is the perfect environment for finding bargains. For example, there are plenty of Greek companies with fine economics, strong balance sheets and a shareholder friendly management that are selling for less than 4-times after tax normalized earnings. Let’s say that Greece, for one reason or another, leaves the Euro and reverts to the Drachma. If this currency were then devalued by 50%, that stock would then be valued at 8-times after tax normalized earnings, which is still very cheap. The same scenario is starting to play out in Spain and Italy.
Investing in China a Conundrum
We made a mistake investing in Qiao Xing Mobile Communication (QXMCF) for Chou Asia Fund. We were aware of some of the negatives and in the 2011 annual report, we wrote, “The negatives are not as obvious, but deserving of caution. Key among them:
1) The founder and CEO has taken some questionable actions. Since China’s business environment is a bit like the Wild West, it is difficult to find companies and/or management with a totally pristine reputation. Moreover, a lot of businesses, including Qiao Xing’s, are intertwined.
2) Most of the cash is held in China. Cash may not be accurately stated or it cannot be repatriated to North America in an economically efficient manner.
3) Most revenue numbers cannot be verified.
4) Accounting for receipts is not a common practice in China.
5) You cannot verify the company’s numbers even though it retains a well known accounting firm, is listed on NYSE, and thus must adhere to strict compliance and accounting standards.”
Unfortunately, our reservations were proven correct and there is a strong possibility that fraud was committed by the founder and CEO. It is unlikely that we will recover all the money we invested in QXMCF. Essentially, we made an unforced error like they say in tennis, or took an unnecessary penalty that would send us to the penalty box if it were hockey.
Canadian Real Estate
As we said before, of the G8 nations, Canada has performed best since the Great Recession of 2008 and has been widely lauded for its fiscal and economic performance. Its real estate prices have reflected that positive opinion. But therein lies the problem. In most countries, real estate prices
have declined substantially, while in most of Canada, especially in the big cities, prices have actually increased. Based on ratios such as rent-to-house-price, disposable-income-to-house-price, Canadian house prices are out of line with historical standards. In addition, household debt as a percentage of disposable income is unprecedentedly high. This does not mean that real estate prices will decline soon, but it does indicate that valuations are stretched.
A few months ago, Richie Boucher, who is the CEO of Bank of Ireland, was discussing real estate prices in Canada. As we know, real estate prices in Ireland have dropped by 50% from its peak. In contrast, Canada is experiencing a building boom and Toronto is said to have more condominiums under construction than any other city in the world. He joked that he has been hearing that lots of Irish guys are emigrating to Canada to work in real estate construction trade, and cautioned: “Watch out Canada if Irish pubs start sprouting in Canada”.
NAME CHANGE OF THE AUDITORS: As a result of a merger effective March 1, 2012, our auditors Burns Hubley LLP are now known as KPMG LLP.
FOREIGN CURRENCY CONTRACTS: None existed at June 30, 2012.
CREDIT DEFAULT SWAPS: None existed at June 30, 2012.
CONSTANT MATURITY SWAPS: None existed at June 30, 2012.
REDEMPTION FEE: We have a redemption fee of 2% if unitholders redeem their units in less than two years. None of this fee goes to the Fund Manager. It is put back into the Fund for the benefit of the remaining unitholders.
INDEPENDENT REVIEW COMMITTEE: The Manager has established an IRC as required by NI 81-107. The members of the IRC are Sandford Borins, Bruce Kerr and Joe Tortolano. The 2011 IRC Annual Report is available on our website www.choufunds.com.
As of August 17, 2012, the NAV of a Series A unit of the Fund was $77.12 and the cash position was 14.8% of net assets. The Fund is up 17.0% from the beginning of the year. In $US, it is up 20.3%.
Except for the performance numbers of the Chou Associates Fund, this letter contains estimates and opinions of the Fund Manager and is not intended to be a forecast of future events, a guarantee of future returns or investment advice. Any recommendations contained or implied herein may not be suitable for all investors.