Dear Unitholders of Chou RRSP Fund (Trades, Portfolio),
The net asset value per unit (âNAVPUâ) of a Series A unit of Chou RRSP Fund (Trades, Portfolio) at December 31, 2014 was $35.33 compared to $30.94 at December 31, 2013, an increase of 14.2%; during the same period, the S&P/TSX Total Return Index increased 10.6% in Canadian dollars. In $U.S., a Series A unit of Chou RRSP Fund (Trades, Portfolio) was up 4.6% while the S&P/TSX Total Return Index returned 1.2%.
The table shows our 1-year, 3-year, 5-year, 10-year and 15-year annual compound rates of return.
Factors Influencing the 2014 Results
The weakness of the Canadian dollar against the U.S. dollar had a large positive impact on the results of the Fund. The difference in performance results between the NAVPU priced in Canadian dollars, versus U.S. dollars, is attributable to the fact that on December 31, 2013, one U.S. dollar was worth approximately $1.06 Canadian, whereas one year later, on December 31, 2014, one U.S. dollar was worth approximately $1.16 Canadian.
Torstar Corporation (TSX:TS.B), Interfor Corporation (TSX:IFP), Resolute Forest Products (TSX:RFP), Ridley Inc. (TSX:RCL), Blackberry (TSX:BB) and Canfor Pulp Products (TSX:CFX) were major positive contributors to the Fundâs performance.
The largest equity decliners for the year ended December 31, 2014 were TVA Group Inc. (TSX:TVA.B), Danier Leather Inc. (TSX:DL) and Overstock.com Ltd (OSTK).
During 2014, the Fund increased its holdings of Reitmans Canada (TSX:RET). MEGA Brands Inc. (TSX:MB) was acquired through a wholly-owned subsidiary of Mattel, Inc. (MAT) in April 2014 and the Fund received $17.75 per common share International Forest Products Limited changed its name to Interfor Corporation (TSX:IFP), and Clublink Enterprises Limited changed its name to TWC Enterprises Ltd (TSX:TWC).
A Tale of two Scenarios
I have been managing money since 1981 and one of the benefits of managing money for so long is that you get exposed to many financial and economic scenarios.
When I was thinking about the current market, I couldnât help but recall what happened over the fifteen year period 1966 to 1981. The Dow Jones Industrial Average, hit a high of approximately 1000 in 1966 and for the next fifteen years it would approach that level only to recede back again. Inflation, which was subdued in the 1960s, started to go up in the 1970s, the result of printing money in the 1960s to finance the war in Vietnam.
By 1980, the combination of high inflation and low GDP growth was the story of the day. Economists coined the term âStagflationâ. When Paul Volcker was named Chairman of the Federal Reserve Board (Fed) in 1978, his first mandate was to tame inflation. By June 1981, the federal funds rate rose to 20%. Eventually in June 1982, a highly important economic measure â the prime interest rate, reached 21.5%. The 30-year bond hit a high of 15.2% yield when he put the brakes on money printing. The Dow tumbled, selling at a severe discount to the book value of the Dow.
At that time, I was wondering how much lower the market could go. This was how I looked at the scenario; the interest rate was so high that I felt it could not remain at that level for any extended period of time without just killing the economy. Volckerâs mandate was to break the back of inflation, and when he did that, interest rates were bound to go lower. Even if they didnât, the market was incredibly cheap: approximately 6 times earnings and roughly 6% dividend yield. The Dow had been earning for a long time, on average, 13% on its equity and there was nothing to suggest that it was not going to earn the same in the future.
If interest rates went down, the end result would be that the companies would be worth a lot more. The discount rate that you use to discount future earning power is somewhat linked to the prevailing long term interest rate. When companies borrow money, the rate they pay, depending on their credit rating, is benchmarked to the prevailing interest rate plus or minus a few points.
The climate for investing in 1980 was one of extreme fear. For example, pension funds, as a group, invested only 9% of net investable assets in equities. In contrast, in 1971, 122% of net funds available were purchased into equities; in other words, they sold bonds, to buy more of the equities. Those who wanted to get into the investment field in the late 1970s and early 1980s were considered pariahs at the time, and were to be avoided at all social gatherings as one who would avoid the plague.
At that time I was getting totally immersed in the works of Benjamin Graham. I was hunting for every scrap piece of information I could find in the library on Benjamin Graham and Warren Buffett (Trades, Portfolio). Although I was new to the investment scene then, the scenario had the smell of sure success for any value investor. Not just a success but something that would enable you to cook up a grand career.
This is what I wrote in 1982, my first annual letter to my Unitholders:
"Is this the time to invest? Yes, definitely. Stocks, in this doom and gloom environment, are cheap by every historical standard...What I would propose in the future, if the market is more demoralized than what it is now, is that we should open this Fund to the public. There is no better time to invest aggressively. Stocks are selling at a substantial discount from book value and even during the Great Depression, the Dow Jones Industrial Average did not trade below book value for more than a few months... Companies in the United States are selling at give away prices."
The current scenario is totally the opposite. Some of the questions that bother me now are opposite to what was bothering me in 1981.
1) How low can interest rates go? In Europe, some sovereign bonds are trading at negative yields.
2) The Great Recession occurred in 2008, and now it is 2015 - that is seven long years. Although the recovery has been anemic, at least itâs recovering.
3) The velocity of money for M2 is at an all-time low. This can be further highlighted if we hypothesize about what would happen if M2 moved back up to the historical average. If a regression to the mean were to occurâthe price levels could be 25% higher than what it is today. Carrying this logic one step further, with the current levels of money-printing growing at approximately 7.2% annualized, this could see a potential price level increase of 50%, if the velocity of money were to move back up to the historical average.
No one can predict the future with any high degree of certainty, but you wonder, if the current policies continue for any extended period of time, when will the chickens come home to roost?
4) Deflationary forces are strong now; eventually, the supply and demand will bring everything in to equilibrium as they work through their economic cycles, but you cannot âun-printâ money.
5) Stock prices are close to an all time high if measured by price to earnings ratio, premium to book value or current dividend yield.
6) Junk bonds, the biggest beneficiary of easy money, should be trading at 70, not at 100 cents on a dollar with a 5.5% coupon rate.
7) What happens to the bond and stock markets if interest rates start to rise? In Europe some sovereign bonds are selling at negative yields.
In 1981, I felt the economic conditions were such that you were set up for a huge success. You just needed the courage to load up the truck and buy everything in sight. By contrast, current conditions make me feel that investors are being set up for a heartbreaking disappointment, especially for the unwary.
Canadian Real Estate
We continue to worry about Canadian real estate. As we have said before, Canada has performed best of the G8 nations 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.
If the price of real estate goes down in Canada, it will negatively impact the natural resources industry. We have avoided this industry for the last 20 years. One area that has piqued our interest is the oil and gas industry. We continue to monitor them with great interest.
We are starting to look at credit default swaps (CDS)
One way of assessing investors' appetite for risk is to check the prices of credit default swaps (CDS). In CDS, one party sells credit protection and the other party buys credit protection. Put another way, one party is selling insurance and the counterparty is buying insurance against the default of a specific third partyâs debt. If the protection buyer does not own debt issued by the third party, then CDS are more appropriately viewed as an investment transaction, rather than a hedging transaction, for the protection buyer notwithstanding the insurance-like features of a CDS. In most CDS, the protection buyer makes the premium payments over the life of the CDS, frequently on a quarterly basis.
We believe that CDS are starting to sell at prices that are becoming interesting. At recent prices, they appear to offer one of the potentially cheapest forms of insurance against market disruptions. We are continuing to monitor CDS prices and may potentially invest in CDS in the future. We are looking at who deals in such investments and we want to examine carefully what counterparty risk we may be exposed to. The mechanics of investing in CDS have changed somewhat from six years ago.
To make money in CDS, you donât need a default of the third partyâs debt. A dislocation in the economy or deterioration in the credit profile of the issuer may cause the CDS price to rise from these low levels. The negative aspect is that, like insurance, the premium paid for the protection erodes over time and may expire worthless. There is no guarantee that the Manager will make money for the Fund on any particular CDS or correctly predict an increase of value in any particular CDS.
Other Matters
INDEPENDENT REVIEW COMMITTEE: The Manager has established an IRC as required by NI 81-107. The members of the IRC are Sandford Borins, Peter Gregoire and Joe Tortolano. The 2014 IRC Annual Report is available on our website www.choufunds.com.
As of March 16, 2015, the NAVPU of a Series A unit of the Fund was $34.46 and the cash position was approximately 22.1% of net assets. The Fund is down 2.5% from the beginning of the year. In $U.S., it is down 11.3%. While 2015 is off to a slightly negative start, please do not extrapolate these returns into the future.
Except for the performance numbers of the Chou RRSP Fund (Trades, Portfolio), 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.
Yours truly,
Francis Chou (Trades, Portfolio)
Fund Manager
