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Dear Shareholder,
For the year of 2016, the Chou Opportunity Fund (the “Fund”) was down 5.02%, while the S&P 500 Total Return Index generated a return of 11.96% during the same period. The Fund’s prior performance is not necessarily indicative of how the Fund will perform in the future.
Portfolio Commentary
In 2016, the largest positive contributors to the Fund’s performance included the EXCO Resources (XCO, Financial) second lien term loan 12.5%, maturing in 2020, as well as the Bank of America and JP Morgan Chase TARP warrants.
Primary losses came from Fund investments in Valeant Pharmaceuticals, Sears Holdings and Resolute Forest Products.
The Fund initiated a position in Valeant Pharmaceuticals in the first half of 2016.
All shares of the equity holdings of Asta Funding Inc. were sold during the first half of 2016 for a minor gain.
U.S. Bank TARP Warrants
Overall, investments in the TARP warrants of Bank of America (BAC, Financial), Wells Fargo (WFC, Financial) and JPMorgan Chase (JPM, Financial) performed well in 2016, as reflected by the increases in prices of each position shown in the following table.
In the letter for the 2011 annual report, we outlined our thesis as to why we believed that these warrants were attractive long-term investments. We wrote:
“So, what is so unique about these stock warrants? We have considered the following characteristics:
- They are long dated, with most expiring in 2018 or 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.
- The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, this is not seen 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.
- 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.”
Since the price of the TARP warrants is contingent on the stock price of the bank, it was important that we held a view that the banks in general were undervalued. This is what we said about the banks in the 2011 annual report:
- “It has been five years since the financial crisis began in 2007. As each year has gone by, the quality of earnings of the banks has gotten higher, the books have become cleaner, the risks have become lower, and bank management has become far more risk averse. It is too bad that we had to go through so much turmoil to get there.
- The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
- Interest rates will continue to be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at, is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made is quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
- Bank valuations that were below 10 times earnings six months ago have decreased even further, with many bank stocks selling below book and some selling at big discounts to tangible book value.
- 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.
Our investing horizon is long-term – six years or more remain for these bank warrants. Over that period, we believe that the odds are it will work out to be a decent investment, perhaps even more so for the better-capitalized banks. We view it as the glass being more than half full rather than half empty. The bank TARP warrants are complex, with terms and conditions that are unique to each bank, and we encourage you to research them for yourself and draw your own conclusions.”
We are now in the year 2017 and the maturity date for the TARP warrants is less than 3 years from now. As the time element gets shorter, we believe that the warrant is likely to become more speculative by nature and therefore we expect to reduce or eliminate the positions in the various TARP warrants. If we believe that the banks in question may still be undervalued, then we would be more likely to invest in the common stock of the banks. Although, it is important to note that any future decision to sell the warrants or buy the common stock will be based upon our view of the markets as well as the issuers that exist at the time when we make any such investment decision.
EXCO Resources
In 2015, we initiated the position in EXCO Resources second-lien term loan 12.5%, maturing in 2020. This term loan did quite well in 2016, rising in price from 55.8 cents on a dollar at December 31, 2015 to 72.9 cents on a dollar at December 31, 2016, an increase of 30.7% excluding interests received.
EXCO Resources is an independent oil and natural gas company that engages in the acquisition, exploration, development and production of onshore oil and natural gas properties with a focus on shale resource plays in the United States.
We liked this security because it met our criteria for investing in the Oil & Gas sector. The criteria that we considered in analyzing this type of investment is that the security should be:
1.A first or second lien loan or note;
2.Issued by a company with a significantly limited ability to add senior or pari-passu debt to its capital structure; and
3.Of a type that if the company restructures or goes into bankruptcy, the recovery value of the bond is likely to be greater than the current price of the bond.
As of December 31, 2016, the Fund owned about $19 million worth of EXCO’s second-lien term loan ($26 million in par value). This is the largest position in the portfolio, comprising more than 20% of the assets of the Fund (at market value). In addition to the security being very senior in the capital structure, we also hold the view that management seems to be making good decisions with respect to the allocation of capital in a tough environment.
Valeant Pharmaceuticals
At the current price, Valeant (VRX, Financial) stock is not a mouth-watering bargain at less than 3 times earnings or less than 2 times free cash flow because it carries around $30 billion of debt, but it is still relatively cheap. If Valeant can reduce its debt by as much as $8 billion as stated by management, through a combination of organic earnings and the sale of non-core assets, it will remove the feeling that the company is standing on the edge of a precipice.
A large debt means that any small misstep or missed guidance could result in bankruptcy. If the company’s debt is reduced, it will then be valued based on the free cash flow generated from operations. In addition, Valeant is also undergoing criminal investigations over its ties with Philidor. However, we believe the impact of these litigations is likely to be rather limited given that it pertains to only 5% of its revenue. Although, we do emphasize that it is difficult to accurately predict the outcome or impact of any lawsuit.
In conclusion:
- Valeant could return to trading at the normal multiples if its debt is significantly reduced and the impact and costs of litigations are determined.
- The company appears to have good cash flow characteristics, resulting from solid portfolio pipelines.
- While we believe Valeant is cheap, the undervaluation is not as deep as it first appears. One must look at return on a fully capitalized basis to get the full picture. Based on the information we now have, the initial price we paid was on the high side but we believe that the intrinsic value is higher than the average cost we have paid for Valeant.
Sears Holdings
In July 2015, Sears Holdings Corporation (SHLD, Financial) announced that it closed its rights offering and sale leaseback transactions with Seritage Growth Properties ("Seritage"), a newly formed, independent, and publicly traded real estate investment trust ("REIT").
In the transaction, Sears sold 235 Sears- and Kmart-branded stores to Seritage, along with Sears’ 50 percent interests in joint ventures with each of Simon Property Group, Inc., General Growth Properties, Inc. and The Macerich Company. The three entities combined hold an additional 31 Sears Holdings properties. Based on our rough estimate, this represented less than 25% of the company’s real estate assets and Sears Holdings received aggregate gross proceeds from the transaction of $2.7 billion.
However, from our perspective, the most important thing that has happened is that Seritage is now a public company and when its stock trades daily, we have a more reliable way of assessing the real estate value in SHLD indirectly. We also know that pre-Seritage and post-Seritage, the profile and the quality of the properties that is held in Seritage and SHLD is roughly the same.
Considering SHLD’s brand collections and what we believe to be the value of the SHLD real estate portfolio (based in part upon our analysis of the Seritage valuation over the reporting period), it may appear that at the year -end price of $9.29 for Sears (about $994 million in market capitalization), the company is severely underpriced. However, given the company’s net debt of approximately $4 billion, pension deficit of about $2 billion, and the enormous losses it has taken to date to transform its business from a brick and mortar business to an asset-light business, we believe that the intrinsic value of SHLD may have been severely eroded (notwithstanding its real estate and brand portfolio). It is hard to evaluate what kind of value you can assign to company’s “Shop Your Way” program even though management has poured billions of dollars into it. From management’s perspective, they can argue that “Shop Your Way” could be worth more than the capital invested. However, unless it generates significant amounts of cash or cash earnings relative to the capital invested, it is doubtful if it could be worth anything. It is hard to foresee why investors will give a similar valuation of Amazon.com to “Shop Your Way” even though Sears’ membership program has some characteristics similar to Amazon Prime. In conclusion, even if you take the best case scenario and “Shop Your Way” turns out to be profitable, it could be a Pyrrhic victory.
In hindsight, our initial assessment of Sears being worth more than $50 per share a few years ago was most likely too optimistic. This is taking into consideration that we received roughly $13 per share in distribution from various spin-offs and later receiving proceeds from selling them into the stock markets. Nevertheless, we believe that the stock may still be cheap at the current valuation, albeit not at the level that we initially anticipated.
Resolute Forest Products
Resolute Forest Products (RFP, Financial) is primarily involved in Newsprints, Specialty Papers, Wood Products and Market Pulp. As the downturn in global commodities intensified, RFP was not spared as all four of the company's business segments got hit. Management has concentrated on lowering the cost of every segment but these actions were not enough to compensate for the deterioration of prices in their respective markets.
At year-end 2016, the market price of RFP was at $5.35 per share. At $5.35 per share, the market capitalization of the company is roughly $480 million dollars. As we have explained in the past, the company continues to have consolidated sales of close to $3.6 billion and in each of its major business segments, it is a global leader. It continues to be the biggest volume producer of wood products east of the Rockies, the third largest in North America for Market Pulp, the number one producer of newsprint in the world and the largest producer in North America of uncoated mechanical paper and an emerging tissue producer. With the exception of the Wood Products segment, which continues to have revenues of approximately $500 million, the other three segments each continue to have revenues of approximately $1 billion. We believe that each of the 4 business segments could fetch at least $400 million in a normal market, and as a result, RFP may be undervalued.
Goodwill
For the 2015 annual report, this is what we wrote:
“We have not done as well as the market for a couple of years and we wanted to take this opportunity to address that:
1)We could explain that we have been managing money for than 30 years and explain that there will always be times where we are going to underperform for a period of time.
2)We could point that in 2004, we won the Morningstar Manager of the Decade award in Canada.
3)We could write a lengthy tome of more than 100 pages on each of our significant holdings with the goal of demonstrating convincingly why we believe that they are so cheap and why we believe that the market is so wrong.
4)We could write about why we believe that our sound investment principles and a commitment to integrity and being fair to our investors should translate into better results over the long term business cycle.
But at the end of the day, when all is said and done, the reality is that we have not done well in the recent past and, particularly, in the previous year. So, as a gesture of goodwill and what we believe to be the fairest way to behave, we made a voluntary capital contribution of $918,468 which approximates to the 2015 management fees that we were paid by Chou Opportunity Fund. We have also decided to voluntarily waive the fee going forward for the calendar year 2016.”
Since doing a good deed feels good, we have decided to waive the fee going forward for the calendar year 2017. Caution to the Investors
Investors should be advised that we run a highly focused portfolio, frequently just two or three securities may comprise close to 50% of the assets of the Fund. In addition, the Fund has securities that are non-U.S. and could be subjected to geopolitical risks, which may trump or at least negatively influence the financial performance of the company. Also, we may enter into some derivative contracts, such as credit default swaps and interest rate swaps, when we feel that the market conditions are right to use those instruments. Because of any or all of these factors, the net asset value of the Fund can be from time to time more volatile than at other times. However, we are not bothered by this volatility because our focus has always been, and continues to be, on how inexpensive we believe the Fund’s portfolio holdings are relative to what we believe to be their intrinsic value.
Also, the Fund’s cash position was approximately 20% of net assets as at December 31, 2016. This large cash position may depress returns for a while as we hunt for undervalued securities. Obviously, if there is a severe correction in the market in the near future, it will cushion the Fund against losses while providing us with the wherewithal to find good investment opportunities. But for now it could be a drag on returns.
Yours truly,
Francis Chou (Trades, Portfolio)
Portfolio Manager and CEO
Chou America Management Inc.
The investment and portfolio performance views in this report were those of Portfolio Manager as of December 31, 2016, and may not reflect his views on the date this report is first published or anytime thereafter. The views are intended to assist the shareholders of the Fund in understanding their investments in the Fund and do not constitute investment advice. This letter may contain discussions about certain investments held and not held in the portfolio. All current and future holdings are subject to risk and to change. There can be no guarantee of success with any technique, strategy or investment.
This letter contains discussions about voluntary fee waivers and voluntary capital contributions of Chou America Management Inc., the investment adviser to the Opportunity Fund (the “Adviser”), with respect to fund operations during or following the year ending December 31, 2016. Any such voluntary arrangement can be modified, terminated, or discontinued by the Adviser at any time; provided that the amount of any such waiver or capital contribution may not be recouped by the Adviser at a later date. The Adviser is under no obligation to make a voluntary fee waiver or voluntary capital contribution in the future for any reason. The Adviser made its decision to implement both the voluntary waiver in, and the voluntary capital contribution to, the Opportunity Fund subsequent to, and independent of, the decision of the Board of Trustees to the Trust to renew the Investment Advisory Agreement, as discussed in this report.
The S&P 500 is an unmanaged index representing the average performance of 500 widely held, publicly traded, large capitalization stocks. One cannot invest directly in an index.
