The following is a summary of Francis Chou’s lecture, given to the Richard Ivey School of Business on August 19th, 2008.
Mr. Chou began his lecture with some pointed questions to the audience. When you go shopping do you look for bargains? And when you find bargains does it make a good purchase and good financial sense? Presumably the majority of the audience raised their hands as Mr. Chou declared them to have the makeup of good investors (I did not attend this lecture in person and the audience was not visible on the video recording). He stated further that if you can take those principles from your everyday shopping experiences and transfer them to the stock market then you are well on your way to being a good investor. You do need to learn accounting however as it is the language of business.
Mr. Chou’s views on the pharmaceutical industry are that it contains good, strong companies with high returns on capital although a negative aspect is that it’s really hard to forecast the pipeline; you never know what new drugs competitors will be coming to market with in the coming years and which will be the blockbusters. To mitigate this risk he bought a basket of companies in the sector. Regarding allocation he says that if you are finding bargains in troubled industries you diversify, but if you are finding bargains in good companies then you concentrate.
The reason he saw the pharmaceutical sector as a good bet was because they were beaten down due to expiring patents. He saw this as a good opportunity to step in and buy a basket as there are sure to be new drugs coming through the pipeline in some of these firms, especially with the amount of R&D spend these companies expense. He foresees holding this basket for upwards of 5 years until there are significant events in the industry to drive the sector higher. He also mentioned that in a scenario like this, when you feel the whole sector has been hit and you want to diversify, an ETF is a good option.
As a side-note, when valuing companies Mr. Chou will never rely just on price-to-earnings as earnings can easily be manipulated. He likes to look at free cash flow multiples as well. And regarding evaluating the quality of management, he says to look at capital allocation over many years, not just one year. Additionally, numbers tell a story so you want to look at the numbers first and then evaluate management qualitatively as well.
The largest take-away for me from this presentation is the value of diversifying in certain industries, even as a value investor. I’ve always learnt that as a value investor you want to select the stock that is undervalued and have conviction in its true value, which mitigates the need for diversification and only risks minimizing your returns if you do. Mr. Chou points out a great example of an industry where you may know there’s value but you also have to realize the limitations inherent in making a selection as you never know which company’s laboratory the next blockbuster drug will come from.
Towards the end of his lecture Mr. Chou said something that I would like to reproduce here verbatim. He said, “If you believe in the value principles and you buy cheap just like you do in your day-to-day life and you think it makes good business sense, just do that in the stock market and you will be successful. The only difference in the stock market is that sometimes it plays on psychology; it plays on your own psychology, on your fears, your greed and sometimes when you buy a stock and it’s cheap it can get even cheaper. If you know what you’re doing and you know you’re buying it cheap and you have that courage to do what is right regardless of what the crowd is doing, there’s no reason why you should not be successful.” He then went on to say, “And that’s what I did, I just stuck to my guns.” A great presentation by a great investor that should give us all the extra bit of conviction we need to stick to ours.
Video: The Ben Graham Centre for Value Investing