April 27, 2020
Dear Unitholders of Chou Associates Fund,
After the distribution of $1.31, the net asset value per unit (“NAVPU”) of a Series A unit of Chou Associates Fund at December 31, 2019 was $103.28 compared to $103.26 at December 31, 2018, an increase of 1.3%; during the same period, the S&P 500 Total Return Index increased 25.2% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund was up 6.5% while the S&P 500 Total Return Index increased 31.5%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.
Factors Influencing the 2019 Results
The equity holdings of Bausch Health Companies, DaVita Inc., Citigroup, JP Morgan Chase, and Goldman Sachs Group Inc. contributed positively to the Fund’s performance during the year.
The main negative contributors to the Fund’s performance in 2019 were the equity holdings of Resolute Forest Products Inc., Spirit Airlines Inc., and Sears Hometown and Outlet Stores.
The Canadian currency appreciated against the US dollar, which also negatively affected the Fund.
During the period, the Fund reduced its holdings of Citigroup Inc., DaVita Inc., JPMorgan Chase, Goldman Sachs Group, Wells Fargo & Company, and MBIA Inc. The Fund also sold the equity holdings of Ascent Capital Group Inc., Sanofi, Sears Holdings Corporation, and Sears Hometown and Outlet Stores.
There were no new investments added to the Fund in 2019, and the Fund did not write any new covered call options in 2019.
Portfolio Commentary
The Impacts of COVID-19
COVID-19 reminds me of a story going back to the 1919 Stanley Cup Finals between the Montreal Canadiens and the Seattle Metropolitans. Six months before the finals, the Spanish flu had been raging across North America and Europe. At the time, the finals were a best-of-five series and after five games, each team had won two games and one game was tied. To decide the winner, a sixth game had to be played. The problem was that four of the top hockey players for the Canadiens were stricken with the Spanish flu and couldn’t play. The Canadiens did not have enough players to field a team, so they decided to forfeit the sixth game to the Metropolitans. But instead of accepting victory, Seattle rejected the noble gesture, saying they could not take the Stanley Cup because of the circumstances affecting the Montreal Canadiens. That is what we call “sportsmanship” of the highest order. Thirty years later, the NHL declared both Montreal and Seattle as the joint winners of the 1919 Stanley Cup.
In a similar vein, you can see that with COVID-19, health care workers, citizens, pharmaceutical companies and other constituents are working together to get the virus under control, with no one acting as the big hero or taking undue credit.
COVID-19 is a new disease and humans, as we know, have no immunity to it. However, the actions of almost all the governments in the world have caused severe economic disruptions. Every industry has been affected to some extent – some worse than others. The stock market reacted accordingly. As one pundit opined: the stock market of 2020 is worse than a divorce – you lose 50% of your assets and you still have to quarantine with your spouse for 14 days.
Eventually, the dust will settle and the economy will get back to normal. Our aim is to buy securities that have been beaten up more than others. Some stocks are down 5%, while others are down 80%. Provided the intrinsic value is the same, the chance and extent of a rebound are higher for securities that are more beaten down. For example, if a stock is worth $100 and it drops to $50, you have lost 50% of your investment. However, for $50 to go back to $100, you need to make a 100% return. The table below gives you an idea of how much you need to gain to get $100 from the percentage drop you experienced.
Financials – Banks and Insurance
Banks – In general, we do not think that the intrinsic values of the banks have depreciated much in the long-term. In the short-term, the revenues and net interest margins may take a hit due to low interest rates (close to zero), and defaults on bad loans will likely increase under the current anemic economic conditions. However, we think the loose monetary policy of today with its excessive printing of money will benefit the banks in the long-term, since banks are always the first beneficiary of easy money. Having endured the annual stress tests, banks are also in much better financial shape than they were during the Great Recession of 2008.
Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) – We believe it is the best run company in the world. They have great operating companies that generate huge amounts of cash relative to the capital deployed. When they cannot deploy them at an acceptable rate of return, they give it to Warren Buffett (Trades, Portfolio) to redeploy them in the purchase of new companies or the stocks of excellent companies at a reasonable price. This is a type of company that executives should study carefully. Instead they are given all kinds of cookie cutter type examples in business schools. Berkshire Hathaway has been operating since 1965 under Buffett and it is not a one-day wonder.
Berkshire Hathaway has grown to as much as 32% of the Fund’s net assets over the years due to significant capital appreciation. We are quite happy to hold them for the long-term, but the overconcentration of securities over 10% of the Fund can be frowned upon by regulators. As a result, we have reduced the Fund’s position of Berkshire Hathaway in early 2020. Some of the replacements may be stocks as well as fixed-income instruments.
Airlines
We believe the airlines will survive over the long-term, but it may take a year or two before revenues return to what they were in 2019. We believe the intrinsic values of airline stocks have been worsened by roughly 30%, but the stock prices have dived by more than 50%. Our holding, Spirit Airlines (SAVE, Financial), is among one of the best in the industry. If the airline industry does recover, we believe there would be a relatively quick recovery for Spirit Airlines, with their low-cost structure and strong balance sheet.
Nevertheless, there are still lots of uncertainties in evaluating the airline stocks right now. One big unknown is the amount of government bailout for airlines and the terms that come with it. Thus, we do not know the cost and the amount of equity dilution that shareholders may have to take on the chin. We live in a country with free enterprise, and the intrinsic value of companies should be dictated by economic fundamentals of the business in principal. However, here we are looking at Washington with our bowl in hand to determine what the business could be worth. It is just an asinine way to evaluate a business. Another way of looking at it is to push back what we thought the intrinsic value was going to be in 2023 by two or three years and then discount the value from there.
EXCO Resources (“EXCO”)
On January 15, 2018, EXCO (EXCE, Financial) filed voluntary petitions for a court-supervised reorganization under Chapter 11 of the U.S. Bankruptcy Code to facilitate a restructuring of its balance sheet, which was saddled with expensive transportation and other contracts. On November 5, 2018, EXCO filed a restructuring plan, stating that holders of the 1.75 lien term loans would receive 82% of the new common stock of the company, subject to dilution by a management incentive plan. However, this plan did not come to fruition due to the company’s inability to raise enough capital and an amended plan of reorganization was offered to the creditors on April 10, 2019.
Based on the valuation analysis by EXCO’s investment banking firm, PJT Partners Inc., under the amended plan, the 1.75 lien term loan holders would receive 38.8% of the new common shares, resulting in a recovery of 27 cents on the dollar or 27% (given the total principal outstanding for the 1.75 lien term loans was US$742.2 million).
In early July of 2019, the company emerged from bankruptcy and the 1.75 lien term loans were converted into 28.38 equity shares for every $1,000 in par value, after netting out certain adjustments. We received 1,518,570 shares of EXCO in the Fund.
Looking back on this investment, we underestimated how long the price of natural gas would stay low for, and how low it has been relative to the price of oil. Historically, there had been a strong relationship between the prices of oil and natural gas. Thinking about the two fuels in terms of energy equivalency, 6,000 cubic feet (6 mcf) of natural gas has the same amount of energy content as 1 barrel of oil. In the past, this 6 to 1 ratio guided the relationship between oil and natural gas prices, but for the last few years the ratio between prices had gone up to as high as 50 to 1.
In practical terms, there are always frictional costs and time needed to convert from oil to natural gas. In a free enterprise society, businesses are always adapting and they are looking for the most cost-effective way of running a business. This includes individuals too. We have seen how solar energy and electric cars have replaced a portion of fossil fuels for their energy consumption. In time, if the ratio of oil to natural gas prices is in excess of 10 to 1, there will be new efforts to use more natural gas at the expense of oil and the historical equilibrium will be restored. The historical ratio of 6 to 1 can be stretched to maybe 10 to 1, but 50 to 1 is asking too much.
Lo and behold, most investors felt that the ratio of 6 to 1 was totally broken. There was a new paradigm of 30 to 1. But on April 20th the price of oil fell into negative territory. You had to pay someone to take the barrel of oil from you. Unbelievable! The ratio had dropped below 6:1 to 0:1, albeit temporarily.
The crash of the oil sector has made us quite bullish on the natural gas sector. So much irresponsible money had been poured into the oil sector which indirectly impacted the natural gas industry. When you drill for oil, the by-product you get is natural gas. The excess production of shale gas through fracking is one of the main reasons why natural gas prices have stayed at such a low price for so many years. With capital withdrawn from the oil industry, distressed oil and gas producers will cease production and the excessive supply will shrink over time.
On the demand side, another market that is opening up for natural gas is Asia, which could be an important export market of U.S. natural gas in the form of liquefied natural gas (LNG). The price of natural gas can compete directly with the price of coal and natural gas has much lower environmental impacts compared to coal. China, S. Korea, Japan and Taiwan are shuttering coal plants and replacing them with natural gas plants. In time, we believe LNG prices will rise as demand for it rises exponentially. Since EXCO is mainly a natural gas producer, we remain optimistic about its future over the long run. Compared to its peers, the company is also better positioned given its post-bankruptcy cost structure.
We are also looking to buy more bonds in oil and gas companies whose prices have been severely beaten down due to the recent oil price war between Russia and Saudi Arabia.
Resolute Forest Products (“RFP”)
As of December 31, 2019, the market price of Resolute Forest Products (RFP, Financial) was US$4.20 per share, down 47% from the price at year end 2018.
RFP has been a huge disappointment since our initial purchase some eight years ago. It shows how tough it is to turn around a troubled company despite the best efforts of management.
Having said that, it is quite comical to experience how a commodity stock can be hammered beyond all logical comprehension. RFP paid a special dividend of US$1.50 a share in 2018, and it is trading at US$1.17 per share in April 2020. Two months ago, the company announced that it would buy back 15% of its common shares for US$100 million. At the current price of US$1.17, the market capitalization is US$99 million. In other words, instead of buying back 15% of the company with US$100 million, it can now buy back 100% of the company.
In general, our experience with a commodity business that has virtually no pricing power is to be cautious when management talks about investing in new equipment or upgrades that would significantly lower the cost structure compared to its competitors. That may be true for six months to a couple of years, but in time, competitors will have a new cost structure that is as competitive if not superior to the company. It is the same treadmill where hardly anyone in the industry can make a decent return on the assets invested in the company. The same story can be seen repeatedly in various commoditized industries. There is no sustainable long-term advantage in a mediocre business with no pricing power. It is important not to get seduced by discount to book value. If the company cannot generate a decent return on book value over a long period of time, that book value is not worth much.
Does Value Investing Work?
With the lackluster returns by value funds in recent years compared to growth and index funds, there is some doubt as to whether value investing can still work in the current market. We hold the view that value investing certainly works, but only when executed properly.
Sometimes it is easier to blame the market environment than to admit our own faults. Although factors such as low interest rates, the popularity of passive investing and elevated market valuations played a role in blunting returns for value investors, we also accentuated the problem. The key to value investing is appraisal. If that is not precise enough, everything falls apart. We tend to fish in troubled waters, and what caused the biggest problem in recent years was that our appraisal of troubled companies was off the mark.
When we thought a company was worth 100 cents, it was actually worth closer to 60 cents. We tended to give much higher weight to asset values and not enough weight to the value of the operating company. We used the asset value as a huge security blanket and became blind to the deterioration of the worth of the operating company. A case in point is Sears Holdings. We were correct that the real estate plus the value of brand names would afford some cushion against losses. However, we were inaccurate in our assumption that Eddie Lampert would maximize returns for shareholders based on the real estate assets, and the value of the retail company Sears had at the time of purchase. Instead, he tried to reinvent the company, suffered huge losses along the way and almost completely eroded the value of the considerable real estate assets that Sears held. Although the value of downside protection is important, most of the returns from an investment comes from the increase in the intrinsic value of the company, or the closing of the gap between the discounted purchase price to the full intrinsic value. When neither of the two happens, then investors would like to see the assets and the brand names divested or sold, sooner rather than later, for the benefit of shareholders.
We can proudly say that in Sears we lost an insignificant amount of money on a simple dollar basis (as one Republican suggested, it should be classified as “Trump change”). However, we did lose a tremendous amount of money in opportunity cost over that 10-year period. Trump change or not, it was still an unforced error.
That was a mistake of commission. We also made a bundle of mistakes of omission.
Over the last 30 years, roughly half our portfolio was in troubled companies and the other half was in good companies. So, we are well acquainted with investing in both types of companies. But what happened over the last few years was that we spent most of the time undervaluing the good companies. When our assessment showed that the investments were worth 100 cents, they were more accurately close to 150 cents, thus causing us to miss most of those opportunities. These “omissions”, though they are unseen mistakes, are nevertheless as real as mistakes of commission.
In summary, although the markets have been less kind to value investing, we exacerbated the problem as practitioners.
Caution to the Investors
Investors should be advised that we run a highly focused portfolio, frequently just three to five 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 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. The Fund did not have any excess cash as at December 31, 2019.
Other Matters
FOREIGN CURRENCY CONTRACTS: None existed at December 31, 2019.
CREDIT DEFAULT SWAPS: None existed at December 31, 2019.
U.S. DOLLAR VALUATION: Any investor who wishes to purchase the Chou Funds in U.S. dollars may do so.
REDEMPTION FEE: We have a redemption fee of 2% if unitholders redeem their units in less than 3 months. 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, Peter Gregoire and Joe Tortolano. The 2019 IRC Annual Report is available on our website www.choufunds.com.
As of April 27, 2020, the NAVPU of a Series A unit of the Fund was $79.24 and the cash position was approximately 10.7% of net assets. The Fund is down 23.3% from the beginning of the year. In U.S. dollars, it is down 29.0%.
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.
Yours truly,
Francis Chou (Trades, Portfolio)
Fund Manager
