August 25, 2020
Dear Unitholders of Chou Associates Fund,
The net asset value per unit ("NAVPU") of a Series A unit of Chou Associates Fund at June 30, 2020 was $73.09 compared to $103.28 at December 31, 2019, a decrease of 29.2%; during the same period, the S&P 500 Total Return Index increased 1.7% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund decreased by 32.3% while the S&P 500 Total Return Index decreased 3.1%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.
| June 30, 2020 (Series A) | 1 Year | 3 Years | 5 Years | 10 Years | 15 Years | 20 Years | |
| Chou Associates Fund ($CAN) | (26.3%) | (12.7%) | (8.7%) | 1.7% | 1.6% | 4.9% | |
| S&P 500 | ($CAN) | 11.8% | 12.5% | 12.7% | 16.8% | 9.6% | 5.5% |
| Chou Associates Fund ($US)1 | (28.9%) | (14.0%) | (10.2%) | (0.8%) | 0.9% | 5.3% | |
| S&P 500 | ($US) | 7.5% | 10.7% | 10.7% | 14.0% | 8.8% | 5.9% |
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-Month Results
The largest decliners in the period were the equity holdings of Wells Fargo & Company, Resolute Forest Products, Bausch Health, Citigroup, and EXCO Resources.
The increase in prices of DaVita shares and Overstock preferred shares helped to offset some of the losses. The Canadian currency depreciated against the US dollar, which also positively affected the Fund.
During the period, the Fund reduced its holdings in DaVita, Berkshire Hathaway, JPMorgan Chase, and Bausch Health. The Fund also received Overstock Series A-1 preferred shares as digital dividends.
The Fund did not make any new investments or sell any covered call options in the first half of 2020.
Portfolio Commentary
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 β some worse than others and we are in a wait and see attitude before we commit excess funds to the market.
Financials β Banks and Insurance
Banks β 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 will benefit the banks in the long-term with its excessive printing of money, 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) β 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 had 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.
Resolute Forest Products ("RFP")
As of June 30, 2020, the market price of Resolute Forest Products (RFP, Financial) was US$2.11 per share, down 50% from the price at year end 2019. 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 was trading as low as US$1.17 per share in April 2020. Back in March 2020, the company announced that it would buy back 15% of its common shares for US$100 million. At the lowest year-to-date price of US$1.17, the whole market capitalization would be approximately US$99 million. In other words, instead of buying back 15% of the company with US$100 million, it could repurchase 100% of the company at one point. RFP shares have since recovered 300% to US$4.69 as of August 25, 2020.
One bright spot has been their lumber operations. The high prices for lumber should make up the declines in newsprint and specialty papers. The COVID -19 pandemic has shifted the focus more towards lumber/pulp/tissue operations and I believe that should generate greater cash flow in the future.
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.
Bausch Health Companies Inc. ("Bausch")
In early August, Bausch Health Companies Inc. (BHC, Financial) announced that it is planning to spin off its eye care business, Bausch + Lomb, into an independent publicly traded company. This will allow the company to concentrate on its gastroenterology, aesthetics/dermatology, neurology and international pharma business.
Chairman and CEO Joseph Papa said, "We've looked at the value of our pure health companies like Alcon and Cooper and believe that Bausch + Lomb would compare very favorably when investors have an opportunity to make a judgment about the relative value of the stand-alone business".
Comparables like Cooper Companies and Alcon Inc. are currently trading between 18 and 20 times EBITDA. If Bausch + Lomb trades at similar multiples as a stand-alone company, the total value of Bausch Health using sum-of-the-parts method, net of debt, should be worth north of $35 per share, as an inference. For a long time we have felt that Bausch was undervalued, but the investors were not giving credit that management has done a good job in running the operations, selling non-core assets, as well as de-leveraging its balance sheet. They felt the process was too slow, we hope the spin-off of Bausch + Lomb unit will be the catalyst that is needed for investors to price the company closer to its intrinsic value.
EXCO Resources ("EXCO")
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 (ASX:EXS, Financial) in the Fund. The equivalent price is $9.5144 per share of EXCO.
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 has gone up to as high as 50 to 1.
Long story short, it was not such a great idea in investing in the 1.75 lien of EXCO.
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.
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.
We believe the value investors can empathize with the picture below:
Picture: Courtesy of David Shapiro @davidshapiro61
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.
Other Matters
FOREIGN CURRENCY CONTRACTS: None existed at June 30, 2020.
CREDIT DEFAULT SWAPS: None existed at June 30, 2020.
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 August 25, 2020, the NAVPU of a Series A unit of the Fund was $81.80 and the cash position was approximately 4.6% of net assets. The Fund is down 20.8% from the beginning of the year. In U.S. dollars, it is down 22.0%.
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
- The alternative method of purchasing Chou Associates Fund in $US has been offered since September 2005. Performance for years prior to September 2005 is based on the $US equivalent conversion of the results of the Chou Associates Fund ($CAN). The investments in the Chou Associates Fund ($CAN) are the same as the investments in Chou Associates Fund ($US) except for the currency applied.
