August 20, 2021
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, 2021 was $128.66 compared to $93.50 at December 31, 2020, an increase of 37.6%; during the same period, the S&P 500 Total Return Index increased 12.0% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund increased by 41.3% while the S&P 500 Total Return Index increased 15.2%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual
compound rates of return.
|June 30, 2021 (Series A)||1 Year||3 Years||5 Years||10 Years||15 Years||20 Years|
|Chou Associates Fund ($CAN)||76.0%||5.9%||7.9%||6.0%||4.7%||7.1%|
|S&P 500 ($CAN)||28.3%||16.4%||16.6%||17.8%||11.5%||7.5%|
|Chou Associates Fund ($US)1||92.8%||8.0%||8.8%||3.4%||3.9%||8.1%|
|S&P 500 ($US)||40.8%||18.6%||17.6%||14.8%||10.7%||8.6%|
Factors Influencing the First Six-Month Results
The largest increase in the period were the equity holdings of Resolute Forest Products Inc., MBIA Inc., Overstock.com (OSTK, Financial) and Wells Fargo & Company (WFC, Financial). The Canadian currency appreciated against the US dollar, which also negatively affected the Fund.
During the period, the Fund reduced its holdings in The Goldman Sachs Group Inc. (GS, Financial), Resolute Forest Products Inc., Wells Fargo & Company and Citigroup Inc. (C, Financial) The Fund eliminated its holdings in DaVita Inc. (DVA, Financial).
The Fund did not make any new investments or enter into any foreign currency contracts in the first half of 2021. The Fund sold a few covered call options on the equity holdings of Resolute Forest Products Inc., MBIA Inc., and Bausch Health Companies Inc. during the period ending June 30, 2021.
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 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.
As of June 30, 2021, the market price of RFP was US$12.20 per share, up 86.5% from the price of US$6.54 at year end 2020. In spite of that, 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 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. RFP shares have since recovered 942.7% to US$12.20 as at June 30, 2021.
Rarely do we see such a depressed valuation but when it occurs, the most important thing is not to capitulate when the relevant facts and the investment rationale are strongly in our favor. Our goal is to buy companies at 60 cents on a dollar but if it falls to 10 cents on a dollar, we get more excited. If we had the room to buy more RFP, we would have ceratainly done so. These declines can really test our fortitude and our conviction on being a value manager but we felt that, in time, RFP would be trading closer to its intrinsic value. That was what happened during the first six months of 2021.
One bright spot for the company has been its lumber operations. The high prices for lumber should make up for the declines in its newsprint and specialty papers business segments. The COVID-19 pandemic has shifted management’s focus more towards its lumber/pulp/tissue operations and we 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.
In early August 2020, Bausch Health 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".
Comparable companies like Cooper Companies and Alcon Inc. are currently trading between 18 and 20 times 2022 EBITDA estimates and 25-30 times trailing EBITDA estimates. If Bausch + Lomb trades at similar multiples as a stand-alone company, the total value of Bausch Health using a sum-of-the-parts method would be worth north of US$45 per share (net of debt). We felt that Bausch has been undervalued for a long time, but investors were not giving credit for management doing a good job in running the operations, selling non-core assets, as well as deleveraging its balance sheet. They felt the process was too slow. We hope the spin-off of the Bausch + Lomb unit will be the much-needed catalyst for investors to price the company closer to its intrinsic value.
In early July 2019, the company emerged from bankruptcy and the 1.75 lien term loans were converted into 28.38 equity shares for every US$1,000 in par value, after netting out certain adjustments. We received 1,518,570 shares of EXCO in the Fund. The equivalent price was US$9.51 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 to invest in the 1.75 lien term loans of EXCO.
Our investment in MBIA Inc. dates back to 2012, with an initial cost at about US$6.00 per share. It is one of the most interesting investments in a long time, and we have watched the company’s development with great attention over the years. To use a baseball analogy, we believe that we are somewhere in the sixth or seventh inning of the game. We are much closer to a more definitive resolution on the company’s various lawsuits with regards to the ongoing bankruptcy proceedings in restructuring the Puerto Rico bonds.
To understand the parent company MBIA Inc., one has to separate out its two principal subsidiaries – the “Good One” called National Public Finance Guarantee Corporation (“National”) and the “Bad One” called MBIA Insurance Corporation (“MBIA Corp.”). As far as our analysis shows, the parent company and National have been ring-fenced from the operations of MBIA Corp. since 2014. In the latest 10-K of MBIA Inc., the company stated that:
“Given the separation of MBIA Inc. and MBIA Corp. as distinct legal entities, the absence of any cross defaults between the entities, and the lack of reliance by MBIA Inc. on MBIA Corp. for the receipt of dividends, we do not believe that a rehabilitation or liquidation proceeding of MBIA Insurance Corporation by the NYSDFS would have any material economic impact on MBIA Inc.”
National’s primary business has been to provide financial guarantee insurance to the United States’ public finance markets, their financial guarantee insurance policies provide investors with unconditional and irrevocable guarantees of the payment of the principal, interest or other amounts owing on insured obligations when due. National has ceased pursuing the writing of new financial guarantee policies, and its primary activity today is to provide ongoing
surveillance, including remediation activity where warranted, of its existing insured portfolio of US$41.9 billion gross par outstanding as of December 31, 2020. This is the side of the business with exposure to the Puerto Rico bonds.
We won’t go into details of the “Bad One” MBIA Corp., but simply to highlight that its book value is negative US$31.97 per share as of year-end 2020.
We would like you to forget the operations of the companies for a second and concentrate on the following: the ferocity of the company’s share buybacks, the change in adjusted book value per share (“adjusted BVPS”) and the change in GAAP book value per share (“GAAP BVPS”) over the years.
|Shares Outstanding (Mils)||53.7||79.4||89.8||91.5||135.2||151.5||191.9|
|Price Paid on Buybacks||$7.50||$9.10||$8.28||$7.56||$6.33||$7.30||$9.44|
Source: Capital IQ and company filings, all currencies in USD.
As seen from the chart above, the number of shares outstanding were reduced significantly from 191.9 million shares to 53.7 million shares from 2014 to 2020. Also, notice the increase of adjusted BVPS from US$24.21 in 2014 to US$35.95 in 2020 and a decrease in GAAP BVPS from US$20.47 to US$2.53 over the same period.
We want to pay special attention to the adjusted BVPS because the financial impact of the “Bad One” is subtracted from the calculation. In our view, it should more closely represent the intrinsic value of the company. The GAAP BVPS of the combined company has decreased due to the decrease of the GAAP BVPS of the “Bad One” over the years. It is interesting to note how management has shifted its focus from highlighting how high the adjusted BVPS was up until 2018, to showcasing how low the GAAP BVPS was from 2019 onwards.
While the company explained it as an accounting change, the timing conveniently suits their purposes. Compare the company’s presentation of its financials in the 10-K before and after 2018:
To see charts, go here.
Although the parent company has used up the authorization to buy back shares, it still has another US$300 million at National that can be used for share buybacks. Assuming that management gets new authorization for more share buybacks at US$10 per share, the adjusted BVPS could then jump to a whopping US$68.80 per share. Such is the power of the buy backs when it is bought at such a low price relative to adjusted book value per share. What
management is doing with the amount of buybacks and the significant discount to adjusted BVPS is unprecedented in corporate history.
As for National’s business, it is an asset play that is in runoff. We believe the assets as presented by management are solid, and that there are potential tailwinds from the restructuring of the Puerto Rico bonds and the various lawsuits related to that.
In 2008, when MBIA Inc. got into trouble with its misadventures in toxic securities, MBIA was nicknamed “Management Brain Injury Association”. In a few years, that nickname will be buried forever.
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.
FOREIGN CURRENCY CONTRACTS: None existed at June 30, 2021.
CREDIT DEFAULT SWAPS: None existed at June 30, 2021.
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 2020 IRC Annual Report is available on our website www.choufunds.com.
As of August 20, 2021, the NAVPU of a Series A unit of the Fund was $133.30 and the cash position was approximately 6.0% of net assets. The Fund is up 42.6% from the beginning of the year. In U.S. dollars, it is up 41.5%.
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.