It's been a rough couple of years for the Chou Funds. They came through the tech bust of 2000-2002 unscathed (in fact, they made big profits) but this recession has battered them severely, leaving award-winning manager Francis Chou poorer (he rebated most of the management fees for the Chou Europe Fund and the Chou Bond Fund) and searching for answers as to what happened and why.
The performance record speaks for itself. Over the year to Feb. 28, the Chou RRSP Fund lost 42%, Chou Europe was down 38.4%, Chou Bond gave back 35.8%, Chou Associates Fund lost 31.6%, and Chou Asia Fund dropped 17.5%. It was a humbling experience for a money manager who until 2006 had consistently made profits for his clients.
So what went wrong? Lots of things actually and in his usual candid way he provides all the gory details in the funds' 2008 annual report, which has just been made public. The main reason for the poor results, he says, was that he moved too soon.
Chou is a value manager who searches for securities that are trading below their intrinsic worth. He foresaw the potential troubles looming in the housing, credit, and derivatives markets but he moved too quickly to take advantage of the opportunities.
"Based on the information we had in 2007, we purchased some stocks at prices that, in hindsight, were too high," he writes. "The ensuing economic crisis, credit freeze and deleveraging severely impacted the intrinsic values of some of the stocks we purchased. As you may be aware, the intrinsic value is based on the sustainability of earning power and when it is negatively impacted by any severe economic crisis, the intrinsic value is impacted also. As a consequence, we suffered a permanent loss of capital investing in those companies...A unitholder facetiously said that we suffered from a severe case of premature accumulation."
One of the major problems facing all money managers now is a repricing of risk, he says. "Currently the spreads between the higher risk securities and U.S. Treasuries are at near historic highs," he says. "Other indicators are showing that investors are running scared, and banks and financial institutions are hoarding capital instead of lending." He cites several examples:
1. The spread between U.S. corporate high yield debt and U.S. Treasuries is now over 1,600 basis points (16 percentage points). Two years ago it was 311 basis points (bp).
2. The spread between U.S. investment-grade bonds and U.S. Treasuries was approximately 85 bp two years ago; it is now over 550 bp.
3. In December, four-week U.S. Treasury bills were auctioned off with a 0% yield (currently they are yielding 0.08%). The yield on 10-year U.S. Treasury bonds is 2.94%, down from 4.75% two years ago. In September 1981, it was 15.3%.
His conclusion: "This is the worst time to hold cash and short-term Treasuries
unless you believe we are headed into a 1930s style depression. If you believe that you should redeem all of your fund units."
And where do we go from here? Chou suggests that we need to capitalize "zombie companies" as quickly as possible in order to unfreeze credit markets and get the economy moving forward. If that means temporary nationalization, so be it. "We would prefer to give companies that are insolvent and failing the opportunity to reorganize and restructure their capital structure in an organized way," he writes. "When they do emerge from reorganization, they will come out leaner and stronger. What we are seeing now is that the U.S. government has pledged $9.7 trillion (and still counting) to counter the financial crisis. Billions of dollars have been given to prop up failing financial institutions and still they are asking for more financial assistance. The requests from the very large financial institutions are not based on business and investment merit but more on the line that if they don't receive more bailout money, they would have to file for bankruptcy and that would precipitate a chain reaction that will totally paralyze not only the U.S. financial system but also the entire Western banking system."
He frets that the actions now being taken by governments will bring inflation roaring back at some point down the road. "Almost all governments whose economies have been adversely affected by the financial crisis have been providing all kinds of liquidity including printing money to minimize the impact of the credit freeze on their economies. Historically, that is how nations have tackled their debt burden and this episode is no different. In the short term it may work, as the liquidity will counter some of the deleveraging and credit freeze in today's crisis. But longer term such actions can bring huge unintended consequences including the return of high inflation and the likely debasement of the U.S. currency. We don't know the timing of it but all that excess liquidity will have to go somewhere when normal times return."
Want some good news? Chou thinks all the negatives, real and potential, have been priced into the market and that things should gradually start to get better. "If one wants to look at the current situation in a contrarian manner, most of the bad news is already reflected in the stock prices. We don't know whether the stock market has hit bottom yet but we suspect that when we look back at the current environment 10 years from now, we will classify this as one of the best periods for buying stock and debt securities," he concludes.
Let's hope he's right.
The performance record speaks for itself. Over the year to Feb. 28, the Chou RRSP Fund lost 42%, Chou Europe was down 38.4%, Chou Bond gave back 35.8%, Chou Associates Fund lost 31.6%, and Chou Asia Fund dropped 17.5%. It was a humbling experience for a money manager who until 2006 had consistently made profits for his clients.
So what went wrong? Lots of things actually and in his usual candid way he provides all the gory details in the funds' 2008 annual report, which has just been made public. The main reason for the poor results, he says, was that he moved too soon.
Chou is a value manager who searches for securities that are trading below their intrinsic worth. He foresaw the potential troubles looming in the housing, credit, and derivatives markets but he moved too quickly to take advantage of the opportunities.
"Based on the information we had in 2007, we purchased some stocks at prices that, in hindsight, were too high," he writes. "The ensuing economic crisis, credit freeze and deleveraging severely impacted the intrinsic values of some of the stocks we purchased. As you may be aware, the intrinsic value is based on the sustainability of earning power and when it is negatively impacted by any severe economic crisis, the intrinsic value is impacted also. As a consequence, we suffered a permanent loss of capital investing in those companies...A unitholder facetiously said that we suffered from a severe case of premature accumulation."
One of the major problems facing all money managers now is a repricing of risk, he says. "Currently the spreads between the higher risk securities and U.S. Treasuries are at near historic highs," he says. "Other indicators are showing that investors are running scared, and banks and financial institutions are hoarding capital instead of lending." He cites several examples:
1. The spread between U.S. corporate high yield debt and U.S. Treasuries is now over 1,600 basis points (16 percentage points). Two years ago it was 311 basis points (bp).
2. The spread between U.S. investment-grade bonds and U.S. Treasuries was approximately 85 bp two years ago; it is now over 550 bp.
3. In December, four-week U.S. Treasury bills were auctioned off with a 0% yield (currently they are yielding 0.08%). The yield on 10-year U.S. Treasury bonds is 2.94%, down from 4.75% two years ago. In September 1981, it was 15.3%.
His conclusion: "This is the worst time to hold cash and short-term Treasuries
unless you believe we are headed into a 1930s style depression. If you believe that you should redeem all of your fund units."
And where do we go from here? Chou suggests that we need to capitalize "zombie companies" as quickly as possible in order to unfreeze credit markets and get the economy moving forward. If that means temporary nationalization, so be it. "We would prefer to give companies that are insolvent and failing the opportunity to reorganize and restructure their capital structure in an organized way," he writes. "When they do emerge from reorganization, they will come out leaner and stronger. What we are seeing now is that the U.S. government has pledged $9.7 trillion (and still counting) to counter the financial crisis. Billions of dollars have been given to prop up failing financial institutions and still they are asking for more financial assistance. The requests from the very large financial institutions are not based on business and investment merit but more on the line that if they don't receive more bailout money, they would have to file for bankruptcy and that would precipitate a chain reaction that will totally paralyze not only the U.S. financial system but also the entire Western banking system."
He frets that the actions now being taken by governments will bring inflation roaring back at some point down the road. "Almost all governments whose economies have been adversely affected by the financial crisis have been providing all kinds of liquidity including printing money to minimize the impact of the credit freeze on their economies. Historically, that is how nations have tackled their debt burden and this episode is no different. In the short term it may work, as the liquidity will counter some of the deleveraging and credit freeze in today's crisis. But longer term such actions can bring huge unintended consequences including the return of high inflation and the likely debasement of the U.S. currency. We don't know the timing of it but all that excess liquidity will have to go somewhere when normal times return."
Want some good news? Chou thinks all the negatives, real and potential, have been priced into the market and that things should gradually start to get better. "If one wants to look at the current situation in a contrarian manner, most of the bad news is already reflected in the stock prices. We don't know whether the stock market has hit bottom yet but we suspect that when we look back at the current environment 10 years from now, we will classify this as one of the best periods for buying stock and debt securities," he concludes.
Let's hope he's right.
