“You need to have that cushion, that margin of safety, against a mistake in your judgment.” –Â Frances Chou
No doubt, it is a significant honor to be in a book about exceptional investors, to be a member of an exclusive club that includes luminaries such as Warren Buffett (Trades, Portfolio), Irving Kahn and Donald Yacktman.
But looking at the performance of Frances Chou over the past decade reveals that even giants sometimes have feet of clay – a lot of volatility with year-to-year returns riding a roller coaster.
So what is Chou doing as an investor? And if we should invest like him, or in his mutual funds, how should we do it?
Who is Chou?
Chou emigrated to Canada in 1976, age 20, with a high school education and $200 in his pocket. A self-taught investor, the 25-year-old Chou was working as a repairman at Bell Canada when he and six other employees formed an investing club in 1981.
In the five years between 1976 and 1981, Chou had discovered the books of Benjamin Graham and the idea of buying dollar bills for 40 cents. The idea resonated with him; as a child in India, he had been responsible for family grocery shopping in markets that had no listed prices; what he now calls intrinsic value had to be determined through negotiations with stall holders. As a bargain hunter in Indian grocery markets, he transferred some of those skills to Canadian and American stock markets.
The club was a phenomenal success and made each member wealthy. He says an investor who gave him $80,000 in 1981 is now worth $5 million. In an interview with The Investors Podcast, Chou says the early 1980s was a wonderful time for value investors because sky-high interest rates had pulled investors out of equities and into debt securities. He says, "The market was incredibly cheap: approximately six times earnings and roughly 6% dividend yield." He also said, “Those who wanted to get into the investment field in the late 1970s and early 1980s were considered pariahs at the times and were to be avoided at all social gatherings as one would avoid the plague.”
In 1984, Chou left Bell Canada and started as a retail analyst at GW Asset Management. Not only was this an opportunity to become a full-time investment manager, but it also connected him with Prem Watsa (Trades, Portfolio), who would later start Fairfax Financial and go on to have several successful decades of being “the Canadian Warren Buffett.”
According to an article in Canadian Business, he was certified as a chartered financial analyst in 1985 and in the same year registered himself as a portfolio manager and investment counsel.
In 1986, Chou converted the investment club into the Chou Associate Fund. The firm’s mutual fund, which carried the same name, launched in the same year.
Chou continues to run the firm, working with just one assistant. He says he and Watsa continue to be very good friends. He has been widely recognized for his long-term results; William Green included Chou among the 33 investing legends in his 2015 book, "The Great Minds of Investing."
Unless otherwise noted, the biographical section is based on information at GuruFocus and The Investors Podcast.
If not a true rags-to-riches story, this is as close as it gets. The spark that brought on the riches phase came from the books of Benjamin Graham. In Graham, Chou found a kindred spirit, one who shared his interest in buying low and selling high.
What is the Chou Associate Fund?
The firm, now Chou Associates Management Inc., is based in Toronto; it also has an affiliate, Chou America Management Inc.
Five mutual funds make up the Chou Associates stable; they are listed below, along with their fund symbols and net asset values (in Canadian dollars):
- Chou Associates Fund (CHO100): $448.8 million.
- Chou Asia Fund (CHO300): $35.6 million.
- Chou Europe Fund (CHO200): $13.7 million.
- Chou Bond Fund (CHO400): $42.6 million.
- Chou RRSP Fund (Trades, Portfolio) (CHO102): $88.8 (an RRSP is a Canadian registered pension vehicle).
For the Associates Fund, the objective is long-term growth by investing in securities that Chou considers undervalued. He starts with American equities but also invests in Canadian and foreign common shares and preferred shares. The other funds fill specific niches, presumably niches in which his clients have expressed an interest. Information on the funds comes from SEDAR, the Canadian equivalent of the SEC’s EDGAR.
Also in the SEDAR filing, Chou discloses, in the Risks section, that Watsa’s Fairfax Financial owned 24% of the fund’s units as of Dec. 31, 2016. That information is included in the Risks section because the Associates Fund would have to sell a "significant portion" of its holdings to complete the transaction; in turn, that could negatively affect all investors in the fund (that is a theoretical risk).
The Associates Fund is responsible for the lion’s share of the firm’s investing efforts. With nearly half a billion in net assets, it is enough to give Chou critical mass but not enough to force him to hire more staff. It remains a one-man shop.
Chou’s Investing Strategy
His first statement about investing, in the Associate Fund’s fact sheet, is to note that the key is maintaining "strong disciplines" – price discipline, especially –Â when adding to the portfolio.
The relationship between the current price of a company’s securities and its intrinsic value generally affects how much of its securities are held in the Fund’s portfolio. By doing this, Chou aims to provide an extra margin of safety and reduce overall portfolio risk.
Stock selection depends more on company strengths and weaknesses than on short-term market factors. His analyses of companies focus on the following characteristics and metrics:
- Balance sheet strength.
- Cash flow.
- Profitability.
- Industry position.
- Special strengths.
- Growth potential.
- Management ability.
Having invested in a company, Chou is a patient, long-term investor. This leads, he says, to low portfolio turnover, lower transaction costs and deferral of accrued capital gains. Further, he runs a relatively concentrated portfolio, generally 25 to 35 companies in each portfolio, including the Associates Fund. A concentrated portfolio, he adds, allows him to stay current with developments in, and communication by, each company.
If the market becomes unruly, or overly volatile, he reserves the right to put more of the Fund’s assets in short-term, fixed-income securities. Chou says this strategy allows him to protect capital while waiting for better market conditions.
According to the Canadian Business article, Chou has been buying junk bonds for 15 years. He considers these securities to be the equivalent of value-based common stocks. That explains why he looks for companies that have gone bankrupt, with their notes available for 60 cents on the dollar, but he prefers junk bonds that can be bought for 20 cents on the dollar. Because equity valuations are high, he believes junk bonds offer solid yields at good prices.
In March Chou reported that one big bet on junk bonds was paying off. He took a position in EXCO Resources’ second-lien term loan, 12.5% and maturing in 2020. In 2016, the loan’s value jumped from 55.8 cents on the dollar to 72.9 cents on the dollar, an increase of more than 30% (excluding interest received).
In the 2016 Letter to Unitholders, Chou addresses two contentious issues: pharmaceuticals, particularly Valeant (VRX), and Sears Holdings (SHLD). Of Valeant and the pharmas, he says, “As if Valeant has not given enough pain and anguish to our unitholders, we believe pharmaceutical stocks as a group are selling at attractive valuations, even when you take the debt into consideration. They generate their earnings in cash and some of them are down more than 50% from their highs, which is what caught our attention initially.” So despite the beating he’s taken in Valeant so far, he keeps holding – as a tenacious value investor should –Â because his research tells him the company is still undervalued.
He has a similar perspective on Sears Holdings, although he thinks its intrinsic value has slipped a material amount. “In hindsight, our initial assessment of Sears being worth more than $50 per share a few years ago was most likely too optimistic. This is taking into consideration that we received roughly $13 to $17 per share in distribution from various spinoffs and later received proceeds from selling them into the stock markets. Nevertheless, we believe that the stock may still be cheap at the current valuation, albeit not at the level that we initially anticipated.”
One final, but telling note: Chou has refunded fees when his investing style did not work for clients and fund unit holders. The Globe and Mail reported that the MER (management expense ratio) for the Chou Europe Fund was minus –Â minus –Â 2.88% for 2008, rather than its normal, positive 1.88%.
In many respects, Chou has taken a path that resembles those of other value investors: buy bargains and hold them until they get back to intrinsic value. To that mix, Chou adds junk bonds, saying they are equivalent to beaten-down equities. He also continues to hold companies that most of the market has written off. And, he strongly emphasizes discipline, being patient and giving the market time to work.
Chou’s Holdings
The firm provides this list in its Chou Associates Fund fact sheet:
GuruFocus lists the following as the top 10 holdings in the Chou Associates Fund (names, symbols, proportion of portfolio), as of June 30:
- Valeant Pharmaceuticals International Inc. 16.64%.
- Berkshire Hathaway Inc. Class A (BRK.A, Financial) 12.03%
- JPMorgan Chase & Co. (JPM.WS, Financial) 9.92% (.WS = warrants)
- Wells Fargo & Co. (WFC.WS, Financial) 6.97% (.WS = warrants)
- Resolute Forest Products Inc. (RFP, Financial) 6.88%
- Citigroup Inc. (C, Financial) 6.53%
- Sanofi SA (SNY, Financial) 6.19%
- Teva Pharmaceutical Industries Ltd. (TEVA, Financial) 5.28%
- Goldman Sachs Group Inc. (GS, Financial) 5.24%
- Endo International PLC (ENDP) 36.34%
A relatively diverse collection of companies; at the top of the list is Valeant, which could only be an asset to value investors. Two other major pharma companies and a strong financial trio in Berkshire Hathaway, JPMorgan Chase and Wells Fargo dominate the portfolio.
Chou’s performance
A lot of red on this performance chart from GuruFocus, signaling that Chou has been outperformed by the Standard & Poor's 500 multiple times over the past 10 years:
Looking at longer cumulative periods, Chou consistently outperformed the S&P 500:
- 15-year: outperformed by an average of 0.8% per year.
- 20-year: outperformed by an average of 1.7% per year.
- 25-year: outperformed by an average of 1.8% per year.
- 30-year: outperformed by an average of 0.4% per year.
This chart, from the SEDAR Management Report, shows the results of investing on the first business day in January and selling on the last business day of December. It also helps highlight the volatility of the portfolio:
As we’ve seen with many gurus profiled in this space at GuruFocus, value investing is a tough business in a bull market. They have good years from time to time, but overall, investors with short- to medium-term goals would likely benefit more from an ETF that indexes the S&P 500.
Conclusion
For longer-term investors, Chou might be a better bet. When (not if) the next significant correction occurs, this guru will no doubt find his share of outstanding bargains, deals where he can buy dollar bills for 20 cents to 60 cents.
Complicating this scenario, though, is Chou’s age. Now in his early 60s, he has a limited number of years ahead, although other guru investors have worked well past normal retirement age. No successor appears to have been named, an important consideration in a one-person shop.
As to investing with Chou, the experience of recent years suggests a prudent investor would buy when the price of the Associates Fund (or his other funds), take a dip.
In other words, be a value investor with Chou’s mutual funds, in much the same way he invests in the broader markets.
Disclosure: I do not own shares in any of the companies listed, and I do not expect to buy any in the next 72 hours.
