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Holly LaFon
Holly LaFon
Articles (9701)  | Author's Website |

Francis Chou's Chou Associates Fund Manager's Letter 2017

Missive from the value investor

June 15, 2018 | About:

March 15, 2018

Dear Unitholders of Chou Associates Fund,

After the distribution of $2.63, the net asset value per unit (“NAVPU”) of a Series A unit of Chou Associates Fund at December 31, 2017 was $112.18 compared to $110.60 at December 31, 2016, an increase of 3.8%; during the same period, the S&P 500 Total Return Index increased 13.5% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund was up 10.9% while the S&P 500 Total Return Index returned 21.8%.

The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.

The biggest positive contributors to the Fund’s performance in 2017 included JPMorgan Chase and Wells Fargo warrants expiring in October 2018, and the equity securities of Resolute Forest Products, Citigroup Inc., Overstock, and Berkshire Hathaway Class A shares.

Equities of Sears Hometown and Outlet Stores, Ascent Capital Group, and MBIA Inc., as well as EXCO Resources 1.75 lien term loans were the main negative contributors to the Fund’s performance in 2017. The Canadian currency strengthened against the US dollar, which also negatively affected the Fund.

During the period, the Fund decreased its holdings of Overstock, JPMorgan Chase warrants, Citigroup Inc. and Nokia OYJ. The Fund also sold holdings in Chicago Bridge & Iron, General Motors warrants, Valeant Pharmaceuticals, Sears Canada, and EXCO Resources 8.5% bonds, due April 2022.

New additions during the year included equity stakes in DaVita Inc., Teva Pharmaceutical and Endo International. The latter two securities were sold before the year-end.

U.S. Bank TARP Warrants and Equities

Overall, investments in the TARP warrants and equities of the U.S. banks performed well in 2017, as reflected by the price increases of each position shown in the following table:

The maturity date for the TARP warrants is now less than a year away. As the time element grows shorter, we believe the warrant is likely to become more speculative and therefore we expect to further reduce or eliminate the positions in the various TARP warrants. If we believe that the banks in question may still be undervalued, then we will be more likely to invest in the banks’ common stock.

However, it is important to note that any future decision to sell additional warrants or buy the common stock will be based on our view of issuers and the markets at such time.

EXCO Resources

As of December 31, 2017, the Fund owned about US$32.8 million worth of EXCO Resources (EXCO)’s 1.75 lien term loans (converted from the second-lien term loans held in Feb. 2017), with US$53.5 million in par value. This is the largest position in the portfolio, comprising more than 10% of the assets of the Fund (at market value).

We liked this security because it met our criteria for investing in the oil and gas sector. The criteria we considered in analyzing this type of investment include that the security should be:

  1. A very senior term loan or note;
  2. Issued by a company with a significantly limited ability to add senior or pari-passu debt to its capital structure; and
  3. Of a type that should the company restructure or go into bankruptcy, the recovery value of the bond is likely to be greater than the current price of the bond.

In addition to the security being very senior in the capital structure, we also hold the view that management seems to be making good decisions with respect to the allocation of capital in a tough environment.

On January 15, 2018, EXCO filed voluntary petitions for a court-supervised reorganization under Chapter 11 of the U.S. Bankruptcy Code in order to facilitate a restructuring of its balance sheet. EXCO Resources is saddled with very expensive transportation and other contracts. During a bankruptcy proceeding, those contracts that have a present value of, for example $200 million, could potentially be renegotiated to as low as $20 million. The longer that EXCO does not restructure through a bankruptcy, the more value is potentially eroded from the 1.75 lien term loans. As of now, we think the value of the EXCO 1.75 lien term loans should be about 80 cents to 100 cents on a dollar. On December 31, 2017, it was priced at 61.25 cents on a dollar.

Valeant and the Pharmaceutical Industry

We continue to believe that the pharmaceutical industry is selling at an undervalued price. In the semi-annual report, we detailed why we thought it was cheap. We wrote the following:

As if Valeant (VRX) has not given enough pain and anguish to our unitholders, we believe pharmaceutical stocks as a group are selling at attractive valuations. They generate their earnings in cash and most of them are selling at less than 10 times cash earnings. Some of them are down more than 50% from their highs, which is what caught our attention initially. It may look like we are adding more emotional fuel to the fire from our experience with Valeant but we look at mispriced stocks on a case-by-case basis. Given our current favorable view of the pharmaceutical industry generally, as next discussed in greater detail, we expect to invest in stocks of more than two or more pharmaceutical companies (that is, to utilize a so-called “basket approach”), in order to reduce the potential adverse effect on fund returns that could result from Food and Drug Administration (FDA) approval and patent expiration issues faced by a single company.

A Historical Perspective

What the pharmaceutical industry has been going through lately reminds me of what happened in the U.S. in 1994. A year earlier, then-president Bill Clinton appointed his wife, Hillary, to head a committee to prepare legislation for overhauling the U.S. health-care system, sending ripples of fear among investors of pharmaceutical stocks. It appeared as if drug prices would be set by the government on the basis of what it would cost to manufacture the product rather than being set by the market. Almost all pharmaceuticals stocks dived for the next of couple of years to unreasonable bargain levels.”

Investors were particularly nervous between Clinton’s victory in November 1992 and throughout Clinton’s health-care reform proposal from 1993 to 1994 (see Figure 1).

The health-care reform package was eventually defeated in August 1994, sending an air of relief to the pharmaceutical stocks. They returned to their more fairly valued levels set from 1994 to 1998 (see Figure 2). The Republican revolution led by Newt Gingrich gave Republicans control of the Senate and House of Representatives, putting the final nail in the coffin for a health-care overhaul under the Clinton administration.

Below are the graphs that compare the prices of three pharmaceutical stock prices both before and after August 1994.

In conclusion, we believe pharmaceutical stocks as a group are selling at attractive valuations, in comparison to the free cash flow and earnings they generate. The recent price drops may present one or more attractive long-term investment opportunities for us.”

However, in the beginning of the fourth quarter, due to the amount of U.S. bank warrants and stocks that we sold, we had realized capital gains of close to $18.14 per unit. If we were to pass down the capital gains to our unitholders, it would leave a large tax burden to them during the income tax season. This tax burden would be easier to bear for our unitholders if we had outstanding returns for the last few years. However, the reality is that we did not have the best of years. In order to mitigate the problem or eliminate it, we sold all the pharmaceutical stocks in which we had unrealized losses, hoping to buy them back a month later (31 days) at close to the same price we sold them. Sometimes, there are other stocks in the same industry that are equally cheap and we would buy them as a hedge in case the stocks we sold ran up in price. That is why we added DaVita Inc. to our portfolio at about $54 per share. Unfortunately, since timing was not our greatest strength, the pharmaceutical stocks took off in December and we did not get the full benefit of their rise. Luckily, we had DaVita Inc. in our portfolio, which increased 33% to $72.25 at year-end 2017, softening some of the blow from the rise in the other pharmaceutical stocks.

In the first quarter of 2018, we have bought back some of our holdings in Valeant Pharmaceuticals and Endo International when they came down in price.

Market Index

The latest craze in the investment world has investors buying into market indices in droves in the form of low-fee and passive electronically traded funds (ETFs). As we have noted before, the indices on average are tough competitors. However, when huge sums of money are allocated passively without regard to the value of the underlying securities, it can create serious price distortions. Indexes are made up of a basket of securities, such as the Dow Jones Industrial Average (DJI) which is made up of 30 large publicly traded stocks. Index ETFs seek to mirror and track the benchmark index with the same holdings and weightings. As money is poured into the ETFs of these popular indexes, the major beneficiaries are the constituents of the indexes. As a result, these companies become overvalued while companies outside of the indexes languish in price. This is reminiscent of the Nifty Fifty bubble in the early 1970s. Similar to the current index mania, these 50 well-established growth stocks were considered buys at any price, sending them to levels that were unjustified on the basis of intrinsic value. The delusion was short-lived as they collapsed shortly after in the 1970s. As one Forbes columnist described it, “the Nifty Fifty were taken out and shot one by one.”

One question we had was why can’t we make a basket of stocks with the same financial and economic characteristics as the indices but trading at lower valuations? Following this logic, we made a crude attempt at constructing such a sample portfolio of 30 stocks based on basic screenings. As of February 2017, the 30 companies in the DJI were trading at an average price of about 30 times earnings, five times book value, 13 times TEV/EBITDA2, and four times TEV/Sales. Based on the industry weighing, leverage ratio and 10-year average of returns on equity, capital and asset, we selected 30 U.S. stocks with similar financial and economic characteristics as the DJI. Please see the full list of sample portfolios in Exhibit A.

As summarized in the chart above, while the sample portfolio shares similar debt levels, margins and long-term returns, they are on average trading at significant discounts with only 15 times price to earnings ratio, almost half that of the DJI. This means ETF investors are paying on average $30 for every dollar of corporate earnings, when they only need to pay $15 for every dollar of earnings in the sample portfolio. In other words, instead of a 6.7% annualized yield, ETF investors in the DJI are only getting a 3.3% annualized yield on average. As a result, we think there is a very high chance that this sample portfolio would beat the DJI index over time.

That being said, there were several limitations to the selection of the sample portfolio. For one, the average size of the companies in terms of market capitalization was much smaller than those of the DJI. The average market capitalization was $20 billion in the sample portfolio compared to $227 billion in the DJI. A case could be made that due to the size differences, the relative competitive positioning and stability of earnings could also differ. However, small companies tend to grow at a faster rate than larger cap companies do, as shown in a five-year sales CAGR of 1% for the DJI, as compared to 8% in the sample portfolio. Secondly, the stocks were weighted equally in the sample portfolio whereas the DJI is price-weighted. With more sophisticated screening and modeling techniques, one could potentially construct a more comparable portfolio at 10 times earnings with solid economics, rather than 15 times earnings in the sample portfolio. While the particular selections could be improved, the basic principle and logic would still apply.

Sears Holdings

In hindsight, our initial assessment of Sears Holdings (SHLD) being worth more than $50 per share a few years ago was most likely too optimistic. This is taking into consideration that we received in excess of $23 per share in distributions from various spin-offs and right offerings, which we later sold in 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.

In 2017, the annualized average monthly interest rate we received from the stock lending program for Sears Holdings was about 64% (not a typo). This shows how heavily shorted the Sears stock has been. In 2017, the stock price of Sears Holdings dropped $5.71 per share or 62% from $9.29 to $3.58 per share, all in US dollar. However, we received US$7.25 million from security lending interests during the year, equivalent to $6.41 per share, which more than covered the drop in price. Despite the interest payments received however, it has not been a good investment for the Fund.

Short-Term Performance Impacts Long-Term Returns

We have been out of sync with the market for about four years – the longest stretch so far. Generally, it has not bothered us because we expected to underperform the market 30% – 40% of the time, based on our history of managing money for over 35 years.

A lot of investors are not aware that short-term results can have a huge bearing on the five- and 10-year annualized compounded returns. For example, let’s take Fund A and Fund B. Fund A has consistently returned 7% per year for 10 years and therefore its compound rate of return over the 10-year period is 7%. Fund B, on the other hand, returns 8% for the first nine years but suffers a loss of 20% in the 10th year. Its compound rate of return for the 10-year period drops significantly to 4.8%. The impact is more pronounced for the five-year returns, a similar decline of 20% in the fifth year would have decreased the five-year compound return from 8% to merely 1.7% for Fund B versus 7% for Fund A.

Another example is to compare our 2014 and 2017 returns and see what the Fund’s 10- and 15-year returns were against the S&P 500.

The important thing is that we continue to be confident in our value investing principles and the process we use to buy and sell stocks. We are trying to buy securities at 60 cents on a dollar. Another way to look at it is that when you buy stock at 10 times earnings versus the market at 25 times earnings, other things being equal, you are getting a 10% annualized yield versus the market giving you a 4% annualized yield. This reasoning is logical and should outperform the market in the long run. However, there will be periods – like we are going through now – where it does not appear to be working.

Most of the time when value investing has not worked, it is during periods when the market is trading at an elevated level. Based on historical ratios, the current prices for stocks are not cheap. However, if interest rates stay at these levels for an extended period of time, the stocks are not expensive at all.

Suffice to say that we are not comfortable with the current market levels and we are not convinced that interest rates will stay this low for an extended period of time. We would consider it fortunate if the market returns more than 5% 6% a year for the next 10 years from these current lofty levels.

In conclusion, we do not believe that we have entered a new paradigm; there is definite room for improvement in stock selections, but the principle of value investing is sound and, in time the logic will prevail.

Frank Martin – A Great Exemplar

The value funds have not performed well in general against the index over the last five years or so, but we want to bring your attention to how one value fund is coping. One of our good friends is Frank Martin, who runs the investment firm Martin Capital Management (MCM). As a stock market historian and writer with high convictions, he wrote some of the best letters on the Street and we would urge all our investors to read the ones he wrote over the last 10 years at www.mcmadvisors.com/newsmaterials. What particularly piqued our attention this year was the action he took in today’s market.

This is what Frank Martin wrote to his investors:

“Prediction is risky business most [of] the time, but in high-adrenaline eras like the present it is downright foolhardy. Rather, our all-consuming preoccupation is with preparedness. Toward that end, we wound down both of our onshore and offshore Hummingbird Funds effective May 31, 2017, and all money originally invested, plus gains, has been returned to investors. Although the earliest lockup didn’t expire until late September, we saw no reason to continue charging the higher fund fees, with few compelling investment prospects on the near-term horizon.

As an expression of our gratitude, we offered all Hummingbird investors help in finding a new home. Many chose to return to the safe haven of MCM’s separately managed accounts. To demonstrate—in a tangible and personally sacrificial way—our concern about the lack of legitimate opportunities, we reduced our base fee to 50 basis points for all MCM clients.”

One must truly admire what Frank Martin has done. When almost every portfolio manager is chasing more assets and charging higher and higher fees even when they know that there are very few opportunities in the market, he insisted on doing what is right for his investors. Avoiding all temptations to do otherwise, he wound down his funds and reduced his fees to 50 basis points for all MCM clients. We should all salute him for being such an exemplar.

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.

Also, the Fund’s cash position was approximately 19% of net assets as at December 31, 2017. This large cash position may depress returns for a while as we hunt for undervalued securities. Obviously, if there is a severe correction in the market in the near future, it will cushion the Fund against losses while providing us with the wherewithal to find good investment opportunities. But for now, it could be a drag on returns. If we cannot find any bargains, the large cash position may stay for a long time.

Other Matters

FOREIGN CURRENCY CONTRACTS: None existed at December 31, 2017.

CREDIT DEFAULT SWAPS: None existed at December 31, 2017.

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 2017 IRC Annual Report is available on our website www.choufunds.com.

CHANGE OF AUDITOR: On September 27, 2017, the Chou Funds’ Independent Review Committee has approved a change of the Funds’ auditor from KPMG LLP to Grant Thornton LLP, effective as of December 15, 2017. This change was made by Chou Associates Management Inc. solely for operational purposes and not as a result of any disagreements with the former auditor.

RISK RATING: As of August 25, 2017, the risk rating of the Fund was changed from “Medium to High” to “Medium”. The Manager used the investment risk classification methodology under NI 81-102 Investment Funds, which came into force effective Sept. 1, 2017, to determine the risk rating of each Fund. These risk re-classifications are not as a result of changes to the investment objectives, strategies or portfolio management of the Fund.

As of March 15, 2018, the NAVPU of a Series A unit of the Fund was $107.27 and the cash position was approximately 7.1% of net assets. The Fund is down 4.4% from the beginning of the year. In U.S. dollars, it is down 7.9%.

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

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

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