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August 20, 2018
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, 2018 was $109.76 compared to $112.18 at December 31, 2017, a decrease of 2.2%; during the same period, the S&P 500 Total Return Index increased 7.7% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund was down 6.4% while the S&P 500 Total Return Index returned 2.7%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.
Factors Influencing the First Six-Month Results
The biggest positive contributors to the Fund’s performance in the first half of 2018 included the equity holdings of Endo International, MBIA Inc. and Nokia.
The Canadian currency depreciated against the U.S. dollar, which also positively affected the Fund.
Equities of Ascent Capital Group, Sears Holdings Corporation, Wells Fargo, as well as the 1.75 lien term loan of EXCO Resources were the biggest negative contributors to the Fund’s performance in the first half of 2018.
During the period, the Fund decreased its holding in Nokia. New additions included equity stakes in Valeant Pharmaceuticals, Allegiant Travel Company and Spirit Airlines. The previous holdings in Valeant Pharmaceuticals were sold before year-end 2017.
U.S. Bank Common Stock and TARP Warrants
Overall, investments in the TARP warrants of Bank of America, Wells Fargo and JPMorgan Chase performed well for the Fund, as reflected by the increases in prices of each position shown in the following table.
The maturity date for the TARP warrants are now less than a year away. As such we have to make a decision on whether to sell the TARP warrants or convert them to their equivalent common shares of the corresponding banks. If we believe that the bank(s) 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.
We will briefly discuss the mechanics and tax consequences of converting these TARP warrants to their corresponding common shares. A unique characteristic of these warrants is the ability to convert them to common shares via a cashless transaction. Instead of paying for the exercise price of the warrants in cash at the time of conversion, these warrants are only payable by netting out the number of the common shares issued upon exercise of the warrants that in total equal the exercise price.
For example, assume we purchased warrants of XYZ at $5 with an exercise price of $35, and the common stock of XYZ shares is trading in the market at $50. When we exercise 100 units of the warrants, instead of paying $3,500 for the new XYZ shares in cash ($35 per share times 100 units) and receiving 100 shares of XYZ, there won’t be any cash outlay and we will only receive 30 shares of XYZ. The remaining 70 shares will be implicitly sold at the current market price of $50 per share for $3,500 to pay for the total exercise price of $3,500.
In consultation with the Fund’s Canadian tax and accounting advisers, our understanding is that there will be immediate capital gain taxes incurred on the 70 shares of XYZ implicitly disposed of during the conversion process. In the example, the Fund will realize a capital gain of $700 which is equal to the proceeds of $3,500 less the new cost base of $2,800 ($40 per share times 70 shares). This is lower than the immediate capital gain that would be realized from directly selling the TARP warrants.
EXCO Resources
As of June 30, 2018, the Fund owned about US$23.9 million worth of EXCO Resources (EXCO, Financial)’s 1.75 lien term loan (converted from the second-lien term loan held previously in Feb. 2017), with approximately US$53.5 million in par value. This is one of the largest positions in the portfolio, comprising approximately 9% of the assets of the Fund (at market value).
At the time of purchase, we liked this investment because it met our criteria for investing in the oil and gas sector. The criteria that we considered in analyzing this type of investment is that it should be:
- A very senior term loan or note;
- Issued by a company with a significantly limited ability to add senior or pari-passu debt to its capital structure; and
- Of a type that if the company restructures or goes into bankruptcy, the investment’s recovery value is likely to be greater than its current price.
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 to facilitate a restructuring of its balance sheet. EXCO Resources is saddled with very expensive transportation and other contracts. During a bankruptcy proceeding, contracts that have a present value of, for example $200 million, could potentially be renegotiated to as low as $20 million. We believe that when EXCO comes out of bankruptcy, the 1.75 lien holders will most likely own most of the new common stock of the company. If over the longer term our current assumption regarding this investment prove to be correct, we think the value of the EXCO 1.75 lien term loans should be appreciably higher than the June 30, 2018 price of 44.75 cents on a dollar.
Pharmaceutical Industry
We believe that pharmaceutical stocks as a group are selling at attractive valuations. They generate their earnings in cash and at the time of purchase, they were selling at less than 10 times earnings. Some of them are down more than 50% from their highs, which is what caught our attention initially. As discussed earlier in past reports, we invested more than two 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. We have invested in the following pharmaceutical stocks:
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.
Sears Holdings
In hindsight, our initial assessment of Sears Holdings (SHLD, Financial) 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 market.
In 2017, we initiated a stock lending program where the Fund received interest on the shares lent. For Sears Holdings, the total security lending interest we received for the year was about $7.25 million or about $6.41 per share, all in U.S. dollars. This shows how heavily shorted the common shares of Sears Holdings have been. For the six-month period ending on June 30, 2018, the total security lending interest received was $483,596 or about $0.43 per share, all in U.S. dollars. In spite of the interest income earned from security lending, plus the approximately $23 per share received in distributions from various spin-offs and rights offerings, it has not been a good investment.
Resolute Forest Products
As of June 30, 2018, the market price of Resolute Forest Products (RFP, Financial) was at $10.35 per share, giving a market capitalization of roughly US$935 million dollars. As we have explained in the past, the company continues to have consolidated sales of close to US$3.5 billion and in each of its major business segments, it is a global leader. It continues to be the biggest volume producer of wood products east of the Rockies, the third largest in North America for market pulp, the number one producer of newsprint in the world and the largest producer in North America of uncoated mechanical paper and an emerging tissue producer. The wood products segment continues to have revenues of approximately US$800 million, while the other three segments each continue to have revenues of approximately US$900 million. We believe that each of the four business segments could fetch at least US$400 million in a normal market and, as a result, RFP may be undervalued.
With the new CEO coming in, there is more optimism on what the company can do with its four business segments. This is reflected in the stock price as it has moved up from $4.60 in March 2017 to $10.35 as of June 30, 2018.
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 year-end 2014 and June 2018 returns, and look at 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, 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.
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, 2018.
CREDIT DEFAULT SWAPS: None existed at June 30, 2018.
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.
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 effect on 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 August 20, 2018, the NAVPU of a Series A unit of the Fund was $119.27 and the cash position was approximately 2.1% of net assets. The Fund is up 6.3% from the beginning of the year. In U.S. dollars, it is up 2.5%.
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.
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.
