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Francis Chou: Valeant, NIRP And a test to see if you’re a value investor

Francis Chou‘s Chou Associates Fund letter for the first half ended June 30, 2016.

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Dear Unitholders of Chou Associates Fund,

The net asset value ("NAVPU" or "NAV") of a Series A unit of Chou Associates Fund at June 30, 2016 was $92.66 compared to $115.50 at December 31, 2015, a decrease of 19.8%, while the S&P 500 Total Return Index decreased 2.5% in Canadian dollars. In $US, a Series A unit of Chou Associates Fund was down 14.1% while the S&P 500 Total Return Index returned 3.8%.

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

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Francis Chou, Chou Associates

Francis Chou - Factors Influencing the First Six-Month Results

Positive contributors to the Fund’s performance during the period ended June 30, 2016 included equity securities of Berkshire Hathaway Inc., MBIA Inc., Overstock.com, and the term loan of EXCO Resources Inc. Equities of Sears Holdings Corporation, Resolute Forest Products, Nokia Corporation, Citigroup Inc., and warrants of Wells Fargo & Company were negative contributors to the Fund’s performance during the same period. The US dollar depreciated against Canadian currency, which also negatively affected the Fund. The fund decreased its holdings of Berkshire Hathaway by 50% and increased its position in Sears Holdings Corporation by 60%, and significantly added to the term loan of EXCO Resources Inc.

New additions during the period include an equity stake in Valeant Pharmaceuticals International, the senior unsecured debt of EXCO Resources Inc. 8.5%, due April 2022, and debt securities of Westmoreland Coal Company 8.75%, due January 2022.

Market Commentary

EXCO Resources

In 2015, we initiated the position in EXCO Resources second-lien term loan 12.5%, maturing in 2020. We liked this security because it met the criteria for investing in the Oil & Gas sector.

The criteria were that the security should be:

  1. First or second-lien loans or notes;
  2. Situations where the ability to add senior or issue pari-passu debt is significantly limited; and
  3. If the company restructures or goes into bankruptcy, the recovery value of the bond is greater than the current price of the bond.

We continue to add to the position and as at June 30, 2016, we owned $39.5 million worth of EXCO Resources second-lien term loan. This is one of the largest positions in the portfolio, comprising just below 10% of the assets of the Fund (at market value). We like this security because it is very senior in the capital structure and we believe that management is doing a great job in allocating capital in a tough environment. We also like the fact that the CEO, Mr. Wilder, has bought over $10 million worth of common stock in the open market and is required to purchase at least $23.5 million of additional shares prior to September 9, 2016. We strongly support EXCO's strategic plan as it continues to focus on three core objectives: restructuring the balance sheet to enhance capital structure and extend structural liquidity; transforming EXCO into the lowest cost producer; and optimizing and repositioning the portfolio. The three core objectives and the Company's recent progress are detailed below.

1. Restructuring the balance sheet to enhance capital structure and extend structural liquidity – The Company is focused on improving its capital structure and providing structural liquidity. As of June 30,
2016, EXCO had $246 million in liquidity. During the second quarter of 2016, EXCO reduced its indebtedness through the repurchase of $12 million in principal amount of senior unsecured notes due 2018 ("2018 Notes") and $12 million in principal amount of senior unsecured notes due 2022 ("2022 Notes"), utilizing $5 million in cash. These repurchases resulted in an estimated reduction in interest expense of approximately $2 million per year. In addition, EXCO's cash flows from operations, reduced capital programs and proceeds received from the sale of certain assets allowed the Company to reduce its indebtedness under its Credit Agreement by $11 million during the quarter.

On August 10, 2016, EXCO announced a cash tender offer to buy back $101.3 million of the 8.5% senior notes due 2022 at a discount of 40 cents on the dollar to the principal amount. This further reduces the Company’s indebtedness.

2. Transforming EXCO into the lowest cost producer – Lease operating expenses decreased by 11% compared to the prior quarter primarily due to the renegotiation of its saltwater disposal contracts, modifications to chemical programs and reduced workover activity. Since the fourth quarter of 2015, the Company has reduced its total workforce by 28%, including 20% of its general and administrative employees and 38% of its field employees. Since the fourth quarter of 2014, it has reduced its total workforce by 59%, including 58% of its general and administrative employees and 61% of its field employees. General and administrative expenses (excluding equity-based compensation and severance costs) have decreased 17% from the first quarter of 2016 primarily due to lower personnel costs.

3. Optimizing and repositioning the portfolio – The Company executed a series of non-core asset divestitures as part of its portfolio optimization initiative. In May 2016, the Company closed a sale of certain non-core undeveloped acreage in South Texas and its interests in four producing wells for $12 million. In July 2016, the Company closed a sale of its interests in shallow conventional assets located in Pennsylvania and retained an overriding royalty interest. EXCO's ability to reduce both capital and operating costs has improved well economics across its portfolio. The wells being drilled in 2016 are targeting rates of return in excess of 80% in the North Louisiana region and 30% in the East Texas region.

The company may need some time to achieve the three core objectives, but in the meantime, we are clipping coupons of 12.5% on a current price of about 60 cents on a dollar. That equates to a current yield of approximately 20%.

Valeant Pharmaceuticals

Valeant Pharmaceuticals International, Inc. (NYSE/TSX: VRX) is a multinational specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products primarily in the areas of dermatology, gastrointestinal disorders, eye health, neurology and branded generics. Major subsidiaries of the company include Salix Pharmaceuticals, a maker of gastrointestinal medicines, eye-care company Bausch & Lomb and skin-care company Medicis Pharmaceutical.

What jumps out initially when you first look at Valeant is how much debt it has relative to revenues, free cash flow and product pipelines ($31 billion of debt as of Q2 2016 relative to $10 billion of last twelvemonth revenue and approximately $5 billion of EBITDA2). There is no question that the company has a diversified array of drugs and it generates solid free cash flow, but it also carries an enormous level of debt on its balance sheet. This degree of leverage not only increases the risk for the investor, but may also give the impression that the company is extremely cheap when examining its price to earnings (P/E) ratio.

In the recent Q2 filing, Valeant released its management guidance for the 2016 Expected Adjusted Earnings Per Share (EPS) to be $6.60 – $7.00. For simplicity sake, let's assume its earnings for 2016 will be $7.00 per share and test the value based on that assumption. We will analyze the situation using a multiple of 14, which is the average P/E multiple a company on the Dow Jones Industrial Average has sold for over the past last 100 years. The earnings multiples investors choose for evaluating a company can vary widely depending on a host of factors, such as sustainable earning power, growth rates, strong balance sheet, pricing power, etc.

So using a 14 times P/E multiple, the expected price per share would be about $98.00 (see Table 1 on the next page for the full calculations). This price reflects a stunning 79% discount from the actual trading price of $20.14, as of June 30, 2016. The discount appears to provide an ample margin of safety for investors.

Francis Chou, Chou Associates

However, while the company looks cheap from an equity standpoint, would it still look as cheap if the company was fully funded by equity? Let’s take the same $7.00 EPS as suggested by management, multiply it by the shares outstanding of approximately 348 million in order to arrive at the levered earnings of $2.4 billion. (To calculate the unlevered earnings, we assumed an effective tax rate of 15% and projected interest expense of $1.7 billion based on its last twelve month figures.) After adding back the interest expense and subtracting the taxes, the resulting unlevered earnings would be approximately $3.9 billion. Now, if we were to apply the same P/E multiple of 14x to the unlevered earnings, we’d get to a total enterprise value of $54.2 billion, accounting for minority interest and cash on the current balance sheet. Compared to the current enterprise value of $37.3 billion based on the latest trading price, this revised value would represent only a 31% discount on the basis of total capitalization.

A simplistic way to look at it is to assume you are buying a house for $100. If you put in $25 and borrow $75, then this $25 becomes your equity value. If this house was listed on the stock exchange and the equity was trading at $5 for a total capitalization of $80, you wouldn’t say that you were getting a great bargain because you were getting something worth $25 for $5. Instead, you would make the connection and say that the house was selling for $80 versus its intrinsic value of $100.

When you factor in Valeant’s leverage, it quickly becomes clear that the stock isn’t as much of a bargain as it first appears. This concept also applies when looking at their earnings yield calculated based on equity investments, where the $7.00 EPS based on the current price is equivalent to a 35% earnings yield, which is a proxy for the firm’s Internal Rate of Return (IRR). However, this calculation is also misleading, as it overstates the return while understating the risk of losing principal if the firm’s intrinsic value were to decline. So be careful with your valuation when a company has a lot of debt.

At the current price, Valeant stock is not a mouth-watering bargain at less than 4 times earnings, but it is still relatively cheap. If Valeant can reduce its debt by as much as $8 billion as stated by management through earnings and the sale of non-core assets, it will remove the feeling that the company is standing on the edge of a precipice. Any small misstep or missed guidance could result in bankruptcy. When the company’s debt is reduced, it will then be valued based on the free cash flow generated from operations. In addition, Valeant is also undergoing criminal investigation over its ties with Philidor. However, we believe the impact of the litigations are rather limited given that it pertains to only 5% of its revenue.

In conclusion:

  • There is a high chance that Valeant will return to trading at the normal multiples once its debt is significantly reduced and the impact and costs of litigations are determined.
  • After all, the company still has good cash flow characteristics, resulting from solid portfolio pipelines.
  • While we believe Valeant is cheap, the undervaluation is not as deep as it first appears. One must look at return on a fully capitalized basis to get the full picture.
  • Debt has to be used with caution, as it is a double-edge sword. If we take the previous example of the house, when the total value of the house is $80, then the equity portion of the house is $5. If the price of the house rises to its intrinsic value of $100, then the equity portion of the value rises to $25. In this situation, the principal value increases fivefold. It is only at the moment of sale that you can determine the actual return you earn by calculating the "Annualized Internal Rate of Return" or "IRR", which is one of the favorite buzzwords for hedge funds and private equity firms. However, it is important to look at the downside as well. If you make a mistake in your analysis or if there is an economic downturn and the intrinsic value falls to $75, your equity portion is wiped out.

Test of great value investor potential

Some twenty years ago, the following test was developed to ascertain whether or not an individual could make it as a value investor. As you are well aware, investing is not done in silos. You have to take all pertinent information and check how it is interrelated.

There are 4 test questions. Answer them in sequence. Don't miss one. Please do not cheat.

Giraffe Test

1. How do you put a giraffe into a refrigerator?

Correct answer:

Francis Chou, Chou Associates

Elephant Test

2. How do you put an elephant into a refrigerator?

Did you say, open the refrigerator, put in the elephant, and close the refrigerator? Wrong Answer.

Correct Answer:

Francis Chou, Chou Associates

Lion King Test

3. The Lion King is hosting an Animal Conference. All the animals attend ... except one. Which animal does not attend?

Correct Answer:

Francis Chou, Chou Associates

Okay, even if you did not answer the first three questions correctly, you still have one more chance to show whether you have any innate qualities to be a value investor. If you get it wrong, you could be deluding yourself and may have to seek counseling.

Crocodile Test

4. There is a river you must cross but it is used by crocodiles, and you do not have a boat. How do you manage it?

Correct Answer:

Francis Chou, Chou Associates

When this test was administered to fourth graders, most of them were able to answer some of the questions but 90% of adults could not answer even a single question. This shows what Modern Portfolio Theory can do to investors.

Negative-Yield Fixed Income Instruments - An Unmitigated Disaster in the Making

We are alarmed by the torrent of negative-yield bonds issued by European and Japanese central banks. We believe that more than $10 trillion of such bonds have been issued globally to date. Investors have been gobbling them up as if there is no tomorrow. They are not aware of the enormous risks they are taking here. Even a modest increase in interest rates will culminate to an unmitigated disaster. Please stay clear of such bonds. We wouldn't touch it with a barge pole – let alone a 10-foot pole.

Caution to the Investors

Investors should be advised that we run a highly focused portfolio. In addition, we may have securities that are non-U.S. and could be subject 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 with regard to CDS and interest rate swaps. Because of these factors, the net asset value of the Fund can be volatile. However, we are not bothered by this volatility because our focus has always been, and continues to be, on how inexpensive we believe the investments are relative to their intrinsic value.

Other Matters

Change Of Service Provider: We are pleased to advise you that we have moved from Citigroup Fund Services as our asset servicing provider, and we have transitioned custody, fund valuation and recordkeeping for the Chou Funds, managed by Chou Associates Management Inc. to CIBC Mellon effective December 14, 2015. CIBC Mellon is a Canadian leader in asset servicing, with more than C$1.5 trillion of assets under administration on behalf of many of Canada’s largest investment funds, pension plans and other institutional investors.

Please note this is only notification for our investors, and you are not required to change or update your information. All business practices will remain consistent and you should not notice any change to your day-to-day transactions.

Covered Call Options: The Fund had no covered call options in its portfolio as at June 30, 2016.

Redemption Fee: We have a redemption fee of 2% if unitholders redeem their units in less than 12 months. None of this fee goes to the Fund Manager. It is put back into the Fund for the benefit of the remaining unitholders. Please note this change will be in effect for all funds moving forward.

Independent Review Committee: The Manager has established an IRC as required by NI 81-107. The members of the IRC are Sandford Borins, Joe Tortolano and Peter Gregoire. The 2015 IRC Annual Report is available on our website www.choufunds.com.

As of August 12, 2016, the NAV of a Series A unit of the Fund was $100.60 and the cash position was approximately 10.3% of net assets. The Fund is down 12.90% from the beginning of the year. In $US, it is down 7.02%.

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

Fund Manager

See the full PDF below.

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