Value Investing

Francis Chou: Q4 Letter To Shareholders – Long Sears

Francis Chou letter to investors

Dear Shareholder,

During the 12 month-reporting period that ended on December 31, 2014, the Chou Opportunity Fund (the “Fund”) was up 4.88%, while the S&P 500 Total Return Index (the “S&P 500”) generated a return of 13.69% during the same period. The Fund’s past performance is not necessarily an indication of how the Fund will perform in the future.

Francis Chou: Portfolio Commentary

Our investments in the TARP warrants of Wells Fargo were up during the year increasing in value from $15.83 as of December 31, 2013 to $21.36 as of December 31, 2014. TARP warrants have several characteristics that make them appealing long-term investments. Specifically, they are long dated, with most expiring around 2018-2019. This time frame of four-plus years is intended to allow banks the potential to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant. In addition, we note that the terms of the warrants may require the strike price to be adjusted downward for any quarterly dividend that exceeds a set price. This is rarely seen in a stock warrant. An example: for Bank of America, class ‘A’ warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent per share.

We also hold TARP warrants of Bank of America and JPMorgan, and as a group, we still consider them undervalued on a long term basis because the stocks underlying the TARP warrants are still cheap. Our common stock investment in MBIA. did not perform well because of concerns over its exposure to Puerto Rico’s economic and financial situations, decreasing in value to $9.54 as of December 31, 2014 from $11.94 as of December 31, 2013. Although we believe that MBIA is cheap based on book value, it makes it harder to evaluate its intrinsic value when the main operating business has been mothballed for a while. Time is not on the side of investors in that type of business.

Our investments in the common stock of Resolute Forest Products were up during the year. They increased in value from $16.02 as of December 31, 2013 to $17.61 as of December 31, 2014.We sold 50,000 shares of Resolute Forest Products at $20 in order to decrease the Fund’s holding in this stock as a percentage of its total assets.

The common stock of Sears Holdings dropped in value from $49.04 as of December 31, 2013 to $32.98 as of December 31, 2014. When viewed in isolation, this constitutes a loss. However, there is a small gain if you give consideration to the overall effect of the following transactions that Sears Holdings did in 2014:

1) It spun out Lands’ End in April. We received 86,213 shares of Lands’ End. When we sold it between the prices of $45.04 and $48.09, it amounted to approximately $13.81 per share of Sears Holdings.

2) In October, it distributed a rights offering whereby each right entitled the holder to purchase 0.375643 of a common share of Sears Canada for each share of Sears Holdings common stock owned as of the record date at a purchase price of U.S.$9.50 per share. When we sold the rights, it amounted to approximately 10 cents per share of Sears Holdings.

3) Also, in October, it distributed a rights offering whereby the holder received one right for every 85.1872 shares of the Company’s common stock held as of the record on October 30, 2014. Each right entitles the holder thereof to purchase, at a subscription price of $500, one unit, consisting of (a) a 8% senior unsecured note due 2019 in the principal amount of $500 and (b) 17.5994 warrants, with each warrant entitling the holder thereof to purchase one share of the Company’s common stock. The warrants will be exercisable upon issuance at an exercise price of $28.41. When we sold the rights, it amounted to approximately $2.83 per share of Sears Holdings.

In total, we received $16.74 per share of Sears Holdings through spin-offs and rights offerings. On September 30 and October 1, we bought 261,548 shares of Sears Holdings when it was selling at a depressed price of just below $25. On October 24, we sold 200,000 shares at approximately $40.25 to bring the Sears Holdings to just below 15% of the Fund’s assets. We feel more comfortable at this level of concentration.

As we have indicated before, we believe that Sears Holdings is a misunderstood story. There are many moving parts but we believe Sears Holdings’ intrinsic value lies in its real estate assets. It also has other valuable assets such as Kenmore, Craftsman and Diehard. Being a traditional department store has become a tough business during the last decade but, according to management, Sears is transitioning its historic focus on running a brick and mortar department store into a business that provides and delivers value by serving its members in the manner most convenient for them: whether in store, at home or through digital devices.

The value of its real estate allows Eddie Lampert, the controlling shareholder and CEO, the time and money to effect the changes. What Lampert is doing is the right thing to do, considering the possible outcomes – if it works, it’ll be a multi-bagger; if the transformation does not work out as expected, we believe the real estate values are high enough that we would not lose money in our investment at current prices after netting out all liabilities. If real estate was the only play from Lampert’s viewpoint, it seems that he would have liquidated the company a long time ago.

Other negative contributors to the Fund were securities of Overstock.com, Sears Canada and Sears Hometown and Outlet Stores Inc.

We initiated positions in common stock of Ascent Capital Group Inc., Chicago Bridge and Iron Company, and Class ‘B’ warrants of General Motors Company.

Francis Chou: We are starting to look at credit default swaps (CDS)

One way of assessing investors’ appetite for risk is to check the prices of credit default swaps (CDS). In CDS, one party sells credit protection and the other party buys credit protection. Put another way, one party is selling insurance and the counterparty is buying insurance against the default of a specific third party’s debt. If the protection buyer does not own debt issued by the third party, then CDS are more appropriately viewed as an investment transaction, rather than a hedging transaction, for the protection buyer notwithstanding the insurance-like features of a CDS. In most CDS, the protection buyer makes the premium payments over the life of the CDS, frequently on a quarterly basis.

We believe that CDS are starting to sell at prices that are becoming interesting. At recent prices, they appear to offer one of the potentially cheapest forms of insurance against market disruptions. We are continuing to monitor CDS prices and may potentially invest in CDS in the future. We are looking at who deals in such investments and we want to examine carefully what counterparty risk we may be exposed to. The mechanics of investing in CDS have changed somewhat from six years ago.

To make money in CDS, you don’t need a default of the third party’s debt. A dislocation in the economy or deterioriation in the credit profile of the issuer may cause the CDS price to rise from these low levels. The negative aspect is that, like insurance, the premium paid for the protection erodes over time and may expire worthless. There is no guarantee that the Manager will make money for the Fund on any particular CDS or correctly predict an increase of value in any particular CDS.

Francis Chou: Debts at Negative Yields

I never thought that in my lifetime that we would ever see a situation in a developed economy when there is a negative yield on interest rates. A few weeks ago, Finland floated a five-year notes at a negative yield. It sold 1 billion euros of notes at an interest rate of negative 0.017%. In other words, noteholders or bondholders are willing to pay the government the privilege of holding its notes. And this is not an aberration. Countries like Germany, France, Sweden, Netherland, Belgium and Austria have seen their two-year sovereign debt trading at negative yields.

Not to be outdone, a corporate bond of Nestle 3/4% maturing in October of 2016 is trading at a negative yield. So, you have come to this ridiculous situation where you can borrow money for free.

The question is, how to capitalize on the situation? There are several possible ways of doing that but one way of seeking to take advantage of this type of situation is through an interest rate swap. An interest rate swap is a derivative contract between two counterparties whereby they agree to exchange one stream of interest payments for another, over a set period of time.

We are still considering the use of interest rate swaps and other similar derivatives. If we do use these contracts, we will do our best to quantify the risk of loss from these contracts and minimize losses if interest rates do not move in the manner that we anticipate. Of course, there is no guarantee that our use of these interest rate derivatves will work as intended or that we will accurately predict or analyze the direction of future interest rates.

Francis Chou: Caution to the Investors

Investors should be advised that we run a highly focused portfolio, frequently just two or three securities may comprise close to 50% of the assets of the Fund. In addition, we have 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 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.

Also, at year-end our cash position was approximately 41.3% of net assets. This large cash position may depress returns for a while as we hunt for undervalued investments. 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 buy depressed investments – but for now it could be a drag on returns.

Yours truly,

Francis Chou

Portfolio Manager and CEO

Chou America Management Inc.

Francis Chou

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