Francis Chou’s Chou Associates Fund annual letter for the year ended December 31, 2016.
Dear Unitholders of Chou Associates Fund,
After the distribution of $0.07, the net asset value per unit (“NAVPU”) of a Series A unit of Chou Associates Fund at December 31, 2015 was $115.50 compared to $124.19 at December 31, 2014, a decrease of 7.0%; during the same period, the S&P 500 Total Return Index increased 20.7% in Canadian dollars. In $U.S., a Series A unit of Chou Associates Fund decreased 22.0% while the S&P 500 Total Return Index returned 1.4%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.
Chou Associates Fund – Factors Influencing the 2015 Results
The weakness of the Canadian dollar against the U.S. dollar had a positive impact on the results of the Fund. The difference in performance results between the net asset value per unit (NAVPU) priced in Canadian dollars, versus U.S. dollars, is attributable to the fact that on December 31, 2014, one U.S. dollar was worth approximately $1.16 Canadian, whereas one year later, on December 31, 2015, one U.S. dollar was worth approximately $1.38 Canadian.
Positive contributors to the Fund’s performance during the period ended December 31, 2015 were the warrants of JPMorgan Chase & Company.
The Chou Associates Fund initiated equity security positions in Ascent Capital Group Inc. as well as in the second-lien term loan of Exco Resources 12.50%, due October 2020.
Securities of Resolute Forest Products Inc., Sears Holdings Corporation, Berkshire Hathaway Inc., Goldman Sachs Group Inc. and Nokia Corporation ADR were the largest negative contributors to the Fund’s performance during the same period.
The Fund decreased its holdings of Nokia Corporation ADR by 25%.
Olympus Re Holdings Limited was dissolved in February of 2015, and the Fund received a final liquidating distribution in the amount of $643,930.
Chou Associates Fund – Portfolio Commentary
Throughout 2015 and the early part of 2016, stock and bond markets were not cheap in general but some sectors were hit so badly that it makes sense for us to dig deeper when looking at them. For example, let’s take a look at the oil and gas sector whose stocks and bonds have fallen dramatically over the past few years:
The first part of the table above shows the Enterprise Value at December 31, 2013 for two companies – Comstock Resources and Exco Resources. Enterprise Value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents. Enterprise Value is a measure of what stock and bond investors think the entire company is worth.
Lower down on the table is a comparison of these companies’ Enterprise Values at December 31, 2013 to the current price of their senior bank debt and their first or second lien bonds. The first or second-lien paper for these companies is currently yielding 42.6% – 49.8%, an attractive rate of return. When you purchase such a senior paper during normal times, the yield to maturity is frequently far below 10%. If the company goes bankrupt, and has little or no bank debt (which is senior to the first or second-lien bonds), most often the second-lien or even first-lien holders will end up owning 90% of the restructured company. Investors today can buy into these papers (first or second-lien) at a fraction of what Enterprise Values were at December 31, 2013 and also below that of the PV-10 value for the year ended 2015. For example, an investor can pay $0.40 for a unit of CRK’s secured bonds, which is equivalent to paying $280 million in total for all its secured bonds. This is only 17% of CRK’s Enterprise Value back in 2013. Although this is a simplified manner of looking at companies, it contains important and valuable information. These numbers are showing that regardless of what happens to the company going forward, you are more than likely to make a decent return on your investments.
We are looking to purchase more debt securities of oil and gas companies but our focus is on:
- First or second-lien loans or notes;
- Situations where the ability to add senior or issue pari-passu debt is significantly limited; and
- If the company restructures or goes into bankruptcy, the recovery value of the bond is greater than the current price of the bond.
In the same vein, many stocks that we consider as undervalued went down even further. Let’s discuss two of our biggest holdings, Resolute Forest Products and Sears Holdings.
Chou Associates Fund – Resolute Forest Products
Resolute Forest Products (RFP) is primarily involved in newsprints, specialty papers, wood products and market pulp. As the downturn in global commodities intensified, RFP was not spared, hitting all four of the company’s business segments. Management has concentrated on lowering the cost of every segment but this wasn’t enough to compensate for the deterioration of prices in their respective markets.
It is hard for us to believe that RFP is trading as low as $4 per share. At $4 per share it means the market capitalization of the company is selling for less than US$400 million dollars. The company has consolidated sales of close to $4 billion and in each of its major business segments, it is a global leader. It is 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. With the exception of the wood products segment, which has revenues of approximately $600 million, the other three segments each have revenues of approximately $1 billion. Each of the four business segments could easily fetch at least $400 million in a normal market.
In our opinion, the company’s “normalized EBITDA (Earnings before interest, taxes, depreciation and amortization)” is approximately $400 million. In other words, with RFP trading at $4 per share, the market value of the company is being priced for about 1 times normalized EBITDA. The company does have net debt of approximately $365 million, but even if you include net debt, the market is valuing the entire company for less than 2 times normalized EBITDA. It had cash of approximately $300 million a year ago but used approximately $156 million to acquire Atlas Paper and is spending $270 million to convert some of its pulp mills in Calhoun, Tennessee to produce tissue papers.
A couple of years ago, it bought Fibrek Inc. for approximately $126 million. So, if you add the bolt-in acquisitions of Fibrek ($126 million), Atlas Paper ($156 million) and its conversion to tissue paper ($270 million), you end up with $552 million. In addition, the company has tax loss carryforwards of approximately $2 billion which it can use to offset future gains and income. All these factors lead us to believe that at current prices, RFP is very undervalued.
Chou Associates Fund – Sears Holdings
In July 2015, Sears Holdings Corporation (SHLD) announced that it had closed its rights offering and sale-leaseback transactions with Seritage Growth Properties (“Seritage”),