Value Investing

Chou Associates Fund 2015 Annual Letter – Sears Holdings Hurts Returns

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

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

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:

Chou Associates Fund

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:

  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.

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”), a recently formed, independent, publicly traded real estate investment trust (“REIT”).

In the transaction, Sears sold 235 Sears- and Kmart-branded stores to Seritage along with Sears’ 50 percent interests in joint ventures with each of Simon Property Group, Inc., General Growth Properties, Inc. and The Macerich Company, which together, hold an additional 31 Sears Holdings properties. Based on our rough estimate, this represented less than 25% of the company’s real estate assets.

Sears Holdings received aggregate gross proceeds from the transaction of $2.7 billion, which provides the Company with enhanced financial flexibility to accelerate investments in its transformation to an asset-light, member-centric, integrated retailer.

However, from our perspective, the most important thing that happened was that Seritage is now a public company and when its stock trades daily, we have a more reliable way of assessing the real estate value in SHLD indirectly. We also know that pre-Seritage and post-Seritage, the profile and the quality of the properties held in Seritage and SHLD is roughly the same.

At the current price of $15 for Sears, the company is being priced in the market for about $1.5 billion. Even if you include the debt of roughly $3 billion, we believe that the price of Sears is severely underpriced.

However, the comparison is not apples to apples. Seritage is a clean real estate company whereas SHLD has some serious problems with its retail operations. As every day goes by, the losses from operations are eroding the value of SHLD that comes from its real estate and brand names. Those brand names such as Kenmore, Craftsman and Diehard, we believe collectively could be worth as much as $3 billion. The transformation from the bricks-and-mortar business to their member-centric Shop Your Way (www.shopyourway.com) is happening; whether it is going to be successful or not is another story. These types of ventures should be classified as “venture capitals” and in spite of all the positive spins written about the transformation, it is still a hit or miss affair. Still, netting out all the negatives and all the losses from operations, we believe that the intrinsic value of Sears is far above the current price of $15.

Chou Associates Fund – Deflation vs Inflation

In the history of mankind, we have never really been in a kind of environment where one could make an equally strong case for deflation or for inflation. The arguments for both sides are quite compelling.

If you believe in deflation, these are the points one could make:

  1. China, the recent locomotive of global growth, is lurching ahead at an ever slowing speed. Its economy and financial markets in 2015 went through tremendous turmoil, affecting all markets worldwide. China has been a huge success story for the last 30 years as it was responsible for taking away large amounts of manufacturing jobs from developed economies. Its economy grew annually at a double digit rate and we thought this growth would not show any signs of slowing down appreciably in the near future. Even after the Great Recession of 2008, China’s economy grew at a pretty good clip. However, most of the growth occurred not because of demand but due to enormous spending by all sectors of its government on unneeded housing and infrastructure. As a result, if one were to go to China now, he would notice a tremendous number of ghost cities with empty houses, empty highways and no people;
  2. As shown by the weakness in commodity prices, it will take a while for demand to absorb all the excess capacity built up over the last 20 years;
  3. Some sovereign bonds carry negative interest rates;
  4. The recovery of the global economy from the Great Recession of 2008 has been sluggish at best.

On the flip side, one could make an equally compelling case for inflation to roar back some time in the future:

  1. How low could interest rates go? At negative yields they can’t go much below zero;
  2. Although the recovery has been anemic, at least in nominal terms there has been some recovery;
  3. The velocity of money for M2 is at an all-time low. This can be further highlighted if we hypothesize about what would happen if M2 moved back up to the historical average. If a regression to the mean was to occur, the price levels could be 25% higher than what it is today. Carrying this logic one step further, with the current levels of money-printing growing at approximately 7.2% annualized, this could see a potential price level increase of 50%, if the velocity of money were to move back up to the historical average;
  4. Normal market forces, the incessant balancing of supply and demand, will bring everything into equilibrium as the boom-bust cycle produced by artificial credit creation works itself out, but you cannot ‘un-print’ money.

The current situation reminds me of a story about an exchange between Winston Churchill and MP Bessie Braddock:

At one time when Churchill was drunk, Bessie Braddock yelled at him, “Winston, you are drunk, and what’s more, you are disgustingly drunk.”

Churchill retorted, “My dear, you are ugly, and what’s more, you are disgustingly ugly. But tomorrow I shall be sober and you will still be disgustingly ugly.”

That’s how I feel about deflation and inflation (eventual consequences of printing too much money).

Chou Associates Fund – Volatility & Returns

As you are well aware, the cardinal principle underlying the investments in the Chou Associates Fund is to pay far less than what the company is worth, measured by sustainable earning power and/or hard assets that are not depreciating in value. In other words, we want to have an adequate “Margin of Safety” and this concept is what distinguishes investment from speculation.

This table is an abridged version of the table produced on the inner cover of the annual report:

Chou Associates Fund

In the years 1999 and 2008, we had negative returns, but we were able to bounce back in the following years. An investor who put in $10,000 on December 31, 1986 would have an account worth $212,854 as of December 31, 2015. Even if one invested at a high, let’s say in 1998 or 2006, you would have still done reasonably well long term. When you are a value investor, you have no control on short-term volatility. While the future is never certain, we believe the margin of safety principle has served us well and will continue to serve us well in the future. However, the stock markets are highly volatile and there will be periods or years where we may have negative returns. The current environment reminds us of 1999 – stocks that were expensive became more expensive and stocks that were cheap became cheaper. Eventually, however, the cheap stocks will move closer to their intrinsic value. We would like to encourage our unitholders to review and understand the table as it may help them see where they stand. As you can see, we have done reasonably well in the long run.

Nevertheless, we would also stress that the amount of money that investors choose to invest in the Fund should only be to the extent that they can afford to experience a temporary decline of 40% or more of their investment. This may sound drastic but sleeping well and not getting too anxious are also important considerations both for the manager and the investor.

Chou Associates Fund

Chou Associates Fund – Other Matters

FOREIGN CURRENCY CONTRACTS: The Fund hedged Canadian dollars against U.S. dollars at 1.3036. The notional amount was US$100,000,000. We closed out the contract and realized a loss of approximately US$4,356,000. The Fund also hedged a second amount for US$50,000,000 at 1.3083, and it is currently outstanding.

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. Founded in 1996, CIBC Mellon is 50-50 jointly owned by Canadian Imperial Bank of Commerce (CIBC) and by BNY Mellon, a global leader in asset servicing with US$28.5 trillion under custody and/or administration as at September 30, 2015.

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.

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.

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 2015 IRC Annual Report is available on our website www.choufunds.com.

As of March 18, 2016, the NAVPU of a Series A unit of the Chou Associates Fund was $93.22 and the cash position was approximately 17.6% of net assets. The Fund is down 19.3% from the beginning of the year. In $U.S., it is down 14.3%.

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

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