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August 20, 2019
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, 2019 was $100.38 compared to $103.26 at December 31, 2018, a decrease of 2.8%; during the same period, the S&P 500 Total Return Index increased 13.9% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund was increased by 1.3% while the S&P 500 Total Return Index returned 18.5%.
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 major positive contributors to the Fund's performance in the first half of 2019 were the equity holdings of Bausch Health Companies, Citigroup, and Goldman Sachs Group.
The largest decliners in the same period were the equity holdings of Endo International PLC, Resolute Forest Products, and the EXCO Resources 1.75 lien term loan. The Canadian currency appreciated against the U.S. dollar, which also negatively affected the Fund.
During the period, the Fund exited its holdings in Sanofi and Sears Holdings Corporation, and reduced holdings in DaVita Inc.
Call options on the common shares of Resolute Forest Products and Sears Hometown and Outlet Stores expired in the first half of 2019. The Fund bought back call options of Endo International PLC expiring in January 2020 with a strike price of US$15.00, and sold call options of Sears Hometown and Outlet Stores equity expiring in July 2019 with a strike price of US$2.50.
Currently the Fund holds four U.S. bank stocks in its portfolio: JPMorgan Chase, Wells Fargo, Citigroup and Goldman Sachs. The common stocks (and their respective TARP warrants before conversion) have performed really well over the last several years and have appreciated significantly from their purchase or conversion price. That said, we continue to believe that the bank stocks as a group are selling at a cheap valuation. They are over capitalized and have been using the excessive capital to buy back shares and/or raise dividends.
The Fund is also a long-term investor in Berkshire Hathaway. The company, through the various portfolio holdings of its subsidiary insurance companies, also has significant investment exposure in the financial sector. As a result, we may reduce our holdings in some of the Fund's bank stocks.
On January 15, 2018, EXCO (OTCPK:EXCE) 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, which was saddled with expensive transportation and other contracts. On November 5, 2018, EXCO filed a restructuring plan, stating that holders of the 1.75 lien term loan would receive 82% of the new common stock of the company, subject to dilution by a management incentive plan. However, this plan did not come into fruition due to the company's inability to raise enough capital and an amended plan of reorganization was offered to the creditors on April 10, 2019.
Based on the valuation analysis by EXCO's investment banking firm, PJT Partners Inc., under the amended plan, the 1.75 lien term loan holders would receive 38.8% of the new common shares resulting in a recovery of 27 cents on a dollar or 27% (given the total principal outstanding for the 1.75 lien term loan was US$742.2 million).
Summary of Amended Valuation Analysis (as of May 31, 2019):
In early July of 2019, the company emerged from bankruptcy and the 1.75 lien term loans were converted into 28.38 equity shares for every $1,000 in par value, after netting out certain adjustments.
We remain optimistic about EXCO's future over the long run. We are bullish in the oil and gas sector in the long-term, not withstanding the current bleak environment. Globally, less than 20% of oil and gas reserves are being replaced simply because it does not make sense to drill for oil and gas when the price is below the cost of extracting oil and gas from the ground. We believe the demand for oil and gas should be higher in the future. In time the price equilibrium will be restored and EXCO is now better positioned given its post-bankruptcy cost structure.
We continue to believe that the pharmaceutical stocks as a group are selling at attractive valuations. The companies generate their earnings in cash and were selling at less than 10 times earnings at the time of our purchase. In the latest opioid crises, a few companies have been tarred with the same brush and their stocks have been badly hit, even though their exposure may not be as great as some believe.
We have a small holding in Endo International PLC (NASDAQ:ENDP), a company embroiled in the opioid crisis. The legal uncertainties stemming from these lawsuits, combined with the company's large debt balance have led to a decrease in its stock price.
Resolute Forest Products
As of June 30, 2019, the market price of Resolute Forest Products (NYSE:RFP) ("RFP") was US$7.20 per share, giving a market capitalization of about US$640 million dollars. This was after US$1.50 per share in special dividends that we received in December 2018.
With the appointment of Yves Laflamme as RFP's new CEO in February 2018, there is more optimism on what the company can do with its four business segments. However, the stock continues to trade at less than five times earnings. It is a very cheap stock but the company competes in highly cyclical industries that are currently facing some head winds.
It has been a disappointment since our initial purchase some eight years ago. It shows how tough it is to turn around a troubled company in spite of the best efforts of management.
In general, our experience with a commodity business that has virtually no pricing power, is to be cautious when management talks about investing in new or modernizing existing equipment that would significantly lower the cost structure compared to its competitors. That may be true for six months to a couple of years, but in time competitors will have a new cost structure that is as competitive if not superior to the company. It is the same treadmill where hardly anyone in the industry can make a decent return for the assets invested in the company. The same story can be seen repeatedly in various commoditized industries. There is no sustainable long-term advantage in a mediocre business with no pricing power. It is important not to get seduced by discount to book value. If the company cannot generate a decent return on book value over a long period of time, that book value is not worth much.
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.
FOREIGN CURRENCY CONTRACTS: None existed at June 30, 2019.
CREDIT DEFAULT SWAPS: None existed at June 30, 2019.
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 2018 IRC Annual Report is available on our website www.choufunds.com.
As of August 20, 2019, the NAVPU of a Series A unit of the Fund was $90.89 and the cash position was approximately 0% of net assets. The Fund is down 9.5% from the beginning of the year. In U.S. dollars, it is down 11.0%.
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.
This article first appeared on GuruFocus.