Analyst Report: Chou associates

Moving to the sidelines during frothy markets and capitalizing on downturns has paid off in the past for Francis Chou. While his deep-value approach is far from safe, we expect him to take calculated risks and we expect he’ll be able to navigate through this current crisis adroitly, which is why this fund is one of our analyst picks.

For the past several years, Chou has expressed concern about loose lending practices and inflated real estate prices in the U.S., warning that the resulting buildup of leverage in the financial system could cripple the markets. As a result, Chou focused on preserving capital. By June 2006, he had stashed nearly half of this fund’s assets in cash, and that’s where it remained during most of last year. Then, after his warnings about a potential credit crunch proved to be prophetic, he began, in late 2007, to put some of his cash to work.

He’s a generalist who doesn’t rely on the support of any analysts. Instead, he first screens according to fundamental criteria to find securities that appear attractive. He then conducts research on the individual companies that made the first cut. However, he generally doesn’t go through each idea with a fine-toothed comb. While macroeconomic analysis is part of his investment process, it plays a relatively minor role.

He has continued to make new investments over the past couple of quarters, with his cash weighting falling from 41% at the end of 2007 to 16% at the end of June. He’s been finding opportunities that he deems cheap and that have a large margin of safety – discounts of at least 40% to 50% to what he thinks they are be worth – be it stocks or corporate bonds.

Although the fund is typically equity-heavy, Chou’s been particularly excited about distressed debt. Recently, he made a sizable debt investment in forest-products company Abitibi-Consolidated of Canada. Abitibi’s industry has been out of favour because of the high Canadian dollar and the gloomy outlook for the housing market, which Chou doesn’t think is out of the woods. However, he believes that the company will be able to repay its debt, which has been yielding more than 35%, when it comes due in mid-2010.

Treading in such murky areas is dangerous because a misstep can wipe out the invested capital. And with financial statements being more complex with off-balancesheet liabilities clouding the picture, it can be difficult to estimate accurately a company’s true worth.

That said, Chou has had past success with buying securities that the market cast aside. For example, after the telecom bust in 2000, he snapped up senior debt of then troubled Time Warner Telecom, Worldcom, and Level 3 Communications – all at well under 50 cents on the dollar. These turned out to be terrific investments that helped the fund return 21.4% and 30% in 2001 and 2002, respectively.

Over the past year, Chou’s defensive stance has helped the fund keep its losses modest. Its 8.3% loss ranks fourth best in the global small/mid-cap category (one of the top three is Chou Asia – a Chou-managed fund that despite its name, isn’t concentrated enough in Asia to be included in one of the Asian Equity categories), while the median fund shed 17.1%. The fund’s 20-year annualized return stands at 12.4% with low volatility. It’s a testament to how well Chou has managed risk over the years.

OF NOTE

Along with equities, Chou’s investments include risky distressed-debt issues. Investors would be wise to think of the fund’s fixed-income exposure as equity.

Chou, admittedly, made the mistake of holding on to King Pharmaceuticals Inc. (KG/NYSE) and Biovail Corp. International (BVF/TSX) too long. As a result, the stock prices have fallen significantly from their highs.

Comparing this fund with a peer group or to an index is notoriously difficult since Chou doesn’t manage the fund with any benchmark, sectors, or market capitalization in mind.

Chou decided to implement a strategic currency hedge on roughly 30% of the fund’s assets earlier this year. While he had never made strategic hedges before, he’s done so now to help smooth out some of the currencyinduced volatility.

The fund’s low management-expense ratio is 1.75% – lower than every other fund in the global small/midcap equity category with a minimum investment below $100,000.

The fund’s success is exclusively dependent on Francis Chou. While he has an emergency backup plan, he doesn’t have a successor.

Fairfax Financial owned 16.8% of this fund’s outstanding units as of Sept. 3. A rapid liquidation of this position could be challenging for Chou.

Philip Lee is a fund analyst at Morningstar Canada.