The Chou Associates Fund
Value investing encompasses many different strategies. However,
one common theme is that value stocks should be significantly
undervalued by the market based on some measure. For example, in the
classic text "The Intelligent Investor", the late Benjamin Graham
recommended sticking to companies that have a long record of earnings
growth and dividend payments. Filtering these stocks through a
detailed set of financial ratio requirements then leads the investor
to good value stocks. Other common implementations of the value style
might focus instead on a particular price ratio, such as price to
sales, or some other quantity.
Declining markets provide opportunities for value investors when
stocks get beaten down well below their intrinsic worth. As a result,
the relative performance of the value and growth styles tends to be
cyclical. The last three years, for instance, have been comparatively
good to value investors. Sadly, because of the multitude of value
strategies, no single benchmark is truly appropriate.
Take the Barra Canada Value index for instance. Stocks from a
universe of 200 large-cap companies are ranked using a score derived
from the book-to-price ratio and the dividend yield. The set of
stocks with high scores whose total market float represents 50% of the
original universe forms the Value index. Although this index reflects
the performance of strategies based on price-to-book and dividend
yield, it has little to say about other value strategies. Another
problem with the use of relative rankings is that, in all likelihood,
the lowest scoring stocks in the Value index in fact do not represent
good value in an absolute sense. Moreover, what constitutes good
value for one investor may not be good enough for another. For the
record though, the Barra Canada Value index grew an average of 4.5%
annually over the last three years, while the Growth index (formed
from the remaining stocks) suffered a 14.5% average annual loss.
The value style meshes well with a cost-focussed approach to mutual
fund investing. By purchasing a low-fee mutual fund that follows a
value style, an investor avoids paying excessively for the privilege
of owning units of the fund. Furthermore, a fund that is paying low
multiples for its stocks is also probably holding them for the long
term, which should keep transaction costs low. So, it's an all around
bargain. From a more empirical standpoint, it happens that value
managers are well represented among equity funds that charge lower
than average fees, but this is by no means an exclusive club.
Some of the better known value funds that have a low management
expense ratio (MER) include the Saxon group of funds, as well as funds
offered by Mawer, and Leith Wheeler. Also included in this group are
the Chou funds run by part-time fund manager Francis Chou. In the
rest of this article I focus on the Chou Associates fund. Its sister
fund, Chou RRSP, is very similar in style and composition but, unlike
the Associates fund, it respects the 30% foreign content limit for
Chou Associates Fund
The Chou Associates fund is among the select group of funds that
made money over the past three years. Indeed, in 2002, the fund
posted a remarkable return of 30%, and for the period 2000-2002 its
average annual gain was 19.6%. Although it is listed as a U.S. Equity
fund by both GlobeFund and Morningstar, the Associates fund is
actually more of a North American fund. A sensible benchmark is,
therefore, 50% S&P 500 Total Return and 50% S&P/TSX Total Return
indices. In sharp contrast to the Chou Associates fund, this hybrid
benchmark lost 17.2% in 2002, and suffered an average annual loss of
10.2% during the same three years.
The fund has been managed by Francis Chou since it went public in
1986. Prior to this it was managed as part of a private investment
club. Mr. Chou is perhaps unusual among money managers in that he
manages both the Associates and RRSP funds in his spare time. When he
is not adding value for his investors he is a vice-president of
Fairfax Financial. Chou's funds have been near the top of their class
for many years, which speaks volumes about the merits of his approach.
In late 2002 the Associates fund received a $50 million investment
from Fairfax, increasing the fund's assets by almost a factor of six.
To avoid any potential conflicts, or the appearance thereof, Mr. Chou
has entered into appropriate arrangements with Fairfax concerning
trading activities. Furthermore, he is foregoing any compensation or
benefits arising from his position as a Fairfax executive.
The Chou Associates fund aggressively follows a contrarian deep
value style with discipline. Mr. Chou favours well-managed companies
that have a solid record of prudent capital management and at least
ten years of sustained return-on-equity of greater than 15%.
Following a self-described "Margin of Safety" credo, he also looks for
a stock price that is far below what a rational investor would pay for
the company. Once purchased, stocks are generally held for the long
term, as illustrated by the fund's low 28% average turnover.
Recently, Mr. Chou has also been taking advantage of attractively
priced distressed securities, including, notably, Tyco (TYC) stock as
well as Time Warner Telecom (TWTC) and Worldcom (WCOEQ) senior notes.
When it comes to taking advantage of investment opportunities,
Francis Chou doesn't believe in half measures. For example, at the
time of purchase, the Worldcom senior notes accounted for 9.2% of the
fund. These went on to post a 53% return by the end of last year. In
his 2002 annual report, Mr. Chou justifies this aggressive stance
stating "What good does it benefit an investor if he does not take
advantage of his good ideas in a meaningful way? Good ideas are rare
and may only pop up every few years."
Of course perception and reality are sometimes at odds where
bargains are concerned, as Mr. Chou freely admits. The fund's
investment in Touch America Holdings (TCAH), for example, ended the
year at only about 20% of it's average initial cost. This serves as a
reminder of the risk inherent in distressed stock plays.
At the end of 2002, the Associates fund's portfolio included twenty
stocks and four corporate bond issues. The fund's cash position was
over 60% of assets because of the influx of money from Fairfax. Of
the invested portion of the portfolio, 31% was in Canadian stocks and
the balance was held in U.S. securities. The top three stocks were
Berkshire Hathaway (BRK.A), Criimi Mae REIT (CMM), and BMTC Group
(GBT.A). As of the end of May, an expanded position in Orthodontic
Centers of America (OCA) had bumped Criimi Mae down to the number
three slot, and cash represented about 50% of assets. The fund's cash
reserve will be slowly deployed as good investment opportunities
arise. It is worth noting, however, that in recent years the fund has
maintained cash levels of the order of 20%.
As of May 14th, the minimum investment level for the fund was
lowered to $10,000. Individuals with identified high net worth can
buy directly from the manager. Otherwise the fund is available
through brokers and dealers to investors in Ontario, Manitoba,
Saskatchewan, Alberta, and British Columbia. Of course, if you buy
through a discount broker you should be able to have the fund's
front-end load waived. The fund also charges a 2% redemption fee for
those investors who redeem their units within two years. Any fees so
collected are reinvested in the fund.
With a 1.87% MER the Chou Associates fund lies near the 2% upper
limit that I advocate, and this has proven to be a bargain price given
the fund's excellent long-term track record. Having said this, it
should be emphasised that past performance is no guarantee of future
returns. According to Francis Chou the market is not cheap, and the
Associates fund's returns going forward should be expected to be in
the single digits for at least the next few years. The Chou
Associates fund is appropriate for moderately aggressive investors who
seek long-term capital appreciation.
Carl Wolfe, PhD