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Disciplined Value
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 registered investments.

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

July 2003

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