Dear Unitholders of Chou Associates Fund,
After the distribution of $0.41, the net asset value per unit (“NAVPU”) of a Series A unit of Chou Associates Fund at December 31, 2022 was $155.04 compared to $142.25 at December 31, 2021, an increase of 9.3%; during the same period, the S&P 500 Total Return Index decreased 12.5% in Canadian dollars. In U.S. dollars, a Series A unit of Chou Associates Fund increased by 2.1% while the S&P 500 Total Return Index decreased 18.2%.
The table shows our one-year, three-year, five-year, 10-year, 15-year and 20-year annual compound rates of return.
| December 31, 2022 (Series A) | 1 Year | 3 Years | 5 Years | 10 Years | 15 Years | 20 Years | |
| Chou Associates Fund ($CAN) | 9.3% | 14.7% | 7.1% | 7.7% | 6.0% | 6.2% | |
| S&P 500 | ($CAN) | -12.5% | 9.2% | 11.1% | 16.1% | 11.1% | 9.0% |
| Chou Associates Fund ($US) | 2.1% | 13.1% | 5.5% | 4.4% | 3.8% | 7.0% | |
| S&P 500 | ($US) | -18.2% | 7.6% | 9.4% | 12.5% | 8.8% | 9.8% |
Rates of return are historical total returns that include changes in unit prices, and assume the reinvestment of all distributions. These annual compounded returns do not take into account any sales charges, redemption fees, other optional expenses or income taxes that you have to pay and that could reduce these returns. The returns are not guaranteed. The Fund’s past performance does not necessarily indicate future performance. The table is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of the mutual funds or returns on the mutual funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing.
Factors Influencing the 2022 Results
The major advancers in the year were the equity holdings of EXCO Resources Inc., Resolute Forest Products Inc., and Berkshire Hathaway Inc. The decliners in the year were the equity holdings of Bausch Health Companies Inc., Citigroup Inc., MBIA Inc., and Wells Fargo & Company. The Canadian currency depreciated against the US dollar, which also positively affected the Fund.
During the year, the Fund reduced its holdings in Resolute Forest Products Inc., MBIA Inc., Berkshire Hathaway Inc., and Bausch Health Companies Inc. The Fund also sold off its holdings in JPMorgan Chase & Company and The Goldman Sachs Group Inc. The preferred shares of Overstock.com, Inc. were converted into common shares.
The Fund initiated investments in Ally Financial Inc., Synchrony Financial, and Liberty Global PLC. The Fund also invested in the warrants of Hertz Global Holdings Inc.
Portfolio Commentary
Capital Gains Refund Mechanism
The Capital gains refund mechanism (CGRM) is a benefit provided under the Income Tax Act to limit potential double taxation on capital gains. The Income Tax Act (ITA) states that the same economic gain should not be taxed twice, (i.e. a gain should not be taxed once within the fund and also once by the unitholder).
In practical terms, what it means for the Fund, is that if there are significant redemptions, there is a formula that calculates how much unrealized gains we can sell to make it realized so that current unitholders are not subjected to capital gains taxes in the future.
At the beginning of the fourth quarter, we found that the Fund had nearly $68 million of unrealized gains. This is a big chunk, and it would have put a severe tax burden on unitholders in the future. There were also large redemptions from the Fund, so we looked into how much CGRM it had generated. The answer was approximately $40 million. This meant that we could realize $40 million of unrealized capital gains without any tax consequences for the year 2022, thus reducing large tax bills in the future for unitholders. As a result, we sold some shares of several securities such as Berkshire Hathaway, JPMorgan Chase & Company, The Goldman Sachs Group Inc., and Resolute Forest Products Inc. to utilize close to 100% of the CGRM.
The Common Theme In New Purchases
We purchased shares in several new companies. They are half-decent companies that generate tons of free cash flow, sell at a low multiple of earnings, and have management that we can trust to make operating and capital allocation decisions wisely. But if there is a common theme in the new purchases, it is that they have been big buyers of their own stock over the last few years. We also believe that if their shares fall further, they will repurchase them in significant quantities in the market. What this entails is that their intrinsic value will increase on a per-share basis. That is music to my ears.
However, there is one caveat regarding companies buying back their shares. They should not be in a declining industry where new technology or processes will make their products less valuable. And as a corollary, the company should not buy back shares if it is a piece of CRAP (Cannot Realize A Profit). In this case, the remaining loyal shareholders are getting a larger piece of a crappy company.
I remember a time 20 years ago when the newspaper industry was in decline because of the advent of the internet. I thought it would take ten years before the newspaper industry faced a massive decline in advertising revenues. In a challenging industry, I was told a company goes bankrupt two ways; first slowly and then suddenly. But it is more like going quickly and then the bottom just falls out.
Be Careful with the Conventional Definition of Safety
When 2021 ended, we were concerned that inflation would raise its ugly head. It is unprecedented how much money has been printed over the last 15 years, and we felt it was a matter of time before you had to pay the piper. We were happy to stay in cash/short-term treasury bills unless we found a mispriced equity. We were not enthused with buying long-duration treasury bills to gain an extra 50 basis points in yields, and we felt that any investor buying any A-rated paper with a long duration was playing with fire. An investor trades for a gain of 50 basis points (0.5%) in interest income for a potential capital loss of 40%. We were happy staying in cash equivalents which were virtually paying 0%. In 2022, our cash level was as high as 24% of the net assets of the Fund.
If you look at the chart below, you can see the devastation caused by buying a long-duration A-rated paper such as treasury bills, supposedly the safest security in the world.
At the beginning of 2022, it was trading at $147.17 but dropped to $87.32 at the end of 2022 for a loss of 40.7%. So much for being the safest security in the world!!
We are wary of buying any financials such as banks or insurance companies whose assets consist of large portions of long-duration treasury bills, fixed-income assets, or 30-year fixed residential mortgages.
Resolute Forest Products Inc. (RFP, Financial)
In June 2022, RFP announced that Domtar would be purchasing the company. The transaction will be carried out by way of a merger between RFP and a newly created subsidiary of Domtar, providing for the conversion of each share of RFP common stock into the right to receive US$20.50 per share, together with CVR (Contingent Value Rights) entitling the holder to a share of future softwood lumber duty deposit refunds. Each share, on a fully diluted basis at closing, will be entitled to receive one CVR.
Looking back on RFP, there is an important lesson for investors. RFP paid a special dividend of US$1.50 a share in 2018. In 2020, the company announced that it would buy back 15% of its common shares for US$100 million. In spite of all that information, the stock traded as low as $1.17 per share – meaning the whole market capitalization was approximately US$99 million. In other words, instead of buying back 15% of the company with US$100 million, it could have repurchased 100%.
The investment in RFP shows you what it takes to have the mindset of a value investor. I wrote about it in 2021’s annual letter, but it’s worth repeating. “When the stock is that cheap, assuming that you don’t own any shares, a rational investor should back up the truck and buy every share that is offered in the market. But what makes it difficult for some investors to buy is not the rational side of their mind but more the psychological aspect of it. In the stock market, you are bombarded with noises that affect a person’s rationality. It can get radically altered. Stock prices can move unrelated to the fundamentals of a business. During a bull market, you may see several stocks trading at anywhere from 50 times to more than 100 times earnings, and conversely, there can be several stocks that sold at 10 times earnings going down to below five times earnings. The fundamentals of the company are ignored and instead, investors are transfixed on the price movements of the last couple of years. Then new narratives are written most convincingly on why these are the “new” paradigms, and why they are not worth giving weights and considerations to what the assets are worth and what the company can earn over several years. I remember talking to one value manager in 1999 when the tech stocks were in full bloom. He said, “I have a family to feed and I will keep losing assets if I don’t accept the new headlines and paradigms. Sticking to buying companies that are undervalued is not the way to be successful in the long run”. He changed his philosophy before the techstocks were about to go into a severe decline over the next couple of years.”
EXCO Resources Inc. (EXCE, Financial)
In early July 2019, the company emerged from bankruptcy and the 1.75 lien term loans were converted to 28.38 equity shares for every US$1,000 in par value, after netting out certain adjustments. The equivalent price was US$9.51 per share of EXCO.
Since it is a private company, I am not at liberty to divulge the latest financial statements, but what I can tell you is that my calculation of its PV-10 value was more than US$2 billion (roughly $38 per share) based on the New York Mercantile Exchange (NYMEX) forward pricing as of June 30, 2022, and the net proved reserves was 2.7 trillion cubic feet equivalent. Its number of outstanding shares was 51,584,500. We estimate its EBITDA for the year ending 2022 will be approximately US$275 million to US$300 million.
As a comparison, in 2018, the PV-10 value was US$750 million.
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. Also, the Fund’s cash position was approximately 24.0% of net assets as at December 31, 2022.
Other Matters
FOREIGN CURRENCY CONTRACTS: None existed at December 31, 2022.
CREDIT DEFAULT SWAPS: None existed at December 31, 2022.
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 2022 IRC Annual Report is available on our website www.choufunds.com.
As of March 17, 2023, the NAVPU of a Series A unit of the Fund was $151.93 and the cash position was approximately 20.2% of net assets. The Fund is down 2.0% from the beginning of the year. In U.S. dollars, it is down 3.4%.
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 (Trades, Portfolio), Fund Manager
