Chou Associates Management founder Francis Chou. (Portrait by Jennifer Roberts)
Francis Chou says he owes his career to the Financial Post. In 1979, a 25-year-old Chou, then working as a Bell telephone technician, opened up the paper and gazed upon an article about value investing. He knew nothing about stocks, but the piece spoke to him. It reminded him of growing up in India and having to shop for groceries for his family, where he was constantly comparing prices. If he saw a bag of rice at one place, he’d go to another to look for the same thing at a lower price. Value investing, he says, is almost the same exercise. “You don’t haggle on price, but when you go to a store and you find a good product for 40% off, you buy it,” he says.
Chou started reading as much as he could on value investing. In 1981 he asked six of his Bell Canada colleagues if they would be willing to invest with him. He put about $50,000 in the market and started making money. While most of those first clients have long since cashed out, one client gave him $80,000 to invest later that year and that person is now worth $5 million, says Chou, who adds that he’s been doubling his money about every five and a half years.
Chou has become a renowned value investor—in 2015, Barron’s called him one of the World’s Best Investors. He also helped Prem Watsa, a colleague at boutique investment firm Gardiner Watson in the 1980s, understand why insurance companies are good investments. He was working with Watsa when the latter bought Markel Financial Holdings, the precursor to Fairfax Financial Holdings Ltd. (TSX: FFH).
With only a high school diploma, Chou obtained his Certified Financial Analyst designation in 1985 and registered as a portfolio manager and investment counsel. A year later he officially launched Chou Associates Management and its flagship product, the Chou Associates Fund, which evolved out of the private placement fund his Bell Canada colleagues invested in.
Back then value investing was relatively easy. People didn’t invest in stocks the same way they do today and good companies priced at six times earnings were the norm. The flip side was that stocks didn’t move a whole lot. “They didn’t go anywhere for years,” he says, “but you could keep hunting for bargains.”
Today, the opposite is true. Stocks have seen enormous gains and price-to-earnings ratios have skyrocketed. Now, companies trading at 22 times earnings are a dime a dozen, he says. That’s made his job a lot more difficult. “It’s much harder to find bargains,” he says. “It’s so different.” Other value managers are buying stocks at higher valuations, but Chou is a deep-value investor who tries to find bigger discounts than his peers. He typically wants to own a company that’s trading at a 40% discount to what it’s really worth. If the markdown isn’t steep enough, he won’t buy, even in this environment.
That said, deals do pop up. Most of the companies Chou owns have seen their values drop for some reason—maybe the sector has fallen out of favour, as we saw with oil and gas last year, or a company has missed an earnings target, or there’s a funding or liquidity issue. Whatever challenge the business is facing, though, it should only be temporary. “We want companies that can overcome those problems in time,” he says.
Of course, it’s impossible to foresee if a business will indeed rise from the ashes, which is why Chou does plenty of due diligence before buying. First and foremost, he wants his companies to have positive cash flow and the ability to grow earnings. Management needs to know what it’s doing, too. The top executives are the ones who will determine whether the company realizes its value. Chou also thinks about all the things that could impair intrinsic value—maybe something will prevent earnings from growing, for instance. “We always look at what could go wrong,” he says.
If he ends up making the wrong choice, then a failure won’t affect his portfolio as much as it would someone who bought the stock at fair value. “You need to have that cushion, that margin of safety, against a mistake in your judgment,” he says. One company that currently fits his style is Resolute Forest Products (NYSE: RFP), a Montreal-based pulp, paper and wood products producer. The firm has had a rough go of it since the recession, with prices for all its products declining. Yet Chou doesn’t think it should be trading under US$5 a share. “That means the market cap of the company is selling for less than US$400 million, but it has consolidated sales of close to US$4 billion,” he says. He thinks that each individual segment could sell for US$400 million alone. If it continues to sell as much as it has, the market will eventually see the value in this business. For now, he says, “It’s very undervalued.”
In 2002, Chou started buying junk bonds, which, he says, aren’t that different from value-priced equities. He’s looking for companies that have gone bankrupt and whose notes are now trading at 60 cents on the dollar. But he wants to buy that debt at about 20 cents. He scooped up a lot of loans to these kinds of companies, mostly oil and gas, nine months ago. (One he described in his last annual investor letter was Dallas-based Exco Resources. “If the company restructures or goes into bankruptcy, the recovery value of the bond is greater than the current price,” he wrote.) With equity valuations at historic highs and government bonds barely eking out a return, junk bonds offer solid yields at a good price, he reasons.
At the moment, no sector stands out in terms of valuation—it’s all expensive, he says—but he’s being patient. He did buy some stock in January 2016, when markets corrected, and he’s holding about 20% of his portfolio in cash that he intends to deploy when the companies he wants to own take a dive. And they will get cheaper, he says. He’s not sure when, but, as he learned on his shopping runs in India, there’s always a better price around the corner. “There are cycles and periods where you can buy stocks cheaply,” he says. “Maybe the whole market doesn’t come down, but there will be pockets of opportunity.”
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