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My interview with Francis Chou of Chou Associates originally appeared in my national bestselling book, Market Masters, which is available at Chapters, Indigo, and Coles as well as Costco and Amazon.ca.
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Francis Chou is arguably the only staunch Graham-and-Dodd value investor in Canada today. I say “staunch” because both the concept and application of value investing have become diluted over the years since Benjamin Graham fathered the philosophy in 1949’s The Intelligent Investor. Benjamin Graham would seek out and buy a dollar’s worth of tangible assets for 50 cents. Value investing has evolved, though, because tangible assets are not as prevalent in companies today as they were in the decades from 1890 to 1980, when industrial, transportation, chemical, steel, textile, and oil and gas companies represented the majority of the stock market.
Today, an investor cannot simply “buy a dollar’s worth of assets for 50 cents,” since most companies that make up the stock market do not consist entirely of tangible assets, but rather, to a greater extent, intangible assets. Intangible assets include — but are not limited to — trademarks, copyrights, patents, and brands. Notable examples of predominant intangible companies are Google, Apple, or Microsoft. Success as a Graham-style value investor in today’s market is limited because intangible assets do not hold the same value nor do they produce the same predictable returns as tangible assets. For example, Graham could quite easily and confidently calculate the liquidation value of a steel manufacturer’s machinery and equipment based on readily available market prices, as one key input to determine the worth of that company. From there, he would invest in that steel manufacturer if, say, its current assets exceeded its total liabilities (net current asset value). But how do you calculate Microsoft’s worth when intangible assets make up the majority of its business? Think about it, the value of intangible assets can be transitory in that they often do not stand the test of time from the effects of innovation or competition. Even Benjamin Graham, late in his career, declared, “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published, but the situation has changed a great deal since then.”
Given today’s reality, Francis Chou has still been able to successfully apply the same Graham-and-Dodd value investing principle to his security selection in both tangible- and intangible-asset-based companies. Using as an example Warren Buffett, who went from being a staunch Graham value disciple to more of a growth at a reasonable price investor, I asked Francis whether he’s ever felt the need to change, to which he replied, “As my knowledge of businesses has grown, I’ve bought good companies as well as mediocre companies. I’m all over the place — wherever I can find bargains.” While deep-value investing represents the core of Francis’s philosophy, he’s complemented his funds with other securities, ones that do not fit into a “deep value” category.
Francis was a 25-year-old repairman for Bell Canada when he pooled $51,000 from himself and six coworkers to start an investment club. That investment club would eventually blossom into Chou Associates Management Inc., which now has around $1 billion of assets under management. The flagship Chou Associates Fund has boasted a long-running and consistent track record since its inception in 1986. Francis sent me Bloomberg screenshots of the Chou Associates Fund’s 15- and 20-year annual com- pound returns. Fifteen-year compound annual return: 11.69% versus S&P 500’s 4.23%. Twenty-year compound annual return: 13.19% versus S&P 500’s 9.81%.
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Both Bloomberg screens were fascinating. The 20-year chart showed the Chou Associates Fund trailing the S&P 500 from 1995 to 2001, during the technology bubble, then vastly outpacing it from 2001 to 2015. Value investing won. Morningstar has shown that the Chou Associates Fund has achieved the highest return of all Canadian mutual funds between 1986 and 2015. Amazingly, Francis achieved the highest returns over this long period with one of the lowest standard deviations in the industry, meaning that his fund experienced only minor volatility or ups and downs. Therefore, the Chou Associates Fund actually ranks the highest according to the Sharpe ratio of portfolio risk-adjusted returns. Using his fund as an example, Francis will often say that the Modern Portfolio Theory (MPT) is bunk. “MPT says that to get high returns, your standard deviation has to be higher; however a positive correlation between risk and return is not found here [in my funds].”
Francis’s was the most challenging interview to secure for this book. It took a letter, multiple phone calls, and multiple emails to both him and his assistant to finally schedule our talk. Francis told me, “You can get all of this information from my annual report” or “Go use what’s been written on me online.” However, I pleaded with Francis that those resources would not suffice, as I needed to produce an in-depth, informal, and entertaining interview. Finally, I got the interview. And trust me, it was worth it.
Francis’s office is located north of Toronto, far removed from Bay Street. It’s just him and his assistant, Stephanie, who work in the office, an office so spare that you could probably fit everything in it into one box. Francis is definitely not an accumulator of things, and he is the embodiment of a successful value investor. This tells you that all you really need to invest is a computer, account, and good ideas.
There is a tinge of sarcastic humor to some of what Francis says. At times, you’ll need to read between the lines, and his humor may not always come through on the first read. Also, occasionally during our interview, Francis would expect me to answer some of his questions. He asked me, “What’s the most important thing to check in the bank?” to which I incorrectly answered, “ROE.” He turned me, the interviewer, into the interviewee. To find out what I should have said, and to learn from a value investing master, you will have to read the interview.
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Pre-Interview Lessons
Bargain: a term usually used by value investors to denote a value stock.
Business Moat: the illustration of competitive advantage, which is usually created by strong brands, unique assets, long-term contracts,
market position, or some combination of all of these factors.
Dollar-Cost Averaging: when investors continue to put money into a stock while its price on the market declines, either to reduce the average purchase price (and limit their loss), and/or to buy more when it’s cheaper, signifying a value stock opportunity.
Intangibles: non-physical assets, such as brand, that cannot be easily or accurately quantified by accountants and can be subject to depreciation- based changes in perception alone in some cases, or write-downs on erroneous acquisitions (i.e., “Goodwill”) from the past that did not realize an ample return.
Modern Portfolio Theory (MPT): a systematic approach to portfolio diversification based on asset class allocation (e.g., bonds, stocks, etc.), that seeks to maximize return for a given amount of risk in one’s port- folio.
Quantitative Easing (QE): when a central bank (e.g., U.S. Federal Reserve) creates new money to buy financial assets, most commonly bonds, in order to influence higher private sector spending and to meet the designated inflation target during recessions or downturns in the economy.
Valuation: the worth of a company or asset.
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Francis Chou Interview
How many clients are currently invested in your funds?
It’s hard to say for sure, but I assume in the area of one hundred thousand accounts.
You manage about $1 billion in assets. Is that in total, or just in the Chou Associates Fund?
That’s in total, including the Chou America Mutual Funds.
How much assets under management did you start with at your firm?
Back on July 1, 1981, I started with $51,000 when I was at Bell Canada. That’s phenomenal growth. You came to Canada for work. You were actually born and raised in India, is that correct?
Yes, in a city called Allahabad in India. But my parents moved to India from China.
Why did they move to India?
My dad got a job as a university professor, teaching history, philosophy, Chinese history, and Chinese language.
Did your parents influence you early on to invest in the market?
No, my dad died when I was seven years old.
I am sorry to hear that. When did you first become interested in the mar- kets? Was it once you moved to Canada?
I came to Canada in 1976. I became interested in the markets shortly thereafter, probably around 1979.
What was the spark that got you interested in the markets?
Buying bargains, which I was doing all my life while I was in India. After my dad died when I was seven years old I started to do most of the shopping for the family. In India the shopping is very different than it is here. If you go to Loblaws, the price of everything is marked, so you just pick whatever you want, pay at the cashier, and then off you go. In India, you have to haggle for everything. But haggling is not that simple. Before you can haggle, you first have to go to several vendors to determine the quality, and then compare the prices, so that you can buy the best quality at the cheapest price.
I can see the bridge — you buy bargains in the market, too.
That’s correct. So, in a way, I was doing the same thing in India. Everything you buy, whether it’s milk, meat, vegetables, or whatever else there — it was my job to make sure I was paying the lowest price for the best quality.
And then you were introduced to The Intelligent Investor, and value investing, which solidified your investment strategy.
Yes, I read something, most probably in the Financial Post in 1979,
saying that the father of value investing was Benjamin Graham. So one thing led to another, and I found my niche, so to speak.
Were you personally buying stocks early on?
No, I did not buy stocks then — I had no money. I was scrambling for a living.
You got a job at Bell Canada, gained some assets, and then decided to start up that investment club, which I believe included five or six of your coworkers?
Yes, there were six.
Where are those six coworkers now?
Some have died. That was a long time ago — 1981, which was 34 years ago. While some former coworkers have died, others are alive, and worth a lot of money.
The ones who are still alive — how wealthy are they now?
One of them who is around my age gave me $80,000 to invest in 1981 and right now he’s worth $5 million. When he gets to the age of 80, if we continue to compound at that same rate, he will be worth close to $60 million. And if he lives to 90 years old, he’ll be worth $200 million, just from that original $80,000, assuming that we can maintain the compound rate we have earned in the past. But even if that original $80,000 investment grows to just $100 million, that is a lot of money for a telephone technician. There are tens of thousands of MBA students graduating every year from elite universities in North America. How many of them can boast about developing a net worth close to $10 million in their lifetimes, let alone $100 million?
He’s financially independent now.
Yes, he doesn’t need anything. There are a few guys like that.
Do you still keep in touch with all of the original investors from your Bell Canada investment club?
Some of them; not all of them.
Did any divest their shares?
Yes. Most probably.
How did you initially turn the club’s $51,000 into $1.5 million? What did you invest in?
The returns were compounding fast. Later on some new money came in and the $51,000 grew.
But do you have examples of some of the early investments that you took on?
Those were some of the best times to invest. You could buy anything and you would probably do well.
Businessweek issued a feature article just before that period. It was entitled “The Death of Equities.” I believe that it was written in 1980. 1979.
Yes, 1979. Their headliner statement was completely wrong. 1981–1982 was the start of a long-term bull market. Do you attribute your early success to that bull market?
No, not at all. Read my annual letter of 1981. My success has nothing
to do with the fact that it was a bull market.
[I did read it. The quote below is from that annual letter.]
Is this the time to invest? Yes, definitely. Stocks, in this doom and gloom environment, are cheap by every historical standard. . . . What I would propose in the future, if the market is more demoralized than what it is now, is that we should open this fund to the public. There is no better time to invest aggressively. Stocks are selling at a substantial discount from book value and even during the Great Depression, the Dow [Dow Jones Industrial Average] did not trade below book value for more than a few months. . . . Companies in the United States are selling at giveaway prices.
Interesting — your foresight was spot on.
So, you cannot say that my success is because of the bull market.
You said the opposite of what the experts said at the time — you said that the stock market was alive, not dead.
That’s right. My 2014 annual letter explains the framework of what I was thinking at that time.
I have been managing money since 1981 and one of the benefits of managing money for so long is that you get exposed to many financial and economic scenarios. When I was first thinking about the current market I couldn’t help recalling what happened over the 15-year period from 1966 to 1981. The Dow hit a high of approximately one thousand in 1966 and for the next 15 years it would approach that level only to recede back again. Inflation, which was subdued in the 1960s, started to go up in the 1970s, the result of printing money in the 1960s to finance the war in Vietnam.
By 1980, the combination of high inflation and low GDP growth was the story of the day. When Volcker was named Chairman of the Federal Reserve board in 1978, his first mandate was to tame inflation. By June 1981 the federal funds rate rose to 20%. Eventually, in June 1982, a highly important economic measure, the prime interest rate, reached 21.5%. The 30-year bond hit a high of 15.2% yield when Volcker put the brakes on money printing. The Dow tumbled, selling at a severe discount to book value.
At the time, I was wondering how much lower the market could go. This is how I looked at the scenario: the interest rate was so high that I felt it could not remain at the level for any extended period of time without just killing the economy. Volcker’s mandate was to break the back of inflation, and when he did that, interest rates were bound to go lower. Even if they didn’t, the market was incredibly cheap: approximately six times earnings and roughly 6% dividend yield. The Dow had been earning, for a long time, on average, 13% on its equity and there was nothing to suggest that it was not going to earn the same in the future.
If interest rates went down, the end result would be that the companies would be worth a lot more. The discount rate that used the discount future earning power is somewhat linked to the prevailing long-term interest rate. When companies borrow money, the rate they pay, depending on their credit rating, is benchmarked to the pre- vailing interest rate plus or minus a few points.
The climate for investing in 1980 was one of extreme fear. For example, pension funds, as a group, invested only 9% of net investible assets into equity. In contrast, in 1971, 122% of net funds available were purchased into equities; in other words, they sold bonds to buy more of the equities. Those who wanted to get into the investment field in the late 1970s and early 1980s were considered pariahs at the times, and were to be avoided at all social gatherings as one would avoid the plague.
At that time I was getting totally immersed in the works of Benjamin Graham. I was hunting for every scrap piece of information I could find on Benjamin Graham and Warren Buffett. Although I was new to the investment scene then, the scenario had a smell of true success for any value investor. Not just success but something that would enable you to cook up a grand career.
Okay, you clearly had the correct foresight, and took the right bet on the stock market.
Yes. It was not a speculative bet but a bet based on reason and logic.
You can see how confident I was. I knew my stuff. That’s why I can say without hesitation that my success was not because of the bull market.
So, it’s about making the right call, and then having the conviction to invest. Are you as confident in the market now? Multiples seem high.
Everything is so high. But I wrote about that too in my 2014 annual
report. In the last half I provide a framework where I contrast the cur- rent scenario to the scenario in 1981. Everyone is so bullish but I’m really negative. Look particularly at the last sentence in my 2014 annual report. By contrast, current conditions today make me feel like investors are being set up for a heartbreaking disappointment, especially for the
unwary.
Are lofty valuations in the market today the result of quantitative easing programs around the world?
Yes. A lot of people don’t understand the dangers, so they can see the
bullish side, but not the negative side.
And so, when rates eventually go up, people will cycle out of equities and go into bonds?
Yes, but we don’t know for sure. We only know that the rates can
change in the future. The same thing happened in 1981. I didn’t know the market was going to take off in six months, but I knew you couldn’t get stocks any cheaper than their prices at the time, though all the numbers were indicating that everyone was running away from the stock market. Pension funds were running away from equities and you could see that. So, basically, my success in 1981 wasn’t because I was just there; it was because I understood what was happening.
You had conviction.
I took a stand.
After running the investment club for many years, you joined GW Asset Management. And that’s where you met Prem Watsa.
That’s right. After working seven years at Bell Canada, it was time to leave. I had already delivered some great numbers by 1982. From ’81 to ’82, in a six-month period, do you know how much the TSX dropped?
No.
40%. When I was running the fund, how much do you think my fund dropped?
10%?
5%.
That’s great. I’ve heard that you were the “most talented employee” at GW Asset Management.
No. I don’t know about that.
Whether true or not, why would people say that about you?
Could be just hindsight, because I’m successful now.
How did you meet Prem Watsa at GW Asset Management?
Prem was working there. He had been working at Confederation Life, and then Gardiner Watson wanted someone to run an asset management company as a subsidiary of Gardiner Watson, so that was how Prem landed there in late 1983.
You and Prem have been close since. And if we were to compare the port- folio of Fairfax Financial Holdings to your Chou Associates Fund, there are some commonalities. For example, Resolute Forest Products.
Value funds tend to have a 5% overlap. My funds may have commonalities with the funds of a lot of other value guys.
I would understand that for a stock like Google, but not for a smaller stock like Resolute Forest Products.
Resolute has more than a $1 billion market cap.
Okay, moving on then. Do you work best alone?
Yes, I just work on my own. I’ve been doing it since I started my fund.
It’s just you investing in the funds?
Yes. Normally you need 40 to 80 people, when one has seven funds and $1 billion in assets.
What do you do for the most part on a regular day?
Just read.
What do you read?
All the newspapers, and all the publications such as Newsweek, Forbes, the Economist, as well as trade magazines, politics, scientific journals, and biographies. I read about anything and everything. Nothing is irrelevant. Investing is not done in isolation. When you read about great men and women of the past, it is like having a conversation about world affairs in your living room. It is not only educational but it builds perspective about life and business in general. I have been involved in business and investing for close to 40 years and when you have been doing this for so long you will always encounter situations similar to what these great people have faced in their lives. By reading about them, you know what kind of actions they took and how well it worked for them. You cannot ask for better guidance than that.
Do you take on positions from any of the companies that you read about in the news?
No. My first job is to check whether the company in question meets my investment criteria. It could be a good company, a bad company, or it could be a CRAP. Do you know what CRAP means?
No. Is it an acronym?
It means “cannot realize a profit.”
What do you expect from CRAP companies — that they’ll eventually turn around and generate a profit?
You examine the capital structure first. In terms of priority, you look
at the most senior bonds, down to the most junior bonds, and finally to equities. But sometimes you can buy a senior bond at 40 cents on the dollar and if it goes into bankruptcy you can get 80 cents on a dollar.
Was that why you bought into Sears, which you have a stake in? Was it because of the real estate that may be worth more on the books than what it’s trading at on the market?
Yes, the real estate is worth more than what the stock is trading at on the market.
How do you generate your best investment ideas?
I do screens, read a lot, and talk to other talented portfolio managers to see where they are seeing bargains.
So you have a sounding board.
Before you make a purchase, you should look for investors who are negative on the stock.
You want to test your logic?
Disconfirm your own thesis.
Would you consider yourself a deep-value investor?
Most probably. And that’s how most would label me. But in some ways it’s not really true, because I also buy a lot of good companies.
So, you’re a lot like Warren Buffett then. He went from just picking up cheap “cigar butts” and getting a couple more puffs to investing in quality companies for a fair price, too.
I do the same.
How have you evolved?
As my knowledge of businesses has grown, I’ve bought good companies as well as mediocre companies. I’m all over the place — wherever I can find bargains.
So what’s your portfolio allocation? You mentioned that you primarily buy into CRAP. But how many quality companies do you own?
It depends, based on the time period. In the nineties I had a lot more “good” companies than I do now. To purchase good companies right now you need to pay more than 25 times earnings. That is not cheap. So I just go wherever I can find bargains. For instance, in the years 2000 to 2002, I was basically in distressed bonds. I just go wherever I can find something undervalued.
Where are you finding value now?
There is hardly anything to buy.
So there’s a lot of cash on the sidelines?
Yes, and I think if you break even over the next five years, you will have some of the best numbers five years down the road.
Do your funds experience higher performance than your peers during bad markets?
By and large, I had better performance than other mutual funds in bad times.
How were you investing right before the financial crisis? Did you foresee the crisis?
You should read my 2006 annual report. In it, I warned investors and explained how I was already planning on going into CDSs [Credit Default Swaps]. Here is what I wrote about the stock market, potential banking crisis, and sub-prime mortgages in that report:
According to the Bank for International Settlements, con- tracts outstanding worldwide for derivatives at the end of June 30, 2006 rose to $370 trillion. We are alarmed by the exponential rise in the use of derivatives. No one knows how dangerous these instruments can be. They have not been stress-tested. However we cannot remain complacent. We believe the risk embedded in derivative instruments is pervasive and most likely not limited or localized to a particular industry. Financial institutions are most vulnerable when (not if ) surprises occur — and when they occur they are almost always negative.
As a result, we have not invested heavily in financial institutions although at times their stock prices have come down to buy levels. Some 30 years ago, when an investor looked at a bank, he or she knew what the items on the balance sheet meant. The investor understood what criteria the bankers used to loan out money, how to interpret the loss reserving history, and how to assess the quality and sustainability of revenue streams and expenses of the bank to generate reasonable earnings. In a nutshell, we were able to appraise how much the bank was worth based on how efficiently its bankers were utilizing the 3-6-3 rule.
The 3-6-3 rule works like this: the bank pays 3% on savings accounts, loans out money to businesses with solid financials at 6%, and then the banker leaves the office at 3 p.m. to play golf.
That was 30 years ago and you can see how easy it was to evaluate a bank.
Now, when an investor examines a bank’s financials, he or she is subjected to reams of information and numbers but has no way of ascertaining with a high degree of certainty how solid the assets are, or whether the liabilities are all disclosed, or even known, much less properly priced. As the investor digs deeper into the footnotes, instead of becoming enlightened, more doubts may surface about the true riskiness of the bank’s liabilities. Those liabilities could be securitized, hidden in derivative instruments, or morphed into any number of other instruments that barely resemble the original loans.
We wonder whether bankers are using a rule that is as difficult to understand as their derivative instruments. We call it the 1-12-11 rule: namely, the bank pays 1% on checking accounts, loans out money to businesses with weak financials at 12%, and the banker leaves the office at 11 a.m. to play golf with hedge fund and private equity managers where they discuss how to chop and/or bundle the loan portfolios into different tranches and create, out of thin air, new derivative products that are rated triple A (from products that originally were B-rated). These products are then sold to institutions (who may be oblivious of the risk involved) that are reaching for yields.
The above example is written tongue-in-cheek and it is not meant to be entirely representative of what bankers do. It is meant to show just how creative participants have been in producing new derivative products, with little regard for a sound understanding of their leverage and true risk characteristics. We may be witnessing a “tragedy of the commons” where the search for quick individual profits is causing a system-wide increase in risk and reckless behavior.
How did the sub-prime mortgage lenders contribute to the problem?
Some of the greatest excesses of easy credit were committed by sub- prime mortgage lenders. Credit standards were so lax and liberal that homeowners didn’t even need to produce verification of income to be able to borrow up to 100% or more of the appraised value of their houses.
What was your conclusion?
My report concluded as follows:
From these examples, it appears obvious that investors are throwing caution to the wind. Risk is not priced into riskier securities at all. Whenever the majority of investors are purchasing securities at prices that implicitly assume that everything is perfect with the world, an economic dislocation or other shock always seems to appear out of the blue. And when that happens, investors learn, once again, that they ignore risk at their peril. We continue to diligently look for undervalued stocks and will buy them only when they meet our price criteria — in other words, when they are priced for imperfection.
Interesting. Can you expand on Credit Default Swaps?
This is what I wrote on Credit Default Swaps [CDSes] in 2006: In terms of investment ideas in derivatives, we believe that CDSes are selling at prices that are compelling. At recent prices, they offer the cheapest form of insurance against market disruptions. In CDSes, one party sells credit protection and the other party buys credit protection. Put another way, one party is selling insurance and the counterparty is buying insurance against the default of the third party’s debt. The Chou Funds would be interested in buying this type of insurance.
To give you some sense of perspective, in October 2002, the five-year CDS of General Electric Company was quoted at an annual price of 110 basis points. Recently, it was quoted at an annual price of less than eight basis points.
To make money in CDSes, you don’t need a default of the third party’s debt. If there is any hiccup in the economy, the CDS price will rise from these low levels. The negative aspect is that, like insurance, the premium paid for the protection erodes over time and may expire worthless.
Unfortunately I could not get the approval to purchase CDSes for my funds quickly. I was having some problems get- ting regulatory approval, getting comfortable with counter- party risks, and so on.
Let’s focus on your current investment process: do you invest bottom-up?
Yes. Initially I analyze bottom-up and then I go top-down. For example, let us look at the banks. What’s the most important thing to check in the bank?
ROE?
No. It is the loan portfolio, the book of business. You start with the loan portfolio and then you go from there. But most investors invest in terms of premium or discount to book value. That is a serious mistake. Let’s say the year was 2006. You examine the loan portfolio and see all the junk there. As a result, you wouldn’t touch a U.S. bank with a barge pole. The question about loan growth becomes irrelevant then.
So you don’t systematically scan stocks for low book value?
No. I’m a businessman. I have the benefit of having worked in operations. So I have an understanding of business, and not just book value. I bring another element to my analysis.
It’s your wisdom and experience that makes you successful. You don’t indiscriminately scan and invest in stocks.
Exactly.
How do your holdings post such strong returns?
I’m trying to buy 80 cents for 40 cents. It does not matter whether they are good companies, bad companies, or distressed companies.
Then how do you evaluate intrinsic value so that you can buy bargains?
The first thing you have to do in this business is to make sure that your valuation is accurate. That’s how it starts. If you think a stock is worth
$100, you try to buy it at $60. But if your valuation is wrong, and four years down the road it turns out it’s worth only $60, then you won’t make it in this business.
How do you ascertain that your valuation is accurate?
You’re a businessman and you look for these assets. Then you ask, “If I were to buy this company, how much would I pay?”
You also ensure that there’s a catalyst, right?
Buy and wait works most of the time, but a catalyst accelerates the process and generates higher returns.
Have you taken on a position that didn’t work out right away but worked out in the long run?
Oh, yes.
Can you share an example?
Yes, one instance happened two years ago when I bought a stock called Overstock.com that I thought was worth closer to $25. I bought it for Chou Opportunity Fund around $14 and it promptly went down to $7. I bought some more at that price. A bargain at $14 became a super bargain at $7.
Why did you think that it was worth closer to $25?
That was just my valuation. That’s what I thought it was worth based on its inventories, revenues, double-digit percentage growth in revenues, the potential of the business, the website, and a combination of factors that didn’t show up in the operating statement. Eventually, it went up a year later to $34.
Once an investment reaches your target price — in Overstock’s case, $25 — do you start to sell?
Yes, I would start selling then.
And then allocate that capital in other positions?
Yes.
With Overstock, you practiced dollar-cost averaging. It went lower, and you bought more shares.
No, it was not precisely dollar-cost averaging. You don’t automatically buy when it goes down. It all depends on your valuation. In this case, it was still worth $25 after reassessing it after the drop, so at $14, I was getting a 44% discount and at $7, I was getting a 72% discount.
Has there been a time though when you sold out of a stock because it dropped?
No, you don’t sell because of that. But if my revised valuation is $7, I would sell it. It would mean my original valuation of $25 was wrong.
I see. So, if the business deteriorates along with the stock price, then you would sell?
Yes, if I think the valuation is now not $25, then I’ve made a mistake.
A downward revision to $7 would prompt me to sell. The decision is totally based on valuation.
Normally you don’t invest in technology, correct? Overstock is close, but it’s e-commerce.
I shy away because of obsolescence and so on. I cannot predict the
future of technology, and I don’t know what will happen two years from now where there could and probably would be newer technology.
But you invest in BlackBerry — why is that?
Some of my investment choices like BlackBerry are because their patents are worth so much more than their stock price. For example, I bought some BlackBerry when it was around $7 because I valued the patents at about $13.
I’m interested in your thoughts on the Indian market. You were born there.
Indian people are highly intelligent and highly creative.
I agree — they generally are highly educated.
There’s no reason why Indians shouldn’t flourish in India.
Have you taken on any positions in Indian companies?
At this time, no.
Do you plan to?
We are looking into it.
Which companies would you look at in India?
I would take the same approach as I do here.
But I imagine a lot of them would be startup companies that you’d avoid.
They need to have some history. I am someone who will look at 10-year history, even a 20-year history.
Do you look for consistent earnings?
Yes. I don’t mind even if the revenue decreases as long as management is doing the right thing. I don’t want to chase businesses where management is making decisions that don’t make economic sense.
What about increases in book value. Is that important?
I think increases in intrinsic value are more important than increases in book value.
What’s the difference?
Sustainable earning power, business moats, and competitive advantage relate more closely to intrinsic value and therefore are more important than just increases in book value.
So you also need to understand whether or not a company will have competitive advantage for the long term?
Yes, five years, ten years down the road, if you’re going to go the route of good companies.
How can you predict that?
Well, with firms such as Sears and BlackBerry, you don’t know. Therefore, you look for asset coverage like real estate or patents. With others, like Coca-Cola, you can predict for sure.
Which companies generally don’t have enduring competitive advantage?
Technology companies for sure. Mining and commodity companies come to mind, too.
Do you have anything else to add?
It’s important to remember that investments are most profitable when the selection process is most businesslike. Therefore, you must have the skill level to evaluate a business. As for assets, evaluate what they are worth, because the accuracy of that valuation will determine how well you perform as an investor. I enjoy doing this. It’s very hard to say but I think the best way to describe it is that I’ve found my calling, which makes it easier and more enjoyable.
Do you have a succession plan in place?
At this time, I don’t. I’m still fairly young. One of the benefits of starting young is that one can have a 30-year record, even 35 like I have, and I can still manage the funds for a while. That is one of the benefits of starting so early.
Have you groomed anybody, though?
At this time, no. Eventually, I will have to. That question will get more pressing as I get older.
Are you considering having your kids enter the business?
I’ll leave it to them to decide. This business of investing and how I do it is very psychological.
By psychological you mean that when you have a conviction you stick to it, right? You don’t sell out based on general market sentiment?
You have to go against the grain. You have to do your own independent work, your own analysis, and you stand on the merits of your own judgments. The stock market will tell you in two years, maybe four years down the road, whether you’ve been accurate or not.
Have your kids shown an interest in the business?
One is seriously interested at this time.
Value Investing Thoughts
What struck me most about Francis was his strong sense of confidence. He is very certain of himself, his performance, and his outlook.
His track record shows that his predictions have come to pass, whether they were good or bad for the markets. In the early eighties he predicted that the future would bring higher equity market prices as rates started to decrease. That’s precisely what happened. Now he warns that an imminent increase in rates would hamper equity markets. Time will tell.
Francis mentioned to me that he personally started buying Fairfax Financial (FFH) stock at $3.25 early on in his career. FFH is now around
$605 per share. You don’t have to do the math to fathom that the return on his investment in Fairfax Financial is mouth-watering. While Francis is no longer on the senior management team at Fairfax Financial, he still considers its founder and CEO, Prem Watsa, a close friend and confidant. I will close this section with Francis Chou’s investment philosophy, as he describes it on his firm’s website:
The investment process followed in selecting equity investments for the funds is a value-oriented approach to investing. This involves a detailed analysis of the strengths of individual companies, with much less emphasis on short- term market factors. Far greater importance is placed upon an assessment of a company’s balance sheet, cash flow characteristics, profitability, industry position, special strengths, future growth potential, and management ability. The level of investments in the company’s securities is generally commensurate with the current price of the company’s securities in relation to its intrinsic value as determined by the above factors. That approach is designed to provide an extra margin of safety, which in turn serves to reduce overall portfolio risk. The manager may decide to maintain a larger portion of the fund’s assets in short-term fixed-income securities during periods of high market valuations and volatility. This temporary departure from the fund’s core investment strategy may be undertaken to protect capital while awaiting more favorable market conditions.
Says Francis, “We do nothing fancy. We are just looking for undervalued stocks.” Francis provided me with the following information about the three areas on which they focus:
- Good companies
› Sustainable earning power (look at owner’s earnings) for the last 10 years, generally not in mining, commodities, or IT
› Management showing reasonable allocation skill
› Companies that are not highly leveraged
› Companies selling for less than 10 times earnings
- Mediocre companies
› Liquidation value
› Potential turnaround situation
› Sum of the parts valuation
- CRAP (cannot realize a profit) companies
› Look at bonds first
› Start with the most senior bonds in the capital structure
› Assume it’s going bankrupt
Finally, at a value investing conference, Francis presented this closing advice for the audience:
In conclusion, if you stay patient, buy when it’s cheap, and don’t chase the stock when it runs away from you, there’s no reason for you not to beat the market. The market is there for you to take advantage of, not to let it control you. Have the courage of your conviction, courage of your work, courage of your analysis, and courage of your judgment, and you should beat the market.
Francis Chou Investing Lessons
- Relating shopping in India to investing: “It was my job to make sure I was paying the lowest price for the best ”
- “I contrast the current scenario to the scenario in 1981. Everyone is so bullish.”
- “I didn’t know the market was going to take off in six months [in 1981], but I knew you couldn’t get stocks any cheaper.”
- “When you read about great men and women of the past, it is like having a conversation about world affairs in your living It is not only educational but it builds perspective about life and business in general.”
- “My first job is to check whether the company in question meets my investment criteria. It could be a good company, a bad company, or it could be a CRAP [cannot realize a profit].”
- “I do screens, read a lot, and talk to other talented portfolio managers to see where they are seeing bargains. . . . [And] before you make a purchase, you should look for investors who are negative.
- “I just go wherever I can find For instance, in the years 2000 to 2002, I was basically in distressed bonds. I just go wherever I can find something undervalued.”
- “Whenever the majority of investors are purchasing securities at prices that implicitly assume that everything is perfect with the world, an economic dislocation or other shock always seems to appear out of the blue. And when that happens, investors learn, once again, that they ignore risk at their own peril”
- “We continue to diligently look for undervalued stocks and will buy them only when they meet our price criteria — in other words, when they are priced for imperfection.”
- “Initially I analyze bottom-up and then I go top-down.”
- “Most investors invest in terms of premium or discount to book That is a serious mistake. Let’s say the year was 2006. You examine the loan portfolio [of a bank] and see all the junk there. As a result, you wouldn’t touch a U.S. bank with a barge pole.”
- “I’m trying to buy 80 cents for 40 cents. It does not matter whether they are good companies, bad companies, or distressed”
- “The first thing you have to do in this business is to make sure that your valuation is accur If your valuation is wrong . . . then you won’t make it in this business.”
- “You’re a businessman . . . you ask, ‘If I were to buy this company, how much would I pay?’”
- “I don’t know what will happen two years from now where there could and probably would be newer technology.”
- “I don’t want to chase businesses where management is making decisions that don’t make economic sense.”
- “Sustainable earning power, business moats, and competitive advantage relate more closely to intrinsic value and therefore are more important than just increases in book ”
- “Investments are most profitable when the selection process is most businesslike. Therefore, you must have the skill level to evaluate a business.”
- “You have to go against the grain. You have to do your own independent work, your own analysis, and you stand on the merits of your own judgments.”
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Robin Speziale is the national bestselling author of Market Masters, which is available at Chapters, Indigo, and Coles as well as Costco and Amazon.ca. He lives in Toronto, Ontario. Learn more about Market Masters.
Robin R. Speziale 
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