Francis Chou immigrated to Canada in 1976 with $200 to his name. Without a college degree, Chou worked as a telephone repairman for Bell Canada, then formed an investment club with co-workers after reading about Benjamin Graham's teachings. Today, Chou is the fund manager of Chou Mutual Funds. Below are his answers to questions from GuruFocus readers.
Commodities have been in a severe bear market for the last three years. What are your thoughts on the valuation of base metal and energy companies at the moment?
They are still too expensive. However, some of the bonds of energy companies are quite cheap. For example, one good buy appears to be Exco's 8.5% 2022. It is trading at 64 cents on a dollar, which I think is a great price. As a caveat, I would feel more secure if I could buy a basket of these types of securities rather than just Exco. Also, you have to keep in mind that âproven reservesâ is not an absolute number. It moves with the price of oil and gas.
Which macro parameters do you monitor to help you assess whether markets are overheating â and why?
I use them when they are out of historical normal range.
Who is your all-time favorite investor â and why?
Benjamin Graham is my favorite investor. His 'margin of safety' principle is so profound that it is applicable everywhere. I have bought equity securities of good and mediocre companies in the United States, Canada, Europe, China, Japan, as well as distressed securities such as junk bonds, and they have worked out really well as long as 1) my valuations are accurate and 2) I bought them at a severely discounted price.
You run a very concentrated portfolio. How do you (from an emotional standpoint) deal with large swings in positions that have such heavy weightings? Do you have any tricks to help deal with becoming emotionally attached to a security?
We only look at intrinsic value and what the ratio of the stock price to intrinsic value is. That's all that matters. Everything else is noise.
How do you know if you have enough information to make a purchase decision?
I will make a purchase when I think the odds are 80% in my favor, given all the information provided. You also ask yourself whether you are willing to put 10% of the assets of your fund in that one stock, and if the answer is 'no,' your subconscious mind is telling you that you have strong doubts about your valuation or the company and therefore you need to take a few days off and then come back and reassess the company and your valuation.
What is your current process for finding investment ideas? What is your current due diligence process?
I just read a lot and do screens on a regular basis.
What is the range of earnings/FCF multiple you are willing to pay for a company with limited growth prospects, say 2% to 4%, but good return on capital and stable earnings/FCF? What is your thought process in coming to that conclusion?
I would say no more than 10 times earnings/FCF multiple. It is extremely hard to quantify the answer, but one way for those who are mathematically inclined is to look at it from an earnings yield viewpoint. So at 10 times earnings/FCF multiple, youâre getting a 10% earnings yield, growing at 2-4%/year. The market has given close to 10% a year, so you need to match that.
What is the range of earnings/FCF multiple you are willing to pay for a company with above-average growth prospects, 6% to 8%, and good return on capital and stable earnings/FCF? What is your thought process in coming to that conclusion?
I am willing to pay no more than 12 times earnings/FCF multiple. Youâre getting 8% earnings yield growing at 6-8%/year. You need to beat the market of at least 10%. You can do your math from here.
If you had to buy a stock on limited information/due diligence and subsequently hold it for five years but could choose any aspects/factors of the company to research, what would be your top five areas on which to focus? What is your thought process in coming to that conclusion? What were the other areas of concern you deem to be important but did not make it to the top five?
My areas of concern are
- sustainable earning power for the last 10 years,
- not in mining, commodities or IT or in any industry that is subject to rapid change or change in commodity prices,
- management showing reasonable allocation skill,
- companies that are not highly leveraged, and
- companies selling for less than 10 times earnings.
Plus, you want to be highly cautious if you suspect that management is not ethical and financial numbers are not being transparent.
Looking at your Chou Associates Fund, around 37% of the investment and more than 60% of the unrealized gain are concentrated in just three securities: Berkshire Hathaway, Wells Fargo and Nokia. It looks like a concentration due to a "let your profit run" investment style (a la Philip Fisher and Charlie Munger (Trades, Portfolio)). To me it seems more proof that, while it is true that one can successfully buy undervalued securities and sell for profit when they are fully valued, the real big gain and wealth is usually generated by long-term ownership of a great company (compounders), especially if bought at favorable conditions during a market crash. What is your view?
I have bought companies that were anything from financially and operationally distressed companies to wonderful, financially sound companies, and in my experience there is an immense benefit in buying outstanding companies that does not show up in numbers. There are numerous hidden margins of safety in 1) wonderful economics of the business, 2) great management who know how to allocate capital, 3) growing and sustainable free cash flow that are being deployed wisely, 4) you can make a mistake of paying up and still it may not matter that much because the intrinsic value is growing at a reasonable clip, and so on. The difficulty is in identifying them.
Out of 100 companies that one thinks are wonderful now, only five will turn out to still be wonderful in 40 years. That is the crux of the problem. You can easily end up with Eastman Kodak, Sony, Montgomery Ward, Sears, etc. However, for those who have the business foresight and the rare ability to pick wonderful companies with a very high success ratio, this is the most satisfying way to invest. On top of that you also gain a couple of points after you pay your capital gains taxes.
For ordinary mortals, buying average to above average companies at reasonably discounted prices a la Benjamin Graham style will work out quite well and have returns that are quite acceptable.
Even for outstanding companies, buying them as cheaply as possible has a meaningful impact on returns. For example, if you bought Wells Fargo on December 31, 1994, your 20-year return to December 31, 2014, would be an exceptional 14.8% (with dividends reinvested in stock) according to Bloomberg, but if you bought it on December 31, 1999, your 15-return to December 31, 2014 would be an acceptable 9.8% annualized. However, if a Canadian mutual fund bought Wells Fargo in December 1994, that 14.8%, after all fees and expenses, would be closer to 10%. The reason being that the average MER (Management Expense Ratio) of a Canadian mutual fund is approximately 2.8% plus there are other frictional costs associated with managing a portfolio. In conclusion, buying them as cheaply as possible has a meaningful impact on returns.
Can you please mention your criteria in picking good investments? What metrics do you usually look for?
What I look for are
- sustainable earning power for the last 10 years,
- not in mining, commodities or IT,
- management showing reasonable allocation skill,
- companies that are not highly leveraged, and
- companies selling for less than 10 times earnings.
Your portfolios have a lot of stocks positioned for inflation and rise in interest rates. People like Prem Watsa (Trades, Portfolio) are concerned about deleveraging. If your judgment on the direction of markets is wrong, your funds can get hit hard. Why do think deleveraging is not an issue?
When we make a decision on buying a stock, it is company-specific and based on how undervalued it is. Our macro view does not have a bearing on our stock selections. So if the portfolio gets hit and it results in a permanent loss of capital, it is because we made a valuation error and not because of my macro views. If you construct your portfolio based on your inflation/deflation view, you will be badly hurt if it turned out to be different from your views.
What is your opinion of Brookfield Asset Management? What about its three funds: infrastructure, property, renewable energy?
No opinion.
What in your opinion is Value Trap? Can you give us examples?
In my opinion, value traps are errors in judgment, a mistake made on the part of the manager when valuing a company. As an example, a manager might think a company might be worth 100, buys it at 60, but it turns out in reality that the intrinsic value is less than 60.
Being as the macro environment is so particular in terms of Central Banks' intervention, manipulated interest rates and record money printing, what are your macro opinions and do you weigh them more than in the past?
Iâd read about it and update myself, but I donât give it that much importance when it comes to buying undervalued companies. I try to avoid companies in industries that are in bubble or close to bubble territory.
How do you distinguish between a bargain value investment and a company that is selling cheap for a good reason?
The key thing in investment is your accuracy in estimating the companyâs intrinsic value. A company that is selling cheap for a good reason means that the value may not be as high as perceived by the investors.
What indicators do you use to decide: When to sell winners? When to sell losers?
My main indicator is when itâs priced at intrinsic value. I start scaling out when it reaches 90% of its intrinsic value.
With losers, you always recheck your premises and re-estimate the intrinsic value, before deciding to sell or not.
How much research do you do before you have conviction to take a position?
For most stocks, Iâve been following them for 30 years, and when it falls within the range of undervaluation, I may then begin to start thinking about buying it. You should always feel like the odds are at least 80% in your favor before taking a position. Don't commit unless you have high certainty.
What do you think are the best warning signs of a stock bubble?
The Tobin ratio is the best warning sign of a stock bubble.
What type of things do you use to help you invest? Fundamentally: What are the things you specifically like to use when you study a company's fundamentals for investment? Can you let me know what you use to determine valuation, timing and weighting for a potential investment?
When I invest, I look for
- sustainable earning power for the last 10 years ,
- not in mining, commodities or IT,
- management showing reasonable allocation skill,
- companies that are not highly leveraged, and
- companies selling for less than 10 times earnings.
The above is for good companies. For crappy companies, you are looking at sum-of-the-parts valuation and what each part could sell for to a rational business person.
Technically: What are you using as a professional investor to determine good entry points and exit points? Can you explain what great indicators, tools and strategies you use?
Value investing is tough enough. There are so many cognitive biases you are fighting against. To introduce another element which has nothing to do with valuations is asking for trouble. Putting any kind of emphasis on what other idiots are doing in the marketplace is a recipe for disaster.
For value investors, doing anything technical is like adding arsenic to your food.
While reading financial statements, what do you look for when considering whether to buy the stock?
You should have a quick idea of what the company is worth while reading the financial statements, and if the stock price is selling at a big discount to your valuation, thatâs when you look to do more detailed work. I look for sustainable earnings power and high return on equity plus a low entry price. For crappy companies, you are looking at sum-of-the-parts valuation and what each part could sell for to a rational business person.
What's more important as a source of long term (5-10 years) value creation for investors: profitability of the company (ability to maintain a high ROIC over the long term) or starting valuation? Looking at pretty much any long-term chart, it seems that share prices are very closely correlated to earnings, which suggests earnings are the predominant driver of capital returns, more so than valuation. Therefore, is it better to get ROIC right (being the engine of long-term earnings and dividends) or entry price?
I have bought companies that were anything from financially and operationally distressed companies to wonderful, financially sound companies, and in my experience there is an immense benefit in buying outstanding companies that does not show up in numbers. There are numerous hidden margins of safety in 1) wonderful economics of the business, 2) great management who know how to allocate capital, 3) growing and sustainable free cash flow that are being deployed wisely, 4) you can make a mistake of paying up and still it may not matter that much because the intrinsic value is growing at a reasonable clip, and so on. The difficulty is in identifying them.
Out of 100 companies that one thinks are wonderful now, only five will turn out to still be wonderful in 40 years. That is the crux of the problem. You can easily end up with Eastman Kodak, Sony, Montgomery Ward, Sears, etc. However, for those who have the business foresight and the rare ability to pick wonderful companies with a very high success ratio, this is the most satisfying way to invest. On top of that you also gain a couple of points after you pay your capital gains taxes.
For ordinary mortals, buying average to above average companies at reasonablydiscounted prices a la Benjamin Graham style will work out quite well and have returns that are quite acceptable.
Even for outstanding companies, buying them as cheaply as possible has a meaningful impact on returns. For example, if you bought Wells Fargo on December 31, 1994, your 20-year return to December 31, 2014, would be 14.8% (with dividends reinvested in stock), but if you bought it on December 31, 1999, your 15-return to December 31, 2014 would be 9.8% annualized.
Both are important; theyâre not exclusive to each other. It is important to get companies at a lower price because you need a margin of safety, as humans are prone to errors on valuations. You need a cushion against making mistakes.
What is your opinion on index funds for the average investor?
For the average investor, itâs a great idea. Ninety percent of portfolio managers will underperform the market after all fees are deducted. So the index funds give you 9-10% (S&P 500) and 7-8% (TSX) and for most portfolio managers itâs difficult to beat that over a 30-year period.
What is the best valuation in value investing?
The best valuation is low sustainable free cash flow to the stock price.
What is good advice for those who have just started to learn value investing?
I recommend doing a lot of screens; read a lot about value investors. Make sure you study behavioral psychology and apply them to yourself, not to others. Understand your own cognitive biases.
How important is a strong balance sheet for your evaluation? Is there a line you will not cross once the asset/liability ratio gets too weighted on the liability side, even though growth and earnings may be stellar? When looking at total assets, do you take intangibles out of the equation?
A strong balance sheet is extremely important; it gives the company the resources to tackle problems that may come up unexpectedly. Itâs a margin of safety. If the company has too much debt, you buy the bonds instead. Yes, I do take intangibles out as theyâre recorded when a company pays above book value in an acquisition, and thereâs always a possibility that the company paid too much.
Rising interest rates are inevitable. How would you allocate assets to galvanize one's portfolio to cope in such an environment?
Buying good companies with good balance sheets will insulate you to a degree either in a deflation or an inflation scenario. Do not let the inflation/deflation talk sidetrack you from buying financially sound undervalued stocks.
What are your stock selection criteria and process? Can you walk us through your stock-picking thought process, step by step, from the genesis of an idea to identifying an opportunity and the validation process to build the conviction to take a position?
My stock selection criteria are
- sustainable earning power for the last 10 years ,
- not in mining, commodities or IT,
- management showing reasonable allocation skill,
- companies that are not highly leveraged, and
- companies selling for less than 10 times earnings.
Do you share Mr. Watsa's deflation concern? If so, why? If so, how are your investments protected from deflation? If not, is this why you are not invested in Fairfax? If this is not the reason, why are you not invested in Fairfax?
No, I do not share the same degree of concern. There are many deflationary forces acting on the economy presently, but with the amount of money being printed, eventually you will see inflation.
But Mr. Watsa will do well regardless of what scenario plays out because his orientation is long term, he has a great eye for bargains, and the mental fortitude to buy them when they are cheap.
The Chou Funds are not invested in Fairfax because of perceived conflicts of interest. Do not let the inflation/deflation talk sidetrack you from buying undervalued stock.
Have you considered investing in Markel and what is your view of Markel?
Yes, itâs a great company, and if it comes down to an undervalued price, we may buy it. I have known and worked with Steven Markel in 1985, and he runs an excellent company. Plus he hired an excellent investment guy by the name of Tom Gayner (Trades, Portfolio).
How do you objectively approach an assessment of the valuation of BlackBerry in the context of John Chen's four-part business model for the company, given that we have limited visibility at this point of the business model's evolution?
We went and looked at it from a defensive mindset. We think the patents are worth north of $10. If what John Chen is doing works out, thatâll be a big bonus.
What are your price targets or price-to-book ratio targets for Bank of America and Citigroup?
Most probably ratio targets not worth more than 14 times earnings.
What is your view of Sears?
I am not sure how long you have owned Sears, but Bruce Berkowitz (Trades, Portfolio) has owned Sears for years and years and years, only to see the financial condition of the company deteriorate year after year. The financial statements look like a melting ice cube. I understand they have real estate, but it looks like they will be slowly selling it off to fund losses from the operating business. Hoping they transition to internet sales seems very speculative. Eddie Lampert has had to lend the company money this year just to keep it going. Isn't that a red flag? If the ice cube keeps melting, when do you pull the plug? You have about 10% of your position in Sears. Bruce Berkowitz (Trades, Portfolio) mentioned in his Fairholme Fund (Trades, Portfolio) investors letter that Sears' net assets are roughly $150/share. I understand the property, plant and equipment's market value is not the same as the book value, but how could you come up with a close enough value as an outsider with so many factors to consider in valuing the PP&E?
If Sears is so valuable, why is its stock price so persistently low without someone stepping in to buy it? What would Lampert buy it for if it were to require further emergency funding on an ongoing basis? What do you think of â and are you participating in â the Sears Canada rights offering? What is your estimated band range for value of Sears Holdings and Sears Canada?
We have to start with some basic assumptions.
- Eddie Lampert is a rational person.
- Sears, as a department store, as a bricks-and-mortar business, is not a viable
- Its value is in real estate
- It has roughly $30 billion plus in sales, and if any portion of that $30 billion plus can business in the future.
- What Lampert is doing is the right thing to do, considering the alternatives. If it works, itâs a multi-bagger. If it doesnât, at least you will always have the real estate to cover what the stock price is at currently.liquidated the company a long time ago.
- If real estate was the only way to play from Lampertâs viewpoint, he would have be made profitable out of it, itâs worth trying even if it generates a few billion dollars in losses.
Most probably the company is worth, in my estimation, roughly $40-80, net of all liabilities. For Sears to be considered a great business, it has to have a great operating business; otherwise it is just an asset play. For now it is just an asset play.
What do you think of other TARP warrants besides Bank of America? AIG, for example?
Theyâre good buys; so also is GM 'B' warrant though it does not have some of the protection of the TARP warrants.
What is the most valuable asset of Overstock?
Its website and its third-party fulfillment business.
What is your intrinsic value in Resolute Forest Products? How does it vary from the valuation Prem Watsa (Trades, Portfolio) has? Why RFP? It looks like a pension/union burdened business with an underlyingbusiness that shrinks every year.
The book value of RFP is approximately $30, and it has 3-4 business segments that are most probably worth book value themselves. I donât know how Prem values RFP.
When assessing intrinsic value, what are the most common mistakes people make?
Overvaluing the company by basing its calculations on one-year earnings rather than a sustainable earnings power over longer periods.
What value opportunities do you currently see in the Canadian market?
I see hardly any value opportunities in the Canadian market.
How many stocks do you have in your portfolio? What factors prompt you to sell the stock in your portfolio?
15-20 stocks each.
What are your opinions about mining companies? Do you look at them?
No, I donât look at them. For smaller mining companies, theyâre like promoters lying on top of a barren hole.
What are your thoughts on Berkshire Hathaway B, and what are the differences between B and A?
Intrinsically and essentially, they are the same except the B sells at a small discount to A.
Which companies do you consider today to be trailblazers for the next decade?
On the retail side, Amazon.com is a trailblazer for the next decade.
What are your current thoughts on Danier Leather? It has been in the Chou RRSP portfolio for a substantial period of time. Would you be a buyer at this level?
Theyâre in a tough business, and itâs been a dog. I would not buy Danier now as a single stock, but rather as a basket, a la Ben Graham style.
I saw that your largest stake is in Nokia. This suggests you do not share the same concerns about rapid changes in the technology industry as Warren Buffett (Trades, Portfolio). Could you please explain why you think companies within this industry are sufficiently predictable?
We bought it thinking the patents were worth more than $8/share, and we bought them at $2/share. Anything that works out on the operating front will be a big bonus.
Do you think ShopYourWay can give Sears a competitive advantage against Amazon or Walmart?
If it doesnât work out, Lampert will be called âLostYourWay.â
How has your investment strategy evolved to fit with your strengths and personality?
At the beginning, we went with Ben Grahamâs style when looking for companies, but as my business knowledge grew, we invested into different types of securities such as convertibles, junk bonds or turnarounds.
As a mutual fund manager, how do you deal with fund redemption in times of crisis to avoid their bad behavior to affect the well-behaved investor you manage money for?
With redemptions during times of crisis, it can accentuate fund performance negatively. Having large positions of cash makes it less of a jarring experience to investors who maintain their positions as we donât have to sell off stock to support redemptions.
Are there good strategies to avoid fund redemption that affect the overall fund performance?
A good strategy is having a large cash balance and a fairy godmother who will fund your redemptions.
What would you change in the present rules that regulate mutual funds to both increase the efficiency of mutual fund manager capital allocation and reduce risk for investors in mutual funds?
I would change the criminalization of excessive and unnecessary paperwork.
What percentage of the resources of your fund is dedicated to seeking new investors vs. finding good investing opportunities? Does that ratio change over time?
None. In general, we have not spent time or money looking for new investors.
Who are your favorite types of investors in your fund?
My favorite investors are those investors who give me their money and then leave me alone.
Would you mind sharing investment mistakes that you have made? Why do you think you made the mistakes? Did you repeat any of the mistakes more than once? What did you do to prevent making the same mistake more than once?
Weâve made a lot of mistakes, and most of the mistakes were avoidable, and they were due to optimism and not double-checking oneâs premises. To prevent making the same mistake, you have to understand your own mindset and why you were emphasizing something more than the others.
What kind of business should be avoided, based on your experience?
Startups, mining and the IT industry.
What was your most memorable investment idea from your early years?
It is hard to say what my most memorable investment idea was as there are so many of them. For Berkshire Hathaway fans, Wesco Financial was selling for $8 and book value was $28 with Munger at the helm in the 1980s.
Can you describe your typical weekday and weekend when you first started investing? How did you juggle being a value investor and working full time?
I just read all day, from newspapers to magazines to my Bloomberg.
Regarding the JPM and WFC warrants, at what rate do you see both of these banks growing their tangible book values for 2014-2018? What multiple do you estimate for these banks in 2018? I mean P/TBV.
I estimate 6%/year, and 1.5.
Why is it that the USA total market cap/GNP ratio has risen significantly, but the P/E ratio of the S&P 500 hasn't risen that high?
The P/E ratio hasnât gone up that high because the earnings per share has gone up.
Do you believe that Canada will soon face a deep housing correction? If so, how can we position ourselves to benefit from this situation?
Yes, try to rent rather than buy a house.
Where should I be looking to invest Canadian dollars? Normally I would convert to U.S. and buy U.S.-denominated equities; however, the exchange is not favorable at this time.
Look for the most undervalued stock.
What's the story behind getting introduced to professional investors and eventually landing an investment job?
Hone your skills as a value investor before looking for an investment job. If youâre really good and passionate about value investing, eventually someone will pick you.
Why is it that corporate earnings have risen so much in America, but the GNP hasn't risen as quickly as the corporate profits?
The GNP hasnât risen as quickly because the operating margins have gone up.
Do you believe that there is a risk of deflation in Europe? If so, how do you deal with it given the value opportunities you see there?
No. It depends on the definition of deflation. Forty years ago, when I was learning investment, deflation meant a contraction of greater than 10% and associated with what happened in the Great Depression of 1929. Now, flat is called deflation.
Are you hiring at all?
At this time, no.
