Chou Associates 2008 Annual Report
Noted Canadian value investor Francis Chou writes in his 2008 letter to investors in the Chou Associates funds:
INVESTING TOO EARLY: One of the hazards of being a value investor is that every now and then you are bound to buy stocks too early. Over the last few years, we have communicated through our letters, our deep concern about the easy credit, irresponsible lending, housing bubble and the potential dangers of derivatives like CDOs (collateralized debt obligations) impacting financial companies. As pessimistic as we were over the years, we did not anticipate how severely these factors would paralyze and cripple the financial system when the bubble did burst. There was no place to hide.
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Repricing of Risk
At the time of writing two years ago, preservation of capital was given little consideration. However, in 2008 there was a huge repricing of risk. For example, the greater the probability of permanent loss of capital, the greater the spread should be between a particular debt instrument and risk-free treasuries. Currently the spreads between the higher risk securities and U.S. treasuries are at near historic highs. Other indicators are showing that investors are running scared, and banks and financial institutions are hoarding capital instead of lending. The following are some examples:
1) Two years ago, the spread between U.S. corporate high yield debt and U.S. treasuries was 311 basis points; a year ago it was 800 basis points. Currently, it is over 1,600 basis points, down from its peak of over 1,900 basis points in December 2008. (Source: JP Morgan).
2) Two years ago, the spread between U.S. investment grade bonds and U.S. treasuries was approximately 85 basis points; a year ago it was approximately 274 basis points. It is now over 550 basis points, which is slightly down from its peak of 592 basis points in December 2008. (Source: JP Morgan).
3) In December 2008, an auction of 4 week treasury bills ended with a 0% yield (currently they are yielding 8 basis points or 0.08%). The yield on 10 year treasury is 2.94% (up from 2% in December 2008) but down from 4.75% two years ago. In September 1981, it was 15.3%.
4) Today, investment bankers and anyone working for the financial/investment industry are considered the new pariahs of society. They are the butt of jokes. My favorite one is, 'What is the difference between an investment banker and a pigeon'? 'At least a pigeon can still put a deposit on a house'.
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ZOMBIE COMPANIES: The Fed and the U.S. government have a tough job in tackling the financial crisis and, whatever actions they take, they are scrutinized, criticized and/or second guessed. There is no one perfect approach. Every approach has its pros and cons. However, where zombie companies are concerned, we would prefer to give companies that are insolvent and failing the opportunity to reorganize and restructure their capital structure in an organized way. When they do emerge from reorganization, they will come out leaner and stronger. What we are seeing now is that the U.S. government has pledged $9.7 trillion (and still counting) to counter the financial crisis. Billions of dollars have been given to prop up failing financial institutions and still they are asking for more financial assistance. The requests from the very large financial institutions are not based on business and investment merit but more on the line that if they don't receive more bailout money, they would have to file for bankruptcy and that would precipitate a chain reaction that will totally paralyze not only the U.S. financial system but also the entire Western banking system. The sooner we recapitalize the zombie companies in some form or the other (including nationalization for a short-term period) the quicker we can unfreeze the credit market and get the economy moving again.
MARK-TO-MARKET ACCOUNTING: We have been hearing of late that the current financial mess is caused in part by mark-to-market accounting. Nothing could be further from the truth. The financial mess was caused by misguided policies and actions on the part of some companies and would have occurred regardless of whether this accounting rule was in place or not. As investors, we prefer transparency and clarity and unless these rules exist, companies will not disclose what the assets are currently worth in the market. Obviously, when there are extenuating circumstances like the period we are in now, good and toxic assets may be priced at unduly low prices. In such a case, we would favour a provision that gives companies some grace period before they have to take action to shore up their balance sheets either through asset sales or by raising capital. In the end, transparency should prevail over opaqueness and undisclosed market values in the financial statements.
INFLATION: Almost all governments whose economies have been adversely affected by the financial crisis have been providing all kinds of liquidity including printing money to minimize the impact of the credit freeze on their economies. Historically, that is how nations have tackled their debt burden and this episode is no different. In the short term it may work, as the liquidity will counter some of the deleveraging and credit freeze in today's crisis. But longer term such actions can bring huge unintended consequences including the return of high inflation and the likely debasement of the U.S. currency. We don't know the timing of it but all that excess liquidity will have to go somewhere when normal times return.
MORE REGULATION: Yes, we will have a more regulated environment going forward. You can bet your last dollar on it. There is a need for regulatory reforms to ensure that, in the future, the near collapse of the world financial system does not happen again. And more regulation of financial institutions will most certainly lower their future growth and profitability. We need to also get away from the notion of 'too big to fail'. Failing financial companies have used this excuse to hold us ransom in giving them financial assistance.
PENSION ASSETS: Most corporate pension plans have a majority of their assets invested in equities. With the markets down at least 40% across the world, we can safely assume that pension assets are down significantly. Eventually, companies have to make up the shortfall of their underfunded pension assets and therefore, their cash flow and earnings will take a significant hit in the future.
RECOVERY OF THE STOCK MARKET AND ECONOMY: The economy may get worse before it gets better. However, I have strong faith in the strength and resilience of a free market system. In the 20th century, the standard of living went up seven times in spite of the Great Depression, two World Wars, the oil embargo in the 1970s, interest rates of 15% or more to combat inflation and so on. The current financial crisis is severe, probably not as bad as the Great Depression, but worst of all the recessions in the 20th century. One unitholder said, 'This market feels worse than a divorce. You lose 50% of your assets and you still have your spouse'. The good news is, if one wants to look at the current situation in a contrarian manner, most of the bad news is already reflected in the stock prices. We don't know whether the stock market has hit bottom yet but we suspect that when we look back at the current environment 10 years from now, we will classify this as one of the best periods for buying stock and debt securities.
BANKING SECTOR: Banks that have not been affected by the financial crisis will do quite well in the future. With the governments driving the treasuries to yield nearly 0%, the spread between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. For the first time in many years, banks are being paid handsomely for the risks they are taking. See the section under 'Repricing of Risk'.
CREDIT DEFAULT SWAPS (CDS): In general, the CDSs are way overpriced. What a dramatic difference from two years ago. To give you some sense of perspective, in October 2002, the 5 year CDS of General Electric Company was quoted at an annual price of 110 basis points. Two years ago, it was quoted at an annual price of 8 basis points and lately it is priced at over 900 points. Some pricing in the CDS market is absurd. Barrons (March 9, 2009) reported that, 'A Merrill Lynch analyst Friday noted it was more costly to protect oneself from the possibility of a default by Berkshire Hathaway (ticker: BRKA) than one by Vietnam. And General Electric (GE) CDS prices outstripped those of Russia -- a country that a dozen years ago actually did default on its foreign debt'.