During the year 2011, the Chou Equity Opportunity Fund (the “Fund”) lost 17.78% of its value while the S&P 500 generated a return of 2.11% during the same time period. The majority of the losses incurred by the Fund were related to our investment in the retail and financial sectors. These sectors combined represented approximately 60% of the Fund’s assets as of December 31, 2011. We continue to believe our holdings in these sectors are deeply undervalued and that the losses we took in 2011 are temporary. 2011 was one of those years where macro events such as the Euro crisis made stocks that we believe are undervalued go down further. We are long term investors with an investment time horizon of at least five years. Experience has taught us that attractive prices often come with short term headline risks and negative investor sentiment. These factors can cause stock prices to fall far more than we believe is justified by the current value of their underlying businesses. During times such as these, our ability to remain patient and disciplined will be the key to our investment success.
Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company's future prospects, its position in the industry and how well it will do in a future economy. We believe that the following factors indicate that Funds holdings in the financial sector continue to provide attractive investment opportunities:
- It has been five years since the financial crisis began in 2007. As each year has gone by, the quality of earnings of the banks has gotten higher, the books have become cleaner, the risks have become lower, and bank management has become far more risk averse. It is too bad that we had to go through so much turmoil to get there.
- The U.S. government will not let major financial institutions fail.
- The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
- Interest rates will continue to be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at, is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made is quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
- Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur. In addition, this positions them well to meet the upcoming Basel III requirements.
- The books of financial institutions were carefully examined by various U.S. government regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP).
- Stress Test Results conducted in 2009, 2010, 2011, and those that will be conducted in 2012, have given and continue to give the U.S. government the assurance it needed before allowing some banks to resume paying dividends and to buy back stock.
- U.S. banks are benefitting from concerns about European banks and financial institutions. As concerns continue about European banks’ and financial institutions’ exposure to bad credit, bank deposits and capital investments are leaving Europe and coming into large U.S. banks.
- Bank valuations that were below 10 times earnings six months ago have decreased even further, with many bank stocks selling below book and some selling at big discounts to tangible book value.
- Concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
We have invested in common stocks of financial institutions as well as in TARP warrants of financial institutions. These are stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank's stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.
So, what is so unique about these stock warrants? We have considered the following characteristics:
- They are long dated, with most expiring in 2018 or 2019. This time frame of six-plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
- The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, this is not seen in a stock warrant. This is a truly stringent condition. In this case, we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class 'A' warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
- Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
Even so, everything is not hunky dory for the financial sector. Banks and financial institutions continue to face many issues and challenges. We have listed a few here:
- We still do not fully understand or trust the numbers.
- Financial regulatory reform may reduce earning power.
- New Basel rules may require more capital and reduce profits.
- There may be a double dip recession.
- The unemployment rate may go higher and create more defaults.
- Commercial real estate prices may fall dramatically.
- Banks are still not marking loans on their books properly.
- Residential real estate prices may fall further.
- States and municipalities are in bad shape.
- Litigation continues to be a serious risk.
Our investing horizon is long-term - six years or more remain for these bank warrants. Over that period, we believe that the odds are it will work out to be decent investment, perhaps even more so for the better-capitalized banks. We view it as the glass being more than half full rather than half empty. The bank TARP warrants are complex, with terms and conditions that are unique to each bank, and we encourage you to research them for yourself and draw your own conclusions.
As we previously noted, we saw the majority of losses in retail. In our opinion, concerns about the sustainability of the economic recovery in the U.S., uncertainty in Europe, and growing concerns of a slowdown in China have created a buy opportunity in the space. We believe that the companies we own are trading at a large discount to their private market value and have enough balance sheet flexibility to endure any short-term hiccups in the domestic/global economy. In addition, these companies have either been actively buying back shares and/or management has a large ownership stake in the company. To date, our investment thesis in retail has not worked out and has caused losses in the portfolio. However, we remain confident in our long-term view of the sector.
Effective March 1, 2012, the Fund will change its name to the Chou Opportunity Fund. Concurrent with this change, the Fund will eliminate its investment policy to invest normally at least 80% of its net assets in equity securities and financial instruments that provide exposure to equity securities. The Fund will continue to invest primarily in equity securities. This change is intended to position the Fund to execute its investment strategies by purchasing the most compelling investments at specific price points and holding investments over a longer time horizon for long-term growth of capital.
Portfolio Manager and CEO
Chou America Management Inc.