If there was one fund manager I would recommend to my parents and sister it would be the one I am writing to you about today.
He started in an unusual way
He came into fund management in a very unusual way.
He ended his formal education at Grade 12 in India and immigrated to Canada in 1976. In 1981, while working as a technician for a phone company, he started an investment club with C$51 000 that would later become one of the funds he still manages today.
For the last 20 years he has operated two of Canada’s most successful investment funds. So successful that in 2004 he was named Morningstar’s fund manager of the decade.
The man I am talking about is Francis Chou of Chou Associates Management Inc. located in Toronto Canada.
His investment approach is probably as simple as it gets:
“find bargains and maintain discipline; if you cannot find bargains stay in cash.”
Based on the awards Francis has received its amazing how successful such a simple investment strategy can be.
Read his helpful reports
Francis also writes very helpful reports to his investors that are easy to understand and always teaches you something valuable about investing. (His investment newsletters can be found here: Francis Chou Annual Reports)
For example in his 2010 annual letter he gives the following advice to investors considering investing in non-investment grade bonds.
It’s an area of investment that has worked very well for him over the long term and he wanted to share pitfalls you can avoid.
Before you invest in a troubled company
Before he invests in a troubled company these are the main criteria he looks for:
1. Where does the debt security you are considering rank in the company’s capital structure?
And what would the company be worth if it had to liquidate?
Francis start by setting a desired target rate of return, and then tries to buy the most senior security in the capital structure that meets his return target.
Experience has shown that it is prudent to give up some return by buying senior debt versus taking a chance on more junior securities even though they have the potential to earn a much higher return.
2. How competent is management?
He says that assessing the competence of management is as critical when buying debt securities as it is when buying equities.
Francis seeks management teams that are passionate about their work and own enough equity in their company to care deeply about its future. He is not interested in companies with managers who are just doing their job, collecting their salaries, stock options and other perks.
He says one of the best times to invest in a debt issue is when a company is facing a short-term liquidity issue rather than an operational issue.
3. Is the underlying business strong and able to generate consistent free cash flow?
The economics of a business are important as ultimately a company has to repay or restructure its debt. In either scenario, having a strong underlying business that can generate strong cash flow is vital.
He warns to be careful when buying into an industry with excess capacity since overcapacity is normally equated with negative or below average return on capital.
4. What do the bank and bond covenants look like?
Is there a cash flow sweep recapture? In some instances, debt comes with a cash flow sweep, which means that free cash flow left after all the needs of operations have been met can be used to buy back debt at par from debt holders.
This cash flow sweep could be monthly, quarterly or yearly. For example, R.H. Donnelly’s bank debt has a quarterly cash flow sweep and was trading at 77 cents. However, every quarter, whatever free cash flow that is left is used to buy back the bank debt at 100 cents.
5. What does the company’s balance sheet look like and what is its liquidity position
Will it need to raise additional capital?
He mentions it is important to understand the liquidity position of the company and know if it has adequate resources to pay interest on current debts and any debts that may be maturing.
If the company has to raise capital to meet its financing and operational needs, oftentimes this capital is very expensive and dilutive to existing bondholders.
6. If the company goes through a restructuring, will it cause permanent damage to the business by diminishing the value of the brand or by alienating customers?
If the company decides to restructure, it has implications not only for the company and its employees but also for its customers.
It is critical to understand the impact on customers and if they will continue to do business with the company or move to a competitor instead. If it is the latter, there will be diminished revenues and possibly negative cash flows.
His best bond investment ever
He then goes on to describe one of his best bond investments in Brick Ltd. a retailer of largely lower-end household furniture, mattresses, appliances and home electronics.
Brick Ltd. had a financing/liquidity issue in 2009 and in May of that year, succeeded in raising $120 million to recapitalize their balance sheet, pay off senior notes and partially repay their Operating Credit Facility.
Francis was already impressed with the company and was further impressed when the founder of the company said he was willing to invest $10 million on the same terms as the other debenture holders.
The Debt Unit consisted of $1,000 principal amount 12% senior secured debentures maturing in five years, and 1,000 Class A Trust Unit purchase warrants.
Each warrant entitled the holder to purchase one Class A Trust Unit for a strike price of $1.00, which was very close to the stock’s trading price.
Under the able stewardship of Mr. Bill Gregson, Brick continues to make a remarkable turnaround.
Francis? $1,000 investment is now worth $2,925, not counting the 12% coupon he has been clipping all along.
Another remarkable thing about Francis – He gave back fees
Who has ever heard of a fund manager giving back past and future management fees?
Francis did, for a period of five years.
In March 2009 he announced that, because of disappointing results, he would waive and refund almost all management fees from September 2003 to December 2008 (just over 5 years of fees) for the Chou Europe fund.
But that’s not all.
In the December 2010 annual fund report Francis said as his record since inception of the Chou Europe Fund has not been as good as he would have liked he would not be charging management fees for the next three years, starting from January 1, 2011 through December 31, 2013.
Who cannot trust a manager that treats you this fairly?
Learn from his letters
I suggest you spend a bit of time working through Francis’ management letters. It may be the best time you may spend all year improving your investment knowledge.
And best of its entirely free.
Here are the links again:
Francis Chou Annual Reports
Francis Chou Semi-Annual Reports
Other articles on Francis I came across can be found here:
The manager who gave back his fees
Chou Runs His Fund the Way He Runs His Life – and That’s a Good Thing
Video of a presentation by Francis Chou at the Ben Graham Center for Value Investing