Morningstar: An objective analysis of Chou Associates Mutual Fund-- the only MF I own

Chou Associates	Fund Analyst Pick

David O'Leary | 11 Sep 07 |

Chou's prescient call on subprime lending is yet another example of why we highly recommend this manager. In recent months, much of the financial world's attention has centered on the U.S. subprime lending market. Francis Chou had been waiting patiently for the fallout we've witnessed recently. While we know other managers who had forecasted an event like this, Francis Chou attempted to capitalize on his forecast in a somewhat unusual manner. With a history of similarly impressive investment decisions, Chou has clearly demonstrated his remarkable investment acumen, and Chou Associates remains one of our very favourite equity offerings. In prescient fashion, Chou stated in his 2006 annual report that subprime lending practices in the U.S. could result in dark days ahead for global stock markets. The combination of potential interest rate increases, over-extended homebuyers and falling real estate prices were a recipe for disaster according to Chou. More importantly, he argued that the market wasn't properly accounting for these risks. Specifically, Chou believed that credit default swaps (CDS), a form of insurance against a bond's default, were trading at bargain basement prices given the risks looming over the market. Unfortunately, at the time he wanted to begin buying CDS's -- which are a type of derivative -- for this fund, securities regulations prevented him from doing so. In order to buy these, he was required to give unitholders 60 days notice. And even after the required 60 days, Chou experienced a further delay as he waited for clarification from the Ontario Securities Commission on the issue. Essentially by the time he was clear to trade, a large chunk of the opportunity in the CDS market had evaporated. Chou illustrates the size of this opportunity by pointing to mortgage insurer Radian's five-year CDS. In early 2007 it was trading at roughly 50 basis points before peaking around 1000 basis points when market fears over the subprime market escalated last month. Most recently, it has traded down to the 550 basis points range. Although the fund's 11.9% annualized return over the past three years is lacklustre compared to many other funds in the Global Small/Mid Cap Equity category, we're not too concerned. Chou typically underperforms in hot markets. And despite missing this latest opportunity, his foresight is commendable. As Chou awaits further opportunity, sitting on a cash position of nearly 50%, investors can take comfort in the fact that their investment should be protected well if markets continue to deteriorate. And with an MER of just 1.75%, investors aren't paying much while they wait. Of Note Despite the fact that Chou Associates has over 20 years of performance history, the fund's 3-star rating only reflects its performance over the past three years. There are not enough funds in the Global Small/Mid Cap Equity category with a five or 10-year performance history to factor these time periods into the star rating. Chou stepped down from his role at Fairfax Financial in the spring of 2007 since he was no longer drawing a salary from Fairfax and his time had been exclusively devoted to running the Chou funds. And although he did not feel there was a conflict of interest between his dual roles, officially ending his employment with Fairfax eliminates any questions altogether. Although this fund has typically resided in the U.S. Equity category, Chou has included a number of non-U.S. names over the years. Furthermore, he has stated that he plans to make this the most global fund in his line-up. Chou currently doesn't hedge the fund's currency exposure, and doesn't normally do so. However, he will put hedges in place opportunistically. The fund currently has no exposure to energy and holds marginal positions in the materials and technology sectors. The fund's largest weightings are in telecommunications and consumer services. All of Chou's offerings can be purchased in U.S. dollars.

Morningstar Rating (as of 31 Jul 07) Strategy Francis Chou is a deep value manager who insists on receiving a "margin of safety" when buying securities. He requires a 40% to 50% discount to fair value. After screening for securities that appear attractive on a quantitative basis, he conducts detailed research on the individual companies that make his first cut. He also incorporates macroeconomic analysis into his investment process, but this plays a relatively minor role. Management Francis Chou, CFA, is president and CEO of Chou Associates Management Inc. in Toronto. He founded his firm in 1981 as an investment club for several Bell Canada employees. Chou Associates was first offered to the public in October 1986. Chou also manages four other funds: Chou RRSP, Chou Asia, Chou Bond, and Chou Europe. Kudos Chou gets top marks for corporate governance and stewardship. This comes as no surprise as Chou invests heavily in his own funds. The fund's MER, at 1.75%, is lower than all other mutual funds in the category with a minimum investment lower than $100,000. The fund's performance is remarkably consistent. It rarely produces a negative three-year return and has never posted a losing four-year return. By comparison, the S&P 500 currently has a negative eight-year return. Anyway you care to measure it (absolute, relative or risk-adjusted), the fund's long-term performance has been nothing short of spectacular. Question Marks The fund's success is exclusively dependent on Francis Chou. If Chou were unable or unwilling to run the fund any longer, it would be unreasonable to expect a replacement manager to post the outstanding results that he has managed to deliver over the years. Fairfax's 26.3% ownership of this fund could present a challenge for Chou if they were to liquidate this position.