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Chou 2018 annual report


ourkid8
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I'd love to know why he waited so long to lend the shares.

 

"In 2017, we also initiated a stock-lending program where the Fund received net earnings on the shares lent of

about US$22.2 million."

 

What sort of percentage return did he get lending those Sears shares? It seems enormous.

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Chart says they received roughly half their purchase price back over the course of a five year period from 2010-2015.  If the value when borrowed averaged around their cost then they would have received about 10% a year for five years.  I occasionally had some SHLD shares lent out myself and I was getting around 60% rates, but only on a fraction of my shares and my broker took half.  10% realized is pretty reasonable.

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I was very impressed with Francis’ explanation as to why the fund has underperformed the past few years. They invested in the wrong stocks; they overvalued troubled companies (overinvested and underperformed) and undervalued quality companies (underinvested and missed their outperformance). It has been said Munger is the person who convinced Buffett to focus on quality. I am hopeful that Francis moves in this direction; and given his close relationship with Fairfax hopefully they also move towards investing in quality value plays.

 

From page 6 of the Annual Report: “Does Value Investing Work?

 

With the lackluster returns by value funds in recent years compared to growth and index funds, there is some doubt as to whether value investing can still work in the current market. We hold the view that value investing certainly works, but only when executed properly.

 

Sometimes it is easier to blame the market environment than to admit our own faults. Although factors such as low interest rates, the popularity of passive investing, and elevated market valuations played a role in blunting returns for value investors, we also accentuated the problem. The key to value investing is appraisal. If that is not precise enough, everything falls apart. We tend to fish in troubled waters, and what caused the biggest problem in recent years was that our appraisal of troubled companies was off the mark.

 

When we thought a company was worth 100 cents, it was actually worth closer to 60 cents. We tended to give much higher weight to asset values and not enough weight to the value of the operating company. We used the asset value as a huge security blanket and became blind to the deterioration of the worth of the operating company. A case in point is Sears Holdings. We were correct that the real estate plus the value of brand names would afford some cushion against losses. However, we were inaccurate in our assumption that Eddie Lampert would maximize returns for the shareholders based on the real estate assets, and the value of the retail company Sears had at the time of purchase. Instead, he tried to re-invent the company, suffered huge losses along the way and almost completely eroded the value of the considerable real estate assets that Sears held. Although the value of downside protection is important, most of the returns from an investment comes from the increase in the intrinsic value of the company, or the closing of the gap between the discounted purchase price to the full intrinsic value. When neither of the two happens, then investors would like to see the assets and the brand names divested or sold, sooner rather than later, for the benefit of shareholders.

 

We can proudly say that in Sears we lost an insignificant amount of money on a simple dollar basis (as one Republican suggested, it should be classified as “Trump change”). However, we did lose a tremendous amount of money in opportunity cost over that 10-year period. Trump change or not, it was still an unforced error.

 

That was a mistake of commission. We also made a bundle of mistakes of omission.

 

Over the last 30 years, roughly half our portfolio was in troubled companies and the other half was in good companies. So, we are well acquainted with investing in both types of companies. But what happened over the last few years was that we spent most of the time undervaluing the good companies. When our assessment showed the investments were worth 100 cents, they were more accurately close to 150 cents, thus causing us to miss most of those opportunities. These “omissions”, though they are unseen mistakes are nevertheless as real as mistakes of commission.

 

In summary, although the markets have been less kind to value investing, we exacerbated the problem as practitioners.”

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I was very impressed with Francis’ explanation as to why the fund has underperformed the past few years. They invested in the wrong stocks; they overvalued troubled companies (overinvested and underperformed) and undervalued quality companies (underinvested and missed their outperformance). It has been said Munger is the person who convinced Buffett to focus on quality. I am hopeful that Francis moves in this direction; and given his close relationship with Fairfax hopefully they also move towards investing in quality value plays.

 

From page 6 of the Annual Report: “Does Value Investing Work?

 

With the lackluster returns by value funds in recent years compared to growth and index funds, there is some doubt as to whether value investing can still work in the current market. We hold the view that value investing certainly works, but only when executed properly.

 

Sometimes it is easier to blame the market environment than to admit our own faults. Although factors such as low interest rates, the popularity of passive investing, and elevated market valuations played a role in blunting returns for value investors, we also accentuated the problem. The key to value investing is appraisal. If that is not precise enough, everything falls apart. We tend to fish in troubled waters, and what caused the biggest problem in recent years was that our appraisal of troubled companies was off the mark.

 

When we thought a company was worth 100 cents, it was actually worth closer to 60 cents. We tended to give much higher weight to asset values and not enough weight to the value of the operating company. We used the asset value as a huge security blanket and became blind to the deterioration of the worth of the operating company. A case in point is Sears Holdings. We were correct that the real estate plus the value of brand names would afford some cushion against losses. However, we were inaccurate in our assumption that Eddie Lampert would maximize returns for the shareholders based on the real estate assets, and the value of the retail company Sears had at the time of purchase. Instead, he tried to re-invent the company, suffered huge losses along the way and almost completely eroded the value of the considerable real estate assets that Sears held. Although the value of downside protection is important, most of the returns from an investment comes from the increase in the intrinsic value of the company, or the closing of the gap between the discounted purchase price to the full intrinsic value. When neither of the two happens, then investors would like to see the assets and the brand names divested or sold, sooner rather than later, for the benefit of shareholders.

 

We can proudly say that in Sears we lost an insignificant amount of money on a simple dollar basis (as one Republican suggested, it should be classified as “Trump change”). However, we did lose a tremendous amount of money in opportunity cost over that 10-year period. Trump change or not, it was still an unforced error.

 

That was a mistake of commission. We also made a bundle of mistakes of omission.

 

Over the last 30 years, roughly half our portfolio was in troubled companies and the other half was in good companies. So, we are well acquainted with investing in both types of companies. But what happened over the last few years was that we spent most of the time undervaluing the good companies. When our assessment showed the investments were worth 100 cents, they were more accurately close to 150 cents, thus causing us to miss most of those opportunities. These “omissions”, though they are unseen mistakes are nevertheless as real as mistakes of commission.

 

In summary, although the markets have been less kind to value investing, we exacerbated the problem as practitioners.”

 

This is all Monday morning quarterback. Had he over-weighted growth stocks and lost money there, and made money in SHLD, he would have said it the other way. "The growth names were worth 60 cents when we thought they were worth 100 cents. The troubled companies were worth 150 cents when we thought they were worth 100 cents. " I could totally see some fund manager saying this after the 2000 dot com crash.  :)

 

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I think in a prolonged period of low interest rates, many investors failed to recognize early on that the "multiple" used for valuation can be a bit more generous than during  normal times... that's just my observation.

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I'd love to know why he waited so long to lend the shares.

 

"In 2017, we also initiated a stock-lending program where the Fund received net earnings on the shares lent of

about US$22.2 million."

 

What sort of percentage return did he get lending those Sears shares? It seems enormous.

 

 

I'm not sure but I believe IB was paying 40% at some points. They pay half to the client so 80% total. I'd imagine an institution would get more than half but not sure. The $22.2 million on $290 million fund that's almost 4% per year in missed return by not doing it earlier (I'm assuming 2 years total time but I'd imagine it was less than that). 

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I think in a prolonged period of low interest rates, many investors failed to recognize early on that the "multiple" used for valuation can be a bit more generous than during  normal times... that's just my observation.

 

Very true. I would add that interest rates have stayed lower for longer, defying the expectations of many investors.

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One thing to point out is that buying funds with a 2% + expense ration are a suckers bet, almost regardless who runs it. It certainly creates a very high hurdle to outperform after fees.

 

+1

Given that Chou is well aware of expense costs and how challenging it is to beat the market, I'm surprised that he has not changed his model of fee structure. Maybe inertia hard to overcome as it's been in place for decades.

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I've seen this paragraph more than once in Chou's reports:

 

"A lot of investors are not aware that short-term results can have a huge bearing on the five- and 10-year annualized compounded returns. For example, let’s take Fund A and Fund B. Fund A has consistently returned 7% per year for 10 years and therefore its compound rate of return over the 10-year period is 7%. Fund B, on the other hand, returns 8% for the first nine years but suffers a loss of 20% in the 10th year. Its compound rate of return for the 10-year period drops significantly to 4.8%. The impact is more pronounced for the five-year returns, a similar decline of 20% in the fifth year would have decreased the five-year compound return from 8% to merely 1.7% for Fund B versus 7% for Fund A."

 

Does this not trouble you in its honesty? We all understand that one won't nail a constant 7% annual return. To get 7% a year, one will have 20% declines - fair enough - but they have to be balanced with years where the return is well over 7%. He seems to be justifying that returns over 5 or 10 year periods are not significant. When one is managing money professionally for others, 10 year returns are significant. One has to live with their losses and gains as averaged out over enough time.

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