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Is value dead?

Francis Chou's funds have suffered a severe beating lately, but he isn't calling in the coroners. Now is the time for bargains, says the star value manager, and he insists he knows exactly where they are

THE cookie-cutter office building stacked amid high-rise condos and streetside retail is not where you'd expect to find the man who oversees $1.2 billion in funds, and who is said to be Canada's top stock-market bargain hunter. Taped to his door is a plain piece of paper that has been run through a printer: "Chou Associates Management Inc.," it reads, implying that nothing of much importance is happening here.

The door is locked, but jiggle the handle of the door and out pops Francis Chou, whom I have come to ask about the strange decline in the once-dominant school of value investing. It's an investing style once described by the late, great value guru Benjamin Graham as the equivalent of rifling through a store's discount bin. In other words, if you are patient enough to search endlessly and smart enough to know the difference between a true bargain and a bad knockoff, then you can make terrific money.

Warren Buffett, a giant of value investing, has achieved an almost impossible compound average annual return of 21.1% from 1965 through 2007 with his holding company, Berkshire Hathaway Inc. (compared to 10.3% for the S&P 500 Index). Other masters, such as John Templeton and Charles Brandes, have also prospered using this approach, as have Canadian names like Irwin Michael, Peter Cundill, Bob Tattersall and Francis Chou. Until recently, that is. At some point in the past year or two, value investing stopped working. Example: For the 12 months to Feb. 29, three of Chou's five funds were down 17% or more, as compared with the previous year. Could this be the death of value?

Chou seems faintly tired of reaffirming his faith that cheap stocks always come back up in price. "This is something that happens every six or seven years," he says. "The stuff that is cheap gets cheaper, and you have no control over it. Eventually, though, the logic prevails if you buy stocks cheap."

His move from the trappings of Bay Street to this nondescript suburban location several months ago was by no means a retreat from the action. For Chou, it was a decision that meant a shorter commute, and one that squares with his complete lack of affectation. An immigrant to Canada from the town of Allahabad, India, Chou arrived in Canada at age 20. He never attended university, be--ginning his career as a tool-belt-wearing technician stringing wire for Bell Canada. His career as a money manager unofficially be--gan in 1981 when he formed an investment club with six Bell co-workers and $51,000 in seed money. "I was more ambitious than just being a technician and I was reading a lot, trying to see what I could do," he recalls. "One day I came across an article in the paper on Benjamin Graham, and then suddenly the light clicked. I felt that was my line." Chou thinks this may have had something to do with his life as a child in India. "In India, you haggle. And in the stock market, you do the same thing. You're looking at what something is worth and trying to buy it cheaper."

Chou read widely to develop his knowledge of investing, and he spent a two-week vacation back in 1982 working as a sort of intern for Bob Tattersall, long-time manager of the Saxon World Growth Fund. Chou's formative period included a stint as an analyst at the investment firm Gardiner Watson with Prem Watsa, now the chairman and CEO of Fairfax Financial Holdings and a highly respected value investor in his own right.

When I raise the subject of eminent value investors with George Athanassakos, a finance professor who holds the Ben Graham chair of value investing at the University of Western Ontario's Richard Ivey School of Business, Chou's name is the first he mentions. Such is Athanassakos's respect for Chou that he has invited him to lecture to his students a couple of times. "He's very shy, very nervous," the professor says of the man Morningstar named as its fund manager of the decade in 2004. "Here you have one of the most successful value investors in Canada, or value investors, period," says Athanassakos, "and he's very nervous about talking to people. He calls me every time and says, 'What do you think I should say?' I tell him, Francis, you're the best. Say whatever you want to say."

Imagine your typical ace mutual fund manager--confident to the point of arrogance, dressed in designer suits and surrounded by office opulence. By comparison, Chou, 52, is quiet-spoken, unfailingly courteous in manner and a modest dresser, if it's fair to judge by the combination of khaki pants and a sports jacket (they may or may not match) that he's wearing today. But appearances reveal little about Chou the value investor. His flagship Chou Associates Fund averaged an excellent 12.2% annually from its 1986 inception through Feb. 29 of this year, and its 10-year numbers beat all comers in the global equity category. Chou RRSP, with a core of Canadian content, had a 15-year average annual return of 12.5%.

Still, there's no question that things did not go well for the Chou group of funds in 2007 and early 2008. Like many other holdings that are managed in the value style, Chou's funds were hammered to a degree that was out-and-out shocking compared to the performance of the benchmark S&P/TSX composite index. Chou RRSP was down 19.2% for the year to Feb. 29, compared with the previous year, and had an annualized three-year return (if you can call it that) of just 0.83%. The index, by comparison, was off only 0.2% for the same 12 months, and up 11% over the three years. Chou says the strong loonie helped undermine his funds, which have considerable U.S. and global holdings. Generally, though, he says that value investing will underperform 30% to 40% of the time.

Value funds were pulverized during the technology stock craze that peaked at the end of the last decade, and then came into their own during the ensuing bear market. Chou's own fund results show other declines in 1994 and 1999 followed by juicy double-digit rebounds. The environment in the first quarter of 2008 seemed especially dire, however. Energy and mining stocks were hot spots on the market, but value investors rarely touch them because commodity prices are a wild card in deciding whether a company is undervalued. When the North American economic slowdown and the U.S. subprime mortgage crisis hit, investors started to panic, but Chou stuck with picks like Wescast Industries (a parts supplier to the struggling North American auto industry) and BMTC Group (a furniture retailer that depends on healthy consumer spending). "Value investors like stocks that are obscure and undesirable, and this is a difficult market for stocks like that," says Athanassakos. "If you are a good value investor, if you really trust what you do, you just wait and you say the market is going to come around."

Chou's recent difficulties mirror what's happened to value investors as a group, both in Canada and the U.S. Aside from Warren Buffett, whose extensive insurance holdings had an excellent year in 2007, value specialists were generally trounced. Mackenzie Financial's Cundill family of funds struggled, as did Bob Tattersall's Saxon World Growth Fund and some of the funds offered to Canadian investors by the noted U.S. value outfit Brandes Investment Partners.

In contrast to the value style of investing, growth focuses on companies that are increasing their earnings and profits at an above-average rate, and whose stocks can thus be expected to rise in price. Growth has been hotter in the past couple of years, but in the long term, value still crushes growth. The MSCI Barra Canada Growth Index had an average annual return of 6.75% for the 10 years to Feb. 29, compared to 10.93% for the value version of the same index. In the U.S., the S&P 500/Citigroup Value Index averaged 5.07% while its growth sibling made just 2.7%. In 2007 and early 2008, however, growth took the upper hand. "If we were looking at one value manager in trouble or a very few cases, you might say there's something going on with those managers," says Dan Hallett, an independent mutual fund analyst who supplies research to investment advisers. "But here's a healthy list of really smart managers who are going through a pretty rough patch. I think it's fair to call the environment difficult on value."

Value investing involves two stages--the first being the search for undervalued companies. Chou uses measures like sustainable free cash flow or the ability to generate earnings in cash every year, with relatively little volatility; he also seeks companies that are well managed, even if they may have run into problems. The next step is to wait for the price of an undervalued company to fall to a level where you can purchase $1 in corporate value for 50 or 60 cents. "In the end, you're trying to ask yourself, How much would a rational investor pay for this company?" Chou says. "And then you try and buy it cheaper." Is there such a thing as being too focused on buying cheap? Chou says he has more regrets about stocks he didn't buy than he does about those he did buy that fizzled. "The sin of omission is a far bigger sin than actually making a mistake," he explains. "When you make a mistake, you can only lose 100% of your money. When you miss on a good stock, they can always go up 500%."

In theory, buying beaten-down stocks provides a margin of safety against big price declines. In reality, value stocks kept falling in 2007 and the first part of this year. Biovail, CanWest Global Communications and Overstock Inc. were all major holdings of Chou RRSP as of the firm's most recent portfolio report, and all had one-year declines of 45% to 55% for the 12 months ending in early March. True value investors just suck it up when their carefully chosen stocks fall in price. "To be successful, you have to be able to withstand these shocks and not panic," says Chou.

The positive side to a slump in value stocks is that managers like Chou have the opportunity to add new stocks to their portfolios. One sector that caught Chou's attention at the end of the first quarter of 2008 was media, arguably the shakiest of all industries right now thanks to the disruptive impact of the Internet. "Twenty years ago, media companies were pristine properties, but now they have a lot of competition and their competitive advantage is being eroded every year. But the price seems to discount a lot of those problems right now." Chou's media picks include CanWest and Torstar--the latter stock was trading around $17 in mid-March, down about 10% from the previous 12 months, and close to 30% in total over the past three years. "It's definitely cheap," Chou says. "We think the valuation is $25 to $35."

Retailing is another area of interest for Chou, who believes the sector has been penalized unnecessarily by investors worried about the slowing economies in Canada and the States. Chou recently bought Sears Holdings, which he likes because it has real estate values of $70 (U.S.) or more supporting the stock (valued in the area of $101 U.S. in early April). "You also get a great investor in [hedge fund manager] Eddie Lampert to deploy capital on your behalf," says Chou. Another recent purchase is Office Depot, which traded around $12 in April and is worth north of $25 in Chou's analysis. "Almost all retailing companies are cheap," he adds. "It's your choice."

Value's recent troubles have led to redemptions from Chou funds, some of them by people so determined to get out that they ate a 2% fee applicable to investors who sell within two years of buying (Chou uses this fee to deter dilettantes who don't understand the long-term nature of value investing, and he directs the money right back into his funds). In contrast to these doubters, Dan Hallett remains convinced of value's value. "It's very important to me," Hallett says. "A key thing that I look for when I'm evaluating the manager of a fund is that I want to know they care about how much they pay for a stock. Not everybody does."

No one's more confident that value will recover than Francis Chou, who over the past 21 years has turned a $10,000 investment in his Chou Associates Fund into $125,258 (that's about 12.8% annually including compounding). To Chou, a stumble like the one this fund experienced in the past year offers a chance for people to do some value investing of their own. "That's the time to put more money in," he argues. "Look at our long-term record. We have always bounced back."

*****

The Long, Happy Career of Francis Chou

1976: Arrives in Canada as a 20-year-old immigrant

1977: Starts working as a technician with Bell Canada

1981: Starts investment club with six Bell co-workers and $51,000

1984: Takes job as an analyst at investment dealer Gardiner Watson

1985: Earns CFA designation

Registers with OSC as a portfolio manager and investment counsel

Chou Associates Fund is converted from an investment club into a pooled fund

1986: Chou Associates Fund is converted into a mutual fund

2003: Chou Associates Fund wins U.S. Equity Fund of the Year Award

Chou RRSP Fund wins Canadian Equity Fund of the Year Award

2004: Named Morningstar fund manager of the decade

2006: Chou Associates Fund wins U.S. Equity Fund of the Year Award

© 2007 The Globe and Mail. All rights reserved.

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