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Jolt from the blue: Francis Chou's candid letter to fund investors

Francis Chou of Chou Associates Management

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Waking to the smell of freshly brewed coffee gives a little perk to the day. But as I was enjoying my first cup, I found something more stimulating: Francis Chou's annual letter to investors.

Mr. Chou manages a small family of value-oriented mutual funds. His flagship, the Chou Associates Fund, has beaten the market by an average of 3.3 percentage points a year over the 20 years ended March, 2013.

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He's well worth reading because it's a rare report that's quite as candid as Mr. Chou's. Most such missives get mashed into grey goo by marketing mavens well before they're released to investors.

The result is hardly edifying, let alone food for thought. In contrast, Mr. Chou's straightforward approach should be appreciated.

For instance, he bluntly states that he's not bullish on most stocks at the moment. His reasons for caution include low interest rates, high debt-to-GDP levels, the sharply expanded money supply, and concerns over distortions to commodity markets caused by the Chinese housing bubble. As a result, he expects to hold more cash this year.

But this sentiment pales in comparison to what he has to say about high yield bonds. He categorically states, "Non-investment grade debt securities are fully priced and, in general, I would stay clear of them."

He adds, "In fact, there is a good chance that these debt securities may now be overvalued, and that the possibility of a large, permanent loss of capital is extremely high." As it happens, the only bond fund Mr. Chou manages is a high-yield bond fund.

But he's more bullish on a few stocks. He particularly likes U.S. banks and the warrants they issued as part of the Troubled Asset Relief Program (TARP). At the start of the year his Associates fund held the warrants of both JPMorgan Chase and Wells Fargo.

Stock warrants give you the right to buy a stock at some date in the future at a price called the strike price. But the TARP warrants are unusual because they won't expire for many years. In addition, many contain rare provisions that reduce their strike prices to account for some portion of any dividends paid.

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Mr. Chou's discussion of his experience with the Bank of America's TARP warrants is candid, and perhaps a little embarrassing, but it's a model other portfolio managers should follow,

You see, he liked the bank's warrants so much he put almost 10 per cent of his fund's assets into them. Unfortunately, the market turned and the warrants fell in price.

In the normal course of events he would just buy more. But, because the position was already near the 10-per-cent limit imposed by fund regulations, he took a different route. It's one that's well known to tax-loss harvesters. He sold the warrants, waited 30 days, and hoped to buy them back at better prices.

But the market foiled his plans and prices rose dramatically in the interim. Regrettably, such mistakes are not uncommon when harvesting tax losses.

Nonetheless, experienced value investors searching for bargains should take a hard look at some TARP warrants despite their recent gains. After all, Mr. Chou's fund held the warrants of Wells Fargo & Co. and JPMorgan Chase & Co. at the end of the year. However, I hasten to add they aren't suitable for less seasoned investors.

While the warrants might be too exotic for most, the common shares of the U.S. banks in question represent easier options. Mr. Chou's fund holds interests in Citigroup, Goldman Sachs, JPMorgan and Wells Fargo. (For what it's worth, I still like Bank of America at current levels even though the stock has gained ground in recent months.)

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When you're enjoying your cup of coffee this weekend, download a copy of Francis Chou's annual report. It'll help you to become a better investor.

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