How value investor Chou wins with bonds

By Andrew Allentuck
Globe Investor magazine online, March 14, 2008

When you read about investment stars, portfolio managers who score high double digit and even triple digit annual gains, managers of bond portfolios usually aren't there. The reason - bonds are a different game, one where risk is less courted than avoided. But when the dust settles after big market busts, it's often the bond managers who are still standing.

Francis Chou, 52, of Chou Associates Management Inc., is one of those survivors. His $90-million Chou Bond Fund (US$), established in the fall of 2005, soared to the No. 1 spot among 65 funds in the high yield sector with an average annual compound gain of 10.4 per cent for the two years ended Feb. 29, 2008, far above the 1.5 per cent average annual compound gain of peers in the period.

Mr. Chou's method can be boiled down to a few principles. As he wrote in his 2007 report to unitholders, "the cardinal principle of investing is to think first about preserving capital before thinking about making money. The greater the probability of permanent loss of capital, the greater the spread should be between a particular debt instrument and risk-free treasuries."

His guide, he says, is Security Analysis, the famous work of Benjamin Graham and David Dodd, published in 1934. "In bonds, Graham and Dodd's emphasis on balance sheets is more important than looking at cash flow," he said. "The principles remain vital today for someone who wants to invest in mispriced bonds." Mr. Chou plays on turf that even conventional junk bond managers avoid.

While about 70 per cent of his fund's holdings is in high-yield bonds, 30 per cent is in distressed debt, that is, bonds that have already defaulted but which can regain value through the usual path of conversion to common equity in restructured businesses. Only about 35 per cent of the fund is invested. The remainder is in cash, awaiting opportunities.

Chou Bond bought bonds of Adelphia Communications Corp., a cable operator based in Coudersport, Penn., in January, 2006 at 60 to 65 cents on the dollar. The company, later bought by Time Warner Cable and ComCast, was bankrupt, the bonds had defaulted and senior managers were imprisoned. Yet Mr. Chou saw an opportunity, for the assets behind the bonds had been mispriced, he explained.

"The bonds had been driven down by what you could call political issues," he said. In 2006, the company was restructured, operating units were sold, and bondholders made a profit about 85 per cent in a year, he said. For Mr. Chou, it was a classic play in separating market perception from accounting reality.

Even with good analysis, buying into high-yield bonds with sub-investment grade ratings and distressed bonds that have defaulted is a chancier business than buying government bonds. Mr. Chou sticks with 10 core principles:

1. Safety - Don't pay more than 60 to 65 cents on the dollar for any risky debt.
2. Homework - It can take as much as a month of study to understand a company's accounts, management and problems.
3. Diversification - Have at least 10 to 15 high yield or distressed bonds in the portfolio
4. Patience -. It can take two or three years for companies to be fixed or restructured
5. Valuations - Do not ignore risk, even when investors fail to price it into assets
6. Confidence - Make sure your estimates are accurate.
7. Modesty - Know what you do not know.
8. Position - When you buy into a bad situation, buy the most senior debt you can find.
9. Liquidity - a company has to have enough cash or saleable assets to pay bondholders
10. Friends - the company should have the ability to go to the market to raise fresh capital that will at least indirectly benefit bondholders.


These principles have worked well in industries that have fallen on hard times. For example, in October, 2005, he bought the convertible bonds of UTStarcom Inc., a telecom based in Alameda, Calif., at 62 cents on the dollar. The company had operating problems and the bonds were depressed by the poor valuation on the stock. The company was turned around, however, and the bonds were redeemed this month at par, turning a 60 per cent profit in a little more than two years.

Some bonds have been flops. Mr. Chou bought bonds of Hollinger Inc. in 2006, then watched them sink along with the company's shares, which have fallen from $20.45 in January, 2004, to a recent price of 87 cents via a collateral agreement with Sun-Times Media Group Inc. Hollinger Inc. is involved in complex insolvency proceedings in Canada and the United States. Mr. Chou's fund continues to hold the bonds, but declining newspaper readership at the Chicago Sun-Times, Hollinger's last significant newspaper holding, continues to weigh down the company's cash flow, he explained. For now, he is holding on to the bonds. "It is a tough market in which to sell this bond."

Speculating in cliffhanger junk bonds that may default and distressed bonds that already have is a game with moving targets. He noted signs that capital markets were due for a reversal in his annual 2007 report to unitholders. "Business school graduates are gravitating in large numbers to hedge funds and private equity funds. Historically, they [the graduates] have been attracted to industries that are about to peak or have peaked. Today, Mr. Chou is buying more telecom bonds. "They have come down in price because of a lot of uncertainty about markets and de-leveraging in the U.S. where we have most of our assets," he explained. "They are in the high yield sector but are not distressed. We expect to make 10 to 15 per cent on these bonds each year for the next 15 years."

Special to The Globe and Mail