Is value dead?

Globe Investor Magazine, May 22, 2008

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."