Tuesday, July 03, 2007

Francis Chou

I have great respect for the deep-value investing style of fund manager Francis Chou. In addition, he has been publishing great annual letters for several years that I think everyone should read from front to end. Here are some notable statements that stood out for me as I was reading through them. (Note: Words in bold are my own)

“Those whom the gods wish to destroy, they first blind them with greed.”

As for what’s new, we are finding pockets of bargains in commodities, commodities-related industries, and companies that have business interests in Eastern Europe and Asia. A proviso, however: because the economics of these types of businesses are not as clear cut, they have to be compellingly cheap before we buy them. We have invested in such companies in the past and have done well with them. -April 15, 1999
This was amazing call given what has happened in the 8 years since this statement. Note his warning about the economics of these businesses.

The Fund is not invested in technology stocks. Their current inflated prices make them unattractive and unsuitable to the investment philosophy of the Fund, which is: 1) To buy above-average to excellent companies run by skilful managers, at a price far lower than what a knowledgeable and rational acquirer would pay for cash; and 2) To buy at deep discount to liquid book value for companies with average prospects.
See my posts on
Marginal Company Investing and the self-test on my own portfolio.

Over time I have sifted through thousands of bargains which have come in different shapes and flavours
such as discount to net-net working capital, discount to book value and low P/E ratio. When all is said and
done, those which continue to give me the greatest satisfaction are the ones which display the following
1) Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
2) Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
3) Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
4) A stock price which is far lower than what a knowledgeable and rational buyer would pay.

If there is a secret to the Buffett/Munger success story, it is their willingness to be brutally honest and realistic in their analyses and assessments. They are highly introspective, always checking and rechecking their assumptions and premises against reality. Executives who sugarcoat business realities and embellish results, downplay issues and disguise potential problems to investors may well fool even themselves. They start believing in their own world of make-believe. Buffett/Munger’s formidable powers of analysis would be worth nothing if they looked at problems with rose colored glasses.
Take this to heart.

Seven questions to be answered for any investment operation:
1) How favorable are the economics of the business and where does the company rank in terms of market share?
2) How sustainable are its earnings stream?
3) How skilful have management been in deploying capital?
4) What is the appropriate discount rate to take?
5) Is the capital structure too leveraged?
6) What would an acquirer pay for in cash?
7) And most important of all, what is the appropriate price to pay for such a company that would give an investor more than adequate margin of safety? Margin of safety is simply paying far less for a company than what it is worth, measured by sustainable earning power and/or hard assets that are not depreciating in value. This concept, while unappreciated and ignored by many at the moment, is what distinguishes investment from speculation.

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