Francis Chou: "Comments on the Market"

This is an excerpt from Chou Associates' Francis Chou's letter to shareholders for 2009 which was recently published in the fund company's Annual Report for 2009.

General Comments on the Market

SOVEREIGN GOVERNMENTS DO NOT DEFAULT ON THEIR DEBT?: It is hard to believe that governments can and do default on their debts and, as the following table shows, even with their power of taxation and the ability to print money, governments have to obey the laws of economics. Just like an individual or a corporation, if governments cannot service their debt, they either default or have their debt rescheduled. As the table also shows, it is not only poor emerging third world or African countries run by dictators that default, but also long established democracies with duly elected governments that are governed by a rule of law and that are considered modern economies. It is an eye opener to see that since the year 1800, Greece has spent roughly 50% of its time either in default or debt rescheduling; Spain has spent approximately 23% of its time in default; and Mexico and Russia around 40%.

Source: This time is different Eight centuries of financial folly by Reinhart & Rogoff

The table is important because it demonstrates that it is not too farfetched to think that well-known democratic countries can and do default on their sovereign debt.

WAS THE GREAT STIMULUS A SILVER BULLET? - THINK AGAIN: It now appears that the great stimulus provided by almost all governments has averted the second Great Depression and the North American economy may well be on its way to recovery. However, looking forward, unless we find a credible way to repay or at least comfortably service the enormous and growing burden of government debt, we are going to face immense challenges. By overloading governments with too much debt, the stimulus may have pushed the problem from the private sector to the government sector and may have made it worse. If we take a snapshot of the growing gross debt as a percentage of GDP before and after the meltdown, we get a pretty good picture of the potential trouble some countries may face in the future.

Source: JP Morgan provided data on Brazil, China, India and Russia. All other data obtained from the OECD.

At some level, debt becomes an intolerable burden and increases the chance of a default. Historically, when gross debt exceeds 70% of a country's GDP, the warning signs start flashing.

While we all wished the great stimulus would prove to be a silver bullet that would resolve all the problems stemming from the world financial crisis, that has hardly been the case. If history is any guide, it takes a long time for countries to successfully emerge from a financial crisis. They must deal with a huge increase in unemployment along with a profound increase in government debt. The problem is exacerbated by lower tax revenues in the future caused by lower output and unemployment. We think the next few years will be rocky, with economies lurching from one crisis to another.

As an investor, we believe there will be enormous opportunities but the key to investment success will depend on how we avoid some of the inevitable potholes we will find in our path.

We would also like to add a caveat to those who are investing in the Chou Funds: markets are inherently volatile in the short term and can adversely affect the Chou Funds. Therefore, investors should be comfortable that their financial position can withstand a significant decline - say, 50% - in the value of their investment.

TOO BIG OR TOO WELL CONNECTED TO FAIL: One would imagine that the great financial crisis would precipitate meaningful banking and financial reform but I doubt that will be the case. As long as the financial institutions are too big or so well inter-connected to the financial system that their failure may precipitate a chain reaction that threatens the world financial system, the government will protect them from failure. The rescue of AIG turned out to be essentially a bailout of the investment banks. When executives, especially CEOs, suffer no serious financial consequences when their actions bankrupt or put their companies in deep financial distress, it encourages risky and unethical behaviour. Such perverse incentives need to be discouraged. The Board of Directors is supposed to protect shareholders but more often than not, directors are just patsies for the CEOs. In a damning 2,200 page report, written by bankruptcy examiner Anton Valukas on Lehman Brothers, he wrote of one episode on March 20, 2007, where the chief administrative officer, Lana Franks Harber of Lehman's Mortgage Capital division, e-mailed a colleague to summarize her discussion with Lehman President Joseph Gregory with regard to her presentation to the Board of Directors: "Board is not sophisticated around subprime market -- Joe doesn't want too much detail. He wants to candidly talk about the risks to Lehman but be optimistic and constructive - talk about the opportunities that this market creates and how we are uniquely positioned to take advantage of them." (italics emphasis added). The report then states, "Consistent with this direction, the Board presentation emphasized that Lehman's management considered the crisis an opportunity to pursue a countercyclical strategy.... Management informed the Board that the down cycle in subprime presented substantial opportunities for Lehman."

More than once, under a bankruptcy restructuring, I have seen the very CEOs who ran the company into the ground getting 5% of the recapitalized company without putting up any of their own money. In most occupations, there are penalties for egregious failure but the CEOs of public financial companies are in a league of their own. Many get paid obscene amounts of money for risky and reckless behaviour. There is a joke on Wall Street: "Today, President Obama announced a salary cap of $500,000 for executives at banks and companies that have received taxpayer bailout money. And the CEOs asked: 'Well, that's $500,000 a week, right?'".

DEBASEMENT OF CURRENCY: Almost all governments whose economies have been adversely affected by the financial crisis have been providing all kinds of stimulus funds to minimize the impact of the liquidity and credit crisis on their economies. They are all falling over (competing with) one another to see who can debase their currencies further.

INFLATION OR DEFLATION: The huge surplus of excess capacity in almost every sector in the world presents a strong case for deflation down the road. But with the explosion of government debt in most of the world, it is hard to believe that governments will let future generations deal with the enormous debt with currencies that will have a higher purchasing power than they have now. Historically, the easy way out for governments has been to inflate their way out of their debt problem.

NON-INVESTMENT AND INVESTMENT GRADE BONDS ARE FULLY PRICED NOW: The historically high spread between U.S. corporate debt and U.S. treasuries narrowed in 2009. Three years ago, the spread between U.S. corporate high-yield debt and U.S. treasuries was 311 basis points; at December 31, 2009 it was 657 basis points, down from its December 2008 peak of 1,900 basis points. Three years ago, the spread between U.S. investment grade bonds and U.S.

treasuries was about 85 basis points; at December 31, 2009 it was 162 basis points, down from its December 2008 peak of 592 basis points. (Source: JP Morgan)

Given the above, we believe that investment and non-investment grade corporate bonds are now fully priced.

It is similar with equities. Most stocks are now close to being fairly priced and it is harder to find bargains. Although we won't likely see the lows that we saw in February/March of 2009, the risks of investing in equities are greater now.

Source: Chou 2009 Annual Report [PDF]