Institutional Investors

Francis Chou: Value Investors Must Remain Confident When Your Strategy Does Not Appear To Be Working

One of the value investors we like to follow closely here at The Acquirer’s Multiple is Francis Chou, founder of Chou Associates Fund. Chou recently released his 2018 semi-annual report in which he urged value investors to stick with their value investing principles in the current market environment saying:

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Q2 hedge fund letters, conference, scoops etc

Francis Chou

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“The important thing is that we continue to be confident in our value investing principles and the process we use to buy and sell stocks. We are trying to buy securities at 60 cents on a dollar. Another way to look at it is that when you buy stock at 10 times earnings versus the market at 25 times earnings, other things being equal, you are getting a 10% annualized yield versus the market giving you a 4% annualized yield. This reasoning is logical and should outperform the market in the long run. However, there will be periods – like we are going through now – where it does not appear to be working.”

Here’s an excerpt from that report:

Short-Term Performance Impacts Long-Term Returns

We have been out of sync with the market for about four years – the longest stretch so far. Generally, it has not bothered us because we expected to underperform the market 30% – 40% of the time, based on our history of managing money for over 35 years.

A lot of investors are not aware that short-term results can have a huge bearing on the five-and 10-year annualized compounded returns. For example, let’s take Fund A and Fund B. Fund A has consistently returned 7% per year for 10 years and therefore its compound rate of return over the 10-year period is 7%. Fund B, on the other hand, returns 8% for the first nine years but suffers a loss of 20% in the 10th year. Its compound rate of return for the 10-year period drops significantly to 4.8%.

The impact is more pronounced for the five-year returns, a similar decline of 20% in the fifth year would have decreased the five-year compound return from 8% to merely 1.7% for Fund B versus 7% for Fund A.

Another example is to compare our year-end 2014 and June 2018 returns, and look at what the Fund’s 10- and 15-year returns were against the S&P 500.

The important thing is that we continue to be confident in our value investing principles and the process we use to buy and sell stocks. We are trying to buy securities at 60 cents on a dollar.

Another way to look at it is that when you buy stock at 10 times earnings versus the market at 25 times earnings, other things being equal, you are getting a 10% annualized yield versus the market giving you a 4% annualized yield. This reasoning is logical and should outperform the market in the long run. However, there will be periods – like we are going through now – where it does not appear to be working.

Most of the time when value investing has not worked, it is during periods when the market is trading at an elevated level. Based on historical ratios, the current prices for stocks are not cheap. However, if interest rates stay at these levels for an extended period of time, stocks are not expensive at all.

Suffice to say that we are not comfortable with the current market levels and we are not convinced that interest rates will stay this low for an extended period of time. We would consider it fortunate if the market returns more than 5% – 6% a year for the next 10 years from these current lofty levels.

In conclusion, we do not believe that we have entered a new paradigm; there is definite room for improvement in stock selections, but the principle of value investing is sound and, in time the logic will prevail.

You can find a full copy of the 2018 semi-annual report here.

For more articles like this, check out our recent articles here.

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