Chou Funds: 2012 Semi-Annual Report

Found via the Corner of Berkshire & Fairfax.

Following up on a past letter, we continue to believe U.S. financial institutions are very cheap and TARP warrants associated with these companies are an attractive way to invest in them. Depending on the price, TARP warrants have several characteristics that make them appealing long-term investments. Specifically, they are long dated, with most expiring around 2018-2019. This time frame of six-plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant. In addition, we believe the strike price will be adjusted downward for any quarterly dividend that exceeds a set price. This is rarely seen in a stock warrant. An example: for Bank of America, class 'A' warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.

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It’s been over three years since the European crisis began and we’re still unable to predict what will happen to the Euro and the 17 Eurozone countries that have adopted the Euro as their national currency. While most believe that to solve its problems the Eurozone must undergo deep structural reform, to date no one has devised a solution that all 17 disparate Eurozone nations can agree on. If the ramifications of Euro crisis on the world economy weren’t so serious, we could all get a good laugh at the comical way the Eurozone club was set up and how that has played out. Nigel Farage, leader of the UK Independent Party, captured the humor in a speech he gave in June 2012.

“I remember being here ten years ago, hearing the launch of the Lisbon Agenda. We were told that with the Euro, by 2010 we would have full employment and indeed that Europe would be the competitive and dynamic powerhouse of the world. By any objective criteria the Euro has failed, and in fact there is a looming, impending disaster. You know, this deal makes things worse not better. A hundred billion [Euro] is put up for the Spanish banking system, and 20 per cent of that money has to come from Italy. And under the deal the Italians have to lend to the Spanish banks at 3 per cent but to get that money they have to borrow on the markets at 7 per cent. It's genius isn't it. It really is brilliant.”

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Based on ratios such as rent-to-house-price, disposable-income-to-house-price, Canadian house prices are out of line with historical standards. In addition, household debt as a percentage of disposable income is unprecedentedly high. This does not mean that real estate prices will decline soon, but it does indicate that valuations are stretched.

A few months ago, Richie Boucher, who is the CEO of Bank of Ireland, was discussing real estate prices in Canada. As we know, real estate prices in Ireland have dropped by 50% from its peak. In contrast, Canada is experiencing a building boom and Toronto is said to have more condominiums under construction than any other city in the world. He joked that he has been hearing that lots of Irish guys are emigrating to Canada to work in real estate construction trade, and cautioned: “Watch out Canada if Irish pubs start sprouting in Canada”.