Yahoo Finance Chou Income Fund 4th Quarter Message to Shareholders
- By Holly LaFon
Dear Shareholder,
For the year ending December 31, 2016, the Chou Income Fund (the "Fund") was up 20.72%, while the Barclay's U.S. Corporate High Yield Index (High Yield Index) generated a return of 17.13% during the same period. The Fund's performance is not necessarily indicative of how the Fund will perform in the future.
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Portfolio Commentary
Fund losses came mainly from positions in debt securities of two Ukranian companies, Avangardco Investments (AVGR.L) and UkrLandFarming Company. Avangardco fell from 50.5 cents on a dollar on December 31, 2015 to 29.0 cents on December 31, 2016. Avangardco Investments is one of the leading agro-industrial companies in Ukraine, focusing on the production of shell eggs and egg products. According to the Pro-Consulting Report, it has a market share of approximately 57% of all industrially produced shell eggs and 91% of all dry egg products produced in Ukraine in 2013.
UkrLandFarming PLC fell from 50.0 cents on a dollar on December 31, 2015 to 31.7 cents on December 31, 2016. UkrLandFarming PLC operates as an integrated agricultural producer and distributor. The company engages in crops farming, eggs and egg products production, sugar production, as well as cattle and meat production and distribution.
We believe that the bonds of those companies are down from their purchase price in large part because that region of the world is highly volatile and is subject to serious geopolitical risk. As a result, we expect the prices of the bonds we purchased to be volatile and could subject the Fund to a permanent loss of capital. Strong balance sheet and decent financial operations count but we believe that when investing in companies located in a region embroiled in a civil war fueled by Putin, geopolitics can trump solid financials.
It is still too early to know whether our foray into Ukraine was an unforced error. So far, with the exception of Mriya, we think it is a short-term quotational loss and not a permanent loss of capital.
Fund gains were principally driven by investment in the Oil & Gas sector. The price of oil and gas recovered somewhat in 2016 and that helped Fund investments in EXCO Resources and Sandridge Energy.
Our initial investment was in the 8.5% 2012 senior unsecured security of EXCO Resources and that security rebounded from 18.5 cents on December 31, 2015 to 50.0 cents on December 31, 2016. The company made a tender offer for the 8.5% at 40 cents on a dollar on July 27, 2016. We tendered to the company and about 86.5% of the bonds were taken up under the offer.
In addition, as indicated in the past, we decided that our analysis of investment opportunities in Oil & Gas bonds would focus on securities that met these criteria.
1) First or second lien loans or notes;
2) Situations where the ability to add senior or pari-passu debt is significantly limited; and
3) If the company restructures or goes into bankruptcy, the recovery value of the bond is greater than the current price of the bond.
We were able to buy EXCO (XCO)'s 2nd lien term loan and Sandridge Energy (SD)'s 2nd lien bonds. Both worked out well although Sandridge Energy had to go through a bankruptcy proceeding before we eventually realized the value of the investment. When Sandridge Energy emerged from bankruptcy in October 2016, the Fund received $206.2 worth of the new common stock and $241.7 worth of the new convertible bonds for every $1000 par value of the bonds at the time of conversion. At December 31, 2016, the combined value of the common stock plus the new bond received was equivalent to 52.6 cents on a dollar compared to 30.5 cents on a dollar as of December 31, 2015. This was an increase of 72.6% from the previous year.
Another big holding that benefitted the Fund was an investment in the 4% convertible security of Ascent Capital Group, Inc. (ASCMA), a company which through its subsidiary, Monitronics International, Inc., provides security alarm monitoring and related services to residential and business subscribers in the United States and Canada. The convertible went up from 65.8 cents on a dollar on December 31, 2015 to 76.0 cents on a dollar on December 31, 2016. At the price of 76.0 cents, the yield to maturity is 12.6%. We feel comfortable holding this debt security based upon our expectation that the company will continue to generate free cash flow and be able to service the debt.
In February 2016, we sold 1,218,000 convertible debentures of Rainmaker Entertainment for 120 cents on a dollar. Lastly, since the announcement in Oct 2016, Rainmaker Entertainment has gone through a two-part merger to acquire Frederator Networks and Ezrin Hirsh Entertainment for $22 million in stock, and created the new entity Wow Unlimited Media Inc. According to the media release, the business combination aims to create a North-American pure-play kids and youth entertainment company poised to capitalize on favourable industry trends. As a result of the corporate restructuring, in December the Fund received 100 cents on a dollar in cash for 20% of the bonds that it held, and approximately 5,555 shares of the new equities were received for every $1000 for the rest of the bonds. This is equivalent to converting the debentures at 18 cents per share. The company then did a reverse 10 for 1 split. On December 31, 2016, the common stock traded at $1.89 which is equivalent to a debenture price of 105 cents on a dollar.
Conclusion
We believe that most of the bonds held in the Fund's portfolio are somewhat underpriced. Most of them are yielding close to 10% yield to maturity, and we believe that even if some of them go through bankruptcy, the recovery value will be at least close to what the bonds are trading at.
Caution to the Investors
Investors should be advised that we run a highly focused portfolio, frequently only two or three securities may comprise close to 50% of the assets of the Fund. In addition, we have securities that are non-U.S. and could be subjected to geopolitical risks, which may trump or at least negatively impact the financial performance of the company. Also, we may enter into some derivative contracts such as credit default swaps and interest rate swaps, when we feel that the market conditions are right to use those instruments. Because of these factors, the net asset value of the Fund can be more volatile than normal. However, we are not bothered by this volatility because our focus has always been, and continues to be, on how inexpensive we believe the securities are relative to their intrinsic value.
This article first appeared on GuruFocus.
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