Fund manager Francis Chou offers some straightforward investing philosophy in his annual report. Among his tips: avoid companies with bladder problems.

I always look forward to reading the annual reports from the Chou Funds. Unlike most corporate documents, manager Francis Chou’s comments are frank, down-to-earth, and sometimes brutally honest. He does not hesitate to tell unitholders when he has goofed and has even been known to reduce his management fee if he feels his performance in a given year was sub-par.

The 2005 Chou Associates annual report landed on my desk recently so I immediately dived in to see what gems he has to offer this time around. One of his main messages is the importance of admitting mistakes early, making needed corrections, and moving on.

To illustrate this, he describes his experience with an unnamed stock he held last year: “The company had high cash holdings and its management had significant stock ownership. Accordingly, we felt that management would act rationally and strive to maximize shareholder value. We gave undue weight to this factor and not enough to compelling evidence suggesting that, historically, management had not managed the business for the benefit of shareholders. In fact, they suffered from a syndrome that is popularly known as the bladder problem: ‘The more cash one holds, the greater the pressure to piss it away.’”

That’s what happened and Mr. Chou ended up dumping the stock. The lesson: “Admit the mistake early on and avoid any temptation to justify or rationalize the decision along the way. After that, make the necessary correction and move on.”

In the Annual Report, Mr. Chou also has some harsh words about the growing cost of corporate governance (some say over-governance) and its impact on investors.

He zeros in on the Sarbanes-Oxley Act, which was passed by the U.S. Congress to tighten corporate governance in the aftermath of financial collapses such as WorldCom and Enron. Although it only applies to U.S. companies and those listed on the American exchanges, he says it may end up costing Canadian investors some of their mutual fund profits.

He writes that the 1.75% management expense ratio (MER) recorded in 2005 by the Chou Associates Fund, which invests primarily in U.S. stocks, is probably as low as it will ever go. In fact, he expects it to rise in future years although he hopes to keep it below 2%. The culprit: Sarbanes-Oxley.

“Complying with the Act will cost businesses listed on U.S. stock exchanges an estimated $28 billion in 2007 (and) the costs will escalate as we move forward,” he writes. “At some point the regulators will have to assess whether the costs borne by the unitholders, as well as the management time and human resources required by fund companies to meet the compliance requirements, are worth the debatable intended benefits.”

Then he adds: “What may also be affected are the style and manner in which letters to the unitholders are written. We believe that our investors would like to hear from their portfolio manager in a straightforward and forthright manner on how he or she is looking at the investment landscape rather than have the letter drastically rewritten by public relations or legal counsel.”

If that implies future Chou Funds reports would be written in bureaucratese, I say amen to that.