What does one do when two of the smartest investors you know have opposing views of where the American economy is headed ?
Prem Watsa, the master of the credit default swap from which he made billions by predicting and then planning for the 2008 credit crisis is still warning of pain ahead. Meanwhile Bruce Berkowitz with his fund up 255% since inception (compared to down 14% for the S&P 500) is positioning for a more normal economy that recovers in fits and starts.
I recently listened to the Fairfax earnings call from Q2 2010 and read some interviews with Mr. Watsa. Here is a recap of what Prem is currently thinking and how he is positioning the company:
First, a bet on deflation with significant upside if correct as explained in the earnings call
“Yes. So we’ve put a little more than a $180 million to the CPI linked derivative contracts. So obviously the maximum we can lose, we bought them for $180 million, and the maximum we can lose over 10 years is $180 million. The notional amount that we disclosed is about $23 billion and they fluctuate, Jeff. They fluctuate up and down and on a daily basis, it’s difficult to determine, but it does give us significant amount of protection.”
Watsa has bought some protection against a long term deflationary environment. If his hunch is correct he can make a bundle (note the notional contract value of $23 billion), and the most he can lose is $180 million. This is very similar to his bet on contract default swaps that were an incredible homerun. Maybe we should be paying attention this time.
What is the reason for this bet ? I’ve read a couple of interviews with Watsa recently. The belief of his team is that two periods in history are similar to where the United States is today. One is the U.S. in the Great Depression. The second is Japan over the last twenty years. In other words they don’t think the financial crisis is over. Their ultimate conclusion is the economy either stays flat as deleveraging continues or it slips and another crisis of confidence occurs and we head back into recession.
In addition to the bet on deflation noted above Watsa has 90% of Fairfax’s equity portfolio hedged as of June 30 and has 15% of the insurance subsidiary portfolio in cash.
Basically Watsa has Fairfax positioned to take advantage of difficult times ahead. If he isn’t correct on this call his investment results will underperform for a couple of years which isn’t a big deal. If he is correct he will be able to thrive while others flounder.
Now on to Berkowitz and his Fairholme Fund.
No better way to explain his thinking than to let you read his most recent shareholder letter:
“Over one-half of The Fairholme Fund’s assets are invested in securities of mostly hated financial services and real estate related companies. After all, “there is no job growth without economic growth; no economic growth without access to credit; no access to credit without a stable, functioning financial system.” Financials tend to lead markets into and then out of recessions followed by asset deflation and then inflation. Never being 100% certain as to events and timing, approximately 20% of the Fund’s assets are in relatively, short-maturity corporate debt and cash equivalents
Over one-third of The Fairholme Focused Income Fund is invested in short-term credits of American International Group, Inc. (“AIG”), General Growth Properties, Inc. (“GGP”) and others that are perceived to be or are in actual financial stress. Underlying equities lead us to believe that all are “money good.” Nearly two-thirds of the Fund is invested in cash and what we consider to be cash equivalents. You should also note our large and growing debt and equity holdings of AIG and GGP. Like their industry brethren, both were in critical condition from last year’s credit freeze and both appear to be thawing from near-death experiences. We believe a moderate climate will allow AIG to repay U.S. taxpayers and GGP to emerge from its self-induced bankruptcy. Further, Fairholme Funds has agreed to buy new GGP trust shares, subject to numerous terms and conditions.
Portfolios are positioned for today’s nascent recovery with its fits and starts. Don’t Lose remains Rule #1 as we strive to be greedy when most remain fearful about the future.”
So while he isn’t predicting smooth sailing, Berkowitz is concentrating his bets on the areas where the most fear has been over the past couple of years. This is clearly where the most upside will be should the economy continue to recover.
In an interview back in May of this year with Bloomberg Berkowitz said that he thought financials could sustain a rally similar to what they had in the 1990s when they increased 7 times in value. He went on to say that he waited to buy financials until he was confident the federal and state regulators had carefully examined the banks and insurers. Because of this he bought only at “crisis” prices and not “death prices” like some smart investors.
I’m not sure who to listen to. One great investor positioned very conservatively and the other trying to be selectively greedy when others are fearful. Both with track records so superior to others that they should be listened to.
