Key Takeaways from Prem Watsa Shareholder Letter: 100% hedged, On US Economy, Chinese Real Estate Bubble
Almost 100% hedged
We began 2010 with about 30% of our common stock hedged. In May and June we decided to increase our hedge to approximately 100%. Our view was twofold: our capital had benefitted greatly from our common stock portfolio and we wanted to protect our gains, and we worried about the unintended consequences of too much debt in the system – worldwide! If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today.
Book Value Compounded 24.7% for 25 years
Book value per share has compounded at 25% per year to $379 per share while Fairfax's stock price has compounded at 21% per year. By the way, this rate of compounding in our stock price over the past 25 years is the best in the property and casualty business (there are only nine public companies with a 25-year track record), second best among all companies in Canada and in the top ten companies in the S&P 500.
North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990
If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today. However, we worry, as we have mentioned to you many times in the past, that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GNPremains flat for 10 to 20 yearswith many bouts of deflation.We see many problems in Europe as country after country reduces government spending and increases taxes to help reduce fiscal deficits. We see the U.S. government embarking on a similar exercise (as it has no other option) and all this while businesses and individuals are deleveraging from their huge debts incurred prior to 2008.
On Chinese Real Estate Bubble
Meanwhile we have concerns over potential bubbles in emerging markets. Consider, for instance, what we learned on a recent trip to China: many house (apartment) prices in Beijing and Shanghai had gone up almost four times – in the past four to five years!; many individuals own multiple apartments as investments with the certain belief that real estate prices can only go up; and maids are taking holidays so that they can buy apartments also. "Buy two and sell one after it doubles to get one for free" goes the refrain! In his essay in Vanity Fair, "When Irish Eyes Are Crying",Michael Lewis says, "Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash." We agree!! Infrastructure and construction spending in China accounts for more than 40% of GDP – a number rarely seen in the past in any economy.
On Commodity Prices
In fact, this demand has resulted in commodity prices going up in a parabolic curve. Combine the increase in commodity prices, substantially from Chinese demand, with hedge funds and others again trying to allocate money to these very illiquid markets, and you can understand why some of these commodities have exploded in price...
Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!
On Municipal Bonds and Coporate Bonds
Of our muni bond portfolio of $5.4 billion, $3.5 billion or approximately 65% are bonds guaranteed by Berkshire Hathaway that we purchased in the fourth quarter of 2008. At current yields of approximately 5.5%, we are getting a pre-tax equivalent yield of 7.9% on a Berkshire credit. It does not get much better than that! It's a great yield, but unfortunately there are none around!! The remaining muni bonds we have are either of essential services like large airports or of large states like California. During 2010, as credit spreads came down to pre-2008 levels, we sold many of our corporate and distressed bonds at a significant profit and we purchased government bonds. We continued to reduce our corporate bond exposure in early 2011.
You know our concern re deflation. Well, Brian Bradstreet of CDS fame came up with a similar idea called CPI-linked derivative contracts. These are ten-year contracts (with major banks as counterparties) that are linked to the consumer price index of a country or region. Say the consumer price index in the U.S. was 100 when we purchased this contract. In ten years' time, if the CPI index is above 100 because of cumulative inflation, then our contract is worthless. On the other hand, if the index is below 100 because of cumulative deflation, then the contract will have value based on how much deflation we have had. If, for instance, the index is at 95 because of a cumulative 5% deflation over 10 years, the contract at expiry would be worth 5% of the notional value of the contract. That's how it works!
Of course, these CPI-linked derivative contracts, like the CDS contracts previously, are traded daily among investment dealers. Prices in these markets will likely be higher or lower than the underlying intrinsic value of these contracts based on demand at the time. So there is no way to say what these contracts will be worth at any time. However, for a small amount of money we feel we have significantly protected our company from the unintended and insidious consequences of deflation. As an aside, cumulative deflation in Japan in the past ten years and in the United States in the 1930s was approximately 14%.
This is the link to the complete letter.