Q&A with Gurus: CEO of Fairfax Financial Prem Watsa
Watsa is the founder, chairman and chief executive of Fairfax Financial Holdings, a $7.7 billion Toronto-based firm, where he has delivered a 5-year cumulative return of 176%, compared to 12.2% of the S&P 500. In 2008, when the market was spiraling to a loss of 37%, he achieved a 21% return for his clients.
Fairfax has a worldwide insurance/reinsurance company operating in over 100 countries with $5 billion of premiums and about $8 billion of shareholders’ capital. Book value per share compounded by 25% per year to $379 per share. Its return on common equity averaged 24% since 1985.
He states in his 2010 shareholder letter, “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.”
After earning his chemical engineering degree from the Indian Institute of Technology, he immigrated to Ontario in 1972 to earn an MBA from the Richard Ivey School of Business of the University of Western Ontario. It was at his first job working for Confederation Life that he was introduced to Ben Graham and David Dodd’s Security Analysis, which forever changed his way of investing. In 1984, Watsa left with his former boss to start their own business, Hamblin Watsa, out of a few individual accounts and $10,000 seed money from a friend in exchange for a third of the shares.
The next year, Watsa started going a Buffett-style path when for $5 million he gained control of Markel Financial Holdings, an insurance company whose $40 million in float he could manage. He has since acquired many other insurance businesses. The set up of Fairfax, as well as its stellar performance, have earned him the title “The Canadian Warren Buffett.”
In his first annual report in 1985, he explained the company’s foundation to investors:
“Our investment philosophy is based on the value approach as laid out by Ben Graham and practiced by his famous disciple, Warren Buffett. This means we buy stocks of financially sound companies at prices below their underlying long-term values. We expect to make money over time, not in the next month or two. In fact, in the short term, stock prices could go well below our cost. In our purchases, we are always trying to first protect your capital from long-term losses (as opposed to short-term price fluctuations).”
Fairfax’s 2008 return was due to heroic actions the firm took in the years leading up to the crisis. They first began noticing that reinsurance companies, including AIG, were taking enormous risks in asset-backed, mortgage-backed, high-yield bonds. If the reinsurers’ risk taking lost them money, they would be unable to pay Fairfax. Watsa’s company decided the best way to protect themselves was through credit default swaps (CDSs), which they began purchasing in 2003. By the end of 2006, they had $276 million in CDSs, with a market value of $72 million. When the market crashed, Fairfax began selling its CDSs, and ultimately earned $2.7 billion in 2008.
Watsa gives five primary reasons for the success of Fairfax Financial:
1) A total focus on building long-term shareholder value, defined as a minimum 20 percent annual return on equity over the long term.
2) A decentralized structure, which gives them a meaningful competitive edge.
3) Leadership that is talented and trustworthy, and, most importantly, without big egos.
4) Never compromising on integrity.
5) A strong financial position in order to protect the company and to allow them to take advantage of opportunities.
Fairfax made a 5% return in 2010, due mainly to market-to-market losses in their bank portfolios, particularly in muni bonds primarily as a result of an increase in interest rates, as well as the elimination of significant gains in their stock portfolios due to an almost 100% hedge.
He has hedged his equity exposure so strongly because he believes the recession of 2008 and 2009 was unlike other economic downturns. If it was, he would be aggressively buying stocks. However, he believes the financial crisis was a once-in-a-hundred-year event with the potential for unintended consequences for years to come. “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 GNP remains flat for 10 to 20 years with many bouts of deflation." His goal is to preserve capital in case the reverberations continue.
Watsa also sees potential bubbles in emerging markets, such as real estate in China. If Chinese demand for commodities evaporates, and U.S. consumers decrease spending, the economy could slow to a crawl.
Watsa’s top holdings as of June 30, 2011, are: Dell Inc. (DELL), AbitibiBowater (ABH), Johnson & Johnson (JNJ), Level 3 Communications Inc. (LVLT), and Research In Motion Ltd. (RIMM). In the last quarter, he bought: Kennedywilson Holdings Inc. (KW), Cninsure Inc. (CISG), New York Times Co. Cl A (NYT), and sold Steward Enterprises Inc. (STEI).
You can ask Prem your investing questions by typing them in the comments section below.