GuruFocus had an opportunity to speak with Prem Watsa, 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 has compounded by 25% per year to $379 per share. Its return on common equity averaged 24% since 1985.
During the one-hour interview, Mr. Watsa answered many questions from GuruFocus users. He shared his thoughts on Fairfax, the economy, Europe, and his investments in Bank of Ireland (IRE, Financial), Research In Motion (RIMM, Financial) and Dell (DELL, Financial).
GuruFocus: Thank you very much for the opportunity, Mr. Watsa. We have never met you, but I feel that we know you very well because we have been following you for many years and write a lot about you. We know that you came to Canada at the age of 24 with $200 in your pocket. We know that you went to get an MBA and became an analyst in an investment company, and then your started your own firm and finally decided to go to insurance. And we also know that you signed your first contract agreement with Steve Markel on a napkin and then grew the business by 25% for 25 years. That's really tremendous.
Watsa: Good fortune along the way, lot of good fortune. And a lot of good people that I've been working with, and some people say fortune, I call it blessings. A lot of good blessings along the way.
GuruFocus: It definitely is not just simply luck, and we really want to learn from you. We have lots of questions from our readers, and many of them are your shareholders too, so lots of questions about Fairfax.
Watsa: The only comment I'll make is I will refrain from providing specifics on individual companies that we might be buying, might be selling, so I won't say any specific names but I'll tell you what I can.
GuruFocus: So one question from our readers and your shareholders is where do you see Fairfax 20 years from now?
Watsa: When we began 25 years ago, if anyone told us where we'd be today, we'd never believe it. All we were trying to do when we began, book value was about $2 Canadian [$1.50 US in those days] and we were trying to double book value every five years. We thought we could do that with the insurance float, and of course opportunities came our way, we were flexible, and we had a ton of good people join us, and today we have done significantly better than what we expected. Our book value has compounded at 25% a year, way more than what we expected. So we simply take a year at a time, we take what comes to us, and we don't make any grand plans. Our history has been to be open to the opportunities ahead of us.
GuruFocus: Do you see yourself always staying in the insurance business or might you become something like a Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and get into other industries?
Watsa: Well Berkshire has an unbelievable track record, and there will be no other Berkshire as far as I'm concerned because it has an outstanding track record and an outstanding investor running it. We do our thing, we're in property casualty insurance and our expectations are twofold. One is property casualty insurance and reinsurance worldwide, the other is investments worldwide. More recently, we made the point that our cash flows are between half a billion to a billion, and we've said that we would look at buying profitable businesses that have been established for a long time. Any business that a founder has run for a long period of time and doesn't really want to sell it other than for estate planning or other similar purposes, we're a buyer for businesses like that as we are decentralized and offer a permanent and friendly home. William Ashley was the first non-insurance company we bought that fit that mold on a small scale.
Our philosophy is very simple: to do well for our shareholders, over the long term, by treating our customers and our employees well. And in our case, we have this principle of donating, or investing, in communities we do business in. We invest at least 1%, and we're looking at 2% of our pre-tax profits, that we put into the communities where we operate. I have to tell you that it's tremendous, it's been wonderful for us to do that. Last year, we made this point in our annual meeting: when a company does well, its customers and its employees do well, but the communities that you operate in do well also. Last year we donated $10 million across our companies, and we invested in these communities. Our whole company when we began was worth $2 million. So we call it doing good by doing well.
GuruFocus: As the company grows bigger, do you think the book value growth will slow down or do you think you can keep the growth?
Watsa: So we have a 15% compounded growth rate, and we think that growth rate continues to be achievable for us. Our capital base is about $8 billion, our investment portfolio is at $24 billion, business premiums are written at about $5 billion, we have international businesses, if you take our equity holdings in companies like ICICI Lombard and the Chinese company, Alltrust, and the others we list in our annual report, at about another $1.5 billion, so we have about $6.5 billion in aggregate premium. So it’s significantly larger than where we began 25 years ago, but in terms of the world markets, we think that there's a lot of opportunity to grow over time and make a 15% real return, which is making an underwriting profit plus interest and dividend income plus capital gains all after-tax. So you put all of that together, we figure mark-to-market book value, including the dividends that we pay out, will over time compound book value at 15% a year. But you know we're not quarterly focused, we've never issued guidance, we've never given any quarterly numbers, so we're focused on performing over a long period of time.
GuruFocus: So you feel comfortable over the long term, 15% is still achievable.
Watsa: Yes, that rate of return continues to be our goal.
GuruFocus: As you buy more and more companies, you have lots of people, CEOs, working at different locations for you. How do you maintain the culture?
Watsa: So to be able to do that, for the first time we put Andy Barnard – who built Odyssey Re beginning with the old Scandia Re and only $150 million of business, and Andy took it to $2 ½ billion over a fifteen year period. He went from only US operations to worldwide operations, and he has done an outstanding job at building Odyssey Re – and more recently we put him in charge of all our insurance operations. He's our chief operating officer for insurance operations. This is a first for us, and we're very excited about that move, so that's his responsibility in terms of keeping in touch with all the companies that we have, making sure that they're focused on underwriting profit, making sure that their reserving is good, working of course with our holding company people in Toronto, but we've got good people in different parts of the world. For Fairfax Asia, we have Mr. Athappan who is a phenomenal success story. He took $20 million of business in 2002 and $50 million in capital – and today the $20 million is more like $350 million+ of business and the capital is through $300 million. No new money was put into the business in the eight years he has run it. Combined ratios in the 75-80% year after year, the reserving is very conservative. So we have very good people like that all over the world, which will make Andy Barnard's job a little simpler, but we've put Andy in charge of all of that. So Fairfax Asia is under Mr. Athappan, and if we expand in other countries in Asia, which I'm sure we will do, that comes under Mr. Athappan. So we will continue to be decentralized with our executives in charge of our different global insurance and reinsurance operations.
GuruFocus: With different operations in different countries, do you feel the culture difference will make an impact on your business or the decision making process?
Watsa: We tried to be careful about who we become partners with, who we associate ourselves with. We have this fair and friendly culture that we've talked about. This fair and friendly culture is one of our guiding principles, and we want people who fit with that, we want partners who fit with that, who think long term. We're not trying to make money at the expense of everything else. If they don't buy into our values, we don't want to be partners with them, so that helps in terms of spreading our culture to any company we acquire.
GuruFocus: How do you measure the performance of your CEOs if you have different companies? Do you measure by the growth of the float or the book in different subsidiaries? How do you measure it over the long term?
Watsa: We look very simply at underwriting profit, and our property casualty business is simply underwriting profit plus good reserving. So we look at the reserving record, which our companies have had a very good record over time, and the underwriting performance based on combined ratios below 100.
GuruFocus: How about growth?
Watsa: We have no growth target at all. We don't pay a dollar for growth. It's all about combined ratios, underwriting profit, and reserves – it’s about the bottom line. And of course that's done by treating your employees well and treating your customers well. The measuring card is underwriting performance, combined ratios below 100%.
GuruFocus: This part seems to be quite different from Berkshire Hathaway. We learned from Warren Buffett that he paid bonus to David Sokol for the performance, for the growth.
Watsa: I think in the insurance business, Warren does the same thing. Very much underwriting profit oriented. Because he made the point, and it's been my experience, that if you focus on growth, you can get into a ton of problems in our business. It's easy to grow: If you cut the price, you can grow, and if you don't reserve properly, you won't find out for four or five years. So if you have top-line targets, it's very dangerous in the insurance industry. Most of our competitors tend to have top-line targets, but we don't. We have shrunk our business in a soft-cycle significantly. Our original company, Markel Financial, shrank its business from $60 million in 1986 to $10 million in 1991-92. Our Crum & Foster has shrunk by about 40% recently. The biggest one that I have seen over the last few years is Zenith, which shrank from $1.1 billion (before we bought it) to $450 million currently. This is a huge drop in top line, which we encourage, we think that's fine. And we don't lay off our employees, we take an expense ratio hit, so we take a combined ratio above 100% through the expense ratio but not through the loss ratio.
GuruFocus: So the business shrank that much, but you can still make an underwriting profit on it?
Watsa: Yes, so when the business comes down significantly like it did with Stanley Zax's company, Zenith, you typically won't make an underwriting profit, but that's only because of the increased expense ratio, and that's fine. You have to be willing to drop the business when it's not profitable and be ready when the market turns. We will expand our business dramatically when it turns. We've done it after 2001, all our companies, even though they were in various stages of being acquired, doubled our premiums after 2001. Our premium base of our 100% owned companies is around $5 billion, and our capital base is about $10 billion: $8 billion of equity, and about $2 billion of debt. So with $10 billion of capital writing $5 billion, we can easily double our premium, well within our capital constraints. When the insurance cycle turns, we have terrific management all in place in each of our companies, and we have the capital, so we'll be ready to expand our premiums significantly.
GuruFocus: So basically you're really thinking long term and waiting for opportunities.
Watsa: Yes, that's right. We're very simply focused on the long term.
GuruFocus: The next question is from one of your shareholders. What do you think about the intrinsic value of Fairfax?
Watsa: Our book value at the end of June of this year was approximately $360 per share, as reported in our quarterly statement. But about intrinsic value, if you look at the fact that our rate of return has been very significant over 5 years, 10 years, 15 years, 25 years, then the intrinsic values of our companies are significantly higher than our book value. Change in book value is not a bad way of looking at change in intrinsic value, but if you think we can make 15% a year as our target, we've achieved better than that in the past, nothing to say we'll achieve that in the next five years, but if we do, then of course the intrinsic value of our company is significantly higher than our book value.
GuruFocus: But you cannot put a number on it?
Watsa: No, that's what I leave for you and all the analysts and everyone who follows us.
GuruFocus: Now we jump to another topic. What do you think about what's going on in Europe? Greece, Italy, what about the solutions and the opportunities?
Watsa: Well Europe, to put it in perspective, I think you might have seen something that I spoke to one of our local newspapers, the Globe & Mail, about. In the story I laid out some of my concerns, and my primary concern, if I can just put it broadly and then come to Europe, is to say that we think we're in a very difficult environment right now, might last for 3-5 years, so it's a longer term deal. It comes from the United States with the austerity program, 0% interest rate, basically the idea that there's no ammunition either with the Fed or with the Treasury, because we've got these huge deficits, larger debt, and 0% interest rates.
So if you go to Europe, it's the same thing. There's austerity programs across the continent, from Germany down to Greece, and Ireland and Portugal. Italy just came out with a 50-60 billion euro austerity program, which means they're raising taxes and they're cutting government spending. So, if you think that the last few years is a recovery from the 2008-2009 recession, the "Great Contraction," if you think this is a normal recovery, then you might be quite positive on stocks and perhaps bonds, corporate bonds.
But we think of this as a one-in-fifty, one-in-a-hundred year event. We think it could be like Japan in the last 20 years or the U.S. in the ‘30s. we think those are the two events that need to be studied, not to say that history will repeat itself, but those are the two events that need to be studied, and there are quite a few similarities in terms of too much debt in the system in the U.S. today and interest rates which are at 0%, so there's no ammo left to get the economy going while individuals particularly are deleveraging and paying back debt. And now governments are doing the same, in a time of deleveraging, in the U.S. and in Europe. So we're prepared for a tough environment.
There's lots of speculation, and I think at the end of the day, the euro will not break. If the markets really force them, then the governments will have to issue a euro bond, one that's backed by all the countries that form the euro zone. Their debt, by the way, if you add all their debt at a percentage of the cumulative GDP, it's about 87%, which is about 100% for the U.S. So if you put all the debts together and come up with a euro bond, they've got a euro currency, they have to have some discipline on the fiscal side, like balanced budgets like California has, and then you come out with a euro bond, and I think that noise level will come down, but the worry is economic growth, or a lack thereof. No growth and perhaps a recession in the U.S. and similarly in Europe, with no sense of how we can get out of it.
GuruFocus: Do you see any investment opportunities there in Europe during the process?
Watsa: We see a lot of opportunities; we just invested in the Bank of Ireland for example. We bought a fairly significant holding in Bank of Ireland, which is the only commercial bank that's not government owned in Ireland. The bank is really well run, by a fellow by the name of Richie Boucher who's CEO.
You're a Ben Graham fan right? So Ben Graham almost went bankrupt in the ‘30s, and this is an interesting point, I keep thinking about this all the time, so Ben Graham was reflecting in the ‘30s and he writes, if you were not bearish, if you're not concerned about the economy in 1925, not in 1927, 28, 29, but in 1925, there was only a 1/100 chance that you survived the depression, because what'd you have looked at was if you were not bearish in 1925, you'd have seen the crash in 1929, drop 50%, and you'd have come right in and thought of it as an opportunity, because the Dow Jones dropped from 400 to 200, went back up to 300, and the second leg after that was a killer, dropping about 90%!! That was a worry, a lot of problems at the time, and I keep thinking of that because the second leg, I have seen in many industries, oil drilling and farm equipment, that second leg can be vicious, and we might well be entering that second stage.
That's what you have to be concerned about, I'm not saying that will happen, I'm just saying a reading of history, of the ‘30s and of the Japanese environment of the last 20 years, should get one cautious, because of course at that time people didn't expect this either, they didn't expect what happened. And there are a lot of similarities. For example, 0% interest rates, we haven't had that since the ‘30s, those types of interest rates. Ten percent deficits, a 10% deficit in the U.S., you have to go back to that time period to see 10% deficits year after year. In Japan, for example, we were quite fascinated by the fact that when interest rates went from 7-8% in 1989-90 and dropped in the next ten years below 4%, 3%, 2% in 10-year Japanese Treasuries, and then eventually went to 1% where they are now. Seven out of the ten largest Japanese life insurance companies didn't survive.
GuruFocus: This is scary if we think about the second leg in the Great Depression. The Great Depression was ended by the second world war. If we have a second leg in the next years, what will pull us out?
Watsa: There is no way to know for sure. It could simply be that once deleveraging has occurred and government and taxation policies have stabilized, the incredibly versatile free enterprise system, particularly in the United States, will slowly begin to expand again through the natural growth in family formation, entrepreneurial allocation of capital, increases in productivity and new innovation.
GuruFocus: So that's also why you think there will be deflation instead of inflation?
Watsa: That's right. In Japan, there's been cumulative deflation the last 15, 20 years of 15%, and in the ‘30s, there was also cumulative deflation of 15-20%. We worry that it's the unexpected that can hurt you. Right now the expected is inflation, but I really think with 9% unemployment and with austerity programs across Europe and America, that's not the problem. The problem is deflation. So we worry, it's not like it will happen for sure, but we worry about it and the impacts of deflation on our businesses. So we bought deflation contracts, we just thought that was an easy way, for small money, to take some insurance against deflation.
GuruFocus: Yeah, actually there's a question from our readers about the difference between the U.S. and Japan. Of course, the debt is similar, the interest rate is going down to zero. One difference our reader pointed out is the culture difference. In Japan, they would protect the company, protect the employees. But in the U.S., the corporations would just go bankrupt, fire everyone, and just start over again. Do you think that makes a difference?
Watsa: Yes, there are many differences, and that's one. But it's the psychological climate that is very interesting to me. I was there in 1988, ‘89 in Japan, and when we asked the Japanese business people, this thing can't last, the markets are so high, the land prices are so high, you know what they said? "We're not like the U.S. We believe in working together, we won't let stock prices come down because we have all our group members owning our stock, and we won't let land prices come down because we'll buy it if anyone wants to sell land." And when you heard that discussion many times, over a week or so, you might actually believe them. You might have thought yourself, my goodness, this can't happen, maybe these guys are different, maybe the market doesn't work here in Japan. And to think today, 10-year government rates have gone from 7-8% to 1%, short term rates to 0%, and the stock market down 75% from 40,000 in 1989 to less than 10,000 today, it's unbelievable to someone who was there in the ‘80s.
Another thing: In the late 1980s, Japanese women, housewives, were taking their grocery money and putting it into the stock market because markets were going up and everyone was excited. Stock prices came down, and for the last10-15 years, Japanese households are only making bank deposits or investing in Japanese Treasury bonds. So the psychology has changed dramatically. And the question is, is the culture different in America that their psychology won't change? That people will continue to spend? House prices are down 50%, stock prices are down, 401k's are down, will they still spend? And my worry is, the answer to that is no. They will start saving, there's already signs of that, and they will be careful about their spending, they will be careful about taking risk, and that is left to be seen. But that's my worry, that psychological change in the American consumer might be taking place right in front of us.
GuruFocus: Okay, so that's actually why you hedge your investment portfolio. You're worried that the second leg might be coming. Do you have any thoughts on the housing markets in the U.S. and Canada? When do you think housing starts will be fully recovered or 80% recovered?
Watsa: We do not know for sure but we think the deleveraging environment in the U.S. could lead to further price erosion and the suppression of housing starts. However, families continue to form and at some point the excesses will be removed and housing starts will grow. They key is that the excesses need to be removed and unemployment needs to stabilize. We are quite concerned that what we have seen in the U.S. could happen in Canada too, particularly if commodity markets retreat, as we have had over a decade of mostly uninterrupted growth in housing starts and house prices in Canada.
GuruFocus: One interesting question from our readers, he said before 2007, you always put a Schiller P/E in your presentation. Is that an indicator you use to measure the market valuation?
Watsa: In our annual meeting, I showed the Schiller P/E, I showed the Schiller real estate index too. But the point there on the price/earnings is a good one. Right now, people look at the S&P 500 and think it's cheap, they think earnings will be at $100 selling at 12x earnings, perhaps less, and the worry of course is that the earnings will not be at 100, that they could be significantly less for the second half of this year and next year, so this environment is one that we worry quite a bit. That's why for ourselves, our stock positions are almost 90% hedged, we have a lot of Treasury bonds and municipal bonds, and we have those deflation contracts. It's amazing to us how after 2008, 2009, when the spreads widened dramatically between corporate bonds and government bonds, they've come down a month, month and a half ago to levels that existed in 2007 and 2008. Now they've started going back up again, so we have very little in corporate bonds, because we basically figure that we're not being paid for taking risk, so if we're not getting paid, we just like owning Treasury bonds, and that's what we've done.
GuruFocus: You mentioned the earnings of the S&P 500. Of course, we know the earnings have been high because profit margins are extremely high from a historical point of view. What do you think about the profit margin? Do you think it will come back to the historical mean?
Watsa: Yes, you know that regression to the mean, that concept, so things going way beyond the mean eventually come down. We saw house prices took off and now they're coming down, and they're still 15-20% off where they have been historically, real house prices adjusted for inflation. So yes, the margins in a tough economic environment will come down again, quite significantly. I mentioned in that article in the Global and Mail that China is also an area that you have to be a little careful because in China they have this construction boom that's going on. There's quite a bit of real estate speculation that's taken place there.
GuruFocus: We noticed that, too.
Watsa: So you might have experienced that, have you been recently to Shanghai or Beijing? I was there just six months ago, and ordinary people, making 65k - 75k, which is a good amount of money/salary in Shanghai, owned four apartments, and their friends owned three-four apartments, and I said, "How high has it gone up?" and he said, "It's gone up three or four times in four years." But if they would just sell one apartment they could re-coup their cost, they'd have $1 million, but unfortunately there's no way they will be convinced to sell because of the current psychology and an overwhelming belief that China's a big country with 1.3 billion people and there are all sorts of reasons why a property price decline won't happen. That reminded me of all sorts of real estate markets, including the one in Dubai that has fallen flat now and of course the U.S. markets, some time back the UK market, some time back in Canada we had the same thing, so these bubbles do break. But in China, it's such a big economy that if it breaks, it will affect the rest of the world, particularly in commodities.
GuruFocus: So back to the question about market valuation. You said you were 90% hedged, what factor do you use to decide whether you will hedge?
Watsa: We've never hedged before, we've only hedged in the last five or six or seven years, and it's this worry that Ben Graham suggested years ago that this current economic environment is different, this is different from any recession we've had. The real estate speculation in America was massive, the destruction of wealth when house prices came down 30-50% was massive, and you have to be very careful. So we operate in a mark-to-market world in terms of our capital. If the insurance business one of these days will turn, and we don't want to be restricted in the ability of our insurance businesses to write more business because the capital's gone down, because of mark-to-market hits. Mark-to-market declines this time may last for some time, as opposed to 2008-2009 when it lasted it seemed for a few months.
GuruFocus: But you did remove your hedge in 2009 when the market crashed right?
Watsa: Yes, we removed that hedge when the markets went down 45-50% and with the gains we made on the hedge we bought more stock. And we had a lot of government bonds at the time, corporate spreads had opened up dramatically and we sold government bonds and bought corporate bonds, distressed bonds and municipal bonds. We had a very good 2008 and a very good 2009.
GuruFocus: Do you think the market valuation plays a role here in deciding hedging? You said when the market goes down 50% you stop hedging.
Watsa: We are hedging not for 5-10% declines, we are hedging big market risk. We're worried about the markets coming down significantly. It might not happen, but we are just very downside protection oriented. We look at downside protection, we worry about that, and we have to live within our means. I keep telling our team, we don't have the Federal Reserve or the Bank of Canada to help us. We always keep a $1 billion + in cash and marketable securities in the holding company. Our financial position is very strong, we have very little maturities in the next five years, that's significant. We don't count on having access to the bond markets and the preferred markets, (we do have access to them and can issue them at any time, but in 2008 and 2009 it was very difficult to issue anything), so we always keep a lot of cash, that's a policy statement for us and of course in our insurance companies too, 25-30% in cash (which is earning very little by the way). So sometime we expect the insurance market to turn and we'll benefit from it.
GuruFocus: So the reason you're hedging is mainly because you run an insurance company. If you ran an independent hedge fund, would you still hedge?
Watsa: If you were running a pension fund, you might not hedge, and if you were running a mutual fund, you might not hedge, because those are relative returns. So a pension fund money manager would look at it, if they drop 20% but the market dropped 50%, he's a hero. We solely focus on absolute return because of the fact that it affects our capital. And there might be a time that our capital is so huge that we don't have worry about it, but at the moment we continue to worry about fluctuations, big fluctuations, not small fluctuations. And given what I told you before, that we think this economic environment that we just came through in the last few years is worrisome to us because we think of it as either Japan or the 1930s.
If you are managing your own money, as we are with the insurance company portfolios, you will want to be hedged because we do not want to incur impairments or the loss of capital, whereas mutual funds and pension funds are more focused on performing relative to their peers.
GuruFocus: So you really think this time is different.
Watsa: Yes, it's a phrase I don't like using, but yes we do think we should worry about it.
GuruFocus: Your mentor Sir John Templeton said it's the four most costly words.
Watsa: John Templeton was my mentor, I'll tell you, I've known him for 30 years, he passed away a few years ago, but John Templeton was always a long-term investor in common stock. I remember in 1999-2000 he said to me, "Prem, buy bonds, forget about common stock, they're too risky." Then, more recently, four-five years ago, he always hedged, and he said "In this environment, what I like to do is buy the best things I like, and I short the things I really don't like."
But I try to be neutral, sometimes more short than long, but that's John Templeton. So John, one of the key lessons he taught me was to be flexible. His investment philosophy was always value oriented, long term, buy at the point of maximum pessimism, but be flexible in your thinking, and that's what we try to apply.
GuruFocus: How about gold? We know that you said gold is a bubble. What do you think will burst the bubble?
Watsa: We've never invested in gold, so I don't really know what will happen to the price of gold. I just see the price of gold going from $300 to $1800 in a very short period of time, and it's quite parabolic, and I remember what happened to silver, I remember what happened to gold 20 years ago. But mostly commodities, there's a lot of speculation in commodities. The price of copper went from $1 to $4. So whatever commodity you follow, they've gone up very dramatically, lots of speculation in commodities worldwide. And my experience, this is when John Templeton would say, never use "This time is different," but it may be this time is different, but these parabolic curves that I've observed don't end well. The ending is not good, you never know when it will happen, but it always happens and there's lots of pain when these prices come down.
GuruFocus: Some people are arguing that gold stock is undervalued. If gold prices come down, can you comment on that?
Watsa: No, I don't follow them so no comment.
GuruFocus: How about currency?
Watsa: We basically hedge. We're worldwide, so we hedge our exposures. If we have liabilities in U.S. dollars, we have U.S. assets. Canadian dollars, Canadian assets. Euros, euro assets, so we basically try to hedge our exposures.
GuruFocus: We have lots of readers ask about Bank of Ireland. Can you explain a little bit of your due diligence process of the Bank of Ireland, do you think that management has told you the truth, and do you see greater capitalization there especially with currency exposure in Europe and regulatory requirements?
Watsa: Bank of Ireland was always the most conservative bank in Ireland, run by a fellow who just became CEO in 2009, Richie Boucher, who we like a lot. In Ireland, house prices dropped 40-50%, and commercial real estate building prices came down significantly (office buildings). So it's very difficult to survive that, and even a conservative bank like Bank of Ireland got hit. But coming out of this, it's the only bank that's a private bank (government has 15% of the shares, rest 85% is in the private markets, which we own a little less than 10%).
What impressed us was that Ireland seems to have taken its medicine, reduced the deficit, increased taxes, cut government spending significantly, so without making too much noise, the Irish have done what they had to do. The government of Ireland, with the ECB, set up some very tough rules: You have to have enough capital to take a 60% hit in house prices coming down from the high and commercial real estate prices coming down 70% from the top, and your capital position should be sufficiently strong take those hits. And that's what they did, they did the rights issue and raised a lot of money to make sure they had the capital to withstand those hits.
In our due diligence, we talked to them, we went through the individual portfolios; it's a well-regarded bank, with centuries of experience, and has a history of being conservative, but in a country where real estate prices fell off the bottom, no bank with their leverage and lots of mortgages could survive that. But we feel really good about it, and it's a long term investment.
GuruFocus: Do you have any sort of time frame for how long it'll take to recover?
Watsa: Maybe five years, maybe longer, so we think of it as long term. We don't buy it for the next year or two, we don't know what will happen in the next year or two, so we're buying it for five years, and maybe even longer.
GuruFocus: What do you think is the real book value on the bank?
Watsa: The real book value right now is running a little below .30 euros, maybe .27-.28, and then in the next few years it might be static, maybe it will go down a little, but it will be dependent on the economy's performance, and it will be dependent on the Bank of Ireland in terms of what it does, in terms of earnings. If you look at Bank of Ireland's track record in the past, it's done very well, and now it's well capitalized, it has a terrific CEO, it has a good management team, so over time, it should do very well for its shareholders. They are focused on doing well for their shareholders.
GuruFocus: Do you think it has a durable competitive advantage?
Watsa: Definitely. It's a full-service bank, privately controlled and listed in the stock market, and not having the government in control of day-to-day operations is a positive. There was a chance, if the rights issue was not done by private interests, that the government would be 70-75%, so the fact that the government is at 15%, and very supportive I might add, is a plus.
With respect to another recent investment, Research-In-Motion (RIMM), you'll find out we own some shares. Research-In-Motion is run by two guys, Mike Lazaridis, who's really the founder, and co-CEO Jim Balsillie, these guys have taken the company from 0 to $20 billion, and in our experience, that's not easy to do. It's very competitive, and yes they have some challenges ahead of them, but the guys who have taken it from 0 to $20 billion will be able to figure their way through this.
For a similar reason, we bought Dell (DELL) when Michael Dell came back. Here's a company that went from 0 to $60 billion in revenue, and tons of hurdles he had to overcome with his management team, and we just figure that the guy who's done that, and still is a significant shareholder, so focused, will figure his or her way out. Of course the valuation is cheap, all of that, but we're very focused on management, and the founder of the company who's had such a wonderful track record, not that they're infallible, but we would bet on them. Particularly right now for RIMM, getting new management would be a disaster, would be the biggest mistake that the board would make.
GuruFocus: So good thing is that both of them have tons of cash in their balance sheet.
Watsa: Yes they have lots of cash, huge cash flows, and the stock prices have come down significantly from their highs. But the fact that the founders – you know it requires a tremendous focus, both companies are in very competitive industries in the tech area – so I just gave you our perspective on the power of engaged founders.
GuruFocus: Thank you very much for answering questions from our readers.
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 has compounded by 25% per year to $379 per share. Its return on common equity averaged 24% since 1985.
During the one-hour interview, Mr. Watsa answered many questions from GuruFocus users. He shared his thoughts on Fairfax, the economy, Europe, and his investments in Bank of Ireland (IRE, Financial), Research In Motion (RIMM, Financial) and Dell (DELL, Financial).
GuruFocus: Thank you very much for the opportunity, Mr. Watsa. We have never met you, but I feel that we know you very well because we have been following you for many years and write a lot about you. We know that you came to Canada at the age of 24 with $200 in your pocket. We know that you went to get an MBA and became an analyst in an investment company, and then your started your own firm and finally decided to go to insurance. And we also know that you signed your first contract agreement with Steve Markel on a napkin and then grew the business by 25% for 25 years. That's really tremendous.
Watsa: Good fortune along the way, lot of good fortune. And a lot of good people that I've been working with, and some people say fortune, I call it blessings. A lot of good blessings along the way.
GuruFocus: It definitely is not just simply luck, and we really want to learn from you. We have lots of questions from our readers, and many of them are your shareholders too, so lots of questions about Fairfax.
Watsa: The only comment I'll make is I will refrain from providing specifics on individual companies that we might be buying, might be selling, so I won't say any specific names but I'll tell you what I can.
GuruFocus: So one question from our readers and your shareholders is where do you see Fairfax 20 years from now?
Watsa: When we began 25 years ago, if anyone told us where we'd be today, we'd never believe it. All we were trying to do when we began, book value was about $2 Canadian [$1.50 US in those days] and we were trying to double book value every five years. We thought we could do that with the insurance float, and of course opportunities came our way, we were flexible, and we had a ton of good people join us, and today we have done significantly better than what we expected. Our book value has compounded at 25% a year, way more than what we expected. So we simply take a year at a time, we take what comes to us, and we don't make any grand plans. Our history has been to be open to the opportunities ahead of us.
GuruFocus: Do you see yourself always staying in the insurance business or might you become something like a Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and get into other industries?
Watsa: Well Berkshire has an unbelievable track record, and there will be no other Berkshire as far as I'm concerned because it has an outstanding track record and an outstanding investor running it. We do our thing, we're in property casualty insurance and our expectations are twofold. One is property casualty insurance and reinsurance worldwide, the other is investments worldwide. More recently, we made the point that our cash flows are between half a billion to a billion, and we've said that we would look at buying profitable businesses that have been established for a long time. Any business that a founder has run for a long period of time and doesn't really want to sell it other than for estate planning or other similar purposes, we're a buyer for businesses like that as we are decentralized and offer a permanent and friendly home. William Ashley was the first non-insurance company we bought that fit that mold on a small scale.
Our philosophy is very simple: to do well for our shareholders, over the long term, by treating our customers and our employees well. And in our case, we have this principle of donating, or investing, in communities we do business in. We invest at least 1%, and we're looking at 2% of our pre-tax profits, that we put into the communities where we operate. I have to tell you that it's tremendous, it's been wonderful for us to do that. Last year, we made this point in our annual meeting: when a company does well, its customers and its employees do well, but the communities that you operate in do well also. Last year we donated $10 million across our companies, and we invested in these communities. Our whole company when we began was worth $2 million. So we call it doing good by doing well.
GuruFocus: As the company grows bigger, do you think the book value growth will slow down or do you think you can keep the growth?
Watsa: So we have a 15% compounded growth rate, and we think that growth rate continues to be achievable for us. Our capital base is about $8 billion, our investment portfolio is at $24 billion, business premiums are written at about $5 billion, we have international businesses, if you take our equity holdings in companies like ICICI Lombard and the Chinese company, Alltrust, and the others we list in our annual report, at about another $1.5 billion, so we have about $6.5 billion in aggregate premium. So it’s significantly larger than where we began 25 years ago, but in terms of the world markets, we think that there's a lot of opportunity to grow over time and make a 15% real return, which is making an underwriting profit plus interest and dividend income plus capital gains all after-tax. So you put all of that together, we figure mark-to-market book value, including the dividends that we pay out, will over time compound book value at 15% a year. But you know we're not quarterly focused, we've never issued guidance, we've never given any quarterly numbers, so we're focused on performing over a long period of time.
GuruFocus: So you feel comfortable over the long term, 15% is still achievable.
Watsa: Yes, that rate of return continues to be our goal.
GuruFocus: As you buy more and more companies, you have lots of people, CEOs, working at different locations for you. How do you maintain the culture?
Watsa: So to be able to do that, for the first time we put Andy Barnard – who built Odyssey Re beginning with the old Scandia Re and only $150 million of business, and Andy took it to $2 ½ billion over a fifteen year period. He went from only US operations to worldwide operations, and he has done an outstanding job at building Odyssey Re – and more recently we put him in charge of all our insurance operations. He's our chief operating officer for insurance operations. This is a first for us, and we're very excited about that move, so that's his responsibility in terms of keeping in touch with all the companies that we have, making sure that they're focused on underwriting profit, making sure that their reserving is good, working of course with our holding company people in Toronto, but we've got good people in different parts of the world. For Fairfax Asia, we have Mr. Athappan who is a phenomenal success story. He took $20 million of business in 2002 and $50 million in capital – and today the $20 million is more like $350 million+ of business and the capital is through $300 million. No new money was put into the business in the eight years he has run it. Combined ratios in the 75-80% year after year, the reserving is very conservative. So we have very good people like that all over the world, which will make Andy Barnard's job a little simpler, but we've put Andy in charge of all of that. So Fairfax Asia is under Mr. Athappan, and if we expand in other countries in Asia, which I'm sure we will do, that comes under Mr. Athappan. So we will continue to be decentralized with our executives in charge of our different global insurance and reinsurance operations.
GuruFocus: With different operations in different countries, do you feel the culture difference will make an impact on your business or the decision making process?
Watsa: We tried to be careful about who we become partners with, who we associate ourselves with. We have this fair and friendly culture that we've talked about. This fair and friendly culture is one of our guiding principles, and we want people who fit with that, we want partners who fit with that, who think long term. We're not trying to make money at the expense of everything else. If they don't buy into our values, we don't want to be partners with them, so that helps in terms of spreading our culture to any company we acquire.
GuruFocus: How do you measure the performance of your CEOs if you have different companies? Do you measure by the growth of the float or the book in different subsidiaries? How do you measure it over the long term?
Watsa: We look very simply at underwriting profit, and our property casualty business is simply underwriting profit plus good reserving. So we look at the reserving record, which our companies have had a very good record over time, and the underwriting performance based on combined ratios below 100.
GuruFocus: How about growth?
Watsa: We have no growth target at all. We don't pay a dollar for growth. It's all about combined ratios, underwriting profit, and reserves – it’s about the bottom line. And of course that's done by treating your employees well and treating your customers well. The measuring card is underwriting performance, combined ratios below 100%.
GuruFocus: This part seems to be quite different from Berkshire Hathaway. We learned from Warren Buffett that he paid bonus to David Sokol for the performance, for the growth.
Watsa: I think in the insurance business, Warren does the same thing. Very much underwriting profit oriented. Because he made the point, and it's been my experience, that if you focus on growth, you can get into a ton of problems in our business. It's easy to grow: If you cut the price, you can grow, and if you don't reserve properly, you won't find out for four or five years. So if you have top-line targets, it's very dangerous in the insurance industry. Most of our competitors tend to have top-line targets, but we don't. We have shrunk our business in a soft-cycle significantly. Our original company, Markel Financial, shrank its business from $60 million in 1986 to $10 million in 1991-92. Our Crum & Foster has shrunk by about 40% recently. The biggest one that I have seen over the last few years is Zenith, which shrank from $1.1 billion (before we bought it) to $450 million currently. This is a huge drop in top line, which we encourage, we think that's fine. And we don't lay off our employees, we take an expense ratio hit, so we take a combined ratio above 100% through the expense ratio but not through the loss ratio.
GuruFocus: So the business shrank that much, but you can still make an underwriting profit on it?
Watsa: Yes, so when the business comes down significantly like it did with Stanley Zax's company, Zenith, you typically won't make an underwriting profit, but that's only because of the increased expense ratio, and that's fine. You have to be willing to drop the business when it's not profitable and be ready when the market turns. We will expand our business dramatically when it turns. We've done it after 2001, all our companies, even though they were in various stages of being acquired, doubled our premiums after 2001. Our premium base of our 100% owned companies is around $5 billion, and our capital base is about $10 billion: $8 billion of equity, and about $2 billion of debt. So with $10 billion of capital writing $5 billion, we can easily double our premium, well within our capital constraints. When the insurance cycle turns, we have terrific management all in place in each of our companies, and we have the capital, so we'll be ready to expand our premiums significantly.
GuruFocus: So basically you're really thinking long term and waiting for opportunities.
Watsa: Yes, that's right. We're very simply focused on the long term.
GuruFocus: The next question is from one of your shareholders. What do you think about the intrinsic value of Fairfax?
Watsa: Our book value at the end of June of this year was approximately $360 per share, as reported in our quarterly statement. But about intrinsic value, if you look at the fact that our rate of return has been very significant over 5 years, 10 years, 15 years, 25 years, then the intrinsic values of our companies are significantly higher than our book value. Change in book value is not a bad way of looking at change in intrinsic value, but if you think we can make 15% a year as our target, we've achieved better than that in the past, nothing to say we'll achieve that in the next five years, but if we do, then of course the intrinsic value of our company is significantly higher than our book value.
GuruFocus: But you cannot put a number on it?
Watsa: No, that's what I leave for you and all the analysts and everyone who follows us.
GuruFocus: Now we jump to another topic. What do you think about what's going on in Europe? Greece, Italy, what about the solutions and the opportunities?
Watsa: Well Europe, to put it in perspective, I think you might have seen something that I spoke to one of our local newspapers, the Globe & Mail, about. In the story I laid out some of my concerns, and my primary concern, if I can just put it broadly and then come to Europe, is to say that we think we're in a very difficult environment right now, might last for 3-5 years, so it's a longer term deal. It comes from the United States with the austerity program, 0% interest rate, basically the idea that there's no ammunition either with the Fed or with the Treasury, because we've got these huge deficits, larger debt, and 0% interest rates.
So if you go to Europe, it's the same thing. There's austerity programs across the continent, from Germany down to Greece, and Ireland and Portugal. Italy just came out with a 50-60 billion euro austerity program, which means they're raising taxes and they're cutting government spending. So, if you think that the last few years is a recovery from the 2008-2009 recession, the "Great Contraction," if you think this is a normal recovery, then you might be quite positive on stocks and perhaps bonds, corporate bonds.
But we think of this as a one-in-fifty, one-in-a-hundred year event. We think it could be like Japan in the last 20 years or the U.S. in the ‘30s. we think those are the two events that need to be studied, not to say that history will repeat itself, but those are the two events that need to be studied, and there are quite a few similarities in terms of too much debt in the system in the U.S. today and interest rates which are at 0%, so there's no ammo left to get the economy going while individuals particularly are deleveraging and paying back debt. And now governments are doing the same, in a time of deleveraging, in the U.S. and in Europe. So we're prepared for a tough environment.
There's lots of speculation, and I think at the end of the day, the euro will not break. If the markets really force them, then the governments will have to issue a euro bond, one that's backed by all the countries that form the euro zone. Their debt, by the way, if you add all their debt at a percentage of the cumulative GDP, it's about 87%, which is about 100% for the U.S. So if you put all the debts together and come up with a euro bond, they've got a euro currency, they have to have some discipline on the fiscal side, like balanced budgets like California has, and then you come out with a euro bond, and I think that noise level will come down, but the worry is economic growth, or a lack thereof. No growth and perhaps a recession in the U.S. and similarly in Europe, with no sense of how we can get out of it.
GuruFocus: Do you see any investment opportunities there in Europe during the process?
Watsa: We see a lot of opportunities; we just invested in the Bank of Ireland for example. We bought a fairly significant holding in Bank of Ireland, which is the only commercial bank that's not government owned in Ireland. The bank is really well run, by a fellow by the name of Richie Boucher who's CEO.
You're a Ben Graham fan right? So Ben Graham almost went bankrupt in the ‘30s, and this is an interesting point, I keep thinking about this all the time, so Ben Graham was reflecting in the ‘30s and he writes, if you were not bearish, if you're not concerned about the economy in 1925, not in 1927, 28, 29, but in 1925, there was only a 1/100 chance that you survived the depression, because what'd you have looked at was if you were not bearish in 1925, you'd have seen the crash in 1929, drop 50%, and you'd have come right in and thought of it as an opportunity, because the Dow Jones dropped from 400 to 200, went back up to 300, and the second leg after that was a killer, dropping about 90%!! That was a worry, a lot of problems at the time, and I keep thinking of that because the second leg, I have seen in many industries, oil drilling and farm equipment, that second leg can be vicious, and we might well be entering that second stage.
That's what you have to be concerned about, I'm not saying that will happen, I'm just saying a reading of history, of the ‘30s and of the Japanese environment of the last 20 years, should get one cautious, because of course at that time people didn't expect this either, they didn't expect what happened. And there are a lot of similarities. For example, 0% interest rates, we haven't had that since the ‘30s, those types of interest rates. Ten percent deficits, a 10% deficit in the U.S., you have to go back to that time period to see 10% deficits year after year. In Japan, for example, we were quite fascinated by the fact that when interest rates went from 7-8% in 1989-90 and dropped in the next ten years below 4%, 3%, 2% in 10-year Japanese Treasuries, and then eventually went to 1% where they are now. Seven out of the ten largest Japanese life insurance companies didn't survive.
GuruFocus: This is scary if we think about the second leg in the Great Depression. The Great Depression was ended by the second world war. If we have a second leg in the next years, what will pull us out?
Watsa: There is no way to know for sure. It could simply be that once deleveraging has occurred and government and taxation policies have stabilized, the incredibly versatile free enterprise system, particularly in the United States, will slowly begin to expand again through the natural growth in family formation, entrepreneurial allocation of capital, increases in productivity and new innovation.
GuruFocus: So that's also why you think there will be deflation instead of inflation?
Watsa: That's right. In Japan, there's been cumulative deflation the last 15, 20 years of 15%, and in the ‘30s, there was also cumulative deflation of 15-20%. We worry that it's the unexpected that can hurt you. Right now the expected is inflation, but I really think with 9% unemployment and with austerity programs across Europe and America, that's not the problem. The problem is deflation. So we worry, it's not like it will happen for sure, but we worry about it and the impacts of deflation on our businesses. So we bought deflation contracts, we just thought that was an easy way, for small money, to take some insurance against deflation.
GuruFocus: Yeah, actually there's a question from our readers about the difference between the U.S. and Japan. Of course, the debt is similar, the interest rate is going down to zero. One difference our reader pointed out is the culture difference. In Japan, they would protect the company, protect the employees. But in the U.S., the corporations would just go bankrupt, fire everyone, and just start over again. Do you think that makes a difference?
Watsa: Yes, there are many differences, and that's one. But it's the psychological climate that is very interesting to me. I was there in 1988, ‘89 in Japan, and when we asked the Japanese business people, this thing can't last, the markets are so high, the land prices are so high, you know what they said? "We're not like the U.S. We believe in working together, we won't let stock prices come down because we have all our group members owning our stock, and we won't let land prices come down because we'll buy it if anyone wants to sell land." And when you heard that discussion many times, over a week or so, you might actually believe them. You might have thought yourself, my goodness, this can't happen, maybe these guys are different, maybe the market doesn't work here in Japan. And to think today, 10-year government rates have gone from 7-8% to 1%, short term rates to 0%, and the stock market down 75% from 40,000 in 1989 to less than 10,000 today, it's unbelievable to someone who was there in the ‘80s.
Another thing: In the late 1980s, Japanese women, housewives, were taking their grocery money and putting it into the stock market because markets were going up and everyone was excited. Stock prices came down, and for the last10-15 years, Japanese households are only making bank deposits or investing in Japanese Treasury bonds. So the psychology has changed dramatically. And the question is, is the culture different in America that their psychology won't change? That people will continue to spend? House prices are down 50%, stock prices are down, 401k's are down, will they still spend? And my worry is, the answer to that is no. They will start saving, there's already signs of that, and they will be careful about their spending, they will be careful about taking risk, and that is left to be seen. But that's my worry, that psychological change in the American consumer might be taking place right in front of us.
GuruFocus: Okay, so that's actually why you hedge your investment portfolio. You're worried that the second leg might be coming. Do you have any thoughts on the housing markets in the U.S. and Canada? When do you think housing starts will be fully recovered or 80% recovered?
Watsa: We do not know for sure but we think the deleveraging environment in the U.S. could lead to further price erosion and the suppression of housing starts. However, families continue to form and at some point the excesses will be removed and housing starts will grow. They key is that the excesses need to be removed and unemployment needs to stabilize. We are quite concerned that what we have seen in the U.S. could happen in Canada too, particularly if commodity markets retreat, as we have had over a decade of mostly uninterrupted growth in housing starts and house prices in Canada.
GuruFocus: One interesting question from our readers, he said before 2007, you always put a Schiller P/E in your presentation. Is that an indicator you use to measure the market valuation?
Watsa: In our annual meeting, I showed the Schiller P/E, I showed the Schiller real estate index too. But the point there on the price/earnings is a good one. Right now, people look at the S&P 500 and think it's cheap, they think earnings will be at $100 selling at 12x earnings, perhaps less, and the worry of course is that the earnings will not be at 100, that they could be significantly less for the second half of this year and next year, so this environment is one that we worry quite a bit. That's why for ourselves, our stock positions are almost 90% hedged, we have a lot of Treasury bonds and municipal bonds, and we have those deflation contracts. It's amazing to us how after 2008, 2009, when the spreads widened dramatically between corporate bonds and government bonds, they've come down a month, month and a half ago to levels that existed in 2007 and 2008. Now they've started going back up again, so we have very little in corporate bonds, because we basically figure that we're not being paid for taking risk, so if we're not getting paid, we just like owning Treasury bonds, and that's what we've done.
GuruFocus: You mentioned the earnings of the S&P 500. Of course, we know the earnings have been high because profit margins are extremely high from a historical point of view. What do you think about the profit margin? Do you think it will come back to the historical mean?
Watsa: Yes, you know that regression to the mean, that concept, so things going way beyond the mean eventually come down. We saw house prices took off and now they're coming down, and they're still 15-20% off where they have been historically, real house prices adjusted for inflation. So yes, the margins in a tough economic environment will come down again, quite significantly. I mentioned in that article in the Global and Mail that China is also an area that you have to be a little careful because in China they have this construction boom that's going on. There's quite a bit of real estate speculation that's taken place there.
GuruFocus: We noticed that, too.
Watsa: So you might have experienced that, have you been recently to Shanghai or Beijing? I was there just six months ago, and ordinary people, making 65k - 75k, which is a good amount of money/salary in Shanghai, owned four apartments, and their friends owned three-four apartments, and I said, "How high has it gone up?" and he said, "It's gone up three or four times in four years." But if they would just sell one apartment they could re-coup their cost, they'd have $1 million, but unfortunately there's no way they will be convinced to sell because of the current psychology and an overwhelming belief that China's a big country with 1.3 billion people and there are all sorts of reasons why a property price decline won't happen. That reminded me of all sorts of real estate markets, including the one in Dubai that has fallen flat now and of course the U.S. markets, some time back the UK market, some time back in Canada we had the same thing, so these bubbles do break. But in China, it's such a big economy that if it breaks, it will affect the rest of the world, particularly in commodities.
GuruFocus: So back to the question about market valuation. You said you were 90% hedged, what factor do you use to decide whether you will hedge?
Watsa: We've never hedged before, we've only hedged in the last five or six or seven years, and it's this worry that Ben Graham suggested years ago that this current economic environment is different, this is different from any recession we've had. The real estate speculation in America was massive, the destruction of wealth when house prices came down 30-50% was massive, and you have to be very careful. So we operate in a mark-to-market world in terms of our capital. If the insurance business one of these days will turn, and we don't want to be restricted in the ability of our insurance businesses to write more business because the capital's gone down, because of mark-to-market hits. Mark-to-market declines this time may last for some time, as opposed to 2008-2009 when it lasted it seemed for a few months.
GuruFocus: But you did remove your hedge in 2009 when the market crashed right?
Watsa: Yes, we removed that hedge when the markets went down 45-50% and with the gains we made on the hedge we bought more stock. And we had a lot of government bonds at the time, corporate spreads had opened up dramatically and we sold government bonds and bought corporate bonds, distressed bonds and municipal bonds. We had a very good 2008 and a very good 2009.
GuruFocus: Do you think the market valuation plays a role here in deciding hedging? You said when the market goes down 50% you stop hedging.
Watsa: We are hedging not for 5-10% declines, we are hedging big market risk. We're worried about the markets coming down significantly. It might not happen, but we are just very downside protection oriented. We look at downside protection, we worry about that, and we have to live within our means. I keep telling our team, we don't have the Federal Reserve or the Bank of Canada to help us. We always keep a $1 billion + in cash and marketable securities in the holding company. Our financial position is very strong, we have very little maturities in the next five years, that's significant. We don't count on having access to the bond markets and the preferred markets, (we do have access to them and can issue them at any time, but in 2008 and 2009 it was very difficult to issue anything), so we always keep a lot of cash, that's a policy statement for us and of course in our insurance companies too, 25-30% in cash (which is earning very little by the way). So sometime we expect the insurance market to turn and we'll benefit from it.
GuruFocus: So the reason you're hedging is mainly because you run an insurance company. If you ran an independent hedge fund, would you still hedge?
Watsa: If you were running a pension fund, you might not hedge, and if you were running a mutual fund, you might not hedge, because those are relative returns. So a pension fund money manager would look at it, if they drop 20% but the market dropped 50%, he's a hero. We solely focus on absolute return because of the fact that it affects our capital. And there might be a time that our capital is so huge that we don't have worry about it, but at the moment we continue to worry about fluctuations, big fluctuations, not small fluctuations. And given what I told you before, that we think this economic environment that we just came through in the last few years is worrisome to us because we think of it as either Japan or the 1930s.
If you are managing your own money, as we are with the insurance company portfolios, you will want to be hedged because we do not want to incur impairments or the loss of capital, whereas mutual funds and pension funds are more focused on performing relative to their peers.
GuruFocus: So you really think this time is different.
Watsa: Yes, it's a phrase I don't like using, but yes we do think we should worry about it.
GuruFocus: Your mentor Sir John Templeton said it's the four most costly words.
Watsa: John Templeton was my mentor, I'll tell you, I've known him for 30 years, he passed away a few years ago, but John Templeton was always a long-term investor in common stock. I remember in 1999-2000 he said to me, "Prem, buy bonds, forget about common stock, they're too risky." Then, more recently, four-five years ago, he always hedged, and he said "In this environment, what I like to do is buy the best things I like, and I short the things I really don't like."
But I try to be neutral, sometimes more short than long, but that's John Templeton. So John, one of the key lessons he taught me was to be flexible. His investment philosophy was always value oriented, long term, buy at the point of maximum pessimism, but be flexible in your thinking, and that's what we try to apply.
GuruFocus: How about gold? We know that you said gold is a bubble. What do you think will burst the bubble?
Watsa: We've never invested in gold, so I don't really know what will happen to the price of gold. I just see the price of gold going from $300 to $1800 in a very short period of time, and it's quite parabolic, and I remember what happened to silver, I remember what happened to gold 20 years ago. But mostly commodities, there's a lot of speculation in commodities. The price of copper went from $1 to $4. So whatever commodity you follow, they've gone up very dramatically, lots of speculation in commodities worldwide. And my experience, this is when John Templeton would say, never use "This time is different," but it may be this time is different, but these parabolic curves that I've observed don't end well. The ending is not good, you never know when it will happen, but it always happens and there's lots of pain when these prices come down.
GuruFocus: Some people are arguing that gold stock is undervalued. If gold prices come down, can you comment on that?
Watsa: No, I don't follow them so no comment.
GuruFocus: How about currency?
Watsa: We basically hedge. We're worldwide, so we hedge our exposures. If we have liabilities in U.S. dollars, we have U.S. assets. Canadian dollars, Canadian assets. Euros, euro assets, so we basically try to hedge our exposures.
GuruFocus: We have lots of readers ask about Bank of Ireland. Can you explain a little bit of your due diligence process of the Bank of Ireland, do you think that management has told you the truth, and do you see greater capitalization there especially with currency exposure in Europe and regulatory requirements?
Watsa: Bank of Ireland was always the most conservative bank in Ireland, run by a fellow who just became CEO in 2009, Richie Boucher, who we like a lot. In Ireland, house prices dropped 40-50%, and commercial real estate building prices came down significantly (office buildings). So it's very difficult to survive that, and even a conservative bank like Bank of Ireland got hit. But coming out of this, it's the only bank that's a private bank (government has 15% of the shares, rest 85% is in the private markets, which we own a little less than 10%).
What impressed us was that Ireland seems to have taken its medicine, reduced the deficit, increased taxes, cut government spending significantly, so without making too much noise, the Irish have done what they had to do. The government of Ireland, with the ECB, set up some very tough rules: You have to have enough capital to take a 60% hit in house prices coming down from the high and commercial real estate prices coming down 70% from the top, and your capital position should be sufficiently strong take those hits. And that's what they did, they did the rights issue and raised a lot of money to make sure they had the capital to withstand those hits.
In our due diligence, we talked to them, we went through the individual portfolios; it's a well-regarded bank, with centuries of experience, and has a history of being conservative, but in a country where real estate prices fell off the bottom, no bank with their leverage and lots of mortgages could survive that. But we feel really good about it, and it's a long term investment.
GuruFocus: Do you have any sort of time frame for how long it'll take to recover?
Watsa: Maybe five years, maybe longer, so we think of it as long term. We don't buy it for the next year or two, we don't know what will happen in the next year or two, so we're buying it for five years, and maybe even longer.
GuruFocus: What do you think is the real book value on the bank?
Watsa: The real book value right now is running a little below .30 euros, maybe .27-.28, and then in the next few years it might be static, maybe it will go down a little, but it will be dependent on the economy's performance, and it will be dependent on the Bank of Ireland in terms of what it does, in terms of earnings. If you look at Bank of Ireland's track record in the past, it's done very well, and now it's well capitalized, it has a terrific CEO, it has a good management team, so over time, it should do very well for its shareholders. They are focused on doing well for their shareholders.
GuruFocus: Do you think it has a durable competitive advantage?
Watsa: Definitely. It's a full-service bank, privately controlled and listed in the stock market, and not having the government in control of day-to-day operations is a positive. There was a chance, if the rights issue was not done by private interests, that the government would be 70-75%, so the fact that the government is at 15%, and very supportive I might add, is a plus.
With respect to another recent investment, Research-In-Motion (RIMM), you'll find out we own some shares. Research-In-Motion is run by two guys, Mike Lazaridis, who's really the founder, and co-CEO Jim Balsillie, these guys have taken the company from 0 to $20 billion, and in our experience, that's not easy to do. It's very competitive, and yes they have some challenges ahead of them, but the guys who have taken it from 0 to $20 billion will be able to figure their way through this.
For a similar reason, we bought Dell (DELL) when Michael Dell came back. Here's a company that went from 0 to $60 billion in revenue, and tons of hurdles he had to overcome with his management team, and we just figure that the guy who's done that, and still is a significant shareholder, so focused, will figure his or her way out. Of course the valuation is cheap, all of that, but we're very focused on management, and the founder of the company who's had such a wonderful track record, not that they're infallible, but we would bet on them. Particularly right now for RIMM, getting new management would be a disaster, would be the biggest mistake that the board would make.
GuruFocus: So good thing is that both of them have tons of cash in their balance sheet.
Watsa: Yes they have lots of cash, huge cash flows, and the stock prices have come down significantly from their highs. But the fact that the founders – you know it requires a tremendous focus, both companies are in very competitive industries in the tech area – so I just gave you our perspective on the power of engaged founders.
GuruFocus: Thank you very much for answering questions from our readers.
