Now first off, let me explain. This is not an article criticizing the investment approach of Mr. Watsa, it is an observation of how his investing style differs from Buffett. There are many ways to skin a cat, and Watsa is clearly great at what he does. Watsa’s performance is definitely very “Buffettish,” some of his investment choices including successful ones aren’t. Here is Watsa’s investment record at Fairfax; it is obviously awesome:
|Common Stocks||5 Yr||10 Yr||15 Yr|
|Bonds||5 Yr||10 Yr||15 Yr|
|Merrill Lynch Corp Bond Index||6.00%||5.80%||6.30%|
Watsa has always been a big fan of Buffett and I thought modeled his investing approach from what he learned. In his 2011 letter to Fairfax shareholders Watsa wrote about his appreciation for the Oracle from Omaha:
“Ihave attended the Berkshire Hathaway shareholders' meeting since there were only 200 shareholders in attendance about 30 years ago. I still find I learn something each year from Warren and Charlie. At the meeting in 2010, I met Bill McMorrow through Alan Parsow, who is a money manager based in Omaha and a great friend. Bill founded Kennedy Wilson, a real estate services and investment company, in 1988, and he now owns 26% of the company. As a result of this meeting, we invested $100 million in a Kennedy Wilson 6% preferred convertible at $12.41 per share, and later purchased $32.5 million of a 6.45% preferred convertible at $10.70 per share and 400,000 common shares at $10.70 per share. Fully diluted we own 18.5% of the company. In 2010 and 2011, we also invested $290 million in several real estate deals with Kennedy Wilson in California, Japan and the U.K. - deals at significant discounts to replacement cost and with excellent unlevered cash on cash returns, in which Kennedy Wilson is the managing partner and a minority investor. We are thrilled to be partners with Bill and his team, who always focus on the downside and have the expertise to manage these investments and finally harvest them. You never know what you will find at a Berkshire meeting!!”
Given his admiration for Warren I ask you this: would Warren Buffett have made any of these recent Fairfax investments?
1) Research in Motion (RIMM) – This investment violates two of Buffett’s stated avoidances. RIMM is a technology company AND it is a turnaround story. Buffett avoids technology companies because he claims to not understand them, which I think actually means that he isn’t comfortable with an industry where technological obsolescence can happen quickly. Buffett understands more than anyone does. Buffett avoids turnaround situations because as Buffett says “most turnarounds don’t turn.” And given the current state of affairs at RIMM, there is some serious turning around needed.
2) Credit Default Swaps – Some investors south of the border such as Michael Burry and John Paulson became very famous for profiting from the 2008 financial crisis through the use of credit default swaps. I don’t think Watsa received his just dues for his prescient call on the housing bubble. As far back as Fairfax’s 2003 annual report Watsa was already writing about the storm clouds building:
"We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds) eliminates the incentive for the originator of the loan to be credit sensitive. Take the case of an automobile dealer. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard). And here’s the rub! These asset-backed bonds are rated based on their historical loss experience record which will likely be very different in the future – particularly if we experience difﬁcult economic times. Also, in the main, these asset backed bonds are a creation of the 1990s, a period when the U.S. experienced one of the longest economic expansions in its history, followed by one of the shortest recessions.
This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S. (excluding ﬁrst mortgage-backed bonds). At the end of 2002,more than 65% of these bonds were rated A or above. In fact, as of December 31, 2002, there were more than 2,500 asset-backed issues rated AAA – signiﬁcantly more than the 13 U.S.corporate issuers currently rated as AAA. Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Unlike active companies, the vehicles issuing these bonds have no management organization and are dependent on the goodwill of the originating company. I can go on and on. Sufﬁce it to say that the principals at Hamblin Watsa are quite concerned about the inherent risks in these types of bonds.
To protect Fairfax and profit from the fallout from the bubble Watsa purchased credit default swaps on the financial entities most exposed to housing bubble and made billions. This was an investment that Buffett likely would never have made, and in this case Watsa’s divergence from the Buffett style paid off handsomely.
3) Deflation Protection – Watsa has followed up his great Credit Default Success with another derivative bet, this time spending over $300 million to profit from deflation. He describes this bet in his 2010 letter to shareholders:
"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%."
Again, I don’t think these CPI derivatives are the type of thing that Buffett would have ever messed with. Buffett has spent his career focused on valuation and protective moats and little time trying to make big macro calls. Watsa was bang on with the Credit Default play. The verdict is still very much out on this deflation bet, but so far it isn’t looking very profitable.
4) Sandridge Energy (SD) – I went back and looked at a couple of comments Buffett has made about management teams and investing:
- Managers who pursue company acquisitions for reasons other than the good of the company - ego trips, the 'institutional imperative' of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, 'Many managerial [princes] remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads'.
- Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements.
When I think about a happy acquisition manager who has overpaid himself even while shareholders suffered, the first guy I think about these days is Tom Ward at Sandridge Energy. Consider the following points from the letters that activist shareholder TPG directed at Sandridge which detail what has gone on:
- One fact summarizes the appalling corporate governance practices of SandRidge - despite the single worst stock performance of any energy company, and among the worst stock performances in the entire U.S. market, and massive discounts applied to the company because of management…payments to Mr. Ward from the company have totaled approximately $150 million over the past five years (astonishing, given the $3 billion market capitalization of the company).
- It is true that SandRidge has eliminated its Executive Well Participation Plan. However, it did so immediately after the market collapse in October 2008, by then paying over $67 million to Mr. Ward, even as 1) markets were collapsing, and 2) the company had less than $1 million in cash and was facing real risk of bankruptcy. Adding insult to injury, the wells that the company re-purchased from Ward were natural gas wells, even as Mr. Ward and the company were publicly proclaiming the need to abandon their natural gas focus and shift towards oil exploration and development. When the company disclosed the purchase, it cited a desire "to retain a greater working interest in future wells, thus increasing proved undeveloped reserves". This declaration was preposterous, considering its publicly stated desire to abandon the initial natural gas focus of the company and switch to oil. And, again, it was even more shocking when one considers the environment of that time - with markets collapsing, the company facing collapse, and natural gas facing collapse.
Despite what I think is pretty questionable behavior or at the very least judgement at Sandridge, Fairfax keeps buying shares in Sandridge and Watsa has voiced his support for Ward as a manager. I don’t think Buffett would touch Sandridge with a ten foot pole.
Results Are All That Matter
In the end, there are no style points when it comes to investing. All that matters is the rate at which an investor compounds money. Whether the technique used is momentum investing, value investing or buying only companies that start with the letter “X” it doesn’t matter. Prem Watsa is great at what he does, even if what he does deviate at times from the path that Buffett advises us to take.