In 2005, Watsa had prepared for disaster: He had 76% of the portfolio of his insurance conglomerate, Fairfax Financial (FFH), in cash and government bonds, and was 50% hedged. The conservative positioning, combined with record losses from hurricanes Katrina, Rita and Wilma, led to the toughest year in the company’s history, at a 17.9% loss of shareholders’ equity (compared to a return of about 4.9% for the S&P500).
Underperforming the market on the short term did not faze him, however, as he worried about the housing market bubble, profligate U.S. consumers, below-zero savings rates, record-low credit spreads, and a number of other global factors culminating in a “1 in 50 year or 1 in 100 year event.”
2006 proved better financially for Fairfax, with significantly less catastrophe activity, though Watsa remained cautious about U.S. financial markets, and maintained the same level of hedging as the previous year and 78% of the portfolio in government bonds and cash. In 2007, his investment portfolio returned 14.4%, but sustained $1.063 billion in liabilities for the S&P 500 hedges.
When the disaster Watsa anticipated finally hit in 2008, he was prepared, with its stock positions fully hedged, and a government bond position of approximately 75% of its investment portfolio. The large cash position allowed him to invest heavily in four Canadian companies mentioned in his 2012 letter: H&R REIT (TSX:HR.UN), Canadian Western Bank (TSX:CWB), Mullen Group (TSX:MTL) and GMP Capital (TSX:GMP).
H&R Real Estate Investment Trust (REIT) owns 295 office, industrial and retail properties and two development projects located primarily in the greater Toronto area and has a market cap of $4.62 billion. When markets crashed in 2008, the company’s stock plunged as much as 77%
Crimped financial markets were making it difficult for the company to complete the building of what would be the largest office building in Toronto when Fairfax stepped in. As the company explains in its 2008 annual letter:
“Last December, we agreed to a private placement of $200 million from Fairfax Financial in the form of unsecured and redeemable 11.5% debentures, plus warrants to purchase H&R stapled units. We are offsetting higher financing costs by taking advantage of recessionary conditions in the construction industry in order to reduce costs. We have entered into fixed-price contracts covering approximately 70% of the budgeted hard construction costs of the project, and upon closing of The Bow construction financing, we expect to enter into an interest rate swap to limit our interest rate exposure on the financing.”
Watsa’s $200 million investment resulted in realized proceeds of $391.2 million, a 105% gain on the investment.
Canadian Western Bank is the largest public bank headquartered in Western Canada, and has a $2.23 billion market cap. In 2008, its stock fell as much as 65%. Concurrently, the bank posted its 82nd consecutive profitable quarter, record annual earnings surpassing $100 million, record annual total revenues and 16% year over year loan growth, in spite of the difficult market conditions. In the fourth quarter, it also raised its dividend 10% from the previous year.
Watsa decided to invest $57.2 million in preferred shares and warrants of this bank, which ultimately produced $80.2 million in gains, or a 140.2% return.
With a $1.91 billion market cap, Mullen Group is a holding company and the largest provider of specialized transportation and services to western Canada’s oil and natural gas industry, and a dominant trucking and logistics supplier in Canada. Its stock in 2008 dived as much as 58%.
The company’s debt also ballooned to $518 million by the end of the year, most of which it took on for acquisitions to grow its business and that did not start maturing until 2016. Moreover, it used a portfolio of its $150 million credit line to make another acquisition, which it hoped would allow it to grow until the economy recovered, while it sought to conserve cash, reduce debt and reduce costs.
In March 2009, the company strengthened its balance sheet by offering $125 million of convertible subordinated debentures. Watsa purchased $56 million in convertible debentures from the company, which resulted in a gain of $74 million, or 132.2%. The company’s chairman, Murray K. Mullen, thanked him for his financial support in its 2008 annual report:
“I must thank the Fairfax Financial group for their support and investment in Mullen and in particular, Mr. Watsa. Fairfax Financial was the lead investor on this very successful offering and we are pleased to have them as long-term investors.”
Watsa’s smallest investment but largest percentage gain of the four companies was in GMP Capital preferreds and warrants, where he more than tripled his money. GMP Capital is an independent investment dealer, focused on entrepreneur and mid-market segments. Its stock in 2008 lost 86% of its market value.
When the financial crisis struck, the company strengthened its capital position through issuing preferred shares. Fairfax Financial and another unnamed Canadian investor committed to purchasing $25 million of the shares, at $6.50 per 10% cumulative perpetual non-voting preferred limit partnership unit of its newly formed subsidiary, GMP Preferred LP, and a warrant to purchase one fund unit of GMP, with an exercise price of $6.50 at any time over the following five years.
By December 2009, GMP Capital had strengthened its financial position enough to repurchase all of the Series A preferred shares for $7.15 each, and a $0.139 dividend on each share, for a total redemption price of $7.289 per share. The stock’s market price reached $6.50 by February 2009.
Watsa’s $12 million investment produced a $24.9 million gain, or 207.5% percentage gain.
The reason Watsa could be expecting similar opportunities in the near future is the parallel between his positioning then and now. While the investor had 70% of his portfolio in cash and government bonds in 2008, he has 31% in cash and cash equivalents as of year-end 2012. Like back then, the cash position is hurting his returns but as he says in his 2012 letter, “While we suffer from short term pain by having so much cash, it gives us great options for long term gain whenever the opportunity becomes available.”
Also, when he was predicting collapse in 2008, he had roughly half of his portfolio hedged, despite its drag on returns. As of year-end 2012, he has his portfolio 100% hedged, which hampered returns by about half.
He explained his reasons for the new hedges in his 2010 and 2011 annual reports, namely: high total debt to GDP in the U.S., Europe and UK, incipient deleveraging, deficit spending in spite of high unemployment, tepid economic growth and a Chinese real estate bubble. Meanwhile, he believes that markets are ignoring the warning signs hoping for further Central Bank bail outs, although three rounds of quantitative easing have failed to strengthen economic fundamentals.
“This ‘disconnect’ or gap will be closed by either economic fundamentals rising to meet the financial markets or the markets coming down to meet the fundamentals. We think that the latter is likely and that the Fed has simply postponed the inevitable by its QE1, QE2 and QE3 actions,” Watsa said.
Celebrating his 2008 gains from his strategizing in Fairfax’s investor letter, Watsa reminded investors, “Forecasting doesn’t count, building an ark does!”
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