Why Prem Watsa Has Fully Hedged Fairfax Financial’s Equity Portfolio
That gets me feeling a little bit sentimental.
I remember 2008 like it was yesterday.
Early in the year I found watching the very beginning of the crisis unfold to actually be a bit of a rewarding experience. I was fortunate enough to be sitting on a big whack of shares in both Odessey Re and Fairfax Financial (FFH) which were companies loaded with U.S. Treasuries and credit default swaps that were rapidly increasing in value.
The worse the crisis appeared the more Fairfax’s portfolio went up.
Both of those companies (Odessey since acquired by Fairfax) were prepared to thrive in the financial crisis because Prem Watsa and his crew had seen the disaster looming years in advance.
You can see the share price spike upwards in 2008 in the chart above as shareholders were rewarded for Watsa’s foresight.
I enjoyed a good chunk of the ride up with Fairfax, but sold too soon trying to take advantage of what I thought were "too good to pass up on" bargains in the energy sector.
I should have just sat on my hands and stuck with Prem.
I’ll get to the point.
Watsa is again preparing Fairfax for additional market turmoil that he sees ahead. Given how prescient he was last time around I think investors (myself included) should give what he is saying full consideration.
Here is his latest from the 2012 Fairfax letter to shareholders:
Our common stock gains in 2012 were once again substantially offset or eliminated by our hedging program.
While this is disappointing, we continue to be comfortable maintaining our hedges because of all the uncertainties we see in front of us. In 2007, a major U.S. bank CEO famously said “as long as the music is playing you have to get up and dance”. After the Lehman bankruptcy in 2008, this same bank needed $45 billion from the U.S. government to continue in business. Expensive dance!
We prefer to wait for the music to stop and not depend on the kindness of strangers to be in business.
We continue to fully hedge our common stock portfolios because of the reasons first discussed in our 2010 and 2011 Annual Reports. Those reasons have not changed!
Total debt (private and government) as a percentage of GDP in the U.S., Europe and the U.K. are at very high levels, thus limiting the options available to governments. Deleveraging in the private sector has only just begun. In spite of the significant deficit spending in the U.S. and Europe, high levels of unemployment prevail in both areas and economic growth continues to be very tepid. In fact, Europe and the U.K. appear to be heading for another recession.
The markets are ignoring this as they believe the Fed and the European Central Bank will bail us out – again!
Forgotten is the fact that the present Chairman of the Fed, in July 2008, yes July 2008, said that Fannie Mae and Freddie Mac were “adequately capitalized” and “are in no danger of failing”.
In spite of QE1, QE2 and recently QE3, the economic fundamentals remain weak while stock markets and bond markets are back to near record levels, leading Gary Shilling, one of the best
economists we know, to call this “the grand disconnect”. 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.
In our 2010 and 2011 Annual Reports, we discussed the Chinese bubble in real estate. This past Sunday (March 3, 2013), the CBS show “60 Minutes” did a segment on the Chinese residential real estate bubble. They showed vast empty cities with “new towers with no residents, desolate condos and vacant subdivisions uninhabited for miles and miles, and miles and miles of empty apartments.” They called it the biggest housing bubble in history. We agree!
The ultimate collapse of this bubble will have major consequences for the world economy.
Unlike in 2008/2009, when we quoted Grant’s Interest Rate Observer, “the return of one’s money, the humblest investment attribute in good times, is always prized in bad times”, today the “risk on” trade prevails everywhere, with investors reaching for yield in corporate bonds, high yield bonds and even emerging market debt. Junk bonds are yielding 6% (compared to 19% in early 2009) and emerging market debt outstanding has increased almost ten times since 2003. For example, Bolivia’s recent $500 million 10 year bond, issued at 47⁄8%, was 9 times oversubscribed even though Bolivia had not issued a bond in 90 years!! Poland did even better, issuing a 10 year bond at 33⁄4%. Russell Napier at CLSA, in a recent issue of his “Solid Ground”, noted that U.S. dollar emerging market issuance in open ended mutual fund structures is a disaster waiting to happen as these capital flows can go into reverse! This is particularly negative as external debt in many emerging market countries has increased to dangerous levels.
In the same report, Napier also provides a fascinating historical survey of the pitfalls of reaching for yield – particularly when government risk-free rates are very low. Indeed, over the last few hundred years, trying to achieve a 5% – 6% long term yield when U.S. and U.K. government yields were half that led to the destruction of much capital.
We have had massive fiscal and monetary stimulus since 2008 with interest rates effectively zero – and economic recovery is still limping along. We continue to believe the 2008/2009 great contraction was not like any other recession the U.S. has experienced in the past 50 years. We think it has many similarities to the U.S. in the 1930s and Japan since 1990 – and Japan is still fighting deflation 20 years later.
From the distant past comes the warning of our mentor, Ben Graham, whom I have quoted before: “Only 1 in 100 survived the 1929 – 32 debacle if one was not bearish in 1925”. We continue to be early – and bearish!
So far, on paper, this conservative stance has cost Fairfax and its shareholders quite a bit of money. Fairfax is sitting on $1.8 billion of unrealized losses (as of Dec. 31, 2012) in its equity hedge and CPI derivative portfolios.
Of course, that was what the situation looked like last time in 2006 when Watsa’s credit default swaps looked like a bad idea.
Prem Watsa. Always early, and usually right.