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Why Prem Watsa Has Fully Hedged Fairfax Financial’s Equity Portfolio

March 18, 2013 | About:
CanadianValue

CanadianValue

210 followers
We just passed the five-year anniversary of the collapse of Bear Stearns and are heading into the five-year anniversary for a bunch of other ugly 2008 moments.

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.

1878961621.jpg

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.

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 4.1/5 (19 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 1 year ago
So just who all is this side of the fence? Hussman, Klarman, Watsa... Who else?

...and on the other side of the fence? Buffett? (Except his view is 20 yrs. out, not 2 or 3 yrs. or fewer), Whitman?
JUDS1234567
JUDS1234567 - 1 year ago
Jeremy Grantham, Robert Rodriguez and Steve Romick
longleaf
Longleaf premium member - 1 year ago
Just wonder what will be their next buy when the crisis is coming.
abhunia
Abhunia premium member - 1 year ago
Can anyone confirm, exactly what hedges Mr. Watsa has put in place for his stock portfolio? Are they just protective puts on every stock in the Fairfax portfolio or is it something else?
luishernadez
Luishernadez premium member - 1 year ago
The hedge are short positions on mayor indexes, not on their mayor stock holdings.

The crash that we can certainly count on is in the bond market. Obviously, if the bond market crashes, the equity markets should also suffer, but just temporarily for the currently cheap stocks.

AlbertaSunwapta
AlbertaSunwapta - 1 year ago
Rising interest rates could cause the equity markets to suffer for a number of years.

The corporate rush to refinance would grind to a halt if the trend reversed, and from that point on, any company issuances would hit their earnings. More importantly, the margin expansion that has occurred with the arrival of lower cost debt (and wage pressures) should stop unless offset by some other lowering of costs (energy, technology, wages, taxes, commodities...). The benefit of lower cost financing though should be temporary and theoretically competition should bring prices down (or not rise as rapidly) and those record margins should get squeezed back towards historic levels.

If that isn't bad enough, potentially higher taxes to pay off federal debt hits earnings again. And of course there's the risk of less gov't spending hitting inventory turnover and sales. ...And bad demographics for a while too. If things pan out this way there's not much left supporting earnings except hoping for increased demand for stocks over the supply available - and we all know how fast gov'ts and companies can print paper! :-)

If rates start to rise I'll be looking for cash rich companies and companies that don't have to go to the markets. I'm hoping Marty Whitman writes a book on that!

Index investing might get pretty scary.
huang.touchstone
Huang.touchstone premium member - 1 year ago
to prepare the worst situation in global economy is a choice. but hard to say it is a sure thing. to judge the future trend of the macro-economy is the most difficult job in the world. that is why economists may earn their living. too many contradictory views fight for each other. also that is why Mr. Buffett never guess the economy but pay attention to the individual company. it is undeniable that the US economy is picking up and the Europe is still in recession with no light in the end of the tunnel. As to China's real estate situation. first the tape shown is proved not being correct. second each year there more than 12 million couples to get married plus wealthier people upgrade to their second home. the government puts all the policies to control the fast-rising price of the house and bank also executes strict mortgage financing measures with more than 70% advance payment requirement for the second house buyers in most cities. but the market appears that price rises and house sold. the law of demand and supply tells all. So I Don't agree with what Mr. Watsa say about the current China's house market. there is still a long way for the market to burst from the bubble. but it takes time.
gobbydigoo
Gobbydigoo - 1 year ago


Gobbydigoo [color=#808080; font-size: 12px; line-height: normal] - [/color]Just now

I like what I read about Fairfax Financial but I read an article in the NY Times signaling that Fairfax Financial is under IRS or SEC Investigations. Does anyone have any info? Does anyone think it is a good bet with these kind of rumors?
gobbydigoo
Gobbydigoo - 1 year ago
I have done some research on this issue since my previous posting and reviewed the transaction in question, articles and expert reports that are publicly available.

After review, it is my opinion at some point Fairfax will have to pay our government back the $400 million plus interest and penalties. I also believe their could be some unknown litigation expenses sure to follow.

My conclusions, best case, Fairfax will lose 10% of its value when this occurs. I believe with interest and penalties Fairfax will need to pay our government 650 - 750 million dollars. Worst case, Fairfax will lose up to 20-30% of its value if this leads to future class action lawsuits or reawaken old SEC investigations which could add many millions more to what Fairfax will have to repay our government.

I could also see some short term management fallout over this transaction, costing a few key finance people their jobs, leading to short term management uncertainty.

My conclusions, current investors need to be careful with their current positions and future investors should keep an eye out for a buying opportunity as I do believe Fairfax has solid Management and is well run as this author explains.

I am curious if anyone else has differing opinions they are willing to share. Does anyone feel this information is already factored into the current price of Fairfax stock? Does anyone feel my conclusions are wrong?
superguru
Superguru - 1 year ago
"Deleveraging in the private sector has only just begun."

Is this correct? I thought worst of deleveraging was over. What can we expect of Watsa is correct?
vgm
Vgm - 1 year ago
Watsa addressed this at the Annual Meeting, stating that in the 1930s private+public debt to GDP in the US was 300%, whereas today it's 380%. And the EU and Japan are in a similar situation. As far as I can understand, it's the main reason he believes deflation to be a a strong possibility. Central Bank actions are unable to overcome the huge debt load. The markets would be in a depressed state in a deflationary environment.

This is all described in a terrific set of notes from the Fairfax AM by Ben Claremon at Cove Street Capital: http://covestreetcapital.com/Blog/?p=935
AlbertaSunwapta
AlbertaSunwapta - 6 months ago

I recently asked if anyone was buying FFH and for their thoughts on its hedges and got zero responses.  

In vgm's post above you'll note its derivatives on CPI.  These are also very interesting.

http://www.gurufocus.com/forum/read.php?2,243196

 

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