Third Quarter Market Hedging
According to Fairfax Financial’s third quarter financial results released Oct. 31, Watsa’s investment side of the business returned around 6% for the third quarter, short of the Russell 2000 index’s 10% but beating the S&P 500’s 5%. But these gains from his expert positioning were mitigated by two things: mark-to-market losses from bonds due to rising interest rates, and hedging.
Watsa never hedged his portfolio before the past six or seven years. Why is he doing it now? Because short-term underperformance is worth it to avoid permanent losses, which are a real possibility ahead, according to Watsa, whose gloomy outlook he has held for the past several years for the markets did not change in the third quarter.
We are maintaining our defensive equity hedges due to our concern about the financial markets and the economic outlook," he repeated again in his latest third quarter release. The release adds later that it has hedged investments “In response to the significant appreciate in equity market valuations and uncertainty in the economy…”
Watsa also told GuruFocus in an interview last year: “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.”
At Sept. 30, 2013, Fairfax’s equity and equity-related holdings are hedged 100.1%, valued at $7.813 billion compared to the company’s total equity and equity-related holdings of $7.809 billion, from 100.6% at Dec. 31, 2012. Watsa believes so strongly in the necessity of the hedges that Fairfax took a loss of $477.9 million and $301.7 million in its equity and equity-related holdings after equity hedges in the third quarter and first nine months of 2013, respectively.
Watsa had his portfolio fully hedged in 2008, helping him evade the worth of the crash of that year. He removed the hedges in November 2008, after the market dropped 50% from its high, gaining 16.4% for 2008.
The current full hedging of Fairfax’s portfolio has persisted since at least 2010. Watsa began the year just 30% hedged, increasing to 100% in May and June. He delineated in his 2010 and 2011 annual letters his reasons for distrusting the market’s rise, saying most recently in his 2012 letter:
“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…”
(Read more of Watsa’s market views in his 2012 investor letter here.)
As BlackBerry announced today, Fairfax has lost in its effort to outright buy the technology company after controlling more than 10% of its shares since a year ago, but is still going for a larger stake. Instead, Watsa and other institutional investors will inject $1 billion worth of convertible debentures into the company within the next two weeks, of which Fairfax’s part will be $250 million.
The 6% convertible debentures are each convertible into a common share of BlackBerry at a price of U.S. $10.00, a 28.7% premium to their Nov. 1 closing price, with a term of seven years. Conversion of all of the shares would give the group 16% ownership of the company.
Management changes coming as part of the agreement include the replacement of the company’s CEO, Thorsten Heins, with John S. Chen as interim CEO until a permanent executive can be found. Watsa will likely play a major role in the selection of a new chief as he becomes the lead director and chair of the Compensation, Nomination and Governance Committee.
“Fairfax is a long-time supporter, investor and partner to BlackBerry and, with this investment, reinforces its deep commitment to the future success of this company,” said Prem Watsa. “I look forward to rejoining the BlackBerry Board and to working with the other directors and management team, under John Chen’s leadership, to shape the next stage of BlackBerry’s strategy and growth.”
The market responded negatively to the news, with shares tumbling 16.4% on Monday, to $6.49 per share.
BlackBerry on Oct. 2 reported to the SEC that it sold only roughly 2 million of its recently launched BlackBerry 10 smartphones in the second quarter, a hopeful turnaround product for the company. It also reported a $965 million net loss due largely to a $934 million charge for unsold BlackBerry 10 units.
Over the past five years, BlackBerry has seen its EBITDA per share decline at a rate of 25.6%, while book value increased at a rate of 15.6%. The infusion from the group of investors will boost its cash position from its current $2.34 billion as of second quarter end, while management engages in turnaround or sell plans. The company has no debt.
Most of Watsa’s other top positions were flat or advanced for the third quarter, with Johnson & Johnson (NYSE:JNJ) up 1.2%, Resolute Forest Products (NYSE:RFP) flat, Level 3 Communications (NYSE:LVLT) up 26.6% and SandRidge (NYSE:SD) up 23%.
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