Canada’s best Warren Buffett (Trades, Portfolio) analog, Prem Watsa (Trades, Portfolio), spoke this week on his “concern about the financial markets” that caused him to increase his hedges on his common stocks even as he posted millions in losses in the portfolio for the first half of 2016.
Watsa, founder of insurance conglomerate Fairfax Financial (TSX:FFH, Financial), increased his equity hedge ratio to 115% as of June 30, from 88.1% on Dec. 31. A financial statement attributed the increase to added short positions in stocks and stock index total return swaps, along with unrealized depreciation of equity and equity-related holdings.
"We are maintaining our defensive equity hedges and deflation protection as we remain concerned about the financial markets and the economic outlook in this global deflationary environment,” Watsa said.
Roughly 100% hedging on Watsa’s portfolio began in 2010 and has muted returns, costing 4.2% in total return that year. Watsa at the time said he expected markets to reverse and unrealized losses on hedges to disappear, the realized gains would significantly add to book value per share, his favored measurement of the company.
Over the years, Fairfax’s per-share book value has snowballed. It compounded at a rate of 20.4% per year through 2015, and grew from $1.52 in 1985 to $403 in 2015.
Watsa’s adept management also manifest in the company’s stock price. Its 19.4% per-year compound rate over its 30 years in business also places it as the best in the property and casualty industry and the second best of all companies in Canada. It also lands Fairfax among the top 10 companies of the S&P 500.
For the second quarter, reported July 28, Fairfax saw $208.3 million in losses on equity and related investments. Watsa, a value investor, saw several of his top positions decline in the quarter as the market fluctuated, including smartphone pioneer BlackBerry (BBRY, Financial) which is more than a third of his portfolio and a gargantuan turnaround project. BlackBerry was down 16% for the quarter, with a total loss of 16% year to date.
Other big positions also declined. Kennedy Wilson (KW) fell 15%, and Resolute Forest Products (RFP, Financial) fell 1%. But others were up, such as second-biggest holding IBM (IBM, Financial) which gained 3% and Overstock (OSTK, Financial) which gained 9%.
Hedges failed to compensate for the down quarter, also losing a net $204.9 million, for a total equity loss of $415.2 million.
Fortunately, Watsa’s bond portfolio did make up for it. Bonds contributed $639.9 million to Fairfax coffers, bringing the total portfolio to a gain of $229.2 million.
Most of the bonds were composed of U.S Treasuries and U.S. state and municipal bonds, which Watsa said “principally reflected the impact of decreases in interest rates in 2016.” Net gains on bonds were $639.9 million and $1.07 billion in the second quarter and first six months, compared to net losses on bonds of $657.2 million and $516.1 million in the second quarter and first six months of 2015.
Though Watsa has voiced his caution on markets for several years, the alarm sounded slightly louder in his 2016 comments.
“All of our concerns about the financial markets may be coming to a head in early 2016,” he told shareholders in his March letter.
Watsa listed a number of economic conditions weighing into his worries, including low commodity prices, a recurring 2008-2009 housing situation, China’s economy, a dead high yield bond market due mainly to oil and mining issues, emerging market bond buying by mutual funds, QE in Japan, a spreading view that stocks are a good investment irrespective of price, among others.
“You can see that our average combined ratios for the last two five-year periods have been excellent (i.e., float at no cost) but the average total return on our investment portfolio in the last five years has been the lowest in 30 years,” Watsa said. “This has been by design as we worried about the speculation in financial markets and the potential for a 50-100 year financial storm. And we wanted to be sure to survive that!”
Further on he wrote, “As we have said, it is better to be wrong, wrong, wrong, wrong, wrong and then right, than the other way around!”
See Watsa's portfolio here. Start a free 7-day trial of Premium Membership to GuruFocus.
