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The Science of Hitting
The Science of Hitting
Articles (489) 

Some Thoughts on the Fairfax Equity Hedges

Lessons learned from a look back at Prem Watsa's old shareholder letters

March 13, 2018 | About:

Prem Watsa (Trades, Portfolio), chairman and CEO of Fairfax Financial (TSX:FFH), released his shareholder letter last week. In the letter, he discussed the company’s relatively poor investment results in recent years, largely due to the decision to hedge equity exposure in the investment portfolio (bold added for emphasis):

“In 2011, I wrote to you that the major risks for the economy would be felt in the next three years and after that, common stocks would do very well over the next decade... Unfortunately, we did not eliminate our index hedges after three years, since we continued to be concerned about the economy, but that changed when the new U.S. administration got elected in 2016. We quickly eliminated our index hedges and have virtually eliminated our individual shorts also, and it is extremely unlikely that we will resort to shorting to protect our portfolios in the future.”

This all started back in early 2010, when Fairfax hedged about 30% of its equity exposure. Shortly thereafter (May and June of 2010), Watsa decided to increase the hedge to cover approximately 100% of Fairfax’s equity portfolio. As we all know, that “bet” has not worked out – and it shows in the results. Over the past decade, the returns for the common stock portfolio selected by Hamblin Watsa (Fairfax’s wholly-owned investment manager) has underperformed the S&P 500 by more than 4% per year – and that’s before including the equity hedges (over the past five years, underperformance has been more than 8% per year). I assume that this result includes any individual short positions.

This article will review the key sections from Watsa’s shareholder letters from 2010 to 2016 to see if there are any key lessons we should take from this experience. I’ve selectively trimmed certain sections to shorten the article and to avoid restating arguments made in earlier letters.

2010

“If the 2008 - 2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today. However, we worry, as we have mentioned to you many times in the past, that the North American economy may experience a time period like the U.S. in the 1930's and Japan since 1990, during which nominal GNP remains flat for 10 to 20 years with many bouts of deflation.

We see many problems in Europe as country after country reduces government spending and increases taxes to help reduce fiscal deficits. We see the U.S. government embarking on a similar exercise (as it has no other option) and all this while businesses and individuals are deleveraging from their huge debts incurred prior to 2008.

Meanwhile we have concerns over potential bubbles in emerging markets. Consider, for instance, what we learned on a recent trip to China: many house (apartment) prices in Beijing and Shanghai had gone up almost four times – in the past four to five years!; many individuals own multiple apartments as investments with the certain belief that real estate prices can only go up; and maids are taking holidays so that they can buy apartments also. ‘Buy two and sell one after it doubles to get one for free’ goes the refrain! In his essay in Vanity Fair, 'When Irish Eyes Are Crying,' Michael Lewis says, ‘Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.’ We agree!!”

2011

We continue to fully hedge our common stock portfolios as our concerns about the U.S. discussed in our 2010 Annual Report persist, and have been magnified by the financial crisis in Europe, including the underlying austerity programs, and the recent bursting of the Chinese real estate bubble…

To combat the great contraction of 2008 - 2009, the U.S., as well as Europe and most countries in the world, went 'all in' with huge stimulus programs. They have no ammunition left now and austerity is the slogan of the day…

As for Europe, 2011 laid bare the leverage there, with the assets of its banking system being 2.6 times its GDP. France’s top five banks, for example, have assets of $9 trillion versus a GDP of $2.7 trillion for France. Much of the assets of the French banking system (and other countries in Europe) are financed by 'wholesale' funds as opposed to stable retail deposits. Today, while we think this is very unlikely, there is the possibility of the Euro breaking apart, with disastrous consequences to the world economy. All of this reminds us of the late 1980s in Japan, when it was reported that Japanese housewives were buying stocks with grocery money. For the last ten years, after the Nikkei Dow Jones came down by 75% from its high, the Japanese housewives have been keeping their money in Japanese government bonds or in bank deposits yielding less than 1%. The point is, the psychology changed in Japan, and the question today is whether the same thing has happened in the U.S. and Europe after the great contraction in 2008/2009…

As for China, late in 2011 the Chinese bubble in real estate burst. Developers have reduced prices by 25%+ to sell apartments in Shanghai – causing riots by angry buyers who paid full price. Expect apartment prices in China to come down significantly in the next few years. This may result in a hard landing in China, again with major consequences for the world economy.

Yet optimism continues to prevail in the financial markets as corporate spreads are back to levels prior to the great contraction in 2008 and stock markets are rallying on hopes of repeating the increases from the 2008 - 2009 bottoms. Record high profit margins on the S&P 500 are being extrapolated into the future, but they may well regress to the mean. We have a mini-tech bubble in progress similar to the one we witnessed in 1999 - 2000…

Given interest rates at close to absolute zero and no fiscal stimulus bullets available in the western world, we continue to maintain our 100% equity hedge. Ben Graham’s observation that ‘only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925’ continues to ring in our ears…

In time, we will remove our equity hedges as the risks that we see get discounted in common stock prices. The major risks we see are in the next three years, as we expect common stocks to do very well in the next decade.”

2012

“Our defensive hedges of our common stock portfolio cost us approximately $1 billion in 2012 because of rising markets – all unrealized of course, in the sense that we continue to be hedged…

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…

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…

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 continue to be early – and bearish!”

2013

“Our defensive hedges of our common stock portfolio cost us approximately $2 billion in 2013 because of rising markets – a significant portion unrealized of course, in the sense that we continue to be hedged. Given our concern about financial markets and the excellent returns we achieved on our long term investments, we reluctantly decided to sell our long term holdings of Wells Fargo (a gain of 125%), Johnson & Johnson (a gain of 47%) and U.S. Bancorp (a gain of 135%)…

We continue to worry about the unintended consequences, and continue to hedge our common stock portfolio… As I said last year, we are focused on protecting our company on the downside against permanent capital loss from the many potential unintended consequences that abound in the world economy… As they say, it is better to be wrong, wrong, wrong and then right than the other way around!”

2014

“These losses [a cumulative $3.7 billion by the end of 2014] are significant but they are mostly unrealized, and we expect them to reverse when the ‘grand disconnect’ disappears - perhaps sooner than you think! In a declining market, like 2008 – 2009, we expect our common stock portfolio to come down much less than the indices, thus reversing most of the net losses resulting from our hedges. As I said last year, we are focused on protecting our company on the downside against permanent capital loss from the many potential unintended consequences that abound in the world economy… We continue to like the long term prospects of our common stock holdings, while our hedges protect us against our near term economic concerns…

The CAPE Ratio for the S&P500 is currently at 28 times. It has been higher only twice before; both times ended badly. The first time was in 1929 and the second time during the dot.com boom of 1999 to 2002. The rising U.S. dollar (with over 40% of the average S&P500 companies’ earnings coming from abroad) and the current record after-tax profit margins, combined with deflation, could result in significant declines in the earnings of the S&P500 companies – just as the index hits record highs. We say 'caveat emptor,' and continue to be very cautious about our equity positions.”

2015

“We hope the unrealized losses reverse out and turn into profits as they did in 2007 – 2008… We had to endure years of pain before harvesting the gains in 2007 and 2008. We continue to be focused on protecting your company from the significant unintended consequences that prevail today.”

2016

“The presidential election on November 8, 2016 changed the world for us, so we reacted quickly by removing all our index hedges and some of our individual short positions…

Since we fully hedged our common stock portfolio in 2010, we have been frequently asked, as we have constantly asked ourselves, under what circumstances would we remove the hedges. Obviously, a huge sell-off in the financial markets would have led to that result, as the hedges would have performed the purpose for which they were established. What actually happened with the U.S. presidential election on November 8 was the arrival of a new administration focused on dramatically reducing corporate taxes, rolling back a myriad of regulations large and small which unnecessarily impede business, and very significantly increasing much needed infrastructure spending. In our view, this should light up ‘animal spirits’ in America and result in much higher economic growth than what has prevailed in the last eight years… Higher economic growth would result, we think, in higher profits for many companies, so that even though the indices may not go up significantly, we think a value investor like us can ply our trade again with less of a concern of economic collapse. When the U.S., a $19 trillion economy, does well, the world tends to do well! While many risks to global economic growth remain, such as protectionism, China unraveling and the euro disintegrating, we believe the chances for robust growth have significantly increased.”

Conclusion

As Watsa showed in his 2016 letter, the cumulative direct cost of hedging losses on stocks and individual companies was $4.4 billion. This was a costly outcome. I think there are a few lessons we can take away from his experience since 2010.

First off, trying to predict short-term market swings is extremely difficult. I’m thinking of this call in particular: “The major risks we see are in the next three years, as we expect common stocks to do very well in the next decade.” As a long-term investor, I think you are likely to do much more harm than good when you try and call short-term corrections. I don't think the risk (potentially missing out on some or all of a decade where you expect stocks to do “very well”) is worth the reward.

In addition, I think this type of prediction is hard to walk away from. It’s the type of “bet” where there is almost always a plethora of evidence for both sides. As a result, it’s very hard to tell if you’re early – or just wrong. After the first three years passed and the thesis didn’t play out as expected, Watsa didn’t throw in the towel. He essentially doubled down by sticking to the hedges for another three years. Presented with a similar situation, I bet most of us would do the same. For this reason, I think it’s best to avoid bets of this nature. There are easier ways to succeed in investing than reading the macro tea leaves (as a case in point, many of the “potential unintended consequences in the world economy” Watsa worried about five years ago are still legitimate worries today).

Finally, it seems like the macro call impacted Watsa’s decision-making in the individual stock portfolio. Consider what he wrote in 2012: “Given our concern about financial markets and the excellent returns we achieved on our long term investments, we reluctantly decided to sell our long term holdings of Wells Fargo (NYSE:WFC) (a gain of 125%), Johnson & Johnson (NYSE:JNJ) (a gain of 47%) and U.S. Bancorp (NYSE:USB) (a gain of 135%).” Note he did not say (at least not directly) that he believed these securities were overvalued. It sounds like his concerns about the macro picture led him to part ways with some businesses that he would haved liked to continue owning (that seems logical based on his long-term view of common stock ownership). As Watsa explains and shows in his most recent shareholder letter, this was a “costly mistake” that had a meaningful impact on the results at Fairfax (this is on top of the losses on the equity hedges).

I’ll close with something Warren Buffett (Trades, Portfolio) said during a CNBC interview earlier this year (something he has said many times in the past):

“It’s hard to tell with economics – that’s the one thing I’ve learned. We don’t ever try to make money by predicting economics. Macro stuff is very hard to predict… you’ve seen that over the years when people come on [CNBC] and try and predict what the economy is going to do. Charlie and I have never made a marketable security decision or the purchase of an entire business where we’ve talked at all about macroeconomics.”

Disclosure: Long WFC

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

jtdaniel
Jtdaniel premium member - 6 months ago

Hi Science,

Great article. My take is that for those of us in the proletariat who would have difficulty absorbing a $4 billion loss, cash and treasuries are fine tools for hedging, Best, dj

dunyuliu
Dunyuliu - 6 months ago    Report SPAM

Thank you for the great article! It is a good learning to walk through years of Watsa's letters. I totally agree Jtdaniel that cash and treasuries are already good hedges if you are really concerned with the future. Anyway, my take is that we'd better not try to predict the 'Macro stuff' at all.

Thomas Macpherson
Thomas Macpherson premium member - 6 months ago

Great stuff Science. Much like Prem, I've paid for my conservative approach. While Prem hedged against losses, I held roughly 10-15% cash for the last 5-6 years. I've done this because market prices for individual stocks would not meet my required margin of safety. Prem and I have a different operational approaches to risk management, but the strategy of hedging against risk is the same. I haven't calculated the potential lost market opportunity costs of these actions, but I'm pretty sure it's not an insignificant amount. Chalk this one up to Mr. Buffett's thumb sucking problem. Thanks again. Best - Tom

vgm
Vgm - 6 months ago    Report SPAM

For a long period following the crisis, Prem seemed to pay a lot of attention to economist Gary Shilling and publicly praised him. That always surprised me.

Thanks for sharing, Science.

Praveen Chawla
Praveen Chawla premium member - 6 months ago

FFH's tangible book value per share has pretty much stagnated during the past decade, though book value has continued to increase. Certainly the investment of float has not been good.

https://www.gurufocus.com/chart/TSX:FFH#&serie=,,id:price,s:TSX:FFH,,id:Book_Value_Per_Share,s:TSX:FFH,,id:Tangibles_book_per_share,s:TSX:FFH&startDate=1205643600000&endDate=1521176400000

Praveen Chawla
Praveen Chawla premium member - 6 months ago

FFH's tangible book value per share has pretty much stagnated during the past decade, though book value has continued to increase. Certainly the investment of float has not been good.

https://www.gurufocus.com/chart/TSX:FFH#&serie=,,id:price,s:TSX:FFH,,id:Book_Value_Per_Share,s:TSX:FFH,,id:Tangibles_book_per_share,s:TSX:FFH&startDate=1205643600000&endDate=1521176400000

The Science of Hitting
The Science of Hitting - 6 months ago    Report SPAM

Thanks for the kind comments! Just to be clear (and as I'm sure most of you know), I've held my fair share of cash as well. Is there a difference between holding cash for the "right" versus "wrong" reasons? I'd argue there is, but others would certainly disagree. Maybe a topic for another day. Thanks again for the comments!

stephenbaker
Stephenbaker - 5 months ago    Report SPAM

Science, thanks for putting this piece together. Your comments are worth considering (and reconsidering). For someone like Watsa with large sums to invest, he is somewhat limited when overall indices get expensive. Not so for smaller investors - there are always [relatively] cheap and worthwhile investments if you look hard enough. We don't have to stick to public equities and/or public debt.

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