Fairfax Letter March 2014

[tiddman]

When 2 of the greatest investors say there is an issue, i think it is time to be concerned.

 

Interesting to me that both Klarman and Watsa are cautious about market valuations, but Klarman upped his cash holdings while Watsa has bet strongly against the markets.

 

Also Watsa bet against the markets well before valuations got high, I think he started to put on the hedges in 2010.  I don't think Klarman was so bearish back then.

[wisdom]

http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20140227000006&cid=1202

 

Hangzhou housing prices slashed by upto 30%. Apparently this has shocked the local property market.

[SI]

Klarman returned money in 2010.

[stahleyp]

When 2 of the greatest investors say there is an issue, i think it is time to be concerned.

 

Interesting to me that both Klarman and Watsa are cautious about market valuations, but Klarman upped his cash holdings while Watsa has bet strongly against the markets.

 

Also Watsa bet against the markets well before valuations got high, I think he started to put on the hedges in 2010.  I don't think Klarman was so bearish back then.

 

Yeah, SI is right. I don't think Klarman was quite as bearish in 2010 but he was still bearish. For sure.

[gary17]

I'd just add that my contacts in china (owner / operator of a public company and a senior banker ) seems to suggest the problems in china are manageable.  Perhaps we the outsiders see this better than they can,

 

Also, when Buffett has an optimistic view I think it is fair to say that view is shares by Ted, Todd, and munger as well. 

[wisdom]

Buffett is increasing cash - He has increased cash by $27B or 100% from 2008.

 

BRK should have close to $52B cash by now. That is $32B more than Buffett would like.

 

At $2B per month he could be upto $70B in cash by the end of the year.

 

Back in 2010 and 2011 cash was at $34B when BRK was only generating $1B cash per month.

 

In 2008 and 2009 cash was at approx $25B.

 

 

[jay21]

The most compelling thing I have seen in awhile suggesting that deflation can be a very big problem:

 

http://blogs.ft.com/andrew-smithers/2014/03/a-world-awash-with-debt/

 

Are we much more levered than we think?  I don't know much about these charts and there could be a good reason for the increasing ratio.  Maybe the charts here showing assets, liabilities, and equity to GDP show a different story?

 

http://www.businessinsider.com/america-is-not-drowning-in-debt-2013-4

[Guest longinvestor]

Buffett is increasing cash - He has increased cash by $27B or 100% from 2008.

 

BRK should have close to $52B cash by now. That is $32B more than Buffett would like.

 

At $2B per month he could be upto $70B in cash by the end of the year.

 

Back in 2010 and 2011 cash was at $34B when BRK was only generating $1B cash per month.

 

In 2008 and 2009 cash was at approx $25B.

No one else has that problem. Are we going to see the buy back threshold bumped up to 1.3x BV?

[Uccmal]

I am just not seeing the pessimism that Watsa sees.  There are always frothy areas in the market. 

 

What I see is a banking system in the Us that is now over capitalized.  Many multinationals are sitting on colossal amounts of cash. 

 

The commodity rally is over, and has been for a couple of years at least, excluding fossil fuels. 

 

Governments are sitting on huge debts, but the service cost is very low.  Since they control the service costs it is not that relevant.  With job improvements, market improvements, and dividend increases everywhere tax revenues are climbing.

 

The notion that there are no more bullets if things turn down is wrong.  The federal reserve has already freed up 20 b per month in bullets - 240 b per year. 

 

As to China.  If there is really an overbuild still going on then why are commodities so cheap?  IMO their economy is internalizing as people within become more able consumers.  All that pollution is coming from somewhere. 

 

As Packer has stated there is always a crisis somewhere.  Since 1999 I have gone from zero to unemployed through the tech meltdown, two massive hurricane seasons, 9/11, the financial meltdown, the Near collapse of the EU etc,etc, etc. 

 

Finally, when calculating FFHs long term returns you need to remove the first year, at least.  That shaves at least a couple percent off.  In the end game, their returns, while respectable, are nowhere near Berkshires.  And berks cash build has to do with their size and nothing else. 

[ERICOPOLY]

I agree that there are always scary headlines...  etc....

 

However the reason why I started hedging was because of what has been fueling things.  We are once again at a record level of margin debt.  That is something that provides fuel for a fire.  I was also impressed by the astounding amount of private debt that has been racked up in China over the past few years.  Okay, one can argue that culturally they prefer real estate to other forms of savings, but they clearly love the leverage too.  There is something going on there that looks like a stretched rubber band and that feeds on continued growth of credit -- prices should fall/weaken when that credit expansion slows.  And then you have something similar to what the US went through -- a bunch of underwater debt that has no cash flow (they aren't renting these things out).

 

Anyways, it's all too much for me as due to what is most probably a "Low T" diagnosis (were I to go seek one out).

[mcliu]

I am just not seeing the pessimism that Watsa sees.  There are always frothy areas in the market. 

 

What I see is a banking system in the Us that is now over capitalized.  Many multinationals are sitting on colossal amounts of cash. 

 

The commodity rally is over, and has been for a couple of years at least, excluding fossil fuels. 

 

Governments are sitting on huge debts, but the service cost is very low.  Since they control the service costs it is not that relevant.  With job improvements, market improvements, and dividend increases everywhere tax revenues are climbing.

 

The notion that there are no more bullets if things turn down is wrong.  The federal reserve has already freed up 20 b per month in bullets - 240 b per year. 

 

On the other hand, if the situation is so great, why is the Fed still injecting $700 billion into the bond markets every year and being so cautious with tapering?

 

I guess if you believe that the current interest rate environment is normal, then there are definitely many signs of improvement.

 

As to China.  If there is really an overbuild still going on then why are commodities so cheap?  IMO their economy is internalizing as people within become more able consumers.  All that pollution is coming from somewhere. 

 

Where is the data that supports that? I'm looking at the latest GDP figures and it shows a big jump in investments from 49% of GDP to 54% while consumption only increased from 48% to 50%. Credit is still growing double digits, probably to finance the increase in investments. The Shanghai index has dropped considerably since 2009 (5 straight years of declines!) reflecting the low ROEs in corporate China. Yet, despite the low returns, overall investments has jumped by 20% yoy.

[ERICOPOLY]

See, here's a chart of NYSE margin debt since 1995:

 

http://advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-the-SPX.php

 

I would love to find a longer-term chart.

[Cardboard]

While I mentioned previously that I would ignore Fairfax following their non-follow through on buying out Blackberry, I still read the annual letter. Shame on me.

 

By the way, I don't buy the excuse of not following through because they discovered during due diligence that Blackberry could not be bought via an LBO. I mean, any decent investor with available public information could quickly calculate a reasonable amount of additional debt that could be serviced from recurring cash flows and disposable assets.

 

The transaction was presented as a cash offer with partners and with full reputation on the line. Once it fell apart, we are now supposed to believe that Fairfax and very capable Hamblin Watsa and Mr. Watsa himself being a director of BBRY for a long time, had to rely on outsiders or consultants if you will, to figure out that an LBO or adding a bunch of expensive debt on BBRY was impossible... You can draw your own conclusion a few different ways. One thing is certain, if I was a shareholder attending the meeting, I would question him directly about this train of thought.

 

Now getting back to the letter, I would point out that copper has experienced a noticeable drop recently. Unlike oil, it is not impacted much if at all from geopolitical events hence when it drops sharply as it did, it is a sign that something is amiss on the demand side. If you add this to the recent debt default in China and noticeable over-building, they may be on to something. At least, the timing now seems more right than before.

 

Cardboard

[Uccmal]

I am just not seeing the pessimism that Watsa sees.  There are always frothy areas in the market. 

 

What I see is a banking system in the Us that is now over capitalized.  Many multinationals are sitting on colossal amounts of cash. 

 

The commodity rally is over, and has been for a couple of years at least, excluding fossil fuels. 

 

Governments are sitting on huge debts, but the service cost is very low.  Since they control the service costs it is not that relevant.  With job improvements, market improvements, and dividend increases everywhere tax revenues are climbing.

 

The notion that there are no more bullets if things turn down is wrong.  The federal reserve has already freed up 20 b per month in bullets - 240 b per year. 

 

On the other hand, if the situation is so great, why is the Fed still injecting $700 billion into the bond markets every year and being so cautious with tapering?

 

I guess if you believe that the current interest rate environment is normal, then there are definitely many signs of improvement.

 

As to China.  If there is really an overbuild still going on then why are commodities so cheap?  IMO their economy is internalizing as people within become more able consumers.  All that pollution is coming from somewhere. 

 

Where is the data that supports that? I'm looking at the latest GDP figures and it shows a big jump in investments from 49% of GDP to 54% while consumption only increased from 48% to 50%. Credit is still growing double digits, probably to finance the increase in investments. The Shanghai index has dropped considerably since 2009 (5 straight years of declines!) reflecting the low ROEs in corporate China. Yet, despite the low returns, overall investments has jumped by 20% yoy.

 

I never said the situation was so great.  I provided counterarguments to the same noise that comes out of FFH ever year.  They dont know any better than anyone else.  Specifically, the running out of bullets argument Is what I was talking about.  The way I see it the magazine is being refilled slowly but surely. 

 

Have a look at historical interest rates, going way back, if you dont believe they can stay very low for a very long time. 

 

Do you really believe anything you get from China at all, either the stats that FFh provides, or the ones you are providing.  We are dealing with a great big black hole over there.  And the officials in China are dealing with the same black hole.  I am real skeptical.  The only tangible thing we can see is that commodity prices (ores) have come off from the boom years.  That shows me that there aren't Manhattans being built every month. 

[matjone]

See, here's a chart of NYSE margin debt since 1995:

 

http://advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-the-SPX.php

 

I would love to find a longer-term chart.

 

http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3153&category=8

[gary17]

i am wondering if there's any meaning to looking at margin debt as a ratio to the credit balance...  as oppose to looking at the margin debt alone.    i attached a graph. 

 

also, does anyone know what 'foreign reserve' means -- i've heard that China has a lot of foreign reserve - but in very practical terms, what does that actually do? is it like cash in the bank they can use? 

 

i think the one thing China has also going for them in terms of monetary policy is they control their currency exchange rate.  not sure if that's a plus or minus. not an economist here... but just thought between that and the interest rate and the foreign reserve - whatever that is - they have a few tools to play with.

 

thanks

[ourkid8]

Since we have all become macro investors, here is another data point which shows the US economy continues to expand and 4th quarter GDP growth maybe revised higher! For me, I continue to buy companies selling below intrinsic value.  I am not concerned what will happen to the global economy in the short term. 

 

http://mobile.reuters.com/article/idUSBREA2B1H020140312?feedType=RSS&irpc=935

 

Tks,

S

[TwoCitiesCapital]

Finally, when calculating FFHs long term returns you need to remove the first year, at least.  That shaves at least a couple percent off.  In the end game, their returns, while respectable, are nowhere near Berkshires.  And berks cash build has to do with their size and nothing else.

 

If you remove the first year because "they're so small and results were easy" then you should adjust for the removal of the CDS gain in 2008 because they were no longer small and that required a great deal of macro-economic and investment insight. And before anyone pipes up and says it makes sense to remove that due to it's one-time nature (I typically agree), think about this: if deflation occurs anywhere near the scale that they envision, they'll be pulling in 10+ billion from their hedges and deflation bets....so maybe it's not such a one time recurring gain at all.

[ERICOPOLY]

I know a lot of people recoil at discussing macro...

 

Do you recoil at doing a credit check for somebody you intend to lend money to?

 

The foreign markets are the buyers of US exports, and if they slow down their buying, it's going to hurt US equities similar to if they started making lower payments on a loan.

 

That's what I think of it.  You have all these American brands that the Chinese love to spend their new-money wealth on.  If they have a major hiccup, like if their real estate has a 60% nose-dive, then they'll stop importing all these luxury items.  That will ripple around and impact a lot of US business.  Same with Europe etc...

 

So I think paying attention to the credit health of the major consumers of US exports is a bit like paying attention to the FICO score of someone you are going to lend to.

 

Anyways, I will make out like a bandit if the Russell 2000 crashes, and I will make out like a bandit if the shares of BAC go to $22.  So I am open to either outcomes -- each one will grow my wealth.  I am actually scared shitless for the global markets... but because we can't predict when, I'm still leaving open the upside to $22.

 

[frommi]

Its possible that you are right and after reading these stories i am scared, too. But in the end thats always the reason why something becomes cheap, because the majority is scared that the world goes to hell. Nobody knows how this all will play out, perhaps the property market in china crashes and it doesn`t influence the stock market? Or the government/central bank does something surprising?

 

Shorting means to bet against the humans that are working for success in all these companies/countries, so you have a lot of headwinds. And as soon as you are in your position you are actively searching for reasons why the world has to go to hell. And you get angry when the market doesn`t react like it should.

[ERICOPOLY]

The Russell 2000 has compounded at 7% annualized since the peak in 2007.

 

The world isn't scared!  Margin borrowing is at a peak -- seriously, it is. That isn't fear -- it's trumpets.

[ERICOPOLY]

Shorting means to bet against the humans that are working for success in all these companies/countries, so you have a lot of headwinds.

 

Employees at companies are working for success.

 

What I'm doing is protecting myself from the presently heavily leveraged greedy humans that will get margin calls when their overvalued assets plunge a wee bit.

[frommi]

This overvaluation can go away when the market just goes sideways. But you are far more successful than i am in investing, perhaps i should listen to you :).

[wisdom]

http://www.bloomberg.com/video/china-has-a-real-estate-bubble-saxena-QEQyoXq4QQa~JE2wvwm9rQ.html

 

apparently housing in China is now valued at 400% of GDP.

[ERICOPOLY]

This overvaluation can go away when the market just goes sideways. But you are far more successful than i am in investing, perhaps i should listen to you :).

 

I am going to make a lot of money if the market doesn't crash and if BAC keeps heading higher.  But I've written $22 strike calls.  Used the proceeds to buy the IWM calls that hedge my IWM short.

 

Then all the BAC is hedged at $15 and $17 strike.  I've also written some SHLD puts.  I've closed out my C position and am contemplating the same for JPM. 

 

I believe that I won't lose much if anything if the markets merely stand still (I have decay from the puts I've written, the calls I've written, the dividends I expect to receive, and then there is decay on the calls I've purchased and the puts I've purchased.

 

But in short, I'm heavily leveraged on BAC to the upside, and heavily leveraged in Russell 2000 short for the downside.

 

I can accept either BAC trudging on, or total market wipeout.  Both are winners. 

 

I'm prepared for pretty much all comers.  My position is different from FFH because I've hedged against the Russell 2000 moving against me (using call options).  They've made no money in four years and I've made a killing (lucky perhaps).  If the market continues to march on, or at least if BAC does, I will still keep making terrific gains.

 

So, don't take my bearishness as a sign that I'm giving up all hope.  It's just that I'm taking it very seriously now whereas before I was brushing off the naysayers.