Good blog post on FFH

[AZ_Value]

I enjoyed it. Thanks for posting.

 

However, just something to think about from a return perspective. Let's say if the post would have been written in 2009. Watsa would be looking like a genius over Buffett, I'd think. The fact the market has been manipulated by the Fed, doesn't mean he's wrong. Yeah, so far it looks like he's wrong, but I think he'll be proven to be right. These guys very often look like idiots...until they're not. Cases in point - Buffett in 1999 or Burry in 2006 with Greenblatt pulling money out. We shall see.

 

For fun, here's what I'm thinking. Let's say, someone asked you what your returns would after about 6 years if you would have bought the S&P 500 in 2007 at the height at that we'd then enter the worst recession since the Great Depression. One you expect negative returns? I'd think so. But that's not what happened

 

If one would have bought the S&P 500 near the height in 2007 and didn't sell, you would still have returns of roughly 5.5%. That seems too good to be true! It's better than a lot of time periods...let alone one of the worst periods ever.

 

Good points Paul.

 

But unfortunately life doesn't work like that. I don't have to stop at 2009 and then disregard the following 5 years just because I'm being asked to. It's my right and prerogative to look at everything. Which is why I made it a point to make sure I detailed the various factors I don't like and it wasn't necessarily that they lagged the market. I wanted to point out exactly what I didn't like that they were doing.

 

Like I said it really doesn't matter to me how you want to explain it, talking about the Fed or other factors, or what the track record is, I just don't believe it is given to man to be able to predict stuff like inflation and deflation (especially the type of deflation Prem is talking about). Actually if you put a gun to my head and asked me to choose I'd rather go with the guy predicting inflation because the odds are in his favor since deflation is so rare.

 

[james22]

Evaluating FRFHF not in isolation but rather how its addition impacts the overall risk and return of my portfolio as a whole, I like to think its deflation fear offsets other's inflation fears.

 

The bear to Buffett’s bull

 

Unlike Warren Buffett, who can sometimes be described as a cheerleader for the U.S. economy, Prem Watsa and Fairfax are the opposite. Watsa believes that the causes of the global financial crisis cannot be so easily remedied. These causes include high levels of government debt and high unemployment in the U.S. and Europe. Adding to these global issues, some housing-related Canada-specific problems that are also beginning to surface. This is why Fairfax has a large equity hedging program in place to offset what they see as a high-risk environment throughout the world. For investors looking for a bearish company to play against Buffett’s bullishness, Fairfax just might be up their alley.

 

http://beta.fool.com/whichstockswork/2013/06/14/canadas-versions-of-berkshire-hathaway/37148/

[Munger_Disciple]

Excellent work, AZ_Value!! One of the best posts I have read in a long time.

[AZ_Value]

<quote>They constantly have to pay cash because of those swap contracts (even if in their mind, it will be recouped eventually if they keep the contract and the equities fall.</quote>

 

On the Russell index swaps I believe FFH switched some of their long equity positions into long swaps so that they would help generate cash settlements to offset those arising from the index swaps.

 

On the deflation swaps which are mark to market through IFRS accounting because they act as purchased option contracts (don't count toward hedge accounting).  The counter party may have to escrow funds, according to Fairfax's wishes, but Fairfax's loss is limited to the premium paid plus or minus the closing value of the contract.  There were some questions regarding the counter parties to these contracts at the ASM.

 

This is why I regret so much that I didn't make it to Toronto, so I have to rely on you guys to tell me what they said.

 

On the Russell index swaps I believe FFH switched some of their long equity positions into long swaps so that they would help generate cash settlements to offset those arising from the index swaps.

 

Now is this something that they said you're quoting? Or did you see that somewhere (If so could you point us to where you saw that)

 

Because here's what I can personally see, this is straight from their annual report:

 

https://dl.dropboxusercontent.com/u/72385227/Fairfax%20Derivatives%20Table.JPG

 

Where is the switch into long swaps happening since from what I can tell the long swaps positions  actually almost went away entirely from $1 billion in notional value in 2012 to $260 million in 2013.

 

I'd be interested to know where you got that from. If you heard it from a member of the Fairfax team directly or somewhere else. Thanks.

 

As for the CPI derivatives, that is correct, the maximum amount they can lose is the premium they paid to initiate the contract

 

 

[giofranchi]

Hi guys!

I am just back from two wonderful days in Toronto. :)

 

AZ_Value,

I will certainly read your blog. And I will answer to each point you bring up. Let me just say that I am more convinced than ever that FFH is a great company and will go on compounding capital at high rates of return. ;)

 

Cheers,

 

Gio

 

[stahleyp]

I enjoyed it. Thanks for posting.

 

However, just something to think about from a return perspective. Let's say if the post would have been written in 2009. Watsa would be looking like a genius over Buffett, I'd think. The fact the market has been manipulated by the Fed, doesn't mean he's wrong. Yeah, so far it looks like he's wrong, but I think he'll be proven to be right. These guys very often look like idiots...until they're not. Cases in point - Buffett in 1999 or Burry in 2006 with Greenblatt pulling money out. We shall see.

 

For fun, here's what I'm thinking. Let's say, someone asked you what your returns would after about 6 years if you would have bought the S&P 500 in 2007 at the height at that we'd then enter the worst recession since the Great Depression. One you expect negative returns? I'd think so. But that's not what happened

 

If one would have bought the S&P 500 near the height in 2007 and didn't sell, you would still have returns of roughly 5.5%. That seems too good to be true! It's better than a lot of time periods...let alone one of the worst periods ever.

 

Good points Paul.

 

But unfortunately life doesn't work like that. I don't have to stop at 2009 and then disregard the following 5 years just because I'm being asked to. It's my right and prerogative to look at everything. Which is why I made it a point to make sure I detailed the various factors I don't like and it wasn't necessarily that they lagged the market. I wanted to point out exactly what I didn't like that they were doing.

 

Like I said it really doesn't matter to me how you want to explain it, talking about the Fed or other factors, or what the track record is, I just don't believe it is given to man to be able to predict stuff like inflation and deflation (especially the type of deflation Prem is talking about). Actually if you put a gun to my head and asked me to choose I'd rather go with the guy predicting inflation because the odds are in his favor since deflation is so rare.

 

Right. I'm not saying we should disregard the past 5 years. I'm simply saying that we should all be aware of our biases when looking at time periods. The past 20 years have been some of the more aggressive Fed financial engineering in a long, long time (perhaps ever). Also, sometimes these long cycles can take a while to pan out - much longer than most expect.  I'll agree that it's not given to man to be able to predict things like inflation or deflation though!

[vinod1]

 

There were two points that clarified this hedging issue for me, one point at the Railcar event, and one during the shareholder dinner.

 

At the Railcar one of the FFH guys mentioned that the Canadian regulators would at most give 50% credit to their equity investments.  This is a major issue, so they have two choices.  They can invest in bonds and cash and get full credit, or hedge the equity to get full credit.  They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

So in order to satisfy the regulators they need to be protected against a lost.  At some point the market will fall, it's not a matter of if, but of when.  When the market falls they can dump the hedges and make more investments without a hedge.  The math on this works because they're able to double down on investments and with a 50% regulatory penalty they don't lose any ground.

 

At the dinner Paul made a few comments reinforcing this but also went a step further.  It's almost as if there are two things going on here.  The team is investing as they always have, they are generating the types of returns they want.  They're very confident in the investments they have now, that Greek REIT, restaurants etc.  It's a timing issue, they expect the market to fall before these investments are realized.  And to be able to invest at all they need to show to regulators that their capital won't be wiped out.  So they are forced to hedge.  The hedge protects them in a downdraft, but it's almost independent of the underlying investments.

 

Someone quoted Prem as saying that protecting capital is the most important issue, and that AIG took decades to build billions in equity that was wiped out in a year.  Remember that Fairfax is first and foremost an insurance company.  They are not a hedge fund, or a mutual fund.  All of their activities support their insurance, and this is how regulators view them as well. 

 

So why haven't they ever called this out explicitly?  It doesn't seem in good taste to call out regulators.  But I think it's even simpler then that.  I think that Prem and his team take this for granted.  They are an insurance company, they deal with regulators and capital issues all the time.  This is the lens they think in, I think they presume that investors understand this as well.

 

Thank you! That provides a lot of additional color on the hedges. Very helpful.

 

I am not entirely convinced of the rationale

 

1. I do not see a big issue with stocks being counted only as 50% for statutory reasons. It is not even close to being a binding constraint on Fairfax w.r.t. how much business they can underwrite. Per the AR.

 

"On average we are writing at about 0.8 times net premiums written to surplus. In the hard markets of 2002 – 2005 we

wrote, on average, at 1.5 times."

 

So they can easily write twice as much if not more given their current levels. If stocks constitute 70% of statutory surplus, and it weighs only 35% they still would had a statutory level of about 65% of their current level. Down but not so much that it effects their business.

 

Second, Fairfax really is making most of the money on investments rather than on underwriting. So why constrain yourself on your strength (investments) to make way for possible making a bit more money on the part which is not really your strength (underwriting)?

 

2. "It's a timing issue, they expect the market to fall before these investments are realized."

 

Put simply it seems to be market timing.

 

Vinod

[vinod1]

I don't know, my knowledge of Fairfax went from zero to everything I know by attending the events in Toronto.  In the US if you're a holding company that owns a bank you are regulated even though the subsidiary does the banking.  My guess is that insurance is similar, the actual operating entity is regulated, but the holdco is as well.  This is to prevent a situation where the holdco makes decisions that could financially jeopardize the subsidiaries.

 

My understanding is that banking is an exception. That is why you do not see Berkshire having any banking sub but having lots of insurance subs.

 

AIG is another example, lots of insurance subs which are regulated individually but parent falls under Fed as they own a smallish bank.

 

Vinod

[giofranchi]

AZ_Value,

I have barely got to the disclaimer on page 1 and I have already found something I don’t understand… You say you own a few shares “just so I can get the annual report sent to me and attend the annual meeting if I want to.”

Well, I have attended the annual meeting twice (in 2010 and this year), and I have never been asked a certificate to show I own FFH shares (an identity card is all I have been asked)… On the other hand, the AR is perfectly downloadable in pdf file… Therefore, I don’t see any true reason to own only “a few shares”.

Now I will go on reading. ;)

 

Gio

 

[Packer16]

One issue I don't think that addressed is Fairfax's sweet spot for investing (value and in many cases distressed securities) compatible with insurance?  In my mind Fairfax's type of investing yields nice results long-term but takes more risk than lets say BRK or MRK's approach maybe more akin to LUK's pre-Handler days.  I think where the issue comes in is used that type of investing with an insurance company whose policyholders by regulation and demand want stability.  A interesting question is should maybe Fairfax get out of the insurance business and become an distressed investor/manager akin to LUK?  I think in the long term this may be a better strategy that aligns FFH's strengths with a structure to take advantage of that strength.  Maybe they can spin off the insurance business retain an equity stake and become an investment holding company akin to LUK.

 

Packer

[giofranchi]

One issue I don't think that addressed is Fairfax's sweet spot for investing (value and in many cases distressed securities) compatible with insurance?  In my mind Fairfax's type of investing yields nice results long-term but takes more risk than lets say BRK or MRK's approach maybe more akin to LUK's pre-Handler days.  I think where the issue comes in is used that type of investing with an insurance company whose policyholders by regulation and demand want stability.  A interesting question is should maybe Fairfax get out of the insurance business and become an distressed investor/manager akin to LUK?  I think in the long term this may be a better strategy that aligns FFH's strengths with a structure to take advantage of that strength.  Maybe they can spin off the insurance business retain an equity stake and become an investment holding company akin to LUK.

 

Packer

 

Packer,

First of all let me tell you it was great to meet you in person! ;)

Now I have “promised” to answer AZ_Value’s points, therefore I won’t have time to comment much else. But let me tell you I completely disagree with your suggestion. FFH is becoming a powerful force in insurance worldwide, and is buying insurance companies all over the globe in a very opportunistic way. It is what they truly know and what they do best.

I asked Mr. Watsa at the AM about regulatory constraints, and he answered they will be able to raise their investments in equities, they will be able to invest in high-yield bonds, they will be able to invest in private businesses, etc.

I have no reason to believe he was not sincere. :)

 

Gio

 

[giofranchi]

AZ_Value,

I also find your comment on underwriting results a bit misleading. You make it sound like 2013 has been nothing but good luck… Instead, like they have very often shown, it is now more than 10 years the average accident year combined ratios is below 100%, and reserves are redundant. ;)

 

Gio

 

[giofranchi]

AZ_Value,

Now to the equity hedges… But we have already talked about them for ages!! With the benefit of hindsight they have been a mistake! And their timing has been terrible! But a past mistake doesn’t mean they will prove to be a mistake at the present time too! As an ex-shareholder you have been lucky enough not to suffer from the bad timing decision to put on the equity hedges… good for you! Now what? Do you still believe they are a mistake also at today’s prices? This is the only question a shareholder should be concerned now. The past is past, the future is the only thing that matters.

But, you might argue, if they have made such a mistake in the past, I don’t trust them for the future either… That’s your choice! And one I strongly disagree with. This is the reason:

 

Each company, like each individual investor, has different situations and needs. And each one must devise the best strategy for him/herself, in order to always be solvent, to always continue business undisturbed, and to always have cash when opportunities arise. Lots of people show the arrogance to presume they know FFH’s situation and needs better than Mr. Watsa… They usually say: “I am in Buffett’s camp… look at how Buffett do things… etc.”. Not realizing each company and each individual investor are stories of their own, and that to generalize is the most dangerous thing they could do… You are in Buffett’s camp? No! You are absolutely not! And neither you know better than Mr. Watsa what’s good for FFH.

 

Gio

 

[tiddman]

They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

They did, though, they issued 1 million shares in November 2013 at Cdn$431/sh.  I had totally missed this until AZ pointed it out.

 

This dilutes shareholders and raises cash, but actually increases book value since the stock issuance was done at a significant premium to book. I have mixed feelings about this, on one hand if they really are cash strapped because their "hedges" are moving against them I think they need to be be a little more clear on what risks these hedges pose to shareholders.

 

On the other hand quite frankly I am surprised that Fairfax stock is continuing to trade so high, it's at around 1.3x book now.  When was the last time you remember it trading at such a premium?  From that perspective Watsa may as well issue as many shares as he can since he's raising cash with overvalued stock and increasing book value.

[tiddman]

1) There were lots of questions about this at the railcar and at the dinner.  One thing that came up is when they would exit the hedges.  The answer was: a) if everything goes down as they expect, they'll cash out and invest the cash; b) if everything goes up, they will realize the gains and take off a corresponding amount of hedges, as they did this year (I interject here that I agree with the comments regarding selling of long term positions, particularly WFC).

 

This sounds a little bit like, heads I win, tails I sell all of my long term investments at a loss?

 

I think the situation that Watsa isn't adequately considering is that the stock market remains flat to slightly higher over say the next 5 years.  The hedges will continue to require cash, he'll continue to sell his equity positions, and book value will continue to decline. This would be a pretty big disaster from an investment return and opportunity cost perspective.

 

Then, what are the chances that one of the next 5 years are going to be a really bad year in insurance?  I would say definitely greater than zero and history has shown that Fairfax hasn't done much better than others in bad years.  What if the market goes up for 2 more years and then there's a terrible year in insurance where they write a 115% combined ratio?  I think that is a pretty scary prospect.

[giofranchi]

The whole part “Cash Burden” is very difficult to understand… Even more so because Mr. Watsa’s actions are crystal clear. They go like this:

 

If you don’t see great opportunities, be patient, stay in cash (at the dinner a member of the FFH team said: I would have liked to invest this way: to stay in cash almost always and to swing only when truly outstanding opportunities come my way… But I was never able to do that!). An alternative to this approach is something Mr. Templeton practiced with success: buy the stock you like the best, sell the one you like the worst. The advantage of this approach over cash is that you should be able to earn an alpha. The disadvantage is that it is much more volatile. So, it depends on what you prefer at a given moment: to earn some alpha, or stability. If Mr. Watsa is selling, it is probably because he wants to be sure about its buying power, should some opportunities arise. He simply prefers right now the stability of cash to the profitability (and great volatility in the short run) of a long/short strategy.

That’s all! ;)

 

Gio

 

[giofranchi]

I think the situation that Watsa isn't adequately considering is that the stock market remains flat to slightly higher over say the next 5 years.  The hedges will continue to require cash, he'll continue to sell his equity positions, and book value will continue to decline. This would be a pretty big disaster from an investment return and opportunity cost perspective.

 

Don’t confuse the short-term with the long-term: in the long-term FFH equity portfolio has always outperformed the indices. In the long-term they will make money, not lose it! Even if nothing truly significant happens to make them change strategy. ;)

 

Gio

 

[stevevri]

I think the situation that Watsa isn't adequately considering is that the stock market remains flat to slightly higher over say the next 5 years.  The hedges will continue to require cash, he'll continue to sell his equity positions, and book value will continue to decline. This would be a pretty big disaster from an investment return and opportunity cost perspective.

 

This is something I hadn't seen mentioned until now and have wondered silently. What if Prem is right but wrong? You have central banks pushing a lot of cash out there. While right now deflation may be their concern, things can change quickly and you could easily have a scenario where the market stays flat or gains small but inflation eats up all of those gains.

[giofranchi]

CPI Contracts + Blackberry

They have been discussed ad nauseam… I wouldn’t really like to hear anything more about them, anyway…

 

CPI Contracts:

What matters is only the asymmetrical bet. Nothing else. Macro, micro, bla, bla, bla… If you find a coin and you get the chance to gain 10 if heads comes out or lose 1 if tails comes out, will you flip it?

Nothing else to say.

 

Blackberry:

As I have always said, much ado about nothing: they have always made mistakes investing in equities, they will go on making mistakes. Their track record has always being stellar, it will continue to be very good.

Nothing else to say.

 

Gio

 

[giofranchi]

The graph about debt:

 

It is total debt that matters. Probably you are looking at gov. debt, which is only a part of total debt. Total debt bottomed at the end of the ‘40s, exactly when stocks bottomed. ;)

 

Gio

 

[giofranchi]

Your whole argument about “the long-term” is very misleading. If Mr. Watsa’s defensiveness today is proven right, those numbers will change dramatically in a matter of just a few years… It is exactly like keeping cash for a very long time, and then investing in a truly outstanding opportunity: until that opportunity materializes, your track record seems very poor, than all of a sudden it becomes wonderful! Mr. Watsa at the AM has said the investment business is primarily characterized by how quickly things change. He simply has been waiting for three years now…

 

Gio

 

[mcliu]

Your whole argument about “the long-term” is very misleading. If Mr. Watsa’s defensiveness today is proven right, those numbers will change dramatically in a matter of just a few years… It is exactly like keeping cash for a very long time, and then investing in a truly outstanding opportunity: until that opportunity materializes, your track record seems very poor, than all of a sudden it becomes wonderful! Mr. Watsa at the AM has said the investment business is primarily characterized by how quickly things change. He simply has been waiting for three years now…

 

Gio

 

Good post. I think most people have stopped believing in large market declines after the bull market of the past 5 years. When valuations decline, and it inevitably will, the results will show a different story. I like what FFH is doing. They haven't forgotten the first rule of investing: never lose money.

[oddballstocks]

Your whole argument about “the long-term” is very misleading. If Mr. Watsa’s defensiveness today is proven right, those numbers will change dramatically in a matter of just a few years… It is exactly like keeping cash for a very long time, and then investing in a truly outstanding opportunity: until that opportunity materializes, your track record seems very poor, than all of a sudden it becomes wonderful! Mr. Watsa at the AM has said the investment business is primarily characterized by how quickly things change. He simply has been waiting for three years now…

 

Gio

 

Good post. I think most people have stopped believing in large market declines after the bull market of the past 5 years. When valuations decline, and it inevitably will, the results will show a different story. I like what FFH is doing. They haven't forgotten the first rule of investing: never lose money.

 

This is a theme I've seen on the board recently.  It's as if the good times will never end and markets never decline.  Somehow 2008/2009 is viewed as a fairly harmless blip that we navigated through without issue.  I don't remember it like that at all.  I remember how the fear was so strong, not just for investors but everyone.  Friends who had never invested a dime were watching the news to see how bad the stock market was doing and wondering how things would survive.  Since that time I've kept cash on the sidelines.  In retrospect it's been stupid because I could have juiced my returns a little more for the past five years.  Yet no one knows when the next crash or downturn will happen, and the last one caught a lot of people off guard.  I'd rather be patient and be able to seize opportunity than miss out.

[writser]

Gio: at what point would you reconsider your investment in Fairfax? Since your thesis is relying on excellent management have you set any rules for judging that? And aren't you afraid that you will develop a positive bias regarding Fairfax since you spend so much time defending it? :)

[Liberty]

They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

They did, though, they issued 1 million shares in November 2013 at Cdn$431/sh.  I had totally missed this until AZ pointed it out.

 

This dilutes shareholders and raises cash, but actually increases book value since the stock issuance was done at a significant premium to book. I have mixed feelings about this, on one hand if they really are cash strapped because their "hedges" are moving against them I think they need to be be a little more clear on what risks these hedges pose to shareholders.

 

On the other hand quite frankly I am surprised that Fairfax stock is continuing to trade so high, it's at around 1.3x book now.  When was the last time you remember it trading at such a premium?  From that perspective Watsa may as well issue as many shares as he can since he's raising cash with overvalued stock and increasing book value.

 

What matters is not book value, though, it's IV. If Fairfax considers that they are worth more than BV (in the same way that Buffett considers that BRK is worth substantially more than BV), then issuing new stock above BV could still be dilutive if it is below IV.

 

I don't know if that's the case now, though. I find Fairfax's IV very hard to estimate these days.