vinod1

+1 It is good to see underwriting going in the right direction, but it is aided by $440 million reserve release. Accident year CR is at 100%. Vinod

I hope someone asks a question on the CPI derivatives. Despite all the hoopla about deflation in Japan, the CPI index there peak to bottom went down by less than 5%. Fairfax seems to be preparing really for a repeat of Great Depression. Otherwise CPI derivatives do not provide much bang for the amounts being invested. Vinod

Fairfax could have done either of the following: 1. Buy puts. That would have been true insurance. 2. Had brought some protection in case stocks shoot up. Four years ago it seemed likely that markets would go down again. Fairfax was positioned as if this is nearly certain. Fairfax bought the hedges as a protection against 1 in 100 year event. Has it been Fairfax's assessment that the market had much less than 1 in 100 chance of shooting upwards? What kind of insurance is it that if it does not work out produces as much losses as it is supposed to protect? Vinod

In hindsight, but Fairfax lost $4 billion cumulatively pre-tax over the last 4 years on equity hedges and CPI derivatives. All this to protect $4 billion in equity investments at cost. Vinod

Gio, Makes sense. Thanks for pointing out that the hedges were on Russell 2000. Let us hope the markets cooperate in providing an opportunity. Vinod

Gio, For me, for FFH to be "right" on the hedges, S&P 500 would have to fall significantly below (say 20% or more) the level at which they hedged (~1060). This would imply S&P 500 to go down to about the 800 level. What is your criteria for FFH to be right on the hedges? I say this not to disrespect Watsa in any way. They got 3 big macro calls right (Japan 1989, Tech bubble in 2000 and 2008 crisis). Even if they got this wrong, that would make 3 macro calls right out of 4. That is a pretty good ratio on such complex macro events. Vinod

Ross, Thanks for setting this up and sharing with all of us. A great idea and I really like your approach to weighting the portfolio as well. Did you consider equal weighting for say the top 10 stocks with no cash allocation. I would think this might more clearly reflect the board's ability to pick stock vs S&P 500. This could be a separate portfolio. The current method combines a bit of board ability to market time (due to cash) and also introduces some noise around the stock weights. Vinod

Fantastic post oddballstocks. I only wish you have written this a few years back. I had come to pretty much similar conclusion but not before wasting some effort. Thanks Vinod

Not quite. Growth is funded by investment and that is invariably done by issuing more stock. So while earnings would grow in line with GDP and stock market would grow in line with earnings, that does not translate into a corresponding per share growth in earnings which is what really matters to the investor. Vinod

Could it be hindsight bias? There are risks every year, but in some years it is more pronounced than others. 2005, 2006, 2007 happened to be such years but it only materialized in 2007. If things have played out only slightly differently (Govt stepping in for Lehman and possibly some arm twisting to get AIG CDS counter parties to back off, etc) we might have had an economic impact similar to 2000 tech bubble burst. In hindsight it is easy to think that the financial crisis of 2008-2009 has a clear cut sign from the housing bubble. I do not think that is really the case. Personally I was worried about housing bubble and high stock market values due to high profit margins which I thought were a near certanity to mean revert. I was very defensive but it worked out for all the wrong reasons. I had no clue about all the leverage and the risks that turned up are not remotely close to what I was worried about - except for the housing bubble. The lesson I took from it is that when valuations are rich, bad things happen in ways we cannot anticipate and it is better to ensure that we live to fight another day i.e. no deep losses of 50% magnitude. Vinod

Looking another way, how much is HWIC really being constrained if 1. They are able to invest in CDS 2. They are able to invest in deflation swaps (or whatever they are called) 3. Or in any number of distressed investments they are able to make The primary constraints are really 1. Taking whole companies private and being able to count it towards statutory assets 2. Percentage of the shareholders equity being allocated to stocks. They have reached 80%, so the additional 20% is really the biggest drag that I see. Vinod

The way I see it, Fairfax model has been to invest Float in Bonds to fund expected liabilities. It was costing 3% but they had generated close to 10% on these bonds. Equity which is available to fund any unexpected liabilities is being invested anywhere from 45%-80% in stocks and they are able to generate 17% on the invested amount. The 17% return on stocks might be less than what HWIC is able to achieve if they are completely unconstrained in their stock allocation as you mentioned. However, since they are able to generate above 22% returns on total equity a while back, insurance operations providing float have on the whole added to the return since their returns on stock have provided only 17% returns. Would they have been able to add 5% annually if they are completely unconstrained? I am not so sure. JNJ and Kraft might not be the cheapest at that time but in an alternate scenario where we ended up in Great Depression II or something similar, others might not have survived. Given Watsa's bearishness, I suspect even in an unconstrained stock portfolio JNJ & Kraft would have had a place. With bond yields where they are now, I suspect insurance operations are likely going to be a drag going forward and we would likely see the scenario you suggested being played out. Vinod

You also need to add the dividend yield to the cost of the LEAP. Vinod

To use an example take BRK $100 strike call 2016 LEAP that is selling at about $23.6 while BRK is trading at $115.6. Since the term is roughly 2 years on the LEAP (from now until Jan 2016) I rounded it to 2. Old way would be (23.6 + 100 - 115.6) / (100 x 2) This gets you 4% annual costs. The more accurate way (115.6 - 23.6) * 1.x ^2.0 = 100 This gives you 4.25% annual interest. Not that significant since LEAP is only 2 years out and interest cost is relatively low, but as interest cost or term increases, the difference would be significant. Vinod

I used to calculate it the following way: (LEAP cost + strike price - stock price) / (strike price x term of LEAP in years) This gets you the rough annual borrowing cost but it is not accurate as you are prepaying the interest upfront. Eric has recently pointed this flaw and although the above calculation would still get you the cost for 1-2 year LEAPS roughly right, it would be better to calculate it the way he mentioned it. I am copying what he wrote in another post (I do not have the thread link but I did make a copy): You are prepaying all of this interest, long before it is due, which is effectively an interest-free loan to the very person you are borrowing it from. Thus, you aren't really borrowing as much as you think. Therefore, you have to figure out how much you are really borrowing first, before then calculating what interest rate you are really paying. And that is an easy calculation. Given: BAC stock price $15.60 BAC "A" warrant price $6.54 Strike price $13.30 x= cost of leverage interest rate $15.60 - $6.54 = $9.06 Now you need merely solve the following equation for 'x': $9.06 * 1.x^5 = $13.30. I'm using 5 years in the calculation to keep it simple, even though we're not exactly 5 years from expiry. Viinod

+1 Why lever up on something that is at 90% of IV with recourse leverage deep into a bull market? If you really that confident, why not just use LEAP? You can get 2016 BRK.B $100 strike option for $23.6. That gives you nearly 5x leverage for 2 years at an interest rate of about 4.25%. Vinod

You would get a "rebalancing bonus" when you add a non-correlating asset and you rebalance periodically. See http://www.efficientfrontier.com/ef/996/rebal.htm I wonder if you are capturing that effect. Vinod

How is that even possible? I had also assumed it would be all or nothing always. Are you using fixed income for cash? Thanks Vinod

I just tried re-doing this where the year before the market as a whole goes down. e.g.: Year 1: 15% Year 2: 15% Year 3: 15% Year 4: -15% Year 5: 15% where in years 1-4 in x% cash, year 5: 100% allocated. This makes the idea work a bit better. If you assume this occurs every 5 years, with the above returns, your extra cash only has to make 45% the fifth year to match the returns. At 6 years: 67%, at 7 years: 78%. That starts to be similar to Pabrai's rules, assuming he can pull off those big returns on the down years. However, note that the % cash does not matter. If the rule holds, then you should just be 100% in cash in years 1-4 and then 100% in at the high returns on year 5. Thus, I haven't seen anything where having a low percentage of cash is better than a high percentage, it either breaks the threshold or it doesn't. During GD, the stock market went down 89% for the stock market as a whole and 86% for large cap. I am thinking if you have losses in this range just having cash should make up for all the drag. Any scenario where you have market going up long term would I think make a cash allocation a drag. What about periods when the market is volatile but maybe it just stays at that level at the end of a 10-15 year period. Vinod

1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform. 2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation. Vinod

I did not read the whole thread, but I had a similar situation at the end of last year. I had a few HP 2013 calls that were being quoted around 2c, I put a limit order for 1c and then tried a market order but it did not execute. Since the amount I invested is very small I did not give it much thought. I wrote a post on this and there was a suggestion that I could get a friend to put in a bid, but others have commented that it might be matched up to someone else's ask. Vinod

I think Fairfax was expecting the 2nd dip like US had in 1932 and a very deep recession. Otherwise, they would not have hedged at S&P 500 value of 1062. Buffett came out with "Buy America" article when S&P 500 was at 900 a couple of years earlier. It could not have been due to valuation. GMO and even Hussman consider fair value to be about 1000 - 1100. Hedging would not have been for a mere 10-20% drop in value, they must have been expecting something like 30-40% from the hedge level of 1062 or S&P 500 to fall to something like 640 to 740. That is an economy in deep trouble and very deflationary. Vinod

In Hussman's defense, it takes real guts to lay out his rationale every week for why the fund is positioned that way it is. I do not think anyone would do such a thing if they do not have real conviction. The problem I see is that he thinks the way markets behaved the past 100 years are pretty much how markets behave in the next 100 years. Thus you see not a hint of probabilistic thinking, for example, by even entertaining the thought that profit margins might be higher in the future than in the past or that they could be higher for a longer period of time then they have in the past, etc. He seems pretty convinced they would revert in short order. Vinod

As far as Grantham is concerned, you need to understand where he is coming from. His firm invests money for institutions and his objective is to earn a couple of percent over the respective asset class returns. He is spectacularly successful in that regard if you measure it over the full market cycle. If you look at his record of asset class predictions over the next 7 or 10 years period around the time of the internet bubble, he nailed it something like 10 out of 10 in rank order of performance. He started one of the very first index fund, so he is not really into security selection. In addition, the firm now manages something like $100 billion. Vinod

I thought Shiller's is making the same exact point. No bubble but on expensive side. Vinod