ERICOPOLY

I don't have a job and I need cash to fund the cost of living. In a position such as mine, once the portfolio generates enough income to fund all of my expenses, I can then truly say that I care not what Mr. Market does. A dividend is a way of incrementally tapping my portfolio's intrinsic value at 100%, and Mr Market can't get in the way. A no-dividend policy simply means that I can only tap the intrinsic value of my investments at the 100% level only when Mr. Market says so. And that might never happen. Another thing to consider is that if size is the anchor of performance, why get bigger? Paying a dividend might, in theory, improve the returns of the capital left behind. Then there are the people with jobs that don't want extra income -- they perhaps care not about the dividend. Or the people with so much money that they don't need more income -- they might like a no-dividend policy as a way of tax reduction. There is no best answer. Different strokes for different folks.

This year I sold puts for a reason other than income. In Feb/March I was selling far out of the money naked puts for 20% of notional (GE, AXP, MSFT, SHLD, WFC, etc...) to fund at-the-money FFH calls for 20% of notional. Throughout this entire year I have been 100+% notional long FFH via calls. By the time FFH dropped to $250, I was tired of being scared so I switched from a deep-in-the-money FFH long call strategy to an at-the-money FFH long call strategy. The puts I wrote expire in 2010 while the calls I bought expire in 2011. FFH is still down YTD by about 20%, but I'm now only down 3%. This is because the premium in the puts I wrote are basically worthless now while the premium in the calls I bought have barely decayed at all. Otherwise I'd be down 20%. So anyway, yes, I wrote the puts to generate income but really I was running a strategy that would benefit from the 2010 expiry I sold vs the 2011 expiry I bought, coupled with a deep hedge against further decline (I sold puts at very low strikes). Unfortunately, I didn't just buy the shares of the companies I wrote puts on -- but to do so would have exposed me to market risk I wasn't in the mood for. So for whatever it's worth, I'm lucky that I'm not down 20% as I was the day I started to implement the strategy. Just pointing out that not everyone sells puts only for income. Another reason somebody might write naked puts is for meeting a margin call. You might have a concentrated position in FFH and your broker could flip out and raise the maintenance margin requirement on you. Should that happen, write puts on something with a lower maintenance margin requirement and use the premium to buy puts on your FFH position. That should meet your margin call. In this situation, if you had a large capital gain on your FFH position you wouldn't want to sell it to buy calls as that would trigger a taxable event -- so the puts is the only answer I think.

If you take it as a given that the 80% is going down in a hopeless spiral, then no the 20% will not overcome the 80%. Prem does not take it as a given. Here is a quote from him: "The ultimate test is will the 80% start spending and we will not know that for some time." http://www.financialpost.com/story.html?id=1307083

Buffett has stated that we won't have a real estate situation like Japan's because our population is growing and therefore housing demand is growing. That's pretty much what we said on this board a couple of years ago. It makes too much sense. US is growing and Japan is not (to me it is very clear). Prem stated that the US reacts quickly, as opposed to Japan. It's unclear to me exactly what he means by that, however it sounds like he is not ready to compare the US to Japan. But look at this answer of Prem's. Does it sound like he intends to unload at $900 and sit in cash? It doesn't to me. It sounds to me like he would rather just buy and hold for the long term. His actions (not selling at the end of 2008) very obviously point this out. Otherwise why didn't he sell, and for what reason would he sell now if he didn't then? Q How long will it take for fear to disappear? A "The U.S. reacts quickly, as opposed to Japan. But it's a question of pessimism, which means it's not a bad time to buy for the long term. We could have four or five years of difficult times. We really don't know." http://www.financialpost.com/story.html?id=1307083

"Obama has come with a very significant stimulus plan. The Treasury Secretary has a very thoughtful way of handling the banks and yet no one believes it's the bottom. "Today we've some of the biggest actions by the U.S. government in terms of stimulus, interest rates at zero and nobody believes it'll have any impact." - Prem Watsa, Feb 2009

As for the market topping out... the market is roughly where it was when the year started -- Fairfax was heavily invested in equities at the time, presumably expecting markets to go higher, not lower.

El Nino is said to be responsible for the light year in 2006. There were Atlantic hurricanes, they just didn't make landfall (wind shear weakening them before landfall, or blowing them off course).

I think that you get roughly $1 of equities for every $1 invested in FFH at today's price. It seems like a 12% return on their equity portfolio over the next 10 years will get you 17% return on the stock if you assume: 1) a modest expansion of B/V multiple (say 1.2x) to offset taxes paid/due on the equity gains 2) 5% per annum boost from the float (pretty easy this year with the tax-free muni bonds) So is a 12% return possible?

Canadian government carries out aerial bombing raids on schools of porpoises blamed for predation on cod.

I think I read that Fairfax looks at it's insurance exposures and keeps them positioned such that a major catastrophe won't hurt them by more than a single year's investment income. A total wipeout of WFC to $0 (however improbable) would cost FFH about 6% of book value. The position is also only marginally larger than their JNJ position. For whatever it's worth it seems to me like the WFC exposure is not really that large.

Aha, here it is from Viking's post: 7.6 million WFC shares at $18.41 (46% of total new FFH purchases) I know WFC has had this tremendous run from it's bottom, but it's not all that spectacular of a run from where they bought most of their WFC shares. Of course they still might lighten up like you say, but I don't think they will because of the breadth of options they had before them at the time they were buying. They would likely have discussed this problem of needing to lighten up after a 30% pop at the time they initially had built their big position. Then perhaps somebody in the room would have said "Look, if we're going to settle for a 50% gain on the incremental invested dollar, why not put the money into something else, given that everything else in the market is getting slaughtered too? That way we can avoid paying out the tax on the realized gain." They did a year or two ago state in the annual letter that they had realized belatedly that they'd like to hold higher quality investments long term for tax benefits. You are probably right, but I guess I will be disappointed a little bit if so.

Their initial 3.5 million share stake in WFC cost them $21.93 per share (that's the price listed in the 2008 annual report). I believe their average cost is in the high teens. From my understanding they were fully bought in before it traded under book value. Average cost is probably in the $17-$18 range. Somebody posted the ORH holdings from the NAIC filing the other day and it looked like there were WFC buys in the $17.50 range. I believe (maybe it was Al) somebody mentioned that (at the annual meeting) the officers claimed to have bought the stock down to $15 but then no more. (stock then fell nearly 50% more)

They held $100m in WFC at $30 at Dec 31st. I hope they have not sold any of it. Buffett's opinion on WFC's earnings power makes it a cheap stock even at 1.5x book.

A 2% chance of blowing up is a 98% chance of survival. The chance of that single company surviving 50 consecutive years is .98^50 = .364. 36.4% isn't great, but it's not quite as fatalistic as you made it sound.

Page 10 of the Crum&Forster 10-k states that, for the past 3 years, earthquake coverage has represented between 5.2% and 6.6% of the total property gross premiums written. http://www.cfins.com/assets/downloads/financial/CFHC-10K-02272009.pdf

I think back in the early 1990s recession Fairfax traded at 65% of book value. That's when they bought back 20+% of the shares. Right now it seems like the shares trade at the same BV discount as last September right before the short selling ban. Except this time the holdco has better cash flow due to the NB takeover. Less hedges though.

I should have stated explicitly, but I was referring to the chart where he simply plots gold price against his theoretical gold model. He says the following: "It is based solely on historical money supply (US dollars) and gold supply data."

He is linking monetary inflation to gold prices. However, in theory we can have continual annual monetary inflation for the rest of eternity without actually pushing up prices of consumer goods (if monetary inflation does not exceed increases in productivity for example). That is something I find very strange. I would expect gold to behave like a real asset (maintain it's real purchasing power) -- but this guy doesn't see it that way. He simply says all that matters is the money supply -- so in theory if an ounce of gold buys a few square feet of house today, it could buy a billion square feet of house at some point far out in the future. Now that doesn't make sense. Monetary inflation does not necessarily lead to price inflation -- except this guy seems to be suggesting it should always push up the price of gold (leading to real price increases of gold as measured by the quantity of goods an ounce of gold can purchase). The argument may be that more dollars chasing a fixed supply of gold, however if there are productivity gains to precisely offset the increase in dollars then it should not be pushing on the price of gold.

And in that same John Mauldin article this quote is important: Also, Lacy pointed out, in a conversation which helped me immensely in writing this letter, that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. You asked how this compares to the 1970s situation -- in the 1970s there wasn't this threat of correction due to mean reversion in velocity. I think this could throw a wrench in the plans of the goldbugs.

Read this article from John Mauldin that will explain velocity to you. The last paragraph that I've quoted suggests that an increase in the money supply is needed to prevent deflation when the velocity of money is slowing. http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2008/12/05/the-velocity-factor.aspx Now, let's introduce the concept of the velocity of money. Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base. So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M. (In last April's discussion of the velocity of money I used "P" instead of "Y". Lacy Hunt tells me the more correct statement of the equation is Y=MV, and I defer to the expert. Sorry for any confusion.) Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4. But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet. Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14. Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000. Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

The Jan 2009 Leaps began selling in June or July 2006 (forget which). From year to year it hasn't been consistent.

Admittedly, I don’t yet know enough about 1921, but as for the others, I could offer good reasons why their lower levels might be understandable. One group (the U.K. and the U.S. in 1974 and the U.S. in 1982) had very high interest rates providing formidable short-term competition with stocks. (In the long term, the Fed Model logic is simply false, but in the short term – up to a year – it does work for behavioral reasons.) These markets also had very high infl ation, which in the short to intermediate term has a compelling explanatory power for P/E ratios. To keep it simple, high inflation rates typically come with lower than average P/Es and vice versa. I added the bold for emphasis. We had a discussion back in March and when I said that the 1982 low had something to do with the high interest rates and high inflation I was accused of thinking in a Fed model (and Grantham's thinking around stocks being real assets was cited as a reason why the P/E shouldn't go down with inflation). Well, Grantham himself addresses this topic in his latest letter. So anyways, he too thinks that investors took the high interest rates and inflation into account when they pushed the P/E down on the market. Grantham doesn't say it needs to be that way or anything like that, but he acknowledges that it gives investors an alternative with high yield to earn while on the sidelines (one of my points), and that high inflation rates typically come with lower P/E ratios (perhaps because people want to feel like their earnings yield is at least as high as the going rate of inflation). It's just funny that here we were talking about this very thing, and then Grantham writes about it in the same quarter.

Thanks.

Well, I would say that if we are going to get into the business of discussing quantitative easing I think we also need to discuss a decline in the velocity of money. This famous citation of Milton Friedman goes something like this "Inflation is always and everywhere a monetary phenomenon". But I saw (forget where) a criticism of Friedman that said in essence that Friedman based his reasearch on a 30 yr period of time where velocity of money was relatively stable. So perhaps his finding just isn't relevant to a falling velocity environment where quantitative easing may merely offset a fall of velocity (or perhaps fail to fully offset it!). I'm not a knowledgable economist so I am of limited value in that kind of discussion. I think that if we are talking about real stores of value we ought to simply plot where gold is today vs where real prices are today and leave the forecasting of where inflation is headed to somebody else. Paying a real dollar premium for anticipated inflation doesn't seem wise if you want to recover 100% of your purchasing power.

The terminal points change everything. My motiviation in discussing the real price volatility of gold is to ensure that people understand this before thinking that they can put money into gold as a store of value until an anticipated inflation storm passes. One day that person will want to switch out of gold and perhaps the price will only be 1/2 of where it is today in real dollar terms, similar to what we saw earlier this decade. That's what has me thinking about whether TIPS make more sense than gold for store of value. You might not get CPI computed precisely, but on the other hand you aren't taking the price volatility risk. The government marks up the value of the TIPS annually at the pace of inflation, but you get taxed on that as a "gain" (and you have to pay the tax each year, even if you don't sell your holding). So with a 10% rate of CPI gain, you'll wind up with only a gain of 6.5% (at a 35% tax bracket). The tax on TIPS is a reward to the government for driving up the CPI -- I think it is flawed. Okay. I follow you now. Understand that I'm not a gold bug, I was merely trying to see if there was any validity to Parsads suggestion that that article may be a precursor to a bubble in gold prices. I'm a fan of using psychology, human nature, to anticipate things, but I feel harder data is important too. I thought Parsad may have been unintentionally misleading by putting the cart before the horse. I, it appears mistakenly, assumed that long run inflation was in line with long run gold prices, and that if something merely moved up with inflation, then how could we suspect bubble? Anyway, I understand you to be a math wiz and I was typing on my iphone last night so I may not have asked my question fully, but can you equate for us the home price in gold example you give using the peak price of gold, whenever that occured, during the 1970s or 1980s? I think the gold price was 800 something as you are probably aware, but I don't know what home prices to use? As your reply suggest this breaks down depending on your starting date. Without one key number, I have to assume that home prices were lower in the 70s and 80s than at the peak of the bubble and now. That the average price of gold, now and then, may have been roughly the same which would mean more house in gold then versus now. Am I thinking about that correctly? For others who care: As I keep saying, I'm not a gold bug and I'm not trying to defend gold or its price. I believe, like Seth Klarman, that an investment should produce annual cash flows in contrast to a speculation which doesn't. Yours Jack River I don't think you are mistaken to believe that gold largely tracks inflation over the very long term. But it doesn't get there in a straight line. There are some nice charts here on the historical price of gold: http://www.finfacts.ie/Private/curency/goldmarketprice.htm You would have paid roughly $19 for gold in 1800 and might have sold it for: a gain of 57% in 1970 (170 year holding period) a gain of 4,300% in 1980 (180 year holding period) a gain of 1,400% in 2001 (201 year holding period) a gain of 4,900% in 2009 (208 year holding period). Curiously, you drew the conclusion that house prices long term track inflation, but after a 6 year spike you concluded that it was a bubble. But gold also tracks long term inflation, the 6 year price volatility has been far more extreme than with housing, but you seem skeptical of a bubble. Both asset classes largely track inflation over the long term. I just find it interesting that you found a bubble in the one that has seen a far less extreme upward price swing. I think you are right to identify housing as a bubble, but is the reason why you shy away from gold as a bubble perhaps influenced by the higher volatility in real gold prices?