TwoCitiesCapital

Fairfax would already be well north of $1,000 if their underwriting/run off/ asbestos/environmental claim/ blackberry/ hedges/ aquisitions/ exchange rateinvesting results over the last 7 or so years wasn't so awful. I think this is slightly disingenuous. 1) Fairfax has done a great deal to improve and expand its insurance operations. The next hard market will certainly show how much money these guys can generate and you certainly can't blame them for the market conditions or underwriting less. 2) they certainly lost alot of money on their initial investments in BlackBerry, but the recent ones have been brilliant. They've moved higher up the capital structure, receive a 6% coupon, and have an option for 10% of the company that is already far in the money. They're near, or above, break even and Blackberry probably wont be the tragedy many thought it would be for Fairfax. The amount they've made in.similar distressed investments (Bank of Ireland) mite than covers the potential losses here. 3) they've lost tons of money hedging but they've clearly articulated their strategy and most knew this was a possible outcome. At this point, I'd rather them stay hedged with the U.S. market historically expensive. Also, the deflation hedges have years of life left on them and the CPI strike prices have adjusted upwards and Europe still has low growth and zero rates. Spain could borrow for 10 years for less than the U.S could last week. That sounds like a continent on the brink of deflation if you ask me. You can't call this a failure until they expire as it was clear that Prem recognized it could take a decade to be "right." I've only owned FFH since 2010, but I've been very happy with the results so far. I'm surprised it has even gone up as much as it has given all of this was known at the time I invested and the anchors of low rates, hedges, and a soft market have persisted. It's all about expectations and nobody should have expected massive gains barring a market collapse.

I'd be more convinced if the article went into detail about the lack of hedges or why they will be ineffective. It's not enough to say that he's writing insurance and leveraging up without putting the amount of leverage or hedging into context. If he's putting the premiums in interest rate calls, floating rate notes, and etc then I'm not so certain that this would end badly. I would want more clarity on this if I was an investor in his funds though. On a side note, this new normal environment sounds like an environment that is always on the brink - slow growth and low interest rates set the stage for higher inflation or deflation depending on the policy response. Clearly Gross doesn't think there will be inflation but PIMCO was also one of the counterparties for Fairfax's deflation derivatives. Seems like Pimco might even get hurt on the deflationary side of things despite being a bond fund. The sweet spot for Gross is staying right in the middle where we are, but I think that's alot to ask for another 3-5 years

In one of his books, James Montier references research as to the time frame of out performance. A basket of value stocks generally outperformed the markets but the biggest piece of the performance comes in years 3-5 from when it became undervalued. The median holding period for value managers was also found to be somewhere between 4-5 years. It seems that somewhere around 3-5 is the sweetspot for relative out performance. Application wise, if it hasn't done much by year 3 or 4 it might be time to call it quits. If it has, holding another year or two may not be a bad idea.

Zach, I agree that BBRY's impact isn't so large as to cause a major impact on FFH's valuation. However, I think your valuation of the converts may need some refinement. The call option embedded in the convert went from $2 out of the money to in the money during the quarter. This is surely worth more than 12 million on a $500 million par value convert with a 6% coupon and $10 conversion price. I have no idea what the value of the converts was prior to the run. My assumption was that they'd be valued near par (maybe even above given the yield) if the option isn't in the money and on the value of the underlying and capitalized 6% yield once it is. I'm sure it's not quite as simple as that but the gain from the converts won't mimic the gain in the stock unless if the stock is trading above the conversion price. Regardless if how much the gain was, impact to FFH is snall which was the point.

I think you're over estimating the impact this will have on Fairfax. It was a very good quarter for BBRY. Fairfax 46M shares would have resulted in a profit around 100M for the quarter. Their 500M in convertibles would've registered income/gains of around 12M in the quarter. $112M is less than 1 percent of Fairfax's market cap. This is what Prem was talking about when he was downplaying the results of BBRY in FFHs investment portfolio when it was doing poorly. Even if it went to $20 we'd only see a 10% return on today's current price.

Just curious who your admin is...so I have a reference point in a few years if I go this route.

I wonder why Bruce sold on That day. Am I reading this right? He sold on a huge down day? Is it possible he got lucky? With such large transactions I can sear the counterparties agreeing to terms and fixing dates etc in advance. Maybe it just happened to coincide with the major down day.

The WSJ article also mentioned a private equity component. You won't see that listed either. It's possible, that like other value managers, he is finding fewer opportunities and has moved more to cash/alternatives that don't need to be reported.

I get different figures 4000(1.1)^10 = 10375 in year 10 earnings or about $22.28 per share in earnings Placing an arbitary multiple of 15x on this figure yields a price per share near $335 in year 10. Since this is the expected future value in year 10 then you would need to discount this back at a suitable rate to determine the price today. Depending on the rate you choose, the value will be different. The rate will be determined by your assessment of other investment opportunities and the risk involved in this one.

Yes...but no one compares their current position to that of their grandparent's 100 years ago. It's more likely that they compare it to their situation over past decade and it's not better for most in that frame of time. In fact, real wages have been falling for most people over that time and they've been burned by two 50% drops in the stock market and a severe drop in home prices. I'm not saying that this is the fault of the rich, but when the majority of the population is worse off then they were a decade ago, and a handful of elites are significantly better off than a decade ago, you can be damn sure the wealthy will be vilified and taxed until something evens the odds again. It's quite funny how the ignorance of the masses works. I live in NYC and watched the Occupy Wall Street movement back in the day. I liked how the whole 1% framework came about and they'd protest the houses of bank CEOs like Dimon...but successful hedge fund managers make bank CEOs look middle class. Anybody taking home $500M-$1B a year makes Jamie Dimon look like a punk. If you're after income/wealth inequality, it's the hedge fund managers they should've been protesting and it's the hedge fund managers of the world that skew this wealth/income strata so heavily to the 1/10th of 1 percent. Anyhow, you can be sure something will eventually get done. Politicians work for the fat cats but you can be sure that they're self-preserving as well. They'll tax the hell out of the wealthy before they let the masses remove them from their positions.

It has been a very good year indeed. If the market trend remains the same, we could very likely see 200M in gains from the equity hedges in Q2. That would be a nice tailwind. Despite valuations becoming more rich, I can't bring myself to sell because I really like the fortress and downside insurance policy that Fairfax has become in my portfolio. I'm very aware that it's price will also drop in a market route (most likely); however, I'm also aware that if I know they're printing billions in dollars despite that then I'm far more comfortable holding on and adding to it if that happens. That's much better than most businesses whose short/medium term prospects decline as well (just not as much as their share price). Also, I have no ability to predict bond markets but I'll say this: 1) Over the last 6 years, yields have fallen when the Fed wasn't buying and have risen when they were. The exact opposite of what one would traditionally expect. The Fed is tapering and thus far bonds have followed suit with yields falling from 3+% down to 2.6% on the 10 year. My guess is that buying bonds with printed money is intended to be inflationary (rising yields) and not buying them is deflationary (falling yields). Certainly fits the pattern. 2) I am far more tempered in my opinion of the likelihood of deflation then I used to be (being wrong for 4 years will do that), but I will say this: unprecedented levels of debt facing individuals, corporations, and governments is hugely deflationary in the wake of any economic downturn. I would think that there is very definitely the possibility of yields taking out 1.4% again if we hit a rough patch. I think it will take a lot to break this multi-decade downward trend in rates. 3) Having $100B in deflation insurance across Europe and the United States is incredible protection to have in this environment. Especially since strikes were reset higher and more protection was bought cheaper and we still have over 7 years of life left in them. $100B in notional would result in a huge windfall for Fairfax in the event of troubled times. The contracts would pay for themselves with just 0.75% deflationary print across their geographical coverage. I like this "low" bar. The bulk of this coverage is the EU area where the rules for QE and monetary policy aren't quite clear and Draghi has his hands somewhat tied. IF deflation were to occur, this would be massive for FFH - potentially providing them with billions in liquidity at a down point in the market. This could literally define their average returns for the next decade if they're right about this. Knowing that I have something in my portfolio that will mint money in the event of a severe downturn makes it a lot easier for me to be aggressive in other areas without worrying.

Great post to get us bulls to consider the flip side of the argument. You've connected some dots that I failed to connect myself and make a compelling case. I have one nitpicky piece of feedback: When discussing U.S. debt/GDP you show a graph of the leverage of government debt to GDP. This seems reasonable but I believe it's incorrect. I don't have proof on hand but I'm pretty sure Prem was referencing total debt (private, corporate, and public). The picture is a lot different when you consider all three. Also, I haven't run the numbers myself, but are the calculations if actual book value growth inclusive of the CDX bets that Watsa typically excludes? If so, I believe this should be reevaluated. Thanks for the thoughts

I've been thinking about Russia's chronic P/E problem and have begun to wonder if it really matters as long as the stocks maintain high dividends. You have the opportunity to buy a stock that trades at 100 and pays a dividend of 10. Assuming no growth we can consider two scenarios over a 15 year holding period. 1) the stock doubles and dividend proceeds are reinvested 2) the stock remains at the same price and proceeds are reinvested. Does it surprise you that investors actually stand to make more in scenario two? I guess my point is that the ability to reinvest at chronically depressed prices is a boon for investors over the long term. Obviously you could make the argument that once it doubles you could sell and invest in something else that subsequently doubles, but there's no guarantee those opportunities will be around or revalue quickly. I don't think chronic discounts are a bad thing. Rather, you can invest in them and reinvest the dividends in the chronically undervalued security when you have difficulty finding better opportunities and then reinvest the dividends in other companies once you think you've found a quality double. These are simply a vehicle that allow you to compound the free cash flow coming into your portfolio each quarter rather than compounding capital gains. You wouldn't ever need to hold much cash if you knew you could reliably have a portfolio that would yield 10% in cash each year. Am I wrong to think this way? It almost seems like the same reason Gio likes Lancashire. It replenishes his cash.

For those who are complaining against HFT for fear your orders won't be filled, I have bad news for you...that's the market. It's not illegal for someone to pay more than you to buy or receive less than you to sell resulting in your unfilled order. The problem with HFT, as I see it, is the following: 1) Data firms, like Reuters, have previously did subscriptions to HFT firms to receive releases seconds beefier the public allowing them to immediately trade upon market moving information prior to its public release and 2) many of these companies are just glorified momentum traders that provide a false sense of market depth/liquidity that disappears in bad times. If you think stock A trades so many shares a day and is this large and liquid enough to build a large position in, you may be surprised and negatively affected when 60% of that volume disappears and volatility spikes during a bear market. 3) I'm pretty sure the banks have found even more lucrative ways to disadvantage clients and each other that are beyond my understanding. There's no other way they'd be paying the fees they're willing to pay for access to these HFT lines

Does Klarman need to become more like Buffett? What about a Schloss? Should he have been more like Buffett too? I'm really surprised by these kind of comments. Prem has a phenomenal track record using a more Graham-esque type approach with occasional macro hedging. Why would we want him to change that? There's nothing to suggest he'd be better at employing a Buffett like approach. Paying up for quality like Buffet does requires exceptional business acumen and a deep understanding of multiple businesses/industries to understand where the earnings picture is going. I'm not saying doesn't have this ability, but it's not just a switch you can flip on and become less Graham and more Buffett. Prem has been extremely successful with his approach. Let's leave the man to it.

Didn't take the time to read all 8 pages, and I'm sure the point has already been made, but I felt compelled to answer just in case it hadn't. To assess if we're doing any good you have to ask yourself what service you're providing if that could be deemed as good. Intelligent investors in general provide for more efficient markets. Efficient markets should move capital to companies/individuals who provide a good return on that capital by providing services of value to society. Without relatively efficient capital markets, it'd be hard for companies look Google and Walmart and others to positively impact the lives of the millions (or billions) that they affect over the course of a life time. You may not individually provide for this, but by being an intelligent investor, you become part of a system that makes this possible. Otherwise, companies like Google and Walmart would have to rely on money that they were able to raise privately which probably wouldn't have been nearly enough for them to have generated the scale that they've achieved.

I am starting to do some digging on Gundlach and I wouldn't say he is doing macro. Since the credit crisis he has an almost barbellish portfolio that mixes non agencies (credit sensitive) and agencies (non credit sensitive), which can offset inflation and deflation scenarios. He also says he doesn't try to predict rates. Although, I think he will occasionally add an inverse IO or support bond if he thinks rates/prepayments have over shot and they offer good relative value. I am trying to look for a good HY fund (I'm thinking closed end to avoid redemption issues) to invest in for the next inevitable down cycle. I like Gundlach a lot. I had a large piece of my portfolio in DBLTX not too long ago and it did 10% with minimal volatility the first year. Was nearly flat for me through June 2013ish when I switched into his CHEfs that were then trading at 7-10% discounts with 7-8% yields. Those have done well too. DSL still has a 5% discount and a fat yields but is certainly more volatile. DBLTX does follow a barbell strategy. I haven't tried to dissect DSL strategy too much but I know a large chunk of it is dollar denominated foreign high yield and that its 40% leveraged.

Hi guys - I'm hoping to tag along here instead of starting another thread. I've looked at real estate in the past in wasn't able to get financing for extremely attractive properties back in 2010 (-unfortunately). However, my circumstances have changed over the years and I have a lot more money to work with, friends with money to work with, and 4 years of additional recovery that will hopefully allow banks to actually lend to credit worthy people. Anyhow, since I'm considering this again, I'm looking for advice on how many of you have structured the legal entity. I had an LLC registered before but just did that mostly for tax benefits (pass through taxes at my low rate as opposed to corporate rates). Can you guys tell me the positives/negatives of doing an LLC, LP, C Corp, etc. from your knowledge and experience?

To your question #1, the value to shareholders would still be dependent on some sort of unwind of the sweep amendment from 2012, without which it will be really hard to have any recovery. But assuming that happens, shareholders would probably still have plenty of value even if this reform is executed. If you unwind the sweep and revert to the 10% dividend, Fannie's got a total capital stack (remaining gov't prefs + market prefs + equity market cap) of something like 70bn, and is earning perhaps 20bn/year in NIM and fees on its existing portfolio (which would be in full runoff if this reform is implemented). Depending on the speed of runoff and on credit losses, you could have plenty of value in the common. To your #2, it's not clear to me that this is so stupid for the average Joe. Yes, he will perhaps pay more for his mortgage (maybe marginally so... if the last 90% is government guaranteed, the private capital first 10% can be pretty expensive and still produce a cheap result overall). But he's also paying taxes, and those taxes were (in the end very visibly) subsidizing risk-taking on behalf of Fannie's private shareholders. I also doubt the 30-year mortgage will disappear; the primary risk Fannie and Freddie reduce is the credit risk in mortgages which is generally not too much higher in a 30-year fixed structure than in other structure. I'd expect it would be moderately more expensive, as would almost all other conforming mortgages. Fannie Mae and Freddie Mac also package the mortgages into securities and sell/service them. Unless private market issuance really steps up, the liquidity in this market would largely be removed. If banks can't sell mortgages to be securitized they'll be less likely to accept the interest rate risk of a 30Y mortgage. Even if private issuers step in, they can't access capital as cheaply and would still result in more expensive products (i.e. higher 30Y mortgage rates). Also, tax payers could ensure their money wasn't at risk by refusing to elect politicians who support these mass bail outs or demand higher capital ratios with the government's implicit backstop. Neither of these options require getting rid of the 30 Y.

I don't have a position in these but have been trying to follow the events: 1) Can anyone briefly describe why it's unlikely that the current proposal by the Senate Banking Committee won't be executed on or why shareholders would be left with anything if it is? It certainly seems easier to use Fannie and Freddie as opposed to hoping that private capital will step up as they're already in existence and have established themselves within a mutli trillion dollar market; however, there certainly seems to be political will to kill them. Even the average Joe, who is most likely to be hurt by losing the 30 year mortgage, doesn't seem to understand this implication and is generally behind the idea of dismantling them. How do you discount idiocy?

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.

No, using today's earnings levels the market is not high at all. 15x forward earnings is completely normal. It's not 30%-50% overvalued unless you consider/believe that margins are abnormally high today. Using the Shiller P/E or Tobins Q suggests 30-50% overvaluation BEFORE considering that margins are above historical levels. You're using one year's earnings in a time when labor is slack and interest rates are low supporting historically high margins and high multiples. The beauty of Shiller's figure is hat it is intended to take the average over the cycle...not simply at its peak. Any long term indicator suggest that we are largely overvalued at this point. It's not an opinion that margins are high. It's a mathematical fact. Margins have traditionally reverted and have traditionally been lower than they are today. The questions isn't are margins elevated. The only question is when they will revert. 1 year? 5 years? It's really anyone's guess but I don't really think its up for debate about how richly valued the market is. It's really more of a question on how much more richly valued it could get and how long it will take to revert. The numbers simply don't lie. The simple answer is this: all investments are in competition with one another. If bond rates are low, people will bid up stocks until future stock returns are low too. We're in an environment with high stock multiples that were driven up by low interest rates. This would be fine if interest remain at 2.5% forever, or go lower, but we all know they'll have to rise at some point. No one really knows when that is but it will eventually happen and multiples will have to compress so the forward expected returns on stocks is comparable relative to the rising rate of forward returns in bonds. Compounded on this fact is that you have multiple potential causes for large, global economic shocks AND margins that are historically above average where reversion zone could lead to 20-30% declines. So to summarize: 1) historically expensive market with no clear driver of future multiple expansion 2) several mean reverting statistics that are above trend (multiples, margins, bond prices ) 3) potential of several large economic shocks that could quickly affect markets Against all of this you simply have the hope that people will continue paying higher and higher prices and multiples. Earnings aren't growing at 5-10% a year and the market returns can not continue to outpace earnings like they have done. It's not impossible to make money going forward, but I think that any reasonable person who knows math and history can see that returns will likely be disappointing going forward.

Totally agree with you about Risk. I'm not telling people to hoard guns, food, and gold and pull all money out of markets. There is always risks to investing and that shouldn't stop you from investing. It's not stopping me and it's not stopping Fairfax. We're both simply being more conservative then we would generally be due to higher perceived risk. I see more risk in markets today because prices are significantly higher, debts are significantly higher, and economies are less robust in their ability to respond to crisis. On top of this, it doesn't even have to be a crisis in the America that causes an American market drop. Just look to 2011 how escalation in the European crisis dropped U.S. markets by 20%. Secondly, I do NOT feel better about the government holding the debt. This only distances those who pay for it from the cost of supplying it. This is essentially begging for there to be greater amounts of malinvestment without prudent management - the government hasn't prudently managed its budget at any point in recent history. 30% overvalued means 23% decline back to fair value. 50% overvalued means 33% decline back to fair value. However if you can expect a 7% return if you were to purchase the index for fair value, then over the course of one year going forward you can expect the following range of losses: 17.7% loss over one year if market is 30% overvalued today and it declines to fair value (and you make 7% return on fair value) 28.7% loss over one year if market is 50% overvalued today and it declines to fair value (and you make 7% return on fair value) So you would be expecting a loss of somewhere between 17.7% to 28.7% over the course of the next year if the markets are 30% to 50% overvalued today and they merely decline to fair value. It's interesting to calculate this out -- 30%-50% sounds a lot scarier than 17.7% to 28.7%. But I think I got the math right. I think we are both reasonable enough to recognize that declines generally overshoot and don't stop once they reach averages. Plus, a lot of those figures are based off of averages inclusive of today's earnings, margins, financial asset values, etc. etc. etc. In a declining market, margins will fall, asset values will fall, and multiples will fall. A 30% overvaluation using today's figures could easily lead to a 30-50% in equity indices using newly reduced inputs to get to a present "fair value".

ok. but this tends to happen every 30 or 40 years. And it just happened 5 years ago. So is that a wise bet? I see a two tiered market. I see massive overvaluation in a growing number of "hope and change" type companies. And I see reasonable valuation in many good companies like msft, apple, qcom, aig, lots of small financials, etc. It's funny that these once in 30-40 year events actually seem to happen way more regularly than that... As Gio pointed out, 2000 there was a 50% decline due to the tech bubble. 2008 there was a 50% decline due to the housing bubble/over leveraged financial system. By most historical measures (Shiller P/E, Tobin's Q, historical margins and current P/Es, etc), we are anywhere between 30-50% overvalued. Whose to say in 2018 there won't be a Chinese property crisis since there are literally multiple empty cities and credit has continued to expand.... Or an escalation of Europe's problems as at the end of 2011...but without the quick resolution since the main tool proposed then has since been determined illegal. Did you know that interest rates doubled in Spain, Ireland, and Greece in a matter of weeks during this period? We are literally a matter of weeks away from these countries bleeding if rates shoot to 10% for any significant period of time. Or anothe recession in the U.S.? Or a contagion from worsening conditions in emerging markets? My point is, a crisis may or may not come. But there is a serious amount of risk in the system with unprecedented debt levels at the global level, unprecedented connectedness within the global financial system, an obvious capital spending bubble and debt bubble in China, Europe/U.S. constantly on the brink of 0 growth/recession, and unprecedented levels of speculative liquidity driven by central bank injections. Maybe we fly though all of this without a scratch on us. Maybe we crash and the results are devastating. Just because you made it to your destination safely doesn't mean it was stupid to wear your seatbelt. I'm just glad Fairfax is wearing their seatbelt and driving slowly. Nobody is forcing people to buy the stock. If you don't like the current state of the hedges, don't buy it until they take them off.

I find the below notable: 1) Insurance and investment income was 563M pretax in a mediocre environment (insurance market not particularly hard and interest rates relatively low). Keep in mind that the insurance end could double capacity. Insurance is going to be a much bigger piece of this company (even without hedges) and its very good progress to see these companies growing and becoming profitable 2) totally digging the increase in deflation hedges. I know this is a point of contentionon this board, and the hedges are unpopular, but this is precisely what makes my portfolio robust and anti fragile. Imagine if equity markets fell by 50-70% and Fairfax has billions in cash when it happens. the whole global QE, the moral hazard of bailouts, unprecedented amounts of debt, and the interconnectedness of the global financial system make me uneasy. Debts are generally being refinanced at lower rates which generally allows for, and encourages, more borrowing delaying the day of judgement. That just means when it does come it's that much bigger. Maybe there won't be a crisis and everybody gets along and manages massive loads of debt forever...but I guess I just don't have that much faith in people...and for good reason! I've lived my entire life surrounded by them! 3) I know it's pointless to say "what if", but had they not been hedged, they would have earned nearly $2B on a $9 billion market cap. I'm ok with those types of returns (and larger) once the generalized hedging ends. This is just a way for us to see the true earnings power that the company is capable of.