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Fairfax Letter March 2014


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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.

 

 

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I appreciate Prem's enthusiasm!  While it's not a big thing, someone might want to kindly mention to him that less is often more when it comes to exclamation marks.

 

What do you mean, sir!!!!! 

 

I think he got that from me.  If he starts ending every paragraph with "cheers", then you can definitely blame me!!!!  Ooops!!  My bad!!!  Cheers!!!

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"At the end of 2013, we had approximately $734 per share in float. Together with our book value of $339 per share and $100 per share in net debt, you have approximately $1,173 in investments per share working for your long term benefit – about 9% lower than at the end of 2012."

 

IF Fairfax can earn 5% on investments per share going forward and you pay today's price of $430/share, the implied return is 13.6%..

 

 

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Thanks for posting the letter.

 

"Given our concern about financial markets and the excellent returns we achieved on our long term investments, we reluctantly decided to sell our long term holdings of Wells Fargo (a gain of 125%), Johnson & Johnson (a gain of 47%) and U.S. Bancorp (a gain of 135%)."

 

Wow. Didn't they say a couple years ago that these were core long-term holdings? Maybe I'm misremembering, I'll have to dig that up after I'm done. Still, I was surprised that they sold it all, especially Wells, a Buffett favorite.

 

Not necessarily bad if they redeploy the capital in even better things, but it's still surprising to me.

 

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The tone of this letter is the opposite of the cheery optimism Berkshire/ Warren Buffett have- is it conceivable that both could have excellent results? 

 

Watsa and Fairfax have a deep value approach that would make them sell at "fair value" , very different from Buffett's hold forever philosophy. They also buy very different companies .

 

PW was very bullish on how JNJ in the 2012 letter

 

"If P/E ratios revert back to their mean, shares of companies like Johnson & Johnson can provide compound

growth rates of 20%+ in the next decade"-  PE ratios arguably overcorrected- wonder if that caused them to sell these names

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Little surprised they kept 2/3 of bank of ireland and let The US banks go !

 

 

Thanks for posting the letter.

 

"Given our concern about financial markets and the excellent returns we achieved on our long term investments, we reluctantly decided to sell our long term holdings of Wells Fargo (a gain of 125%), Johnson & Johnson (a gain of 47%) and U.S. Bancorp (a gain of 135%)."

 

Wow. Didn't they say a couple years ago that these were core long-term holdings? Maybe I'm misremembering, I'll have to dig that up after I'm done. Still, I was surprised that they sold it all, especially Wells, a Buffett favorite.

 

Not necessarily bad if they redeploy the capital in even better things, but it's still surprising to me.

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It is a good letter but I still feel they have not given up on the macro the market is going to fall hypothesis.  So where are we with the grand disconnect hypothesis.  The economy is getting better with unemployment below 6.7% in the US and rising real estate prices in major metro markets of the US.  I guess the disconnect is in GDP growth but what do you expect of the aircraft carrier US.  The actual investment in capital equipment has been reduced to match demand but the benefits of increasing productivity in sales and distribution continues.  These increases in productivity have led to unemployment and a pool of folks with a skills mismatch.  Part of the mismatch is the education industries customers having access to cheap funds with no underwriting standards (including expensive education in fields with very few jobs).  I think students and parents are getting it with price and the willingness and interest of the students to be there being a major factor in the education decision. 

 

The other factor that led to the 2008 decline was leverage in the household and private sectors.  The levels toady are much lower today.  The government sector has taken on more debt but since they control the currency and can be spender of last resort I do no have a problem with this.  I think part of the long term solution is debasement of the dollar which will be seen a modest inflation in an what would normally be a deflationary scenario.

 

The only exit to date from these hedges have been realized losses.  If they were to exit today the losses would $1.6 billion more than $75.5 per share the cumulative gains to date.  This also includes the gain from a once in a century adverse event.  I do not see FFH predicting this today (expect maybe in China) so where are the gains going to come from?  I could see if they were short the Chinese equity/property market but they are short a remotely correlated market at best (the US equity market).   

 

If they want to remove risk why don't they reduce their debt rather than hedging the both the market and any potential inflation away.  I think they should remove the rest of them today before they continue to generate losses as they sell equities.  If the modest inflation scenario plays out the losses will continue as the large decline never materializes.

 

Packer

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Packer,

As they keep selling stocks, also their equity hedges keep declining… So, what you are suggesting is in fact automatically happening!

The problem is: when to aggressively invest in equities again?

Here macro imo has very little to do… You might agree with how the Shiller P/E is calculated, or you might disagree… It doesn’t really matter: as long as it keeps getting higher and higher, the disconnect between PRICES and VALUES will get larger and larger. If they think it is already too large, they will need to see a contraction in that metric (or other metrics, like P/S, Market Cap/GDP, the Q Ratio), to move again into equities aggressively.

Please note that the larger the capital you manage becomes the more you are affected by “the tide”, or by what the general market does. I don’t know how your portfolio would behave, if the general market were to correct heavily… Maybe, it would keep increasing in value nonetheless… But you know very well your portfolio is not FFH’s: they need to invest in relatively large companies to move the needle, and large companies which are deeply undervalued today are very hard to find. And large companies that in a serious market correction would behave uncorrelated to the general market are even harder to find.

 

Gio

 

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Packer

I believe they are betting on this one in a hundred event happening where we see deflation in Europe and China bubble burst. I can agree with him on China. I'm not sure how to look at Europe... But Prem is expecting what had happened to Japan to happen in Europe.  Now if these two does happen, then it would affect the US. The added risk here is also that after the Great Recession, there appears to be no more tools in the box for the governments around the world to deal with all this.  So this could be a big and sustained decline.

 

I think for some of us that risk might be tolerable. But harder for Prem / Fairfax. The bottom line is how likely will all of this unfold , and when.

 

The one thing I never really understood is if the QE has been helping the US or everybody ... Even economies in Europe and Asia. I mean the US is pumping money into the uS economy. But are there boarders as to how the money flows? I would imagine money flows more easily today than many decades ago when previous recessions happened.

 

 

It is a good letter but I still feel they have not given up on the macro the market is going to fall hypothesis.  So where are we with the grand disconnect hypothesis.  The economy is getting better with unemployment below 6.7% in the US and rising real estate prices in major metro markets of the US.  I guess the disconnect is in GDP growth but what do you expect of the aircraft carrier US.  The actual investment in capital equipment has been reduced to match demand but the benefits of increasing productivity in sales and distribution continues.  These increases in productivity have led to unemployment and a pool of folks with a skills mismatch.  Part of the mismatch is the education industries customers having access to cheap funds with no underwriting standards (including expensive education in fields with very few jobs).  I think students and parents are getting it with price and the willingness and interest of the students to be there being a major factor in the education decision. 

 

The other factor that led to the 2008 decline was leverage in the household and private sectors.  The levels toady are much lower today.  The government sector has taken on more debt but since they control the currency and can be spender of last resort I do no have a problem with this.  I think part of the long term solution is debasement of the dollar which will be seen a modest inflation in an what would normally be a deflationary scenario.

 

The only exit to date from these hedges have been realized losses.  If they were to exit today the losses would $1.6 billion more than $75.5 per share the cumulative gains to date.  This also includes the gain from a once in a century adverse event.  I do not see FFH predicting this today (expect maybe in China) so where are the gains going to come from?  I could see if they were short the Chinese equity/property market but they are short a remotely correlated market at best (the US equity market).   

 

If they want to remove risk why don't they reduce their debt rather than hedging the both the market and any potential inflation away.  I think they should remove the rest of them today before they continue to generate losses as they sell equities.  If the modest inflation scenario plays out the losses will continue as the large decline never materializes.

 

Packer

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I have been wondering how they would get out of the hedges, as the markets and economies continue to improve, and they continue to show ever-increasing losses.  Time is not on the side of the short seller.  I guess the answer is that they'll continue to sell stocks and an associated portion of the hedge, so the whole thing will unwind over time.  It is really a shame to lose so many gains, from what is probably a once in a lifetime market recovery.

 

Like others I completely don't understand the hedges.  To call them a hedge is a bit of a misnomer, they are really a strong bet against the markets.  If they had just wanted to be cautious, they could have held cash or decreased their overall leverage.  Holding excess cash at a time of market declines offers an opportunity to profit. But they went a step further and put on the "hedges".  Holding excess cash you miss out on gains if the market goes up, but holding hedges, you experience losses.

 

There may be some overvaluation in parts of the markets and some financial institutions are probably to some extent propped up by the Fed policies. But the economy is also clearly improving, slowly, across the board, and perhaps more importantly the "go-go" attitude that led to the crisis is absent.  I could see betting against a certain sector of the market or betting on volatility but betting against the broad markets at this juncture just seems nuts to me.

 

The rationale and execution of betting against the credit default swaps and profiting from the downturn was absolutely brilliant, but I wonder if this success unduly affected their thinking about such events.  That may have been a once in a lifetime event.  It would be a shame for them to give back those gains over subsequent years hoping to catch lightning in a bottle twice.

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I think the weakness in the Europe/China breakdown is why won't they debase like the US?  Let the Euro and Yuan fall like a rock along with the US by printing and allowing inflation.  The alternative of Japan is always out there to prevent tight monetary policy.  What this means in my mind is monetary inflation offset by labor and goods deflation.  Which is the scenario where FFH will underperform the worse.  My big question is why are they doing this when the don't have to.  If you have an insight on security or market segment (CDS) then you can make a bet with variables you can get comfortable understanding but when you get to the whole stock market your into way too many variables.  It appears FFH is stepping out of there circle of competence (and everybody elses too look at Ray Dalio's 2013 returns for example).  If they are using this as a hedge, I would think they would get rid of their debt first, no?

 

Packer 

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I find the below notable:

 

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.

 

 

 

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.

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I find the below notable:

 

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.

 

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, etc.

 

Well, they think this happens anytime the disconnect between PRICES and VALUES becomes too large… It happened in 2000, it happened again in 2008… Twice in less than 10 years.

 

Gio

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I don't think the overvaluation is in the big indexes. spy dia. isn't that where their shorts are? what happened in 2000 is that the crazy stuff came way down and that money went into boring, cheap, solid, dividend paying stuff. And those stocks did exceedingly well for about 3 years before hitting a speed bump.

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I believe they don't want to deleverage because that affects their earning power and hence intrinsic value.

 

The hedges can sit until they realize the gain. So if their time horizon is long ,then it makes sense they want the leverage to build up the intrinsic value and when the time is right get rid of the hedges.  I guess while he sees uncertainty in macros he's also recognizing there are cheap businesses out there to own. For example bank of ireland. And blackberry.

 

 

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what happened in 2000 is that the crazy stuff came way down and that money went into boring, cheap, solid, dividend paying stuff. And those stocks did exceedingly well for about 3 years before hitting a speed bump.

 

Yes! And that’s why the “average” stock is even more expensive today than it was in 2000… Wow!

 

Maybe you don’t think the S&P500 is overvalued today… Yet, its Shiller P/E has to at least stabilize… If it keeps getting higher and higher… I hope you agree with me that sooner or later we will reach the overvaluation threshold. ;)

 

Gio

 

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what happened in 2000 is that the crazy stuff came way down and that money went into boring, cheap, solid, dividend paying stuff. And those stocks did exceedingly well for about 3 years before hitting a speed bump.

 

Yes! And that’s why the “average” stock is even more expensive today than it was in 2000… Wow!

 

Maybe you don’t think the S&P500 is overvalued today… Yet, its Shiller P/E has to at least stabilize… If it keeps getting higher and higher… I hope you agree with me that sooner or later we will reach the overvaluation threshold. ;)

 

Gio

 

not sure I agree. the spy hit 1500 in early 2000, and that was 14 years ago. It's 1880 now. So I think the indexes were valued way higher back then. I see the typical stock cheaper now, although not absolutely cheap. To me the market today is kind of "mini" version of 1998-2000. valuations of crazy stuff not as rich as late 90s. indexes not as rich. average stock not as rich. not as many ipos. But we are certainly headed in that direction of overvaluation. But still there are places to hide out, as I mentioned earlier.

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