Fairfax Letter March 2014

[giofranchi]

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.

 

Well… maybe!

Anyway, the question remains the same: when will FFH invest aggressively in stocks again?

And my answer is: when they will see that those metrics, which compare PRICES to VALUES for the general market (be it the Dow, the S&P, or the Russell), at least stabilize.

As long as they keep getting higher and higher, like they are still doing, I don’t think we will see FFH’s equity portfolio become larger.

 

Gio

 

[plato1976]

I am not sure if you can call qcom as cheap

I never truly understood when qcom 's patent cliff would come, and royalty is responsible for 2/3 of its earning... So it's hard to assign a PE to its current earning.

 

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.

[ERICOPOLY]

To call them a hedge is a bit of a misnomer, they are really a strong bet against the markets. 

 

I see it as a weak bet because if the markets go down their gains from the hedges will be largely offset by their losses on their equities.

 

If they had just wanted to be cautious, they could have held cash or decreased their overall leverage.

 

They had some concentrated investments that would have been difficult to unload in a hurry.  They also had significant capital gains tax consequences to face.  Both problems are avoided by hedging against the index.

 

Besides that, holding cash wouldn't have avoided the opportunity costs -- so it would be no real advantage versus where they stand today.

 

 

Holding excess cash you miss out on gains if the market goes up, but holding hedges, you experience losses.

 

The losses are offset by the gains on the equities they hold.  Cash is no better.

 

[ERICOPOLY]

They closed out JNJ.  For last 4 years, it has been hedged against offsetting Russell 2000.  The offsetting hedge was closed out when JNJ was sold.

 

How did that paired investment do since 2010? 

JNJ  +45.3%

Russell 2000:  +76%

 

It is less bad than this because of dividends, but I think JNJ did not beat the index.

 

WFC is up 61.83%.  Again, it was a loss versus the index.  Perhaps not much of a loss with dividends.

 

USB is up 64.28%.  A loss versus the index.  Dividends would have made it close.

 

Basically, no gains were made here since they began to hedge them in 2010.

 

Interesting though, I would think the gains were largely due to earnings.  Wells Fargo and USB have earned a lot of money over the last four years.  Both companies have grown their per-share earnings by quite a bit.

 

Put it this way, Wells Fargo is only up 61.83% versus 4 years ago.  Is that really a reason to sell today?  The stock was trading around a P/E of 10 4 years ago.  A significant amount of that gain was in the form of retained earnings.  The company is safer than 4 years ago, better loan portfolio, healthier borrowers, more capital.  Stronger per-share earnings, and we're closer to the end of deleveraging.  Yet they sell it anyhow for no gain over that period (erased by the loss they booked on the hedge).

 

[gary17]

Eric

I think we must not underestimate a blow up of china and Europe same time as I noted above - these events could have a lot of impact on US financials, and the governments around the world have very few options left... Interest is already low! And we have been printing money.

 

Of course, Prem will look smart IF these events unfold, 

 

What nobody knows is WHEN

 

 

[ERICOPOLY]

Eric

I think we must not underestimate a blow up of china and Europe same time as I noted above - these events could have a lot of impact on US financials, and the governments around the world have very few options left... Interest is already low! And we have been printing money.

 

Of course, Prem will look smart IF these events unfold, 

 

What nobody knows is WHEN

 

How much lending has US Bancorp done to borrowers in China?

 

I agree that markets will go down, but remember... it was hedged against the market.  So what's the point of selling?

 

The market might unwind back to 2010 level, but these banks very well might not -- there is all that retained earnings since then. 

 

[gary17]

Eric

I think we must not underestimate a blow up of china and Europe same time as I noted above - these events could have a lot of impact on US financials, and the governments around the world have very few options left... Interest is already low! And we have been printing money.

 

Of course, Prem will look smart IF these events unfold, 

 

What nobody knows is WHEN

 

How much lending has US Bancorp done to borrowers in China?

 

I agree that markets will go down, but remember... it was hedged against the market.  So what's the point of selling?

 

The market might unwind back to 2010 level, but these banks very well might not -- there is all that retained earnings since then.

 

I think the question we should be asking is how much lending have US Bancorp, WFC, BAC, etc done to borrowers that have financial ties in China / Europe -  the financial system is so well connected now... the risk today is the "unknown unknowns" --

 

I was reading the other day how the Bank of Japan chief saw no need of intervention - he had one job and probably went to school for very long - and he missed it.  All the experts in the world missed the Great Recession.  Even Buffett has said he didn't see 08 coming so he invested in Moody's.  The greatest minds put the EU together and didn't see the mess they are in now... 

 

I guess that's what Prem is worried about - this 1 in a 100 year event that nobody can fathom. 

 

When the planes hit WTC - nobody thinks it could collapse - my structural prof told me nobody believed it could collapse.  Well - he spent the next 5 years in committees to try and figure out why it did.  And perhaps that's just Prem being cautious - he wants to prevent getting wiped out for something he or others have not been able to foresee...

 

Gary

 

[Packer16]

If Fairfax is worried about those items why don't they short China and European bank indicies?  I am sure investment banks could put together a derivative for them.  The hedge against the US indicies is worse than the Russell hedge against the US securities they hold.  I still don't understand the debt they have on the balance sheet if they are hedging market risk. 

 

Packer

[ERICOPOLY]

I think the question we should be asking is how much lending have US Bancorp, WFC, BAC, etc done to borrowers that have financial ties in China / Europe -  the financial system is so well connected now... the risk today is the "unknown unknowns" --

 

Take a US multinational company that exports to Europe, China, and other emerging markets.  They will lose sales and profits will fall.  Their record margins will contract.  So the index will fall.

 

However as IBM's sales suffer, their profits suffer directly.  But they are still able to pay their bank loans. 

 

Being a relatively less profitable exporter doesn't mean you can't still go on paying interest on your loans.

[beerbaron]

The following are a bit scary:

China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of

more than 50 Manhattans – in just five years!

 

Assuming 25% of China's worker are working in an office that would mean about 10 square meter per worker that has been added. I wish I had 10 square meter for my personal office.

 

BeerBaron

[TwoCitiesCapital]

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.

 

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.

[Packer16]

My question is when was there not a potential crisis?  In the "good ole days" you had the cold war with a nuclear threat that could destroy the world.  Then you had the emerging markets contagion in the 1990s.  The internet bubble, the housing bubble.  When does it end???  You just need to make an assessment is the current situation worse than the past.  I would say at this point no because the leverage in the system is to the gov't.  Look at all the $ the Fed tried to force feed the banks.  Where did it go?  Right back to the Fed as excess reserves so I don't see the leverage in the US at least. 

 

Frankly, I feel better the debt is on the gov't balance sheet versus household and businesses as the gov't can always print there way out of trouble but households and businesses cannot.

 

Packer

[Nnejad]

The following are a bit scary:

China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of

more than 50 Manhattans – in just five years!

 

Assuming 25% of China's worker are working in an office that would mean about 10 square meter per worker that has been added. I wish I had 10 square meter for my personal office.

 

BeerBaron

 

By commercial buildings, doesn't that include retail/industrial?

Still, this is 50 sq ft of commercial buildings per Chinese person added since 2008.

The US has total commercial building sq ft per person of 242. The US has added ~ 24 sq ft of commercial buildings per person since 2003.

 

i.e.

1) China has added twice as much per person over half as much time, and

2) the US includes a major boom period (2003-2008) while China is just over the subsequent bust period.

[ERICOPOLY]

By most historical measures (Shiller P/E, Tobin's Q, historical margins and current P/Es, etc), we are anywhere between 30-50% overvalued.

 

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.

 

[ERICOPOLY]

The US has added ~ 24 sq ft of commercial buildings per person since 2003.

 

How many people have left the farms in the US over that period of time seeking jobs in the city?

 

I don't dispute that China has been building excess capacity, but I find it hard to compare China to the US due to the demographic migration of Chinese to cities from farms.  Having said that, I don't know if that effect was already fully completed by 2008 or if the migration is still ongoing.  And yes things can be overdone even if there was significant ongoing migration -- but it matters how long the excess capacity will remain truly excess... meaning how long will it take for that space to get filled if people are still migrating.

[ERICOPOLY]

Tesla is quite likely overvalued, but I found this pretty misleading:

 

Tesla Motors, for example, sold 22,477 cars in 2013 but commands a market cap of

$31 billion, while Fiat, which we like, sold 4.4 million cars but has a market cap of only $14 billion.

 

Porsche of course sold for more than $20billion in 2012, and produced less than 140,000 cars at the time.  Compare that to Fiat which sells roughly 32x more cars and yet is valued quite a bit less than VW paid for Porsche.

 

Had they instead compared Porsche to Fiat in the same manner, would it not have made it sound as though Porsche was wildly overvalued in 2012?  Yet they still found a private buyer.

 

And yes, Tesla sells less than Porsche and is more highly valued.  I'm just saying that their wording makes it sound all that more overvalued by comparing Tesla to Fiat, instead of comparing Tesla to Porsche.  No need to exaggerate the optics with distorted comparisons.

 

[Yours Truly]

It seems like there are a lot of experts on all things China in here!

 

Maybe in the future when China drowns from "excess capacity", we'll start arguing about India in a state of bubble!

[TwoCitiesCapital]

My question is when was there not a potential crisis?  In the "good ole days" you had the cold war with a nuclear threat that could destroy the world.  Then you had the emerging markets contagion in the 1990s.  The internet bubble, the housing bubble.  When does it end???  You just need to make an assessment is the current situation worse than the past.  I would say at this point no because the leverage in the system is to the gov't.  Look at all the $ the Fed tried to force feed the banks.  Where did it go?  Right back to the Fed as excess reserves so I don't see the leverage in the US at least. 

 

Frankly, I feel better the debt is on the gov't balance sheet versus household and businesses as the gov't can always print there way out of trouble but households and businesses cannot.

 

Packer

 

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.

 

 

By most historical measures (Shiller P/E, Tobin's Q, historical margins and current P/Es, etc), we are anywhere between 30-50% overvalued.

 

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".

[Packer16]

I see price at or above average (probably lower than average given LT interest rates - all indicators that show higher than average rate use history as guide when rates were higher and are higher than most expectations going forward), debts are higher but monetization is an acceptable way to reduce debt with a little austerity (this BTW was how the Post WWII debt was reduced - the difference then was the tight labor and raw material markets because a large portion of the world was following communism so if we have excess labor then the inflation can be used to offset the deflationary forces of excess supply) and I don't see how the economies are any less robust than in the past (do you know of any specifics here beyond higher debt which can be monestized?).  TIA.

 

 

Packer

[ERICOPOLY]

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".

 

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.

 

 

[hyten1]

question are these net values?

 

we all know new things get added, but some old property get taken out or re-purpose, just wondering

 

hy

 

The following are a bit scary:

China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of

more than 50 Manhattans – in just five years!

 

Assuming 25% of China's worker are working in an office that would mean about 10 square meter per worker that has been added. I wish I had 10 square meter for my personal office.

 

BeerBaron

 

By commercial buildings, doesn't that include retail/industrial?

Still, this is 50 sq ft of commercial buildings per Chinese person added since 2008.

The US has total commercial building sq ft per person of 242. The US has added ~ 24 sq ft of commercial buildings per person since 2003.

 

i.e.

1) China has added twice as much per person over half as much time, and

2) the US includes a major boom period (2003-2008) while China is just over the subsequent bust period.

[Alekbaylee]

And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China. The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where speculators have borrowed at low rates across the world and invested in China, almost always backed by real estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China, watch out!

This is really scary for the entire world...  :o

[ERICOPOLY]

I'm curious how long the excess vacant space will last (not to say there isn't a bubble that will pop first... but how long will it take them to grow into these shoes):

 

Estimations are that Chinese cities will face an influx of another 243 million migrants by 2025

 

http://en.wikipedia.org/wiki/Migration_in_China

 

 

Guys, how many Manhattans is that?

[Green King]

And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China. The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where speculators have borrowed at low rates across the world and invested in China, almost always backed by real estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China, watch out!

This is really scary for the entire world...  :o

 

how does one know if that is true ? how would one know if that is happening ? i would like to know how someone measure that.Also wouldn't they just do the same thing they did here.

[gary17]

Hot money is true. In Taiwan , especially Taipei. Real estate doubled or triples the last two years ... Just ask Zippy!

 

Same in Beijing, Shanghai , and HK.

 

Why is The HK real estate guy  lee Kai shing getting out of real estate in HK? He probably see something coming