Fairfax Letter March 2014

[prevalou]

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

Don ´t forget China foreign exchanges reserves are $ 3,8 trillions and it can smooth some capital withdrawals

[frommi]

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

 

If this is true, than where has that money gone? The chinese stock market has gone sideways for more than 3 years now. Bank of America has sold its stake in china last year. It looks like they are now talking china down. http://ftalphaville.ft.com/2014/02/03/1759962/in-defence-of-chinas-shadow-banks/

[treasurehunt]

I spent a good amount of time this weekend reading Buffett's old letters to shareholders and it struck me that it would be interesting to compare Berkshire's performance after its first 28 years to that of Fairfax (which just completed its 28th year).

 

Annual Increase in Book Value Per Share

Berkshire: 23.6%, Fairfax: 21.3%

 

Shareholders' Equity

Berkshire: $8,926 million, Fairfax: $7,187 million

 

Total Assets

Berkshire: $17,132 million, Fairfax: $35,959 million

 

Debt

Berkshire: $1,155 million, Fairfax: $2,969 million

 

Total Dividends Declared Per Share

Berkshire: 0, Fairfax: $70 (roughly)

 

Annual Increase In Shares Outstanding

Berkshire: 0.05%, Fairfax: 5.3%

 

Number Of Years With Declining Book Value Per Share

Berkshire: 1, Fairfax: 6

 

Berkshire's insurance operations did not look too good at the end of 1992; they had had underwriting losses for the previous ten years or so. Fairfax's insurance operations look just fine in comparison, I think.

 

Overall, Fairfax's performance doesn't quite measure up to Berkshire's but it is not very far off. One big difference is that Berkshire had an annual increase in book value per share of 27.1% between 1978 and 1992 -- the last 14 years of the 28 year period. Fairfax, on the other hand, increased book value per share by only 5.7% per year in the last 14 years. Perhaps size has become an anchor for Fairfax much faster than it did for Berkshire?

 

And one final thing -- Prem writes pretty good letters, but Buffett's old ones are brilliant!

[Liberty]

I spent a good amount of time this weekend reading Buffett's old letters to shareholders and it struck me that it would be interesting to compare Berkshire's performance after its first 28 years to that of Fairfax (which just completed its 28th year).

 

Annual Increase in Book Value Per Share

Berkshire: 23.6%, Fairfax: 21.3%

 

One thing I wanted to do when I was reading the recent letter but haven't had time yet; calculate their CAGR if you remove the first year that is like 180%. It's an outlier with such a small amount of capital that it doesn't seem like it's useful to include.

[gary17]

I think if you adjust for inflation Buffett"s company was a lot bigger than Fairfax today.

[phil_Buffett]

for me it makes absolutely no sense to sell us bank and wells Fargo and Holding bank of ireland. when a big 1 a lifetime crash Comes, ireland will be over. i would be happier to hold wells Fargo than bank of ireland. i dont believe that bank of ireland and ireland itself will survive a Crash today.

[Kraven]

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

 

This is a seriously flawed analogy and only meant to incite fear.  It's the equivalent of showing a chart of 1929's stock market vs today's and asserting we're in for the same result.  The aggregate amount of asset backed securities was not the cause of the crisis.  Certain securitized products contributed to the crisis, but I am not even sure many of those would have been counted under the rubric of "asset backed securities" (most of which were actually perfectly fine).

[thefatbaboon]

Can someone help me understand this market over-valuation hypothesis because I'm really struggling. 

 

Here are the worlds biggest companies:

 

Apple, Exxon, Microsoft, Google, Berkshire, General Electric, Johnson&Johnson, Walmart, Chevron, Wells Fargo

 

Do you guys think they are expensive?  (Out of the 10 names I'd say 1.5 are expensive.)

 

Of course there are a bunch of go-go companies like Amazon, Facebook, Tesla, Twitter etc.  But they do not dominate the overall market (a la 1999).  And, even in healthy markets there have always been pockets of speculation. 

 

What do the bears imagine happens if they are right and the market declines?  Will central banks raise interest rates??  I just don't follow the logic.  Interest rates are essentially zero.  How is it possible that shorting a bunch of debt-free large cap companies that are trading at 11-15 times earnings (6%-9% earnings yields) can ever be a sensible investment choice in a world of zero interest rates??  Even if the bears are right, China implodes, Europe deflates, and all the companies mentioned above lose 25% of their earning power…isn't one still better off holding companies with no debt, significant dividend capacity and 4%-7% earnings yields because the central banks are most certainly not going to greet such a crisis by raising interest rates?

 

Listen, I understand that a broad collapse such as this would no doubt offer up better prices than today, perhaps significantly so. But the risk/reward doesn't seem right to me.  Isn't it safer to buy some strong companies and if the global economies are ok you'll double your money over the next seven years, and if the economies collapse your companies will survive, pay you a dividend and stock prices will probably be marginally higher is seven years.  Even in a bear scenario your return will be better than buying cash or investment grade bonds today.

 

Personally, nothing makes me more nervous than speculating on Doom.  I don't think I could sleep at night.  Setting my sail against the immense tide of human history, a tide that only seems to have gotten stronger and quicker with every generation.  We are living at a time of the most obscene progress.  Jet airplanes, televisions, phones, computers, internet, globalized manufacture, a plethora of free and for fee entertainment, cheap furnishings, automobiles, statins, low child mortality, the longest life expectancy.  I don't know how someone can short our economy and not spend every waking minute absolutely terrified.

 

 

[SharperDingaan]

You might want to keep in mind the highly likely probability that money laundering underpins much of that unused capacity.

 

To do money laundering you need a hot inflow, to fund an investment in country X; to borrow against, & then repatriate the inflow. You create a local bank, use it to fund construction loans to build the asset, & increase the LTV ratio to push up the collateral value of the asset. It is of course a Ponzi scheme, the last in will hold the bag, & it requires construction loans - but you don't need anyone to actually use the constructed asset.

 

Vegas was the early version of this, & it was strictly US mob. Dubai is a more recent version, but primarily Russian mob. China is primarily local. Country X gets a lot of new assets ready to go, with zero cost after the scheme collapses. Excess capacity that eventually displaces existing business with older & less attractive assets. Dubai becomes the next Vegas, so long as the ruler allows it to happen - & everybody wins.

 

SD

 

[value-is-what-you-get]

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?

That would be one Manhattan per month for 11 years.  That,s a lot of subways!

 

 

 

 

[giofranchi]

Ok guys, the equity hedges have been a big mistake…

 

Sincerely, I couldn’t care less now. Whoever reads this letter and doesn’t see the entrepreneurial global force FFH is becoming, simply lacks entrepreneurial spirit. It is so self-evident!

1) The best way to play the emerging markets story: FFH.

2) The best way to play an European recovery: FFH.

3) Even in North America, despite the headwind of high general market prices, FFH will go on purchasing whole businesses.

People have been fixating on these equity hedges and are completely missing the whole FFH story.

Nothing else to say.

 

Gio

 

[tiddman]

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.

 

I think this is basically a normal market. Overall valued reasonably, some undervaluation in areas, and some overvaluation in others. Markets are a place for speculation as well.

 

I remember trying to find stocks to buy in 2006 and 2007 and you couldn't find anything with a P/E of less than 20-25, even companies on the fringes of the economy like subprime lenders and money-losing startups were at huge valuations.

 

Today's market just doesn't seem like that. Huge banks like BAC and WFC still appear cheap even with lots of unused capital.

[tiddman]

The Brookfield Asset Management 2013 letter has interesting comments about the property markets in China, which they have just started to get into.

 

http://brookfield.com/_Global/42/documents/relatedlinks/6190.pdf

 

The China Story

 

Our success depends on our ability to find opportunistic investments in real assets around the world, underwrite and acquire the assets, and operate them well in order to generate our targeted returns. While we have made small investments in China in the past, we were unable to find a significant opportunity where we could invest comfortably. During 2013, we found such an opportunity with a portfolio of Shanghai commercial properties.

 

The Chinese economy is incredibly large and diverse, and contains some economic regions that at best would be described as “pioneer,” has regions that are classically “emerging,” but most importantly has regions that are fully competitive on a global stage. Our view is that the Chinese economy will experience peaks and valleys along a rapid growth path. But by being careful with how we invest and by being integrated into the economy, these transitions will provide many opportunities for us, as they do in other countries around the world.

 

The misunderstanding by many Western observers lies in the premise that once China stumbles, it will fall behind, and never come back. To put this into context, one can compare China to the United States. In 1820, agriculture represented 80% of the U.S. economy. By 1920, agriculture had declined to 25%, and during this century of transition and growth there were both good and not so good economic periods. Contrast that to China, where in 1975 agriculture represented 80% of the Chinese economy and by 2030 it will represent 25%. In these 55 years of transition there were, and will be, many economic cycles. But like the U.S., we believe China will be a good place to invest over the long term.

 

The most commented on economic item is the impact of a Chinese slowdown on China, and the global economy. Our take is that many forget that this is largely the law of big numbers at work as the Chinese economy is now the second largest in the world. One must remember that at $8 trillion, even 6% growth creates a GDP increase which in itself is larger than most countries’ GDP, and in aggregate as large as the growth being added by the United States to the world’s economy annually.

 

We were fortunate to find a Chinese partner that not only recognized that our brand of institutional capital management, asset management and operations is greatly needed within China, but also owns one of the highest quality commercial property portfolios in the country. While we will only own 22% of the entity, we will be providing a number of our people into positions within the company. Our growth plans for China Xintiandi will be market and opportunity dependent, but we believe we can assist our partner in becoming one of the leading owners and operators of premier commercial properties within China.

 

The initial portfolio of properties owned by China Xintiandi consists of over 3.4 million square feet of premier quality office and retail assets in two truly irreplaceable locations within Shanghai. We believe Shanghai is one of the world's leading cities and we are thrilled to be able to be a part of its future.

 

[investmd]

I spent a good amount of time this weekend reading Buffett's old letters to shareholders and it struck me that it would be interesting to compare Berkshire's performance after its first 28 years to that of Fairfax (which just completed its 28th year).

 

Annual Increase in Book Value Per Share

Berkshire: 23.6%, Fairfax: 21.3%

 

Shareholders' Equity

Berkshire: $8,926 million, Fairfax: $7,187 million

 

Total Assets

Berkshire: $17,132 million, Fairfax: $35,959 million

 

Debt

Berkshire: $1,155 million, Fairfax: $2,969 million

 

Total Dividends Declared Per Share

Berkshire: 0, Fairfax: $70 (roughly)

 

Annual Increase In Shares Outstanding

Berkshire: 0.05%, Fairfax: 5.3%

 

Number Of Years With Declining Book Value Per Share

Berkshire: 1, Fairfax: 6

 

Berkshire's insurance operations did not look too good at the end of 1992; they had had underwriting losses for the previous ten years or so. Fairfax's insurance operations look just fine in comparison, I think.

 

Overall, Fairfax's performance doesn't quite measure up to Berkshire's but it is not very far off. One big difference is that Berkshire had an annual increase in book value per share of 27.1% between 1978 and 1992 -- the last 14 years of the 28 year period. Fairfax, on the other hand, increased book value per share by only 5.7% per year in the last 14 years. Perhaps size has become an anchor for Fairfax much faster than it did for Berkshire?

 

And one final thing -- Prem writes pretty good letters, but Buffett's old ones are brilliant!

 

Even though BRK and FFH are based on the same principles of writing good insurance, & using the float to invest, the tone of the respective 2013 annual letters is completely different. While Buffett is clearly very optimistic about the future of America, Watsa has decided to play for the one in 50 event and admits to being very bearish.

 

Tough climate when 2 very similarly minded individuals think so differently. Delimma for investors who follow the two.

 

[investmd]

Ok guys, the equity hedges have been a great mistake…

 

Sincerely, I couldn’t care less now. Whoever reads this letter and doesn’t see the entrepreneurial global force FFH is becoming, simply lacks entrepreneurial spirit. It is so self-evident!

1) The best way to play the emerging markets story: FFH.

2) The best way to play an European recovery: FFH.

3) Even in North America, despite the headwind of high general market prices, FFH will go on purchasing whole businesses.

People have been fixating on these equity hedges and are completely missing the whole FFH story.

Nothing else to say.

Gio

 

Even ignoring the equity hedge, the investment portfolio produced less than 5% return in 2013! Hard to fathom. Thoughts around the poor 5 year results on investments with or without hedging? On the other hand glad to see the insurance business is doing well with operating margins <100%.

 

[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?

That would be one Manhattan per month for 11 years.  That,s a lot of subways!

 

I have an interesting game for you guys at the Fairfax dinner.  How many Manhattans can you down and remain seated in your chairs?

 

[giofranchi]

Even ignoring the equity hedge, the investment portfolio produced less than 5% return in 2013! Hard to fathom.

 

Profits from equity and equity related investments in 2013 were $1,445 million, while Preferred stocks + Common stocks + Investments in associates at December 31 2012 were valued at $6,359. That’s a return of 1,445 / 6,359 = 22.7% (dividends excluded and BB included ;) ).

Given the fact that $1,324 million were realized gains, the annualized return might be significantly higher, depending on when those securities have been sold. :)

 

Gio

 

[giofranchi]

Even ignoring the equity hedge, the investment portfolio produced less than 5% return in 2013! Hard to fathom.

 

Profits from equity and equity related investments in 2013 were $1,445 million, while Preferred stocks + Common stocks + Investments in associates at December 31 2012 were valued at $6,359. That’s a return of 1,445 / 6,359 = 22.7% (dividends excluded and BB included ;) ).

Given the fact that $1,324 million were realized gains, the annualized return might be significantly higher, depending on when those securities have been sold. :)

 

Gio

 

From the annual letter, he says:

 

In 2013, we had a total investment return of negative 4.9% (versus an average of positive 4.4% over the past five years and positive 8.9% over our 28-year history) mainly because of our 100% hedge of our common stock portfolio. If we had not hedged, our total investment return in 2013 would have been a positive 3.6%. In our 28-year history, we have had negative total investment returns in only three years: 1990 – (4.4)%; 1999 – (2.7)%; and 2013 – (4.9)%. In

the past, these returns reversed the following year, as shown in the table in the MD&A! As we said earlier, as of February 28, 2014, we had an unrealized mark to market gain in our investment portfolio of more than $1 billion – after tax, this would have eliminated our net loss in 2013.

 

Yes, that is total investment return. Of which the return from its equity portfolio is only a part. But total investment return suffered from $995 million unrealized bond losses... What's so hard to fathom? Practically every bonds portfolio suffered mark to market losses in 2013.

 

Gio

[frommi]

Gio would you invest in bonds at the current rates?

I can`t really imagine how anyone can really hold bonds at the current point for the longer term. Heck i am even thinking about shorting them for a lower overall portfolio risk. (I have some REIT`s)

 

And i bet that FFH is already back to zero when it comes to gains this year, because the Russel has broken the top and interest rates have risen since the letter.

 

For me Prem`s actions look like someone who has made a macro bet, has proven to be wrong and he doesn`t correct himself. For a trader this is a no go, an investor might be getting away with  subpar returns. (look at the performance of the last 4 years) FFH looks like a giant levered long/short hedgefund which for me seems to be overvalued at current prices. What if the market repeats 2013 for the next 2-3 years like in 1997-2000?

When i read the letter correct book value has declined in 2013 from 378$ to 339$ thats -10.3%. When that repeats for 2-3 years its very hard to recover that loss and this is totally possible when the market rallies further and interest rates go back up to 4 or 5%.

[mcliu]

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

 

If this is true, than where has that money gone? The chinese stock market has gone sideways for more than 3 years now. Bank of America has sold its stake in china last year. It looks like they are now talking china down. http://ftalphaville.ft.com/2014/02/03/1759962/in-defence-of-chinas-shadow-banks/

 

All the money's gone into factories, infrastructure and real estate, hence the huge over-capacity in most industries and double digit RE value gains across China, even in the Tier 3/4 cities. It's also why the stock market has gone nowhere since overcapacity is causing such low ROEs.

 

People may be underestimating the amount of fixed-asset investment in China.

[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?

That would be one Manhattan per month for 11 years.  That,s a lot of subways!

 

It's the same pace as the past 5 years -- per the FFH letter, they've built over 50 Manhattans the past 60 months.

 

So if they need to keep building 1 every month for the next 11 years, then I'm scratching my head.

 

Is the 243 million person migration over next 11 years really happening or isn't it?

[ERICOPOLY]

I've been thinking about this discussion all day.  I don't really understand how 250m people can leave the farms for the city over just 11 years unless there is an urgent need for them.  Doesn't make sense.

[StubbleJumper]

I've been thinking about this discussion all day.  I don't really understand how 250m people can leave the farms for the city over just 11 years unless there is an urgent need for them.  Doesn't make sense.

 

 

Something similar occurred in England during the Industrial Revolution.  Changing technologies and practices in the agriculture sector freed up significant labour that migrated to towns and cities to fuel the IR.  The scale of agriculture in China would suggest that there will be ample opportunity for the agriculture sector to shed labour over coming years.

 

SJ

[ERICOPOLY]

I've been thinking about this discussion all day.  I don't really understand how 250m people can leave the farms for the city over just 11 years unless there is an urgent need for them.  Doesn't make sense.

 

 

Something similar occurred in England during the Industrial Revolution.  Changing technologies and practices in the agriculture sector freed up significant labour that migrated to towns and cities to fuel the IR.  The scale of agriculture in China would suggest that there will be ample opportunity for the agriculture sector to shed labour over coming years.

 

SJ

 

They need city jobs to afford housing.  Unless the city parks are large enough for their tents.

 

But what jobs?

 

I get the fact that the past migrants to the cities took factory jobs -- all that stuff at Walmart is made in China.

 

But have we saturated the demand for Chinese factory labor?  Is there untapped demand for manufactured goods from China?

 

[StubbleJumper]

I've been thinking about this discussion all day.  I don't really understand how 250m people can leave the farms for the city over just 11 years unless there is an urgent need for them.  Doesn't make sense.

 

 

Something similar occurred in England during the Industrial Revolution.  Changing technologies and practices in the agriculture sector freed up significant labour that migrated to towns and cities to fuel the IR.  The scale of agriculture in China would suggest that there will be ample opportunity for the agriculture sector to shed labour over coming years.

 

SJ

 

They need city jobs to afford housing.  Unless the city parks are large enough for their tents.

 

But what jobs?

 

I get the fact that the past migrants to the cities took factory jobs -- all that stuff at Walmart is made in China.

 

But have we saturated the demand for Chinese factory labor?  Is there untapped demand for manufactured goods from China?

 

 

That's the wrong way to think about it.  It's not that the cities are demanding labour; rather the countryside is shedding agricultural labour.  This has occurred steadily since the discovery of agriculture in Mesopotamia, but accelerated during the industrial revolution.  And, that's what is going on in the developing world.  The adoption of technology will force people to urbanize, and that is what will generate wealth (as it always has).

 

SJ