Fairfax Letter March 2014

[wisdom]

Predictions about the bandwidth required in the future have come true with recent developments and we will have to lay more fibre for the future.

 

But, a lot of companies that built that network went out of business in the early 2000's.

 

Just because there will be demand in the future, that by itself does not justify building out the infrastructure right now. You have to build it as the demand appears and the economics justify it.

[PJM]

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?

 

Chinese markets are not understood properly because a lot of reports/stats are very biased to show exuberance. No denying that there may be oversupply of credit/cheap money which has lead to speculation on real estate, however Chinese problems can be fixed and I think the NPC is taking some really strategic steps which is not properly understood as people are so focussed on short-term numbers such as PMI, CPI etc

 

Here is an article from Andy Xie (one of the most reputed Chinese economist) who had a reputation of openly criticising the Chinese policies, but lately he has been sounding positive especially in highlighting the fact that slowing economy is a good thing for China which will help it over the long run.

 

http://english.caixin.com/2014-03-06/100647590.html

(When the transition to market-based resource allocation is complete, the country's per capita income will rise quickly, to US$ 20,000 from the present US$ 7,000. That is the grand prize that the country should focus on.)

[TwoCitiesCapital]

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.

 

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.

 

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.

 

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.

 

 

[kmukul]

I am actually surprised to read this read on this forum :) But its not fair if Prasad or someone doesn't put the point of view of Prem. In hindsight you can see hedges had issues but then in hindsight every one is right and most likely its already reflected in FFH price , its also more of a one off thing may be next time they will be better off when they use hedges.

 

One thing that disappointed me more then hedges was Prems love for Tom Ward. that was also discussed a lot on this board but I don't think any conclusion was made and most likely we will have the same thing here.

[ERICOPOLY]

Using the Shiller P/E or Tobins Q suggests 30-50% overvaluation BEFORE considering that margins are above historical levels.

 

I believe you are double counting.

 

The forward P/E is 15x.  That's normal.

 

But several years ago, earnings were far lower.  So were profit margins.  So when you start using Shiller P/E, you are mixing in many years of lower profit margins. 

 

In other words, you are saying "Look at how high the P/E is when you blend it with much lower profit margins".  That's what Shiller P/E is telling you.

 

Shiller's P/E is useful to help detect periods like this one where the forward looking P/E might be a lot higher than it looks -- because it might look low at this (potentially fleeting) moment merely due to abnormally high profit margins, or a credit bubble causing artificial demand, etc...

 

[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?

 

 

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

 

I understood your point about needing less bodies in the fields (shedding agricultural labor).

 

I am wondering do they become unemployed or what do they do next?  I remember 10 years ago it was clearly cheaper to manufacture many goods in China.  But today I believe the costs gaps are much slimmer, and energy is cheaper in the US.  We're even spinning yarn in the US again.  Tesla decided it was cheaper to do some of it's manufacturing in California of all places, rather than China. 

 

So I'm just wondering how that all impacts the "For Hire" signs in Chinese cities.  Merely a slowing of manufacturing growth should leave an impact on the rate at which people will take up jobs in Chinese cities.

 

Anyways, I'm not firmly arguing these points.  Rather, these are the areas I'm confused about and I want somebody to explain why 250 million people will find city jobs -- what jobs are the Chinese cities currently trying to fill that these people are skilled for?  Are we still in a transitional phase where China is growing it's factory labor force at the same pace as the last five-ten years?

 

Like in the United States -- if somebody is no longer needed on a farm, it doesn't mean that for certain he is going to get a job in a city.  It could just mean that he is unemployed, right?

 

[hyten1]

also there are many jobs that comes with a urban setting (services folks, store clerks, janitors, window washers, gardener, trashman etc. etc.)

 

 

 

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

 

I understood your point about needing less bodies in the fields (shedding agricultural labor).

 

I am wondering do they become unemployed or what do they do next?  I remember 10 years ago it was clearly cheaper to manufacture many goods in China.  But today I believe the costs gaps are much slimmer, and energy is cheaper in the US.  We're even spinning yarn in the US again.  Tesla decided it was cheaper to do some of it's manufacturing in California of all places, rather than China. 

 

So I'm just wondering how that all impacts the "For Hire" signs in Chinese cities.  Merely a slowing of manufacturing growth should leave an impact on the rate at which people will take up jobs in Chinese cities.

 

Anyways, I'm not firmly arguing these points.  Rather, these are the areas I'm confused about and I want somebody to explain why 250 million people will find city jobs -- what jobs are the Chinese cities currently trying to fill that these people are skilled for?  Are we still in a transitional phase where China is growing it's factory labor force at the same pace as the last five-ten years?

 

Like in the United States -- if somebody is no longer needed on a farm, it doesn't mean that for certain he is going to get a job in a city.  It could just mean that he is unemployed, right?

[ERICOPOLY]

I am afraid I am buying into the China thesis of Fairfax.  I have this nagging feeling that an inflection point has arrived for a while now where demand for China's exports has slowed. 

 

The last three paragraphs are resonating with me:

 

http://www.theguardian.com/business/2014/jan/05/george-soros-chinese-slowdown-biggest-worry

 

The financial crisis showed the weakness in the idea of becoming the workshop for the world when that world couldn't afford to go on buying. To keep the wheels turning, local authorities and other government agencies were allowed to borrow.

 

Last year the Chinese leadership said it recognised that plan was flawed, and public sector debt needed to be cut. But when the economy slowed dramatically after borrowing was restricted, the policy was quickly reversed. The subsequent boost looks shortlived, even if China has billions of dollars in foreign exchange reserves to soften any economic blow.

 

Soros said: "China's leadership was right to give precedence to economic growth over structural reforms, because structural reforms, combined with fiscal austerity, push economies into a deflationary tailspin. But there is an unresolved contradiction in China's current policies: restarting the furnaces also reignites debt growth, which cannot be sustained for much longer than a couple of years."

[giofranchi]

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%.

 

frommi,

I don’t share your concerns about FFH, and here is why:

 

Bonds:

 

FFH bonds portfolio was mainly assembled in 2008-2009 and, like Mr. Watsa has often reminded us:

Our Brian Bradstreet purchased $1 billion in California state government bonds in 2009, most of this position directly from the government at a 7.25% yield when California was considered to be on the verge of being non-investment grade. Those bonds are yielding 4.55% today!! Our muni bond portfolio (tax exempt and taxable) continued to do well in 2012. We have $1,279.5 million in unrealized gains in these bonds (approximately 22.9% on our cost) while earning $310 million annually in interest.

That was at the end of 2012. Today those bonds are certainly much more attractive! I am not saying they are as attractive as they were in 2009, but they are probably yielding around 6%. Not bad! Especially with the leverage FFH is able to use. Unless those bonds default, and most of them are insured by Berkshire, mark to market losses are not all that relevant, and there will be sure and substantial gains.

 

Equities:

 

Why is everyone assuming that FFH’s portfolio will go on underperforming the indices?!?! Just because it has done so last year?! FFH’s equity investments have a long history of outperforming the indices, and they will probably outperform again in the future.

 

What I do see:

 

An outstanding organization that through the opportunistic purchase of insurance companies all over the world is becoming more and more global. So many opportunities for growth. I am exited to see what they will be able to accomplish during the next 15 years.

 

Gio

 

[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

 

I understood your point about needing less bodies in the fields (shedding agricultural labor).

 

I am wondering do they become unemployed or what do they do next?  I remember 10 years ago it was clearly cheaper to manufacture many goods in China.  But today I believe the costs gaps are much slimmer, and energy is cheaper in the US.  We're even spinning yarn in the US again.  Tesla decided it was cheaper to do some of it's manufacturing in California of all places, rather than China. 

 

So I'm just wondering how that all impacts the "For Hire" signs in Chinese cities.  Merely a slowing of manufacturing growth should leave an impact on the rate at which people will take up jobs in Chinese cities.

 

Anyways, I'm not firmly arguing these points.  Rather, these are the areas I'm confused about and I want somebody to explain why 250 million people will find city jobs -- what jobs are the Chinese cities currently trying to fill that these people are skilled for?  Are we still in a transitional phase where China is growing it's factory labor force at the same pace as the last five-ten years?

 

Like in the United States -- if somebody is no longer needed on a farm, it doesn't mean that for certain he is going to get a job in a city.  It could just mean that he is unemployed, right?

 

 

Mostly what happens is that older farmers will simply retire and not be replaced by their children (who migrate to the city).  The farm gets liquidated and assets are bought by neighbours.  My guess is that the farmer population in China is getting a little bit older every year as children move to the city and do not takeover the family farm. 

 

In a few cases, people stop farming due to financial failure (ie, insolvency, or inferior income prospects). It's conceivable that some of those people might just end up on welfare (because you cannot get unemployment benefits), but my observation is that people who ran their own business rarely end up on welfare.  They almost universally have enough motivation and drive to find some sort of job, even if it's just a job pumping gas in town.

 

In the particular case of China, I'm not sure that being on welfare is even an option.  I always assumed that the situation was basically Chinese people either need to work, leach off their family, or starve.

 

As a matter of interest, here's a link to a chart depicting the evolution of the US agriculture sector:

 

http://www.washingtonpost.com/blogs/ezra-klein/files/2012/10/number-of-farms-in-united-states.png

 

 

The interesting thing is that the US lost two-thirds of its farms over the course of 40 years.  This occurred mainly as technology was developed and mechanization was adopted in the US and western Europe.  However, in the case of China, they do not need to wait to develop new technology or farming practices, all they need to do is adopt existing western practices.  It may be that the Chinese farm consolidation could be even steeper than our experience in North America.

 

SJ

[thefatbaboon]

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.

 

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.

 

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.

 

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.

 

I'm not sure I accept the premise that interest rates have to go up.  Of course they do if inflation picks up.  But that is precisely what is NOT going to happen in the Watsa deflation hypothesis.  So, in a world of low interest rates which would only get lower in a deflationary environment, and accepting that one has to buy something with ones money (cash, re, stocks, bonds), how can one not choose reasonably valued large caps over any of the other alternatives?  It has the additional benefit of working out nicely if the deflation hypothesis is wrong too.

 

As for the argument about unreasonably fat margins - I am not smart enough to untangle the truth.  The American economy is completely different today compared to 30, 50, 100 years ago.  How does one compare a Nike that is based on outsourcing and branding to an old manufacturing company?  How does one compare Google and Apple to the old IBM or Ford with there hundreds of thousand of employees? How does one compare a modern biotech company to the old chemical companies?  The world changes, capital productivity changes.  Modern companies split up their businesses and outsource their low returns to low income parts of the world and keep their high return parts.  My guess would be that margins and the productivity of capital have been increasing since the Industrial Revolution.  And since globalization this has been further exaggerated by the ability to farm out low return parts of businesses to developing countries.

 

Like I said before I'm not talking about timing and trading here. Because we all agree that something bad might happen tomorrow in China, Ukraine or wherever and prices could come down 30%.  I'm talking as if one had to buy something today to own for the next ten years.

[Guest Dazel]

 

China's problems are no secret...they have been front page news for 3 years. From what I have seen Prem has no bet directly against China. He has hedged a deflationary spiral that would destroy the world's equity.

 

George Soros trades daily. His flip flop in theory and specific news driven headlines on the death of the Euro were all signs of a bottom. Now after its debt and markets have recovered he is happy with the euro? Great...rear view mirror is great.

 

Prem and Soros are hedgers...we need to except that....it does not mean we will "crash" but is protection against it. They need to explain to shareholders why in Prem's case he has lost over $3 billion hedging...because things could go very wrong if the second biggest economy crashed. He had better have been scared! I now like his position as a hedge for me...I made it clear on Gio's buying Fairfax thread that I bought a lot of Fairfax recently...happily actually...a nice gain!

 

Soros said China have billions in availability to repair their economy in foreign reserves. They actually have $4 trillion! They will turn up the spigot like every other country if they have to.

 

The united states debt has risen from $4.5 trillion to over $16 trillion since 2008. I believe Prem is worried that China would ignite  a global run....and the Fed would not have any bullets and we Know where Europe is...the Hedges are from a global perspective.

 

It is in the best interest of the world for all countries do well...we are interconnected and that scares Prem and it scares me...China on it's own is fine...they have to watch stimulus because they drive up commodity prices when they do it...the untied states growth is good for everyone but no one more so than China.

 

Dazel

 

[vinod1]

Prem made the following comment in the annual letter.

 

"As we did last year, we remind you that cumulative deflation in the U.S. in the 1930s and Japan in the ten years

ending 2012 was approximately 14%. It is amazing to note that including 2013, Japan has suffered deflation in most

of the last 19 years – beginning about five years after the Nikkei index and real estate values peaked."

 

Japanse CPI data shows a deflation of only 1.0% over the last 10 years (2003 to 2012). Even peak to bottom from 1998 to 2013 the deflation is only about 5%. Does anyone know what inflation data Prem is using for Japan?

 

Link to CPI data on Japan:

 

http://www.stat.go.jp/english/data/cpi/1588.htm

 

http://www.e-stat.go.jp/SG1/estat/CsvdlE.do?sinfid=000011288548

 

Thanks

 

Vinod

[vinod1]

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.

 

Margins are high but as pointed out by Pzena, ROE are roughly in line with average. But companies and investors care more about (correctly in my view) return on equity. The fact that a company increased its margins from 5% to 10% would not automatically invite competition and drive down margins if ROE say remain only 8%. Companies had to deploy a lot more assets to generate these margins.

 

http://www.pzena.com/heading-our-research/investment-analysis-4q13.php

 

What are your views on this?

 

If God gave you a peek at interest rates over the next 20 years and they remain in the 2-3%, how would your view about equity valuations change, if any?

 

Not trying to argue with you, just trying to understand different viewpoints on this topic.

 

Thanks

 

Vinod

[Guest 50centdollars]

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.

 

Margins are high but as pointed out by Pzena, ROE are roughly in line with average. But companies and investors care more about (correctly in my view) return on equity. The fact that a company increased its margins from 5% to 10% would not automatically invite competition and drive down margins if ROE say remain only 8%. Companies had to deploy a lot more assets to generate these margins.

 

http://www.pzena.com/heading-our-research/investment-analysis-4q13.php

 

What are your views on this?

 

If God gave you a peek at interest rates over the next 20 years and they remain in the 2-3%, how would your view about equity valuations change, if any?

 

Not trying to argue with you, just trying to understand different viewpoints on this topic.

 

Thanks

 

Vinod

 

+1

 

Good point. If interest rates stay low for the next 5 years, you can make an argument that stocks are undervalued.

[gary17]

It is quite interesting that with the Malaysian airline , all the nations in one of the most disputed parts of the water in this world are working together ... This gives me some comfort when dooms day comes they'd be trying to figure out a solution.

[benhacker]

I've posted about this ROE comparison vs. margins before.  I agree it's more meaningful than margins generally.  But the question I have is in a world of 3% long rates is a 12-14% corporate ROE really reasonable?  I think it's not regardless of historical 'average'.  Separately, I think the "B (Equity or Book)" for US companies is overstated "versus history" (I think it's more accurate than historical) due to goodwill accounting (and perhaps it's understated a bit due to R&D accounting)... which means ROE is too high because of the rate environment and also apples to apples it's too high vs history.

 

I personally think the aggregate market is obviously too high... but especially smaller companies (S&P100 companies seem high-ish to me, but maybe not crazy).  Looking through the top 50 Russell 2k companies is funny, sad, and instructive at the same time.  Of the top 25, 5 have negative GAAP earnings, and 7 trade above 50x GAAP.  I would bet that 10 year forward returns for the Russell will be 1-2% annualized nominal.

 

Just my 2 cents.  Of course buying cheap stocks is still the thing to do as always.

 

Ben

 

My non-taxable accounts (no shorting possible) are still 90-95% long... just think it's interesting to see the contortions (not referencing this thread) that many are going through to defend an obviously overvaluled market.  low rates for a generation, non-GAAP forward earnings, ignoring negative earning companies (without realizing it), etc etc etc.

 

Crazy...

[tiddman]

I've posted about this ROE comparison vs. margins before.  I agree it's more meaningful than margins generally.  But the question I have is in a world of 3% long rates is a 12-14% corporate ROE really reasonable?  I think it's not regardless of historical 'average'.  Separately, I think the "B (Equity or Book)" for US companies is overstated "versus history" (I think it's more accurate than historical) due to goodwill accounting (and perhaps it's understated a bit due to R&D accounting)... which means ROE is too high because of the rate environment and also apples to apples it's too high vs history.

 

I seem to remember Buffett saying that the long term average ROE for American companies was something like 11%.  I can't remember if that accounted for leverage or not.

 

For example IBM's ROE is often in the 60-120 range, but they have been aggressively issuing debt and buying back stock, essentially a slow-motion LBO.  Return on capital or return on enterprise value might be a better metric.

 

I don't think that 14-15% is normal/sustainable, though wonder if there is some skew in those numbers.  For example a lot of businesses have not been investing much over the past 5 years and earnings have only recently recovered.  If they were waiting for earnings to increase before investing then equity might be artificially low until they start to invest.  Also tax rates may be artificially low if corporations lost money in the past 5 years and have tax credits.

 

BAC's ROE is something like 5%, and was running 15-20% in the 90's and early 2000's.  I'd expect other large banks to be in the same area, because they have been required to retain capital but prohibited from investing it.  So while the market average ROE might be high, there are plenty of examples of quality companies with low ROE.

[Kraven]

These types of threads are interesting and frankly full of inconsistencies.  People like to proclaim that they are "bottoms up" investors, but then spend all their time attempting to figure out the macro.  It's trying to predict the unpredictable.  Even Buffett gets in on the act a bit.  He talks about the market cap/GDP indicator (a favorite of many on the board here), yet in his latest letter says "in the 54 years we [buffett and Munger] have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions".  The latter part is particularly interesting. 

 

On the other hand, someone could argue that the macro is just another data point for figuring out whether a stock is cheap or not, yet Buffett says it never even comes up.  But in other places he says the market cap/GDP figure is his favorite indicator.

 

There is so much angst these days.  A cheap stock is a cheap stock.  If interest rates being 100 or 200 bp higher changes that determination, it wasn’t a cheap stock to begin with.  Market volatility will come and go and I’m sure we are due for a big decline at some point.  I really enjoyed the latest Buffett letter.  I liked the part about his personal investments and particularly the tribute to Ben Graham.  I think folks would do well to keep in mind his take on Mr. Market when he described a neighboring farmer standing at his property line shouting out prices every day.

 

[vinod1]

I've posted about this ROE comparison vs. margins before.  I agree it's more meaningful than margins generally.  But the question I have is in a world of 3% long rates is a 12-14% corporate ROE really reasonable?  I think it's not regardless of historical 'average'.  Separately, I think the "B (Equity or Book)" for US companies is overstated "versus history" (I think it's more accurate than historical) due to goodwill accounting (and perhaps it's understated a bit due to R&D accounting)... which means ROE is too high because of the rate environment and also apples to apples it's too high vs history.

 

Ben

 

Question is what would cause ROE's to go down? There has to be massive investment by companies take advantage of high ROE, to drive down ROE to more "acceptable" levels. We do not see that. Massive investment is also precisely what GMO says is one way to keep profit margins high!

 

Vinod

[turar]

I understood your point about needing less bodies in the fields (shedding agricultural labor).

 

I am wondering do they become unemployed or what do they do next?  I remember 10 years ago it was clearly cheaper to manufacture many goods in China.  But today I believe the costs gaps are much slimmer, and energy is cheaper in the US.  We're even spinning yarn in the US again.  Tesla decided it was cheaper to do some of it's manufacturing in California of all places, rather than China. 

 

So I'm just wondering how that all impacts the "For Hire" signs in Chinese cities.  Merely a slowing of manufacturing growth should leave an impact on the rate at which people will take up jobs in Chinese cities.

 

One factor could be just the internal market. China has been export-oriented for the whole world, but as their population gets richer, they would be the consumers of their own manufacturing capacity?

[zenith]

It looks like Seth Klarman is on the same bandwith as Prem with respect to the market valuation.

http://www.zerohedge.com/news/2014-03-08/seth-klarman-born-bulls-bitcoin-truman-show-market

 

He mentions the same companies as Prem does, NFLX, TWTR etc.

 

couple of great qoutes

"the stock market, heading into 2014, resembles a Rorschach test - "what investors see in the inkblots says considerably more about them than it does about the market."

 

also

 

"In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987".

 

When 2 of the greatest investors say there is an issue, i think it is time to be concerned.

 

[giofranchi]

These types of threads are interesting and frankly full of inconsistencies.  People like to proclaim that they are "bottoms up" investors, but then spend all their time attempting to figure out the macro.  It's trying to predict the unpredictable.  Even Buffett gets in on the act a bit.  He talks about the market cap/GDP indicator (a favorite of many on the board here), yet in his latest letter says "in the 54 years we [buffett and Munger] have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions".  The latter part is particularly interesting. 

 

On the other hand, someone could argue that the macro is just another data point for figuring out whether a stock is cheap or not, yet Buffett says it never even comes up.  But in other places he says the market cap/GDP figure is his favorite indicator.

 

There is so much angst these days.  A cheap stock is a cheap stock.  If interest rates being 100 or 200 bp higher changes that determination, it wasn’t a cheap stock to begin with.  Market volatility will come and go and I’m sure we are due for a big decline at some point.  I really enjoyed the latest Buffett letter.  I liked the part about his personal investments and particularly the tribute to Ben Graham.  I think folks would do well to keep in mind his take on Mr. Market when he described a neighboring farmer standing at his property line shouting out prices every day.

 

Kraven,

I also don’t like these kinds of threads… If you want to speak about FFH, well then speak about the company! Instead, very few people do so.

 

But, to be clear, imo “macro” has nothing to do with “general market valuation”. I don’t care much about macro (I wouldn’t have invested in ALS otherwise!), yet I am worried about general market prices.

 

General market valuation applied to the S&P500 is no different than trying to value a portfolio of 500 companies. Not easy, of course! ... I guess 500 companies are a lot even for you! But the idea is the same:

to compare prices with values.

The "headlines" Mr. Buffett speaks about are totally different things.

 

The short-cuts often used to value a market, and that have a long-term track record of reliability, might be somehow questionable… in the end, though, they are nothing but simple means to avoid much trouble and work: that is to value 500 companies, one by one!

And you know what? I guess that, if you’d make the effort to study and value each of those 500 companies, you would come to the conclusion that portfolio of 500 companies is not of your liking at all! ;)

 

Gio

 

[mals]

If we assume for a moment, that Fairfax hedges are not entirely because of desire to make macro bets. Then here are thoughts that are worth considering.

 

1. Fairfax's equity hedges - Let us analyze for a moment as to why Fairfax needs / wants these hedges vs why Berkshire / Markel do not.

 

Berkshire is cash rick and huge. Market dislocations are unlikely to affect their liquidity in any meaningful way. Berkshire is also more US oriented - which maybe a more stable market than some that Fairfax is in - with respect to insurance and investments both.

Markel - is about the same size and therefore should also be concerned. As far as I can tell they are - lots of cash and bond tenure has been falling. Maybe Markel is simply more conservative in their ambition for returns and are content with sufficient liquidity at this point. Markel's insurance business is more specialized and has had historically good combined ratios - and so may be has to worry less about its insurance business stability. Businesses Markel owns are also more local and as far as I can tell more stable and not leveraged.

 

Would love to hear what others think on why the differences between their strategies?

 

2. Fairfax deflation hedges - why these? I would say, part business protection and part macro bet.

 

My understanding - deflation is a double whammy for an insurance company. Float returns diminish - as the yields go down. And more importantly, deflation happens only if the economies are depressed and so business is tepid. So as an insurance leader, if you are worried about deflation, you try to protect yourself. Add to that the fact that deflation protection was / is probably very cheap, and if you are an opportunistic investor, you go ahead and do more than just protect yourself.

So here it does appear to me that Prem Watsa is playing macro bets. But the bet is perhaps asymmetric - losses are finite if it does not work out, and possible gains are a multiple of the losses. And gains accrue at a time when the firm will likely reallyneed the gains.

 

Thoughts?

[tiddman]

Would love to hear what others think on why the differences between their strategies?

 

The 2 major differences between Fairfax and Berkshire are 1) Berkshire has substantial operating (i.e. non-investment, non-insurance) earnings, and 2) Berkshire has far less leverage.

 

The operating earnings allow Berkshire to "coast" more and to provide it with basically an endless amount of investable funds without being entirely reliant on insurance, which by its nature is volatile.  When either insurance or investments have a bad year, or both, Berkshire will most likely still show gains and have plenty of funds to invest.  It also gets an immediate tax break when there is a large insurance loss since it always has lots of taxable income to offset.  This blunts the impact of large one-time losses such as 9/11 or hurricane Katrina.

 

Fairfax not only doesn't have this kind of cushion but is also more highly leveraged.  This is less true today with a debt/equity of 1/3 but 10 years ago it was closer to 2/3.

 

These things make Fairfax inherently more volatile.  In a sense it is a two-legged stool and it has in its history had a few precarious periods including one where they almost got into serious trouble.  I think those years influenced Watsa's thinking and led to his brilliantly executed bet against credit default swaps in 2008 and must also contribute to his very cautious/fearful stance today.  My opinion is that I would rather have operating earnings than portfolio hedges but different strokes for different folks.

 

Whenever you hear Buffett talk he is always the optimist, even in the dark days of the crisis, and every shareholder letter is upbeat and positive.  I think this is because he has built an investment vehicle nearly free of risk and all he has to think about is his next deal or Dilly Bar.  Fairfax's position is not so secure and needs constant attention and so from Watsa you hear a much more cautious message.