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Annual letter from Prem


StubbleJumper
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A few notes after reading the letter this evening.

 

I must say, i thought they were a lot more underwater in greece than they actually are. By my calculations only about 15% underwater and all due to Eurobank. Sounds hopeful but not too sure about the new greek gov't.

 

Also, phenomenal work by Andy Barnard across the entire breadth of insurance operations.

Finally a good defense of the recent capital raise for the Brit acquisition. It is accretive in the

net in all relevant measures.

 

I'm astonished at the acquisitions made in India since 2012 and their growth rates. You just cant buy

that kind of growth at a sane price in the developed world, and I'm glad he is finding that for us over there. Though from a small base the runway is very long. I'd much rather be invested there than uber or one of the high flyers mentioned.

 

The recent eastern European acquisions appear to have been done at steal prices.

 

Sounds to me like Samsung did approach them and Watsa etc. wouldn't sell! Him specifically mentioning they wouldn't sell sounded like that for me.

 

 

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I was also pleased by the Asian growth.  The one note I did have was on the hedges.  The equity hedges since 2010 have now cost $3.7 billion in BV which represents about 40% of BV. 

 

The CPI hedges have cost about 5% of BV (about half the losses of the CDS hedges before they went up).  The other note on the CPI hedges is they are tied to an index which includes food and energy and it has only turned negative with the large decline in oil prices in the past 6 months.  If you look at the CPI excluding food and energy it is still increasing at a rate of 1.5% per year.  So unless the CPI excluding food and energy starts to decline, the CPI should start to increase.

 

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I was also pleased by the Asian growth.  The one note I did have was on the hedges.  The equity hedges since 2010 have now cost $3.7 billion in BV which represents about 40% of BV. 

 

The CPI hedges have cost about 5% of BV (about half the losses of the CDS hedges before they went up).  The other note on the CPI hedges is they are tied to an index which includes food and energy and it has only turned negative with the large decline in oil prices in the past 6 months.  If you look at the CPI excluding food and energy it is still increasing at a rate of 1.5% per year.  So unless the CPI excluding food and energy starts to decline, the CPI should start to increase.

 

Packer

 

This is what I also don't get, especially in relation to the oil bets that are highly dependant on high oil prices. If those are meant as a sort of hedge, wouldn't it make more sense to hedge bet on other highly inflatable goods?

 

(More comments later)

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"The equity hedges since 2010 have now cost $3.7 billion in BV which represents about 40% of BV."

 

And that is a friendly comparison. If you compare to the stock portfolio with a year end value of $4.9 billion that is 76%. Compared to 2013 year end values of $3.9 billion that is 95%.

 

That is not hedging. These are losses from pure short selling. Hedging is normally a small percentage of your assets or an inverse investment with an assymetric payout.

 

I mean what are they trying to protect against? Most of the money is and has been invested in bonds which have benefited from 35 years of decline in long term interest rates. In other words, that is investing pretty much directly into an hedge or one that benefits from deflation.

 

IMO, the CPI derivatives are fine or a small percentage of assets and extra spice to the deflationary nature of a large fixed income portfolio. The equity hedges I don`t get.

 

Cardboard   

 

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IMO, the CPI derivatives are fine or a small percentage of assets and extra spice to the deflationary nature of a large fixed income portfolio. The equity hedges I don`t get.

 

I also think that in retrospect equity hedges will be seen as a big mistake...

 

This doesn't mean it makes sense to take them away now, in the 7th year of a spectacular bull market for stocks, with global deleveraging that still has to begin, economies burdened by massive debts, and the Shiller PE of the S&P500 fast approaching 28...

 

Gio

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Moreover, I don't know if it makes sense for FFH to go on hedging their stocks portfolio... But it surely is very useful for me! At this point in the market cycle I am very happy to have half of my portfolio in businesses that will do very well, if the market goes on undisturbed... And the other half invested in FFH that will do very well if the market starts going south...

 

In other words, I don't want FFH to only be "protected"... I want it to actually make lots of money in a market crash! And imo that's exactly how FFH is positioned today: it will make some money as long as the market keeps going up, and it will make much more when the market starts to turn down.

 

Gio

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Way to early to tell. The latest PPI was down big. That will work its way through the economy. All commodities are down, except a few. Food will fall, we have way too much over capacity. Corn prices today would much lower without ethanol consumption and now with low oil prices ethanol makes little sense. We are awash in oil. Next up to fall will be beef prices. The nature of the industry makes it a longer to turn up or down. Input feed prices have come down a lot and supply is being held back as farmers increase their herds. That will turn shortly, it always does.

 

 

I think they bought into deflation whole hog. It was the wrong decision. Even without hindsight.

 

Too early to say that.  If China slows further, deflation will increase.  Cheers!

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I think the big weakness in the commodity decline leading to deflation argument is how little commodity prices influence CPI.  When the commodities where inflating like crazy there was little inflation so why would not the opposite be true?  If you look closely at the January CPI release, the only reason there was deflation was falling energy prices.  The CPI ex food and energy is still going up at 1.5% per year.  In addition, you have some companies increasing wages (Walmart and others).  So unless you expect a sustained decline in energy and food prices that can overcome the core inflation of 1.5%, I just do not see how deflation happens with the US CPI. 

 

I think if the measure is Swiss Francs or Danish Kroner then you will see deflation but not the US$ or Euro where QE will ensure deflation will not happen in $ or Euros.

 

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Packer:

 

1.  I think some of the increase in wages came from recently enacted minimum wage raises..one time effect...possibly.

2.  I think the trade weighted $USD (DXY) - currently at around 96 - continues on a steady climb to 120 over the next couple of years (deflationary)

3.  I think the Chinese would love to drop the value of their currency - which is (was?) tied to $USD - that would be deflationary.

4.  As much as folks have been focused on Greece, I think Japan is worse off - huge debt, shrinking demographic.

5.  Risk of Chinese hard landing is increasing.

6.  At some point the recent international currency volatility will cause some linkages to snap...will it be contained?  Then what happens to the bond market?  For sure US bonds will rise (falling yield - increase in Fairfax bond portfolio).

 

That said, I agree with the points you make...it's a tough call.

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That is a very valid point regarding commodities rising. 

 

Regarding the January CPI, deflation was predominately from energy but you can't say it was the only reason. 

 

If you look at all items less food and energy, commodities less food & energy commodities, new vehicles, used cars and trucks, medical care commodities were all down in January.  Apparel was also down on a non SA basis (-1.1%) but up modestly 0.3 on SA basis.  Apparel unadjusted is down 4% YOY. 

 

Basically it's fairly safe to say that most all consumer goods in the CPI less food and energy were down in January.  Goods only make up 25% of the CPI less food and energy.  Services make up the other 75% and shelter makes up a huge portion there.  Housing as you know turns on employment and that doesn't seem to be a problem anytime soon.  Household formation also appears to have turned the corner.

 

So almost everything in the CPI is flat or declining, including food, energy, and consumer goods in January.  The only items supporting CPI is shelter and other services. 

 

I also agree with you regarding QE... and to quote buzz lightyear, "To QE infinity and beyond..."

 

 

I think the big weakness in the commodity decline leading to deflation argument is how little commodity prices influence CPI.  When the commodities where inflating like crazy there was little inflation so why would not the opposite be true?  If you look closely at the January CPI release, the only reason there was deflation was falling energy prices.  The CPI ex food and energy is still going up at 1.5% per year.  In addition, you have some companies increasing wages (Walmart and others).  So unless you expect a sustained decline in energy and food prices that can overcome the core inflation of 1.5%, I just do not see how deflation happens with the US CPI. 

 

I think if the measure is Swiss Francs or Danish Kroner then you will see deflation but not the US$ or Euro where QE will ensure deflation will not happen in $ or Euros.

 

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- Currency wars to generate growth could lead to deflation.

- decrease in capital spending in energy and commodity industry - one of the largest sources for employment and capex over the last 7 odd years. Could further impact demand.

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I think the big weakness in the commodity decline leading to deflation argument is how little commodity prices influence CPI.  When the commodities where inflating like crazy there was little inflation so why would not the opposite be true?  If you look closely at the January CPI release, the only reason there was deflation was falling energy prices.  The CPI ex food and energy is still going up at 1.5% per year.  In addition, you have some companies increasing wages (Walmart and others).  So unless you expect a sustained decline in energy and food prices that can overcome the core inflation of 1.5%, I just do not see how deflation happens with the US CPI. 

 

I think if the measure is Swiss Francs or Danish Kroner then you will see deflation but not the US$ or Euro where QE will ensure deflation will not happen in $ or Euros.

 

Packer

 

I largely agree with you on the limited impact of commodities and energy. The other thing to mention is that after a 50% decline, commodities' impact on the CPI index is significantly more muted going forward. I disagree with you on wages though - the positive wage print in January was largely due the CPI deflator that they use as the denominator and not because there was a large rise in the nominal pay. Walmart wages may be a bellweather for future wage increases, but I think walmart wages are a very small piece of the wage picture and don't mean much in isolation. We need a tighter labor market for there to be a sustained increase and I tend to believe that there is still quite a bit of slack.

 

I agree though - we won't see sustained deflation unless if it makes it's way into housing. I think the biggest impediment to the inflation story in the near term will likely be the strength of the dollar. Just like oil, this will translate into pricing decreases through almost everything that is purchased outside of services. I think dollar strength and the price of oil will contribute to deflation through calendar year 2015 and possibly into 2016 depending on the status of our record oil supplies in storage and the continuing strength of the dollar. It will need to enter the housing market to extend beyond that. I tend to agree with Gio on this one though - I think something as simple as a stock market decline could be the trigger.

 

After 6 years of being told to ignore risks, investors have levered up their exposure to equities through margin debt while US equities are priced for perfection. A strong dollar and potentially increasing wages will weigh on corporate margins that are currently significantly above their historical trend. Paired with extremely high stock valuations and the potential for rising rates and you have a stock market disaster - declining margins and declining multiples could easily spell a 50% decline. Magniffy this by the margin debt and we could see some spectacular blow ups that have larger economic implications that affect wages and employment. This is simply speculation - I just get the feeling investors aren't the only ones who've been ignoring risks and that the implications of a risk-off environment will be felt far beyond the stock market. Full disclosure: I recently purchased 1 year put options on the S&P at 1900.

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The one disconnect I see with FFH thesis is low inflation to slight deflation and stock multiples of low to mid teens.  This would imply and ERP of 7% (very high by historical standards).  If they are right about low inflation lets say 1% (which I agree with), a 1.5% LT bond premium and a more normal ERP of 4 to 5% and a 2% earnings growth rate, it implies a normal stock multiples of 17 to 20 of next years earnings.  We are in that range now.  It is not expensive under FFH's scenario but is expensive for an inflationary environment.

 

The one difference between now and all of the other stock rallies are the low bond yields.  In 2000 and 2007 bond yields were providing reasonable returns versus 0 or negative now. 

 

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I am not saying you are wrong, but where is the evidence on the margin debt?

http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8

The one disconnect I see with FFH thesis is low inflation to slight deflation and stock multiples of low to mid teens.  This would imply and ERP of 7% (very high by historical standards).  If they are right about low inflation lets say 1% (which I agree with), a 1.5% LT bond premium and a more normal ERP of 4 to 5% and a 2% earnings growth rate, it implies a normal stock multiples of 17 to 20 of next years earnings.  We are in that range now.  It is not expensive under FFH's scenario but is expensive for an inflationary environment.

 

The one difference between now and all of the other stock rallies are the low bond yields.  In 2000 and 2007 bond yields were providing reasonable returns versus 0 or negative now. 

 

Packer

 

Agreed. I think Prem was banking a lot on deflation and not sustained disinflation. If inflation stays at 1-2%, then the multiple on equities could reasonably be inflated all else being equal. This would NOT. be the case in a deflationary scenario with falling earnings, falling asset values, and increasing leverage ratios. I wish he was able to call the tops and bottoms,  but I know that he's not. I disagreed with hedging my entire equity exposure so, as a result, I was far more aggressive in my own portfolio and allocated less to Fairfax in the past few years - that has changed recently though. I've doubled my holdings of Fairfax, have been reducing my margin positions, purchased puts on the S&P, and have been moving into European and EM equities over the past two years with little direct exposure in the US. I think that the next 2-3 years pose significantly higher risks for US equities than the past and tend to think this will be the period that Prem looks like the genius who was just early again.

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Way to early to tell. The latest PPI was down big. That will work its way through the economy. All commodities are down, except a few. Food will fall, we have way too much over capacity. Corn prices today would much lower without ethanol consumption and now with low oil prices ethanol makes little sense. We are awash in oil. Next up to fall will be beef prices. The nature of the industry makes it a longer to turn up or down. Input feed prices have come down a lot and supply is being held back as farmers increase their herds. That will turn shortly, it always does.

 

 

I think they bought into deflation whole hog. It was the wrong decision. Even without hindsight.

 

Too early to say that.  If China slows further, deflation will increase.  Cheers!

 

To be clear, I was talking about the U.S. only. He may be correct on deflation in other places.

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From the annual letter:

 

"I have learned that the tech world is very difficult to predict and things change very quickly." 

 

Sorry but that statement strikes me as odd in that it seems he just figured that out about the technology business. Not a lot of moats in that industry. 

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