Fairfax chairmans letter 2015

[JBTC]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation. I think the odds are an order of magnitude lower.

 

Vinod

 

This is an important point - thank you for making it.

 

Just mentioning some scary (or bullish) outcomes without attaching odds is a very bad practice, whether intentional or not.

 

Investors often become enamored with the magnitude of certain outcomes, but forget that odds are all important in investing.

 

[benhacker]

Vinod,

 

I would think that the gains would not really show up in one quarter. Deflation would be a long drawn out process so the gains would have be to realized over many years. Again I could be wrong.

 

Yeah, as the contracts are marked to market each quarter, collateral is passed from one party to the other.  There are many ways to mark (to model) the contracts, and I'm sure any bank selling these would value them more conservatively than Fairfax if times get rough so as to post as little collateral as reasonable (without being called out for having a lack of collateral to post...), but with each measurement period, the bank would have to post collateral to back the net change to Fairfax if the contracts start moving in Fairfax's favor.

 

Certainly, a 40% deflation like the GD would be a long drawn out affair, but the valuation change in contracts like these would move slowly each quarter to suck collateral in from the IB to Fairfax.  A 1 quarter valuation change + the difference in valuation methodology would be the only thing at risk even if Fairfax held the contracts for massive gains over 5 years (as an example only).

 

Hope that helps.

 

[vinod1]

Vinod,

 

I would think that the gains would not really show up in one quarter. Deflation would be a long drawn out process so the gains would have be to realized over many years. Again I could be wrong.

 

Yeah, as the contracts are marked to market each quarter, collateral is passed from one party to the other.  There are many ways to mark (to model) the contracts, and I'm sure any bank selling these would value them more conservatively than Fairfax if times get rough so as to post as little collateral as reasonable (without being called out for having a lack of collateral to post...), but with each measurement period, the bank would have to post collateral to back the net change to Fairfax if the contracts start moving in Fairfax's favor.

 

Certainly, a 40% deflation like the GD would be a long drawn out affair, but the valuation change in contracts like these would move slowly each quarter to suck collateral in from the IB to Fairfax.  A 1 quarter valuation change + the difference in valuation methodology would be the only thing at risk even if Fairfax held the contracts for massive gains over 5 years (as an example only).

 

Hope that helps.

 

Thanks! That is how I was thinking too although I did not factor in the valuation methodology.

 

Vinod

[james22]

Prem's point isn't that you should've stayed out of the market for the full 25 years  as much as it was that most people don't really have a 15 year time horizon to break even on a nominal basis (and even longer on an inflation adjusted basis).

 

I repeat myself, but the time- and dollar-weighted investment horizon of a 25 year-old is only about 12 years.

 

http://media.pimco-global.com/pdfs/pdf/VP001-050107%20Better%20Glidepath.pdf

[petec]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation.

 

 

From meetings etc. I think that's about right.  He's well aware the world might muddle through.  He just wants to make 100% sure that Fairfax survives if it does not.

[Uccmal]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation.

 

 

From meetings etc. I think that's about right.  He's well aware the world might muddle through.  He just wants to make 100% sure that Fairfax survives if it does not.

 

I dont think the implications of a great depression scenario have been thought through by Prem, or the posters here.  Fairfax would not survive a great depression on the scale of the 1930s - It simply wouldn't.  Blackberry would cease to exist in days, the entire restaurant business would collapse, the Greek Banks would shut, insurance sales would stop...  most of the insurance business would close.  The least of his problems would be collecting on his negative bets.  All of the money, if it could be collected, would be eaten up to pay back the float due to shrinking premiums.  Never mind the civil disruption, violence etc -  The property/casualty business would be sunk under massive, continuous claims.  This would not be a gentle, civil 1930s depression - the world has changed and gotten more crowded. 

 

Prem keeps stating that governments have used up their ammunition to fight another financial crisis/recession.  I disagree.  Governments, excepting China and India, have done very little infrastructure spending, above the normal run rate.  Much of the world could easily ramp this up to fend off a great depression.  All they have to do is print money - in a deflation that should not be a problem.  The US could have done it in 2009, but for the gridlock in congress.  It was easier to let the fed lead the way.

 

FiNally, and perhaps most telling is that FFH keeps on investing in its future.  Prem hasn't even skipped a beat.  This is contrary to the way the press gloms onto the negative bets.  He is not a pessimistic as everyone thinks by the way the letter reads.  Look at the actions of FFH.  Not a month goes by without an announcement of another aquisition or deal. 

 

 

 

[Jurgis]

+1 on what Uccmal said.

 

Also, if Prem wants 100% guarantee of survival in GD, he should not be investing in Sandridge, Blackberry, Greek banks, etc.

[JBTC]

 

FiNally, and perhaps most telling is that FFH keeps on investing in its future.  Prem hasn't even skipped a beat.  This is contrary to the way the press gloms onto the negative bets.  He is not a pessimistic as everyone thinks by the way the letter reads.  Look at the actions of FFH.  Not a month goes by without an announcement of another aquisition or deal.

 

Agree!

 

Plenty of money managers talk pessimism but act quite rationally. I am not sure why that is.

 

Maybe sounding cautious makes one look smart and conservative. Maybe in today's treacherous world, there is a market for it, as investors simply cannot bring themselves to trust anyone who doesn't sound worried.

 

Too bad many tend to follow their words, not their actions.

 

[petec]

 

I dont think the implications of a great depression scenario have been thought through by Prem, or the posters here.  Fairfax would not survive a great depression on the scale of the 1930s - It simply wouldn't.  Blackberry would cease to exist in days, the entire restaurant business would collapse, the Greek Banks would shut, insurance sales would stop...  most of the insurance business would close.  The least of his problems would be collecting on his negative bets.  All of the money, if it could be collected, would be eaten up to pay back the float due to shrinking premiums.  Never mind the civil disruption, violence etc -  The property/casualty business would be sunk under massive, continuous claims.  This would not be a gentle, civil 1930s depression - the world has changed and gotten more crowded. 

 

My conversations with them lead me to think they have thought this through, and researched it, in considerable detail.  They believe that a GD would be an incredibly tough period for insurers which is why they have these high-payout, asymmetric bets as insurance.  All the while, as you say, they are investing heavily (and cleverly IMHO) in their business on the assumption that disaster does not strike.

 

Now, whether that means he thinks a catastrophe is 10%, 20%, or 30% likely I'm not going to guess at.  What I meant by my post, which maybe wasn't clear, is that I don't think he thinks another GD is necessarily a high probability event (as in, well over 50%).  Yet, when you read his letters, you could be forgiven for thinking that he did.

 

What I do think he thinks is a high probability event is a significant asset price sell-off.

 

Of course, I'm speculating on both counts.  I can't read his mind.

 

 

[vinod1]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation.

 

 

From meetings etc. I think that's about right.  He's well aware the world might muddle through.  He just wants to make 100% sure that Fairfax survives if it does not.

 

I dont think the implications of a great depression scenario have been thought through by Prem, or the posters here.  Fairfax would not survive a great depression on the scale of the 1930s - It simply wouldn't.  Blackberry would cease to exist in days, the entire restaurant business would collapse, the Greek Banks would shut, insurance sales would stop...  most of the insurance business would close.  The least of his problems would be collecting on his negative bets.  All of the money, if it could be collected, would be eaten up to pay back the float due to shrinking premiums.  Never mind the civil disruption, violence etc -  The property/casualty business would be sunk under massive, continuous claims.  This would not be a gentle, civil 1930s depression - the world has changed and gotten more crowded. 

 

Prem keeps stating that governments have used up their ammunition to fight another financial crisis/recession.  I disagree.  Governments, excepting China and India, have done very little infrastructure spending, above the normal run rate.  Much of the world could easily ramp this up to fend off a great depression.  All they have to do is print money - in a deflation that should not be a problem.  The US could have done it in 2009, but for the gridlock in congress.  It was easier to let the fed lead the way.

 

FiNally, and perhaps most telling is that FFH keeps on investing in its future.  Prem hasn't even skipped a beat.  This is contrary to the way the press gloms onto the negative bets.  He is not a pessimistic as everyone thinks by the way the letter reads.  Look at the actions of FFH.  Not a month goes by without an announcement of another aquisition or deal.

 

+1

 

That makes a lot of sense.

 

Vinod

[petec]

 

FiNally, and perhaps most telling is that FFH keeps on investing in its future.  Prem hasn't even skipped a beat.  This is contrary to the way the press gloms onto the negative bets.  He is not a pessimistic as everyone thinks by the way the letter reads.  Look at the actions of FFH.  Not a month goes by without an announcement of another aquisition or deal.

 

Agree!

 

Plenty of money managers talk pessimism but act quite rationally. I am not sure why that is.

 

Maybe sounding cautious makes one look smart and conservative. Maybe in today's treacherous world, there is a market for it, as investors simply cannot bring themselves to trust anyone who doesn't sound worried.

 

Too bad many tend to follow their words, not their actions.

 

Or maybe having asymmetric insurance enables you to sleep well while being long (I'm referring to the deflation bets here, not the hedges).

 

I do think that Prem's willingness to buy whole businesses, but not to be net long assets whose prices are set daily by stock markets, is a guide to where and how he sees risks.

[petec]

 

I dont think the implications of a great depression scenario have been thought through by Prem, or the posters here.  Fairfax would not survive a great depression on the scale of the 1930s - It simply wouldn't.  Blackberry would cease to exist in days, the entire restaurant business would collapse, the Greek Banks would shut, insurance sales would stop...  most of the insurance business would close.  The least of his problems would be collecting on his negative bets.  All of the money, if it could be collected, would be eaten up to pay back the float due to shrinking premiums.  Never mind the civil disruption, violence etc -  The property/casualty business would be sunk under massive, continuous claims.  This would not be a gentle, civil 1930s depression - the world has changed and gotten more crowded. 

 

 

The more I think about this part of your post the less I agree with it.

 

In a real GD, the deflation swaps could easily post gains big enough to cover a total wipeout of the equity portfolio - which would not happen in any case since the equities are hedged.  Since the deflation swaps are collateralised they, at least, would be collected upon (I can't remember the details of the equity hedges but I know FFH have taken care with their counterparties).

 

The bonds would likely also do well.

 

Meantime the insurance businesses go into emergency mode exactly as you suggest - but that is precisely why Prem is so keen to have a protected balance sheet.

[benhacker]

The more I think about this part of your post the less I agree with it.

 

it's too bad that this piece of Fairfax always gets the focus, but just to put some #'s.

 

GD GDP decline was 40%.

 

Notional portfolio of CPI puts for Fairfax is like $110B.

 

So... yes, Petec is right.

 

the gains on the swaps would cover not just the EQUITY portfolio, the gains would cover a wipeout of the equity & fixed income portfolio.... or really, a zeroing out of 100% of Fairfax assets.

 

Again, this doesn't defend Fairfax's stance, or how they frame their letters to shareholders which I think deserve some valid critiques, but arguing against a bar bell portfolio by claiming extreme outcomes will kill it without actually running some basic numbers is probably not the way to critique FFH.

 

The size of their CPI bet appears to clear be designed to protect the entire company from world ending loss... whether that was worth betting 8% of common equity on is another question... but it will protect them in a GD scenario, however unlikely.

[BTShine]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation. I think the odds are an order of magnitude lower.

 

Vinod

 

This is an important point - thank you for making it.

 

Just mentioning some scary (or bullish) outcomes without attaching odds is a very bad practice, whether intentional or not.

 

Investors often become enamored with the magnitude of certain outcomes, but forget that odds are all important in investing.

 

Well said.  It always strikes me when looking back at historical stock charts for the S&P, Dow, etc. that periods with 'big losses' often times had losses of 20-30%, and often they were erased by gains shortly after.  Clearly, anything can happen, but the odds are usually that prices stay relatively stable. 

[lessthaniv]

It was interesting to me the tone of Prem's letter as compared to Buffett who lambasted the party-line pessimism.

[Uccmal]

The more I think about this part of your post the less I agree with it.

 

it's too bad that this piece of Fairfax always gets the focus, but just to put some #'s.

 

GD GDP decline was 40%.

 

Notional portfolio of CPI puts for Fairfax is like $110B.

 

So... yes, Petec is right.

 

the gains on the swaps would cover not just the EQUITY portfolio, the gains would cover a wipeout of the equity & fixed income portfolio.... or really, a zeroing out of 100% of Fairfax assets.

 

Again, this doesn't defend Fairfax's stance, or how they frame their letters to shareholders which I think deserve some valid critiques, but arguing against a bar bell portfolio by claiming extreme outcomes will kill it without actually running some basic numbers is probably not the way to critique FFH.

 

The size of their CPI bet appears to clear be designed to protect the entire company from world ending loss... whether that was worth betting 8% of common equity on is another question... but it will protect them in a GD scenario, however unlikely.

 

The criticisms of my stance from Petec and you are fair.  Assuming all goes well, or badly, perhaps they survive.  Following on Vinods comment about the odds of a Gd repeat, we cant really know. 

 

To follow on to your later comments Ben:  It is a heck of a drag on investment performance.  Maybe, just collecting cash onto the balance sheet instead would be another strategy, which is what Buffett does.  That being said, Brk. cash flow would dry up in a GD scenario. 

 

A GD or slightly less noxious scenario is certainly something I give some thought to, but dont dwell on too much. We, who were on this message board, in 2008/09 have some real experience to apply, should such a situation recur. 

[TwoCitiesCapital]

 

My point is, reading Prem Watsa's letters, I get the feeling that the likelihood of another GD is something of order of 20% or 30% or something like that. He never mentioned the probabilities, but just reading between the lines that is what I would infer - maybe not the right interpretation. I think the odds are an order of magnitude lower.

 

Vinod

 

This is an important point - thank you for making it.

 

Just mentioning some scary (or bullish) outcomes without attaching odds is a very bad practice, whether intentional or not.

 

Investors often become enamored with the magnitude of certain outcomes, but forget that odds are all important in investing.

 

Well said.  It always strikes me when looking back at historical stock charts for the S&P, Dow, etc. that periods with 'big losses' often times had losses of 20-30%, and often they were erased by gains shortly after.  Clearly, anything can happen, but the odds are usually that prices stay relatively stable.

 

I get the exact opposite impression - I notice a handful of periods of flat to negative returns for a span longer than a decade and ask myself it that is an acceptable outcome and if there is any way to get out of the way of it before it happens.

 

So far, there have been pretty reliable indicators that would have let investors know to get out in the past...

 

 

[petec]

 

I get the exact opposite impression - I notice a handful of periods of flat to negative returns for a span longer than a decade and ask myself it that is an acceptable outcome and if there is any way to get out of the way of it before it happens.

 

 

+1

 

Also, I don't think comparing Buffet's optimism to Watsa's pessimism is an accurate reading of what either is saying.

 

Buffett is saying that the quality of life of the average American will improve over time.  I haven't read anything from Watsa that has contradicted that.

 

Watsa is saying that all the debt makes the world look 1929- or Japan-like, and maybe it's worth being cautious on asset prices and maybe deflation.  Buffett hasn't said either specifically, but he has spent his entire career warning about being contrarian and building a fortress balance sheet, which I think is how Watsa also thinks.

 

I'm not saying that if you put them in a room they'd see eye-to-eye, and clearly Buffett hasn't hedged his equities which is the clearest indication that they've had at least one differing viewpoint, but characterising one as bullish and one as bearish rather misses what each has actually been saying - especially Buffett.

[Alekbaylee]

A question I've been pondering for a while now: all these refugees fleeing their countries for a better life in Europe and now in Canada are going to need jobs of course but also houses, cars, furniture, appliances, clothes, food, etc. Isn't that somewhat good for our economies? Maybe not right away as governments (meaning the taxpayer) need to fund all sort of support programs, but on the longer run.

 

Thoughts?

[wisdom]

An average house in Canada is $500,000. How long do you think it will take them to get jobs where they can afford to buy a place When our median income is around $50,000 and even lower for immigrants?

 

Yes, in the long term it should be beneficial, but, we took 25,000 refugees compared to our annual immigration of 250,000 plus. So the refuges are only 10% or so.

[Alekbaylee]

Good point Wisdom but let's not forget that many of them are well educated or business oriented and will work themselves out of the misery sooner than one think, either by themselves or with the help of their communities and families. If peace is restored in their country (which I truly wish) then they might go back, otherwise they'll stay, strive and prosper. Call me optimistic... :)

[petec]

Good point Wisdom but let's not forget that many of them are well educated or business oriented and will work themselves out of the misery sooner than one think, either by themselves or with the help of their communities and families. If peace is restored in their country (which I truly wish) then they might go back, otherwise they'll stay, strive and prosper. Call me optimistic... :)

 

You're right.  It's a positive.  It's the key factor in overcoming demographic change.  So long as the host nation integrates them and lets them succeed, which isn't politically easy.

[valueinvesting101]

Quote from the letter:

 

The bad news is that the 9% cost us $234 million or five times book value. While many of you may think I am losing it, we think, over time, ICICI Lombard will be worth every dollar we have invested in it – and more! It is an outstanding company. Our total investment in ICICI Lombard stands at $347 million.

 

So last 9% cost them $234 million but total investment stands at $347 million. Is this investment carried at purchase price instead of reflecting current valuation for entire stake based on latest purchase price? Based on price paid for latest purchase, value of the 35% stake should be $910 million.

[giofranchi]

These are my main comments about the letter:

 

 

 

 

 

 

 

 

 

 

Cheers,

 

Gio