Reduction in Equity Hedges to 50%

[vinod1]

I took a small position today at $442.

 

It could be that people who thought this would have downside protection and see it as a "cash equivalent" are reducing their exposure now that the hedges are reduced. From the press statement, they mention that they could eliminate the hedges completely. 

 

Vinod

[Jurgis]

It could be that people who thought this would have downside protection and see it as a "cash equivalent" are reducing their exposure now that the hedges are reduced. From the press statement, they mention that they could eliminate the hedges completely. 

 

Right. Part of attraction to FFH was the deflation hedges/optionality and market hedges. They removed half of market hedges and deflation hedges are less attractive with inflation possibly picking up. So then you look at FFH naked and have to decide if that is attractive. If FFH was at price comparable to BRK, it might not be very attractive naked vs BRK. Now that it's at a (way?) "cheaper" price than BRK, maybe it is.

 

Disclosure: I have large positions in both FFH and BRK. Haven't added recently.

[vinod1]

Bought some more at $437. Still a smallish position.

 

Vinod

[Luckyone77]

This reminds me of the joke about the guy on death row down in Alabama who was about to be lethally injected. Staring at the guy as he was strapped in the gurney awaiting his final moments, the Warden asked him if he had any last words.

 

The prisoner thought about it for a minute and in his slow southern drawl finally said..."You know, Warden, I do. I just want you to know that I'm gonna learn a lot from this."

[Partner24]

Ahahahah so funny.

 

I've told since the very beginnings of these hedges that they were some kind of an ark. Terrific if it rains, but we could get very thirsty if the sun would keep shining. They've predicted rain since years. Really predicted it to us over and over again.

 

Bad forecast.The sun have kept shining and the patient shareholders that we are are thirsty.

 

I knew that possibility and kept my shares. So it was MY decision.

 

But the main problem here is the lack of candor. So, Trump is here and you change totally the forecast because of that?

 

Bull**** doesn't taste good. They bought high and sold low and made economical forecast that were wrong. Billions of dollars lost. That's ok, but no turds on top of that.

 

Please. Let's call a cat a cat. If you don't admit your mistakes, you'll keep repeating them.

 

 

[ERICOPOLY]

I remember an interview Prem gave in 2009 where he was favorably saying QE/stimulus had been working and he claimed he would be watching carefully for signs of protectionism, because trade wars made the Depression deeper/worse.

 

Now we get the candidate that has all but promised protectionism and Prem gets bullish. 

 

Just an observation.

[JBird]

This reminds me of the joke about the guy on death row down in Alabama who was about to be lethally injected. Staring at the guy as he was strapped in the gurney awaiting his final moments, the Warden asked him if he had any last words.

 

The prisoner thought about it for a minute and in his slow southern drawl finally said..."You know, Warden, I do. I just want you to know that I'm gonna learn a lot from this."

 

LOL-- Thanks for sharing that

[petec]

The irony here is that I bought and held Fairfax mainly as protection against a market correction. Turns out that the only thing that corrected was Fairfax while the market soared. I don't fault them for their macro bet, as I shared their belief, but it clearly has been dead wrong.

 

Me too.  Then again, a big position in FFH was what gave me the confidence to have the rest of the portfolio in stuff that has gone up recently, so the position has done its job for me.

 

I do, however, fault them for their horrible stock picking. That's on them.

 

Precisely.  The hedges were always justifiable IMHO based on 1) long term equity valuations (even if they were dead wrong) and 2) protecting a levered company (they were insurance and were repeatedly explained as such).  What wasn't justifiable IMHO was 3) failing to protect the upside as someone here has mentioned and 4) poor stockpicking.

 

Coming back to this discussion after a couple of weeks away, thanks to Parsad and Bsilly for very informative comments earlier.

[SharperDingaan]

It's useful to look at the structure of the BIS rules around bank & insurance capital.

 

- Invest in whatever you want but 'haircut' it for capital purposes - the more risky the bigger the haircut

- Risk manage however you want - but you hold a pool of hedges & unencumbered treasuries to cover the black swans

- Bi-annual stress testing. Ongoing regulatory examination

- Leverage, contained within regulated limit

 

The black swans are covered by stress testing to determine magnitude, then hedged against the 'financial system' to spread the risk.

System wide the aggregate treasury pool, reduces the overall risk within the 'financial system'.

 

For any individual institution; if the size of your pool of treasuries is roughly 2x (margin if safety) the size of your maximum loss (per the stress tests), you don't need to hedge any more. You are using your pool of treasuries to self insure, and saving the annual 'insurance cost of hedging'. Exactly what FFH is doing. 

 

It would also appear that FFH has recognized that as long as they could invest the pool of treasuries margin of safety, at more than the cost of hedging; they could make quite a 'macro' spread. If the surplus pool of treasuries investment were part of a global shift into 'infrastructure assets' (Trump), it would also reduce the cost of hedging as the 'financial system' overall 'de-risks.' Hence, what appears to be a game change in strategy.

 

More significant, it that it gives an idea of where the $ for infrastructure rebuilding;

1) would come from, 2) the mechanism, & 3) the magnitude

 

Very elegant,

& as we would expect.

 

SD

 

 

 

 

 

[petec]

SD - very useful, thanks.  Although I am not sure I follow your last comment about the pool of $ for infrastructure?

[cwericb]

I tend to get frustrated with those who complain about FFH because I believe they actually do know what they are doing. But no one is right every time on all things.

 

I have a large percentage of my portfolio in Fairfax and have been that way for about 10 years and I am quite satisfied.

 

Yes, I had to grit my teeth in the recent slide but when I look at my portfolio as a whole it was pretty well evened out by my other holdings - holdings that I probably wouldn’t have owned if not for my belief that FFH offered some protection on the downside.

 

Petec and I are on the same page

“Then again, a big position in FFH was what gave me the confidence to have the rest of the portfolio in stuff that has gone up recently, so the position has done its job for me.”

And again when you says: “The hedges were always justifiable IMHO based on 1) long term equity valuations (even if they were dead wrong) and 2) protecting a levered company (they were insurance and were repeatedly explained as such)”

 

The last part of this quote is 100% correct and yet many investors still couldn’t seem to grasp this no matter how often and clearly it was stated.

 

In general, over the past years when markets went down, FFH went up, when markets went up, FFH slid, maintained or went up. It has also provided me with a balance against Canadian dollar depreciation.

 

To me, Fairfax has been insurance of another kind.

[racemize]

This leveraged argument only makes sense on the surface.  If they needed 100% equity hedges to protect the leverage, then they couldn't be 50% now, and they couldn't have taken them off in 2009.  So, sure there may be some base hedging that has to happen, but it isn't 100%.  A large portion had to be a bet, and they refuse to call it one.

[SharperDingaan]

Imagine a bank loan asset portfolio of 125M, liabilities of 100M & equity of 25M. After risk adjusted capital haircuts the 125M of assets is 100M, & there is essentially zero equity to absorb shocks (many major EU banks). The bank/regulator runs a series of different stress test scenarios; under the worst scenario the value of the assets would fall to 85M - if they could sell them, & the bank would be bankrupt.

 

To prevent bankruptcy the regulator would demand the bank hedge to produce an offsetting gain of at least 20M (assets at 105% of liabilities), an unencumbered pool of treasuries (5%+ of liabilities) in case the assets can't sell, and risk adjusted equity at around 12% (Tier 1 Capital Ratio). As the size of the treasury pool is driven from the stress tests; multiply the size of the treasury pool by a margin of safety (2x in our example) - just in case the forecast is wrong (common engineering practice). Unfortunately the treasury pool earns squat, & barbells the asset portfolio.

 

But if you add a bigger hedge & hold less risky assets - the maximum possible stress test loss declines, and the pool of treasuries can be smaller. The surplus treasuries can be sold and invested in infrastructure - producing both a higher return than treasuries, and much more effective ALM matching. This is the fund flow to infrastructure.

 

When everybody starts doing this, it diverts bank capital currently supporting the riskiest loans into less risky infrastructure, AND MULTIPLIES THE EFFECT. That 20M of high risk loan, required 10M of risk adjusted capital, which can now support 30M+ of lower risk infrastructure loan. This is both the mechanism, and source of bank capital supporting the funds flow to infrastructure.

 

The loan universe de-risks from high risk loans getting pulled. Borrowers have more cash flow to service their loans (from a stronger economy) - & pay the higher interest rates on their loans (net zero impact on borrowers). And if a bank or two fails along the way - there isn't going to be a lot of sympathy; it's evidence of change.

 

It's very slick, & very elegant.

Unfortunately it has the squids sucker marks all over it.

 

SD

 

 

SD - very useful, thanks.  Although I am not sure I follow your last comment about the pool of $ for infrastructure?

[petec]

Imagine a bank loan asset portfolio of 125M, liabilities of 100M & equity of 25M. After risk adjusted capital haircuts the 125M of assets is 100M, & there is essentially zero equity to absorb shocks (many major EU banks). The bank/regulator runs a series of different stress test scenarios; under the worst scenario the value of the assets would fall to 85M - if they could sell them, & the bank would be bankrupt.

 

To prevent bankruptcy the regulator would demand the bank hedge to produce an offsetting gain of at least 20M (assets at 105% of liabilities), an unencumbered pool of treasuries (5%+ of liabilities) in case the assets can't sell, and risk adjusted equity at around 12% (Tier 1 Capital Ratio). As the size of the treasury pool is driven from the stress tests; multiply the size of the treasury pool by a margin of safety (2x in our example) - just in case the forecast is wrong (common engineering practice). Unfortunately the treasury pool earns squat, & barbells the asset portfolio.

 

But if you add a bigger hedge & hold less risky assets - the maximum possible stress test loss declines, and the pool of treasuries can be smaller. The surplus treasuries can be sold and invested in infrastructure - producing both a higher return than treasuries, and much more effective ALM matching. This is the fund flow to infrastructure.

 

When everybody starts doing this, it diverts bank capital currently supporting the riskiest loans into less risky infrastructure, AND MULTIPLIES THE EFFECT. That 20M of high risk loan, required 10M of risk adjusted capital, which can now support 30M+ of lower risk infrastructure loan. This is both the mechanism, and source of bank capital supporting the funds flow to infrastructure.

 

The loan universe de-risks from high risk loans getting pulled. Borrowers have more cash flow to service their loans (from a stronger economy) - & pay the higher interest rates on their loans (net zero impact on borrowers). And if a bank or two fails along the way - there isn't going to be a lot of sympathy; it's evidence of change.

 

It's very slick, & very elegant.

Unfortunately it has the squids sucker marks all over it.

 

SD

 

 

SD - very useful, thanks.  Although I am not sure I follow your last comment about the pool of $ for infrastructure?

 

Very elegant, until the money flooding into infrastructure ensures that bad projects get done!

[SharperDingaan]

The great thing about squids is that they can also squirt a lot of ink - to hide the evil!

Kind of reminds one of the Greek monks talked about in the Michael Lewis book, 'Boomerang'

 

SD

[giofranchi]

This leveraged argument only makes sense on the surface.  If they needed 100% equity hedges to protect the leverage, then they couldn't be 50% now, and they couldn't have taken them off in 2009.  So, sure there may be some base hedging that has to happen, but it isn't 100%.  A large portion had to be a bet, and they refuse to call it one.

 

Joel,

 

You and Vinod might be right of course! But I also understand Parsad's reasoning.

What we all can I agree with is the last 5 years BVPS growth has been disappointing.

Therefore, mistakes have been made: equity hedges have cost lots of money and equity investments have performed so poorly they sometimes lost money in a rising market...

On the other hand, bond investments have been very good and insurance underwriting has improved very significantly.

 

That has been the recent past. Now the future: they have $10 billion of cash and are selling for 1.1xBVPS: is FFH going to be a good investment going forward?

 

Most would say they have become good insurance underwriters and are still very good bond investors, and most would judge them as very poor stock investors.

The question imo is: will they become once again good stock investors?

If they succeed, FFH might perform very well from here.

 

But of course I don't know the answer to that question.

 

Cheers,

 

Gio

 

[beerbaron]

Welcome back Gio.

[racemize]

I agree--they are much more interesting now than they have been in a while. My problem though is that they do not appear to be honest with shareholders or themselves if they are not able to call this a mistake. And that worries me going forward.

[giofranchi]

I agree--they are much more interesting now than they have been in a while. My problem though is that they do not appear to be honest with shareholders or themselves if they are not able to call this a mistake. And that worries me going forward.

 

It will be interesting, I guess, to read what Prem will have to say about equity hedges in his 2016 AL. He has always defended equity hedges in his letters so far, for the very same reasons Parsad has written about. I tend to agree with you that in Prem's mind they were not just meant to protect a levered company, but were a call on the stock market too (a macro bet). This being said, I wouldn't call his behavior so far "dishonest": equity hedges have always been very well documented and presented to shareholders, and each one of us could have formed his/her own idea about them. Someone sharing Parsad's view, others sharing yours, others still being somewhere in between (like me).

Until a trade is over, you shouldn't really expect a 'mea culpa', should you? Even if a trade performs poorly for a long time. You should know this very well! Now I am sure your fund is having extraordinary results, but for a long time you kept defending your strategy even if it was lagging behind the general market. And I have admired you very much for the strength of will you were showing!

Now that the "equity hedges" trade seems to be over, or at least radically changed, I agree it would be great to hear Prem reason about what went wrong and why.

 

Cheers,

 

Gio

[giofranchi]

Welcome back Gio.

 

Thank you!

 

Gio

[racemize]

I agree--they are much more interesting now than they have been in a while. My problem though is that they do not appear to be honest with shareholders or themselves if they are not able to call this a mistake. And that worries me going forward.

 

It will be interesting, I guess, to read what Prem will have to say about equity hedges in his 2016 AL. He has always defended equity hedges in his letters so far, for the very same reasons Parsad has written about. I tend to agree with you that in Prem's mind they were not just meant to protect a levered company, but were a call on the stock market too (a macro bet). This being said, I wouldn't call his behavior so far "dishonest": equity hedges have always been very well documented and presented to shareholders, and each one of us could have formed his/her own idea about them. Someone sharing Parsad's view, others sharing yours, others still being somewhere in between (like me).

Until a trade is over, you shouldn't really expect a 'mea culpa', should you? Even if a trade performs poorly for a long time. You should know this very well! Now I am sure your fund is having extraordinary results, but for a long time you kept defending your strategy even if it was lagging behind the general market. And I have admired you very much for the strength of will you were showing!

Now that the "equity hedges" trade seems to be over, or at least radically changed, I agree it would be great to hear Prem reason about what went wrong and why.

 

Cheers,

 

Gio

 

I think perhaps I'm sounding much more negative than I feel.  I think FFH is a good company, and I have been a long time admirer of them.  I owned them for 3 of the recent underperforming years and really appreciated the asymmetric nature of several of their macro calls.  My issue was and I guess is that there is nothing asymmetric about hedges 100% or greater, and I think it simply cannot be true "protection" as has been implied--no one else requires that protection and they themselves haven't over time.  So the dishonesty to me is the label being applied--some amount is protection, but the other amount is clearly a macro call.  I just want them to say "this is a macro call and it didn't work out".  That's really it.  Just honesty about what the strategy actually was/is.

 

Approaching this from a different perspective, I absolutely agree that there is very little difference between being wrong and being early; however, I don't even think they'll ever say that, because they won't call it a bet in the first place!--the narrative is "we did this for protection" not "we made a bet", so there is never any reason to say they were wrong!  Even ignoring that issue, I don't think it is intellectually honest to say "I was early, not wrong" if you are 6 years in.  Timing does matter, as it reduces the IRR even if it works out.  I have the same feeling with Berkowitz and Sears Holding.  I think it is almost impossible for the equity hedges and/or Sears to work out with an acceptable IRR for either of them now, so I think the mea culpa may be warranted.  We can wait until the trade is fully over though and see what they say, but I have my doubts since in some senses the trade is over as they reduced the hedges by 50% already.

 

With regard to our fund, I view the situation quite differently.  Our position has always been on the micro and should be judged on its returns, which is just standard value investor talk.  As you know, we had a big position in banks and it got bigger this year during all the macro uncertainty.  Our stance was they were cheap and would work out over time, and that may or may not be true.  Right now it looks like it was true.  In my mind, we didn't call the investment one thing when it was actually another.  Moreover, this is also over a 2-3 year period, not 6 years.  I feel that if I were in Berkowitz shoes for Sears, for example, which hasn't worked out over a very long period, I would already be saying the initial investment in Sears was clearly a mistake, but that I thought it had the potential for good returns from the present point. 

 

Saying all this another way, I think Buffett would be apologizing all over the place.  He apologized for investing in airlines when it worked out for him!

[racemize]

Also, I am happy to go ahead and say we put too much in banks in 2014 and that was a mistake!

[giofranchi]

Ok Joel!

Thank you very much. Always enjoy sharing thoughts with you.

 

Cheers,

 

Gio

[no_free_lunch]

Does anyone know when fairfax pays it's dividend?

[DynamicPerception]

Last year:

 

TORONTO, ONTARIO--(Marketwired - Jan. 5, 2016) - Fairfax Financial Holdings Limited (TSX:FFH)(TSX:FFH.U) announces that it has declared a dividend of US$10.00 per share on its outstanding multiple voting and subordinate voting shares, payable on January 27, 2016 to shareholders of record on January 20, 2016.