Reduction in Equity Hedges to 50%

[rb]

 

FFH places macro bets.  These were never intended as hedges.  They were macro bets on the economy.  I think it was just an opportune time to reduce them.  I wouldnt read it as a specific comment on the economic potential.  And as someone else has said, if you believe markets are going up, you believe that economies are going to get juiced why would you keep deflation hedges?

I think it was just this. There was a lot of style drift at FFH. They made so much money with macro calls in 2000s and it was easy. So that went to their head and started doing macro bets. However as an economist I know that while it looks easy macro is very, very hard.

[Guest longinvestor]

 

FFH places macro bets.  These were never intended as hedges.  They were macro bets on the economy.  I think it was just an opportune time to reduce them.  I wouldnt read it as a specific comment on the economic potential.  And as someone else has said, if you believe markets are going up, you believe that economies are going to get juiced why would you keep deflation hedges?

I think it was just this. There was a lot of style drift at FFH. They made so much money with macro calls in 2000s and it was easy. So that went to their head and started doing macro bets. However as an economist I know that while it looks easy macro is very, very hard.

+1. As I watched Prem speak at his AGM in 2009, 10, 11...noticed that there was an aura about him given the success he had with the macro calls that lead up to the crisis.

[petec]

 

One thing I will say in favour of this decision: many on here have questioned whether FFH are capable of changing their minds when the facts change.  They are.

 

Whether it is the right thing to do is another matter.

 

I think the reality is that they realized quite a while ago that their equity hedges were a bad decision.  They just needed some event so that they could “save face”.  Trump was simply a convenient excuse to reverse a decision and say “Yeah, we are removing the hedges because of Trump” instead of “Yeah, we are removing the hedges because we were wrong.”

 

Do you have any evidence for this?  I'm not disputing it, but your view (that they care about saving face) is quite important and carries much more weight if you have a reason for it than if you're sitting at home guessing (like I am).

 

I don't have any hard evidence of this.  My (Watergate-style) attempts to bug Prem's office have so far been unsuccessful.

 

I am relying on soft evidence, such as:

1)  The length of time (many years) these hedges have been turned on; they can't stay on forever; why now really?

2)  The virtually indisputable reality that these hedges were a bad idea, and destroyed what could have been otherwise good results.

3)  My knowledge and experience with the consistency principle; part of my job is to negotiate successful results for my clients on an almost daily basis, and I never cease to be amazed at how difficult it is for people to change their mind without some way to save face.  I have developed an entire negotiation strategy centered on providing my counterpart a clear way to save face, thus easing his/her ability to change their mind to my client's benefit; it works wonders.

4)  The very odd timing of this reversal, after the markets have gone UP a substantial amount.

5)  The suddenness of the decision; no one really expected a Trump win, so they made this decision in a matter of a few days.  Is that really a long enough time to fully evaluate the new reality; perhaps.  But the suddenness seemed odd - like they were seizing the moment during all of the hysteria - knowing that the newsworthiness of removal of the hedges would get lost in a sea of post Trump election hysteria.

 

I guess it just strike me that there was sentiment to remove these for some time; but doing so is a clear admission that they screwed up. 

 

In reality, there is probably a bit of truth to both narratives.  The probably DID view the world as having changed, but I think in larger part also viewed it as a convenient way to save face.

 

So, yeah, I am sitting at home guessing just like you.

 

Maybe so, but it's intelligent guesswork and insightful - thanks.

 

For me the key error wasn't having or expressing a macro view, or trying to protect the company (which was a key motivation).  It was doing so in such an expensive way by failing to hedge upside cheaply too.

[petec]

Prem has been beating the drum for years on the disconnect "between the markets and the economic fundamentals". How does the election of trump warrant a 180-degree flip in strategy? Reads like a complete capitulation to me as the market hits record highs.

 

It is a capitulation. 

 

As for why the election changes things, I'm reading across from PW's comments on Modi: he seems to be a believer in how pro-business government can spur growth (and reflation) and clearly he sees that in a Republican clean sweep (as do I, at least to a point).

 

My bigger issue is why he hedged 100% (as opposed to 50%) of his equities to start with, but that's been discussed endlessly here.

 

One thing I will say in favour of this decision: many on here have questioned whether FFH are capable of changing their minds when the facts change.  They are.

Facts haven't changed! They just got it all wrong! In my view, this is latest nail in Prem's coffin and proves that he is one of the shittiest money managers in this business. Sooner they will give their investment portfolio to outside managers the better.

 

Ha ha - trust me, there are *many* worse.

[Parsad]

You guys are all over the place.  He's got $10B in cash now, why the hell would he need equity hedges?!

 

I've always said this, and I repeat it again...Fairfax hedges because they operate with a greater degree of leverage than Berkshire and some other insurers.  They have debt and a relatively high asset to equity ratio.

 

If bonds or equities fall, it can affect their level of statutory capital in the insurance subsidiaries and they would not be able to write business or invest that capital when opportunities are greatest. 

 

They had a ton of bonds and some equities, thus they needed to hedge in case both were impacted in some manner.  Now they have a ton of cash...they don't need to hedge.

 

For every other investor, you don't need to worry about macro or take out hedges.  Buy low, sell high and hold cash.  Simple!  Less frictional costs than hedging and you don't have to worry about Brexit, deflation or some other event.

 

Cheers!

[Daphne]

Thank you for your voice of reason in this discussion Sanjeev. There's no mystery here, Prem has been pretty transparent about why he hedged and your point about the cash hoard reducing the need makes perfect sense.

[chrispy]

Very interesting and informative way of putting it Parsad.  It will be interesting to see what they do with all of that $$$

[bsilly]

Thanks for the insights Parsad.

 

I’m sure I agree 100%. At the end of the last quarter, before selling the long bonds, Fairfax had over $6 billion of cash, versus the mark to mark equity portfolio of $4.1 billion. I don’t think cash was a factor in decisions regarding the equity hedge.

 

I think the reason for reducing the hedge is simple. With the mark to market equity portfolio down to $4.1 billion,  the hedge was up at $7.6 billion. They were overexposed (net short), with no downside protection. As foreshadowing,  they actually purchased $1.1 billion in S&P calls in the last quarter to limit the exposure.

 

They are still maintaining a big hedge, it had just gotten out of whack with the size of the equity portfolio. So they right sized it. They were probably hoping to do this opportunistically and make a little money, but ultimately couldn’t hang on / got a bit uncomfortable with the exposure. I think it was the right move to cut it back. The mistake was to be in that position to begin with - and it was a bit costly for shareholders. But that is hindsight.

 

That's my take anyway.

 

All the best. I hope you are keeping well!

 

[steph]

As a long term investor in FFH, I hope that they will finally just admit that those equity hedges were a bad investment decision.  We all take bad decisions and that is how it should be otherwise you don't take enough risks.  But it is important to admit to your shareholders that you made a mistake.  FFH always put this in 'unrealised losses' even though the markets have almost doubled since they started hedging.  I would be very disappointed in Prem if he doesn't admit now.

[roundball100]

As a long term investor in FFH, I hope that they will finally just admit that those equity hedges were a bad investment decision.  We all take bad decisions and that is how it should be otherwise you don't take enough risks.  But it is important to admit to your shareholders that you made a mistake.  FFH always put this in 'unrealised losses' even though the markets have almost doubled since they started hedging.  I would be very disappointed in Prem if he doesn't admit now.

If you buy fire insurance and then at the end of the year, it turns out that your house did not burn down, that doesn't mean it was a mistake to buy fire insurance.

[steph]

As a long term investor in FFH, I hope that they will finally just admit that those equity hedges were a bad investment decision.  We all take bad decisions and that is how it should be otherwise you don't take enough risks.  But it is important to admit to your shareholders that you made a mistake.  FFH always put this in 'unrealised losses' even though the markets have almost doubled since they started hedging.  I would be very disappointed in Prem if he doesn't admit now.

If you buy fire insurance and then at the end of the year, it turns out that your house did not burn down, that doesn't mean it was a mistake to buy fire insurance.

 

Strange reasoning, but anyway: the day I lose 40% or more of the value of my house on insurance in 5-6 years time, I will admit that I made a big mistake.  My wife will let me know.  :)

[naboo]

I agree with Sanj said.  FFH sold the bond at not perfect, but very good time (around 1.75), now they have tons of cash in hands. If they didn't sell the hedge, that won't be the hedge any more, that's shorting the market.

 

Let's see how market reacts in long term. FFH now is only 1.1x times book with strong underwriting and $10B cash.

[Cardboard]

Can someone explain to me why you would hedge bonds with equity hedges?

 

Cardboard

[vinod1]

You guys are all over the place.  He's got $10B in cash now, why the hell would he need equity hedges?!

 

I've always said this, and I repeat it again...Fairfax hedges because they operate with a greater degree of leverage than Berkshire and some other insurers.  They have debt and a relatively high asset to equity ratio.

 

If bonds or equities fall, it can affect their level of statutory capital in the insurance subsidiaries and they would not be able to write business or invest that capital when opportunities are greatest. 

 

They had a ton of bonds and some equities, thus they needed to hedge in case both were impacted in some manner.  Now they have a ton of cash...they don't need to hedge.

 

For every other investor, you don't need to worry about macro or take out hedges.  Buy low, sell high and hold cash.  Simple!  Less frictional costs than hedging and you don't have to worry about Brexit, deflation or some other event.

 

Cheers!

 

I do not understand this logic relating equity hedges and going from bonds to cash.

 

A P&C company has investment capital from

 

(a) its own equity capital that serves as "statutory surplus", in effect the money it put down to get permission to write insurance policies and

 

(b) float from money collected from its policy holders that is paid out later on as claims are made.

 

Most companies invest the vast majority of both (a) and (b) in bonds and cash. Some companies (Like Berkshire, Markel, Fairfax) have figured out that investing (a) in stocks is a much more profitable endeavor.

 

They really cannot invest (b) also in stocks, since they need to be absolutely certain that they can payout the claims as they come due. So these funds are primarily invested in bonds and cash.

 

Now, Fairfax has followed this pattern as well. It has historically on average allocated very roughly about 25% to cash, 50% to bond and 25% to stocks. The 25% allocation to stocks is essentially shareholder capital supporting the insurance business - part (a).

 

Fairfax had hedged its stocks i.e. part (a), from 1 in 100 year storm or Great Depression kind of risks. I can understand that.

 

But the reason it has sold its long bonds is because of inflationary risks from recent political events. This is essentially moving money within part (b). That is money that needs to be paid out to policy holders. If there is a risk of inflation, it makes sense to keep more money in cash. That is what they did.

 

What has reducing bond risk in portfolio part (b) got to do with reducing equity risks in part (a), I do not see the logic at all. Granted the portfolio is fungible but risks remain distinct and one does not offset the other.

 

Vinod

[bsilly]

Just to correct a typo - my post above should read "<i>I'm <b>not</b> sure I agree 100% </i>" - which should be clear if you read the rest of it.

 

Allow me to be clearer:

 

- you cannot hedge equity with cash (agree cardboard)

- the argument is moot because they had over $6 billion in cash anyway

- Prem needs explain clearly, and admit the mistake of being overexposed to an adverse market move.

 

I for one don't really buy statements about how the prospects for the stock market have changed under a Trump presidency. Nobody knows.

 

Anyway - I still think Fairfax is a great company, but there are always lessons to be learned, and room to improve.

[naboo]

"We hedged our equity investments to protect our shareholders' capital from exposure to the impact of deteriorating economic fundamentals," said Prem Watsa, Chairman and CEO of Fairfax. "We constantly monitor these hedge positions relative to economic fundamentals. We believe the U.S. election may result in fundamental changes that may bolster economic growth and business development. As a result, there is the potential for a longer term rally in U.S equity markets that reduces the need for the capital preservation protection of equity hedging."

 

 

My understanding is the hedge is equity hedge, but it was also for overall market/fundamentals. Since FFH changed their view, bond selling and hedge reduction is reflected to the change.

[Rainforesthiker]

As a long term investor in FFH, I hope that they will finally just admit that those equity hedges were a bad investment decision.  We all take bad decisions and that is how it should be otherwise you don't take enough risks.  But it is important to admit to your shareholders that you made a mistake.  FFH always put this in 'unrealised losses' even though the markets have almost doubled since they started hedging.  I would be very disappointed in Prem if he doesn't admit now.

If you buy fire insurance and then at the end of the year, it turns out that your house did not burn down, that doesn't mean it was a mistake to buy fire insurance.

 

Strange reasoning, but anyway: the day I lose 40% or more of the value of my house on insurance in 5-6 years time, I will admit that I made a big mistake.  My wife will let me know.  :)

 

Agreed; this was not insurance; this was a macro bet that went awry.

[Luckyone77]

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

 

Judging by the volume on the US Stock Exchange which is about 10x the normal trading, somebody is bailing out big time. Unless I'm missing something here, I guess Fairfax still must not think their stock is worth it at these prices as they haven't used any of their 10b to buy their own stock back. I have my fingers crossed that they're smarter than their stock performance and return would have you believe.

[cwericb]

"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. "

 

Ditto. I don't know about you but I am starting to run out of antacid.

[naboo]

FFH should start thinking to buyback their shares.

[Daphne]

Given the volumes, does anyone think we might be back in the last decade's shorting game?

[no_free_lunch]

Given the volumes, does anyone think we might be back in the last decade's shorting game?

 

Wasn't the shorting triggered by large insurance losses?  What is motivating the short sellers today?

[Daphne]

I think the market may be betting that ffh lost a ton when they removed the hedges but am open to other thesis about volume and price

[rb]

Nah... S&P is really liquid.

[drzola]

Prem should take FFH private by having Flatt find it a home?

Crazy But???

 

Cheers.