2018 shareholders letter

[KFS]

2018 shareholders letter

 

https://s1.q4cdn.com/579586326/files/doc_financials/2019/2018-Shareholders-Letter.pdf

 

 

[investmd]

Prem Watsa is an eternal optimist & infectious about it.

Anticipated returns of 15%/year - can hope that works out.

 

What do folks think of approx $1.5B/yr in buybacks? About 8% of market cap.

 

[Spekulatius]

BIAL (Bangalore airports) seems like a nice business. I wish there was a direct way to invest in it.

[StevieV]

Some unstructured thoughts:

 

(1) The underwriting seems to be under control and going reasonably well.

 

(2) I like the mea culpa on shorting.  Good to acknowledge mistakes and learn from them.

 

(3) I generally don't like exclamation points, and didn't care the sprinkling of them here.  Just say what you want to say.

 

(4) Nice dividend and interest income.

 

(5) The 15% "target" seems more of an aspirational target than a mid-range or average result target.  I'd prefer they communicate this differently.  Perhaps a range of possible returns depending upon equity, fixed income and underwriting returns.  They achieved neither the underwriting "target" or the investment target.

 

(6) Sort of a swing for the fences portfolio.  I own KW myself, and consider that more of a steady performer.  But, a lot of the others are more volatile businesses.

 

(7) Also not a fan of the opening - we would have done great, except we didn't.

 

(eight) I think the dividend and interest income, plus reasonable underwriting should be a good baseline driver of returns.  Equity returns will be a wild card.

 

 

----------------

 

Edited to write out the "eight".  Not sure why, but the board was automatically changing my number 8 to an emoji.  It wasn't showing up when I typed it, so I was not sure how to edit.  In any event, the last point is simply another of my thoughts, and I meant no special meaning for the last point.

 

[shalab]

With FRFHF reporting, I always dig deeper. The headlines, including Prem's comments are unfortunately misleading.

 

Here is an example:

 

In page 11, Watsa says:

 

Henry Singleton from Teledyne was our hero as he reduced shares

outstanding from approximately 88 million to 12 million over about 15 years. We began that process by buying back

1.1 million shares since we began in the fourth quarter of 2017 up until early 2019 – about half for cancellation and

half for various long term incentive plans we have across our company

 

Page 83 of the annual report:

 

Diluted number of shares at the end of 2018 - 28.397 million

Diluted number of shares at the end of 2017 - 26.1 million

 

Using the diluted shares, I get a book value of 414 at the end of 2018. Reducing 10 dollars paid out as dividend, the book value is at 404.

 

2018 shareholders letter

 

https://s1.q4cdn.com/579586326/files/doc_financials/2019/2018-Shareholders-Letter.pdf

[shalab]

Regarding BIAL ( or KIA ) being a good business, yes it is. However, many parts of the business is regulated by the government and rightly so.

 

Here is an article about the profit it made in 2017-2018. There is pressure on the government to reduce or cut the UDF (usage development fee) which has been the major source of profit.

 

https://economictimes.indiatimes.com/industry/transportation/airlines-/-aviation/bengaluru-airports-profit-soars-33-to-rs-848-crore/articleshow/67037829.cms

 

[chrispy]

BIAL is also discussed further in the Fairfax India report.

 

The letter from Prem is fine, and I like it more then previous years. But, mentioning that value has been losing to growth and value will someday outperform again is a little ridiculous in this context. Their investment results aren't just trailing the indices by a percent of two, their picks have been bad. Hence why he always has to justify them.

Buy profitable, simple companies and stick to reasonable position sizes.

[petec]

Buy profitable, simple companies and stick to reasonable position sizes.

 

That easy, huh? ;)

 

I'm kinda kidding. Kinda.

[StubbleJumper]

I read the letter on Saturday and refrained from commenting for a couple of days.  A few opinions:

 

1) If Prem wants to emulate the people in Omaha and write a 20-page letter, he badly needs to hire an editor.  There's no shame it in, Warren has used an editor for years.  At times, the letter seemed to be effectively a stream of consciousness listing every little company that FFH owns, irrespective of whether anything interesting happened at those companies during 2018.  It's nice to get a bit of colour on those companies, but if there was a theme or message that was intended through that shotgun approach, it escaped me.  The repeated silliness stating, "the best is yet to come!!!!!!!!!!!" was very tiresome.  I could do with less pumping and exclamation points, and more operational performance. 

 

Could a guy like Rob Carrick or somebody like that help Prem to tighten up his prose?

 

 

2) There wasn't a great deal of broader insight transmitted in this letter.  Now, that's no criticism of Prem, but in past letters there have been observations or nuggets about the industry or financial markets that I have found useful (FWIW, I didn't find that I obtained much broader insight from BRK's letter this year either).

 

 

3) What can you say about a letter that basically says, "We would have done better if we hadn't made so many shitty investments."  It's pretty tough for Prem to polish that turd.

 

 

4) Prem did a pretty good job telegraphing FFH's operating earnings potential.  That, IMO, is the base upon which higher valuation will be achieved.

 

 

5) Why is there still conflicting messages about hedging?  On the CC, the CEO mishandled a discussion about a potential drawdown in equity markets.  Prem's letter went to great lengths to communicate that there would be no more equity hedging because FFH learned its lesson.  It also observes that US economic growth has been strong, rates have bumped up, inflation looks like it's bottomed out, there's a long runway, etc, but despite those clear and obvious conditions, FFH will continue to hold CPI derivatives worth a notional $114 billion.  About this, I am perplexed.  It's only a $25m market value, but if you are trying to communicate that you are moving on from hedging mistakes in the past, why not liquidate this position.  That large notional value demonstrates that FFH was only speculating on inflation to begin with (ie, if you were hedging you would choose a hedge ratio and then buy your protection...the CPI derivatives exceed FFH's combined assets and gross revenue for a year).  If Prem and Brian have changed their perspective about world markets (which is a legitimate thing to do, and there's no shame in changing your mind), just sell the damned things and recoup the $25m, which happens to be about $1/share of capital.

 

 

6) How did the India/Pakistan conflict escape mention?  What percentage of FFH shareholders' capital is in India, to what extent has the conflict recently affected asset valuations, and what's the way forward?  I understand that the Indian culture is somewhat more fatalistic than western culture, but I would have expected some sort of reflections from FFH about the situation and whether it at all changes their approach on a going-forward basis.

 

 

7) Underwriting has been good, even though cats pushed up the CR a little.  Did anyone else take a peek at the loss triangle in the annual (it was nice when the loss triangles of all the major subs were included in past years)?  The reserve redundancies have become ridiculous.  Now, this is better than the alternative where adverse development is ridiculous, but seriously, they have been systematically overestimating their accident year claims by ~10% (see page 70 of the AR).  As I said, this is better than the alternative, but at what point does an auditor call bullshit on this?  Or is it a happy circumstance where the current accident year is overestimated, but that is offset by reserve releases from previous years?

 

 

8) Am I alone in thinking that many of the smaller international insurance acquisitions look pretty shitty (see page 15 of the letter)?  I get that many of these countries are demonstrating rapid economic growth, which portends well for the size of the future insurance market.  But, stealing a term from President Trump, if you are going to invest in "shit-hole" countries, wouldn't it at least be nice if the investment was profitable?  Seriously, Prem has listed 15 international subsidiaries and when you round the numbers, 12 of them have a CR of 98 or higher.  Do you go to a shit-hole country for a CR of 98?  Return on invested capital doesn't look great (see page 59 of the AR).

 

 

9) I like the table presenting FFH's lottery tickets (see page 20 of the letter).  Chances are that FFH ends up taking a ~10% bath on that portfolio of higher-risk debt, but all it would take to offset that would be one or two good wins on the lottery tickets.  Currently, it looks like FFH's number is coming up for Seaspan, but it's still early.  Hopefully they'll match 5 or 6 numbers to hit the jackpot on a couple of those.

 

 

10) Am I alone in finding it ironic that Prem should mention Bitcoin and General Electric on the same page, but with different conclusions?  I find that both are impossible to value and have steered well clear!  Prem seems to hold one in disdain but embraces the other.  Interesting.

 

 

 

I've spent less productive Saturday mornings doing other things than reading the letter and perusing the AR, but nothing much changes for me after this release.  It's time for FFH to drop the excuses and to execute.  The market is from Missouri and is saying,  "Show me."

 

 

 

SJ

[petec]

 

5) Why is there still conflicting messages about hedging?  On the CC, the CEO mishandled a discussion about a potential drawdown in equity markets.  Prem's letter went to great lengths to communicate that there would be no more equity hedging because FFH learned its lesson.  It also observes that US economic growth has been strong, rates have bumped up, inflation looks like it's bottomed out, there's a long runway, etc, but despite those clear and obvious conditions, FFH will continue to hold CPI derivatives worth a notional $114 billion.  About this, I am perplexed.  It's only a $25m market value, but if you are trying to communicate that you are moving on from hedging mistakes in the past, why not liquidate this position.  That large notional value demonstrates that FFH was only speculating on inflation to begin with (ie, if you were hedging you would choose a hedge ratio and then buy your protection...the CPI derivatives exceed FFH's combined assets and gross revenue for a year).  If Prem and Brian have changed their perspective about world markets (which is a legitimate thing to do, and there's no shame in changing your mind), just sell the damned things and recoup the $25m, which happens to be about $1/share of capital.

 

 

Haven't read the letter yet, but thanks for your summary - useful.

 

I'm not sure relating the notional to revenues or assets is useful. They'd only make the notional if absolute CPI went to zero, IIRC, and that seems unlikely! They could have made a couple of billion, maybe more in a depression, but nothing like the size of the notional. My major complaint is not that they hold this but that they should have structured their hedges this way: deep out of the money derivatives that offer outsized gains on low probability outcomes for (relatively) low absolute cost.

 

Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds). That transforms the economics of a 98% CR. Also, some of these businesses will probably benefit from operating leverage as they scale.

[wachtwoord]

I agree the tone of the letter is infantile. I'm sure Watsa isn't infantile but coming across as such is not good.

 

I also believe Watsa's macro view is highly flawed. This wouldn't be an issue if he would act macro agnostic however he made huge bets in the past and even though he claims to have learned from the past I see him comment on Bitcoin which is a macro thing and quite clearly outside of his circle of competance. He seems to overly rely on his own ability on matters he knows little about which is a large risk going forward.

 

Finally I agree that the 3rd world insurance businesses look like crap. What's the plan there?

[StubbleJumper]

 

5) Why is there still conflicting messages about hedging?  On the CC, the CEO mishandled a discussion about a potential drawdown in equity markets.  Prem's letter went to great lengths to communicate that there would be no more equity hedging because FFH learned its lesson.  It also observes that US economic growth has been strong, rates have bumped up, inflation looks like it's bottomed out, there's a long runway, etc, but despite those clear and obvious conditions, FFH will continue to hold CPI derivatives worth a notional $114 billion.  About this, I am perplexed.  It's only a $25m market value, but if you are trying to communicate that you are moving on from hedging mistakes in the past, why not liquidate this position.  That large notional value demonstrates that FFH was only speculating on inflation to begin with (ie, if you were hedging you would choose a hedge ratio and then buy your protection...the CPI derivatives exceed FFH's combined assets and gross revenue for a year).  If Prem and Brian have changed their perspective about world markets (which is a legitimate thing to do, and there's no shame in changing your mind), just sell the damned things and recoup the $25m, which happens to be about $1/share of capital.

 

 

Haven't read the letter yet, but thanks for your summary - useful.

 

I'm not sure relating the notional to revenues or assets is useful. They'd only make the notional if absolute CPI went to zero, IIRC, and that seems unlikely! They could have made a couple of billion, maybe more in a depression, but nothing like the size of the notional. My major complaint is not that they hold this but that they should have structured their hedges this way: deep out of the money derivatives that offer outsized gains on low probability outcomes for (relatively) low absolute cost.

 

 

Okay, I guess the starting point of the conversation should be, "What is FFH trying to hedge against?"  What would be the bad outcome of deflation that requires protection?  I can offer a few possibilities: 1) FFH's fixed interest debt increases in real terms as a result of deflation, 2) FFH's equity portfolio might be adversely affected by deflation, 3) the collectability of amounts from reinsurers might become dubious, 4) corporate bonds could become shakey, 5) other?

 

On the liability side, deflation might actually result in reserve releases because presumably IBNR would decline?  Deflation would be good for the real value of their sovereign bonds and possibly their munis.  What else?

 

So net it out: what's their net exposure?  What kind of hedge ratio should be selected for that notional exposure (somewhere between 0% and 100%)?

 

I thought I was being rather charitable when I compared the $100+ billion to their total assets.  If you assume that the entire asset base would be adversely affected by inflation with no offsetting benefit on liabilities, and if you were so risk averse that you wanted a 100% hedge ratio, you need what, ~$64 billion notional?  Being even more charitable, assume that a year of revenue would all be adversely affected with no offsetting benefit from expenses, that would be another $18-ish billion?  So in my wildest dreams, that wold be ~$80 billion notional protection required?

 

Hedging is hedging.  Speculation is speculation.  So which is FFH currently doing, and does it mesh in any way with Prem's broader macro observations in the letter?

 

 

Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds). That transforms the economics of a 98% CR. Also, some of these businesses will probably benefit from operating leverage as they scale.

 

Sure, that's the theory, but what do you make of page 59 in the AR (or for that matter, the Asia breakdown on page 115)?  Did we get a fair return on the capital that FFH has deployed? Adjusting for the risk of holding assets in shit-hole countries which do not always have a strong legal system, low levels of corruption, or stable central bank policy, are you happy with what you see on page 59?  What kind of return would be fair for the risks involved with shit-hole assets?

 

 

SJ

[Spekulatius]

I have reduced my shares before the annual report came out, and sold most of my remaining shares, except a tracking position after reaiding this.

 

Reasons

1) share solution ( ~2M more shares). This isn’t Teledyne.

2) continued book value losses.

3) too many crappy investments. FFH is really too complex for its size and it’s not working.

 

I recycled some funds into BRK last Friday, but have further thinking to do how to reinvest the proceeds.

[rb]

Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds).

 

If that's the case and you feel so confident then why don't you just go and buy a shitload of Brazilian bonds instead?

[TwoCitiesCapital]

I have reduced my shares before the annual report came out, and sold most of my remaining shares, except a tracking position after reaiding this.

 

Reasons

1) share solution ( ~2M more shares). This isn’t Teledyne.

2) continued book value losses.

3) too many crappy investments. FFH is really too complex for its size and it’s not working.

 

I recycled some funds into BRK last Friday, but have further thinking to do how to reinvest the proceeds.

 

I've also reduced my shares, but it was basically because my thesis didn't play out. I loaded up on Fairfax expecting two things to happen:

 

1) Interest/Dividend income would dramatically increase over the following 2-3 year period due to rising rates which would lead to share price appreciation

2) Significant buybacks at prices from $450-550 USD would likely be accretive if income was to rise dramatically

 

I sold most of the shares that I had purchased based on disappointing outcomes in both regards.

 

10-year rates rose to 3.2% prior to falling back down to 2.6%. With low inflation and limited pressure in the near/mid-term from rising front-end rates, it's hard for me to make a case for rates to rise as significantly as originally anticipated. I'm not saying Fairfax should've played the short-term game, but they did miss an opportunity to lock in longer-term rates and the opportunity set for increasing interest income in the near-term appears challenged.

 

Further, buybacks have been less than I anticipated based on Prem's first comparison to Teledyne...and have been further diluted by compensation and share issuance that were unanticipated at the time of purchase.

 

I still some shares and would be willing to add in the low 400s near book value, but there doesn't appear to the be the catalyst for anything to change with the company or help them achieve the 15% ROE that I initially anticipated.

 

[petec]

Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds).

 

If that's the case and you feel so confident then why don't you just go and buy a shitload of Brazilian bonds instead?

 

The childish answer is: because I already have a shitload of Brazilian equities.

 

The better answer is: because as you well know, a float-levered insureco with a sub-100% underwriting margin is going to return more than a sovereign bond even if 100% of its float is invested in that same sovereign bond. Fairfax's Brazil operation has underwriting profits, and has growth potential since insurance is underpenetrated in Brazil and the country is entering a cyclical upswing and possibly also a disinflationary boom (if the government gets its reforms done).

 

The majority of the underwriting losses in Fairfax's Latin American operations came from Argentina, which (unlike Brazil) is a hyperinflationary basket case - but it is undergoing some very promising reforms. Time will tell.

[petec]

I agree the tone of the letter is infantile. I'm sure Watsa isn't infantile but coming across as such is not good.

 

I also believe Watsa's macro view is highly flawed. This wouldn't be an issue if he would act macro agnostic however he made huge bets in the past and even though he claims to have learned from the past I see him comment on Bitcoin which is a macro thing and quite clearly outside of his circle of competance. He seems to overly rely on his own ability on matters he knows little about which is a large risk going forward.

 

Finally I agree that the 3rd world insurance businesses look like crap. What's the plan there?

 

Out of interest do you think Watsa's style has changed or did you not like it from the start (whenever that was, for you)?

 

Watsa has as much right to comment on bitcoin as anyone else. Bitcoin can only be understood through two lenses: 1) crowd psychology and tulip bubbles and 2) fiat currency collapse. The first - which is the one he used - is well within his circle of competence as a value investor.

 

My framework for the third world insurance businesses is this: if one or two of them find that sweet nexus you occasionally get in insurance where a superb manager meets a superb opportunity, then you've seeded the next ICICI Lombard or First Capital. My guess is that's the game plan, but it's only a guess. The opportunity stems from the fact that in most of these places insurance will grow faster than GDP, because it is currently underpenetrated.

[petec]

 

Okay, I guess the starting point of the conversation should be, "What is FFH trying to hedge against?"  What would be the bad outcome of deflation that requires protection?  I can offer a few possibilities: 1) FFH's fixed interest debt increases in real terms as a result of deflation, 2) FFH's equity portfolio might be adversely affected by deflation, 3) the collectability of amounts from reinsurers might become dubious, 4) corporate bonds could become shakey, 5) other?

 

On the liability side, deflation might actually result in reserve releases because presumably IBNR would decline?  Deflation would be good for the real value of their sovereign bonds and possibly their munis.  What else?

 

So net it out: what's their net exposure?  What kind of hedge ratio should be selected for that notional exposure (somewhere between 0% and 100%)?

 

I thought I was being rather charitable when I compared the $100+ billion to their total assets.  If you assume that the entire asset base would be adversely affected by inflation with no offsetting benefit on liabilities, and if you were so risk averse that you wanted a 100% hedge ratio, you need what, ~$64 billion notional?  Being even more charitable, assume that a year of revenue would all be adversely affected with no offsetting benefit from expenses, that would be another $18-ish billion?  So in my wildest dreams, that wold be ~$80 billion notional protection required?

 

Hedging is hedging.  Speculation is speculation.  So which is FFH currently doing, and does it mesh in any way with Prem's broader macro observations in the letter?

 

Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds). That transforms the economics of a 98% CR. Also, some of these businesses will probably benefit from operating leverage as they scale.

 

Sure, that's the theory, but what do you make of page 59 in the AR (or for that matter, the Asia breakdown on page 115)?  Did we get a fair return on the capital that FFH has deployed? Adjusting for the risk of holding assets in shit-hole countries which do not always have a strong legal system, low levels of corruption, or stable central bank policy, are you happy with what you see on page 59?  What kind of return would be fair for the risks involved with shit-hole assets?

 

SJ

 

I agree with your reasoning, but I think it is based on faulty facts:

 

1) Back when they were worried about debt bubbles collapsing Fairfax looked hard at how insurers performed in the great depression. They discussed this in investor meetings (can't remember if they discussed it in letters/calls). Obviously equities collapsed (= FFH book value virtually gone). More surprisingly underwriting profits disappeared too as cash-poor insurers desperately competed to write premiums in the face of collapsing demand. The result was not that there were offsetting drivers in insureco P&Ls, but a total meltdown which most companies did not survive. I think that fear is what drove their entire hedging programme - both equity and deflation swaps.

 

2) As I understand it if you buy $100bn notional and CPI drops 10% below strike, you make $10bn. To make the full notional amount of $100bn, CPI would have to fall 100%, which is unlikely since it implies that the CPI basket of goods would cost nothing and the value of money would be infinite. Given that Fairfax regularly highlighted that CPI dropped 17% in both the GD and in Japan post-bubble, I assume that's the kind of thing they were worried about if things got really bad. If so, $110bn notional protected at most $20bn of assets. In fact I think it was quite a bit less because IIRC Fairfax bought the swaps below strike, meaning you needed several % deflation before you made money. In more likely scenarios, upside was never going to be more than $2-3bn. So under no realistic assumption did they exceed a 100% hedge ratio.

 

I don't really care what they do with a $25m position, so I won't argue on that one.

 

Haven't got to the AR yet so can't answer your last question.

[Spekulatius]

I have reduced my shares before the annual report came out, and sold most of my remaining shares, except a tracking position after reaiding this.

 

Reasons

1) share solution ( ~2M more shares). This isn’t Teledyne.

2) continued book value losses.

3) too many crappy investments. FFH is really too complex for its size and it’s not working.

 

I recycled some funds into BRK last Friday, but have further thinking to do how to reinvest the proceeds.

 

I've also reduced my shares, but it was basically because my thesis didn't play out. I loaded up on Fairfax expecting two things to happen:

 

1) Interest/Dividend income would dramatically increase over the following 2-3 year period due to rising rates which would lead to share price appreciation

2) Significant buybacks at prices from $450-550 USD would likely be accretive if income was to rise dramatically

 

I sold most of the shares that I had purchased based on disappointing outcomes in both regards.

 

10-year rates rose to 3.2% prior to falling back down to 2.6%. With low inflation and limited pressure in the near/mid-term from rising front-end rates, it's hard for me to make a case for rates to rise as significantly as originally anticipated. I'm not saying Fairfax should've played the short-term game, but they did miss an opportunity to lock in longer-term rates and the opportunity set for increasing interest income in the near-term appears challenged.

 

Further, buybacks have been less than I anticipated based on Prem's first comparison to Teledyne...and have been further diluted by compensation and share issuance that were unanticipated at the time of purchase.

 

I still some shares and would be willing to add in the low 400s near book value, but there doesn't appear to the be the catalyst for anything to change with the company or help them achieve the 15% ROE that I initially anticipated.

 

I agree on all counts. I think it’s fair to say that the thesis as most of us envisioned it a year ago didn’t play out and is unlikely to play out in the near term future.

[vinod1]

StubbleJumper makes very good points. However, I think shorting and CPI bets are better understood from the perspective of Mr. Watsa the individual.

 

Rewind back to the 2007-2009 period. Fairfax reported massive gains on the CDS portfolio, and many of us who have loaded up on Fairfax and its subs felt great at that time and patting ourselves on our backs for this. 

 

How would this have felt for Prem? After all, we Fairfax investors were on a high just from taking advantage of Fairfax gains. He is one of the handful of investors who came out with billions of dollars of gains directly during the period. For 3 years book value exploded and it is hardly a stretch to think he must have felt like a genius, especially when every other company is wallowing in misery.

 

I can recall a period like that, when my LEAPS on BAC paid off big time, then after a couple of months of research on O&G companies, invested in Sandridge Energy LEAPS and they paid off like 5x in a few short months. I was on a high and contrary to my normal behavior invested in HP LEAPS with very little research. Fortunately, it is only 0.1% of portfolio and to make a long story short, the HP LEAPS went to zero the moment Leo Apotheker did a deal with Autonomy.

 

I think the "rush" from the 2007-2009 gains might have been a contributing factor. It was never about hedging.

 

If you are really concerned about Great Depression type scenario, do you invest in crappy companies like Blackberry, Sandridge Energy, Greek/Irish banks, restaurants?

 

Further look and what he has done on the business side, he went ahead and bought a bunch of other companies.

 

Is this what you expect when you are preparing another Great Depression?

 

(Hat tip to UCCMAL for pointing these out in one of the earlier discussions.)

 

One more thing. Even when you have hedged 100% of the equity portfolio, you promise to investors 15% annual returns? There is a snowball chance in hell that you would reach that objective without a major market crash.

 

The only logical explanation that fits the facts is that Prem is expected a market crash and the S&P 500 shorts and CPI portfolio is a market call. Pure and simple. It is a market call that did not work out.

 

All the explanations - avoiding 1-100 year event, hedging, etc. do not fit the facts.

 

Prem is a wonderful person from everything that I gather. He has build a multi billion dollar company from scratch. Nothing can take these things away from him.

 

But as investors we have to separate Prem the wonderful person from Prem the CEO. He got the market call wrong. It happens. The problem is not being able to acknowledge it. Calling it hedging is just plain wrong. 

 

Vinod

 

 

 

[petec]

StubbleJumper makes very good points. However, I think shorting and CPI bets are better understood from the perspective of Mr. Watsa the individual.

 

Rewind back to the 2007-2009 period. Fairfax reported massive gains on the CDS portfolio, and many of us who have loaded up on Fairfax and its subs felt great at that time and patting ourselves on our backs for this. 

 

How would this have felt for Prem? After all, we Fairfax investors were on a high just from taking advantage of Fairfax gains. He is one of the handful of investors who came out with billions of dollars of gains directly during the period. For 3 years book value exploded and it is hardly a stretch to think he must have felt like a genius, especially when every other company is wallowing in misery.

 

I can recall a period like that, when my LEAPS on BAC paid off big time, then after a couple of months of research on O&G companies, invested in Sandridge Energy LEAPS and they paid off like 5x in a few short months. I was on a high and contrary to my normal behavior invested in HP LEAPS with very little research. Fortunately, it is only 0.1% of portfolio and to make a long story short, the HP LEAPS went to zero the moment Leo Apotheker did a deal with Autonomy.

 

I think the "rush" from the 2007-2009 gains might have been a contributing factor. It was never about hedging.

 

If you are really concerned about Great Depression type scenario, do you invest in crappy companies like Blackberry, Sandridge Energy, Greek/Irish banks, restaurants?

 

Further look and what he has done on the business side, he went ahead and bought a bunch of other companies.

 

Is this what you expect when you are preparing another Great Depression?

 

(Hat tip to UCCMAL for pointing these out in one of the earlier discussions.)

 

One more thing. Even when you have hedged 100% of the equity portfolio, you promise to investors 15% annual returns? There is a snowball chance in hell that you would reach that objective without a major market crash.

 

The only logical explanation that fits the facts is that Prem is expected a market crash and the S&P 500 shorts and CPI portfolio is a market call. Pure and simple. It is a market call that did not work out.

 

All the explanations - avoiding 1-100 year event, hedging, etc. do not fit the facts.

 

Prem is a wonderful person from everything that I gather. He has build a multi billion dollar company from scratch. Nothing can take these things away from him.

 

But as investors we have to separate Prem the wonderful person from Prem the CEO. He got the market call wrong. It happens. The problem is not being able to acknowledge it. Calling it hedging is just plain wrong. 

 

Vinod

 

Totally agree with this (except that in this letter he has finally come out and simply said the equity hedges were wrong and "dangerous"). In fact to "crappy companies" I would add overlevered companies. Why the hell do you get involved with Resolute if you fear a deflationary depression?

 

My referencing the Great Depression was simply to point out that they actually did a lot of research into what happens to insurecos in a deflation, but came to a different conclusion to the one that SJ speculated on.

 

Ultimately both factors are at play - the overconfidence drives the market call, but there has to be a thesis to give it a veneer of respectability and dispel any cognitive dissonance. The thesis (that insurecos really suffer in a depression) was sound - the issue was they wildly overestimated their competence in calling the market/economy.

 

Anyway, I've bored myself to death about the hedges so I will stop.

[wachtwoord]

I agree the tone of the letter is infantile. I'm sure Watsa isn't infantile but coming across as such is not good.

 

I also believe Watsa's macro view is highly flawed. This wouldn't be an issue if he would act macro agnostic however he made huge bets in the past and even though he claims to have learned from the past I see him comment on Bitcoin which is a macro thing and quite clearly outside of his circle of competance. He seems to overly rely on his own ability on matters he knows little about which is a large risk going forward.

 

Finally I agree that the 3rd world insurance businesses look like crap. What's the plan there?

 

Out of interest do you think Watsa's style has changed or did you not like it from the start (whenever that was, for you)?

 

Watsa has as much right to comment on bitcoin as anyone else. Bitcoin can only be understood through two lenses: 1) crowd psychology and tulip bubbles and 2) fiat currency collapse. The first - which is the one he used - is well within his circle of competence as a value investor.

 

My framework for the third world insurance businesses is this: if one or two of them find that sweet nexus you occasionally get in insurance where a superb manager meets a superb opportunity, then you've seeded the next ICICI Lombard or First Capital. My guess is that's the game plan, but it's only a guess. The opportunity stems from the fact that in most of these places insurance will grow faster than GDP, because it is currently underpenetrated.

 

I think Watsa and Fairfax are very good value investors and underwriters. I don't believe they have any sort of edge at a macro level and therefore are adding variance with zero reward (at best, in reality it comes at a cost). I wish they would focus on what they are good in cause this would be a world class investment (I am a shareholder btw).

 

I mentioned Bitcoin because it's indicative of him having (and sharing in the context of his annual shareholder letter) an opinion about something he does not comprehend while having confidence in his uninformed opinion. In the case of Bitcoin I don't mind as he isn't basing an investment decision on it, but his certainty in the face of a flawed understanding scares me.

[obtuse_investor]

Great conversation, everyone.

 

Meta thought: I am only hearing ffh bears. No bulls around. I happen to be agreeing with the bears. Maybe it’s just my frustration.

 

Second level thinking: if I am hearing so much negativity about this business, this is probably a better time to buy than to sell.

[petec]

Great conversation, everyone.

 

Meta thought: I am only hearing ffh bears. No bulls around. I happen to be agreeing with the bears. Maybe it’s just my frustration.

 

Second level thinking: if I am hearing so much negativity about this business, this is probably a better time to buy than to sell.

 

Put me down as a (long term) bull. I sleep like a baby with this position - although I probably wouldn't without the robust debate on here, which really makes me think, so thanks all.

 

Unrelated but interesting: https://www.imf.org/en/News/Articles/2019/03/11/na031119-greece-economy-improves-key-reforms-still-needed

 

I know being "among the best performers in the Eurozone" isn't saying much, but it's better than being among the worst. I think Eurobank could be an exceptional investment as the economy starts to reflate.

 

 

[Dazel]

There is nothing new....

Looking forward....I like where they sit....lots of options.

Time to perform that simple.

 

Dazel