Fairfax results?????????

[Guest Bronco]

Richard, this will be my last post on this topic b/c I don't want to go overboard.

 

But if your focus is value per share, which I am ok with - how the hell is it better to limit one's options to one investment vs. unlimited investments?  Makes zero sense to me.  My point, mentioned over and over, is that excess cash should be allocated to the best possible investment.

 

That will increase value per share much more than your approach, without exception.  It is why Buffett is who he is, and everyone else scratches their head.

 

Think of this analogy - you are a judge in a neighborhood beauty pageant.  If you pick the hottest girl, you get $10.  If you pick the ugliest, you get $1.  Well, your wife is in the contest, and you always pick her, year after year.  You only get $5.  You could be getting $10, but you feel the pressure from your wife.

 

Now in the real world, the CEO (and board) are the judges.  They pick the same investment, year after year (their own stock).  It is simple.  It is lazy.  Wall Street loves it.  Naive investors love it.  They get their $5 year after year.  But they could be getting $10. 

 

Buffett goes for the $10. Allocates to the best possible source.  Isn't afraid.  Isn't fat.  Isn't lazy.  Isn't stupid.  Doesn't listen to conventional "wisdom".  He eats his own cooking.  He wants his money to flow to the best opportunity.  That is why it drives me crazy when these great capital allocators get lazy.  Doesn't make sense to me.  Never will. 

[Grenville]

93% hedged!

 

"Fairfax holds significant investments in equities and equity-related securities, which the company believes will significantly appreciate in value over time. In response to the significant appreciation in equity market valuations during 2009 and the first half of 2010 and uncertainty in the economy, the company continued hedging its equity investment exposure by entering into total return swaps referenced to the Russell 2000 index (at an average Russell 2000 index value of 646.5) in addition to its existing swap contracts referenced to the S&P 500 index (at an average S&P 500 index value of 1,062.5). At June 30, 2010, these hedges represented approximately 93% of the company's equity investment exposure. The market value and the liquidity of these investments are volatile and may vary dramatically either up or down in short periods, and their ultimate value will therefore only be known over the long term."

 

Also another company bought in runoff through TIG.

 

http://www.marketwire.com/press-release/Fairfax-Financial-Holdings-Limited-Second-Quarter-Financial-Results-TSX-FFH-1297790.htm

 

[T-bone1]

Book of $382. I think this was a great quarter considering the insurance and investment environment!

[StubbleJumper]

Yep, for this quarter they beat their hurdle of 15% annualized ROE.  Good job in a tough environment.

 

Anyone else think it was strange to see growth in Net Written at NB?

 

SJ

[ERICOPOLY]

Yep, for this quarter they beat their hurdle of 15% annualized ROE.  Good job in a tough environment.

 

Anyone else think it was strange to see growth in Net Written at NB?

 

SJ

 

I haven't looked yet, but was it due to currency translation to USD?

[RichardGibbons]

Good points, Ericopoly and Bronco.  I agree, with the caveat that the decision needs to take into account all the second order effects.  I really like your point, Eric, about the second-order effects of downsizing. 

 

In other words, suppose the beauty contest is actually a dating game called "upgrade your wife", and you can keep playing the game until you pick a contestant other than your wife.  In that case, the optimal strategy isn't to pick the $10 contestant, because then  you only get $10 as a result of the second order effect.  The right strategy is to keep picking your wife, making $5 day after day, because the impact of the second order effect is bigger than than maximizing your value.

 

Or to state another way, the true value of the contestant isn't their price, but the discounted value of the future cash flows that result from picking that contestant.  :)

 

That said, I also think that many of the Buffett decisions that you are defending aren't rational decisions to maximize shareholder value but are rationalizations, because when you invert them, they don't make sense.  i.e. if you have always have to preserve extra capital for when a good idea comes along, then shouldn't you similarly want to get extra capital by issuing shares as frequently as you can?  (If holding capital increases shareholder value, shouldn't getting more capital by issuing shares similarly increase value (except you happen to be constantly on the thin knife edge where neither issuing nor buying back increases shareholder value)?)

 

Of course, it's fine for him, and everyone else, to be irrational sometimes.

 

Richard

 

[ERICOPOLY]

That said, I also think that many of the Buffett decisions that you are defending aren't rational decisions to maximize shareholder value but are rationalizations, because when you invert them, they don't make sense.  i.e. if you have always have to preserve extra capital for when a good idea comes along, then shouldn't you similarly want to get extra capital by issuing shares as frequently as you can?  (If holding capital increases shareholder value, shouldn't getting more capital by issuing shares similarly increase value (except you happen to be constantly on the thin knife edge where neither issuing nor buying back increases shareholder value)?)

 

That wouldn't be a bad idea as long as you were issuing shares at good to great prices and were able to find investment opportunities at stupid cheap prices.  You would then be improving your blended prospects.  I think Berkshire issued shares for acquisitions.

 

If the company is a Berkshire or Fairfax I believe the shareholders are there for the investment fund aspect of it -- they effectively want HWIC or Buffett/Munger to manage their money for them.  So my attitude towards those companies is that they should be doing just that -- always making the better purchase if a better looking woman walks across the room.

 

However, if the company is not an investment vehicle... like if we're talking about MSFT for example, I don't want them to invest in anything that isn't strategic to their business.  I don't want them for example investing in shipping stocks, or purchasing shares in JNJ, etc...  It's just different to me -- I want to invest in MSFT if I'm buying MSFT.  If MSFT is going to bring YHOO into it's fold, then so be it -- that's part of their strategy.  But investing in JNJ has nothing to do with their strategy.  So I don't think MSFT should be buying the best looking lady in the room -- I think they should just buy their own stock, make a strategic investment, or return the cash.  Preferable just return the cash.  I can just sell my MSFT shares if they buy the stock (nice to have a buyer) and if I believe there are better places to invest it would be a good idea to sell.  But with FFH I own the stock because I want THEM to invest the money -- I want a small dividend so that I can eat and such, but I want them to always choose the prettier lady before their own wife.  

 

Just like if I put my money in a hedge fund -- why would I want the hedge fund manager to always reinvest their dividends in their current positions when they could instead start buying up new more interesting positions?  Well, FFH is kind of like a big leveraged hedge fund -- does it make sense to just keep adding to existing positions even if they know there are better opportunities out there?  I mean, that's crazy.  And so what if the existing positions are trading at 15% FCF yield -- guess what, that FCF simply comes from investments that aren't in-and-of-themselves FFH.  FFH is just a whole bunch of investments put together, and then levered with float.  And why not diversify that stream of income that the 15% depends on when the new investment is better than anything in the existing portfolio -- on a blended basis it makes the portfolio stronger.

 

Fairfax and Berkshire are special because the float (combined with dividends) provides a huge amount of new cash to invest.  Let's say you get 10% yield of new cash to invest -- well, if they sink that cash into just two new investments each year, and each investment is a genuine 50 cent dollar, then you have a 20% growth rate I believe.  I mean, if it were a $100 stock and it threw off $10 that were reinvested in half-price dollars, that's effectively the same thing as it throwing off $20.  Even if you never trade the existing investments but rather hold them forever, you still grow at a surprising rate.  The only problem is that you wind up like Berkshire today where that 10% yield becomes so large that there are no 50 cent dollars available anymore due to size.

[valuecfa]

93% hedged is interesting. I thought i was bearish. It is a bit surprising to see nearly the entire equity port hedged and current values. I would have thought they would be at perhaps 70-85% hedged. I peg the S&P only about 10-12% overvalued (I'm curious what their perception of the market overvaluation is). They must see a bit more turbulence in the markets in the near term.

[watsa_is_a_randian_hero]

93% hedged is interesting. I thought i was bearish. It is a bit surprising to see nearly the entire equity port hedged and current values. I would have thought they would be at perhaps 70-85% hedged. I peg the S&P only about 10-12% overvalued (I'm curious what their perception of the market overvaluation is). They must see a bit more turbulence in the markets in the near term.

 

It is especially interesting to see them add to the hedge significantly as the market declined.  I was buying as the market was declining.  Typically we have seen them act in a contrarian manner as well

[ericd1]

Ericopoly, et all...Interesting discussion regarding reinvesting the core positions' FCF into new and different opportunities. It seems to beg a question I've not given much thought to...I'll use sports cars and station wagons for my analogies...

 

With the goal of maximizing wealth over a life-time...What do you think would be the "best strategy" to "assure" long-term success?

 

Should an investor start by building a core portfolio of "under-valued" station wagons paying dividends and re-invest the dividends and new cash in perceived higher return "under-valued" sport cars, or

 

Should he start with a portfolio of "under-valued" sports cars and "upgrade" to new sports cars when they crash, or become station wagons, or

 

Some other combination?

 

I believe Buffett started with sport cars, upgrading to new sports cars until investment size became a factor and he had to buy station wagons...But regardless, he knows how to pick great cars.

 

Looking back over my 40+ years of investing, I may have driven too many sports cars and not enough station wagons.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[ERICOPOLY]

Yes I think as he got bigger he found that he can't turn over 100% of the portfolio into sports cars.  He winds up with an increasing mix of station wagons.

 

If a portfolio of station wagons generate 10% FCF yields, he can still grow at 20% if he can put that 10% into 50 cent dollars.  

 

But he can't get ahold of the full 10% FCF if he is holding merely shares if the managers running the company plow the incoming FCF into buying back shares at merely fair value (or even if undervalued, likely not as good a deal as what Buffett could dig up elsewhere), or use it to acquire new subsidiaries at mediocre prices.   That's probably a major reason why he began to like wholly owned businesses so much.

 

So, accepting his fate of owning more station wagons as Berkshire grew in size, he opted for the kind that gives him full access to the FCF -- that would be the wholly owned variety.

 

Plus he also saves on taxes by not having to sell publicly traded shares to raise cash for reinvestment -- a benefit of buy and hold forever with the wholly owed business is you can get ample cash for reinvestment without triggering capital gains taxes.

[twacowfca]

93% hedged is interesting. I thought i was bearish. It is a bit surprising to see nearly the entire equity port hedged and current values. I would have thought they would be at perhaps 70-85% hedged. I peg the S&P only about 10-12% overvalued (I'm curious what their perception of the market overvaluation is). They must see a bit more turbulence in the markets in the near term.

 

 

The big Russell 2000 hedge was put on at a price that was only about one percent off the current price, well off the market peak a couple of months ago.  Looks like they got scared after the big increase in volatility.  They likely paid a larger premium then than they would have earlier, considering the increase in volatility at the time they increased the hedge.

[T-bone1]

I think it's a total return swap, not put options, so they don't pay for volatility

[Cardboard]

Large changes that I see from Q1 to Q2 on the investment side:

 

- Sizeable reduction in their common stock holdings.

- Big addition to U.S. treasury holdings (long term bonds) from $500 million to around $2 billion.

- Significant position in CPI-linked derivatives. I am not sure if they are the same as the small position disclosed in the 1st quarter, but these ones are clearly to protect against deflation not inflation: "... economic hedge against the potential adverse financial impact on the company of decreasing price levels"

- Addition of a big swap against Russell 2000.

 

That is about as negative as it gets on the equity market.

 

Prem mentioned before that very few investors survived the Great Depression. He then became less negative after November 2008 and only hedged 30% of the stock portfolio in late 09 following large gains in the market. Also, sold most U.S. treasuries. Now we go to 93% hedged of what they consider cheap stocks, profit taking in what was likely considered fairly valued and massive protection against deflation.

 

Cardboard

[Viking]

Cardboard, as I said in an earlier post I was looking to see with great interest what FFH is doing with its investment portfolio. And as you have indicated above they appear to once again be quite bearish on equity markets and more fearful of deflation risks... Something to think about!

[ERICOPOLY]

I've been thinking about their move towards deflation hedging.  They must be worried about the pullback from stimulous as countries adopt new "austerity" measures.

 

It feels like the current level of economic activity is pumped up in a form of "false prosperity" worldwide by all the stimulous -- when it pulls back that's got to result in some form of "new normal" right?

[twacowfca]

I've been thinking about their move towards deflation hedging.  They must be worried about the pullback from stimulous as countries adopt new "austerity" measures.

 

It feels like the current level of economic activity is pumped up in a form of "false prosperity" worldwide by all the stimulous -- when it pulls back that's got to result in some form of "new normal" right?

 

 

Yeah.  New normal as in the mid to late 1930's or in Japan during the last two decades.

[twacowfca]

I think it's a total return swap, not put options, so they don't pay for volatility

 

 

Can you help me understand total return swaps?  I have assumed that these were synthetic versions of what exists in the options and futures markets, but more bargain priced.  How do these work, and why aren't they affected by volatility?

[ERICOPOLY]

I've been thinking about their move towards deflation hedging.  They must be worried about the pullback from stimulous as countries adopt new "austerity" measures.

 

It feels like the current level of economic activity is pumped up in a form of "false prosperity" worldwide by all the stimulous -- when it pulls back that's got to result in some form of "new normal" right?

 

 

Yeah.  New normal as in the mid to late 1930's or in Japan during the last two decades.

 

Japan's unemployment has stayed below 6% -- rising from 2.1% in the early 1990s:

 

http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704249004575384944103200032.html

 

There is a good chart on that page contrasting US 1930s deflation to that of Japan's more recent experience..

 

I find it interesting that they haven't seen the kind of spiraling collapse that people fear when they hear the word "deflation".

[gaf63]

Found the answer to my question on % of US treasuries of total bonds in the 2nd qtr. report

 

12%Canadian incl. provinces

 

15.4%US treasuries

 

19.4% corp

 

45% US states and munis

[biaggio]

I have been trying to fight off the bearish/negative sediment in the media and trying to focus on finding underpriced quality companies.

 

I must admit I feel more fearful as Prem is so bearish and especially seeing that he is more worried about deflation than inflation. (this would    make sense as I have felt the complete opposite-thinking that we will have inflation)

 

What do you think will happen to great companies like JNJ, KO, V, banks in a deflationary environment. I think it was Yachtman who said he likes those companies because they can raise prices with inflation and deflation (people will still want to buy band-aids, coca-cola, have money in the bank that don t earn any interest/but have to pay interest on any funds borrowed).

 

Any changes in investing philosophy or asset allocation?

 

I have felt that buying long term bonds have to be very dangerous considering how little they pay, and considering how much dollars government is going to  have to print in the future.

[onyx1]

 

Can you help me understand total return swaps?  I have assumed that these were synthetic versions of what exists in the options and futures markets, but more bargain priced.  How do these work, and why aren't they affected by volatility?

 

Think of them as simply being long or short the stated asset/index.  The exposure is the same as a cash, but with a TRS the execution is synthetic. TRS's are designed for creditworthy institutions to gain exposure without the need for an initial cash outlay.  Very popular with hedge funds and others seeking leverage and those who seek to avoid the 50% margin rules.  Mechanically, Firm A will contract with Firm B to receive the total return of an asset/index (this will include movement in market price, dividends and any other distributions); in return Firm A pays Firm B Libor plus a negotiated spread on the outstanding balance. Typically these contracts are settled at maturity, and cash margin is exchanged during the contract period as the market price moves up or down.  These contracts be set for any term and pricing is negotiated.  They aren't affected by volatility any more or less than when you buy the underlying cash asset.

 

The beauty of TRS's contracts is flexibility.  They can be used on any asset for any term at a price negotiated with only one counterparty.  Don't know the extent to which FinReg will change all of this.

[oec2000]

I think it's a total return swap, not put options, so they don't pay for volatility

 

 

Can you help me understand total return swaps?  I have assumed that these were synthetic versions of what exists in the options and futures markets, but more bargain priced.  How do these work, and why aren't they affected by volatility?

 

Onyx explains it well. To make it more simple, you could think of the TRS as an over the counter futures contract. Futures prices are a function only of the relative cost of carry of the two reference asset classes (in this case, stocks vs cash).

 

Volatility does not come into the picture at all. Only options have volatility premiums because of the one-sided nature of the contracts (limited loss vs unlimited gain, for e.g.) The premium are sort of like insurance premiums.

[oec2000]

Yep, for this quarter they beat their hurdle of 15% annualized ROE.  Good job in a tough environment.

 

Anyone else think it was strange to see growth in Net Written at NB?

 

SJ

 

SJ, their target is to grow BVPS at 15% p.a. (close to but not exactly the same as 15% ROE especially with share issuance). Also, given the nature of their business, it's more appropriate to evaluate their performance using comprehensive income and not just net income (which is what you appear to have based your computation on).

 

I'm not unhappy with their performance of a slight decline in BVPS (I agree with your earlier comment that quarterly movements aren't that important) but just wanted to point out the difference - which I think is important.

[oec2000]

I've been thinking about their move towards deflation hedging.  They must be worried about the pullback from stimulous as countries adopt new "austerity" measures.

 

It feels like the current level of economic activity is pumped up in a form of "false prosperity" worldwide by all the stimulous -- when it pulls back that's got to result in some form of "new normal" right?

 

Actually, Prem has been quite consistent about deflation risks for some time now. Even before 2008, he was putting out charts of how Japan played out. I believe HWIC pay close attention to Hoisington who have been firmly in the "deflation risk" camp for a while now. It took great conviction for FFH to have massive exposure to US treasuries during the commodity boom in 2008 when everyone else was worried about inflation (I remember myself, foolishly as it turns out, questioning their wisdom of being so exposed to USTs then!)

 

Prem has also consistently questioned whether govt spending alone could offset slowdown in the 70% of the economy driven by the consumer. So, I don't think his/their view of the economy have changed that much since 2007/8. That they managed to catch the bottom of the market and ride it up till recently despite this view is just evidence of their investing genius.

 

They have explained their deflation derivative bet as protection for the insurance business. Unless I'm missing something, the insurance business should be more vulnerable to inflation than deflation given that they collect premiums upfront and pay claims out later. I suspect that the deflation bet is more of an investment bet than an insurance one.

 

As to the point you raise about why Japan's deflation has been less severe than the US in the 1930s, my guess is that it is due to a combination of factors - less safety nets in the 1930s (social security, FDIC) and the more global nature of the 1930s depression. Japan's tradition of lifetime employment must have kept unemployment rates from rising sharply; they also kept their banks alive albeit in zombie states; and Japan benefited from the fact that the rest of the world continued to experience strong growth thus allowing them to maintain very strong current account surpluses which in turn provided them with the domestic savings to finance the govt budget deficits used to fund stimulus spending.

 

The problem this time round is that the deleveraging is more global with the US and Europe together comprising a much larger proportion of world GDP. The rest of 2010 could turn out to be very interesting indeed!