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Prem Watsa interview


T-bone1
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From the latest issue of Value Investor Insight:

 

What environment are you positioned for today?

 

PW: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.

 

The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.

 

So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.

 

Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.

 

 

With that cheery prognosis, what’s an investor to do?

 

PW: What we’ve done is position ourselves not to give back the significant gains we’ve had. We like the stocks we own, such as J&J, Wells Fargo [WFC] and U.S. Bancorp [uSB]. But while we’re holding on to those, we’ve increased our equity hedge ratio as of June 30 to 90%. Those hedges are almost exclusively in the form of shorts on the S&P 500 and Russell 2000 indexes.

 

We’ve trimmed our corporate bond portfolio significantly and have added some to our municipal bonds, which provide a nice stream of income for us. We tend to focus on bonds that support essential government services, say funding the Los Angeles airport, where we’d expect the U.S. government to step in if there was a problem. Our cash position in the insurance-subsidiary portfolio is now about 15%, and is building up again.

 

What we’re basically doing is battening down the hatches and just being very careful here. If the stock market takes off and interest spreads come down even further, our performance might lag for a year or two. But in the spirit of building our company over the long term, we’re willing to take that risk.

 

 

Are you at all concerned about inflation and rising interest rates?

 

PW: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.

 

 

What advice would you give policymakers confronting the environment you fear?

 

PW: There are no easy answers, but I generally believe that the more we allow the economy to naturally adjust, the faster we come out of it. In the U.S., housing starts have gone from 2.2 million per year to 500,000, which is the type of thing that has to happen for the excess inventory of homes to ever be digested. When you’re working off way too much debt in the system, there are no short term fixes for that.

 

I’m not a long-term pessimist. The U.S. and all of us are going to survive and the economy will come back. But I do think we’re on dangerous ground here.

 

 

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Guest Bronco

T-bone - thanks.  Great post. 

 

It is hard to see a rosy picture in the U.S.  I think the ROW is supporting corporate profits, which is fine by me.

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The same examples are always quoted (US in the 30s and Japan in the 90s) to justify a difficult economy. But what about South Korea for instance which was much in debt in 1997 and recovered pretty quickly . There are maybe other examples in Asia or elsewhere. A double dip or flat economy is not a fatality.

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Thanks alot for the link. Very interesting ride.

 

Prem Watsa - Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.

 

Interesting Prem seems to buy into the range bound thesis but is also preparing for a double dip. I think the new normal / range bound thesis is where we are headed (I guess more hope than think). I think it’s the best option and know we can make money during that period trading value. I have positioned my portfolio accordingly and hold 25%. I am also willing to trade when I see deeper values, and am quick to sell on overvaluation.

 

My only issue is how does a small investor protect against a double dip, cash is great but seeing your portfolio shrink is still tough especially if there is no corresponding rebound months later. What are you guys doing aside from cash or gold (I don’t like gold; it just rubs me the wrong way). I think Prem has a point; fear will take hold at some point and we will get a deep pullback. Can one get long dated protection as a small investor for a fairly cheap price?

 

Also Parsad was right FFH is definitely a buy and hold, I think, similar to Berkshire, in 20 years we will think $400 was quite cheap for a FFH share.

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The one thing I've said in the past, and continue to say now, is that Prem's situation is very different than anyone else's on this board.  Fairfax's ability to write insurance contracts is based on the amount of statuatory capital they have.  If you have significant movements in mark-to-market accounting, Fairfax's credit rating could fall to the point where they can no longer write property casualty policies.  They have debt and use 4-1 asset to equity leverage.  A 25% drop in Fairfax's portolio could be very detrimental to the company.  Thus Fairfax has to have more hedges in place than the average investor who operates with no margin or leverage.  Buy cheap, sell dear...bullish and bearish sentiments be damned!  Cheers!

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Buy cheap, sell dear...bullish and bearish sentiments be damned!  Cheers!

 

Well, as we learned in March of 09'. When deflation, or the perception of large deflation, seemed likely all risk assets correlated to 1 (even the cheap ones), even less risky corporate bonds. Even cheap companies (low p/b, p/e) performed very poor in the US and Japan during their respective depressions (if they survived at all), and there was no opportunity to sell dear while the markets fell over 50%. Survival was the game, and leverage was the enemy. While I definitely echo your comments on Fairfax's situation with their leverage and necessity to maintain good ratings for policy writings, it may not be such a bad thing to give a large amount of thought to some of the macro factors in play.

 

Personally, i don't think we will see large deflation. Only, minor deflation (or nil inflation) over the near term, but given current market valuation with that forecast in mind, i have appropriate macro hedges to balance the individual equities positions i have. When i do any type of macro forecasting or investing (top-down analysis) it is strictly for capital preservation and not capital appreciation, so i would not structure any portfolio in such a way that if your macro forecasts, or market valuation perceptions turn out wrong that you would loose a fair amount of money.

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Prem seems to have a similar take to Klarman at least as far as overall concern for the macro picture.  I read that Klarman considers gold to be a decent hedge against currency devaluation risk (that is, high inflation) but a very expensive form of insurance.  Klarman has also bought deep out of the money puts on bonds.  And of course, he is at 30% cash or higher, which he also considers a hedge. 

 

It seems the most respected value investors around are hedging against both inflation and deflation.  The question is whether an individual can use these strategies.  I know individuals can buy gold, though this is hard for a value investor to fathom or make sense of.  What about the puts on bonds -- it seems to me that for small portfolios this is not really viable as a strategy, but I really don't know enough to say.  Would like some help there is anyone is versed in this strategy.

 

What other hedges are there available to an individual investor?  I ask this having read and agreeing with Parsad's comment that Fairfax needs to be much more hedged than individuals.  I'm holding high quality decent dividend paying stocks, and holding Fairfax and Berkshire, keeping 30% in cash.  How else to batten down the hatches? 

 

 

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We’ve trimmed our corporate bond portfolio significantly and have added some to our municipal bonds, which provide a nice stream of income for us.

 

 

From pages 9 & 11 of the 10Q, it looks like FFH is also increasing long dated US bonds as part of its deflation protection.

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Guest Bronco

RRJ - sometimes you can buy puts very cheaply.  S&P short ETFs (probably not recommended).  I think you are somewhat hedged by owning Fairfax, as the business is hedged and you own a piece of that business.  But if you have high quality dividend paying stocks, it sounds like hedging won't be as important if you hold these for a long time frame.  I don't know if it is worth the cost to hedge a pepsi or jnj or coke or p&G, etc. - that is up to you.

 

 

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Well, as we learned in March of 09'. When deflation, or the perception of large deflation, seemed likely all risk assets correlated to 1 (even the cheap ones), even less risky corporate bonds. Even cheap companies (low p/b, p/e) performed very poor in the US and Japan during their respective depressions (if they survived at all), and there was no opportunity to sell dear while the markets fell over 50%. Survival was the game, and leverage was the enemy. While I definitely echo your comments on Fairfax's situation with their leverage and necessity to maintain good ratings for policy writings, it may not be such a bad thing to give a large amount of thought to some of the macro factors in play.

 

I recommend that board members go back and read various old posts from February, March and April of 2009.  There's one terrific post on there about a Bill Gross article where he's saying that "Equities are Dead!"  Well, we know how wrong that was now, don't we.  Gross was taking a macro view on things.  There's also a terrific article by Jeremy Grantham within a couple of weeks of that article saying that "Don't try and time the bottom."  And how right was Grantham?  Investors should never become anchored to an idea or view.  It's tough...damn, I find it hard sometimes...but that's the challenge. 

 

Buy cheap, with a margin of safety, and into things you are comfortable holding for years.  If markets go down, you sell the more expensive ideas and buy anything of equal quality that is cheaper.  On the way back up, you will make your money when the market becomes rational again.  Understand that I am not saying that you should be fully invested.  In fact, everyone should hold some cash.  But don't let noise deter you from applying the investing intellectual framework that has always worked.  Cheers

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An addendum to my comment on anchoring...a perfect example, which is quite amusing to me:

 

...Fairfax Financial Chairman Prem Watsa in our interview with him in the new issue of Value Investor Insight. Few investors navigated the financial crisis more successfully than Watsa, who describes for us not only his thought process and strategy in preparing for the crisis, but also how he's positioning his portfolio today for what he considers a still-precarious future. It's a perfect example of what we aspire to deliver in every issue of VII: timely new ideas from the best investors in the business, but also timeless wisdom that's of great value in any market environment.

 

A few years before, they were shorting the hell out of Prem and Fairfax.  Now they're suggesting positioning their portfolio based on Fairfax's behavior...please excuse the jagged little knife blade I stuck in your back a few years ago, but would you care to do an interview with us?  ;D  That's probably why Prem's such a great leader...he forgives those that trespass against him.  Cheers!

 

 

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As an individual investor without an insurance credit rating to maintain I have been addressing these issues by buying dividend growers who have already successfully weathered the last crash. 

 

These include FFH itself, BCE, PWF, SSW, SLF, GE, HD, KFT (again), JNJ, RUS, KO.  The only significant holding I have right now that doesn't pay a dividend is fbk.

 

I have given up on buying puts, selling puts, or buying calls for now.  Each is too expensive in its own way right now.

 

There is no way to predict the markets even for Prem.  He is just doing the conservative thing that was drilled into him by the near death experience FFH had a few years ago.  If things dont unfold as he suggests FFH may sacrifice 2 or 3 % on returns.  Being in the insurance biz these guys know and have access to far more cheap hedging methods than we as retail investors do.

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I think it is interesting that you have two camps of people, one arguing that the risk is inflation, another that the risk is deflation, and they are each convinced they are right and have a lot of supporting data.  If I had to bet I'd agree more with Watsa than others, though I think he is drawing too much of a parallel between the US and Japan.

 

I think that some of the people worried about inflation are motivated by a distaste for the government bailing and spending programs that were enacted to stem the crisis, they aren't really concerned about inflation per se but are speaking out about government intervention indirectly by complaining about the risk of inflation.

 

The US government is actually doing pretty good on its bailout funds... they borrowed money at near 0% (at times less than 0%) and loaned it out at about 5-15% plus equity kickers.  US tax payers will actually profit from most of these bailouts, rather than be required to fund them.  No inflation there.

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Buy cheap, with a margin of safety, and into things you are comfortable holding for years

 

A man by the name of Warren E Buffett has done this for fifty+ years without hedging. He has been called a lot of things in between but the guy keeps it simple and follows his rules.

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I think it is interesting that you have two camps of people, one arguing that the risk is inflation, another that the risk is deflation, and they are each convinced they are right and have a lot of supporting data.  If I had to bet I'd agree more with Watsa than others, though I think he is drawing too much of a parallel between the US and Japan.

 

I think that some of the people worried about inflation are motivated by a distaste for the government bailing and spending programs that were enacted to stem the crisis, they aren't really concerned about inflation per se but are speaking out about government intervention indirectly by complaining about the risk of inflation.

 

The US government is actually doing pretty good on its bailout funds... they borrowed money at near 0% (at times less than 0%) and loaned it out at about 5-15% plus equity kickers.  US tax payers will actually profit from most of these bailouts, rather than be required to fund them.  No inflation there.

 

Well I'm in the camp of "I don't know what's going to happen but it is dam cloudy in front of us". Mr. Market must give me some very cheap valuations for me to take the market risk.

 

BeerBaron

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We're probally exceptionally unusual, but some things we've learned.

 

(1) All boats sink in a crash, the quality of the boat is irrelevant. If you think there might be a material adverse macro event within 'X' months, why are you holding the boat at all?

(2) At 100% cash, the worst that can happen is that you miss a run up and suffer an inflation loss. If you see the market rising, are you really going to do absolutely nothing for an entire year? And if inflation is maybe 1-2% at best, does it really matter? Were you a PM I'd fire you for doing this. As individual investor inflation is my, & not my PMs 'do nothing' cost.

(3) When everyone owes money & needs cash to repay, shouldn't that demand make cash the pricey asset? I have it, you don't, & you have to sell your asset to avoid a default? And then why should I not use that opportunity?

 

Dont be afraid of cash.

 

SD   

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Guest ValueCarl

SD, in all due respect, have you not experienced enough of the lengths that these central bankers will travel to avoid "pricey money" as respects "supply/demand" factors which would normally govern economics and the cost of funds?

 

How long are you prepared to hold onto negative real rate of returns in cash, as this world turns with all of the machinations and manipulations we continue to witness to date?

 

In the modern bankers world, money will continue to have no price for SAVERS and they will be FORCED out onto the RISK LEDGE so the banker, who is being PAID dearly on his end, might capitalize on them!

 

Is it Japan or GD2, that is the question! I foresee the latter along with some gnashing of teeth to the extent of civil unrest but ultimately, another Great War will be the MO of these damn money changers!

 

With all the machinations not excluding fraud that they are capable of, even Mr. Parsad's plan to wait until he see the whites of their eyes-a formidable downtrend-can make one look foolish with the advent of computer algorithms and HF trading which continues unabated for passive owners who treat their ownership stakes-stock certificates- in corporations like dirty wash rags.

 

One of the few things I can agree with which I heard that scoundrel Greenspan opine about over the years was this:

 

"This is not your father's stock market."

 

So, get out on the RISK CURVE with some others here, but do it The Buffett Way, which he has practiced most of the time, especially with respect to "margins of safety."

 

 

 

 

 

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I agree there is nothing wrong with holding larger cash positions if you see some broad risks. If you hold 50% cash and 50% equities, it will certainly reduce your risk exposure vis a vis a larger equity exposure. However, it is not a true hedge of market risk as you would only lose 50% less than the other fully invested individual that holds a similar basket of securities in full. Relative performance is not really my goal. If i want to hedge against a market decline, i just short the market (take it out of the equation), while holding my basket of undervalued securities. I prefer not to use derivatives like puts, futures, swaps, or commodity hedges.

 

Me and myself have debated the cash vs hedge proposition in the past. I rarely if ever use hedges, but there are times i think it is appropriate. Whereas it makes sense to scale the extent of the hedge relative to your perceived market valuation gap and relative to the environment, while adjusting it as the gap narrows.

 

It all depends on your risk tolerance, forward looking views, and market weights at the time. Fairfax decided to hedge ~90% of their equities exposure. Whereas the majority of other companies (in insurance or other industries) if they had similar draconian views of the market, would likely just reduce their equity exposure to a certain extent by selling a large portion of their basket of undervalued securities, or just open a net short position.

 

Of course, the rub is if you are wrong and the markets continue their upward path. Holding 50% cash instead of hedging would likely provide larger returns. However if you are right and the markets head south (which is what you are actually forecasting) than the opposite would be true, and you would be better off with the hedge. In these circumstances, it seems to me to make sense to hedge your portfolio, instead of raising cash and holding equities under such a draconian view. As, you are better off if the market goes lower when hedging (which is what you think is the most likely scenario), vs holding cash (and being better off only if the market goes higher, which is what you think is not as likely a scenario).

 

If i see risks to be minimal then I would prefer to raise a bit of cash as opposed to hedging to any significant extent. If my views become more draconian, than i would choose to hedge a portion of the portfolio, to an extent that is in proportion to the risks in the market and the size of my equity portfolio.

 

If I see few undervalued securities, i would likely hold a relatively small basket of equities and not hold any hedges. If i see few undervalued securities combined with large overvaluations or large market risks, then i would likely hold a relatively small basket of securities and hedge that basket.

 

I need to get back to work.  :-\ This board can be distracting at times.

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SharperDingaan you nailed it I think. There is nothing wrong with cash especially at this point.

I have a feeling that people are going to be scrambling for cash more and more over the next few years. One of the assets they will have to get rid of is going to be houses but everything else will take a beating at some point. And it probably will be accompanied by shocks (countries going belly up for example, like Japan).

I do not follow Bill Gross too much usually but I am finally impressed by some of his current views on what

is happening to us (http://www.pimco.com/Pages/PrivatesEyeBillGrossAugust2010.aspx).

Our sages (Seth, Prem, Jeremy, Bill and others) are starting to uncover the truth and they are such a pleasure

to read because so intelligent.

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I continue to regard this market as extremely dangerous. It could seize up at any time. All is needed is a small unforeseen event and they happen much more often than we expect.

 

IMO, the real issues that have created the crisis have not been solved: total debt in the system vs GDP and excessive risk taking to generate returns. On the latter, think of things like reaching for yield, carry trades, insane P/E's paid for some growth stocks, derivatives and now we have flash orders.

 

Retaining some cash or hedging at this time seems more than adequate. While I agree that Prem has a business to protect (insurance capacity), there is no reason for an individual investor to not be demanding on a price to value basis. That is the swinging on a fat pitch part. There are still some bargains out there, but they are nowhere near as prevalent or as fat as they were.

 

Regarding Buffett, I would like to point out that the guy was fully into treasuries before the crisis in his personal account. He also had a mountain of cash at Berkshire. This is hedging. He was on the sidelines waiting for fat pitches to show up.

 

Cardboard  

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>I continue to regard this market as extremely dangerous. It could seize up at any time. All is needed is a small unforeseen event and they happen much more often than we expect.

 

Generally speaking the stocks are not as cheap as they were in March 09 but then they are not as expensive as in 2003 or as in 2007. Volatility is a friend of the value investor and some people will make a killing in this environment.

 

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Generally speaking the stocks are not as cheap as they were in March 09 but then they are not as expensive as in 2003 or as in 2007. Volatility is a friend of the value investor and some people will make a killing in this environment.

 

That is correct Shalab!  Also, I think the other distinguishing character today, compared to 2007 or even early 2009, is that alot of businesses have deleveraged.  Governments have piled on debt, and the macroeconomic picture could make stocks volatile, but most companies in North America are in far better shape today. 

 

If the credit markets seized, leveraged financial institutions would continue to be in a bit of a bind, but many are still carrying large hoardes of cash.  Most non-financial businesses already have large cash piles, with reduced levels of debt, and would probably make out quite well in another credit crunch.  Private equity funds and hedge funds that survived, also are sitting on huge amounts of cash due to their macroeconomic views, thus they will be able to meet redemptions or put capital to work.  In general, equities don't hold the same sort of risk we saw in 2008 and 2009.  Volatile yes, but permanent risk to long-term capital...reduced considerably.  Cheers!

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Investors have been on a wild roller coaster ride the past 24 months given how low the market fell in March 09 and how fast and far it has rallied since. People are not built to handle this sort of volatility. My guess is there are a lot of ichy fingers out there; should we get another down draft in the market it could morph into something ugly (and here comes Sept/Oct just as the economy looks to be rolling over...). Should this happen then watch investor sentiment towards equities start to hit generational lows... Then this would begin to look to me to be a real bear market!

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