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Prem and the not so cheery outlook


Munger
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Enjoy...  

 

 

 

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?

 

PM: 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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Again, while it always pays to be cautious, the average investor should remember that Fairfax's portfolio is leveraged 3 to 1 against equity, and total assets are leveraged almost 4 to 1 against equity. 

 

That means a modest 10% loss in the portfolio is a 30% loss in equity for Fairfax.  For the average investor that is nothing, but for Fairfax that could mean a drop in their credit rating or the ability to underwrite adequate amounts of business.  Cheers!

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As always -- this is what makes a market and the investment process so fun -- I see it very much different.

 

Risk of a 10% downturn in the market is almost always present. 

 

Hence, when Prem compares the current situation to the Great Depression or Japan and declares the financial crisis not over, I personally don't believe he is hedging against a 10% decline the market.

 

Best.

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Munger I wasn't saying that Prem was hedging for a 10% drop.  I was just giving a simple example of what a dramatic affect a modest 10% drop could do to Fairfax's portfolio.  In Fairfax's case, if we saw a 30% drop in their portfolio, it would wipe out 90% of their equity!  

 

I always find it amusing how posters assume that some of us are disagreeing with Prem...someone who we've followed since the beginning and have a mentor/student-like relationship with.  We don't hold the Fairfax Shareholder's dinner every year before the AGM, or our own AGM in Toronto at the same time, simply because we think Prem is an idiot.  Other than my own father, there is no one that has, and continues to influence my thinking more than Prem Watsa and Warren Buffett...they are Gods to me...truly Gods to me!  No one has influenced my life more...not a single teacher in elementary, high school or university...no one.  I would bend over and kiss my own ass if Prem asked me to!   ;D

 

But the biggest lesson I've learned from them is to be independent in your thought process.  Every case is not the same.  The average investor's unleveraged portfolio is not the same as Fairfax's.  Even this period will not be the same as the Depression or Japan...it may rhyme, but it will not be identical, as there are too many variables.  The only constant is Ben Graham's principles...buy cheap with a margin of safety and sell dear.  No one knows exactly what we will see...only hindsight will prove who was correct.  As Prem said, things could trend sideways for many years, or we could see a significant correction...no one knows.  Cheers!

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I would say that Fairfax's current stocks exposure is actually lower than for average unleveraged investors fully invested in stocks.

 

Total stocks exposure at Fairfax is around $4.6 billion including stocks at holdco and the fair value of equity investments vs a common book value of $7.9 billion (excludes preferreds). They also have a lot of government bonds which would typically go up in value if stocks are thrown out.

 

So to hedge 93% of this already low exposure is quite a warning sign IMO. We should also remember that KFT and JNJ represent quite a proportion of the total or already defensive positions.

 

Hedges always have a cost (either you pay a premium or you lose with the short/swap), so they must be quite concerned about the possibility of a major correction and not just a small temporary dip to be spending money on that. It is never good for them to see their equity being reduced due to portfolio movement since it impacts their underwriting capacity and ratings, but again let's remember that they are only using a portion of that capacity at the moment.

 

Cardboard

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No, you come out as someone who is mixing opinions on disastrous macro economic scenario with value investing principles.

 

Well, actually I'm trying to point out that it's probably not prudent for the average investor to focus on macroeconomic forecasts, whereas for an insurance company that has significant leverage, it is probably a prudent thing to do.  Alot of people are having a difficult time making that differentiation.  Each to their own!  Cheers!

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Well, actually I'm trying to point out that it's probably not prudent for the average investor to focus on macroeconomic forecasts, whereas for an insurance company that has significant leverage, it is probably a prudent thing to do.  Alot of people are having a difficult time making that differentiation.  Each to their own!  Cheers!

 

That is well put.  Prem has two things going with the hedges.  One is protecting a very large portfolio of money that is not actually FFHs.  The other is an outlier bet on a market collapse.  I dont have issue number one and it is too expensive for me to worry about number 2. 

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Guest broxburnboy

I've come to believe that Prem's first hand experiences with the deflation in Japan is his investing edge in this environment. Fairfax's current prosperity is not due to his adherence to value investing principles, but to the brilliant CDS moves the team made prior to the events of late 2008.

Many value portfolios bit the dust since, as a result of so called "macro" factors trumping the value investing paradigm. Those value managers who survived did so by trading, hedging and shorting, usuallly anethema to value strategists.

When Prem is loading up on index shorts like he did with CDS, he is strongly hedging against a correction, possibly violent, which again will trump the "rising tide floats all boats" value scenario. I think it prudent to take his comments as an understated warning.

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No one has influenced my life more...not a single teacher in elementary, high school or university...no one.  I would bend over and kiss my own ass if Prem asked me to!  

 

But the biggest lesson I've learned from them is to be independent in your thought process.

 

So Sanjeev, if Prem ask you to bend over to do what you wrote, please keep an independant thought process!  ;)

 

Cheers!  :)

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Guest ValueCarl

Let it all hang out!

 

It's the SIGN of the TIMES that RHYME which will continue to get frothier and test all mens' convictions while this global experiment is sorted out. imo

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Instead of defensive macro strategies, I believe individual investors should protect their portfolio by focusing on picking up businesses that will manage to withstand extreme short-lived fat-tailed events AND grow through most deflation/inflation periods. (Sounding like a broken record, as I already mentioned this few times,) Coke's 1920-1940 history is a great example: losing a relatively small portion of its sales during the 29-31 experience and growing thereafter. My strategy is to lean heavily on basic utilities and on businesses that accessibly serve basic human desires, trading at reasonable levels. I won't escape volatility, but longer-term, it'll probably work out fine.

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