Q4 2010 results out

[A_Hamilton]

Having gone through the entire filing, having trouble telling what the maximum amount FFH could lose on the hedge/swaps/derivatives is.  Any insight from board members would be welcome.  Basically a related concern to Partner24's question:  What is the amount they could lose in a 1/50 type opposite events from their hedged event scenario

 

1.  See the notional amounts but that cannot be the max loss because that would have been a very poor (hopefully non-starter) investment decision

2.  See the cost of each derivate/hedge investment line item and see the change in value to reconcile to current market value but that does not give you the total amount they could lose

3.  Nothing in the MD&A that outlines scenarios or any verbage scenarios that says if the Russell goes to x we would lose y on a mark to market basis.  

4.  Nothing in the MD&A or filing numbers that outlines whether they can cap the loss by closing out the hedges/swaps/derivatives at certain points in time or for a certain price or at a certain level of each index.

5.  Nothing in the MD&A to give comfort on how much upside there is in the offsetting income from the hedge/swap/derivates that might mitigate the total loss

 

Ok22 a few thoughts:

1.) Very simple on the the index swaps. They have $3.3 billion in notional against the Russell 2000. For every 1 percent increase in the Russell they lose $33 million. There is no limit to the amount that they can lose, except that they can close out the trade whenever they wish. Same deal with the S&P 500 swaps.

2.) On the CPI linked derivatives, the most that they can lose is their cost basis, or ~$300 million.

3.) See point 1.

4.) See 1.

5.) They don't know how their long portfolio of equities will perform, so there is no scenario analysis possible.

 

[Guest Bronco]

Everyone's dancing around the issue - what is the IV for FFH and what is a fair margin of safety (purchase price) for that IV?

[Myth465]

Everyone's dancing around the issue - what is the IV for FFH and what is a fair margin of safety (purchase price) for that IV?

 

I would say about 1X BV is a fair price to buy at and hold up to 1.5 BV. FFH is worth more than book, but no one will pay it till underwriting improves. The real goal inmo is to hold as an owner and earn the future growth in BV with goals of at least 15% a year (they will be lumpy).

 

As far as trading I would get in during a hard market, or when you know more about the investment portfolio than Mr. Market. I kinda agree with insurance analyst your premium to book depends on consistent earnings based on Interest and Dividends (adjusted for current / future yield) and underwriting profits.

[Viking]

As boardmembers have come to appreciate, FFH tends to be a very volatile stock (although not as much as when they were listed on NYSE) as they tend to zig when the market zags... Furtunately, they have enough disclosure (i.e. 60 page quarterly reports) for most investors to get a general feel for how their underlying business is performing from Q to Q. My preferred investment approach with FFH (and similar to a few other investors on this board I think) is take advantage of the volatility and think about buying when it trades at 0.9 x BV and when it is sitting on significant unrealized gains on investments (resulting in a nice pop in BV when it then reports Q results).

 

Currently, shares are trading at around BV and they are likely sitting on losses in their investment portfolio (meaning mark to market BV is likely lower) given strength of equity markets in Q1. I would like to see the FFH stock price lower (0.9xBV) and stock markets correcting 10 to 15% before getting too excited about getting back in.

[Guest Bronco]

myth and viking - thanks for stepping up and answering the question.  I don't own any shares except for the investment club I am in (we bought at $235).  I have shifted to Loews for varying reasons, but may be diversifying out of that soon due to some covered calls I wrote w/ $45 strike. 

 

I am short on time and therefore I am having trouble finding things I like.  So many things are overpriced and the value plays are in bad businesses (banks, slow moving big tech - MSFT, CSCO).  Need some time to do homework and get new ideas.

[Parsad]

Parsad:  Hope you take no offense at my rather pointed concerns and vexation.  Really like the board and have been a long time FFH fan but am definitely frustrated with some of the recent decisions and this filing's disclosure quality has me a bit more frustrated.  Realize this may not pass the worth your time test:  but if Prem does care to hear from shareholders that think they have legitimate issue(s) to raise, feel free to pass it along if it is appropriate or worth your time.

 

Nope, no worries...that's what the board is for.  By the way, that's why they read the board...right up to the top!  They want to know what you guys think, how you feel and if there are any concerns they can address in future reports.

 

Regarding your questions...these are my answers naturally:

 

1.  The NYSE delisting which I viewed as a bit arrogant and peevish and unnecessarily limiting.  The savings

 

I think this was the exact opposite of arrogance.  It was an admission of error or miscalculation.  They realized the stress and expense related with what happened from 2003 to 2007 was extremely painful and just not worth it.  Plain and simple!  Investors can still buy the stock, and it has no effect on operations or intrinsic value.  I think it was the right move in light of how clearing houses operated before the credit crisis.  It's every company's ambition to be big-board listed in New York.  Prem came to the view that he's fine with being a Canadian insurance company listed in Canada. 

 

2.  Very disappointed with their MD&A and numerical presentation here in this filing.  After all FFH and Prem has been through, thought they would be over detailed when you have a really bad quarter even if it is only bad "looking/short-term" mark to market/ short term etc.

 

It's kind of why I said everyone should just wait to the annual report comes out.  There is an immense amount of disclosure in there.  Prem will probably incorporate a few more things within the letter in light of how shareholders feel after the press release and quarterly.

 

3.  The way too early time of the conference call imho has been making for too few questions especially quality ones

 

C'mon on this one Ok22!  ;D  If people want to ask a question, they should be able to set an alarm clock.  I used to always wake up at like 5:20am PST to listen.  Now I don't because things are running smoothly at the company and I can ask all the questions I want in Toronto each year.

 

4.  The decision to hedge 80%+ of your portfolio.  Why not then just be 20% long invested and in cash?  Long term oriented shareholders should be ok with having dry powder and waiting for FFH to pull the trigger.  Feel like they are being overly cute and complex with the hedge/swap/derivate maneuver and mathematically don't think it makes sense at such a large percentage?  Again, if I am wrong would love to hear a detailed explanation on how you can invest $100 and then hedge $80 and then still make money if the s

 

I'm no fan of hedging.  I think often they just increase your frictional costs, and if you hit one out of the park...it's often just dumb luck with the timing.  Our hedge is just straight up cash in short-term T-bills.  But Fairfax is an insurance company and one with only an A-rating. 

 

With their levered portfolio, any signficant swing (one that you and I could easily handle) could affect their statuatory capital, and reduce their ability to underwrite.  At the same time, any significant drop in shareholder equity can also increase their debt/equity ratio and affect their credit rating.  Remember, for a property casualty insurer...anything less than an A-rating and you're pretty much out of business.  The hedges would not be as important if they held an AA or AAA-rating...but they don't.

 

5.  Unnecessary high bar jump investments like Abiti, canadian retailer turnaround, messy regional airline situation, Level 3, Overstock, usg, dell etc.  They were liquid when lots of higher quality companies/business models were cheap, why stretch for these higher bars to jump over.  Is there something in the DNA that says we like to buy messy insurance companies and fix them so they are attracted to messy equity investments.  fyi, i see and hear their JNJ in the portfolio response but dont consider the price they bought it at to be that great.  JNJ is going to have issues if the stent business has issues as that was masking the growth and margin problems in the rest of the business and with their recent consumer product issues and medical device issues that I see could occur, I don't think that JNJ is at a sufficient margin of safety.  Almost impossible now for JNJ to find a small Neutrogena for a great price and grow it into a large business to make up for medical device revenue/margin issues.

 

Hey, this is where it would pay for you and anyone else to come to Toronto.  You can ask all these questions there.  A couple of years ago I asked them who the genius was that bought Canwest and Torstar!  ;D 

 

Hamblin-Watsa's team are pure Ben Graham students.  They buy distressed stuff that no one wants.  That's what Prem, Roger, Brian et al have always focused on from their early days and really what they still do...think Walter Schloss, not Warren Buffett.  At the same time, they do buy the higher quality businesses that are trading at relatively cheap prices.  For example, they loaded up on financials including WFC, USB, JNJ, WMT, GE all near the bottom of 2009.  They also made a number of similiar investments in high-yielding preferreds like Berkshire.  In regards to OSTK and LVLT...the story isn't over there yet.  With LVLT, I think they aren't that far from recouping all of their investment simply from the interest LVLT has had to pay over the last few years to them...anything else will be icing. 

 

6.  CDS gains caused inflated head syndrome at FFH with respect to investment process?

 

Believe me, there are no inflated heads at Hamblin-Watsa.  The CDS was a one-off attributed to Brian Bradstreet and Francis Chou...no one else.  They were out of ideas back in late 2004, early 2005, and Prem just said in a meeting..."Anyone have any good ideas?"  Brian and Francis had briefly talked about CDS' between the two of them, and then they sheepishly answered "Well, there are these credit default swaps...".  That was it!  They started with a small bet, and as things progressed, or perhaps regressed, in the credit markets, they upped their bet.  These guys all love their jobs...they just enjoy doing what they are doing.  They really don't care about the accolades, but appreciate the respect that any of you guys show to them.

 

In regards to questions about underwriting, etc.  Because premiums have been soft and continue to be soft, Fairfax's combined ratio alongs certain lines will increase dramatically as expenses cannot be cut as fast...that's what you see primarily at Northbridge and C&F...I don't expect Berkshire's business to be much different.  The U.S. combined ratio was so high because of Zenith's 154% combined ratio for the quarter.  I don't have a problem with the high combined ratios at the moment, because I don't want them writing unprofitable business.  When the market turns, you will see Fairfax's subs write large amounts of new business at better rates.  But the returns from these decisions won't be apparent for years.  Cheers!

[oec2000]

oec...your question is good, but it reflects a certain framing.  FFH is an insurance company with a substantial bond portfolio and a much smaller equity portfolio. If you look back over inflationary periods, insurance companies with short durations in their bond portfolios have the ability to roll their bonds over into higher yielding securities.  It's a type of asset conversion that Marty Whitman has written about.  In the event of inflation, insurance companies typically revalue towards a "going concern" model.

 

If you get the chance to go to the Fairfax shareholders dinner, talk to the quiet guy named Brian who runs the bond portfolio -- guaranteed to be worth your time.  FFH has made far more money off bonds than equities in its lifetime, but people mostly like to talk about equities here.

 

-O

 

Omagh,

 

I have spoken to Brian before and I agree absolutely with your assessment - he not only knows what he is doing, he is honest about what he does not know and, most of all, he is very generous with his time and advice.

 

I agree also with your assessment of BB's and FFH's skills in bond investing. Compared to them, Bill Gross is overrated (it will be interesting to see how FFH's deflation bet plays out because PIMCO has apparently made the opposite bet).

 

However, FFH will intially be hurt (in mark to market BV terms) if there is a sharp rise in interest rates. If you check the notes to the Q4 financials, you will see that they materially lengthened their bond duration in Q4 2010. They are certainly not positioned for inflation right now. Everything they have done and said (Prem's mention of a commodity bubble) last year points to a deflationary view. This does not worry me because I think they will be right. I'm just saying that we should not be complacent about how inflation could adversely impact FFH.

 

oec

[QLEAP]

Earnings call transcript at http://www.morningstar.com/earn-0/earnings--22211805-ffh-q4-2010.aspx.shtml

[oec2000]

But like I said approximately a month ago, I think they should take time to explain their hedges better and to let us know what would happen if we would like a 1 to 50 years to 1 to 100 years event that would be the contrary of what they want to protect at first glance (i.e. huge bubble in the stock markets in wich they took a "downside protection").

 

Partner, I thought that the explanation of their short swap positions including exposure, cash settlement procedures, and collateral and counterparty risks in the notes to the financials were pretty clear and detailed.

 

Having gone through the entire filing, having trouble telling what the maximum amount FFH could lose on the hedge/swaps/derivatives is.  Any insight from board members would be welcome.  Basically a related concern to Partner24's question:  What is the amount they could lose in a 1/50 type opposite events from their hedged event scenario

 

1.  See the notional amounts but that cannot be the max loss because that would have been a very poor (hopefully non-starter) investment decision

2.  See the cost of each derivate/hedge investment line item and see the change in value to reconcile to current market value but that does not give you the total amount they could lose

3.  Nothing in the MD&A that outlines scenarios or any verbage scenarios that says if the Russell goes to x we would lose y on a mark to market basis.  

4.  Nothing in the MD&A or filing numbers that outlines whether they can cap the loss by closing out the hedges/swaps/derivatives at certain points in time or for a certain price or at a certain level of each index.

5.  Nothing in the MD&A to give comfort on how much upside there is in the offsetting income from the hedge/swap/derivates that might mitigate the total loss

 

The information is there for us to perform the scenario analyses ourselves. Beyond that, it seems unreasonable to expect management to lay out all the possibilities for us.

 

I don't have the data to investigate the historical record but I would think that the risk of the broad indices going up sharply (100-200%) while FFH's broadly diversified portfolio of equities went nowhere or down would be extremely low unless you think that the guys at HWIC have suddenly become the worst stockpickers in the world. So far, the evidence supports the more reasonable assumption that the loss on the hedges are offset by gains in their long portfolio.

 

A more significant risk to worry about is a sudden sharp rise in interest rates. As the Q4 results show, FFH is not hedged and would be much more vulnerable to this.

[ERICOPOLY]

4.  The decision to hedge 80%+ of your portfolio.  Why not then just be 20% long invested and in cash? 

 

They might be doing it because it's easier to just hedge against the index than to try to wiggle out of all of their positions.  Besides, what if they market doesn't go down after they sell, and then for some reason they decide to go back in?  Well, if they had sold then they would need to pay a capital gains tax.  Hedging is a means of getting out of the market without the tax bill.  Only if the market drops and they book a gain on the hedges do they pay tax... but they only pay tax on the amount that the market pulls back.  Selling your existing holdings might be a much bigger tax bill than the one on the hedge gains.

 

So I bet you there are two reasons why they play this way:

1)  easier to hedge against an index than to get  into and out of big positions

2)  potentially a big tax savings

 

Defenders of Buffett would say that he didn't sell into the hugely expensive market of 2000 partly because of taxes, but that's a lame excuse given that he could have gone the route of hedging against the index.

 

[SharperDingaan]

 

Wait for the IFRS disclosure in the Annual Report.

Some of the hedging structure will become obvious once you understand how MTM unrealized gains/losses on hedged, & trading, positions are to be recognized from Jan 01, 2011 onwards. Other comprehensive income reporting, etc. 

 

SD

[bluedevil]

 

They are certainly not positioned for inflation right now. Everything they have done and said (Prem's mention of a commodity bubble) last year points to a deflationary view.

oec

 

 

Prem confirmed on this last conference call that the recent uptick in inflation has not changed their long-held views on deflation.  They still believe that the recent recession was a BIG deal that the United States will have to grapple with for a long time -- i.e., stock market declines and deflation.  I've always found the thesis to be strong based on the evidence they point to, including Japan and the Depression.  But the one thing I would love to know is how the company accounts for the x-factor (Bernanke), who seems determined to prevent deflation come hell or high water.  They haven't discussed that angle so far as I know, but I haven't been to the annual meetings.

 

[rmitz]

I can't read beyond page 1 of this transcript, does anyone else have better luck?

 

http://www.morningstar.com/earn-0/earnings--22211805-ffh-q4-2010.aspx.shtml

 

I noticed that and just went to the "print" view instead, which has it all on one page.

[beerbaron]

Quick question ...If they plan to hold their muni for the long term, why are they classified as available for sell in their balance sheet?

 

Don't mistake I love that their bonds are marked to market, it makes my life so much easier to value the company.

 

BeerBaron

[Rabbitisrich]

The accounting treatment provides greater transparency and allows for opportunistic sales without sudden reporting shocks. I don't think that it has much effect on statutory capital.

 

Speaking of which, is anyone savvy on the NAIC treatment of cash deposited for collateral? Last quarter FFH posted collateral similar to the fair value of its swaps. Are these amounts +/-'ed from statutory capital?

[oec2000]

4.  The decision to hedge 80%+ of your portfolio.  Why not then just be 20% long invested and in cash? 

 

So I bet you there are two reasons why they play this way:

1)  easier to hedge against an index than to get  into and out of big positions

2)  potentially a big tax savings

 

 

Agreed and I would add the following:

 

1) You can't be a fan of FFH or BRK unless you believe they are great investors who can outperform the broad market indices. Otherwise, you would would be complaining about why they are trying to pick individual stocks instead of buying the indices. If you believe that FFH can outperform the markets, then you would expect them to add value while reducing volatility by hedging this way. This is classic hedge fund stuff - without the 2+20!

 

2) Would shareholders have been better off if they had not hedged their equity portfolios in 2008?

 

Where is the evidence to support the criticisms of their equity hedging strategy? Has anyone even tried to quantify how much they made or lost from the hedging mismatch? For all we know, they may have made a spread from the hedging. Sure, they have foregone the opportunity cost of more equity gains but surely we would be worse off if they had sold the underlying equity positions and taken the tax hit instead?

 

 

[biaggio]

well said OEC2000. Hindsight is always 20/20

 

I feel better after reading the conference call.

 

It sounds like they just wanted to protect their $7.7 B in capital while waiting for the hard market.

 

Most of the decrease in BV was due to the munis which just a paper entry as they plan to hold for the next 10 years (as they are happy getting a tax free 5-6 %, insured by BRK).

 

Also Mr Watsa said on 2 occasions during the CC that he is waiting for further consequences  related to the 2008-09 downturn as he does not feel that it is a regular recession...perhaps he is thinking we will have a Japanese like deflation  and hence the CPI hedges. (I ,like a lot of people on this board, have always felt that we re in for a lot of inflation + I am happy in a preverse way of having my $$$ managed by someone who is way smarter than me + is thinking the opposite of me.)

[biaggio]

I was just thinking...

 

FFH's capital seems to be set up for deflation (bond holdings, CPI derivatives) but if we have a lot of inflation will this bring on a hard market?

 

Will high inflation hurt insurance companies writing insurance in todays soft market? Will they not have to pay higher amounts for claims? Higher claim amounts leading to harder market, which results in FFH using their capital to write more insurance at such a price that they will actually have an underwriting profit which will counter balance losses they have in their CPI derviatives + bond holdings.

 

Sorry if my thinking is a bit convoluted.

 

Could be wishful thinking too.

 

[bluedevil]

 

FFH's capital seems to be set up for deflation (bond holdings, CPI derivatives) but if we have a lot of inflation will this bring on a hard market?

 

 

I think the opposite is true, on balance.  Most insurance companies keep relatively short duration bond portfolios (3-4 years).  If rates rise, they will roll over their bonds into higher yielding investments, which means they can write insurance at lower prices and still make a profit.  According to W.R. Berkeley, for each 1% increase in interest rates, a commercial lines insurance company (depending on how long-tail the business is) can sustain a 3-5% higher combined ratio and still make the same return on equity.

 

In a sense then, I think Fairfax has tripled down on a deflation/disinflation.  If rates remain low or go lower, it will make money off its CPI-linked hedges, its long-duration bond portfolio, and the hard market that should eventually result from the low rates.

[Myth465]

Who asked this question  ;).

 

Please someone at the annual ask this question. I would really like to get the answer to it. Its something I have wondered.

 

http://www.gurufocus.com/news.php?id=123290

 

A Long Time Shareholder Asks a Good Tough Question

 

 

The one thing I did notice in your common stock portfolio, there's a lot of very messy equity decisions that have been made in the last one or two years. When I thought that you guys would have used your liquidity to buy higher quality things given how much money you guys had and how some very large liquid companies were available. I'm just throwing out names not making any suggestions like Colgate, United Technologies were really cheap, but you guys invested in level three and more and of more level three, the pulp company and the regional airline and these sort of things Dell, overstock, USG, and I'm just wondering, is this something in the DNA at Fairfax that attracts you to these overly messy things, I mean just like the history of buying messy insurance companies?

 

 

Watsa Responds

 

 

we have our annual meeting in a couple of weeks, Jaideep. Actually our Annual Report comes out in about two weeks then our annual meeting is in April; I think it's April 20th, it is somewhere there in our annual meeting. Why don't you come for that ask all your questions there, because those are a little detailed questions for a conference call.

 

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

 

I predict that FFH pulls another rabbit out of the hat with the recent bond dislocation.

 

 

Watsa On Potential for Muni Bond Opportunities

 

 

But if I could just tell you, just highlight it again for you, with these Berkshire Hathaway guaranteed, muni bonds, when you're getting 5.5%, 5.75%, some issues at 6%, the pre-tax equivalent is pretty close to 9% – 8.8%, 9% depending on the tax rate. Now, these are bonds that will give you that for 10 years, non-callable for 10. So the way we look at it is that no credit risk with that, there is very little credit risk. We collect 9% on our money approximately for the next 10 years and the fluctuations in the values go into our balance sheet up and down, and doesn't have much impact on us. Another way to look at those muni bonds is to say, what does – that 8.8%, you compare that to 10-year treasuries at 365. So 365 for 10-year treasuries and muni bonds at 8.8% guaranteed by Berkshire Hathaway. So you have that discrepancy and those discrepancies in our view with being in the market for long time they don't last for long and they will change. For example, we go into the marketplace. We can't buy $1 million of Berkshire Hathaway guaranteed bonds even though the yields are 5.75% and 6%. There is none for sale in the marketplace. It's a bid. There is a pessimism on muni bonds across all muni bonds and perhaps some justified but we think totally unjustified and the ones that we have. So we look at this as a time of opportunity but there is if you like the rates but there is very little available

 

[Guest Bronco]

I'm no longer a shareholder for that reason.  I may miss some good trades and investments, but I prefer to identify good businesses and wait for good prices.

 

Although I am a holder of Loews, it seems BRK by far and away has the best quality assets (10B of coke, wrigley debt, preferreds from GE, GS, Swiss Re that he made and are getting paid, GEICO, railroad,etc.).

 

But to be fair, no one, including Buffett, really piled into equities during the crisis like I expected. 

 

How hard would it have been for someone like Buffett to buy a Textron at 1 or 2B?  I get the preferred investments, but..... Anyway, is what it is.

[Myth465]

Those quality assets have earned very little return over the last decade. I prefer the FFH way. Deep value. Deep dirty, dingy, smelly value. Though FFH seems to have interesting taste in deep value. Its always something that makes me go yuck and throw up a bit in my mouth (my investments probably do that for some people).

 

Coke should have been sold about 10 years ago. Holding that great asset has been a waste of time. At the very least puts could have been bought against it. I like those preferreds though.

[Partner24]

Thank you Myth for posting the link.

 

we have our annual meeting in a couple of weeks, Jaideep. Actually our Annual Report comes out in about two weeks then our annual meeting is in April; I think it's April 20th, it is somewhere there in our annual meeting. Why don't you come for that ask all your questions there, because those are a little detailed questions for a conference call.

 

I don't it was a detailed question at all. It was a general question. Why buy cheap messy things instead of high quality things when quality things were pretty cheap? That was a very good general question that could have been answered in the conference call.

 

I'm not complaining at what they have done with their investments. They have their own style and they did overall very well with it since the last 25 years. I agree with them that the municipal bonds were quality things bought cheap, just like JNJ and other investments like that, but the question was not related to the bond portfolio. I think Prem should have answered that question directly in the conference call.

 

 

 

 

[Guest Bronco]

I think Buffett bought 200m shares of Coke for 1.3B  That is worth $12B.  He would essentially owe the IRS $4B if he sold Coke.  On his $1.3B investment, he receives close to $400M per year in dividends.

 

He loves the business, I get it, but I think the tax reasons are why he won't sell.

 

Myth - You may be right on the make ya wanna puke investments - I just don't have the time to understand them and hence I'm out.  But your point on the munis is well taken - I am sure they will do well.

 

 

[Myth465]

I think Buffett bought 200m shares of Coke for 1.3B  That is worth $12B.  He would essentially owe the IRS $4B if he sold Coke.  On his $1.3B investment, he receives close to $400M per year in dividends.

 

 

As ERICOPOLY said puts would have been nice. I mean it was pretty overvalued.