The case for Deflation and FFH's CPI-linked derivatives

[tng]

I don't think many people believe that the base case will be inflation, but most realize that it is a possibility. Prem got the deflation hedges for cheap, and since deflation is not happening, they are clearly underwater. As expected, you buy insurance and the catastrophe doesn't happen, you are worse off. But you don't buy life insurance hoping you will get hit by a bus tomorrow.

 

Just take a look at how the world is reacting to the crisis. Some countries actually choose austerity. If the US went that route (and at the time, there was a small chance that they would), then I think we would have some deflation. Deflation is very high risk to insurance companies, most of them would go bankrupt (I think I remember Prem saying that 9 out of 10 insurance companies in Japan went bust). All your existing policies would flip inside out as you have to pay out more in real terms than you collect in and a deflationary environment would probably knock down the market valuations of all your existing investments. Suddenly, your balance sheet doesn't have enough to cover your insurance policies and you are toast.

 

The deflation hedges were priced cheaply, so it's a small price to pay to take the tail risk off the table.

[kevin4u2]

a company like FFH is especially reliant on management as its key product (investment returns) is directly at the mercy of management.

 

I am not sure how everybody views FFH, but this is a hedge fund with an insurance wrapper, not the other way around.

 

Frank, you are correct.  The use float to generate huge returns.  Look at their history, FFH has increased book value by almost 24% for 26 years.  That is no fluke.  They are very good at what they do. 

 

The formula is simple:  Float + Strong Value Investing = Cash flow machine!

 

Like others here, after reading every annual letter to shareholders since inception I have invested a significant amount into FFH and plan on leaving it there for a good long time.

[ERICOPOLY]

Look at their history, FFH has increased book value by almost 24% for 26 years.  That is no fluke.  They are very good at what they do. 

 

They are certainly very good, however I'm not sure how much of a benefit they got from issuing their shares at a huge premium to book value (it was up to 3x at one point!) -- I think it was quite a bit.

[FrankArabia]

I have read a lot of the FFH annual letters (though not as well versed in them as others here) as well and their record speaks for itself.

 

However, given their current positions, I'm not so inclined at the moment to put money behind FFH. What do you expect to happen now to think their investment gains would work out so well? everything is hedged and they got a few one off derivative. i'm anxious to see how they perform but can't see how they will make their 15% on book in the next few years.

 

 

[kevin4u2]

Look at their history, FFH has increased book value by almost 24% for 26 years.  That is no fluke.  They are very good at what they do. 

 

They are certainly very good, however I'm not sure how much of a benefit they got from issuing their shares at a huge premium to book value (it was up to 3x at one point!) -- I think it was quite a bit.

 

Absolutely, and that is a good point.  Much better to issue equity when the stock price is high.  Crescent Point energy has been playing that game for years, and the income trusts did it for years.  CPG issues new shares consistently at 2x book to fund their high dividend.  The haven't earned a dime in profits for 10 years. 

 

[Uccmal]

Look at their history, FFH has increased book value by almost 24% for 26 years.  That is no fluke.  They are very good at what they do. 

 

They are certainly very good, however I'm not sure how much of a benefit they got from issuing their shares at a huge premium to book value (it was up to 3x at one point!) -- I think it was quite a bit.

 

Very good point.  Financial engineering helped some.  However, they also issued alot of stock well below book as well.  You also need to strip out year 1 which was an anomaly.  Give them 20%, after everything is netted out and 15% going forward, CAGR. 

 

With FFh everything is always in fits and starts. 

[racemize]

I personally have the same amount of BRK as FFH.  I agree that, in the near term, assuming there isn't a big drop and that the deflation bets don't work out, FFH won't move much.  It is my assumption that that is the reason FFH is trading near book value. 

However, at some point they will take off the hedges and move forward again--when everyone knows that, will it still trade at book value?  Maybe not. 

 

Also, the hedges could come in handy if everything goes badly as well.

 

[shalab]

FFH returns as of Dec 31st 2011:

 

5 years -> 19.4%

10 years -> 12%

15 years -> 12.4%

20 years -> 16.1%

 

These are great numbers and I admire Prem for what he has achieved. However I don't expect them to do as well moving forward unless the stock price drops to a low level. The stock price drop is unlikely as the FRFHF poll revealed an IV north of $460 from the believers.

[txitxo]

Reasons to buy FFH:

 

- The american stock market has a Shiller P/E of 22.7. Even in 2009 it never hit a Shiller P/E close to 10 as it usually happens with secular bottoms (Europe got to P/E ~11 this year). The "expensive crap" indicator I use indicates there is high probability of a major crash within a year in NA, give or take, there is too much optimism in the market. The numbers are telling us that NA markets are very risky right now. And if we look at the situation from the political point of view, strange things are going on, the situation in Greece is terrible, but nothing happens, politicians in Spain act as if there is no big rush to solve anything, Israel is obviously preparing for war with Iran but does not pull the trigger.  I am starting to get the impression that world problems are on hold waiting for the US elections. After November we may see a lot of bad news hitting at the same time most of the world major economies.

 

- FFH is hedged, both against a major crash a la 2009, and even against a repeat of the Great Depression of the 30's. They will keep growing their book value despite the hedges, because of their investing skills, and will know when to remove them better than almost any other investor. People who do not like FFH's strategy should have a look at the Nikkei 225 chart since 1990.

 

- Of course Prem Watsa is key to FFH, but there are a lot of smart people working there, you'll need a really nasty case of food poisoning at one of Parsad's dinners to eliminate the company's ability to produce alpha and navigate the market storms.

 

 

[giofranchi]

a company like FFH is especially reliant on management as its key product (investment returns) is directly at the mercy of management.

 

I am not sure how everybody views FFH, but this is a hedge fund with an insurance wrapper, not the other way around.

 

Frank, you are correct.  The use float to generate huge returns.  Look at their history, FFH has increased book value by almost 24% for 26 years.  That is no fluke.  They are very good at what they do. 

 

The formula is simple:  Float + Strong Value Investing = Cash flow machine!

 

Like others here, after reading every annual letter to shareholders since inception I have invested a significant amount into FFH and plan on leaving it there for a good long time.

 

FFH has two enormously important advantages on any hedge fund:

1) Permanent capital: the lack of permanent capital and the constant risk of redemptions are the greatest weaknesses in the hedge fund business model. Like Mr. Buffett has said many times: “Investing is the best business”… except for the risk of redemptions!

2) They have float. And, if they succeed in underwriting profitably, float is, paraphrasing Mr. Buffett, “money that other people pay us to keep… and that puts a great smile on our faces!”

Thanks to these two important advantages, I expect FFH’s future performance to be much better than any hedge funds out there.

 

giofranchi

[giofranchi]

Reasons to buy FFH:

 

- The american stock market has a Shiller P/E of 22.7. Even in 2009 it never hit a Shiller P/E close to 10 as it usually happens with secular bottoms (Europe got to P/E ~11 this year). The "expensive crap" indicator I use indicates there is high probability of a major crash within a year in NA, give or take, there is too much optimism in the market. The numbers are telling us that NA markets are very risky right now. And if we look at the situation from the political point of view, strange things are going on, the situation in Greece is terrible, but nothing happens, politicians in Spain act as if there is no big rush to solve anything, Israel is obviously preparing for war with Iran but does not pull the trigger.  I am starting to get the impression that world problems are on hold waiting for the US elections. After November we may see a lot of bad news hitting at the same time most of the world major economies.

 

- FFH is hedged, both against a major crash a la 2009, and even against a repeat of the Great Depression of the 30's. They will keep growing their book value despite the hedges, because of their investing skills, and will know when to remove them better than almost any other investor. People who do not like FFH's strategy should have a look at the Nikkei 225 chart since 1990.

 

- Of course Prem Watsa is key to FFH, but there are a lot of smart people working there, you'll need a really nasty case of food poisoning at one of Parsad's dinners to eliminate the company's ability to produce alpha and navigate the market storms.

 

txitxo,

I know you are very busy with your Dark Energy endeavor… but I really hope you will write more often in the future! Your latest post was both very thoughtful and funny! ;)

 

giofranchi

[FrankArabia]

Gio,

 

I believe they're hedged on both the up and downside (no net exposure) on equities. Can you help clarify on your statement that they will benefit from their investing wisdom?

[giofranchi]

Gio,

 

I believe they're hedged on both the up and downside (no net exposure) on equities. Can you help clarify on your statement that they will benefit from their investing wisdom?

 

Frank,

I think txitxo explained it very well:

1) Mr. Watsa is locking in the spread between the best stocks he can find and the worst. Furthermore, he has float, which enables him to leverage the return from this strategy.

2) He will know when to remove the hedges better than almost any other investor.

3) If a correction in market prices is coming, Mr. Watsa will have a huge amount of capital to deploy in very good investment opportunities.

4) While waiting, FFH can concentrate on underwriting profitably: it won’t be easy, but with Mr. Barnard at the helm of all insurance operations, I think it can be achieved.

Anyway, I am aware of the fact that book value won’t shoot up in the near term… and probably you will have plenty of time to get on board later!

 

giofranchi

[FrankArabia]

thanks Gio. Always helpful. I'm going to keep my eyes open on this stock for sure.

[Sportgamma]

Gio,

 

I believe they're hedged on both the up and downside (no net exposure) on equities. Can you help clarify on your statement that they will benefit from their investing wisdom?

 

The equity hedge is a short position on the S&P500 and the Russell2000. A very big chunk of their portfolio is in companies such as RFP, RIMM, LVLT and BOI. There is no reason that the market value of these particular investments will move in tandem with the broader market.

 

[warrior]

Hello Dear Members,

One of the paradoxes of buying protective puts is that , in hindsight the strategy is never ideal. Nobody ever knows the best strategy until after the fact. In my view, this approach is costly and requires market timing.

I have a question to fellow members:  what is the cost for FFH having all Hedging strategies? Thanks

 

[txitxo]

Gio,

 

I believe they're hedged on both the up and downside (no net exposure) on equities. Can you help clarify on your statement that they will benefit from their investing wisdom?

 

Frank,

I think txitxo explained it very well:

1) Mr. Watsa is locking in the spread between the best stocks he can find and the worst. Furthermore, he has float, which enables him to leverage the return from this strategy.

2) He will know when to remove the hedges better than almost any other investor.

3) If a correction in market prices is coming, Mr. Watsa will have a huge amount of capital to deploy in very good investment opportunities.

4) While waiting, FFH can concentrate on underwriting profitably: it won’t be easy, but with Mr. Barnard at the helm of all insurance operations, I think it can be achieved.

Anyway, I am aware of the fact that book value won’t shoot up in the near term… and probably you will have plenty of time to get on board later!

 

giofranchi

 

Actually you have explained it much better  :)

[giofranchi]

Hello Dear Members,

One of the paradoxes of buying protective puts is that , in hindsight the strategy is never ideal. Nobody ever knows the best strategy until after the fact. In my view, this approach is costly and requires market timing.

I have a question to fellow members:  what is the cost for FFH having all Hedging strategies? Thanks

 

Warrior,

welcome to the board!

From the beginning of 2011, under IFRS, FFH reports its gains (losses) as marked to market at the end of each quarter. So, you can easily download the Press Releases of the results of previous quarters and see how the price of its hedges and CPI-linked derivatives performed. In 2010 Mr. Watsa wrote that FFH’s equity hedges cost was $936,6 million, while FFH’s CPI-linked derivatives cost was $145,8 million… and they still managed to have net investment gains of $188,5 million! FFH started 2010 with equity hedges at 30%, and raised them at 100% by July 2010.

Hope this was helpful.

 

giofranchi

[warrior]

Giofranchi ,

 

Thank you for info.

 

Also we may agree or disagree with Prem’s on  hedging, however, as he said, he remains bullish over the long term and wanted to retain the equities of the portfolio( an alternative to liquidating all or some) .

In fact, hedging involves accurate market timing, numerous transactions, it also means forgoing dividends and offsetting gain on equity -IF market advances

[giofranchi]

In fact, hedging involves accurate market timing

 

Warrior,

actually Mr. Watsa’s market timing has been awful… 100% equity hedged since July 2010… It has already been a long time! Nonetheless, I still believe that in the end Mr. Watsa’s strategy will prove to be a winner. Of course, no one can know for sure… so, we must wait and see! ;)

 

giofranchi

[giofranchi]

Gio,

 

I believe they're hedged on both the up and downside (no net exposure) on equities. Can you help clarify on your statement that they will benefit from their investing wisdom?

 

Frank,

I think txitxo explained it very well:

1) Mr. Watsa is locking in the spread between the best stocks he can find and the worst. Furthermore, he has float, which enables him to leverage the return from this strategy.

2) He will know when to remove the hedges better than almost any other investor.

3) If a correction in market prices is coming, Mr. Watsa will have a huge amount of capital to deploy in very good investment opportunities.

4) While waiting, FFH can concentrate on underwriting profitably: it won’t be easy, but with Mr. Barnard at the helm of all insurance operations, I think it can be achieved.

Anyway, I am aware of the fact that book value won’t shoot up in the near term… and probably you will have plenty of time to get on board later!

 

giofranchi

 

Actually you have explained it much better  :)

 

Thank you txitxo, too kind!

I would also add a fifth reason:

5) With US small cap priced to deliver a -0,1% annualized return for the next seven years (see attachment), and US large cap priced to deliver a +0,4% annualized return for the next seven years, the world right now is “greedy” with the US stock market. On the contrary, FFH is “fearful”.

 

giofranchi

GMO_7-Year_Asset_Class_Return_Forecasts.pdf

[petec]

Interesting on small caps - it bothers me that the SP500 is on a long term average PE despite all time high margins...but it bothers me even more that the Russell 2000 is on 22x fwd.