Fairfax Annual Letter?

[LC]

the table at the top of page 19 should answer your question. CPI hedges are separate from equity hedges. there is a cumulative 1.8bln loss (which i presume is an unrealized mark to market loss---although some may have been realized as they roll over derivatives into new contracts i suppose)

[Buffett_Groupie]

This is the table you're referring to, right?

 

2010 2011 2012 Cumulative

Equity hedges (936.6) 413.9 (1,005.5) (1,528.2)

CPI-linked 28.1 (233.9) (129.2) (335.0)

===== ===== ======= ======

Total (908.5) 180.0 (1,134.7) (1,863.2)

 

It surely will be a repeat of the following:

 

2003 – 2006 2007 2008

Equity hedges (287) 143 2,080

CDS (211) 1,145 1,290

===== ==== ====

Total (498) 1,288 3,370

[giofranchi]

I missed the dividends - thank you for the correction Gio. Prem has laid out the RIMM thesis and average cost/share. I like that they are hedging (one reason I own them) but I find it hard for them to attain 15% a year going forward regularly. Most people will benefit with lower expectations of 7-9%.

 

shalab,

I think your expectations are very conservative. Imo, to be conservative is a great virtue, so nothing to argue. Anyway, let’s examine how I see things:

The S&P500 closed year 2012 at 1,426.19. It closed year 2000 at 1,317.51. In the 12 years from 2001 to 2012 the S&P500 distributed a cumulative dividend of 298.22. If you add that cumulative dividend to 2012 year end closing price, you get: 1,426.19 + 298.22 = 1,724.4.

That equates to a 2.27% CAGR in price for the S&P500, dividends included.

So FFH has outperformed the market by 9.3% - 2.27% = 7% each year.

Now, we all read Mr. Buffett letters and we know that the S&P500 achieved a 9.4% CAGR in price (dividends included) for the last 47 years.

If in a few years the S&P500 goes back to perform as average, and the outperformance of FFH stays the same, we could expect a 9.4% + 7% = 16% annual return from FFH, if purchased at book value.

Furthermore, and imo this is really key!, FFH, under the general supervision of Mr. Barnard, has the very real chance to start underwriting at a profit consistently. That would be a game changer, and the true reason why I said that good businesses have the tendency to surprise on the upside!

Think of it this way: in 2012 the market utterly disagreed with FFH’s very defensive stance, and its combined ratio (thank you Sandy!) was 99.8%, barely profitable… and yet BV per share increased 6.5% (dividend included), and Mr. Watsa has written in his letter:

More recently, we think the intrinsic value of our company has grown much more than its underlying book value.

Imagine what they could achieve when the market agrees with them, and if they succeed in bringing the combined ratio down to 95% – 96%!

Finally, one of the most important features I look for, when I am appraising with whom to partner, is that he/she be and “under-promising, over-achieving” fellow. I am positive Mr. Watsa is that kind of owner-operator. So, if he says FFH could achieve a 15% CAGR in BV per share going on from here, I tend to believe him (and also to expect some pleasant surprise! :) ).

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

[Sportgamma]

Anybody know what the average duration on the hedges is?

[Packer16]

At what point does this hedge become forecasting and market timing?  If the reflation scenario plays out this could be an unnecessary drag on performance.  Lets compare to 2008.  I estimate that the hedges have probably lost at least another $600 million from year end (given the $1 billion decline with a 15% increase in S&P value) so the total is now $2.4 billion cum losses on an equity of $7.8 billion (about 35% of equity).  At the end of 2006, the hedge losses represented 20% of equity.  The other large difference is the 2008 hedges were 60% against equity and 40% against CDS (a truly overvalued asset), so the losses in bonds via CDS somewhat masked the lower yielding equity hedges.  Now the mix is 80% equity hedge, 20% CPI hedge.  This is bold bet or a high premium to pay that the market will decline given the % of equity it represents.  In addition, you have Marks saying we are in the 5th inning of credit expansion so continued expansion (and increase in the indexes) could drag FFH down.  Does anyone know under what circumstances FFH would change its hedges?  At some point it may be prudent to "trim" the hedges.  I also wonder if the near perfect timing of the hedges last time may be clouding FFH's judgement. 

 

From the evidence I have seen thusfar in the US and the RoW reflation versus deflation is occurring.  They appear to be putting alot of their eggs in the deflation basket with both the deflation swap and equity hedges.  I would agree for the EU but not the US and the RoW.  Under what other scenario (beyond deflation and speculative pricing) do the equity hedges make sense?  I think it would make more sense for the hedges that they think are overvalued (maybe Chinese RE) versus the overall market.  Maybe I am over-reacting but FFH is passing up the equity risk premium (which is still the most material portion of returns).   

 

Packer

[giofranchi]

At what point does this hedge become forecasting and market timing?  If the reflation scenario plays out this could be an unnecessary drag on performance.  Lets compare to 2008.  I estimate that the hedges have probably lost at least another $600 million from year end (given the $1 billion decline with a 15% increase in S&P value) so the total is now $2.4 billion cum losses on an equity of $7.8 billion (about 35% of equity).  At the end of 2006, the hedge losses represented 20% of equity.  The other large difference is the 2008 hedges were 60% against equity and 40% against CDS (a truly overvalued asset), so the losses in bonds via CDS somewhat masked the lower yielding equity hedges.  Now the mix is 80% equity hedge, 20% CPI hedge.  This is bold bet or a high premium to pay that the market will decline given the % of equity it represents.  In addition, you have Marks saying we are in the 5th inning of credit expansion so continued expansion (and increase in the indexes) could drag FFH down.  Does anyone know under what circumstances FFH would change its hedges?  At some point it may be prudent to "trim" the hedges.  I also wonder if the near perfect timing of the hedges last time may be clouding FFH's judgement. 

 

From the evidence I have seen thusfar in the US and the RoW reflation versus deflation is occurring.  They appear to be putting alot of their eggs in the deflation basket with both the deflation swap and equity hedges.  I would agree for the EU but not the US and the RoW.  Under what other scenario (beyond deflation and speculative pricing) do the equity hedges make sense?  I think it would make more sense for the hedges that they think are overvalued (maybe Chinese RE) versus the overall market.  Maybe I am over-reacting but FFH is passing up the equity risk premium (which is still the most material portion of returns).   

 

Packer

 

Packer,

sincerely the more the market disagrees with Mr. Watsa, the less I am worried… Let me explain: today the Shiller P/E10 of the S&P500 is 23.38. At the beginning of 2012 it was 21.21. If 2013 turns out to be as much “risk-on” as 2012 was, by 2014 it will be nearing 26, and we will ever more clearly be running the risk of finding ourselves in a stock market bubble… In Jan 1, 1929 the Shiller P/E10 was 27.06… Even the greatest fans of Mr. Bernanke’s among you, would then start to get seriously worried!

Instead, FFH will have another +6.5% year and won’t have to worry about anything! Never undervalue peace of mind! It is the best place to make sound reasoning and to take the right decisions!  :)

Moreover, the timing of the hedges was far from perfect the last time they proved to be very useful. Quoting Mr. Watsa:

In 2008, we showed you the table below, that quantified our unrealized losses in the 2003-2006 period, which then reversed in 2007/2008.

…

We had to endure years of pain before harvesting the gains of 2007 and 2008.

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

[Packer16]

I disagree with Schiller's approach which is based upon reversion to the mean in interest rates.  I don't think this will happen as long as there is excess capital in the emerging markets and poor governance which will attract capital to the US.  In the past interest rates were high due to lower debt and lack of productive capacity from the communist world who still had to eat and live and consume resources.  This lower cost of capital along will keep interest rates low and we are just are in the early innings of the credit cycle (as Marks has stated) which will drive valuations up.  I think FFH should consider this scenario along with their own in the hedging program.  Also betting against the market as a long-term approach (which this has turned into) I think is not a winning strategy. 

 

Packer

[giofranchi]

Vice versa, I don’t agree with the “Emerging markets new era thesis”. Margins cannot go on expanding ad infinitum, just because emerging markets are consuming more resources than in the past. Capital, imo, is entitled to a fair amount of return. And it cannot grow to the sky. If it does, troubles of any kind will ensue.

Anyway, if you don’t like Shiller’s PE, let’s use replacement cost, or market capitalization vs. GDP: they all paint the same picture!

Mr. Watsa acknowledges that “the grand disconnect” could resolve itself by economic fundamentals rising to meet the financial markets. If that happens, I believed they will recognize it, and quit their hedging strategy. I think we won’t have to wait much longer to know how this will end. And, even if they are finally proven wrong, is it really that unbearable to live with 2-3 years of 6.5% returns? You would know that during the most uncertain investment environment in our lifetime, we have always been well protected and never risked a permanent loss of capital. I am grateful for that!  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

[giofranchi]

The key to making these investments is to be liquid, i.e., having lots of cash to take advantage of opportunities. In 2008, we had 70% of our portfolio in cash and government bonds. Currently, we have 31% in cash and cash equivalents – earning us very little money. While we suffer from short term pain by having so much cash, it gives us great options for long term gain whenever the opportunity becomes available.

- Mr. Prem Watsa

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

[LC]

This is the table you're referring to, right?

...

 

It surely will be a repeat of the following:

...

I hope you're right, but I make no such prediction.

 

In my opinion, I only touch highly levered derivatives when the risk/reward is so skewed I would be comfortable "losing it all". Therefore the price has to be so depressed that a total loss would not be catastrophic, and at the same time A LOT of things would have to go wrong to lose total value. Obviously these situations do not occur frequently.

 

I am not sure of the risk/reward or even the notional amounts of Mr. Watsa's hedging positions, but I am sure of the fact that he is very intelligent. Additionally he has created an excellent organization which would allow him to make a mistake or two if he "got nervous" and purchased such a large hedge.

[Packer16]

I think there is a third scenario that has not been factored into FFH's position, namely, that the Fed monitizes the debt versus real assets (the Fed's goal).  To a certain extent this has already occurred but may continue.  I see what is being done is similar to the UK leaving the gold standard and FFH's scenario is more likely to be seen in Europe where the firms are tied to the Euro standard.  Under this scenario, equities would provide be preferred because they are the real asset as the US dollar devalues and both of FFH's positions would be losers (no deflation and appreciate of equities in nominal dollars - if the hedge were in real dollars then this would not be an issue).  While the probabilities of each of the scenarios can be debated, I wonder if FFH has even considered scenario 3, as the don't mention it in their annual report.           

 

As to capital earning an adequate return I would agree with you if we had an open and free market like in the US and Europe but we do not.  What do you think is going to happen when the Chinese are allowed to invest in foreign markets?  A huge sucking sound out of China to the US.  This is already happening in emerging markets where folks can move their capital out.  The solution to this from an economic perspective is to have these markets be efficient allocators of capital but I think we are going to wait a long time for that.  Just my 2c.

 

Packer

[ERICOPOLY]

Packer,

sincerely the more the market disagrees with Mr. Watsa, the less I am worried… Let me explain: today the Shiller P/E10 of the S&P500 is 23.38.

 

I guess the Shiller P/E10 is now about 15x where they put on the hedges initially (at around 1030 on the S&P500).

 

Not that it matters much to you given that what really counts is where the markets are today (not where they starting hedging), but just a venture down the hindsight 20/20 road for fun. 

 

[enoch01]

 

This is not necessarily a bad thing if the market tanks as Prem has hinted that he expects it to do probably before the middle of the year.

 

Not sure I caught this prediction regarding timing.  Can you point me to it?

[plato1976]

I remember their avg entry is sth like SP at 1200

 

Packer,

sincerely the more the market disagrees with Mr. Watsa, the less I am worried… Let me explain: today the Shiller P/E10 of the S&P500 is 23.38.

 

I guess the Shiller P/E10 is now about 15x where they put on the hedges initially (at around 1030 on the S&P500).

 

Not that it matters much to you given that what really counts is where the markets are today (not where they starting hedging), but just a venture down the hindsight 20/20 road for fun.

[ShahKhezri]

Would anyone here be against them doubling down at these levels?

 

I wouldn't.

[Buffett_Groupie]

I'd double-down the equity hedge.

[tyska]

Seeing this is the Corner of Berkshire And Fairfax, funny how the two leaders it was named for, seem to be putting forward differing outlooks.

[ERICOPOLY]

I remember their avg entry is sth like SP at 1200

 

Packer,

sincerely the more the market disagrees with Mr. Watsa, the less I am worried… Let me explain: today the Shiller P/E10 of the S&P500 is 23.38.

 

I guess the Shiller P/E10 is now about 15x where they put on the hedges initially (at around 1030 on the S&P500).

 

Not that it matters much to you given that what really counts is where the markets are today (not where they starting hedging), but just a venture down the hindsight 20/20 road for fun.

 

I thought they'd gone fully hedged in late 2009, but I went back and looked it up and it was only 25% as it turns out:

 

From the conf call in Oct 2009:

While we like our common stock positions for the long term, a very significant increase in stock prices since March 2009 has prompted us to hedge approximately 25% of our portfolios by shorting the S&P 500 to total return swap contracts. We did this at an average level of 1,062 for the S&P 500.

 

Then the next transcript I could find is the Q2 2010 transcript, but they've garbled the message in the transcript.  It sounds like they are trying to say that 93% of the portfolio was hedged at 646.5 on the Russell2000, but I don't trust the quality of this transcript (notice the number of times it says "technical difficulty"):

 

http://seekingalpha.com/article/217810-fairfax-financial-holdings-ltd-q2-2010-earnings-call-transcript?page=2

 

Yes, I’m sorry. So, in response to the (technical difficulty) in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. (technical difficulty) our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and (technical difficulty) total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500 (technical difficulty). Now, I’ll (technical difficulty) give you some information on the line financials, (technical difficulty). Thank you.

 

 

EDIT:  I guess it sounds more like they added to the prior hedges, and the new Russell 2000 hedges had average level of 646.5.

 

 

[Uccmal]

Seeing this is the Corner of Berkshire And Fairfax, funny how the two leaders it was named for, seem to be putting forward differing outlooks.

 

But are they really so different.  FFH has invested billions in the last couple of years, while holding the hedges.  Alot of investment has been internal, expanding the insurance empire.  With cash dividended to holdco, and subsiduary holding company cash they have been buying private businesses that are certainly going to suffer if another recession hits.  It is looking more and more like a mini berk, excepting the hedges.  Prem, like Buffett is always opportinistic.  I expect they no longer have to take the value garbage such as fbk going forward. 

 

Buffett has been doing the same, using his operating cash flows as his hedge.  Quite frankly, Buffett must have the best real time economic data available of any private investor on Earth.  Berkshire is a microcosm of the worlds supply chain. 

[vinod1]

I wonder how we would view Fairfax if 2008-2009 crisis did not turn out as it did. It is not like the 2008 crisis is a near certanity, so if the crisis had been more contained with housing only declining a little bit and stock market (S&P 500) declining to say only 1100 and with CDS not paying all that much, I would think Fairfax would have a book value of around $200 only at this time. So that would be a 12 year near flatlining of book value, but for the 2008-2009 crisis.

 

I am not trying to take away Prem's achievements, I think they made a very astute macro economic bet (let us say where the odds are 80/20 or some such high number) but they had been a little lucky that it played out in their favor. Now, they are making another bet, which I agree with, but this time it could end up hurting Fairfax in terms of lost opportunity cost.

 

Vinod

[goldfinger]

I wonder how we would view Fairfax if 2008-2009 crisis did not turn out as it did. It is not like the 2008 crisis is a near certanity, so if the crisis had been more contained with housing only declining a little bit and stock market (S&P 500) declining to say only 1100 and with CDS not paying all that much, I would think Fairfax would have a book value of around $200 only at this time. So that would be a 12 year near flatlining of book value, but for the 2008-2009 crisis.

 

I am not trying to take away Prem's achievements, I think they made a very astute macro economic bet (let us say where the odds are 80/20 or some such high number) but they had been a little lucky that it played out in their favor. Now, they are making another bet, which I agree with, but this time it could end up hurting Fairfax in terms of lost opportunity cost.

 

Vinod

 

But isn't there more to earn by keeping their capital strength and strong ratings at all times and then be able to increase the float when opportunities are good?

[Packer16]

I think that depends on where you think FFH is adding the most value today and into the future (underwriting or investing).  I think FFH's strength is investing with underwriting providing more of a supporting role.  In addition, it is also much harder to get better underwriting than investment results.  Therefore, I think they should scale back the hedges or have a scenario when that occurs if the impending decline does not materialize.

 

Packer

[tyska]

Seeing this is the Corner of Berkshire And Fairfax, funny how the two leaders it was named for, seem to be putting forward differing outlooks.

 

But are they really so different.  FFH has invested billions in the last couple of years, while holding the hedges.  Alot of investment has been internal, expanding the insurance empire.  With cash dividended to holdco, and subsiduary holding company cash they have been buying private businesses that are certainly going to suffer if another recession hits.  It is looking more and more like a mini berk, excepting the hedges.  Prem, like Buffett is always opportinistic.  I expect they no longer have to take the value garbage such as fbk going forward. 

 

Buffett has been doing the same, using his operating cash flows as his hedge.  Quite frankly, Buffett must have the best real time economic data available of any private investor on Earth.  Berkshire is a microcosm of the worlds supply chain.

 

One can not completely ignore a hedge that is costing them that much opportunity. But I notice the difference more in the tone of their letters. Maybe to someone who has followed them a lot more closely, that is just their overall different personality. But I have found a lot more of a sky is going to fall at anytime vibe off of Prem. As opposed to a, this problem too shall pass and there is a bright future, from Warren. Although when he does talk up his holdings there is a hint of P.T. Barnum to him.:>)

[Kiltacular]

Whether or not the hedges work out at this point, I think Packer makes a lot of very interesting comments both w/r/t Fairfax proper as well as some of the larger macro issues / goals of the Fed, etc.

 

About a year ago, when latest "rage" was that profit margins were too high, Packer made some insightful comments about why they might not be.

 

Interesting stuff.

[twacowfca]

Whether or not the hedges work out at this point, I think Packer makes a lot of very interesting comments both w/r/t Fairfax proper as well as some of the larger macro issues / goals of the Fed, etc.

 

About a year ago, when latest "rage" was that profit margins were too high, Packer made some insightful comments about why they might not be.

 

Interesting stuff.

 

Yes, thank you, packer for your insightful comments.