Fairfax Annual Letter?

[giofranchi]

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

 

Well, a lot of dumb money, shoveled around by unprepared and naïve people, who get elated by the fact that now at last they can invest in the US, is the stuff gigantic stock market bubbles are made of… I don’t believe that either: the Chinese must deal with a domestic housing bubble that threatens to sweep away the savings accumulated during a lifetime… so, they might be left with little capital to invest abroad! Anyway, even if it were true, it doesn’t mean that “the grand disconnect” is resolving itself by economic fundamentals rising to meet the financial markets, instead it just means that “the grand disconnect” is getting grander and grander.

If you really believe in the “Emerging markets new era thesis”, what do you think would happen if the Fed stops printing money and the US Government stops deficit spending? Most probably the economy would tank and the market would crash, and who cares about emerging markets!

 

Competition, be it in the US and Europe, or worldwide (emerging markets included!), is not the only force that will always check the expansion of profit margins, also a sort of “social contract” must be properly taken into account: a world in which the owners of capital reap all the benefits of enterprise at the expense of the others, who will always be the great majority of people on earth, is not sustainable. Improvements must be constantly pursued, and those who succeed must be satisfactorily rewarded, but everyone must be better off because of their achievements. The great and the rich will always have to take care of the little and the poor. And that means capital will always be soundly rewarded, but the reward it is entitled to must be checked. Think of Mr. Buffett’s argument about taxing the rich, when he says the rich will always keep investing, even if they must pay higher taxes, because the rewards are so great anyway… that’s exactly what I mean!

 

Finally, I must admit I didn’t understand very well what you called the 3rd scenario: could you please elaborate a little bit further? I got it presumes some sort of US$ devaluation… Do you really see that?! The US$ has already devalued for 10 years… and it is a much undervalued currency, if compared, for instance, to the Euro… Exchange rates must make economic sense! The cost of life in Europe cannot be higher than the cost of life in the US, when the average US citizen earns 20% more than the average European citizen… A further devaluing of the US$ against other major currencies would wreck havoc around the world, at least surely in Europe!

Imo, two are the scenarios that matter:

1) economic fundamentals rise to meet the financial markets: when the economy clearly doesn’t depend on money printing and deficit spending anymore, FFH will quit its hedging strategy.

2) the financial markets nose dive to meet economic fundamentals.

 

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]

The third scenario is devaluation of all currencies not tied to real assets or productivity.  I see the US dollar continuing to decline versus the Euro until Germany allows the prining press to run.  Japan has gotten to that point today.  This is the least painful way to reduce the real value of the debt.  In this scenario, real assets (stocks, commodities) retain their value while debt and currencies decline in value.  I see the FFH scenario playing out in Europe and Japan but not the US and maybe not Japan if they follow the US in printing their way out.  You are correct if the FED stops printing the economy and markets would be in trouble but I do not see that happening over the near or mid-term.  The main issue I have with the holding cash argument is the currency is going to decline faster than real assets in the economy (not a very common occurance and thus not considered).

 

Packer 

[giofranchi]

The third scenario is devaluation of all currencies not tied to real assets or productivity.  I see the US dollar continuing to decline versus the Euro until Germany allows the prining press to run.  Japan has gotten to that point today.  This is the least painful way to reduce the real value of the debt.  In this scenario, real assets (stocks, commodities) retain their value while debt and currencies decline in value.  I see the FFH scenario playing out in Europe and Japan but not the US and maybe not Japan if they follow the US in printing their way out.  You are correct if the FED stops printing the economy and markets would be in trouble but I do not see that happening over the near or mid-term.  The main issue I have with the holding cash argument is the currency is going to decline faster than real assets in the economy (not a very common occurance and thus not considered).

 

Packer

 

Thank you! Now I understand what you meant. Although, if Germany doesn’t allow the printing press to run, a 4th scenario becomes the more likely by far: WAR!!  ;D

No, seriously, I think that Europe will have to print even more than the US.

 

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

[link01]

Competition, be it in the US and Europe, or worldwide (emerging markets included!), is not the only force that will always check the expansion of profit margins, also a sort of “social contract” must be properly taken into account: a world in which the owners of capital reap all the benefits of enterprise at the expense of the others, who will always be the great majority of people on earth, is not sustainable. Improvements must be constantly pursued, and those who succeed must be satisfactorily rewarded, but everyone must be better off because of their achievements. The great and the rich will always have to take care of the little and the poor. And that means capital will always be soundly rewarded, but the reward it is entitled to must be checked. Think of Mr. Buffett’s argument about taxing the rich, when he says the rich will always keep investing, even if they must pay higher taxes, because the rewards are so great anyway… that’s exactly what I mean!

 

this, much more than the competition argument, expains why corp profit margins will/must mean revert, imo. without a healthy middle class w/ real income growth, i dont see how business can continue to thrive. how much more can they cut costs? how many more employees can they cut from their payrolls?

 

jeff gundlach has some great slides & graphs pertaining to this issue in his investor cc presentations

[jay21]

Declining profit margins may not necessarily be bad for equity valuations.  Margins could contract because the economy accelerates and more people are hired and corporations pursue more projects and research. 

[Cardboard]

Too high profit margins (pre-tax) are typically taken care of by competition among enterprises who are attracted by them for deployment of their own capital. Just like at Apple where they are forced to invest more to develop new products and/or by competitors selling similar devices at lower prices reducing Apple sales growth.

 

What Buffett described in the 1999 Fortune article that would be related to income inequality was the share of corporate profits after-tax vs GDP. Not high profit margins pre-tax. I just think that we need to be careful about what margins we are talking about. Also need to realize that countries are competing for capital and jobs so if you simply tax more to reduce that share, one will offer lower corporate tax rates attracting enterprises at home. It is a fine balance. Education, currencies, interest rates, taxes, regulations, cost of living, even climate all matter. Whoever believes that they can predict accurately the direction of the economy is a fool considering the inter-relationships between all these factors and many more that I have not listed.

 

One thing that I am absolutely sure of however is that there is no free lunch with anything. Many people fail to realize this and think that governments are different. Maybe because they are large and tough to understand, but at the end of the day, it is an entity competing with other entities (countries) for the development of their GDP and citizens. QE, unending deficits and unaffordable entitlements are not free as some on this board seem to imply. There will be consequences as some countries who are more competitive, let the law of free markets prevail and make more sacrifices should come out on top over time.

 

Cardboard

[JEast]

With respect to the hedging, I am somewhat indifferent.  If you own BRK, you sleep like a baby and if you own FFH, you sleep like a 5 year old. Shades of gray here.

 

My bigger concern is trying to make Crum & Forster look good when they are not.  If one was to add back in all the things that were put into runoff or just shutdown, they have never written below 100% since we bought this turd. And as for redundancies at C&F, none over the previous 10-years that I have seen.  Doug -- take the pens away and go to .4x of surplus.

 

On the other hand, we have ORH that was formed/carved out of the old TIG purchase.

 

 

Cheers

JEast

[ERICOPOLY]

It is a fine balance. Education, currencies, interest rates, taxes, regulations, cost of living, even climate all matter.

 

Happily enjoying the sunshine in Santa Barbara today despite the California taxes -- as you say, "even climate" matters  :D

 

[Cardboard]

Hey Gambler!

 

And California may get much "hotter" as your military keeps getting cut and your country weakened by a love all/socialist administration as North Korea remains free to develop long range missiles and nukes under the protection and blessing of China.

 

Cardboard

[ERICOPOLY]

We're staying at Furnace Creek Resort in Death Valley N.P. later this week.  Back when we booked it, the weather was looking like it would be in the high 70s - mid 80s.

 

Now it's going to be 90s!

 

Plenty hot, don't need the nukes.  This is still winter.

 

[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.:>)

I concede having a fool article agree with me may not be the most ringing endorsement here. :>) But he does have the first name so that may explain his thinking.

 

http://www.fool.com/investing/value/2013/03/11/why-berkshire-and-fairfax-are-my-top-2-stocks.aspx

 

"Playing off each other

I like balance in my portfolio, and owning both Berkshire and Fairfax provides offsetting views of the market and the economy. The two stocks may not move in lockstep, but over time, I think both positions will continue to see strong gains."

 

And I do have both of them in my portfolio, not enough though. Got too sidetracked by thinking the world still needs O&G.

[DynamicPerception]

For those who may not have seen CBS 60 Minutes on China and Housing that Prem mentioned.

About 12 minutes not counting the beginning ad.

 

http://www.cbsnews.com/video/watch/?id=50142079n

[Liberty]

For those who may not have seen CBS 60 Minutes on China and Housing that Prem mentioned.

About 12 minutes not counting the beginning ad.

 

http://www.cbsnews.com/video/watch/?id=50142079n

 

Thanks for posting.

[rmitz]

Finally, I must admit I didn’t understand very well what you called the 3rd scenario: could you please elaborate a little bit further? I got it presumes some sort of US$ devaluation… Do you really see that?! The US$ has already devalued for 10 years… and it is a much undervalued currency, if compared, for instance, to the Euro… Exchange rates must make economic sense! The cost of life in Europe cannot be higher than the cost of life in the US, when the average US citizen earns 20% more than the average European citizen… A further devaluing of the US$ against other major currencies would wreck havoc around the world, at least surely in Europe!

 

I just want to point out that in the US, a great deal of prices/cost of living have been kept lower by keeping worker salaries lower, particularly at the lower end of the service economy; much lower than comparable salaries/benefits in Europe. Huge differences in vacation time, the US workers normally have no health insurance, etc., etc.

 

Also, regarding Warren and Prem's different views, I think I've said before that it's readily explained by a different time scale.

[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

 

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?

 

I agree with the need for keeping capital strength and strong ratings and hedging does provide that benefit. However, I do not think the ability to write more business in hard markets adds all that much to Fairfax IV. I have long given up on expecting any underwriting profits from Fairfax. :) Value is predominantly going to be created by the investing abilities of HWIC.

 

My main point is that most of the value created in the last decade has been due to a macro bet that succeeded. Fairfax now is much better positioned going forward but even with that it would need its macro bets to come through to get to the 15% annual BV growth. In a scenario where their macro bet does not play out successfully I think 15% BV growth is too optimistic unless Watsa pulls out another rabbit out of his hat.

 

Vinod

[ubuy2wron]

No one has commented on what a gem the Asian insurance operations have become," more please sir"

[racemize]

No one has commented on what a gem the Asian insurance operations have become," more please sir"

 

I hope they expand this until it is larger than the NA insurance!

[Zorrofan]

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.

 

I love the idea of FFH following WEB and becoming a mini-conglomerate like BRK, but I hate the businesses Prem has bought - flatware, sporting goods, restaurants? FFH needs to follow BRK into more essential services. Buy quality not cheap crap!!  Why not buy a large stake in a small utility company, and grow the position over time when prices are favourable? But buy something better than flatware!!

 

There, I feel much better having vented.......

 

cheers

Zorro

[Uccmal]

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?

 

I agree with the need for keeping capital strength and strong ratings and hedging does provide that benefit. However, I do not think the ability to write more business in hard markets adds all that much to Fairfax IV. I have long given up on expecting any underwriting profits from Fairfax. :) Value is predominantly going to be created by the investing abilities of HWIC.

 

My main point is that most of the value created in the last decade has been due to a macro bet that succeeded. Fairfax now is much better positioned going forward but even with that it would need its macro bets to come through to get to the 15% annual BV growth. In a scenario where their macro bet does not play out successfully I think 15% BV growth is too optimistic unless Watsa pulls out another rabbit out of his hat.

 

Vinod

 

Hi Vinod, Just curious.  Do you still hold FFH?

 

I wonder sometime how they will do going forward.  I think the route to greater profits for them involves expanding the insurance businesses that are profitable, investing the float in wholly owned businesses or partnerships such as Kennedy Wilson.

[StubbleJumper]

No one has commented on what a gem the Asian insurance operations have become," more please sir"

 

Falcon has been a gem forever.  Just as C&F has been a disappointment since its acquisition.  Some things never change.  However, you are correct that we shouldn't take Fairfax Asia for granted.

[vinod1]

 

Hi Vinod, Just curious.  Do you still hold FFH?

 

I wonder sometime how they will do going forward.  I think the route to greater profits for them involves expanding the insurance businesses that are profitable, investing the float in wholly owned businesses or partnerships such as Kennedy Wilson.

 

Hi Uccmal,

 

I sold FFH at around $420 primarily due to a major portfolio overhaul in 2011. Given all the economic issues in Europe and its potential impact on US, along with US own set of issues and the opportunity set that is available (BAC/AIG/C/GS), I wanted to have a barbell type portfolio. A large allocation of cash (60-75%) coupled with high leverage via warrants and LEAPS on deeply undervalued businesses. I know FFH is hedged but if 2008-2009 crisis taught me anything it is that only cash is truly liquid. So I sold out of FFH.

 

If BAC or AIG works out while FFH is still available around book I would revert back to FFH. I do not see underwriting profits or growth in float making much of difference to growth in book value. Growth will again likely come from portfolio performance but with the hedges in place the macro has to cooperate.

 

Vinod

[vinod1]

Too high profit margins (pre-tax) are typically taken care of by competition among enterprises who are attracted by them for deployment of their own capital. Just like at Apple where they are forced to invest more to develop new products and/or by competitors selling similar devices at lower prices reducing Apple sales growth.

 

What Buffett described in the 1999 Fortune article that would be related to income inequality was the share of corporate profits after-tax vs GDP. Not high profit margins pre-tax. I just think that we need to be careful about what margins we are talking about. Also need to realize that countries are competing for capital and jobs so if you simply tax more to reduce that share, one will offer lower corporate tax rates attracting enterprises at home. It is a fine balance. Education, currencies, interest rates, taxes, regulations, cost of living, even climate all matter. Whoever believes that they can predict accurately the direction of the economy is a fool considering the inter-relationships between all these factors and many more that I have not listed.

 

One thing that I am absolutely sure of however is that there is no free lunch with anything. Many people fail to realize this and think that governments are different. Maybe because they are large and tough to understand, but at the end of the day, it is an entity competing with other entities (countries) for the development of their GDP and citizens. QE, unending deficits and unaffordable entitlements are not free as some on this board seem to imply. There will be consequences as some countries who are more competitive, let the law of free markets prevail and make more sacrifices should come out on top over time.

 

Cardboard

 

Dont Corporate profit margins and Corporate profits as a percent of GDP go hand in hand? Sales in the economy overall do not change dramatically and tax rates have been stable so I would think that they tend to track pretty closely.

 

Vinod

 

 

[Packer16]

Japan is an interesting case study on the end of deflation and the monetization of debt.  If you look at what happens when a central bank prints money to reduce the debt you see that the yen has collapsed but the Nikkei has rallied even more since the BoJ's plans have become more defined.  If this happens to the US and other developed countries then FFH will lose on both ends as the stock hedges will lose money as well as the deflation hedges.  Seeing this makes me even more wary of being all-in on the hedges.

 

Packer 

[steph]

Too high profit margins (pre-tax) are typically taken care of by competition among enterprises who are attracted by them for deployment of their own capital. Just like at Apple where they are forced to invest more to develop new products and/or by competitors selling similar devices at lower prices reducing Apple sales growth.

 

What Buffett described in the 1999 Fortune article that would be related to income inequality was the share of corporate profits after-tax vs GDP. Not high profit margins pre-tax. I just think that we need to be careful about what margins we are talking about. Also need to realize that countries are competing for capital and jobs so if you simply tax more to reduce that share, one will offer lower corporate tax rates attracting enterprises at home. It is a fine balance. Education, currencies, interest rates, taxes, regulations, cost of living, even climate all matter. Whoever believes that they can predict accurately the direction of the economy is a fool considering the inter-relationships between all these factors and many more that I have not listed.

 

One thing that I am absolutely sure of however is that there is no free lunch with anything. Many people fail to realize this and think that governments are different. Maybe because they are large and tough to understand, but at the end of the day, it is an entity competing with other entities (countries) for the development of their GDP and citizens. QE, unending deficits and unaffordable entitlements are not free as some on this board seem to imply. There will be consequences as some countries who are more competitive, let the law of free markets prevail and make more sacrifices should come out on top over time.

 

Cardboard

 

Dont Corporate profit margins and Corporate profits as a percent of GDP go hand in hand? Sales in the economy overall do not change dramatically and tax rates have been stable so I would think that they tend to track pretty closely.

 

Vinod

 

I do understand that in the long run corporate profit margins have to revert to the mean, this is economics 101.  I however do not agree that corporate profits as a percent of US GDP have to revert to the mean.  US companies are exporting much more than before. Many companies do nowadays 50% or more of their business outside of the US.  They report these profits in the US, but these have no relation with the US GDP.

[giofranchi]

I know FFH is hedged but if 2008-2009 crisis taught me anything it is that only cash is truly liquid. So I sold out of FFH.

 

Vinod1, I am not so sure… FFH BV per share increased 53%, 21% and 33% in 2007, in 2008 and in 2009. Its share price increased 24%, 36% and 5% in 2007, in 2008 and in 2009. Better than cash, right?  ;)

 

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