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Hey, Mr. Market! Do I really have to make FFH 50% of my portfolio?


giofranchi

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By that I mean, what stock or stocks have they selected that one would say defines them as investing gurus?  As an example, when one discusses Buffett one of the first stocks that would be discussed would be KO. 

 

My understanding is that Prem and his team use a Graham-type (as well as Templeton-type) approach for investing their float, as opposed to looking for long-term compounders.

 

(Ah, the irony. Conclusive proof, if ever there were any, that Gio's views on FFH are completely without merit!)

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Historically Fairfax has been an average underwriter and average underwriters don't make money. I'm impressed by the 94.2 CR but I view it as a one off event as they have not proven they can maintain that kind of underwriting. You are buying Fairfax for their investment acumen; however, they have fully hedged their portfolio over the last two years and missed out on a once in a lifetime opportunity to pick up some fantastic bargains. Where would Fairfax be if instead of losing 2B on equity hedges, would have used that money to buy bargains over the last two years? The opportunity cost of the money lost is closer to 2.5B-3.5B.

 

$496B in Bond losses is not a paper loss. The gains and book value were overstated to begin with. If you have a 5% note with a $100 par value that was trading at $130 six months ago and falls to $115, that is not a paper loss. What you have in Fairfax is a fantastic manager in a mediocre business (insurance). The management is sitting on a collection of assets that are trading at their highest premium in history (bonds). They are great investors and are managing to grow their equity portfolio slowly, but they made an absolutely terrible investment 2 years ago that has cost the company $2B (the hedge). 

 

If you were pitched an idea, say of a company that makes widgets and breaks even on them. Owns a bunch of gold that they rent out for 4% a year. And has had a darn good track record of making acquisitions, except their largest acquisition (50% of their portfolio) had destroyed the value of their other holdings for the last two years. When asked, they say don't worry, the portfolio will not lose any value but our traditional 15% returns are going to be 5% until we sell. Would you buy?

 

Ross,

sorry, but I disagree with you here.

 

1) “once in a lifetime opportunity to pick up some fantastic bargains”?! Why?! Two years ago the market in general wasn’t particularly cheap… On the contrary, it already was quite expensive… Therefore, I don’t see why we will never see those fantastic bargains again… There is really no reason at all not to expect other bargains that will be at least as lucrative in the future!

 

2) As far as equity hedges are concerned, everyone has different opinions: I still think a lot of people will suffer much larger opportunity costs down the road, when they lack the cash to scoop up even better bargains than those available two years ago… You and others, instead, think only about the opportunity costs FFH has already incurred… I guess we won’t have to wait much longer to know who is right about equity hedges!

 

3) Maybe you are right about bonds… what matters to me is that those bonds were bought below par with an after tax yield of 5.79%, and are insured by BRK. If held to maturity, interests received plus appreciation will get very close to that 7.5% annual return needed to compound BVPS at 15% per year. So maybe their fall in value is real, but only because they increased in value too quickly before… that certainly doesn’t make them a bad investment… but I am sure you don’t really think they are a bad investment… nobody would think that!

 

4) I don’t understand your comparison with a company that makes widgets and breaks… equity hedges are not a bad acquisition… equity hedges are a strategic decision to protect your capital, instead of growing it fast. I have already said it could turn out to be a wrong decision… but I have also already said that I don’t think so! And that is the reason why I invest in FFH, because I agree with what they are doing. If that decision truly is the wrong one, once there is evidence about that, they will change course. But they need evidence! They won’t and shouldn’t change course just because you and others don’t agree with their reasonings!

 

5) Finally, also regarding FFH underwriting results there are many different views… personally, I have a tremendous amount of respect for Mr. Barnard and I think underwriting results are very strictly linked to the quality of management. If you prefer to rely on history, well then look no further than OdysseyRe’s history! If Mr. Barnard succeeds in duplicating for FFH as a whole what he has achieved at OdysseyRe, the good underwriting results certainly won't be only a one time event!

 

giofranchi

 

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By that I mean, what stock or stocks have they selected that one would say defines them as investing gurus?  As an example, when one discusses Buffett one of the first stocks that would be discussed would be KO. 

 

My understanding is that Prem and his team use a Graham-type (as well as Templeton-type) approach for investing their float, as opposed to looking for long-term compounders.

 

Ah, the irony!

 

Yes, quite ironic.  So like WFC, JNJ, LVLT, USB, etc.  You are correct, it would seem.  Those are very much Graham type investments. 

 

I certainly didn't intend to limit being known for investing acumen to requiring one to be a Buffett clone (although I should note that Watsa is known as the Buffett of Canada), however it would appear to me that is primarily the approach that is taken.  There are certainly some "Graham type investments", at least in theory - something like Blackberry is likely to be a balance sheet play although Graham wouldn't have touched it probably. 

 

So which is it?  It would appear to me that the growth in the equity portfolio to date is from "Buffett like" names like WFC and so forth.  Am I wrong about that?

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By that I mean, what stock or stocks have they selected that one would say defines them as investing gurus?  As an example, when one discusses Buffett one of the first stocks that would be discussed would be KO. 

 

My understanding is that Prem and his team use a Graham-type (as well as Templeton-type) approach for investing their float, as opposed to looking for long-term compounders.

 

Ah, the irony!

 

Yes, quite ironic.  So like WFC, JNJ, LVLT, USB, etc.  You are correct, it would seem.  Those are very much Graham type investments.

 

Hehe. Ah, double irony - even better!

 

I think they're flexible. Prem talks about that relatively often in his interviews, but as you rightly point out they're not going to say no to great businesses even if the Hamblin-Watsa approach generally (if I remember correctly) is one of buying below IV and then selling.

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So which is it?  It would appear to me that the growth in the equity portfolio to date is from "Buffett like" names like WFC and so forth.  Am I wrong about that?

 

Gio and others probably know way better than I do, but 'flexibility' is something they talk about alot (I think Prem got this from Templeton, if I'm not mistaken).

 

If I was judging by what I've read in the past on FFH, I'd say they were Grahamites in the past and that is their official investment approach but that as they've grown the names you mentioned begin to look better.

 

Just from the bits I've read.

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(Ah, the irony. Conclusive proof, if ever there were any, that Gio's views on FFH are completely without merit!)

 

This is also another common misunderstanding! And it really seems so obvious to me… Only because I don’t make the technical drawings of the engineering projects we work on, doesn’t mean that I reckon them useless, right? I know that the engineering service business wouldn’t make money without producing and delivering technical drawings. The same applies to FFH: only because I don’t use a Graham-type approach to stocks, doesn’t mean that I reckon it useless, right? I know that FFH wouldn’t make money without investing its float that way.

What I do is to decide if having my firm’s assets invested in the engineering service business and in FFH makes sense, or if there are better alternatives. I look for the best businesses I can find. Then, I let them do their job.

 

giofranchi

 

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(Ah, the irony. Conclusive proof, if ever there were any, that Gio's views on FFH are completely without merit!)

 

This is also another common misunderstanding! And it really seems so obvious to me… Only because I don’t make the technical drawings of the engineering projects we work on, doesn’t mean that I reckon them useless, right? I know that the engineering service business wouldn’t make money without producing and delivering technical drawings. The same applies to FFH: only because I don’t use a Graham-type approach to stocks, doesn’t mean that I reckon it useless, right? I know that FFH wouldn’t make money without investing its float that way.

What I do is to decide if having my firm’s assets invested in the engineering service business and in FFH makes sense, or if there are better alternatives. I look for the best businesses I can find. Then, I let them do their job.

 

giofranchi

 

Hehe. My bad, I was completely kidding (apologies if that didn't come through).

 

You're like a gladiator in the colosseum here fending off lions, tigers, you name it. Me, I'm just sitting in the stands with some popcorn making a bunch of stupid throw-away comments while I enjoy the show.

 

Please continue Gio, this is an awesome thread and I'm learning a bunch from you and all the other commenters (Kraven aside, of course!*)

 

*(I jest)

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S&P500 is up some 6% since the end of June so I don't see anything to cheer at regarding the hedges. BV at a certain time is just a snapshot. The hedges have been hurting performance terribly and mentioning the fact that they didn't lose anything on them as a positive is just ... silly? ;)

 

Gio, some will trade the stock and others won't. Personal preferences, taxes, personality, etc will influence that decision. It turned out ok for me with an annual 10%+ return since 2011 in FFH while otherwise I'd be stuck with 10% at best.

 

tombgrt,

I didn’t point out the zero loss in equity hedges, because I find anything to cheer about it… I thought it was obvious I was comparing Al’s forecast of a $500 million loss to what actually happened, to point out how difficult it is to forecast future results correctly… especially quarterly results! Therefore, I still think that to jump in and out of FFH (like any other stock!) isn’t easy at all.

But, if you are successful at it, well, good for you! And good luck!

 

PS

Ah! Of course, if you think I am… silly… you can always save yourself the pain of reading and commenting my posts! ;)

 

giofranchi

 

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Please continue Gio, this is an awesome thread and I'm learning a bunch from you and all the other commenters (Kraven aside, of course!*)

 

*(I jest)

 

Sorry if I didn't ask the right questions.  I'm just a young guy trying to get educated from the learned experts like yourself.

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Historically Fairfax has been an average underwriter and average underwriters don't make money. I'm impressed by the 94.2 CR but I view it as a one off event as they have not proven they can maintain that kind of underwriting. You are buying Fairfax for their investment acumen; however, they have fully hedged their portfolio over the last two years and missed out on a once in a lifetime opportunity to pick up some fantastic bargains. Where would Fairfax be if instead of losing 2B on equity hedges, would have used that money to buy bargains over the last two years? The opportunity cost of the money lost is closer to 2.5B-3.5B.

 

$496B in Bond losses is not a paper loss. The gains and book value were overstated to begin with. If you have a 5% note with a $100 par value that was trading at $130 six months ago and falls to $115, that is not a paper loss. What you have in Fairfax is a fantastic manager in a mediocre business (insurance). The management is sitting on a collection of assets that are trading at their highest premium in history (bonds). They are great investors and are managing to grow their equity portfolio slowly, but they made an absolutely terrible investment 2 years ago that has cost the company $2B (the hedge). 

 

If you were pitched an idea, say of a company that makes widgets and breaks even on them. Owns a bunch of gold that they rent out for 4% a year. And has had a darn good track record of making acquisitions, except their largest acquisition (50% of their portfolio) had destroyed the value of their other holdings for the last two years. When asked, they say don't worry, the portfolio will not lose any value but our traditional 15% returns are going to be 5% until we sell. Would you buy?

 

Ross,

sorry, but I disagree with you here.

 

1) “once in a lifetime opportunity to pick up some fantastic bargains”?! Why?! Two years ago the market in general wasn’t particularly cheap… On the contrary, it already was quite expensive… Therefore, I don’t see why we will never see those fantastic bargains again… There is really no reason at all not to expect other bargains that will be at least as lucrative in the future!

 

2) As far as equity hedges are concerned, everyone has different opinions: I still think a lot of people will suffer much larger opportunity costs down the road, when they lack the cash to scoop up even better bargains than those available two years ago… You and others, instead, think only about the opportunity costs FFH has already incurred… I guess we won’t have to wait much longer to know who is right about equity hedges!

 

3) Maybe you are right about bonds… what matters to me is that those bonds were bought below par with an after tax yield of 5.79%, and are insured by BRK. If held to maturity, interests received plus appreciation will get very close to that 7.5% annual return needed to compound BVPS at 15% per year. So maybe their fall in value is real, but only because they increased in value too quickly before… that certainly doesn’t make them a bad investment… but I am sure you don’t really think they are a bad investment… nobody would think that!

 

4) I don’t understand your comparison with a company that makes widgets and breaks… equity hedges are not a bad acquisition… equity hedges are a strategic decision to protect your capital, instead of growing it fast. I have already said it could turn out to be a wrong decision… but I have also already said that I don’t think so! And that is the reason why I invest in FFH, because I agree with what they are doing. If that decision truly is the wrong one, once there is evidence about that, they will change course. But they need evidence! They won’t and shouldn’t change course just because you and others don’t agree with their reasonings!

 

5) Finally, also regarding FFH underwriting results there are many different views… personally, I have a tremendous amount of respect for Mr. Barnard and I think underwriting results are very strictly linked to the quality of management. If you prefer to rely on history, well then look no further than OdysseyRe’s history! If Mr. Barnard succeeds in duplicating for FFH as a whole what he has achieved at OdysseyRe, the good underwriting results certainly won't be only a one time event!

 

giofranchi

 

And Ross, this is how Mr. Watsa commented the bond losses during the conference call:

We consider these unrealized bond losses as situations and expect them to reverse over time.

 

giofranchi

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Gio,

 

Of course he expects them to reverse over time. He has made the macro bet that the developed world is in for a big round of deflation! In a deflationary environment, bonds and the equity hedge are going to do very well. The only catch is, we have yet to see the kind of deflation he is predicting. The Fed and ECB are printing money to keep that from happening. I think Watsa would be absolutely correct on his macro call if we were in a truly free market, but that is not the reality. Prem's macro call fights the Fed's monetary policy and has thus far, cost Fairfax a lot of money.

 

We are likely all arguing over peanuts right now, because in 10 years Fairfax will likely be much higher than it is today. I think the crux of the argument is: many here on the board will hold a company with good management until they see management making mistakes. You are willing to hold through the mistakes because you believe management will ultimately guide the company to greener pastures in the future. I understand this line of thinking. If I had so much Fairfax it was difficult to buy and sell all my shares, I would feel the same way, but as a small investor I am nimble enough to get of the train when I see the deck stacked against me. I see over valued bonds, an equity hedge betting on deflation that fights the Fed, and underwriting results that have not been spectacular historically and figure I can find a better investment.

 

 

 

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$496B in Bond losses is not a paper loss. The gains and book value were overstated to begin with. If you have a 5% note with a $100 par value that was trading at $130 six months ago and falls to $115, that is not a paper loss. What you have in Fairfax is a fantastic manager in a mediocre business (insurance). The management is sitting on a collection of assets that are trading at their highest premium in history (bonds). They are great investors and are managing to grow their equity portfolio slowly, but they made an absolutely terrible investment 2 years ago that has cost the company $2B (the hedge). 

I would argue that some of the bond losses are indeed only a paper losses. Reason being, they're offset by insurance liabilities whose balance sheet value is not a function of interest rates (i.e., Fairfax's reserves are established on an undiscounted basis).

 

What that portion is I'm not sure. It would be interesting to see how much of their bond portfolio is strictly part of an asset-liability management program and what portion is for investment purposes. Unless I'm mistaken, I don't think this information is disclosed.

 

There is though an interesting table on page 69 of the interim report with an estimated payment schedule. $6.0b of the $19.0b of the loss and LAE provision are not expected to be paid for 5 years or more. This compares to $5.3b of the $9.6b in bonds with maturities of 5 years or greater.

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$496B in Bond losses is not a paper loss. The gains and book value were overstated to begin with. If you have a 5% note with a $100 par value that was trading at $130 six months ago and falls to $115, that is not a paper loss. What you have in Fairfax is a fantastic manager in a mediocre business (insurance). The management is sitting on a collection of assets that are trading at their highest premium in history (bonds). They are great investors and are managing to grow their equity portfolio slowly, but they made an absolutely terrible investment 2 years ago that has cost the company $2B (the hedge). 

I would argue that some of the bond losses are indeed only a paper losses. Reason being, they're offset by insurance liabilities whose balance sheet value is not a function of interest rates (i.e., Fairfax's reserves are established on an undiscounted basis).

 

What that portion is I'm not sure. It would be interesting to see how much of their bond portfolio is strictly part of an asset-liability management program and what portion is for investment purposes. Unless I'm mistaken, I don't think this information is disclosed.

 

There is though an interesting table on page 69 of the interim report with an estimated payment schedule. $6.0b of the $19.0b of the loss and LAE provision are not expected to be paid for 5 years or more. This compares to $5.3b of the $9.6b in bonds with maturities of 5 years or greater.

On the other hand, some of the gains were paper gains. Which is basically your original point.

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Prem Watsa Very Worried about Deflation and China

2013-08-02 ValueWalk.com

http://www.valuewalk.com/2013/08/prem-watsa-deflation-china/

 

Prem Watsa On Q&A

 

Everyone’s worried about inflation, and have been worried for 5 years. Remember, 2 things, and we’ve said that it in our annual meeting. One, it took 5 years for deflation to set, to come in, in Japan. After the bubble broke in 1989, it was 1995 that deflation set up began. And then for the next 17 or 18 years, you had deflation in Japan.

 

 

---

I might also post an older article...

 

Prem Watsa: China Has Biggest Housing Bubble in History

2013-03-11 ValueWalk.com

http://www.valuewalk.com/2013/03/prem-watsa-china-has-biggest-housing-bubble-in-history/

 

 

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Article about the 2nd qtr results...

 

Checking in on One of Canada’s Super Investors

2013-08-02 Fool.ca

http://www.fool.ca/2013/08/02/checking-in-on-one-of-canadas-super-investors/

 

Foolish Takeaway

 

Because of the hedges that Fairfax has in place, and the cash on hand, it makes the company a very intriguing contrarian betIf Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  Watsa will have cash at just the time you want a super-investor to have cash and Fairfax shareholders will once again benefit from his superior insight.

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Article about the 2nd qtr results...

 

Checking in on One of Canada’s Super Investors

2013-08-02 Fool.ca

http://www.fool.ca/2013/08/02/checking-in-on-one-of-canadas-super-investors/

 

Foolish Takeaway

 

Because of the hedges that Fairfax has in place, and the cash on hand, it makes the company a very intriguing contrarian betIf Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  Watsa will have cash at just the time you want a super-investor to have cash and Fairfax shareholders will once again benefit from his superior insight.

 

 

"If Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  "

 

The thing missing is that the equity portfolio will have losses to match those "big-time gains".  There won't be any "big-time gains" until the markets rebound after they've dropped the hedges.

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"If Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  "

 

The thing missing is that the equity portfolio will have losses to match those "big-time gains".  There won't be any "big-time gains" until the markets rebound after they've dropped the hedges.

 

Exactly. They're hedged, yet people often talk as if they were net short.

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Why not dump this in "TOO HARD" file bin for now and revisit when it trades well below intrinsic value, under 200 or so?

 

This I will never understand…

In a past conference call Mr. Watsa clearly said that he was very satisfied with all the capital they had put together until now trough the years, and what they were trying to achieve with all the hedges in place was to protect that capital. Not to grow it, but to protect it! If you want to grow your capital fast, look somewhere else… I can understand that! But now people say they will buy FFH at $200… which would entail a major decline in BV…

 

So, you are probably investing in a myriad of companies whose management has zero skin in the game, and explains what they do, how and why, half as well as Mr. Watsa & Co. have been doing for more than 25 years… Yet, you are betting that those managers will be successful and will fulfill their promises, while Mr. Watsa & Co. will fail… It might happen! Everything might happen! But to me it makes no sense at all!

 

giofranchi

 

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Article about the 2nd qtr results...

 

Checking in on One of Canada’s Super Investors

2013-08-02 Fool.ca

http://www.fool.ca/2013/08/02/checking-in-on-one-of-canadas-super-investors/

 

Foolish Takeaway

 

Because of the hedges that Fairfax has in place, and the cash on hand, it makes the company a very intriguing contrarian betIf Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  Watsa will have cash at just the time you want a super-investor to have cash and Fairfax shareholders will once again benefit from his superior insight.

 

 

"If Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  "

 

The thing missing is that the equity portfolio will have losses to match those "big-time gains".  There won't be any "big-time gains" until the markets rebound after they've dropped the hedges.

 

I know,... it's technically only a wash, but they protect their company equity base in a sever market crash, while other insurers will be less fortunate. From another perspective,... shareholders are not receiving the returns on the equity portfolio, but are effectively receiving the delta between HWIC's returns and the overall market which can be of course very volatile over the short term. As of June 30, 2013, they have a cushion of over 29% or $7.5 billion in cash and short-term investments to take advantage of market opportunities.

 

I thought you still own some FFH, that you bought some months ago with your portfolio margin.

 

 

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Article about the 2nd qtr results...

 

Checking in on One of Canada’s Super Investors

2013-08-02 Fool.ca

http://www.fool.ca/2013/08/02/checking-in-on-one-of-canadas-super-investors/

 

Foolish Takeaway

 

Because of the hedges that Fairfax has in place, and the cash on hand, it makes the company a very intriguing contrarian betIf Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  Watsa will have cash at just the time you want a super-investor to have cash and Fairfax shareholders will once again benefit from his superior insight.

 

 

"If Watsa is right and equity markets begin to unwind, these big unrealized losses will quickly turn into big-time gains.  "

 

The thing missing is that the equity portfolio will have losses to match those "big-time gains".  There won't be any "big-time gains" until the markets rebound after they've dropped the hedges.

 

I know,... it's technically only a wash, but they protect their company equity base in a sever market crash, while other insurers will be less fortunate. From another perspective,... shareholders are not receiving the returns on the equity portfolio, but are effectively receiving the delta between HWIC's returns and the overall market which can be of course very volatile over the short term. As of June 30, 2013, they have a cushion of over 29% or $7.5 billion in cash and short-term investments to take advantage of market opportunities.

 

I thought you still own some FFH, that you bought some months ago with your portfolio margin.

 

I sold FFH when I bought MBI.  I haven't bought it back yet.

 

I feel like they could buy bonds instead of investing in equities via delta hedging.  Maybe it has to do with the difficulty of getting into and out of their positions.

 

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I feel like they could buy bonds instead of investing in equities via delta hedging. 

 

Well, GreenlightRe, with Mr. Einhorn managing a value long, short investment program, had a positive investment return in Q2 2013, while practically every bonds portfolio suffered losses due to increased rates.

 

giofranchi

 

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