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

[Packer16]

I guess I questioning your assumption that the market level is based upon QE.  It may be partially based upon that to the extent IR are lower than normal but I think financial repression is here to stay and therefore lower than normal rates will be here for a long time.  This in combination with the worldwide savings glut will keep rates low.  Do you disagree?  I think the only way out of the debt burden is to have interest rates low so the debt can be monitized.  This is what the US did post WWII to reduce the US debt coming out of the war. 

 

If the rates stay low then what is going to cause stock prices to decline, in light of the fact that it is not a loved asset class right now (based upon fund outflows)?  I agree there may be a shock but its not like sentiment is great like in 2007 where you get both a shock and sentiment change.  So if there is a shock I would think prices would recover quite quickly.  I think the market will continue to rise unless there is a large spike in interest rates.

 

Packer

[shalab]

Gio - the flow of funds (FFA) rate puts net savings close to 10% not 2% and this is from the government stats. In addition, another thing to factor in is the household networth - it went up by 10% last year and I am sure it is around 70 trillion now.

 

http://www.bea.gov/national/nipaweb/Nipa-Frb.asp

 

The 401(k) balances are also at a record high as of Q1 of this year.

 

http://www.forbes.com/sites/ashleaebeling/2013/05/23/fidelity-401k-balances-reach-record-highs/

 

 

[wisdom]

http://www.bloomberg.com/news/2013-06-30/global-bonds-dive-for-second-month-as-stocks-lose-2-7-trillion.html

 

There will be capital destruction if the central banks are not able to play this perfectly. Most people do not see the obvious -eg.  pull back on QE until Bernanke spelt it out for them and they act as if this is something new.

 

No one knows how this is going to play out. It is best to hedge - just in case things get a bit out of hand. It will be beneficial to have cash at that point of time. It does not have to be a replay of 2008. If this leads to deflation - you can take advantage.

 

If things work out perfectly - well you can focus on the insurance business and other investments. This will play out well if we get inflation. The readjustment in expectations will allow them to deploy all the cash they have.

 

The way I see it - FFH should be able to take advantage of either scenario.

[premfan]

I'm enjoying this thread especially the insights of packer and gio.  I believe in packer's comment where even if there is a shock in the system but rates are still historically low. Stocks should rise or still do fine. I like to keep things simple especially where i have no control in the outcome. Low interests= high asset prices. Right?

 

 

Gio has alot of conviction and assumptions with fairfax. This is great and most people on the board are with you for the love and admiration of prem and his team. But, saying in 10 years the return will be probadly "x" is an assumption where there is no way you can honestly predict. You cant predict something that inherently is unpredictable in nature. No one can predict future CR. Best assumption is using their track record of combined ratio. Also you cant predict their investment return because its basically out of their control. There is no point having an absolute mindset when we live in a relative world.

 

In my business i dont  have to compete with a guy in nyc. I have to worry about being the best business in my chosen niche in my relative mile radius.

 

  This is not coca cola where you can predict to some degree units of coca sold X unit of profit per soda.  This is not colgate or any established consumer brand. This is a company thats in insurance ( unpredictable) and in the financial markets ( unpredictable).  What is predictable is prem will treat shareholders in a fair and friendly nature. 

 

[SharperDingaan]

"Given that, contrary to what happened during the last decade, I expect insurance operations to get better and better, and finally to achieve an underwriting profit, the annual return needed from their portfolio of investments might actually be only around 7%. Historically, instead, they have achieved a 9.4% annual return."

 

Gio, you might want to rethink what this actually means....

(1)Annual weather events are getting more frequent, more certain, & more severe - therefore bigger, & realized, event losses. (2)There is a rising presence of under-priced state cat (flood) insurance - materially lengthening payback periods.

 

Those big realized losses are lowering BV, & most would argue that on those big losses - the payback period is now longer than the time to the next big event. In practical terms; realized net BV losses are getting bigger & compounding negatively.

 

Re-insuring cat risk against the state, is also not a sure thing; as we all found out with AIG. While  states theoretically cannot go bankrupt (therefore you will eventually get paid); unless there is timely & full settlement - you WILL experience a realized BV loss equal to your GROSS exposure. As your investor I will want more yield to compensate for my additional risk.

 

Point is that while intrinsic value may well rise over the holding period; the simultaneous rising noise level could well obliterate it - producing a NET gain of almost nothing.

 

SD     

 

 

 

 

 

 

 

[PlanMaestro]

Gio, I should know better about a lot of things. But seriously, if we were talking about Fairfax and I didn't give importance to its Balance Sheet would you take me seriously? Disregard for the Balance of Payments is just as much of a serious issue as diminishing the importance of a Balance Sheet.

 

http://en.wikipedia.org/wiki/Balance_of_payments

 

When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.

 

While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

 

These are the net investment numbers and I'll leave it at that, most of this is a waste of time anyway.

 

http://en.wikipedia.org/wiki/Net_international_investment_position

 

 

[ap1234]

Gio said:

 

2)  At year end 2012 BRK had only 7% of its total assets in bonds. In what probably is going to be a secular bear for bonds, Mr. Watsa will shape FFH to resemble BRK structure more and more. If bonds are no longer an attractive vehicle for investments, Mr. Watsa will choose other asset classes to get a decent return on FFH’s total assets.

 

Gio, I think it might make more sense to think about the allocation to bonds in relation to Fairfax's book value as opposed to a % of assets given the leveraged business model (i.e. investment portfolio is 3-3.5x the size of book value).

 

At the end of 2012 Fairfax has an investment portfolio of $26.1 billion. 43% of the investment portfolio was in bonds. This implies that Fairfax held $11.2 billion in bonds. According to the annual report, it appears that the duration of the bonds is between 7-10  years.

 

Fairfax’s book value at the end of 2012 was approx. $7.5 billion. The bond portfolio is more than 100% of Fairfax’s book value.

 

Naturally, the 30% of the investment portfolio sitting in cash has a duration less than 1 which lowers the overall portfolio duration. However, I think it is clear that Fairfax has a significant allocaiton to bonds (and likely always will) and will face the headwind from the int. rate environment.

[mcliu]

If the rates stay low then what is going to cause stock prices to decline, in light of the fact that it is not a loved asset class right now (based upon fund outflows)?  I agree there may be a shock but its not like sentiment is great like in 2007 where you get both a shock and sentiment change.  So if there is a shock I would think prices would recover quite quickly.  I think the market will continue to rise unless there is a large spike in interest rates.

 

Earnings could also decline despite the low rates.

 

If you believe that earnings will continue to grow and rates will continue to stay low, obviously what FFH doing is not effective, but on the off chance that the optimal scenario of low earnings and low rates do not continue, then a hedge may be necessary.

 

I'm not smart enough to guess how rates will look in a few years, but in terms of earnings, given where growth rates and margins are at, it seems more likely to be lower than higher.

[Packer16]

Why would earnings decline?  Is somebodies wealth or wages going to decline to cause the earnings to decline?  Is there going to be price competition in excess of input cost declines to cause the decline?  The GDP is still growing (albiet at a slow rate) so why wouldn't earnings grow?  Now wages per capita have been flat but the capita has been increasing so doesn't that mean more earnings overall?  I would agree if GDP was declining but we are talking about a declining rate of growth not real GDP are we not?  Just 2 cents.

 

Packer

[Valuebo]

Good points by Premfan and SD as well. Thank you for the discussion.

 

There is always the possibility of extreme events as well like solar flares. A storm equal to the one from 1859 would cause trillions in economic damage to the US alone! Nothing is certain in this world.

[mcliu]

Why would earnings decline?  Is somebodies wealth or wages going to decline to cause the earnings to decline?  Is there going to be price competition in excess of input cost declines to cause the decline?  The GDP is still growing (albiet at a slow rate) so why wouldn't earnings grow?  Now wages per capita have been flat but the capita has been increasing so doesn't that mean more earnings overall?  I would agree if GDP was declining but we are talking about a declining rate of growth not real GDP are we not?  Just 2 cents.

 

Packer

 

Why wouldn't earnings decline? Aren't profit margins currently at record highs and is mean-reverting? Why wouldn't there be strong competition given the high margins? Isn't there tremendous excess capacity in the economy and hence the extremely low GDP growth rates? Wouldn't some external shock easily push growth rates into negative territory? With a negative GDP growth rate, isn't it likely that earnings will decline?

 

I do agree if we see moderate 3 or 4% GDP growth, it's tough to see earnings decline, but given the sub 2% GDP growth, any shocks to the system can easily push GDP growth below 0%. With monetary policy maxed out at this point, it's hard to see what other tools are at the FED's disposal under those circumstances.

 

I'm not saying that, that's what's going to happen, since growth could just as well accelerate beyond 3% or 4%. I'm just saying, there's substantial risks in the system, and it doesn't hurt to hedge. Obviously, if you believe that GDP will continue to grow inevitably, then there's no point hedging.

 

There's always risks and uncertainty with investing, however, the amount and distribution of the risks vary. At this point in time, just like in 2006/2007, there is substantial excesses in the system that warrant a cautious approach to investing.

[Packer16]

Although I agree earnings per capita may decline why would earnings decline overall?  The reason earnings are not declining is because the inputs for goods and in some cases services are not increasing or increasing less than output.  I think earnings will decline if these inputs increase at a faster pace than productivity and price changes.  Right now there is a surplus of inputs and until that changes I don't see profits going down.  One other aspect in the US is that many capital intensive commodity businesses have been offshored.  These products are being made in China and other developing countries.  So you will have a bias of higher margin firms here in the US as more of the commodities are outsourced.

 

I do agree that negative GDP would to a lead to a decline in profits.  I was impressed buy how little the real US GDP declined in 2008/2009 and how fast it recovered.  It feel 0.3% in 2008 and another 3.5% in 2009 and is now 2.8% higher than the peak in 2007.  Personal Consumption has also recovered to 2007 peak levels with less debt.  If the GDP plods along at 2% growth then why shouldn't profits continue to increase.   

 

As to excesses, I don't see that as many as in 2006/2007.  The only exception is gov't spending and debt but  they have other alternatives to deal with the debt like financial repression.  I see the beginnings of some excess in the credit market but nothing like the levels of 2006/2007.  I am not saying we will not get there and this is an area that requires close monitoring.

 

Packer

[giofranchi]

I guess I questioning your assumption that the market level is based upon QE.  It may be partially based upon that to the extent IR are lower than normal but I think financial repression is here to stay and therefore lower than normal rates will be here for a long time.  This in combination with the worldwide savings glut will keep rates low.  Do you disagree?  I think the only way out of the debt burden is to have interest rates low so the debt can be monitized.  This is what the US did post WWII to reduce the US debt coming out of the war. 

 

If the rates stay low then what is going to cause stock prices to decline, in light of the fact that it is not a loved asset class right now (based upon fund outflows)?  I agree there may be a shock but its not like sentiment is great like in 2007 where you get both a shock and sentiment change.  So if there is a shock I would think prices would recover quite quickly.  I think the market will continue to rise unless there is a large spike in interest rates.

 

Packer

 

Packer,

I just tried to answer your question why I think the hedges will be resolved one way or the other in a matter of 2 to 3 years. The Central Banks are “all in”, first the US and England in 2009, then Europe in 2011, now Japan in 2013. And when you are “all in”, either you win or you lose, right? I think a 2 to 3 years time will be enough to finally understand if their medicine is the right one. If it is the right one, the markets will probably do more of the same. If it is a wrong medicine, I don’t know what will happen… Sincerely, I think nobody knows… We are ingesting that medicine since the bottom of 2009, so how could anyone know what will happen without it? There is just no evidence! Probably, you are right: a brief shock, soon followed by a fast recovery. For what I know, markets could go on utterly undisturbed! But I also cannot rule out a prolonged slump… That’s why imo the hedges are in place today, and why they probably will become meaningless in a 2 to 3 years time.

 

giofranchi

 

[giofranchi]

Gio - the flow of funds (FFA) rate puts net savings close to 10% not 2% and this is from the government stats. In addition, another thing to factor in is the household networth - it went up by 10% last year and I am sure it is around 70 trillion now.

 

http://www.bea.gov/national/nipaweb/Nipa-Frb.asp

 

The 401(k) balances are also at a record high as of Q1 of this year.

 

http://www.forbes.com/sites/ashleaebeling/2013/05/23/fidelity-401k-balances-reach-record-highs/

 

shalab,

sorry but I am not sophisticated enough… at page 3 of the file you have previously posted, I have found a 3.2% personal saving rate for May 2013. That’s the figure to compare with the 2.6% in February 2013. And for that figure I have a chart that goes back to 1959. So I can put those numbers in an historical context. Vice versa, I lack a similar chart for the FFA, so a 10% rate is meaningless to me… But, if you could post it, I will be glad to examine which kind of information it really provides.

Thank you,

 

giofranchi

 

[giofranchi]

Gio, I should know better about a lot of things. But seriously, if we were talking about Fairfax and I didn't give importance to its Balance Sheet would you take me seriously? Disregard for the Balance of Payments is just as much of a serious issue as diminishing the importance of a Balance Sheet.

 

http://en.wikipedia.org/wiki/Balance_of_payments

 

When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.

 

While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

 

These are the net investment numbers and I'll leave it at that, most of this is a waste of time anyway.

 

http://en.wikipedia.org/wiki/Net_international_investment_position

 

PlanMaestro,

I agree: it is a waste of time. ;)

 

giofranchi

 

[giofranchi]

Gio said:

 

2)  At year end 2012 BRK had only 7% of its total assets in bonds. In what probably is going to be a secular bear for bonds, Mr. Watsa will shape FFH to resemble BRK structure more and more. If bonds are no longer an attractive vehicle for investments, Mr. Watsa will choose other asset classes to get a decent return on FFH’s total assets.

 

Gio, I think it might make more sense to think about the allocation to bonds in relation to Fairfax's book value as opposed to a % of assets given the leveraged business model (i.e. investment portfolio is 3-3.5x the size of book value).

 

At the end of 2012 Fairfax has an investment portfolio of $26.1 billion. 43% of the investment portfolio was in bonds. This implies that Fairfax held $11.2 billion in bonds. According to the annual report, it appears that the duration of the bonds is between 7-10  years.

 

Fairfax’s book value at the end of 2012 was approx. $7.5 billion. The bond portfolio is more than 100% of Fairfax’s book value.

 

Naturally, the 30% of the investment portfolio sitting in cash has a duration less than 1 which lowers the overall portfolio duration. However, I think it is clear that Fairfax has a significant allocaiton to bonds (and likely always will) and will face the headwind from the int. rate environment.

 

ap1234,

I was talking about the BRK of today as an example of what FFH could become tomorrow. You say that FFH will always have a high percentage of assets invested in bonds… Why? Regulatory constraints? Maybe… but I am also convinced that Mr. Watsa and his team will go on seeking the best investment opportunities, available within regulatory constraints! If bonds face serious headwinds in the years ahead, Mr. Watsa and his team will reduce the percentage of bonds in their portfolio of investment as much as possible. Don’t you agree?

 

giofranchi

 

[giofranchi]

"Given that, contrary to what happened during the last decade, I expect insurance operations to get better and better, and finally to achieve an underwriting profit, the annual return needed from their portfolio of investments might actually be only around 7%. Historically, instead, they have achieved a 9.4% annual return."

 

Gio, you might want to rethink what this actually means....

(1)Annual weather events are getting more frequent, more certain, & more severe - therefore bigger, & realized, event losses. (2)There is a rising presence of under-priced state cat (flood) insurance - materially lengthening payback periods.

 

Those big realized losses are lowering BV, & most would argue that on those big losses - the payback period is now longer than the time to the next big event. In practical terms; realized net BV losses are getting bigger & compounding negatively.

 

Re-insuring cat risk against the state, is also not a sure thing; as we all found out with AIG. While  states theoretically cannot go bankrupt (therefore you will eventually get paid); unless there is timely & full settlement - you WILL experience a realized BV loss equal to your GROSS exposure. As your investor I will want more yield to compensate for my additional risk.

 

Point is that while intrinsic value may well rise over the holding period; the simultaneous rising noise level could well obliterate it - producing a NET gain of almost nothing.

 

SD     

 

SharperDingaan,

I am not sure I have understood what you mean… but I think I have grasped that you don’t believe in an improvement of FFH’s insurance operations. To that I can only say I have great respect for Mr. Barnard and all he has achieved at OdysseyRe, and great faith in what he could achieve overseeing all FFH’s insurance operations. You said annual weather events are getting more frequent, more certain, & more severe… So what? Tell me the rules, and I will make money! Change can only help a great manager like Mr. Barnard, because he will assess it better than other insurers and better than the insured, therefore will be able to benefit from it!

Insurance is not going away… and it will always be a relative game: the best managers will make money, all the others will lose money. And Mr. Barnard is among the very best! ;)

 

giofranchi

 

[giofranchi]

Low interests= high asset prices. Right?

 

premfan,

I don’t think it is that easy… If it were, please explain Japan and Europe!

 

Gio has alot of conviction and assumptions with fairfax. This is great and most people on the board are with you for the love and admiration of prem and his team. But, saying in 10 years the return will be probadly "x" is an assumption where there is no way you can honestly predict. You cant predict something that inherently is unpredictable in nature. No one can predict future CR. Best assumption is using their track record of combined ratio. Also you cant predict their investment return because its basically out of their control. There is no point having an absolute mindset when we live in a relative world.

 

In my business i dont  have to compete with a guy in nyc. I have to worry about being the best business in my chosen niche in my relative mile radius.

 

  This is not coca cola where you can predict to some degree units of coca sold X unit of profit per soda.  This is not colgate or any established consumer brand. This is a company thats in insurance ( unpredictable) and in the financial markets ( unpredictable).  What is predictable is prem will treat shareholders in a fair and friendly nature. 

 

 

Of course nothing is certain! I just look for something that has the potential to compound capital at 15% annual for a long time, try to understand it as deeply as I can, and then stick with it. That’s all!

 

giofranchi

[giofranchi]

Sorry to all, if sometimes I seem too “aggressive” in expounding my thesis about FFH… I know criticism and skepticism are very important, and I thank you all for pointing at weaknesses in my reasonings! Anyway, when your thesis is the object of criticism and skepticism, even though you know they will ultimately be very useful, it is not always easy to keep calm, and answer in a relaxed and gentle manner… my fault!!

 

giofranchi

 

[Phaceliacapital]

Small FF write up in attachment

[jay21]

ap1234,

I was talking about the BRK of today as an example of what FFH could become tomorrow. You say that FFH will always have a high percentage of assets invested in bonds… Why? Regulatory constraints? Maybe… but I am also convinced that Mr. Watsa and his team will go on seeking the best investment opportunities, available within regulatory constraints! If bonds face serious headwinds in the years ahead, Mr. Watsa and his team will reduce the percentage of bonds in their portfolio of investment as much as possible. Don’t you agree?

 

giofranchi

 

I don't get how you can be bearish on bonds, but agree with Prem's actions.  It appears to me he has a long duration portfolio.  I would think this portfolio would serve as an adequate deflation hedge, which is why i am more critical about Prem's hedges than most.  He has taken a deflation position, he has not hedged for a deflation scenario imo.  I don't know FFH as well as others so if any of my facts are wrong, please let me know. 

[giofranchi]

 

I don't get how you can be bearish on bonds,

 

Jay, could you please elaborate a little bit further? Bonds are in a secular bull that has been lasting for 30 years now…

Thank you,

 

giofranchi

 

[petec]

I can't see how one can be anything other than bearish on bonds for the long term (and I think Prem has said as much) but I agree with jay21 that he's taken a deflation position.  He owns bonds and he runs an insurance business that logically should see combined ratios rise in a deflationary period, so I have never quite understood why the deflation hedges are necessary to 'protect the business' as Prem has described them.  That said he bought them cheap so I actually regard them as a good investment either way.

[racemize]

I can't see how one can be anything other than bearish on bonds for the long term (and I think Prem has said as much) but I agree with jay21 that he's taken a deflation position.  He owns bonds and he runs an insurance business that logically should see combined ratios rise in a deflationary period, so I have never quite understood why the deflation hedges are necessary to 'protect the business' as Prem has described them.  That said he bought them cheap so I actually regard them as a good investment either way.

 

I overheard Monnish talking about fairfax and the hedges at the airport after the Berkshire meeting. He indicated the hedging / stance was largely due to the float / equity. I think he said ffh was at  near 2:1 vs 1.3:1 for mkl or brk. 

 

Then I guess there is the deflation derivatives, but they aren't that expensive.

[giofranchi]

I overheard Monnish talking about fairfax and the hedges at the airport after the Berkshire meeting. He indicated the hedging / stance was largely due to the float / equity. I think he said ffh was at  near 2:1 vs 1.3:1 for mkl or brk. 

 

Then I guess there is the deflation derivatives, but they aren't that expensive.

 

Hi Joel,

I wouldn’t be so sure… last time that I checked, MKL had substantially larger investments in stocks, as a percentage of equity, than FFH!

 

giofranchi