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recent SA article: Fairfax Financial: Well Positioned for a Market Drop Aug 16


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As an investor it is hard to know how much effort you should put forth trying to take advantage of macro forecasts. Is macro forecasting really much more than a fool’s errand ?

 

Consider Peter Lynch who wrote in One Up Wall Street that he spends 15 minutes at the start of each year on macro-economic issues. Warren Buffett isn’t much different than Lynch, preferring to spend his time looking at individual companies rather than thinking about where the economy is going. Lynch and Buffett have both done pretty well ignoring where interest rates are going or how fast the economy will grow.

But then there is someone like Prem Watsa of Fairfax Financial. I’ve been reading Prem’s annual letters to shareholders for a long time. In 2008 as the financial world was falling apart because of derivatives linked to bad lending products Fairfax was reaping billions. Fairfax had years earlier purchased credit default swaps on financial institutions that were the most exposed to toxic mortgage securities.

"While I agree with Buffett and Lynch about the dangers of becoming too obsessed with trying to understand the macro picture, I am not so naïve as to think that I can ignore the warnings of someone like Watsa who is clearly skilled at what he does.As an investor it is hard to know how much effort you should put forth trying to take advantage of macro forecasts. Is macro forecasting really much more than a fool’s errand ?

 

Consider Peter Lynch who wrote in One Up Wall Street that he spends 15 minutes at the start of each year on macro-economic issues. Warren Buffett isn’t much different than Lynch, preferring to spend his time looking at individual companies rather than thinking about where the economy is going. Lynch and Buffett have both done pretty well ignoring where interest rates are going or how fast the economy will grow.

But then there is someone like Prem Watsa of Fairfax Financial. I’ve been reading Prem’s annual letters to shareholders for a long time. In 2008 as the financial world was falling apart because of derivatives linked to bad lending products Fairfax was reaping billions. Fairfax had years earlier purchased credit default swaps on financial institutions that were the most exposed to toxic mortgage securities.

While I agree with Buffett and Lynch about the dangers of becoming too obsessed with trying to understand the macro picture, I am not so naïve as to think that I can ignore the warnings of someone like Watsa who is clearly skilled at what he does."

 

"If you follow Fairfax and Watsa you likely saw a recent article in the Toronto Globe and Mail (Globe) in which Watsa laid out his belief that deflation is all but inevitable. Watsa believes that with interest rates already basically at zero and stimulus spending capability now limited, the United States government is essentially out of ammunition.

And like 5 years ago when Watsa saw the chaos in the financial sector looming, he has positioned Fairfax to not only survive but profit enormously should his pessimistic predictions pan out."

 

a commenter on this article asks: "Zach MansellComments (213)

I believe you have oversimplified the CPI linked derivatives. Not all $48 billion dollars (I think that's about the notional value of the contracts) are tied to cumulative deflation in the U.S.

 

They are separated between the U.S., the E.U., and the U.K. In the 2nd quarter, Fairfax increased its holding of this CPI linked derivatives in the E.U. by a substantial amount. I know this is a nit-picky, but I just wanted readers to realize that the example you have presented is not entirely accurate as not all $48 billion are tied to deflation in the U.S.

 

Also, do you have any clue who the counterparties are for such derivatives? I think this is a brilliant (and cheap) play by Prem Watsa, but as I'm relying more and more on these derivatives as my investment thesis for Fairfax, I become more and more concerned with the counterparties' ability to pay Fairfax billions in the event of such a melt-down in the economy."

 

in a recent ottawa citizen newspaper article, dated sat sept 28,2013, james Bagnall writes:"“Canadian households remain highly leveraged,” wrote TD economist Leslie Preston, “and it will take quite some time for measures of leverage to return to historical norms.”

The amount of debt on Canadians’ personal books isn’t necessarily a problem if interest rates increase gradually and the global economic recovery continues, especially in the U.S. A survey of economists by the Economist Magazine suggests U.S. GDP this year will grow 1.6 per cent, about the same as Canada, and accelerate to 2.7 per cent next year (versus 2.3 per cent for Canada).

As for how quickly, or even if, interest rates rise, so much depends on the ability of central banks to unwind trillions of dollars in risky financial debt accumulated since the beginning of the recession. Some financial analysts, such as Harry Dent, author of The Great Crash Ahead, are convinced that the bursting of the debt bubble will produce an era of deflation and another stock market crash. Eric Sprott — the principal of Sprott Asset Management — has an equally dim view of central bankers’ strategies but believes the end result will be debilitating inflation, with only precious metals such as gold and silver holding their value. Assuming the central bankers do get it right — that is, they preside over a gradual reduction of debt and an increase in economic growth, the consensus is that we’ll get through this, albeit slowly.

 

There is, in fact, no precedent for what we’re about to witness."

 

I personaly do not know a lot of macro-economics, but I am puzzled about whether we should be worried about possible inflation from all the new money created by central banks and their so-called 'quantitative easing' policies OR the deflation that seems to worry Mr Watsa so greatly.

 

If we end up facing high rates of inflation in the future is hedging against deflation of any use or perhaps a large waste of money?

 

I would welcome other board members views on this confusing issue - is it really possible to hedge the economic future?

 

 

 

 

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I would welcome other board members views on this confusing issue - is it really possible to hedge the economic future?

 

Well, I think it becomes a distraction from the broader picture of finding quality investments at a significant discount to its intrinsic value.  At the same time, Fairfax is not just some ordinary investment company, but a leveraged insurer that relies on its capital base to maintain statutory levels so that it can underwrite insurance business.  So, if you are that insurer, and you can buy coverage for what you perceive to be a real risk, at a cheap price when no one was expecting it...then you make that bet.  I wouldn't recommend that bet for the average investor, or most portfolio managers, but for a leveraged insurance company or financial institution, it may be a necessary evil, just like buying currency derivatives for a leveraged bank.  Cheers!

 

 

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If we end up facing high rates of inflation in the future is hedging against deflation of any use or perhaps a large waste of money?

 

To be sure, Prem is betting on the possibility of deflation-- not its inevitability. If we face net inflation in the future a hedge against deflation is lost money, yes.

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  • 3 weeks later...

"If you follow Fairfax and Watsa you likely saw a recent article in the Toronto Globe and Mail (Globe) in which Watsa laid out his belief that deflation is all but inevitable. Watsa believes that with interest rates already basically at zero and stimulus spending capability now limited, the United States government is essentially out of ammunition.

 

 

Note that that article was in August 2011, not 2013. I still like the bet's prospects, long term, but 2 years later it is not working out yet.

 

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no one has aswered my query re whether the usa is more likely to face serious rates of deflation or inflation going forward, in light of their present fiscal predicament?

 

Please be patient.  There is a team working on it.  All top notch people.  They will prepare a report and revert back as soon as possible.  While they are working on it, is there anything else you need?

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I think that there will modest inflation (less than 4%).  The Fed is following the a policy similar to Sweden in the depression where Sweden was able to prevent the deflation in the rest of the world by letting the money supply grow to offset the deflation.  High inflation is driven by wage inflation which I think will not occur for years.  Fortunately, this does not affect that cheap stocks will outperform the market.

 

Packer

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At last year's Fairfax shareholder meeting, I pressed Prem (during the public Q&A) about who the counter parties are for the deflation CPI.  He danced around the topic a bit at first.  I refused to relent.  Finally, he mentioned that the coutnerparties are all "Too Big To Fail" banks around the world.  I would imagine they were of the rank of JPM, BAC, Citi, and Deutsche Bank etc.  Hope this address some of the questions one may have.

 

Personally, I've kind of given up on shorting/hedging via puts, shorting S&P etc.  I've decided to take a page from Buffet's playbook and allocate capital to workouts that involve distribution of cash. 

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no one has aswered my query re whether the usa is more likely to face serious rates of deflation or inflation going forward, in light of their present fiscal predicament?

 

Please be patient.  There is a team working on it.  All top notch people.  They will prepare a report and revert back as soon as possible.  While they are working on it, is there anything else you need?

 

Yeah. The invoice.

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no one has aswered my query re whether the usa is more likely to face serious rates of deflation or inflation going forward, in light of their present fiscal predicament?

 

Please be patient.  There is a team working on it.  All top notch people.  They will prepare a report and revert back as soon as possible.  While they are working on it, is there anything else you need?

 

After reading this, my wife called out from another room:  "Why are you laughing so hard?"

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If we end up facing high rates of inflation in the future is hedging against deflation of any use or perhaps a large waste of money?

 

[in addition to Parsad's comments about the usefulness of such hedges in the context of an insurer with capital considerations......]

 

I look at Fairfax's hedges in an "antifragile" framework -- cheap, deep out of the money options, limited downside, huge non-linear upside.

 

When you're set up in an antifragile way, you don't have to 'predict' crises -- you just know that you'll profit from them when they inevitably occur.  Fairfax is long volatility.

 

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no one has aswered my query re whether the usa is more likely to face serious rates of deflation or inflation going forward, in light of their present fiscal predicament?

 

Please be patient.  There is a team working on it.  All top notch people.  They will prepare a report and revert back as soon as possible.  While they are working on it, is there anything else you need?

Kraven thank you for reassurance, indeed it provides piece of mind.

 

LOL had to step out from the office for cup of SBUX could not stop laughing.

Thanks, it made my day

 

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no one has aswered my query re whether the usa is more likely to face serious rates of deflation or inflation going forward, in light of their present fiscal predicament?

 

Please be patient.  There is a team working on it.  All top notch people.  They will prepare a report and revert back as soon as possible.  While they are working on it, is there anything else you need?

Kraven thank you for reassurance, indeed it provides piece of mind.

 

LOL had to step out from the office for cup of SBUX could not stop laughing.

Thanks, it made my day

 

I wanted to make sure I said thank you to everyone who has expressed their appreciation for the job we're doing.  I have conveyed it to the team and it's really made them feel good about the work they're putting in on this very important project.  They are working night and day on this and all of their other matters have been pushed to the back burner.  This has been quite challenging, but we are more than up to the task of providing you with a result I am sure you will be most pleased with.

 

While we're on topic, there are a few housekeeping issues.  A few people made note of the cost involved.  You should not concern yourself with this.  Of course there will be costs involved, and they most likely will be high, but that's nothing compared to the actionable work product we will provide.  In terms of expenses, I have taken the liberty of having breakfast, lunch and dinner catered for the team.  This is somewhat costly, but enables team members to keep on working through each meal instead of taking the wasteful time of leaving the office.  Team members have also been staying overnight at the Four Seasons or the Ritz Carlton (their choice) to save time on commuting.  There were a couple specialists we flew in - one from our Tokyo office and one from our San Francisco office - and their contributions have already been quite good.

 

We fully expect to complete this project in the coming weeks.  I cannot provide an exact time as we want to make sure every issue is covered from every angle.  Your trust in us pleases us greatly and we know you will be more than satisfied.  If you have any questions in the meantime, please call or email me.  Moreover, if you have any other matters you would like us to attend to, please let me know and I will arrange for that to be covered.

 

Thanks and regards,

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I think that there will modest inflation (less than 4%).  The Fed is following the a policy similar to Sweden in the depression where Sweden was able to prevent the deflation in the rest of the world by letting the money supply grow to offset the deflation.  High inflation is driven by wage inflation which I think will not occur for years.  Fortunately, this does not affect that cheap stocks will outperform the market.

 

Packer

 

I continue to think it is extremely dangerous to make the assumption that something that has worked in the past for Sweden (very very little), will also work today for the US + Europe + Japan (very very big)… They are just orders of magnitudes away! Someone can do something, if nobody else is following suit… But what happens when everybody in the developed world is trying to do the same thing at once? Well, that’s when bubbles are formed! And bubbles end badly.

On the other hand, I agree with Packer that cheap stocks are cheap stocks, and you should always look for them!

 

giofranchi

 

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I look at Fairfax's hedges in an "antifragile" framework -- cheap, deep out of the money options, limited downside, huge non-linear upside.

 

When you're set up in an antifragile way, you don't have to 'predict' crises -- you just know that you'll profit from them when they inevitably occur.  Fairfax is long volatility.

 

WhoIsWarren,

you already know that I couldn't agree with you more! ;)

 

giofranchi

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I think that there will modest inflation (less than 4%).  The Fed is following the a policy similar to Sweden in the depression where Sweden was able to prevent the deflation in the rest of the world by letting the money supply grow to offset the deflation.  High inflation is driven by wage inflation which I think will not occur for years.  Fortunately, this does not affect that cheap stocks will outperform the market.

 

Packer

 

I continue to think it is extremely dangerous to make the assumption that something that has worked in the past for Sweden (very very little), will also work today for the US + Europe + Japan (very very big)… They are just orders of magnitudes away! Someone can do something, if nobody else is following suit… But what happens when everybody in the developed world is trying to do the same thing at once? Well, that’s when bubbles are formed! And bubbles end badly.

On the other hand, I agree with Packer that cheap stocks are cheap stocks, and you should always look for them!

 

giofranchi

 

I guess the question is what other data points do we have and are they more analgous?  I haven't found any.  So at this point this is the best guess I can find.  If you have found any I would like to hear them.  Thanks.

 

Packer

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I guess the question is what other data points do we have and are they more analgous?  I haven't found any.  So at this point this is the best guess I can find.  If you have found any I would like to hear them.  Thanks.

 

Packer

 

No no! We clearly are in uncharted waters! But that’s exactly the reason why I think prudence, or, let’s say it in a fashionable way, “anti-fragility”, might serve us well going forward. :)

 

giofranchi

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