Most recently Fairfax Financial Holdings Ltd. (OTCQB:FRFHF) has been widely tracked by the investment media due to its engagement in the rescue plan for another Canadian company, BlackBerry (BBRY). Although this is not a topic I want to focus on in my article, it perfectly demonstrates the so-called "contrarian" investment philosophy of Prem Watsa, Fairfax Chief Executive Officer. BlackBerry, once one of the more recognizable brand names in the world, today is perceived as a laggard in the global smartphone sector. In effect, nearly nobody thinks there are any chances for this company. But Prem Watsa does think differently, contrary to the others, and only time will tell whether his engagement was beneficiary for Fairfax or was not.
Well, now let me leave the Blackberry affair. What I want to show in this article is the contrarian investment philosophy conducted by Prem Watsa. Watsa, through Hamblin Watsa Investment Counsel Ltd., is responsible for management of the Fairfax and its subsidiaries' investment portfolio. Similar to Warren Buffett of Berkshire Hathaway, the financial target of Fairfax is to "compound mark-to-market book value per share over the long term by 15% annually by running Fairfax and its subsidiaries for the long term benefit of customers, employees and shareholders - at the expense of short term profits if necessary." Taking into account the data available on the company's website, since 1985 the annual book value per share growth rate has amounted to 22.7%, which is much higher than the target.
How was this excellent number achieved? Two factors were crucial:
- Excellent insurance businesses run by Fairfax and its subsidiaries
- Prem Watsa's contrarian investment philosophy, which made it possible to record above average investment results.
This second factor is the one I want to deal with. Generally, in my considerations I am covering the period starting from 2009 when the present bull market in equities began.
First, let us look at the Fairfax investment portfolio. Due to the variable size of that portfolio I operate with its structure rather than with the nominal numbers:
The main portfolio's features are the changes in the share of cash, bonds and common stocks. During the bear market of 2007 - 2009 cash held a rather high share in the investment portfolio. During the bear market climax, at the end of 2008, Fairfax had 30% of its portfolio in cash. Then, very quickly, during the first three months of 2009 the cash level fell to 21% and then even lower. Between the end of 2008 and 31 March 2009 the share of bonds and common stocks in the investment portfolio jumped from 67% to 75%. Some may have forgotten, but in the beginning of 2009 the prevailing sentiment was extremely negative. Fear was everywhere. The majority of the market commentators were busy in developing the catastrophic stories about the financial crisis and nearly nobody was recommending buying equities. Nobody, except for Prem Watsa. During these "dark months" Watsa was heavily changing his investment positions.
But this is just one part of the story and, what is more, these changes were not of particular importance.
Much more important (and this is a main topic) is Watsa's philosophy concerning portfolio hedging. The great investment results recorded by Fairfax originate from clever hedge management. At this point I should explain the term called "Net exposure". Fairfax hedges its equity and equity related holdings against a potential decline "by way of short positions effected through equity and equity index total return swaps, including short positions in certain equity indexes and individual equities" (page 15 of the company's last report). Due to the quality of company's financial reporting, we can easily track the hedges applied by Fairfax. In my opinion the best way to do it is to look at "Net exposure", which measures the difference between the notional value of equity and equity related holdings and the notional value of hedges applied by the company. The negative "Net exposure" means that the notional value of short positions (short hedges) is higher than the notional value of equity and equity related holdings, and vice versa. Now, let us look at the chart below:
The chart shows "Net exposure" calculated at the end of every quarter since 2009. As you can see, at the end of "the raging bear market" of 2008 - 2009 the net exposure was $4,668 million at the end of the first quarter of 2009. It means that at that time the company's equity and equity related portfolio was configured for the coming bull market. If you look at the numbers in the second quarter of 2009 you can see that the pro-bull market net exposure was even higher, namely $5,830 million. The structure of equity and equity related portfolio looked as follows:
You can notice that the equity portfolio was practically not hedged at all. But hold on! The whole financial world sees only the catastrophe and Watsa bets $5.8 billion on the coming bull market? Yes, that is the essence of Prem Watsa's contrarian strategy. What happened then, everybody knows: the big bull market started.
Today, the Fairfax equity portfolio has a totally different net exposure. As the chart above shows, since the third quarter of 2011 the net exposure has been negative. It means that Fairfax has hedged its equity portfolio against a possible decline of the stock market. Again, contrary to the prevailing opinion Prem Watsa thinks that there is a big disconnect between the stock market and the economy : here is an excerpt from Watsa's Letter to Shareholders (in the 2012 Annual Report ):
We continue to fully hedge our common stock portfolios because of the reasons first discussed in our 2010 and 2011 Annual Reports. Those reasons have not changed! Total debt (private and government) as a percentage of GDP in the U.S., Europe and the U.K. are at very high levels, thus limiting the options available to governments. Deleveraging in the private sector has only just begun. In spite of the significant deficit spending in the U.S. and Europe, high levels of unemployment prevail in both areas and economic growth continues to be very tepid. In fact, Europe and the U.K. appear to be heading for another recession. The markets are ignoring this as they believe the Fed and the European Central Bank will bail us out - again! Forgotten is the fact that the present Chairman of the Fed, in July 2008, yes July 2008, said that Fannie Mae and Freddie Mac were "adequately capitalized" and "are in no danger of failing". In spite of QE1, QE2 and recently QE3, the economic fundamentals remain weak while stock markets and bond markets are back to near record levels, leading Gary Shilling, one of the Best economists we know, to call this "the grand disconnect". This "disconnect" or gap will be closed by either economic fundamentals rising to meet the financial markets or the markets coming down to meet the fundamentals. We think that the latter is likely and that the Fed has simply postponed the inevitable by its QE1, QE2 and QE3 actions.
Looking at the equity and equity related holdings at the end of the third quarter of 2013 we see that Watsa has not changed his mind:
Finally, I have one major reservation. In some cases, the contrarian strategy costs money. This year, due to keeping Fairfax portfolio hedged against the potential loses the company printed investment loss in the amount of $1,235 million. Hedging costs ($1,409 million) were the main contributor for that.
Prem Watsa is very well known for applying contrarian investment strategies. During the bear market of 2007 - 2009 this strategy proved to be very profitable. When nearly everybody was losing money, Fairfax made a killing. In 2008, during the worst stage of the bear market the company had net gains on investment in the amount of $2,571 million. Now Watsa, again, has a totally different opinion on the economy and the stock market than the majority. While the broad stock market is still going up and nobody sees the end of it, the Fairfax equity portfolio is totally hedged against a possible market decline.
Is Watsa right? Or maybe he is not? Time will tell but I will be keeping my eye on Fairfax very closely.