Fairfax Financial: An Intelligent Hedge Against Deflation

| About: Fairfax Financial (FRFHF)

I’m from Canada and we have an investor up here who gets a lot of attention. I’m sure you have heard of him but not likely as much as you should have. His name is Prem Watsa and he has an investing track record over the past 25 years that would rival almost anyone.

His team has the following annualized returns from equities (with hedging):

  • Past 5 Years – 14.2%

  • S&P 5 Years – 2.3%

  • Past 10 Years – 17.9%

  • S&P 10 Years – 1.4%

  • Past 15 Years – 17.2%

  • S&P 15 Years – 6.8%

And they aren’t half bad bond investors either:

  • Past 5 Years – 12.6%

  • Merril Lynch Corp Bond Index 5 Years – 5.9%

  • Past 10 Years – 11.9%

  • Merril Lynch Corp Bond Index 10 Years – 6.3%

  • Past 15 Years – 10.0%

  • Merril Lynch Corp Bond Index 15 Years – 6.2%

The vehicle that Watsa invests through of course is his insurance company Fairfax Financial (OTCPK:FRFHF). And while I think Watsa is a more-than-great investor, I’m not as enamored of his insurance business. Fairfax was actually in dire straits in the years leading up to the credit crisis because of acquisitions gone bad. Insurance acquisitions made by Fairfax, where loss reserves were severely understated, had put the company in a precarious financial position. The firm was at the point where one bad year of catastrophe losses could have finished it.

Strangely it was the credit crisis and the investing acumen of the Fairfax team that saved the team from those poor acquisitions. Watsa and group saw the housing bubble forming, they saw it early and they made the right bets to profit from it. The following is from the Fairfax 2004 letter to shareholders:

Given the high stock valuation levels, low treasury yields, unattractive credit spreads and continued risks that we have discussed in previous Annual Reports (a possible run on mutual funds, bonds collateralized with consumer debt, unfunded pension liabilities and the huge increase in the use of derivatives), we have almost half of our investment portfolio in cash and short term investments and the majority of our bond portfolio in government bonds.

We have no exposure to asset-backed securities, including mortgage-backed securities, and our common stock holdings, including our strategic investments, amount to only 13% of the portfolio.

The unprecedented conservatism in our portfolio reflects the uncertain times that we live in and also positions us to take advantage of attractive investment opportunities.

We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds) eliminates the incentive for the originator of the loan to be credit sensitive.

Take the case of an automobile dealer. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard). And here’s the rub! These asset-backed bonds are rated based on their historical loss experience record which will likely be very different in the future – particularly if we experience difficult economic times. Also, in the main, these asset backed bonds are a creation of the 1990s, a period when the U.S. experienced one of the longest economic expansions in its history, followed by one of the shortest recessions.

This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S. (excluding first mortgage-backed bonds). At the end of 2002, more than 65% of these bonds were rated A or above. In fact, as of December 31, 2002, there were more than 2,500 asset-backed issues rated AAA – significantly more than the 13 U.S. corporate issuers currently rated as AAA.

Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Unlike active companies, the vehicles issuing these bonds have no management organization and are dependent on the goodwill of the originating company. I can go on and on. Suffice it to say that the principals at Hamblin Watsa are quite concerned about the inherent risks in these types of bonds.

I think it is incredibly fascinating to go back in time and read the above excerpt from a 2004 letter. If you have read the books from Michael Lewis and others about those who made a fortune from the housing collapse (John Paulson, Michael Burry etc.) you can see that Watsa was right beside Burry as being among the first in spotting the problems. I’m not sure why Prem didn’t make it into these books.

And much like Burry, Watsa made his bets through credit default swaps. For several years he carried CDS positions against the financial institutions most likely to fail because of a housing collapse.

Here is an excerpt from the 2007 annual Fairfax letter which was written in early 2008. So you know things only got more interesting from here.

The headline story for 2007 was our credit default swap (“CDS”) position that we purchased in the past few years. You will remember these are five year swaps (in the main) which, on a mark to-market basis, were down 75% at the end of 2006. We swallowed hard and purchased some more in early 2007. As of June 30, 2007, we had a cost of approximately $341 million for our $18.0 billion notional position which was worth $198 million at market.

And then in July and August of 2007, markets changed! The market value of our CDS position exploded to $546 million at the end of September and, including $199 million in realized proceeds, to $1.3 billion at the end of December 2007 as the credit concerns that we have been writing about for the last few years became reality. After December 31, 2007, the market value of our CDS position increased further and as of February 15, 2008, including cumulative realized proceeds of $850 million, was $2.1 billion.

This is an insurer who essentially doubled its book value over the course of a couple of years because of one great investment that did not involve risking a very large amount of capital. It really is amazing that Prem and Fairfax didn’t get more accolades for this incredible investment.

And not only did Watsa make his CDS bet, but also had a huge position in U.S. Treasuries and a completely hedged equity portfolio that allowed him to make some major investments and acquisitions when the markets tanked.

I think most everyone would agree that given the incredible equity investing track record, the incredible bond investing track record and the incredible macro call on the housing market that Watsa is someone we should pay attention to.

And right now Watsa is singing a tune that is a little different than most others. His big concern is a long term deleveraging of the global economies and the United States and other regions entering a period of deflation like that faced by Japan in the 90s (and still is, really).

But rather than take it from me, have a read of what Watsa is saying now in the 2010 annual letter:

2010 was a disappointing year for HWIC’s investment results because of the two factors mentioned earlier. Hedging our common stock investment portfolio cost us $936.6 million or $45.61 per share in 2010. Our hedging program masked the excellent common stock returns we earned in 2010, of which a significant amount was realized ($522.1 million).

We began 2010 with about 30% of our common stock hedged. In May and June we decided to increase our hedge to approximately 100%. Our view was twofold: our capital had benefitted greatly from our common stock portfolio and we wanted to protect our gains, and we worried about the unintended consequences of too much debt in the system – worldwide!

If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today. However, we worry, as we have mentioned to you many times in the past, that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GNP remains flat for 10 to 20 years with many bouts of deflation. We see many problems in Europe as country after country reduces government spending and increases taxes to help reduce fiscal deficits. We see the U.S. government embarking on a similar exercise (as it has no other option) and all this while businesses and individuals are deleveraging from their huge debts incurred prior to 2008.

Meanwhile we have concerns over potential bubbles in emerging markets. Consider, for instance, what we learned on a recent trip to China: M any house (apartment) prices in Beijing and Shanghai had gone up almost four times – in the past four to five years!; many individuals own multiple apartments as investments with the certain belief that real estate prices can only go up; and maids are taking holidays so that they can buy apartments also. “Buy two and sell one after it doubles to get one for free” goes the refrain!

In his essay in Vanity Fair, “When Irish Eyes Are Crying”, Michael Lewis says, “Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.”

We agree!!

Infrastructure and construction spending in China accounts for more than 40% of GDP – a number rarely seen in the past in any economy. In fact, this demand has resulted in commodity prices going up in a parabolic curve. Combine the increase in commodity prices, substantially from Chinese demand, with hedge funds and others again trying to allocate money to these very illiquid markets, and you can understand why some of these commodities have exploded in price.

Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!”

And Watsa isn’t just hedging his equity portfolio, he also has put a little bet on deflation that could produce some big rewards if it pans out. It is very much like the CDS bets Fairfax had made ahead of 2008 panic in that the bet requires a relatively small capital investment to obtain huge notional exposure. Here is his explanation:

You know our concern re deflation. Well, Brian Bradstreet of CDS fame came up with a similar idea called CPI-linked derivative contracts. These are ten-year contracts (with major banks as counterparties) that are linked to the consumer price index of a country or region.

Say the consumer price index in the U.S. was 100 when we purchased this contract. In ten years’ time, if the CPI index is above 100 because of cumulative inflation, then our contract is worthless. On the other hand, if the index is below 100 because of cumulative deflation, then the contract will have value based on how much deflation we have had. If, for instance, the index is at 95 because of a cumulative 5% deflation over 10 years, the contract at expiry would be worth 5% of the notional value of the contract.

That’s how it works! Of course, these CPI-linked derivative contracts, like the CDS contracts previously, are traded daily among investment dealers. Prices in these markets will likely be higher or lower than the underlying intrinsic value of these contracts based on demand at the time. So there is no way to say what these contracts will be worth at any time.

However, for a small amount of money we feel we have significantly protected our company from the unintended and insidious consequences of deflation. As an aside, cumulative deflation in Japan in the past ten years and in the United States in the 1930s was approximately 14%.

We have invested $302.3million in these contracts and at year-end they had a market value of $328.6million – if you could sell them!! The remaining average term on these contracts is approximately 9.4 years.”

The notional amount of these contracts by the way is $34.2 billion, which I think would make the Fairfax positions potentially worth about $5 billion (on a $300 million bet) - should the United States have a decade like Japan with 14% cumulative deflation. Why in the world someone would take the other side of a bet like this with Watsa is beyond me.

At $357 per share now, Fairfax is actually trading under book value of $379 per share. So despite the incredible run the company has had over 25 years the valuation is actually quite attractive if not a real bargain.

With no net equity exposure, $1.5 billion in cash at the parent company and a highly leveraged bet on deflation, Fairfax could make a very intelligent hedge for your portfolio should this stock market run and economic recovery take a turn for the worse.

And if the recovery and bull market in equities continue Fairfax will do ok with its bond portfolio and insurance operations, it just won’t be a homerun.

That is the kind of bet you should take every time. Heads (deflation and stock market declines) you win big, tails (no deflation and long bull market) you don’t lose much.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.