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.
With that in mind it is worth knowing what Watsa sees coming today, as again it isn’t pretty. Below are my notes from the last quarterly Fairfax Conference call which provides Watsa’s outlook on the economy, equity markets and the insurance cycle as well as where Fairfax is today.
Please note that anything in italics is Watsa speaking on the call.
Balance Sheet Positioned for Difficult Times
The investment record of Watsa and his associates has long been exemplary. Their performance with respect to acquiring insurance companies however is not quite as good. Half a decade ago this was a company teetering on the edge, weakened by unexpected losses from prior underwriting exposure created inside of companies that Fairfax acquired.
Equity issuances at painful share price levels, fortuitously light major catastrophe years and brilliant investment gains bailed Fairfax out of their precarious spot. Not wanting to ever put Fairfax in jeopardy again Watsa has now created a rock solid balance sheet. The conference call presents us with a company positioned to handle whatever situation is presented:
The company held $1.14 billion of cash, short-term investments and marketable securities at the holding company level, approximately $1.11 billion net of the short sale and derivative obligations. Now this is all at June 30, 2011. Finally, we continue to be approximately 86% hedged in relationship to our equity and equity-related securities, which includes convertible bonds and convertible preferred stock.
Loaded with cash and virtually no net exposure to the equity markets. Fairfax is a company positioned to thrive in a major stock market sell-off with cash and hedges ready to both exploit opportunities and profit. Clearly Watsa and his colleagues are cautiously positioned.
Insurance and Investing Similarities – Both Require Extreme Patience
The insurance business is a patient man’s game. You have to be willing to step away when insurance premium pricing in the market is not sufficient to cover the risks being assumed. It is a business that should be perfectly suited to a master investor like Watsa or Buffett as patience is also the number one requirement for investment success. Watsa provides us his opinion of where the insurance market is in terms of pricing and what Fairfax is doing:
It's like everything else associated with markets. You have to be ready. You have to be patient. You can't write when the markets are not appropriate in soft markets, and then you got to wait. And we are patient. We've been in business for 25 years. We've seen the cycles. And so obviously you just wait. And when the opportunity comes, we'll react. We won't until the opportunity is in front of us. And it's the same in the financial markets, Tom. You remember in 2006, in 2007, we were very patient. We had government bonds. We had our stock positions hedged in 2008, completely hedged. But when the markets went down 50% -- hedges up, we bought a lot of common stock. And when the spreads widened dramatically at the end of 2008 and early 2009, we reacted, but you had to be patient. You have to have government bonds. You have to have hedged your stock positions to take advantage of that opportunity. And the Insurance business are very similar. So we are, all of our presidents are being very careful and focused on underwriting, and waiting for that right time when the markets have changed and the opportunity’s in front of us.
It is interesting that Watsa sees both the insurance market and the stock market as places where today there isn’t much worth doing. Fairfax is virtually fully hedged against stock market declines and is not bullish on current insurance pricing either.
Another Derivative Trade Aimed at Profiting Through Difficult Times
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.
Five years ago Fairfax owned Credit Default Swaps on an assortment of financial institutions such as AIG that cost little up front but ultimately paid off huge. The Credit Default Swaps were essentially insurance for bondholders that paid if the company underlying the bonds had financial distress. Fairfax, however, didn’t own the bonds, they just owned the Swaps. Fairfax bought these Credit Default Swaps at minimal cost before anyone else saw disaster looming and sold them at many multiples of their investment as panic ensued. Fairfax made billions. This time around Fairfax has made a similar derivative bet, this time on deflation. Fairfax has paid $428 million for Consumer Price Index derivatives that provide notional exposure of almost $50 billion. Here is an explanation from Watsa as to how these work from the 2010 Annual Report:
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%.
I think I understand this from Watsa’s explanation. If the United States experiences the 14% deflation over the next 10 years that Japan has in the past 10 years these derivatives which cost Fairfax $428 million would be worth 14% x $50 billion = $7 billion. Fairfax would essentially double the equity value of the entire company at a time when others would be floundering.
Can An Investor Afford to Ignore Watsa’s Deflationary Warning ?
It is hard to know what to do with the information that Watsa presents on looming deflation. Clearly he has a huge amount of credibility given how he positioned his company to take advantage of the housing bubble. And it isn’t like Watsa and his team got a hot tip in 2007 to buy Credit Default Swaps. They were already working on how to profit from the housing bubble collapse as early as 2003.
Perhaps a simple thing to do to hedge your portfolio is to have a decent sized position in Fairfax so that you have something positioned to thrive if the dirty thirties are ready for a comeback. With Fairfax trading just slightly over book value it would likely be a pretty solid investment even if deflation does not appear.
Fairfax is sitting on over a billion dollars in cash which makes it rock solid and opportunistic. The vast majority of its $24 billion investment portfolio resides in US Treasuries which will appreciate in value amidst any market turmoil.
This is a company that will do at the very worst ok in all situations and will thrive if then next decade is a tough one.
When considering how much attention to pay to Watsa’s deflation warning, compare the following excerpt from his 2004 letter to shareholders below with what actually transpired in 2008 and 2009. Watsa was four years early and exactly right on his warning:
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.