Fairfax Financial: Predicting Another Major Drop In Stock Prices

| About: Fairfax Financial (FRFHF)

For those who aren't familiar with Fairfax (OTCPK:FRFHF), it is a Canadian company run by Prem Watsa, a man who is frequently referred to as the "Canadian Warren Buffett". Although both Watsa and Buffett practice value investing as taught by Graham and Dodd, they sometimes have very different strategies.

One major difference is the way that they protect their companies from risk. Buffett, through his company Berkshire (NYSE:BRK.A) has always had a solid balance sheet and has always had cash available for a rainy day, but does not appear to be concerned about a drop in stock prices. In fact, he appears to welcome a drop although continuing to buy common stocks such as IBM (which by the way would benefit if stock prices dropped through buybacks). However, Watsa appears to be more concerned than Buffett about a drop in stock prices and has hedged Fairfax's portfolio from a significant drop. Watsa has correctly predicted several crashes including the '87 crash, the Japanese collapse of 1990, the technology stock bubble and the meltdown in 2008 while remaining unnoticed and conservative.

During Fairfax's annual meeting on April 26, 2012, Watsa discussed his reasons for being very concerned about a major drop in stock prices. The major reasons relate to problems in China, Europe, and the US. He mentioned that austerity is all over the place and that when you have deleveraging taking over, you need some other part of the economy to make up for it. In China, he mentioned overbuilding and the bubble in the Chinese real estate market being pricked in October/November 2011 (Real Estate Prices Fall in China). China is a $6-7 trillion economy, so if anything happens to it, it affects commodity demand worldwide. Watsa mentioned that Canada will not be spared if China has a problem and that it will affect the world, which is a reasonable assumption. On a side note, he mentioned that in Toronto and Vancouver, Canada's largest cities, there are also major concerns about the real estate markets and bubbles bursting.

Fairfax's worries about Europe should be well-known by now as Europe has been in the headlines constantly for many months. As for concerns about the US, Watsa spoke about corporate profit margins being high and that many market participants may be extrapolating this into the future, but he cautions that they are a mean-reverting series and believes corporate profit margins are likely to come down significantly, taking stock prices down with them. Many of Fairfax's concerns are outlined in its 2012 Annual Letter to Shareholders.

Deflation, not inflation, is a major concern for Fairfax and appears to be a likely possibility in the near future. Watsa mentioned that despite QE1, QE2, and any other stimulus, the velocity of money is coming down. He related this to Japan in the 90's which had cumulative deflation of about 14%. Japan has had no growth for 20 years in terms of the Nikkei 225 since 1990, but in 1989 nobody would've thought that would happen. Watsa also mentioned the relation to the US in the 1930's and mentioned that unemployment is still high, wage increases are almost non-existent, and global deficits are very high, making deflation, not inflation, more likely. Fairfax is concerned about a significant drop, not 10%, but more like 50%+, in common stock prices and they have positioned their portfolio for the possibility of these risks occurring between the next 1-3 years.

So what can individual investors do to protect themselves from a significant drop in stock prices? One thing is to hold more cash. Another option, and the one that I believe may be a better option, is to hold shares of FRFHF.PK. As Watsa mentioned during the annual meeting in late April 2012, Fairfax is positioning its portfolio to hold about 40% cash, up from 27%. Furthermore, and more importantly, Fairfax has been increasing its holdings of CPI-linked derivatives that benefit if there is cumulative deflation over the next 9 years. He said Fairfax will earn about $2.5 billion if there is deflation or if the market thinks there will be 5% deflation over the next 9 years. I believe that Fairfax will remove these hedges after a 50% drop in common stocks, similar to their CDS that they accumulated from 2003 to 2007 and which they sold in 2008-2009 in order to pick up common stocks after they had dropped. So if and when there is a 50%+ correction in the stock market, it's likely that shares of FRFHF.PK will rise due to their CPI-linked derivatives. This would also provide the individual investor with an opportunity to sell the shares at a profit in order to pick up something else that is then much more undervalued. Alternatively, one could continue to hold the FRFHF.PK shares and watch as their book value continues to grow at their historical long-term growth rate of about 20% per year. There was a great article written last year by a fellow SA author that discusses the CPI-linked derivatives held by Fairfax which can be found here. Although individual investors probably can't buy these derivatives, they can buy shares of FRFHF.PK in order to hedge their portfolios.

Disclosure: I am long OTCPK:FRFHF, BRK.B.

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