Monday, April 29, 2013

Xbox 720 - IllumiRoom

The latest out of Microsoft Research.  Many believe this to be part of the new Xbox, rumoured to be called Xbox 720.  This might be one of the coolest things I have ever seen. The possibilities are endless. 

Best Regards,

Disclosure: Long MSFT

Sunday, April 21, 2013

Fairfax Shareholder Letter Part 2: Get Defensive

As mentioned in the previous post, Fairfax has positioned themselves very defensively.  Why you might ask?  Here are some quotes for you to chew on. 

Deleveraging in the private sector has only just begun.

In our 2010 and 2011 Annual Reports, we discussed the Chinese bubble in real estate.  This past Sunday (March 3, 2013), the CBS show "60 Minutes" did a segment on the Chinese residential real estate bubble.  They showed vast empty cities with "new towers with no residents, desolate condos and vacant subdivisions uninhabited for miles and miles, and  miles and miles of empty apartments."  They called it the biggest housing bubble in history.  We agree!  The ultimate collapse of this bubble will have major consequences fro the world economy. the "risk on" trade prevails everywhere, with investors reaching for yield in corporate bonds, high yield bonds and even emerging market debt... For example, Bolivia's recent $500 million 10 year bond, issued at 4-7/8% was 9 times over subscribed even though Bolivia has not issued a bond in 90 years!!  Poland did even better, issuing a 10 year bond at 3-3/4%. 

We continue to be be early - and bearish!

While commodities prices have yet to collapse (i.e. complete the down cycle)...

As we also said last year, if commodity prices come down after their parabolic increase, Canada will not be spared.  Also, Canadian house prices have gone up significantly, driven by lax policies at CMHC (Canada's equivalent to Fannie Mae and Freddie Mac).  Canadians have accessed their wealth through lines of credit easily available from the Canadian banks.  This has begun to reverse and we are watching from the sidelines. 

In 2012, Fairfax shorted the S&P/TSX 60 index to the tune of $206.1 million (notional amount) at an index value of 641.12 (as of Apr 19th, the index stood at 673.33).

We currently have 31% in cash and cash equivalents - earning us very little money. 

We did remind you last year but here it is again - cumulative deflation in Japan in the past 10 years and int he U.S. in the 1930s was approximately 14%!!  It is amazing to note that including 2012, Japan has suffered deflation in 17 of the last 18 years - beginning about 5 years after the Nikkei Index and real estate values peaked. 

In the last three years, we have had significant unrealized losses from our hedging program and from our CPI-linked derivative contracts... ($1.86 billion)

These losses are significant but we consider them unrealized and expect both of them to reverse when the "grand disconnect" disappears - perhaps sooner than you think! 

This is what I love most about Fairfax, they are very rational, stubborn and stick to their principles. 

Your company is focused on protecting you on the downside of permanent capital loss from the many potential unintended consequences that abound in the world economy. 

Bond Portfolio

The company's fixed income portfolio totals $11.4 billion dollars.  The vast majority is investment grade bonds and 68.1% is rated AA or better.  What is interesting is the comments in the annual report on U.S. state and municipal bonds.  The company owns $4 billion worth of bonds insured by Berkshire Hathaway Assurance Corp in the event of a default.  This makes the credit risk associated with 35% of the fixed income portfolio bullet proof. 

Why Defensive?

So why is Fairfax so defensive?  First they don't see the financial crisis of 2008/2009 as something that has totally corrected itself.  To answer that you have to look at what caused the financial crisis itself, namely excess debt or leverage.  While deleveraging has occurred in the private sector, the public sector has levered up.  Total debt in the system, as highlighted again the the Fairfax annual meeting, is still very high. 

Why does leverage hurt growth?  To understand leverage it is best to be understood in the context of an individual, lets call him Joe.  Lets say Joe earns a decent wage but spends all of his income and has no debt.  Then lets say Joe wants to make a bigger purchase, which is greater than his income.  He has two choices, he can either save or borrow the money.  If he saves the money he will have to under consume now in order to make his purchase in the future.  This is often the most rational approach. 

On the other hand, Joe can borrow the money.  In this case he consumes today and under consumes in the future (until the debt is payed off).  It is important to note that he has to under consume to a greater degree in this case because he not only has to repay the principle but also the interest.  If the money is borrowed on a credit card the under consumption require in the future is huge due to high interest rates. 

Now if Joe and his friends all play the same game of consume today and pay tomorrow, growth is great in the short term.  However in the long term, the economic output of a country will be artificially high because aggregate consumption today higher than it would normally be without the excessive borrowing.  This is also the reason why deflation is likely to occur as demand collapses, along with prices. 

This has been going on for years in Canada, the US and almost every western country.  However in 2008, the private sector has started to reduce debt levels in almost every country, except Canada.  Here we kept on piling on the debt.  Canada has had relative strong economic growth driven by the parabolic rise in commodity prices.

In Canada, the average household is levered to to the tune of 165% of annual income (see graph below) and is becoming heavily burdened by the debt load.  So long as you can continually add more debt you can continue to consume at a relatively high level, but make no mistake you cannot defy economic gravity.  Today many are content to pay interest in perpetuity for past economic gluttony (over consumption).  In the US the consumer had reduced debt levels but the public sector has levered up (along with quantitative easing) the consumption level has held up relatively well. 

So what difference does this make?  If commodities fall, as I expect, Canada will go through a rough process of unwinding these excesses.  If the last jobs report is any indication... the loss of 55,000 jobs that took economist by surprise, we may be in for some turbulent times here in Canada.  Secondly, the Canadian housing market is starting to turn over.  I have read reports of home being purchased in Vancouver with HELOCs so the owners can make interest only payments, can anyone say subprime?  To read more about the good, the bad, and the ugly on real estate and the Canadian economy, I suggest reading this article


For those with significant equity exposure in Canada, particularly banking, you may be at significant risk.  The same goes for those holding Canadian equity mutual funds in RRSPs, TFSA's, etc.  Every Canadian equity mutual fund has huge exposure to Canadian banking, thus housing and consumer credit.  A soft landing for Canada is not likely in the cards.  Now there are ways to protect yourself and perhaps profit from this mess, so buyer beware. 

Owning Fairfax common stock is a wonderful way to protect yourself from the potential issues in the market today.  They are short a number of key markets and have huge deflation protection.  If commodity prices collapse due to issues in China, the US and Canada their deflation protection will be worth billions.  Given that the stock sells for around book value it isn't even expensive.  I can also say that having read their annual report, I can say they are also very conservative in their accounting.  Just compare their assumed returns for pension assets to other companies for an example. 

Last year Fairfax earned 6.5% on equity, a surprisingly strong result given their equity portfolio was 100% hedged.  Look for it to explode if commodity prices or equity markets fall.  If neither happen and the economy muddles along, expect similar mid single digit returns on equity.  So downside is near zero, and the upside is huge.  As I said in Fairfax Shareholder Letter Part 1, it is imperative and prudent to always obsess over the downside

Good Decisions,

Kevin Graham

Disclosure: Long FFH.

Saturday, April 13, 2013

Fairfax Shareholder Letter Part 1: Buy BlackBerry

After reading the 2012 Annual Letter to shareholders of Fairfax Financial Holding, I thought I should post their interesting and different perspective on the markets.  In short, everyone today seems to be accepting an out sized amount of risk today because of quantitative easing.  Prem Watsa (CEO of Fairfax) is having none of it and is very defensive. 

I want to use this post, and the following one, to highlight my highlights of the Fairfax Annual Letter to shareholders.  As I have said before, too many people focus on the upside when investing while value investors fret over the downside.  Anyone who has invested long enough knows that you don't have to have very large gains in your portfolio, so long as you don't suffer huge losses. 

One bad year, say a loss of 33%, means that you have lost 1/3rd of your capital and have to now earn 50% on the remaining capital just to get back to where you started.  Thus it is imperative and prudent to always obsess over the downside.  Ben Graham, the father of value investing, in his book the intelligent investor said, "Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY." (Chp. 20, emphasis mine)

With that introduction in mind let's look at Prem Watsa's Annual Letter.  I will put each quote in italics and bold and my comments will follow.  This will break up this post into two parts just so it's not so too long. 

"OdysseyRE is the jewel in the crown, accounting for almost half our business and producing an average accident year combined ratio in the last ten years (since 2003) of 92.8%."

This truly is an outstanding business and I wish they owned more.  To be honest and rational, the only other really strong business is Fairfax Asia that has a 10 year average combined ratio of 71.8% and a 26.5% compounded annual rate of growth in book value (2002-2012).  However the only problem is Fairfax Asia is writes 1/7th the amount of premiums.  That said, if Fairfax Asia keeps growing at a decent clip, it may well be the crown jewel someday.  The emerging markets have years of strong growth ahead as Prem went on later to say, "All of these (emerging) markets are growing rapidly because of the low penetration of insurance."

The only other problem is their "crown jewels" often compensate for some of less valuable insurance companies that have been running terrible combined ratios over the part couple years.  As I like to say, less is often more.  That said, unless the business is consuming capital there is little reason to sell it. 

"In 2012, we earned a total investment return of only 4.5%...mainly because of our 100% hedge of our common stock portfolio."

Given the hedges this is not a bad result, especially since the downside protection is so high.

"Markets fluctuate - and often in extreme directions... (Discussing his investment in BlackBerry) At it's low of $6-1/2 per share, it sold at 1/3rd of book value and a little above cash per share (it had no debt).  The stock price declined 95% from it's high!"

Mr Watsa then goes on to discuss his rational for the investment in BlackBerry (BB).

"The brand name, a security system second to none, a distribution network across 650 telecom carriers worldwide, a 79 million subscriber base, enterprise customers accounting for 90% of the Fortune 500, almost exclusive usage by governments in Canada, the U.S. and the U.K., a huge original patent portfolio, an outstanding new operating system developed by QNX and $2.9 billion in cash with no debt, are all formidable strengths as BlackBerry makes its comeback!"

While those are all interesting facts, what came next is even more interesting and is the missing link to the Blackberry investment.

"And please note, 1.8 billion cell phones are sold worldwide annually, and of the 6 billion cell phones in the world, only 1 billion are smart phones.  Lots of opportunity for Canada's greatest technology company!"

Boy, he just had to throw that in there... What does it mean?  Well, here is the logic as I see it. 

1) BlackBerry currently has 76 million subscribers worldwide as per their latest earnings, so BlackBerry has a little more than 7-1/2% market share of all smartphones in the world. 

2) The growth of the smartphone market is still in it's infancy since only 16% of worldwide cell phones are smartphones. 

3) Over time, a large percentage of cell phones will be upgraded to a smartphone.  Let's say over the next decade the smartphone market grows from 1 billion to 4 billion (2/3 of total cell phones).

4) If, and I say if, BlackBerry simply retains it's market share in smartphones... How many subscribers will it have?  The answer is over 300 million or over 4 times it's current subscriber base. 

Of course you can make your own assumptions and of course be conservative (everyone else is), but you easily see they have room for a lot of growth.  Even if their market share shrinks, they can still grow their business. 

Now for the ironic news of the day... Guess who has higher gross margins, Apple or BlackBerry?  That right, Blackberry's gross margin was 40.1% in Q1, while Apple's was 38.6%. 

That said Blackberry still has some room to go on the cost side.  If we keep working our way through the income statement for Q1 2013, Blackberry spent $383 million on R&D (14.3% of sales) while Apple spent $1010 million on R&D (1.9% of sales).  Next if we look at Selling, General and Administrative costs, Blackberry spent $523 million (19.5% of sales) verses Apple's $2,840 million (5.2% of sales). 

At the end of the day, the operating margin was 31.6% at Apple in Q1 compared to Blackberry's 6.3%.  Clearly Blackberry has a huge amount of opportunity, especially on the SG&A side.  They just have to work harder, grow market share and their operating margin will increase. 

To be honest about his analysis, I find it amazing how much the market hates Apple stock at this time.  Both Apple and Blackberry have solid businesses is a very fast growing segment of the world economy.  Both companies seem to be selling at distressed prices today given the above facts.  I wonder if Prem and his team shouldn't consider both investments especially given the theme of growth in the smartphone market. 

Stay tuned for part two... (Click Here for Part 2: Get Defensive)

Best Regards,
Kevin Graham

Disclosure: Long FFH.


Tuesday, April 2, 2013

Wells Fargo Annual Report

"In 2012, we grew revenue 6 percent to $86.1 billion, mostly from noninterest income. (Imagine our earnings power when a more normal rate environment returns.) The revenue growth included double-digit growth in our capital markets, commercial real estate, corporate banking, mortgage, asset-based lending, corporate trust, and international businesses." - John Stumpf - 2012 Wells Fargo Annual Report

John Stumpf is an amazing CEO and runs a tremendously profitable company in Wells Fargo (WFC).  I too can only imagine the earnings power when a more normal interest rate environment returns.  Wells Fargo will be an earnings dynamo. 

It was just over two years ago when I woke up and realize what a ridiculously cheap price Wells Fargo was selling at.  Since then I have averaged 16.5% annually plus dividends in a sub optimal economy.  Bring on the good times.  I fully expect the dividend on my original cost to yield over 8% within two years as the economy normalizes and earnings per share reaches $4 in 2014.

I find it remarkable how nobody is interested in a boring, yet high quality bank like WFC.  Meanwhile Warren Buffett is quitely buying 1.2 billion dollars worth of their stock in 2011 and 1.8 billion dollars worth in 2012.  I have been beating the drum on them for the past two years too.  During that time frame, the earnings per share has risen 23.5% annually.  I also believe that an investor today will also realize a benefit from the low relative valuation, not just earnings growth.  Growth and value are joined at the hip.   

Best Regards,
Kevin Graham

Disclosure: Long WFC

Bank of America Annual Report

"While we are not yet where we want to be, our results reflect the underlying strength and earnings potential of the company that I believe will become even more apparent this year."  - Brian Moynihan - 2012 Bank of America Annual Report

I sure hope so Brian. 

Bank of America seems poised to greatly increase profits this year as their litigation issues are really getting behind them.  If the $8.5 billion BNY Mellon (as Trustee) settlement gets approved this summer, there will be only small pieces of litigation remaining.  Please note the funds for that settlement has already been reserved. 

The Legacy Asset Servicing (LAS) division will be mostly wound down at by the end of this year.  If I remember correctly, the company started with over 6 million delinquent mortgages in LAS and began this year with only 2.5 million remaining.  They have already sold off a large portion of those mortgages and will work though countless more this year.  By year end the company estimates they will have only 750 thousand remaining.  In other words they will be close to 90% through all of the "bad" legacy assets by year end. 

I fully expected the stock to run up after the announcement of the Federal Reserve Stress Tests announced a few weeks ago.  The good new is it hasn't and the company has just began buying back up to $5 billion worth of it's common stock.  The lower the stock price the better for those holding the stock long term.  The warrants I hold are long term and I fully intend on holding them for the long term.  The company is also buying back $5 billion of high yielding preferred securities.  Interest alone on those preferred shares equal around half a billion dollars a year. 

With every passing day the company gets more and more of its legacy issues behind them.  The earnings capability will begin to shine through once the costs come down.  I fully expect earnings this year and next to surprise many people. 

Best Regards,
Kevin Graham

Disclosure: Long BAC class A warrants.