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.

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