Sunday, March 13, 2016

Fairfax Financial Holdings Ltd - Prem Watsa Still Sees Substantial Risks

Fairfax Financial Holdings Ltd is a Canadian insurance company. It is run by Prem Watsa, who, due to its investment style,  is regarded as the Canadian Warren Buffett. In this article I am dealing with Watsa's investment policy - apart from his spectacular investments (as, for example, Blackberry), Mr. Watsa also applies an aggressive hedging strategy. 

Investment results

Let me start from an excerpt from Fairfax summary of 2015 results (page 2):

The statement above shows Fairfax investment results and gains / losses made on the company's hedges.  It is clear that in 2015 the company made a net loss of $259.2 on its investment portfolio. This loss was a combined result of:
  • $425.0 million: loss on equities (mainly due to a drop in share prices)
  • $501.8 million: profit on hedges
  • $468.7: loss on bonds (mainly due to a drop in bond prices)
  • $35.7 million: profit on CPI-linked derivatives
  • $97 million: profit made mainly on foreign currency
Of these issues, the most interesting are the first two and CPI-linked derivatives. These issues are classics of Watsa's investment style.

Equity portfolio

In 2015 a majority of world's equity indices were flat of slightly below the 2014 levels. As a result, Fairfax equity portfolio fell in value (a loss of $425 million). However, the hedges, applied by Fairfax, were highly profitable - the company made $501.8 million. As a result, Fairfax made a profit of $76.8 million on its equity portfolio. 

The charts below show the results generated by the equity portfolio and financial hedges. Finally, the third chart shows the overall results, starting from 2009:

Financial exposure

Another thing, at the end of 2015 Fairfax was holding a small long position in equities (equities plus hedges). The company had $6.7 billion in equities but this large position was hedged by a mix of financial hedges of notional value of $5.9 billion. Hence I can say that Fairfax net position in equities was long of $0.8 billion. 

It is quite interesting to see Fairfax equity position in historical context:

As the chart shows, at the end of  2009 Prem Watsa was very optimistic on world's stock markets - his company was holding a large long position in equities and had no hedges. 

However, in 2011 Mr. Watsa changed his mind and between 2011 and 2013 Fairfax equity portfolio was nearly perfectly hedged against the stock market fall. At the end of 2014 and 2015 Fairfax was once again net long - but its exposure to the stock market risk was relatively low.

CPI-linked derivatives

Does it mean that Prem Watsa is optimistic on the world economy? Nothing could be further from the truth. Before the last financial crisis Prem Watsa made a huge bet on a major stock market and U.S. residential mortgage-backed securities breakdown. 
This time, since 2010, Fairfax has been betting on a world deflation. The company bets a vast amount of money on that theme:

As the chart shows, at the end of 2015 Fairfax was holding a $100 billion bet on the world's deflation (yes, there is no mistake - $100 billion US dollars!). 

How does this bet work? Let me cite Mr. Watsa:

“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!”

Is it a risky bet? Well, the company risks only the money spent on entering this bet, i.e. around $656 million. I think it is huge amount of money but Fairfax is going to easily survive even if all this money is lost.  

On the other hand, if Mr. Watsa is right, Fairfax can make a killing. Let me cite Watsa again:

“If, for instance, the index is at 95 because of a cumulative 5% deflation over 6.7 years (the average life of derivative contracts), the contracts at expiry would be worth 5% of their notional value”

And the notional value is around $109 billion - please look at an excerpt below:

Next thing - although the average life of CPI-linked derivatives is 6.6 years (please, look at an excerpt above), it seems that the bet is starting to work for the company. After three years of losses (2011 - 2013), in 2014 and 2015 Fairfax made a profit of $17.7 million and $35.7 on CPI-linked derivatives, respectively:


Fairfax is still betting on a downturn in the world's economy. Although the company is more or less neutral as its equity portfolio is concerned, it bets a huge amount of money on the world's deflation. 


1 comment:

  1. Holy mackeral, SD!

    Friday night and your compulsive reader is drinking wine and scrolling through your past posts looking for what you've written about sierra metals and came upon this one and am astonished! wasn't expecting this! I'm a longstanding shh of FFH and a huge fan of Prem. Was at the FFH AGM again this year (cdn version of pilgrimage to Buffett's Omaha extravaganza.) Prem talked at length about those hedges. But, get this: for first time ever, I phoned FFH head office earlier this week and followed up with an email in response to a solicitation of Prem's at the AGM! scrolling through a mining sector blog and come across this post!!