Friday, July 29, 2016

Prem Watsa Increases Its Hedge Against Stock Market Slump

Today Fairfax Financial Holdings (FFH:TO) released its 1H 2016 results. It is not my aim to provide a detailed analysis of this insurer but Prem Watsa's (the company's CEO) approach to financial markets and economy in general may be, in my opinion, a good lesson for all investors.

To remind my readers, Prem Watsa is well-known for his contrarian investment approach. For example, for many years his company has been betting on major world deflation.

Apart from that, since around 2011 the Fairfax CEO has been negative on US and Canadian stock markets. Therefore, since 2011 he has been using various hedging strategies to hedge his company against the risk of a major stock market downturn.

The current 1H 2016 report discloses that Mr. Watsa did not change his mind:

Fairfax hedge against a major stock market downturn

The chart below shows Fairfax net equity exposure. It is calculated in the following way:

net equity exposure = long positions in equities less short positions held in equity derivatives

As the chart shows, at the end of June 2016 the net position in equities was short of $969 million. It means that the company's exposure in common stocks, preferred stocks, preferred bonds, investments in associates etc. was totally hedged by short positions held in equity total return swaps, index total return swaps etc. What is more, the total short position held in various derivatives was higher than the company's equity exposure (by $969 million). It means that any stock market slump would be profitable for Fairfax.

Note: in 2Q 2016 Fairfax increased its net short position in equity related issues (from $474 million at the end of 1Q 2016 to $969 million at the end of 2Q 2016).

Summing up - Fairfax is well hedged against any stock market slump. If that is a case and US or Canadian stocks go down, Fairfax will make money (and vice versa - if stocks continue their march up, the company will lose money).

CPI-linked derivatives

It is the biggest Fairfax bet. Prem Watsa believes that in the coming years the developed economies will encounter major deflation. To make money on this economic event a few years ago Fairfax opened a huge position in CPI-linked derivative contracts.

The company writes:

"At June 30, 2016 the company owned $112.4 billion notional amount of CPI-linked derivative contracts with an original cost of $668.2 million, a market value of $227.3 million, and a remaining weighted average life of 6.1 years. The majority of the contracts are based on the underlying United States CPI index (52.8%) or the European Union CPI index (40.2%)"

For the time being Fairfax has lost $440.9 million on that deal (this amount is accounted for as "unrealized losses"). What is more, the results delivered by these instrument are very volatile:

As the chart shows, between 2011 and 2013 Fairfax was booking high losses on CPI-linked derivatives but since 2014 the situation seems to be turning in favor of the company. 

Well, Mr. Watsa is a long-term player so during the next 6.1 years many things may happen.

Finally, one question. I wonder why Mr. Watsa has no position in gold?
Any suggestions?

Last but not least - Fairfax share prices action:


It looks like Fairfax is an excellent long-term play. No matter whether US stocks go up or down (look at red lines) - Fairfax slowly goes up.

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