Canada’s Warren Buffett suffers a setback

Fearing that a post-GFC US would repeat Japan’s recent experience, Prem Watsa hedged his company’s entire listed equities portfolio. It was a mistake. 

Known as ‘Canada’s Warren Buffett’, Prem Watsa, Chief Executive of insurer and investment manager Fairfax Financial Holdings (TSE: FFH) has a fine investment record. Fairfax’s book value per share has compounded by more than 19.4% per year in the 31 years to December 2016.

But it was even better eight years ago, having compounded at 25% per year in the 23 years to December 2008.

Watsa was one of the few who foresaw the GFC and dramatic declines in the world’s stock markets as a result of the speculative excesses and the sub-prime induced housing debacle in the United States.

He entered into equity hedges and derivative investments (in the form of credit default swaps or CDS’s) to protect Fairfax from a market meltdown. However, he was early and had to endure years of losses before being proven correct. But after losing some US$500m from 2003-2006, his vindication was swift: these positions garnered US$4.7bn in gains in 2007 and 2008.

Not so good

Since then, however, things haven’t been so good.

Beginning calendar 2010 with around 30% of Fairfax’s equity investments hedged using short sales on indices and common stocks, Watsa soon increased that to 100%.

He believed that the post-GFC economic fundamentals didn’t support ever rising equity and bond prices. Based on his reading of history, he felt there was a risk that the US would endure years of deleveraging where nominal GDP remained flat for 10 to 20 years with many bouts of deflation. In other words, conditions similar to the United States’ experience after the Great Depression or Japan more recently.

He kept these hedges in place until late calendar 2016.

With the S&P 500 including dividends – I’ve used the main US-based index as Fairfax is based in North America – rising 154% since then, this hasn’t been Watsa’s finest hour, as he readily admits.

Fairfax’s book value per share only compounded by 3.7% in the five years to 2015, before falling 6.4% in 2016.

The world changes

However, the election of Donald Trump ‘changed the world for [Fairfax]’.

With Republicans also controlling Congress, Watsa believes the chances of sensible government policies and, with it, robust economic growth have significantly increased.

Watsa swiftly removed all the company’s index hedges and some of its individual short positions. He also adjusted Fairfax’s bond holdings to be much more short term in nature: maturing in one year on average, this means Fairfax’s bond investments will be much less affected by rising interest rates.

The result of this was that the $4.4bn in cumulative hedge losses since 2010 have almost offset the $2.7bn in gains on stocks and $2.2bn on bonds recorded since then.

Bad mistakes, I’ve made a few

Other than confirming that even the best investors make mistakes, are there lessons here for individual investors?

First and foremost, try to find asymmetric bets: where the downside is minimal and the upside is far greater – and more likely – than the downside. This was the case with Watsa’s CDS bets.

By contrast, his post-GFC equity hedges more or less offset any gains or losses on his common stock portfolio. To be fair, that was his intention: he was trying to protect Fairfax against a 1 in 50 or 100 year financial storm and so was content with just the return of his capital rather than a return on his capital.

To me, though, this again shows that trying to predict macroeconomic variables such as economic growth and the chance of recession, currencies, inflation and interest rates is less useful for individual investors than concentrating on finding cheap stocks.

As colleague John Addis notes, whatever risk the media is currently hyperventilating about, ‘it’s important to remember that holding high-quality stocks purchased at reasonable prices is your best protection against inflation, and every other risk’.

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