Thursday, January 29, 2015

Watsa's Massive Bet

All this talk of deflate-gate got me thinking about another kind of deflation.  No, Prem Watsa (Chairman and CEO of Fairfax Financial Holdings (FRFHF)) doesn't have a put option on air pressures of footballs, but he does have a massive bet on global deflation.  It's scary how big the bet has become.

Check this out, from the 2013 letter to shareholders: 


When Watsa first put on this trade, he had $34.2 billion in notional amount on.  As of the end of 2013, there was $82.9 billion.  Now, the initial reference point was that the ten-year cumulative deflation both during the depression in the 1930's in the U.S. and recently in Japan was around 14%.  This means that the possible gain if we see similar deflation around the world can be $11.6 billion!

FRFHF's common equity was $7.2 billion as of the end of 2013, just to give you an idea how big this trade is.  

This is the breakdown by region:

And this is the cumulative loss-to-date from the deflation trade:

Hold on to your chair and look at this table from the 3Q 2014 report:

The notional amount outstanding has increased from $82.9 billion to $108 billion.   That is just staggering.

So let's see how this increase since 2010 compares to FRFHF's common equity:

                                     2010                           3Q2014
Common equity            $7.8 billion                   $8.6 billion
Notional amount         $34.2 billion               $108.0 billion
Potential gain                $4.8 billion                 $15.1 billion
   % of equity                 62%                          175%
Potential loss               $302 million               $639 million
   % of equity                 3.9%                          7.4%

The notional amount looks huge at almost 13x common equity, but since these are basically put options, only the premium paid up front is at risk.

I calculated the potential gain using 14%, which might be aggressive.   The true risk here is that deflation doesn't happen and the puts expire worthless.  In that worst case scenario, FRFHF would lose 7.4% of their common equity; not a disaster.

Remember, too, that these options have an initial period of ten years. As of the end of 2013, the remaining term on the contracts was 7.5 years, so the potential loss actually amounts to something like 1% of common equity per year.   Not a big gamble at all.

How Do Banks Hedge This Thing? 
The corollary to how interesting this trade is to FRFHF is how much of a pain it must be for the banks on the other side.  If we get into a deflationary spiral, banks can end up owing a lot of money to FRFHF.  How do they go about hedging this thing?  I know that CPI futures were planned for listing on the Chicago Mercantile Exchange (CME), but that didn't happen.  Treasury TIPs can be used to hedge, I suppose.

Big banks would also seek out counterparties to take the other side.  There must be plenty of entities wishing to hedge against inflation.   Being short puts won't help against high inflation, though, as they don't make any more than the premium initially received.

Deflation Coming?
In any case, this is very interesting and I've always seen deflation as the higher risk than inflation (again, because of my observation of Japan over the years).

For deflationists, the recent ECB decision to start massive quantitative easing may have been the final hurdle to get over.  If this doesn't stop the deflationary (or at least disinflationary) pressure, then things can get pretty interesting.  

In any case, this is an interesting situation.  This can be the trade of the century if we dip into deflation; the ultimate limited risk (don't lose much if wrong)/ high return (huge gains if right) trade.






28 comments:

  1. Hi Brooklyn, great post.

    Any idea how small Fund/investor could buy into this bet ? I guess they r all OTC made only for the large players

    ReplyDelete
    Replies
    1. Yes, I think it's all OTC. I don't know of any way for retail investors (or even small professional funds) to put on this trade.

      Delete
    2. short tips and buy tsys, you could short TIP and buy IEF

      Delete
  2. Love the blog, and excited for my first chance to (maybe) contribute some useful insights? While it's not a perfect "hedge" for the writers, I have seen a resurgence recently of CPI-linked floaters recently.

    Most have a 0% floor (so they just become free capital rather than offsetting any losses on puts like this) but perhaps that's part of the funding/hedging strategy?

    ReplyDelete
    Replies
    1. Hi,

      That could be. Structured notes are a common way to offload these derivative exposures so that may be part of it. Thanks for dropping by.

      Delete
  3. They say this is an economic hedge, so I presume they will experience losses elsewhere that this is trying to offset. At first glance it would appear this is more than a hedge, but do you have any sense of what areas they will lose in if deflation does happen?

    ReplyDelete
    Replies
    1. That's an interesting question. It depends on how it unfolds. If it unfolds like the 1930's in the U.S., there will be a lot of problems all over the place. The insurance businesses won't do well either, obviously. But if it unfolds like in Japan where things just sort of muddle along, maybe it can be less damaging.

      Delete
  4. Pretty amazing that he would make that trade. I would also say that trade is EXTREMELY contrarian. It's almost the reverse of Warren Buffett's index basket trades he did with the banks back before the crisis. Of course, Buffett had the motivation of earning the premium from the put he sold. But to make a bet about the unwillingness or inability of modern central bankers to print their way out of a crisis (if that is the thinking behind it) is again, deeply contrarian.

    ReplyDelete
    Replies
    1. Yes, I agree. I first wrote about the trade in 2011, and the most popular trade (even in 2014) was to short treasuries as rates were going higher. Even Buffett has been saying that for years. The folks at Leucadia told investor at the last annual meeting that if they don't see inflation coming, that they should sell LUK stock (one of them was investing personally in gold and the other in agricultural land). Even Klarman had deep out of the money puts on treasuries as he thought rates would spike too.

      And the world is still leaning towards higher rates (or at least some "normalization").

      Delete
    2. Oops, forgot to say I meant the last LUK annual meeting that Cumming/Steinberg hosted in 2012.

      Delete
  5. a bit off topic here but I know you're watching this ..

    what do you think of Shake Shack at $48!? thats what, maybe 40x+ EBITDA? let it settle for a couple days then start shorting it?

    ReplyDelete
  6. a bit off topic here but I know you're watching this ..

    what do you think of Shake Shack at $48!? thats what, maybe 40x+ EBITDA? let it settle for a couple days then start shorting it?

    ReplyDelete
    Replies
    1. Well, I think it's safe to say that the prudent course of action is to stand back and watch. That's just nuts. I may take a closer look to try to figure out what level would be an OK buy (of course, it would still be way too high for value investors), but I get the sense that this one isn't going to give us a chance; too much attention etc. CMG was known to be great but Ells was not necessarily a star or anything. It was more like, "huh? a spinoff from MCD?". Meyer is a star, making the rounds of the national TV talk shows etc. So the bubble factor is bigger here, obviously.

      Delete
  7. Any thoughts on CBI after the recent huge decline? Buffets/T&T have been buying. Thanks.

    ReplyDelete
    Replies
    1. Hi,

      CBI is an interesting situation for sure. I bet it does OK over time, but they have a lot of exposure in energy and there will probably be massive cuts in capex there, so you would have to look at CBI 'through the valley', as there might be some ugly numbers to come in the short term.

      Delete
  8. I own FRFHF and have for a few years now. Prem is a smart cookie, no doubt. How can an investor "rough out" a potential return if the best/worst case unfolded and the bet paid off? Lets say Joe Investor lays out 10K today @ $550/sh (rounding out) acquiring 18 shares. what would the best case return be?

    BTW, i really appreciate and enjoy the writing. Its at the top of my bookmarked list.

    ReplyDelete
    Replies
    1. Hmm... That's a good question. I don't know. If we get 10-14% deflation over the next 7-8 years, FRFHF can make more than $10 billion (actually, I didn't take into account the out of the money amount of the puts so a little less). But how that distributes over the year, I have no idea, and how much the other lines of businesses suffer, I have no idea either.

      Let's put it this way. Let's say that other than this 'bet', that FRFHF is a regular business. This deflation bet just means that relative to other companies, they will make 1% less ROE over time (assuming puts expire worthless). But then if we have a deflationary environment over the next few years their is some upside.

      Delete
  9. One other factor worth mentioning with Fairfax is that unless you hedge you're taking on canadian dollar exposure.Maybe that's decent as of now?, but at least recently, it's led to some serious under performance for FRFHF vs FFH.t

    Echo the thoughts on awesome reading your blog. Would be interested in reading your thoughts after the next Loews report feb 9th. I know you're a fan and maybe it's recency bias but I'm hard pressed to find what the Tisch family has done to help this company over the past few years other than just collect salaries.

    ReplyDelete
    Replies
    1. Good point about FX.

      And yes, I am a big fan of L and the Tisch family, but frankly, I've never really owned a big stake. I own it, but it's never been big conviction position for me, and the reason has been pretty much DO and CNA. DO is one of those things that was a great play; they bought up unwanted rigs during the bottom of the crude cycle, and then it was a home run during the big oil runup in the 2000's. Yes, they paid out a lot of cash, but even if you get your initial investment out, if it is still a large part of the portfolio, then it can be a real drag when the cycle turns. This has been a big worry for me, but I didn't really think crude would crash and the cycle would come down so hard either. I wish (and wished at the time) that they would have sold out of it back then.

      The other thing was that they seemed to be so conservative over the years, I feel like they probably missed some opportunities. Look at Buffett and BRK; they're cranking out great numbers and they are much larger so have a much smaller pond to play in. So that was the other factor that sort of made me not want to be heavily weighted in L.

      Having said that, I still like L and maybe I will buy some during this energy downcycle (oh yeah, and their emphasis on energy in general made me nervous too. I don't predict things, but when I see private equity funds, even LUK, L and everyone else piling into energy investments, you know it's not going to turn out well... at least in the near term.

      L is still a very well run shop despite what I say. They avoid large errors, and the past few years has been really strange in may ways. Not everyone is going to always be putting up great numbers all the time (well, except BRK!)...

      But yeah, it seems like I have a lot to say about L, lol... so maybe I'll make a post after the earnings, or maybe after their next annual report.

      Thanks for dropping by.

      Delete
    2. Oh, and by the way, I don't mean at all that L should be or should have been getting in and out of assets by timing cycles. Of course, I would not advocate that at all. What I mean is that when they created DO, they were buying stuff at scrap prices; unwanted rigs were basically given away when the rig count was on the floor for years. DO scooped it up and hit a home run. Then in the mid to late 2000's, the cycle turned and crude was up to $150/barrel and people were tripping over each other grabbing rigs and ordering bigger and fancier rigs etc... Day rates were through the roof. Peak oil was the consensus etc.

      So you would think that value investors who got stuff at distressed prices would have sold out. The old LUK would have gotten out as they actually were explicitly distressed investors, so if things were not longer 'distressed', they got out.

      But I do understand that L is not like that, having owned many assets for decades. I guess they did their best paying out tons of cash during the good years.

      Delete
  10. WAtsa is betting against central bankers!! Fighting them is not an easy task. CEntral banker acroos the world will fight the deflation with printing money. Lets see who will win!!

    ReplyDelete
  11. BI, it seems a little deflation has already occurred. When I look at oil and gas or corn and wheat or silver and copper they are all lower these days. Sure, we need to inflate over the long run. But, isn't no inflation to a little deflation OK short term? What is the impact of having no inflation to 1% deflation over the next three years? Seems like, in that low return environment, stocks would be a popular choice and the market will continue up?

    ReplyDelete
    Replies
    1. Hi, sorry about the late response; I missed this comment. Yes, I suppose it can be OK as long as we don't get into a deflationary spiral. It's possible that nothing really happens that people fear and we just continue to muddle along. And yes, it is good to some extent that we don't have inflation...

      Delete
  12. Brooklyn - you've done some good posts on: Wells, deflation and Japanese banks in the past. What would be interesting would be to combine them together to discuss what Wells might look like in a deflationary environment. The half of their income from non-interest rate sensitive products should hold up okay (right?) but the net interest margin could go down from the current 3% to more like the 1% we see in Japanese banks today. What would that mean for Wells? And how does that square with Stumpf and their new CFO saying that they are fine under any interest rate scenario? Might be some interesting food for thought.

    ReplyDelete
    Replies
    1. Hi, that's a great question. I thought about that before a little (not a lot) and my conclusion was that Japanese banks and U.S. banks are very different in how they are managed. In Japan, most corporations are still run primarily for the employees and government. Shareholders don't matter at all and there is no concept of return on capital. This is not true in the U.S.

      So what would happen here is that if NIMs got to 1%, unless WFC can figure out a way to make a loan while getting a good return on equity, they simply wouldn't make the loan. So either 1. the loan yield would never get that low even if treasury yields did or 2. If loan yields got uneconomically low, good banks would stop making loans and would undergo massive share repurchases instead.

      In Japan, they don't care about return on capital so they will keep making loans because that's what banks are supposed to do. This is the same as the dumb manufacturing companies losing money per unit but trying to make it up with volume. In fact, Japanese companies do think in terms of market share so they don't care if something is profitable or not; they just want to increase market share at any cost.

      Of course, things are less like that than in the past, but if you look at the behavior of the large companies there, they are still managed with zero consideration for return on capital and rational capital allocation (and are motivated by doing what they think they are supposed to do regardless of profit/loss to keep their employees (that they can't fire) busy, their factories (that they can't close) humming etc...

      This is the same with banks; there has been zero (to my knowledge) rationalization in Japan in banking (except mega-mergers that have done nothing to increase efficiency; some merged banks still have two human resource departments etc...).

      This is very different than how U.S. banks would respond so I expect a totally different outcome even if rates went down a lot.

      This doesn't mean that it will be easy, though. It will be tough if rates continued to go down...

      Delete
  13. Great post. I remember you saying you either weren't or weren't holding much Fairfax. Assuming the good track record and quality manager type companies are in your wheelhouse, is there a particular reason?

    Your blog has been a boon in that I've reassessed my investment strategy quite a bit. I've been thinking about adding Fairfax. I thought Watsa was in the MKL and BRK mode, but actually he seems much more risk taking and active. To the point where it's not quite as easily understandable (like MKL and BRK). This deflation bet was case in point, though from this entry, it doesn't seem like such a wild bet. And from my understanding, he's investment portfolio is fully hedged so it's not as wild as I would think. Still, having a massive stake in BBRY just seems more like a hedge fund type bet that makes me think Fairfax's success has a bit of luck in it (albeit decade long luck, eh?). BBRY would be just as crazy as BRK buying a huge stake in ... , oh I don't know, IBM? =)

    No, with IBM, even then, there's some kind of value/great business rationale that can be guessed at. BBRY feels very different. There's more of a sense that a Fairfax investor just has to trust Watsa's bet. Then again, like I said, your entry here explains a lot for the deflation bet and makes it easier to have faith.

    ReplyDelete
    Replies
    1. Hi,

      I actually do own some Fairfax. And no, it's not a BRK in terms of bullet-proofness or anything like that, and MKL is much cleaner and easier to follow. They seem to have a portfolio of high quality assets whereas Fairfax will buy crap but with positive return expectation.

      As for BBRY, I haven't followed it closely. But you know, the best investments people make are the ones where everyone just scratches their heads. Look at everyone second-guessing Buffett on IBM. Who knows how these investments will unfold. But I suspect that the more people second-guess it and scratch their heads, the more money it will make in the end.

      Anyway, as for BRK vs. MKL vs. Fairfax (and others), it's really about what kind of risk you are comfortable with and how much confidence you have in the respective managements. If you don't trust Watsa, I wouldn't invest in Fairfax at all. No need to force the issue. BRK and MKL are good too.

      Delete