Fairfax India Holdings (FFXDF)

This is one of those things that I looked at before and never posted, so here it is. Actually, I didn't write much about it, it was just sitting in my queue.

I know Munger likes China more than India, but I think India is very interesting. I don't think I have to say much about it as it is not a new idea. And yes, India has problems that China doesn't have (democracy that can actually hold back progress unlike in the authoritarian China where the government can just basically do what it wants). But India is still fascinating, especially with all the things going on over there now (pro-business government for the first time etc).

Anyway, as usual, before that, check this out from the Fairfax 2016 Letter to Shareholders.

Here's the long term investment performance of Fairfax (not the India entity):

And what happened in 2016:

...and the summary overall for the period 2010-2016:

Their equity hedge has been very costly, basically a total disaster.  Their hedges cost them $4.4 billion since 2010. Since it was a hedge, you have to look at it on a net basis with the longs; that's a $1.7 billion loss.  Still pretty awful. This is during a period the S&P 500 index went up 12.5%/year. In 2010, they had $4.5 billion in stocks. If this was unhedged and their stocks kept up with the market, it would have added $4.5 billion to their net value instead of losing $1.7 billion; that's a swing of $6.2 billion!  That's huge given their common equity in 2010 of around $8 billion ($8.5 billion at end of 2016).

It's fair to say, though, that if the portfolio wasn't hedged, it might have been smaller than $4.5 billion; the portfolio might have been sold down for risk management purposes.

Since 2007, Fairfax has still outperformed (price basis) the S&P 500 index and all of the so-called Berk-a-likes:

This chart (and other charts), by the way, are updated every day at the Brooklyn Investor website.

Anyway, over the long term, they have done well, so it's not fair to focus just on this one mistake (even though it's a huge one). Many CEO errors cause their companies to go bust, and that hasn't happened here, or anything even close to that.

Here is the other 'bet' Fairfax has on:

This bet doesn't look so interesting these days, but the important point is that the downside in these bets are known and small. It's one of those "if you're wrong you don't lose too much but if you're right you can make a ton" deals. Needless to say, the equity portfolio hedge was not that kind of bet!

Expensive Market
Anyway, I still have conversations about this sort of thing and hear all the time about the markets being expensive, people being confused as to what's going on.

One hedge fund executive (wasn't clear what position was; not sure if he had investment experience/responsibilities) was on CNBC the other day and it was stunning because the comments were based on such extraordinarily static analysis, talking about the uncertainties in the market, how things were expensive etc.

Reflexivity
And it reminds me of a book that I plan to reread (if I can find it!). When I read it years ago, it was incredibly eye-opening, and it feels like a lot of people have forgotten about this sort of thinking. The book is by George Soros, one of the greatest of all time:

   The Alchemy of Finance

He talks about reflexivity, and it sort of differentiates the traditional economists viewpoint based on static analysis versus his more dynamic view of the world based on reflexivity. (This book is more of interest to traders than long term investors).

For example, if the market goes up, most people assume it must go down because it is overvalued. Economists base their views on supply/demand balance so they think things must trend towards equilibrium. Most comments I hear these days tend to be in this camp.

Soros' view is that in fact, an expensive market can make a market even more expensive.  Why? Because if markets go up and gets overvalued, then financing costs go down and can encourage more profit-making and increased earnings, which can drive prices even higher. Economists wouldn't consider this factor. This is in fact what happened in Japan too in the late 1980's.

I think Soros talks about the REIT boom/bust of the 1970's in this book; maybe it was somewhere else. But the above is exactly what happened.

Anyway, I am going to dig up a copy of this; it must be somewhere around here in one of these boxes or piles of books.

Mean Reversion
Sort of related to the above, here's another thing I hear all the time: mean reversion. I too believe in mean reversion. But there are tradable/investable mean reversions and untradable/uninvestable mean reversions.

Values mean revert, usually. As a value investor, we can buy undervalued stocks and assume mean reversion will enhance our returns. This is investable mean reversion. As long as you are not leveraged, you can just wait for the market to prove you right.

Shorting overvalued stocks is also a mean-reversion trade, but it is untradable.  Ask anyone who was or is short Tesla, Amazon, Netflix. Oh, remember L.A. Gear? Or U.S. Surgical? Anything in 1997-2000? Those are untradable because you will get killed trying to short that stuff even if mean-reversion will eventually kick in. Nobody has that kind of staying power.

So what kind of mean reversion do you want? You want mean reversion that happens OFTEN. You want mean-reversion that is tradable.

Not exactly a mean reversion trade, but take index arbitrage. You go long stocks and short future against it (or vice versa). You know from history that the premium/discount fluctuates over time. But you also know that this spread will not diverge too far apart, and you know that at expiration, your long and short will offset and you can realize the spread perfectly with very little risk. That's a spread you can trade safely. (In fact, one of Soros' early strategies was to arb gold prices between New York and London. I think a long distance phone connection was that era's version of a direct optical fiber connection to exchanges today)

How about options volatility? For shorter dated options, trading volatility works too. You may or may not make money, but volatility cycles are often not that long so you can capture volatility by trading options. You may need some staying power, though, because sometimes you sell volatility at 30% and it goes to 40% or 50%. But you know that eventually, these panic levels will subside at some point for much lower volatility.

What about stat arbs?  These guys too, especially the high-frequency guys, are trading mean-reversion. The one mentioned in the Thorp book, I think, was based on 2-week returns in stocks. Stat arbs these days turn over their portfolios multiple times in a day (I am guessing, but we had high turnover a long time ago; I am assuming it's much faster now), which implies a high level of mean-reversion; each trade is not expected to last very long. Things diverge and revert very quickly.

This has two big advantages (well, probably more but let's keep it simple); first, with so much frequency you have that many more data points. With that many trades, you are that much more likely to make money. With time span so short, the risk of divergence, or spreads widening out even more, is minimal.

Imagine trying to trade inefficiencies in the stock market based on tick data where trades last for minutes. What is the risk?  Hint: tiny on each trade, and since you do so many trades, you are well-diversified and if your data is correct, you are more likely to realize the 'edge'.

Now imagine trying to trade inefficiencies in the stock market where people misprice P/E ratios on individual stocks. The expected duration of a trade can be years (the P/E ratio inefficiency probably will not correct within the next week or even month. Unlikely even in the next year; how many years have TSLA, NFLX and AMZN been overvalued?). Now think of the range of stock prices that a mispriced stock can trade at over that time span.  Now you see how huge the risk is.

Of course, sometimes you can see some sort of deterioration in a company, some manic blowoff or some other 'timing' device that might help you nail a short of an overvalued company. But you see how trading just on valuation on the short side is going to be tough game.

The Market
Let's take all of the above thoughts and apply it to the overall market. People always talk about mean reversion of the market P/E ratio, profit margins and things like that.

Are these factors tradable? If the stock market went to 20-30x P/E and then went down to 8-10x and then went up to 20-30x and kept doing that many times over the years (averaging out at 14-15x), then it turns into a tradable idea. You can set ranges too and calculate probable outcomes and manage risk accordingly.

But looking at long term data, that's not really the case. It's more like these things happen very rarely and over long periods of time. Most people talk about what happened in 1929, 1968, 1987, 2000 or whatever. I think it was Buffett (but may have been Munger) who said that to bet on something that happened just a few times over the last 100 years does not sound like a good idea.

Again, the same questions apply: when is the expected reversion? What is the risk? If the reversion is not expected in the short term (next week, next month, within the year etc...), then what is adverse move against you going to cost?

Interest rates mean revert too, but look at the rates in the past 100, 200 years. If you want to realize any 'edge' in the long term mean-reversion of interest rates, you have to play for decades, and the reversion may not even occur within a single generation.

Back to Fairfax India
Emerging markets haven't been so hot in recent years, but I don't think there is any doubt that that is where a lot of growth is going to come from over the next few years. Much of that growth will be captured by global firms to be sure, so owning global companies will give you exposure without having to invest in emerging markets.

But it's fun to have some direct investment overseas when there is an interesting opportunity. I don't think FFDXF is a unique opportunity right now in terms of value/pricing, but it is an interesting opportunity in that you can co-invest with a successful manager in an investment vehicle focused on India that combines listed stocks and private investments. There are not too many of those ideas.

The option to invest in private deals expands the universe of potential investments so increases the odds of finding winners. The closed nature of this vehicle (not an ETF, mutual fund or hedge fund/partnership) allows them to focus on the long term and not worry about liquidity and short term performance.

With these advantages and with a management that we understand that agrees with out own views on investing makes this an interesting opportunity.

Of course, the value approach to investing is not universally accepted, and Fairfax has its own fair share of long-time critics.  So this is only interesting to those who appreciate the Fairfax track record and what they are trying to do in India.

India Macro

Here are some charts from the FFXDF marketing slides from a couple of years ago. You can get all of this at the SEDAR website:  

SEDAR link to FFXDF filings

Nothing really new here, but just to refresh: 

One huge headwind in the global economy is demographics; this is a problem everywhere, Japan, China, Europe and even the U.S. to a lesser extent than the others. 

And this is India:

A lot of potential for growth in India, and recently trending well:

Singapore II?
Watsa compares what can happen in India going forward to Lee Kuan Yew's Singapore starting in the 1960's. Singapore is a great example of a successful nation, and Munger brings it up all the time too. But we have to remember that Singapore was a tiny island city-state with a population of less than 2 million (in the early 1960's), and a current population of less than 6 million. The area of Singapore is smaller than New York City.

It's one thing to rebuild and lead a nation of 2 million, but it's an entirely different matter to try to do the same with a country with a population that exceeds a billion. Try banning chewing gum in a huge country like India with a 1 billion+ population!

But OK, we get the analogy. Maybe India can't repeat Singapore's performance, but with the right policies, they can still do really well.

Past Performance
These things may not be as indicative of future performance as we'd like to think, but here is the track record of Watsa's India investment management team. They have done really well, but we have to keep in mind that the results are very volatile. We are talking about an emerging market, and a highly concentrated portfolio. Plus not much has happened since 2007 (a lot of volatility!).

One thing that Fairfax fans may not like is the management fee structure. This seems kind of normal in the investment world; 1.5% management fee and 20% incentive fee (but only after 5% hurdle). In this day and age, it might sound a little steep. Maybe it's not so bad when you consider that it is partially a private equity fund.

Why not ETF?
Well, if India is so interesting (and I don't mean in the timing sense, by the way. I don't follow India closely enough to tell you even what the sentiment is like, but I think emerging markets overall here has been out of favor), and the fees are too high, why not go with and indexed ETF?

That may be a good idea. I haven't looked in detail at any of the India ETF's, but emerging market ETF's tend to be packed with large, inefficient, formerly state-run enterprises. Plus who knows when the government dumps (IPO's) a large, stodgy, bureaucratic, inefficient state-run organization onto the market for non-differentiating index funds to blindly buy into (this could be one of your funds!).

I think the inefficiencies in these markets tends to favor the active investor.

Plus, here, you are betting on the continued success of the Fairfax/Watsa investment approach. You don't get that in an index.

Speaking of emerging market funds, it seems like emerging markets have grown at a higher pace than mature economies for decades, and yet how come there aren't really any good emerging market funds with good long term track records? Mark Mobius was a big star back in the 1990's. Last time I looked, his funds' performance was not very good. I wonder about that.  Maybe it's something I should look at in another post. I am always intrigued by the idea of emerging markets, but am almost never sure what to do about it!  (uh oh... reading too many Watsa reports... the exclamation point is contagious!).

There was a time in the late 1980's and early 1990's when all you had to do was to own the telephone companies in each of the emerging markets and you could earn hedge fund-like returns (any ADR with a 'com' (not '.com') in the name would have worked).

Conclusion
Anyway, this may not be for everybody, and it will probably be pretty volatile but it's an interesting thing to keep an eye on, or tuck into your portfolio somewhere and just forget about it and check back in a few years.

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.

Fairfax Financial's Interesting Bet

Fairfax Financial Holdings is yet another financial company (insurance) that is run by an incredible manager that has done really well over the years.  I know, I know. This is getting boring.  Just talking about well-run financial institutions trading at book value is not interesting or exciting at all.  I'd rather write about some interesting special situation with more analysis involved.

But I can't not mention stuff that looks interesting just because the bottom line is not that exciting: another financial trading at book value. 

Anyway, there is actually an interesting angle to this one that is more than just another cheap financial.

But first, a little background (but only a little).  Fairfax Financial Holdings is basically an insurance holding company that runs so-so insurance companies but grows through astute acquisitions and unconventional management of 'float' (in the case of Berkshire Hathaway, they manage top quality insurance business with top notch investing results).

Fairfax Holdings is run by Prem Watsa and his letter to shareholders are well worth reading going all the way back. (I really have to set up a link page or post on these "must reads").

Anyway, Fairfax was started 25 years ago and since then the growth in book value per share has been +25%/year.  This is astounding, of course.  It's right up there with Berkshire Hathaway, Leucadia and very few others (actually better).

Here is the history of their book value growth:

You can see, though, that most of the great growth occured in the early years as is often the case with these companies.

Here are the growth in book values over various time periods through December 2010:

Their returns since 2000 hasn't been that bad at all either, despite a flat stock market. We will see what earned those returns later.



How is their investment performance?
As an insurance company, Fairfax receives insurance premiums which they invest.  If their investment returns exceed their cost of float (payouts on insurance losses) they make a profit.

Watsa is known as a very good equity value manager.  Their bond returns are also pretty good.  From the 2010 annual report:

The interesting thing about Fairfax is that unlike Buffett and other value investors, they do actively hedge their equity exposure by using swaps and futures contracts.  I think they have been 100% hedged on their equity holdings in the recent past (meaning that although they own stocks, they are short a like amount so they will not get hurt in a declining market).

Even with stock market hedging (or maybe because of it, even though most people will hurt their performance by trying to hedge), they have earned very good returns in their equity portfolio, gaining +14.2%/year in the past five years versus only 2.3% for the S&P 500 index.

This is slightly different than what David Einhorn does at Greenlight Re; they run an active long/short fund.  It is simliar, though, in that they are not fully exposed to stock market volatility.

Just for the record, here is their large equity holdings which doesn't change all that often. It's always good to see what people with great track records own right now:

How are they as an insurance company?

Here is the long term performance of their insurance business:


Berkshire Hathaway, I think, has a cost of float of around zero over the years.  Fairfax, though, loses around 2.3% per year over time on their insurance businesses. This is what you can call the cost of float.  If you can get investment returns that exceed your cost of float, then you are making a profit. 

This is why Fairfax compares their long term cost of float with long term bond yields (which is a risk free cost of capital indicator).  The fact that their cost of float is less than the Canadian government bond yield means that the insurance business is in fact adding value despite underwriting losses over time.

So what's the big, interesting bet?

OK, so now that we took a quick look at Fairfax, the company, we will take a quick look at the big bet.

First, let's take a look at their recent big bet.  Fairfax recently hit a home run during the 2007-2008 crisis by having a big position in credit default swaps.  For a few years, they were criticized for putting on credit default swaps as a short against the credit bubble.  It did cost them money for a few years.  They also lost money on equity market hedges too, for a few years until those bets paid off big.

Below is a table they included in the 2008 annual report to illustrate this:

They lost money from 2003-2006 in these credit default swaps and equity hedges, but when the sh*t hit the fan, they paid off in a big way. (A credit default swap is a contract that pays out when there is a default on a debt; sort of like an insurance contract on credit; Fairfax bet heavily that there would be a lot of defaults)

Now, I have to say that I don't like insurance companies generally making big bets like this.  An insurance company shouldn't be acting like a hedge fund. But what is interesting here is that they weren't really taking huge directional risk as I think they were paying very little for some of these hedges, especially the credit default swaps which we now know was grossly mispriced.

As long as they don't spend too much capital or take too much risk, it's OK for them to take these asymmetric risk/return bets.  They weren't going to go out of business if their bets didn't pan out.  This is not how the bets were structured.

Also, it's important to remember that Fairfax put on these bets long before Michael Burry became a hero of sorts, and John Paulson's hedge fund made billions shorting subprime loans CDOs.  A lot of hedge funds and others, it seems to me, is rushing into these 'black swan'-type trades and I think a lot of that is driven by Burry/Paulson envy; they all want to find that next big trade.

However, Fairfax was looking for and found this before it has become trendy lately.

Anyway, enough of that.

Deflation!

So what's the trade, already?!  If you read Watsa's annual reports over the past few years, you know that Watsa is expecting a Japan-like balance sheet recession/depression in the U.S. if not the whole world.  He has been hugely influenced by the Japanese economist Richard Koo and his concept of the "balance sheet recession".  (A balance sheet recession is simply a recession driven by all economic actors' rushing to repair their balance sheet by paying down debt as opposed to a traditional cyclical recession where inventory adjustments are made.  A balance sheet recession cannot be exited by traditional easy money policies of lower interest rates as everyone is trying to pay down debt at the same time).

Much of the world seems to be betting on inflation; gold and other commodities are through the roof as continuing easy money from global central banks is seen as inevitable.  They see inflation as inevitable.  Ironically, this is happening at the same time as everyone seems to be rushing into U.S. treasuries in a flight to safety.  

Here's the trade:  Fairfax Financial has put on a huge short trade on the CPI (Consumer Price Index). 

If the U.S. / world follows the pattern of a Japan-like balance sheet recession, then the CPI can go down by 14% over ten years.  This is Watsa's analysis of Japan and the U.S. in the 1930s.

This is not news, actually.  Fairfax put on this trade in 2010 and mentioned it in the 2010 annual report.  But as of the end of December 2010, this trade had a notional value of $34 billion, but as of the end of September 30, 2011, that has increased to $47.4 billion.  The weighted average maturity of these contracts is 8.9 years.   (This trade was set up by entering into an agreement with counterparties (presumably large, global investment banks) whereby Fairfax pays a premium up front and the bank has to pay Fairfax the amount of deflation over the next ten years (if the CPI goes down 10% in ten years, banks will pay Fairfax $47 billion x 10% = $4.7 billion)

For the $34 billion notional position in 2010, Watsa says they paid $302.3 million, or about 0.9% of the amount.  I think we can assume he paid a similar amount in 2011 to increase the position. 

So, if Watsa is correct and there is 10-14% deflation over the next ten years, this trade can potentially make $4.7 billion - $6.6 billion!  That's a huge win if that happens.  If there is no deflation, then they lose $430 million or so.  In a sense, the market is only giving a 7-10% chance of Japan-like deflation occuring.  If you believe there is a greater chance than that, then this can be a homerun.

The beauty of this trade is that the upside potential is huge but the downside is limited to the initial payout of 0.9% of the notional amount.

Also, the shareholders equity of Fairfax Financial was $8.2 billion so you can see how big a trade this is, even though, again, the risk is limited to around 5% or so of Fairfax Financial's net worth.  This is a trade that isn't going to blow up Fairfax if it doesn't turn out well.  This is not the same as, say, buying tons of European soveriegn debt, CDO (collateralized debt obligations) or CMBS (commercial mortgage-backed securities) on leverage.

I am usually not a big fan of these big bets; when money managers veer away from what they know and have become good at, things often don't work out.  There are countless managers who started out as great stockpickers but got distracted into macro-investing and went on to lose boatloads of money.  

But some of these bets seem to be low risk situations.  Another example is David Einhorn at Greenlight who bought a ton of default swaps on Japanese government debt.  I find it highly unlikely that Japan would actually default since they can just print money to repay yen-denominated government debt, but the beauty of the trade is that the market also is not pricing in much of a possibility.  Which means that it is or was a very cheap trade to put on.   Seth Klarman has bought out-of-the-money long dated puts on U.S. treasuries at low prices as he sees higher long term interest rates as a result of all this pump priming as inevitable.   All of these are low cost trades that won't hurt them if things don't pan out.

Yes, this sort of smells like a little bit of Burry envy; trying to find that next big, black swan, outlier trade where the market is not pricing in a certain scenario.  But again, Watsa has already done this before with the credit default swaps.

As long as not much capital is burned in the trade, I suppose it's not such a bad thing (although I would still prefer these guys to focus more on their stock analysis skills!).

Conclusion?

Fairfax Financial has done really well over time and has done well recently too.  Their insurance operations tend not to be the best, but that's the game plan; Watsa seems to like to buy not-so-great businesses on the cheap and then try to fix them up.

Their investments have done really well too, but what might bother some people is Watsa's active hedging and unconventional bets.  It sort of makes me scratch my head too, but he has been successful with it, and it doesn't look like he does anything 'reckless' with big downside exposure.

Most people who try to hedge their stocks using futures tend not to do too well and most of the time, it's better to simply reduce equity holdings to lower risk than to adjust using futures, but again, Watsa had done well with this.

This deflation trade is certainly a big one, but it has the potential to earn a huge amount of money and if it's wrong, the cost is minimal; at 5% of net worth, that comes out to only 0.5%/year expense.

Fairfax, with this sort of performance history is certainly interesting at around book value. 

Fairfax is trading at $406/share (U.S. ADR: FRFHF) versus a book value per share as of the end of September of $402.66.

Their equity holdings are 100% hedged out, so Fairfax doesn't have much market exposure.

This may appeal to those with a bearish view on U.S. and global economy and markets and believe there is a good chance of a Japan-like deflation.

It's also not at all a bad idea for those that are not necessarily bearish.

Of course, at book value or modest premium, I would tend to prefer Berkshire Hathaway.

Anyway, as usual, this is just another idea.  It is a financial so is subject to all sorts of risks of other financials and insurance companies.  Also, you have to take into consideration counterparty risk: who exactly are the counterparties to the CPI deflation trade?  If we do go down the path of Japan or 1930s in the U.S., will the investment bank counterparties still be around to pay off the bet?

As with any financials, there's a whole bunch of risks, so one should really get to know the company and get comfortable with it before buying into it.

And again, as I keep saying, I do keep talking about financials, but that doesn't mean one should have a whole bunch of financials in their portfolio.  Portfolios shouldn't be overly diversified (with many different stocks), but they shouldn't be overly concentrated in any single industry/sector either.