Fairfax Financial Beats Bad Markets
Prem Watsa, Chair of insurance conglomerate Fairfax Financial Holdings Ltd., began to worry about a credit meltdown a few 
years ago. So he and his investment team devised a defensive strategy. Today, Fairfax is in great shape financially, despite lousy markets.
The company has even defied gravity and two weeks ago its credit was upgraded. This reflected its stellar investment performance on its US$19.8 billion investment portfolio, good operations at its underlying insurance companies and a jump in shareholders’ equity from US$2.856 billion in 2006 to US$4.8 billion today.
In 2007, Fairfax, Canada’s largest property and casualty insurer, posted profits of US$1.095 billion compared with US$227.5 million in 2006. In 2008, as more bad news hit markets everywhere, Fairfax’s profit soared to US$631.8 million in just the first quarter.
Watsa is the founder and controlling shareholder of Fairfax and stays out of the limelight. However, this week, he gave The Post an interview and we talked about Fairfax’s contrarian philosophy and about the dangers in markets that lie ahead.
He was born in India and attended one of its prestigious IIT super-universities. He graduated in chemical engineering then immigrated to Canada to join his brother, at his father’s request, attended the Ivey School and became a money manager.
In 1985, he fashioned Fairfax along the lines of Warren Buffett’s business model: It became a property and casualty consolidator and managed their pools of capital. Fairfax is an acronym for fair and friendly acquisitions. And Watsa’s son is named after Buffett’s inspiration, Ben Graham, Godfather of “value investing”.
Another major influence has been the late Sir John Templeton who died this summer at 95 years of age. A bronze bust of Sir John, a mutual fund pioneer and philanthropist, occupies a prominent place in Fairfax’s boardroom in downtown Toronto.
Fairfax’s philosophy has paid off. Since 1985, book value has gone from US$1.50 per share to today’s US$250 a share.
Q: Everybody else is running for the exits and melting down and Fairfax just had its credit rating upgraded so how did you pull this off?
A: “Very simply it goes back to this 100-year storm concern of ours. We took action that reflected our belief that everything was headed downward. Predicting rain doesn’t count, but building an ark does. And that’s what we did. We built an ark and we had a little bit of good fortune. This is why our rating went up.”
“Our focus has had a tremendous effect on our results. Last year we made in excess of US$1.1 billion and in the first quarter 
of 2008, US$631 million. Our capital, shareholders equity in 2006, was US$2.9 billion and it grew by 50%.”
Q: What was your thinking that led to these results?
A: “We have always taken a long term view and in 2003 we started worrying. We were concerned about asset-backed paper. We saw the moral hazard in all this credit that we saw was being blended and blown out. This was because interest rates were dropped to 1% to bail out the technology companies after the bubble burst in 1999 and we saw that this would lead to the real estate and auto loans and credit card problem. We saw that half of consumer spending was from home equity loans. So we protected ourselves. Credit default swaps are why our ratings went up.”
Q: How does that work?
A: “Bond spreads were low, abnormally low because of the credit problem. [Five-year government bonds compared to corporate bonds]. We did swaps but results were not immediate. By 2006 we were down by 75% in that portfolio, but we are long term investors so we took a deep breath and bought more to average down. In July 2007, two of Bear Stearns’s hedge funds failed and in August the crisis occurred. Then our results turned.”
Q: How much has Fairfax made by worrying and buying credit default swaps?
A: “The total in swaps has been US$455 million at the end of March and so far US$1.1 billion has been realized and another US$1 billion unrealized. We have a ton of cash.”
Q: Why has Fairfax predicted better than most others?
A: “You have to be worried a few years ahead of time, then take long term views and positions. History shows that there are 100-year storms and 50-year ones. In 1929, a 100-year storm, only 10% survived the market crash and it was only those who were negative in 1925 and did something about it. Back in 2003, there were signs this would happen.”
Q: How are your investments structured now for the future?
A: “We are not in commodities and missed out on that run-up totally. Value guys miss those cycles. What we do is buy stocks but hedge them against the S&P. Right now, about 25% of our capital is in Treasury bills; 50% is in short-term Canadian or American government bonds and 25% is credit default swaps and some of this is in stocks which are fully hedged.”
Q: What do you mean by value or long term investing?
A: “Our earnings are lumpy [varied]. We have never had guidance in 23 years because we have ups and downs and take the long term view. In 22 years, we have lost money twice but our book value and equity has grown dramatically. We just keep working hard and our insurance companies are operating very well.”
Q: Will long term deflation of real estate and assets affect your property and casualty premium income?
A: “Down the road but it’s not a worry.”
(Fairfax premium income has grown by 104 times since 1985 to US$2.44 billion.)
Q: Is this a 100-year or a 50-year market and what’s the difference?
A: “The 100-year is a Depression. The 50-year is what happened to Japan in 1989 to 2003. We don’t know yet.”
“Japan’s Nikkei index went from 40000 in 1989 to 7500 in 2003 and for 15 years no stocks went up. Stock and real estate markets collapsed. This points out another fact. Our worry is not inflation, but deflation as occurred in Japan. Deflation means it is difficult to rev up an economy through lowering interest rates or stimulus such as deficits or infrastructure spending. This is what Japan found for all those years. Deflation means you have to wait until everything gets digested and that might take a few years.”
Q: Your strategy meant that Fairfax missed the commodities and emerging markets run-ups. Any regrets?
A: “Individuals and foundations diversified into oil, commodities and emerging markets and these went up 50% to 100% in the short term. Value investors miss these short cycles. Now the emerging markets have all reversed their gains. Many investors are in commodities [through extreme leverage] and have pushed up prices. These commodity prices are not sustainable.”
Q: Can we talk about some challenges. Fairfax and others are being audited by the Securities & Exchange Commission about certain accounting practices? What is the status of this?
A: “It’s unresolved. 30 or 40 of us have cooperated with the SEC. A couple of companies have been fined. From our viewpoint, there is nothing to add.”
Q: What’s the latest with the short selling attack mounted a couple of years ago against Fairfax by several hedge funds in the U.S.?
A: “In July 2006, we sued these funds. They have attempted to have our case dismissed, but we have won in court against these motions to dismiss, and appeals. We face just one more dismissal attempt by a fund in August. Then it will be a trial. One defendant has been indicted on fraud charges.”
Q: What influence did Templeton have on your investment strategy?
A: “I met with him, beginning in 1978, every year and would go down to see him in his Lyford Cay home in the Bahamas. He was a long term investor and was very prescient about markets. Like him, I take the long term view, buy the best and short the worst.”
Q: Are you still worried overall?
A: “Risks are spreading to all credit markets and yes this is very worrisome.”
Q: You don’t usually give interviews so why now?
A: “We put our heads down and worked hard and have gotten results. Once in a while we will talk if we have anything to say.”
(Photos: National Post. Watsa at 2002 NYSE listing ceremony; Watsa lecturing to students at Ivey and Watsa March 2008)
This entry was posted on Monday, July 28th, 2008 at 7:28 am and is filed under Investment Pick. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
