Prem Watsa's Thoughts On What Threaten the Global Economy
Prem Watsa has often been referred to as the "Canadian Warren Buffett" for his fabulous track record in investing. He has a very similar business model as Warren Buffet's company where he collects premiums through the insurance companies he owns, and invests these premiums in income generating assets.
His investment letters look very similar to Warren Buffett's which shows the similarities they share in their investment strategies. I just finished reading Prem Watsa's investment letter for Fairfax Financial for the 2015 year. It is one of the great treasures for investment wisdom in the investing world along with Jeremy Grantham's letters, Howard Marks', and Warren Buffett's.
Prem Watsa explains the reasoning for his company's lackluster returns compared to the S&P 500 index being due to insurance contracts that he bought to hedge against losses from the stock market. These contracts oblige Prem to pay a premium every month and if markets continue to rise, the contracts will decrease in value, but if the markets decrease the contracts will increase in value.
He touches a lot upon the risks that threaten the economy and the markets around the world today by going into more detail about the unintended consequences of QE and zero interest rate policies. I highlighted some of the quotes that I found very interesting below:
(1.) "Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013. However, we have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals. These risks may be coming to a head in early 2016, as I write this Annual Report to you – right out of the blue!"
(2.) "The most important risk we saw was that the 2008/2009 recession was not like any we had experienced in the last 50 years. The closest comparables were the U.S. in the 1930's and Japan since 1990. Most investors consider the 2008/2009 recession and crash to be a once in a generation event – and it’s over! We differ because we think we escaped the serious adverse consequences of that recession as a result of huge fiscal stimulus from the U.S., even greater fiscal stimulus from China and the reduction in interest rates to 0% with massive monetary stimulus in the U.S., Europe and Japan through QE programs. There is nothing to fall back on now if the U.S. and Europe slip back into recession."
(3.) "Here are some of the risks we discussed in our recent Annual Reports:
2010 The real estate bubble in China, causing a worldwide commodity bubble.
2011 The psychology of U.S. consumers may be changing to less spending and more saving just like what happened in Japan with Japanese housewives no longer buying stocks after the significant crash in the market in the 1990s period. Record profit margins in the U.S. were being extrapolated into the future as opposed to the historic regression to the mean. Commodities could collapse with the breaking of the Chinese bubble and Canada would not be spared.
2012 The great disconnect between stock markets and the economic fundamentals. Junk bond yields making new lows of 5%-6%. Emerging market countries like Bolivia issuing $500 million of U.S. dollar-denominated ten-year paper at 47⁄8%. We quoted Russ Napier who said that much capital has been destroyed in history by reaching for yields of 5%-6% in a low interest rate environment. After an acquisition binge in 2011 and even earlier, mining companies had begun facing the consequences even though commodity prices had yet to collapse. Speculation in condos was in full swing in Canada.
2013 We listed the problems in China including the fact that it had built the equivalent of 50 Manhattans in the previous five years and it had a shadow banking system even bigger than the U.S. banking system prior to the crash in 2008/2009. In spite of QE1, 2 and 3, economic growth in the U.S. was very tepid! Commodity prices had begun to come down but had not collapsed. We felt with high debt levels in the developed markets and effectively zero interest rates, the government and central banks had no ammunition left to cushion us from unexpected economic events.
2014 We noted deflation had arrived in the second half of 2014 in the U.S. and Europe. Commodities, particularly oil, collapsed. German 30 year bond rates collapsed to 1% and almost half the German bond market was yielding negative interest rates, reflecting deflation. The Schiller CAPE index was at record P/E ratios, only seen twice before – in 1999/2000 and 1929. The rising U.S. dollar was resulting in profit margins of U.S. companies coming down from record levels."
(4.) "As we have said a few times before, the collapsing commodity prices will not spare Canada. Canadian housing prices, particularly in Toronto and Vancouver, have gone up significantly, driven by lax policies at CMHC (Canada's equivalent to Fannie Mae and Freddie Mac). Canadians have accessed their increasing real estate wealth through lines of credit easily available from the banks. Sounds familiar? This is exactly what happened in the United States before the financial crisis in 2008/2009. If history is any guide, this will reverse and we continue to be shocked at the massive debt levels incurred by young people (below 45 years old), with no financial buffer against hard times as the C.D. Howe report, Mortgaged to the hilt, shows."
(5.) "China devalued its currency on August 11, 2015 by 1.9% - the biggest move in 21 years. The Chinese government is trying frantically to support four major markets: its exchange market, its stock market, its bond market (no debt defaults allowed) and of course, the biggest real estate bubble we have ever witnessed. In 2015, China's foreign exchange reserves dropped for the first time in 20 years - by almost $800 billion from the high. Early in 2016, the trend continues!"
(6.) "Imagine my shock when I recently found out that a friend's 90 year old grandmother had an equity weighting of 85% - yes, 85%! And she has a very reputable bank as her investment adviser. When asked to reduce her exposure, she said she couldn't get income any other way!! I have not given up on changing her mind - but it will not be easy!"
(7.) "There is a prevailing view today that common shares are great long term investments, irrespective of price. This is a great example of long term investing gone astray. Of course, there is no country more entrepreneurial than the United States, with the rule of law and deep capital markets that are the envy of the whole world. But as history shows, being bullish in 1929, when the Dow Jones hit 400, meant you had to wait 25 years (until 1954) before the Dow Jones saw 400 again. In the meantime you had to survive a 90% decrease in the index. More recently in Japan, the Nikkei has yet to hit the 40,000 level it traded at in 1989 - almost 27 years ago. It is still over 50% below its all time high in 1989. As they say, caveat emptor!"
(8.) "I have purposely given you a quick summary of all the problems/challenges that the world faces right now. The potential for unintended consequences, and therefore of pain, is huge. This is why Ben Graham said if you were not bearish in 1925 - yes, 1925 - you had a 1 in 100 chance of surviving the depression - really the 1930 to 1932 crash in the stock market that resulted in an 86% loss from the high in 1930. We continue to protect you, our shareholders - and our company - as best we can from the potential problems that we see. As we have said, it is better to be wrong, wrong, wrong, wrong, wrong and then right, than the other way around! We remember it took 89 years for AIG to build $90 billion of shareholders' capital, and only one year to lose it all!"
(9.) "Early in 2016, ten-year TIP spreads (i.e., the spread between ten year inflation adjusted bonds and treasuries) have made new lows, second only to the 2008/2009 lows. Declining TIP spreads, reflecting lower inflation expectations and higher volatility, result in higher prices for our CPI-linked derivative contracts."