Prem Watsa's Temporary Hedging Losses Could Lead to Outsized Gains Again

Prem Watsa 's investing prowess with the float of his Canadian insurance company Fairfax Financial often draws comparisons to Warren Buffett , but the firm reported losses in its portfolio for the third quarter. While stocks delivered positive returns, even with the derelict Research In Motion ( RIMM ) in the portfolio, early hedges ultimately outweighed gains. The last time Watsa was early on hedging, he made billions.

According to Fairfax's financial results, in the third quarter its net gains on common stocks were $151.3 million and on bonds were $204 million. Combined with a small gain on preferred stocks, its total net gains on investments were $355.6 million. The company also reported net losses on common stock and equity index short positions of $490.8 million, and on credit default swaps of $10.7 million. Its combined net losses on financial instruments were $477.6 million.

Combined with several small gains and losses on foreign currency, Fairfax ended the third quarter with a net realized loss of $129.9 million.

In the third quarter last year, hedging performed more handily: Fairfax had net realized gains of several million dollars on bonds and stocks, and almost a billion dollars on common stock and equity index short positions. Its total net realized gains that quarter were $1.14 billion.

Fairfax is a long-term-oriented company that has produced an average of 10.6% over the past five years and 9.6% over its 26-year history. Its third-quarter fluctuation had to do with the scenario Watsa expected for the year not playing out in the time frame anticipated.

Watsa in his 2011 investor letter said that he maintained a 100% equity hedge to protect against a near-term economic downturn "given interest rates at close to absolute zero and no fiscal stimulus bullets available in the western world." Yet one more fiscal stimulus bullet was found when the Federal Reserve in September announced a third round of quantitative easing in which it will purchase $40 billion of agency mortgage-backed securities per month and maintain low rates not to conclude until mid-2015.

The stimulus and other factors boosted the S&P to return 6.35% in the third quarter and 16.44% in the first nine months of the year, even though U.S. GDP has been lower than expected, the deficit has expanded and analysts expect third quarter S&P earnings to be lower than 2011 levels. Watsa hedged expecting the biggest risk to lurk in the near term, seeing good performance for stocks over the next decade.

From his 2011 letter : "As for the United States, as we have discussed many times before, if we thought the 2008/2009 great contraction was like any other recession the U.S. has experienced in the past 50 years, we would not be hedging today. However, we continue to worry that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GDP remains flat for ten plus years with many bouts of deflation. To combat the great contraction of 2008/2009, the U.S., as well as Europe and most countries in the world, went 'all in' with huge stimulus programs. They have no ammunition left now and austerity is the slogan of the day, worldwide!"

The market's rally may have staved off or postponed his thesis unfolding. As of the end of the third quarter, Fairfax maintains short positions "against a potential decline in equity markets" in individual equities, the Russell 2000 index, the S&P 500 index and the S&P/TSX 60 index, it said in its third quarter report.

Watsa has been in a similar hedging-loss situation before that ended lucratively. In 2004, Fairfax held very conservative investment positioning that included hedging a significant amount of its common stock holdings to protect against an equity market decline. It led to an $81.5 million hedging loss and 6.3% return, but Watsa was wary of the environment.

The next year, the conservative investment position, combined with the effects of several hurricans and runoff losses, resulted in a record $498 million loss at Fairfax. Hedging resulted in a $148 million unrealized loss.

"We expect the unrealized losses from our hedges to be just that (i.e., unrealized) and at the end of the day we expect them to protect our portfolios from a 1 in 50 or 1 in 100 year event in the financial markets," Watsa said in his 2005 letter.

Watsa turned out to be spot-on. When that event happened in 2007, Fairfax had the best year in its history.

"Our total investment portfolio had another excellent year in 2007 while we maintained and increased the protection we have built against a 1 in 50 or 1 in 100 year storm in the financial markets," he said in his 2007 letter.

In 2007, he made $1.64 billion in total net gains, including unrealized gains and losses from his S&P 500 hedges and credit default swaps. The return that year was 14.4%.

Hedging results were even better in 2008. When all major stock markets had fallen about 50%, Fairfax reported a 16.4% return and total interest and dividend and net investment gains of $3.3 billion.

"While we are pleased that our forecast of 'the seven lean years are over' did come true, we much prefer the Noah principle, 'Forecasting doesn't count, building an ark does'!" Watsa said in 2008.

Time will tell if the markets have a downturn and his ark building pays off again.

All of Watsa's top stock positions returned gains in the third quarter: Johnson & Johnson ( JNJ ) (up 2%), Level 3 Communications ( LVLT ) (up 4%), Resolute Forest Products (up 12%), Research In Motion ( RIMM ) (up 1.5% and down 48% year to date), U.S. Bancorp ( USB ) (up 7%) and USG Corp. ( USG ) (up 15% and up 148% year to date).

See Prem Watsa's portfolio here. Also check out the un dervalued Stocks, top growth companies and high yield stocks of Prem Watsa.About GuruFocus: tracks the stocks picks and portfolio holdings of the world's best investors. This value investing site offers stock screeners and valuation tools. And publishes daily articles tracking the latest moves of the world's best investors. GuruFocus also provides promising stock ideas in 3 monthly newsletters sent to Premium Members .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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