Jia Lynn Yang at the Washington Post has a good article detailing the record levels of cash on corporate balance sheets right now:
Sitting on these unprecedented levels of cash, U.S. companies are buying back their own stock in droves. So far this year, firms have announced they will purchase $273 billion of their own shares, more than five times as much compared with this time last year, according to Birinyi Associates, a stock market research firm. But the rise in buybacks signals that many companies are still hesitant to spend their cash on the job-generating activities that could produce economic growth.
Some companies are buying back shares partly because they don’t want to invest in developing new products or services while consumer demand remains weak, analysts said.
“They don’t know what they want to do with all the cash they’re sitting on,” said Zachary Karabell, president of RiverTwice Research.
Historically low interest rates are also prompting some companies to borrow to repurchase shares.
The article details the different reasons for doing buybacks. Some, like Microsoft (NASDAQ:MSFT), want to boost their sagging share price by reducing the denominator in the EPS calculation. Others, such as HP are looking at buybacks as a way to offset the dilution that comes from stock options.
Some individuals are critical of buybacks:
But critics say buybacks are a shortsighted way for companies to offload cash when they would be better off investing for the future.
“It’s totally wasted money,” said William Lazonick, a professor at the University of Massachusetts at Lowell and director of its Center for Industrial Competitiveness. “It does not do anything long-term for companies.”
Lazonick added that executives like buybacks because they boost their own stock options.
Defenders of the practice say companies are better off buying back shares if they don’t see opportunities to spend while demand remains weak.
“There are times when the best thing to do might well be to buy back your stock and issue it back again at higher prices,” said Jim Paulsen, chief investment strategist at Wells Capital Management. “There’s nothing wrong with that.”
To me, I see buybacks as a capital allocation decision that is extremely unique to the company in question. A lot of opponents of buybacks will cite academic research which argues that when looked at in aggregate, buybacks don’t do much to increase a stock’s price. When you look at things from a top-down perspective, that is true. The fact is, most CEOs tend to use buybacks when their stock is trading at multi-year highs. They feel on top of the world and must assume that whatever growth has propelled them upwards will keep on coming. This is almost always the worst time to do a buyback. If you are using cash to purchase an asset that is trading beyond its intrinsic value, it’s an easy way to lose money.
Certain companies have proven that buybacks can be a rational and accretive capital allocation decision. Look at Autozone (NYSE:AZO). They bought back almost 70% of their outstanding shares over the last decade. Advance Auto Parts (NYSE:AAP) looks like they might be following the same playbook. Henry Singelton, who Buffett hails a model capital allocator regularly used buybacks and stock issues (for acquisitions) whenever the price was too low or too high. Right now, I would guess that Eddie Lampert at Sears Holdings (NASDAQ:SHLD) is using buybacks to gradually reduce the ownership base till it’s just ESL and Fairholme. At that point he will be able to do some very interesting things with the cash flow generated by Sears.
So I don’t agree with the idea that buybacks are a waste of shareholder money. They just depend on the surrounding environment and the other opportunities that are available. It’s just a matter that has to be studied from a more bottoms up perspective. If you can find a cheap company run by a management team that is savvy at allocating capital, you’ve probably found an excellent long term holding.
John Malone, Liberty Media’s chairman is one dealmaker I’ve been studying more closely these days. He’s really a master at figuring out tax efficient ways of doing deals that create value for shareholders. What I like about him is that in general, investors have made money investing alongside Malone. That’s not always the case when you try to follow other star capital allocators..
Today is Liberty Media’s investor day and you can register for the webcast here. For those interested in the company and some of their business units, these webcasts are very helpful.
Jessica Reif Cohen – Bank of America Merrill Lynch – Analyst
What is your favorite tracker currently and why?
John Malone – Liberty Media Corporation – Chairman
Well, I love all my children and currently, I think that there are buybacks in two of the three that the company is engaged in, or is authorized to do. The third is really — LINTA, we really are not or have not been buying stock back pending a decision on whether or the separation of LINTA into a separate asset-backed company is going to be okay with the bondholders, but I would say each one is sort of different.
Starz on a multiple basis seems cheap to me. We now have strong operating management. Chris [Albrecht] came over from HBO. We’ve had good success with the first couple of major series that we’ve added to the programming lineup. Obviously, the Netflix deal with Epix kind of demonstrates the kind of economics that might be available for that component of the programming right, fairly big numbers. So I think in the short run, Starz is pretty cheap. [LCAPA] is — a sum of the parts analysis, it’s cheap, particularly if you are as enthusiastic about SIRIUS, SIRIUS XM, as we are and I’m quite enthusiastic about it.
And then QVC just continues to grind out massive amounts of free cash flow, that you’re talking there about a leveraged free cash flow asset with cheap leverage and good tax attributes. So that one looks to me like it’s pretty cheap. So I was explaining to somebody a little while ago that in 37 years in the business, we have never issued equity except twice. Once was in September of ‘87 and we bought it back in November of ‘87 after we issued it at about $0. on the dollar and that was when we bought Heritage Communications.
So generally speaking, we’ve always believed that our company was trading cheap on the public market and we’ve been a net acquirer of shares, redeemer of shares, consistently. We’ve never paid dividends because we think shareholders should have the right to decide whether they want to take capital back or not. So buybacks have always been our preferred method for — and we’ve done tax-free distributions which are involuntary, but don’t involve a decision by the shareholders, so those are kind of our ways of returning capital. So I don’t know which one would be my favorite. . .
Speaking of Starz, can you talk maybe about how the Epix Networks transaction has maybe changed some of the possibilities (inaudible) what you were just saying there as it relates to a higher value [of some of the entities] as it stands? What’s the thought process in terms of a billion dollar balance sheet, etc.?
John Malone – Liberty Media Corporation – Chairman
Well, of course, Starz is unlevered. It sits with a billion of cash within the Liberty Starz tracking stock entity and we are not well noted for under-levered enterprises. So it’s unlikely that we’re going to sit with Starz paying a full statutory tax load for very long, so we’ve got to do something. Exactly what we’re going to do, I think, is in deliberation right now.
And clearly, the number one question for us is the issue of the bondholders in Liberty at large relative to the question of substantially all in the creation of the QVC-LINTA separation. That is kind of — as Yogi Berra said, “That’s the fork in the road that we gotta take.” So until we know the answer to that, we’re a little bit frozen in terms of what we do relative to realization on Starz, but as I say, it’s highly unlikely we’re going to let Starz sit there unlevered and sit with zero yield on the cash.
I mean, that’s not — that’s no good. So we’ll do something. We probably won’t really be in a position to do something until probably the first quarter of next year to actually execute something, but we’ll definitely do something. And of course, I’m very high on Chris and the kind of energy he’s bringing to that business, so we’ll see, but obviously, that whole industry is going through a lot of transition. Those digital rights that Starz sits on are clearly worth a lot and I don’t think it’s likely that we’ll sit there and be a passive player in the streaming over-the-top world for very long.
Starz is one I’ve posted about before back in July, so far I’ve been pretty happy with it. At the time, it traded at $53 which I thought was pretty cheap considering the potential up side from their plan to break into original programming now that Chris Albrecht (from HBO) is running the show. In August though, we got a bit of a bonus from the fact that Netflix signed their deal with Epix at a much higher multiple than what they currently pay Starz. If you adjust for that, LSTZA is probably trading around 5x 2012 EV/EBITDA which is not a bad multiple for a company that still has potential to grow and is totally unlevered.
Okay. And as a follow-up, as of the second quarter, Starz had about almost $1 billion of cash on the balance sheet and virtually unlevered at this point paying cash taxes. So what do you think the appropriate use of the cash is right now? Would you consider levering up Starz going forward? And if so, what do you think would be the appropriate leverage for a business like Starz?
Greg Maffei — Liberty Media Corporation – President and CEO
Well, I think you know that Liberty’s history is probably to put more leverage on companies than zero and so it is likely over time that we will add leverage to that company. One of the questions we have had is what is the right configuration for Starz both in terms of the capital side. Obviously the right-hand side of the balance sheet and looking at leverage but also what other assets, what other kind of partnerships do we want to be in? And we have been contemplating and looking at a variety of those.
We have a relatively new CEO as I mentioned in Chris, and led by him but in conjunction with Liberty. We have been looking at ideas about how that asset, how that service would be best positioned for the future and would that require more capital?
And that is why if we have had a hesitation in purchasing stock, in levering up Starz, and those kind of structurally balance sheet questions, that has been in part because looking at the left-hand side, what other assets, what other kind of partnerships did we want?
In addition, we have noted there have been certain milestones along the way to give us confidence in the business, some of which we have hit. The reattribution of Starz Media, the signing of our biggest distribution partner, biggest by number of subs in Comcast. Completion of other partnerships is still out there. Those were all probably important milestones that will give us confidence in the business and a better sense of what the long-term leverage ought to be.
Some people speculated that maybe Netflix would not renegotiate the contract, but I doubt it. They are in the process of dramatically expanding their margins with the shift towards instant streaming and are planning to use the cost savings to acquire digital content rights. Malone’s planned hard spinoff of LSTZA (rather than the current convoluted tracking stock structure) should help clarify the story a bit and get market participants to take notice.
There are some other businesses under Malone’s control that are worth looking at. QVC within LINTA with its free cash flow is pretty impressive when you consider the fact that only 10% or so of audience members are actual customers. If they can figure out a way to increase their conversions, the company could generate a ton of FCF. Then there’s Liberty’s stake in Sirius. Here’s what Maffei has to say:
Unidentified Audience Member
Question regarding the rationale for splitting Liberty into two companies. Isn’t at least over time most of the taxable income generated by the LINTA entity that will be separated from the other two tracker stocks, at least in a corporate form?
Greg Maffei — Liberty Media Corporation – President and CEO
Unidentified Audience Member
And if that is the case, isn’t splitting the Company into two taking away part of the future potential benefit of if you were to buy enough — have enough of a serious stake that you could accelerate the use of Sirius’s NOLs?
Greg Maffei — Liberty Media Corporation – President and CEO
That is a great question. It is one of those ones you can look at and say if you were to own tomorrow 100% of Sirius, $9 billion of NOLs, wouldn’t that be a benefit and wouldn’t you want to keep the whole company together? That is a great question.
It is one of those ones probably that is more theoretical than realistic. Just if you look at the structure of our contract with Sirius, if you look at the Sirius earning capabilities, you look at the issues around making them go [solely], these NOLs. It is just probably a thicket too hard to get to imagine that we would get there. And if you ever did consolidate it, which who knows, there is probably enough other kinds of income at LCAPA that we could potentially shield like our shore against the box and some of the other things that when you look at that combined with the earnings of Sirius, it is just a bridge too far.
You are asking to hold that and say I won’t do a split we believe is beneficial and it is also by the way another issue is who is getting these tax benefits, which group of shareholders? There is just a lot of moving parts there to think about. But it is a great theoretical question.
For those of you that don’t remember, When XM Sirius was teetering towards bankruptcy, John Malone came in and infused the company with $530M of much needed capital via convertible debt, which also gave him a 40% stake in the business. That stake is now worth about $1.89B. Not a bad return in only 1.5 years. Liberty cannot accumulate more than 49.9% of Sirius until the second anniversary of their deal (Feb 2011). I’ve seen some speculation that the company could try to make an offer for the rest of Sirius in 2011 and then use it for a hard spin of LCAPA because it would give the company real operating earnings. Maffei seems to be arguing against such speculation though.
I think that going back and looking at some of Malone’s moves are worthwhile for investors, especially ones that are looking to get better at identifying potential special situations. Looking back at the complicated tracking stock structure that Liberty currently uses, it’s easy to see that an actual hard spinoff would probably unlock some value. And I think if you start thinking about potential balance sheet events, before they happen, when analyzing companies — you’re in a good spot.
Finally, I wanted to include this hour long interview Malone did with CNBC. It’s awesome.
Sorry for the light posting lately. I’ve been tied up with a couple of projects and have had to travel a bit. I should have a regular stream of posts coming up soon.
Many of you might remember my post Learning from Michael Burry where I looked at how he started out to get some insights on his investing process. Now, Bloomberg has a new article that talks a bit about where he is finding opportunities:
“I believe that agriculture land — productive agricultural land with water on site — will be very valuable in the future,” Burry, 39, said in a Bloomberg Television interview scheduled for broadcast this morning in New York. “I’ve put a good amount of money into that.”
Agricultural land is one area I’ve thought a bit about. With populations set to increase globally, there will be more demand for food. The thing I have not figured out is a way to play these trend as a value investor. In recent years we’ve seen short bubbles take hold of certain ag. commodities like wheat. Farmland, which is a bit less direct might actually make more sense. If you think about it, when commodities like wheat rise in price there is a real demand for increased production. Governments will try to do whatever they can to keep prices down, so that their people don’t riot. The value of farmland should increase in the long term even as commodities fluctuate, as long as we continue to see a rise in our population.
Another area Burry is looking at is small Asian technology companies:
“I’m interested in finding investments that aren’t just simply going to float up and down with the market,” he said. “The incredible correlation that we’re experiencing — we’ve been experiencing for a number of years — is problematic.”
Still, it’s possible to find opportunities among small companies because large investors and government officials focus on bigger ones, he said. He is particularly interested in small technology firms.
“Smaller companies in Asia, I think, are neglected,” he said. “There are some very cheap companies there.”
I am curious about whether he is looking at China. In some ways, the general disinterest in Chinese equities reminds me of the behavior he saw after the dot com bubble burst. At that time, the general investor community shunned technology firms, despite the fact that many had cash rich balance sheets with virtually no debt. Many of these companies eventually became net-nets or negative enterprise value companies. These were great investments for the value investors that were willing to ignore the words technology and internet, instead choosing to focus on their balance sheets.
If we look at Chinese microcaps today, many trade at incredibly low valuations. There is a good reason for that. The general investor community is worried about the potential frauds that are lurking beneath the surface. I don’t really know how to pick out Chinese frauds well enough to invest in Chinese microcaps. To some extent, I think it is almost a numbers game. Where if you diversify enough you can expect a certain percentage of your portfolio will go to 0 because of fraudulent activities but that a greater percentage will maintain or increase their value.
I wont invest in these Chinese microcaps, but I can imagine that whoever manages to pick the legitimate companies from the frauds will do extremely well.
Finally, Burry is looking at gold:
Gold is also a favored investment as central banks issue debt and devalue their currencies, he said. Governments haven’t adequately addressed the causes of the financial crisis and may be sowing the seeds for future problems by borrowing, he said. In the U.S., lawmakers showed they didn’t understand how to prevent another crisis when they gave the Federal Reserve and Chairman Ben S. Bernanke additional authority, he said.
“The Federal Reserve, in my view, hadn’t seen this coming and in some ways, possibly contributed to the crisis,” he said. “Now, Bernanke is the most powerful Fed chairman in history. I’m not sure that’s the right response. The result tends to tell me they’re not getting it right.”
To me, gold is really a trade where you are trying to profit from the fears/anxieties of the rest of the market. Some traders are very skilled at gauging that kind of sentiment and figuring out when it will shift so that they can then get out of gold and into other assets. I don’t know enough to be able to do that so I’ll stick with analyzing global businesses that have pricing power.
Bloomberg has a video up where you can hear from Michael Burry himself:
For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.
Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.
The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.
The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.
With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:
The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.
Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.
If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.
In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.
The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.
Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.
So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.
What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).
If you’ve been following the blog lately, one of the trends you will have noticed is the increasing amount of attention I’ve been giving to large cap blue chip stocks. I’ll be the first to tell you that these are not exciting companies. There is no event driven catalyst. But as best in class companies, they remain cheap and pay out strong dividend yields. Johnson & Johnson (NYSE:JNJ) is one that I’ve constantly talked about on here. The story is all rather simple – you are getting a best in class business at a 8.7% earnings yield and 3.7% dividend yield. Yesterday, I saw in the Berkshire Hathaway filing that Buffett has been a buyer as well:
OMAHA (AP) — Berkshire Hathaway partly rebuilt the stake in Johnson & Johnson it had reduced in the last two years to raise cash for other investments, and increased its investment in Wal-Mart Stores in the second quarter.
Berkshire, the holding company run by Warren E. Buffett, detailed its $46.4 billion stock holdings Monday in a filing with the Securities and Exchange Commission.
The document revealed several changes in the company’s portfolio from March 31 to June 30, including decreases in Kraft Foods, ConocoPhillips, Procter & Gamble and M&T Bank. Berkshire also increased its stakes in Becton Dickinson & Company, the Nalco Holding Company and Sanofi-Aventis. The biggest change was in its Johnson & Johnson stake, which grew to 41.3 million shares at the end of June, from 23.9 million shares in March. In 2008 and 2009, Mr. Buffett sold some of its stock in the company to help pay for other investments.
Berkshire held 64.3 million shares of Johnson & Johnson at the end of 2007.
Over the last few quarters I saw Buffett reducing his exposure to JNJ. I figured this was because he needed to raise his cash balance in his portfolio due to the preferred share deals he struck during the crisis and the Burlington Northern Santa Fe acquisition.
With most of that over, I think he is rebuilding his JNJ stake for a few reasons. One, JNJ is large enough to provide the kind of liquidity that is necessary for Buffett to increase his stake without distorting the stock price. Two, JNJ pays a heavy dividend yield that creates cash flow for Buffett to redeploy elsewhere. It’s much better than cash or most of his fixed income options. Finally, JNJ has the kind of long term prospects that Buffett likes in a business. They make products that people will need for a long time. This is a company that managed to survive even the Great Depression. There aren’t a whole lot of companies still around that can boast that fact. That does not mean JNJ or any other large cap blue chip is impervious to sharp market draw downs. Typically, these stocks will fall just like everything else. Sometimes the fall is a little less pronounced because capital flees riskier stocks and enters into some of these more defensive names.
On the credit side of things, JNJ seems to be doing well. The company just placed 10 year bonds at historically low rates:
Johnson & Johnson sold $1.1 billion of bonds at the lowest interest rates on record for 10-year and 30-year securities amid surging investor demand for the highest- rated corporate debt.
The drugmaker, in the first offering by a nonfinancial AAA rated company in 15 months, sold $550 million of 2.95 percent, 10-year notes and the same amount of 4.5 percent, 30-year bonds, according to data compiled by Bloomberg. That’s the lowest coupons for those maturities on record, according to Citigroup Inc. data going back to 1981.
“Even though some faith in the rating agencies has been blown, the triple-A is still sacred,” said Guy LeBas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia.
…In J&J’s most recent debt sale, it sold $900 million of 5.15 percent, 10-year notes that paid 103 basis points more than similar-maturity Treasuries and $700 million of 5.85 percent, 30-year bonds at a 113 basis-point spread in June 2008, Bloomberg data show.
So why might JNJ be undervalued? I think that with all the analyst attention JNJ garners, a sort of short term mindset comes into play. JNJ had a few recalls which reduced sales and in turn forced analysts to lower their estimates. I see these as short term problems, the company has dealt with product recalls in the past. If the company can prove that they can resume their sales growth or simply boost their dividend, I could see the stock begin to trade back up towards its highs from the last few years.
Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.
Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:
Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.
By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:
What environment are you positioned for today?
Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.
The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.
So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.
Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.
Are you at all concerned about inflation and rising interest rates?
Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.
If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.
Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).
My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.