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Watsa sticks to his guns as pessimism proves costly

Prem Watsa, chairman and CEO of Fairfax Financial Holdings

Charla Jones/The Globe and Mail

Prem Watsa is sticking to his bearish views – at a price.

The investor's decision to hedge Fairfax Financial Holdings Ltd. 's stock portfolio in the belief that equity markets are due for a decline cost the company $780-million.

Mr. Watsa has been increasingly vocal about his prediction of a lengthy period of deflation. The ongoing debt crisis in Europe, weakness in the United States and housing problems in China are poised to send markets down sharply for a prolonged period, he says.

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But markets in general have been rising, and Mr. Watsa has been paying the price. The U.S. S&P 500 Index is up nearly 8 per cent so far this year, while Toronto's stock market has risen more than 4 per cent.

The Fairfax chief executive, who made billions from his call on the 2008 financial crisis, is sticking to his bet. Most investors are too optimistic right now, he said in an interview on Thursday.

"We don't feel comfortable with our common stock position without it being fully hedged," he said. "We think for the long term, 10 years, stocks will be very, very good. But the next few years we have to be very careful."

He points specifically to China, where "the real-estate bubble has been pricked."

"Most people tend to think that the Chinese government will be able to hold it," he said. "Our experience is it's very tough, once you prick a bubble, to stop it from coming down significantly."

And he's concerned other major global forces are rapidly reaching a boiling point.

"We have stocks in our portfolio that we like a lot, but in the next few years we're worried about China and Europe, these are big markets, and housing has still got a lot of problems in the U.S.," he said. "So we are still very cautious."

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He suggested that too many investors are reacting to headlines rather than fundamentals.

"The markets are very focused on the short term, on some good number that's come from the United States or elsewhere, and if another number comes out that's not good the market will react in a negative way," Mr. Watsa said.

"In October they thought things were so weak, three months later they think the world is a good place."

Fairfax reported its fourth-quarter and year-end financial results Thursday. It lost $771.5-million in the final three months of the year as its investment portfolio bled $914.9-million. Bonds accounted for almost $100-million of the drop, but the majority of losses stemmed from the hedges on its stocks. (The hedges are designed to offer a counterweight to the stocks, and will make money if their prices decline, to protect Fairfax from declining stock markets).

Fairfax is so pessimistic that, by the end of December, it had hedged its portfolio to the tune of 105 per cent, meaning it is essentially shorting the stock market or betting that it will go down. But markets rose significantly towards the end of last year.

For the full year, Fairfax turned a profit of $45.1-million, a result with which Mr. Watsa says he's content, considering it was the second-worst year for industry-wide catastrophe losses around the world. The Japanese tsunami, New Zealand's earthquake, and flooding in Australia and Thailand were among the disasters that ate into the insurance industry's collective balance sheet to the tune of $105-billion.

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"When you have really bad catastrophe losses, worst-case events, we're willing to lose a maximum of one year's worth of income, which is basically what happened here," Mr. Watsa said.

As a result of the rise in catastrophes, insurance premiums are also rising, and so now is actually a good time to be writing such business, Mr. Watsa added.

"The big advantage is that when this happens, pricing goes through the roof. The pricing in Japan has gone up very significantly, and pricing in Thailand is going up. When I say 'significantly,' I'm talking 50 to 100 per cent, big price increases."

While Fairfax's equity hedges cost it in the fourth quarter, they earned money in the third quarter when markets slumped. All told, the company lost $379-million on stocks during 2011. But its overall investment portfolio had net gains of $691.2-million thanks to more than $1.2-billion in gains on bonds. In addition, it made a further $705-million on interest and dividends.

Mr. Watsa said the single best asset class to be in during 2011 was U.S. long-dated treasuries, and Fairfax had a pile of them.

And he is urging Fairfax's investors to keep their eye on the long term.

Fairfax's book value remained roughly flat last year, including the dividend. But "if you look at the last five years, our book value has compounded at 19.5 per cent, and over the last 26 years our book value has compounded at 23.5 per cent per year," Mr. Watsa said.

"No one has even come close to that in our industry."

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