Fairfax Financial Holdings Ltd. chairman and chief executive officer Prem Watsa speaks during the company's annual meeting in in 2013.Aaron Harris/Reuters
Fairfax Financial Holdings Ltd.'s bearish investments have "come to life" amid threats of deflation in major economies, says chief executive officer Prem Watsa.
Mr. Watsa has spent years warning investors about a great disconnect between stock markets and the underlying economic instability of countries around the world. Now, his warnings about deflationary conditions are taking shape and Fairfax is laying on even more protection.
The company has topped up the hedges on its equity portfolio to 100 per cent this year from 88 per cent at the end of 2015. That amounted to adding to its short positions by a notional value of $938-million, the company said while releasing 2015 financial results.
"You know, in the insurance business, we think of it as one-in-50-, or one-in-100-year storm," Mr. Watsa said on a call with analysts Friday. "We want to protect ourselves. And we think right now, with interest rates at zero for some time and in many cases going negative and a ton of debt in the system, we think that the possibilities on the downside are significant."
Investors are taking notice – the stock has climbed to new highs in recent weeks, up about 16 per cent since the start of 2016.
There's still a lot of volatility to contend with. It's likely the hedges will weather wide swings in market value and liquidity over the short term, and Fairfax has "no intention" of taking its hedges off soon. But Mr. Watsa, who believes in long-term value investing, said the worth of the hedging will be clear many years from now.
Those investors that have been with Fairfax for a while have seen patience pay off. A series of good investments around the time of the financial crisis resulted in $2-billion in profit. And the full hedging position the company has on its equity holdings now parallels its position between 2003 and 2008.
But this time around, Mr. Watsa is particularly concerned with the spectre of deflation rather than the U.S. housing market. And the goal is preservation, rather than profits.
"What we're trying to do is protect our company from worst-case events," Mr. Watsa said. "And deflation is a very difficult environment to make a return in."
Some of the equity hedges are puts on the S&P 500 and the Russell 2000, meaning the company has taken a position that these indexes will decline. In the fourth quarter of 2015, Fairfax took a loss of $113-million on its equity hedging positions. But the company showed net gains of $501.8-million on the equity hedges in all of 2015, which was attributed to a 5.7-per-cent decrease in the Russell index.
The consumer price index-linked derivatives based on the U.S. and Europe have come alive in recent weeks, Mr. Watsa said on the call. "CPI inflation continues to be at or below 1 per cent in the United States and Europe, levels that we have not seen since the 1950s," he said.
Mr. Watsa wouldn't quantify exactly what kinds of gains the CPI-linked derivatives have made in 2016 so far – investors will have to wait until next quarter to check in on hedging figures. He said some of his concerns include negative interest rates in countries such as Japan, falling bank stocks, and the limited impact that rounds of quantitative easing have had on the U.S. economy.
Creating a model to track the movement of these derivatives is "next to impossible," Tom MacKinnon, an analyst with BMO Nesbitt Burns, said in a note to clients. On Friday, the U.S. Labour Department said its core consumer price index increased by 0.3 per cent in January, which was slightly higher than expected. Mr. MacKinnon said the gains may not be material and estimated the derivative contracts "are still 2.5 per cent out-of-the-money, which could suggest we need 2.5-per-cent cumulative deflation going forward before these contracts start to bear fruit."
Mr. MacKinnon noted that Fairfax's move to sell a portion of its $300-million of Greece's bonds at a loss were a drag on investments in the company's quarterly results.
With all the focus on Mr. Watsa's macro views, it can be easy to forget that Fairfax's main source of profits come from its insurance business, operating under various brand names around the world. Fairfax said its underwriting profit was its best yet at $705-million in 2015, up from $552-million one year earlier.