Twenty years junior to Warren Buffett, our Investment Guru of Year 2008 Prem Watsa is known as the “Warren Buffett of the North”, for good reasons, as you will see.
Just as Warren Buffett built Berkshire Hathaway (BRK-A), Prem Watsa built his Fairfax Financial Holding Limited (FFH) empire on the foundation of a collection of excellent insurance subsidiaries, except he cut through the deviations that Warren Buffett experienced during his earlier year -- No time for beating the bushes in textile or retail businesses; if Warren Buffett tried and failed, no need for Prem Watsa to reinvent the wheel.
If short term performance is all that matters, Prem Watsa should pride himself for outshining Warren Buffett considerably in 2008. On February 19, FFH reported best earnings in the company’s twenty-three-year history. Fourth quarter 2008 earning was $346.8 million and annual earning was $1,473.8 million for the 2008 year ($19.62 and $79.53 per diluted share, respectively). Company book value per share reached $278.28 and the company has more than $1.5 billion in cash and marketable at the holding company level.
In a challenging year for investment, Prem Watsa achieved his gain by yanking money from his Credit Default Swaps (CDS) counter-parties who bet on the wrong direction. From Q4 2007 on, and mostly in year 2008, FFH unloaded $12.6 billion notional amount of CDS that it accumulated during the past few years. It realized about $2.0 billion gain, a substantial amount for a company that has $4.9 billion shareholders equity after the fact. The company still carried some $415 million CDS that cost $161 million to acquire. But just as Prem Watsa stated in a recent (February 19, 2009) interview with Diane Francis: "We think the major gains in the CDS contracts are over."
Don’t you feel sorry for him? Too bad he cannot keep on betting against CDS of the now-fallen financial giants, because they have fallen. Sooner or later, he had to unwind his CDS positions and move on to some other investment theme. In that sense, CDS is like what Warren Buffett called “cigar-butt” investment – there is still one and only one puff left and after that you have to move on.
And moved on Prem Watsa has. On one hand, as we reported on December 20, 2008, between October and December 2008, he invest about C$720 million into equity positions in a host of companies. Primarily, he spent C$686 on taking Northbridge Financial Corporation private, further fortifying its insurance business. In another but earlier interview (January 15, 2009) with Diane Francis, Prem Watsa gave an account on the transaction:
“We took Northbridge public in 2003 because we needed the money. We owned it for 23 years and its now Canada’s biggest commercial lines company,” he said. “It went public at 1.2 times’ book value at C$15 a share. In the fourth quarter we had a US$350 million dividend from a U.S. investment so we made an offer to buy out the rest of Northbridge for 1.3 times’ book value and a 30% premium to its average trading price or C$39 a share.”
The deal was not bad for the Northbridge shareholders, neither. Shareholders would have made 20% compounded annually if they had held the stock since 2003.
On the other hand, as we reported on Feb 18, 2009, Prem Watsa has been buying and selling US stocks during the final quarter of 2008. More to this in Part II.
For Warren Buffett, the senior and wiser, however, 2008 has been not so great. We know Berkshire Hathaway’s stock portfolio has suffered significantly, as those of the rest of us did, just a matter how much. As we reported on February 17, 2009, his stock portfolio that GuruFocus tracks used to be close to $70 billion, now it has been reduced to less than $52 billion as of December 31, 2008. Even that is after taking into account of the new positions such as Constellation Energy Group Inc. (CEG) and Nalco Holding Company (NLC), and the positions he added such as Burlington Northern Santa Fe Corp. (BNI) and USG. (USG). Of course he was also reported to have reduced Johnson & Johnson (JNJ).
Of course, Berkshire Hathaway is far more than just a stock portfolio. At the end of Q3 2008, the last time when we had a chance to have a glimpse of Warren Buffet’s book, it had $28 billion in cash or cash equivalent, $30 billion in fixed investment and $76 billion in Equity Investments. All in all, the company’s total asset was about $280 billion, $120 billion of that is shareholder’s equity. These numbers does not speak for the fact that it has the best-run insurance operation and its no-insurance businesses are envied by all the other businesses in the world.
It is not as if Warren Buffett did not have a position in derivatives. Instead of CDS, which made tones of money for Prem Watsa, Warren Buffett disclosed his derivatives in the last years Chairman’s Letter to Shareholders (2007)
Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.
First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.
We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.
The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a
level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Without more information, it is hard to say anything intelligent about the first category of Warren Buffett’s derivative. On the second category, with S&P 500 down 38.5% last year, investors should brace themselves for some nasty surprises, even though no cash event will happen. On the other hand, no rain fall of fortune like the $2.0 billion happened to Fairfax shareholders either.
We are anxiously waiting for Warren Buffett to release his Chairman’s Letter to Shareholders 2008 this weekend (February 28, 2009). You see, if Warren Buffett loses money in stocks, there has to be a well articulated reason; if the rest of us lose money, we are just losing money.
2008 is a year Warren Buffett and Prem Watsa seemed to differ from each other in terms of investment approach and achieved different results. In the next part, however, we will surprise you how similar the two men invest their money.
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