Prem Watsa “China Reminds Me Of US Housing In Boom”


Prem Watsa Fairfax Financial Holdings Ltd (TSE:FFH) – Chairman and CEO on FFH conference call this morning.  Watsa discusses the state of the company with a “year in review” flavor, and looks to the future with a particular emphasis on China.  See  Prem Watsa: China Has Biggest Housing Bubble in History

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Prem watsa Fairfax financial’s year end conference call

Thank you, Rick. Good morning, ladies and gentlemen. Welcome to Fairfax Financial Holdings Ltd (TSE:FFH)’s year-end conference call. I plan to give you some of the highlights and then pass it on to Dave Bonham, our CFO, for additional financial details.

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Our insurance companies had an outstanding year in 2013, with a combined ratio of 92.7%, with excellent reserving and record underwriting profits. OdysseyRe had a record low combined ratio of 84%, while Zenith made an underwriting profit for the first time since we purchased them in 2010.

We realized gains from our common stock portfolios of $1.3 billion in 2013. Excluding all hedging losses, and before mark-to-market fluctuations in our investment portfolio, we earned $1.9 billion in pretax income. Including all hedging losses and mark-to-market fluctuations in our investment portfolio, we reported a $0.6 billion after-tax loss for 2013.

We expect the unrealized mark-to-market losses to reverse in the future. In fact, as of February 11, a few days ago, we had in unrealized mark-to-market gain in 2014 of approximately $900 million. After-tax this would have eliminated our loss in 2013.

In the past we had two years, 1990 and 1991, that we had a negative total return. In both cases we rebounded significantly in the following year.

I caution you, we don’t pay too much attention to short-term fluctuations in market prices. Our common stock portfolios continue to be fully hedged. And we continue to be soundly financed with year-end cash and marketable securities in the Holding Company of $1.3 billion.

Moving on to our insurance and reinsurance businesses, our insurance and reinsurance businesses’ premium volume remained flat in 2013 after a number of years of growth. The combined ratio for our insurance and reinsurance operations in 2013 was 89.1% for the fourth quarter and 92.7% for the whole year.

At the subsidiary level, the increase in net premiums written in the year 2013 and combined ratios were as follows. OdysseyRe, increase in premiums in 2013 was flat; combined ratio of 84%. Crum & Forster, increase in premiums flat; 101.9% combined ratio. Northbridge had a 4.6% increase in premium; 98.2% combined ratio. Zenith 13.1% in premium; 97.1% combined ratio for the whole year. And Fairfax Asia had a 7% increase in premiums, with an 87.5% combined ratio.

As we have said before, very low interest rates and reduced reserve redundancies mean there’s no place to hide for the industry. Combined ratios over time will have to drop well below 100% for the industry to make a single-digit return on equity with these low interest rates. While the short term is always tough to predict, fundamentals we think will eventually play out.

Net investment losses of $1.56 billion in 2013 consisted of the following. Please refer again to page 2 of our press release. Net losses on equity and equity-related investments of $537 million resulted from net gains of $1.4 billion from the table, and a $2 billion net loss on our equity hedge, principally reflecting the temporary mismatch between the Russell Index and our equity portfolio. This is predominantly because of the Russell 2000 significantly outperforming the S&P 500 in 2013.

We realized gains of $1.3 billion on our equity portfolio in the year 2013. The realized loss of $1.4 billion on our equity hedges was due to the sale of common stocks and, consequently, a permanent reduction in our hedges.

Also, we had unrealized losses of $1 billion in our municipal and treasury bond portfolio because of the impact of rising interest rates. We expect the mark-to-market losses to reverse, as I said earlier, over time, and we have seen some of that already.

As we have mentioned in our annual meetings, annual reports and quarterly calls, with IFRS accounting where stocks and bonds are recorded at market, and subject to mark-to-market gains or losses, quarterly and annual income will fluctuate wildly, and investment results will only make sense over the long term.

Core inflation continues to be at or below 1% in the United States and Europe, levels not seen since the 1950s, in spite of QE1, QE2 and QE3. Our CPI-linked derivatives, with a nominal value of $83 billion, are down 76% from costs, and are carried on our balance sheet at $131.7 million, even though they have 7.5 years to run. As I have said to you before, our CDS experience comes to mind.

When you review our statements, please remember that when we own more than 20% of a company, we equity account. And when we own about 50% we consolidate. So that mark-to-market gains in these companies are not reflected in our results.

Let me mention some of those gains. As you can see on page 14 of our quarterly report, the fair values of our investment in associates is $1.815 billion, which is a carrying value of $1.433 billion, an unrealized gain of $382 million that’s not on our balance sheet. Also, as we own 75% of Thomas Cook and 74% of Ridley, which are consolidated in our statements, unrealized gains on market values as of December 31, 2013, on both these positions is approximately $152 million. Thus, total unrealized gains not reflected on our balance sheet is $534 million.

On top of this, Europe properties, our investment in an exceptional REIT with outstanding management, where we have increased our investments of the rights issue, has another unrealized appreciation of $109 million not included in our balance sheet. For a grand total of $643 million, all not on our balance sheet.

Of course, all this works out in the long term so take these mark-to-market fluctuations as just that, fluctuations that have no impact over time. As I’ve said before, the Company held $1.3 billion of cash, short-term investments and marketable securities at the Holding Company and is in a very sound financial position.

We have reduced our equity holdings because of increasing markets by approximately 20%. And we continue to be approximately 100% hedged in relationship to our equity and equity-related securities, which include convertible bonds and convertible preferred stock.

We continue to be very concerned about the prospects for the financial markets and the economies of North America and Western Europe, accentuated, as we have said many times before, by potential weakness in China and emerging markets. We continue to feel that there is a big disconnect between the financial markets and the underlying economic fundamentals.

As of December 31, 2013, we have over 32%, or $8 billion, in cash and short-term investments in our portfolios to take advantage of opportunities that come our way. As a result, in the short term our investment income will continue to be reduced.

Thank you. (Operator Instructions) Jeff Fenwick, Cormark Securities.

Jeff Fenwick, Cormark Securities

Prem, a little bit of movement in the investment portfolio through the quarter here as you mentioned you sold some of your positions and closed out your S&P 500 swap there as well. How are you feeling in terms of the mix today and where you would like to position the portfolio here going forward in 2014?

Prem Watsa

Yes, Jeffrey. We’re quite happy with the way we’ve positioned it, Jeffrey, 100% hedged on our common stock portfolios large cash positions have developed and we have muni bonds predominately protected by Brookshire Hathaway guarantee and we have some US government bonds but very little corporate bonds so we have basically risk averse you would say and concerned about what’s happening in the financial markets.

Jeff Fenwick, Cormark Securities

Yes. So I’ll pass it on to Dave but perhaps just to make the point that we always reserve conservatively on an accident year basis and then of course we watch how the reserves develop. And so we are very conservative on an accident year basis. For all our companies. But Dave, specifically to OdysseyRe, would you add a few comments?

Prem Watsa

Sure. OdysseyRe reported favorable development of $114 million in the year. And $134 million in the fourth quarter. And that was principally related to prior years catastrophe loss reserves developing favorably. And also related to casualty reserves developing more favorably this year.

Jeff Fenwick, Cormark Securities

Okay. And then sorry, at Northbridge was there anything in particular?

Prem Watsa

Nothing specific at Northbridge. Favorable development across all of the lines of business and all of the reserves. And that was about $154 million on the year, $46 million on the quarter.

Jeff Fenwick, Cormark Securities

Okay. And then my second question is related to the investment portfolio so Prem, you’ve been warning about the potential for a hard landing in China. For some time now. And reiterated that a bit again today. Certainly we’re starting to see some cracks in the financial system there so my question is, have you contemplated more direct investment vehicles to potentially profit from a hard landing in China?

Prem Watsa

That’s a very good question. We haven’t identified anything specific. What we are more interested in — China’s a very large economy as you know add anything happening in China will impact the world. China takes almost 40% to 50% of every commodity so of course China will have an impact on Canada and we’ll have an impact on many of the commodity producing countries like Australia and Brazil, other countries in the world. So we are focused on protecting ourselves first and foremost. And not making as much of a gain. Now, some of you will say we are hedged and 100% hedged on the upside and 100% hedged on the downside. So how are we going to make any money? And what happens — we’ve realized a significant amount of gain, $1.3 million from — $1 billion from the common stock portfolios and we’ve reinvested it in things that we like which are significantly down from where they were. And we are protecting our portfolios equity portfolios from significant drops not 5% and 10% drop but like 30% plus drops. That’s what we’re worried about, Paul and in that environment the fact that we’ve sold our common shares that have done very well and about things that haven’t done as well means that we’ll be protected on the downside. We don’t expect to go down as much as the indices. And that’s happened in the past. It happened more recently in 2008 that we came down significantly less and made a lot of money on our hedges and we think that’s yet to happen. But fascinating to me that here we have a huge monstrous bubble in Real Estate in China and you’re asking me to question its written about in the press, a year ago there was a CBS documentary on it. And seems to me that almost no one worried about it. Reminds me what happened in the housing crisis in 2003, ’04, ’05 the boom in housing reminds me of takes me back to the tech boom where companies big companies like Northern Telecom and others were buying companies small little companies for $10 billion and $20 billion with no sales, no revenues and nothing other than a few engineers together. And that takes me back to the 1980s when you have the same type of experience in the oil industry. And the problem with these booms or bubbles is that they relax for some time and you can never tell when it will change. And our experience over 35, 40 years is to stay away from them and have the fortitude to continue to stay away even when you look very wrong. Like last year for example if we were really smart, we wouldn’t have hedged our common stock portfolio. And perhaps begin to hedge it later than the year or now. Well, we’ve never done that over 28 years.

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