Value Investing

Watsa ‘Monstrous Real Estate And Construction Bubble in China’

From Prem Watsa’s 2013 letter to shareholders. We will be covering this year’s event, sign up for our free newsletter to ensure you do not miss any of it.

FAIRFAX  FINANCIAL  HOLDINGS  LIMITED

To Our Shareholders:

 

So all in, the result was a net loss of $565 million and a 7.8% decrease in book value (adjusted for the $10 per share dividend paid) to $339 per share. Since we began 28 years ago in 1985, our compound annual growth in book value per share has been 21.3%, while our common stock price has compounded at 19.0% annually.

While going through our past Annual Reports (a dangerous exercise), some of you long term investors may remember that we first entered the reinsurance business through the purchase of a tiny company called Sphere Re. That experience, and the purchase of Skandia in 1996, made us remark that the reinsurance business is particularly leveraged to a ‘‘few good men and women at the top’’. We saw that again in spades in 2013 as Brian Young and his team at OdysseyRe had the best combined ratio in the company’s history at 84.0%. In fact, we have more than made up for the 116.7% in the catastrophe-ravaged year of 2011. The average combined ratio for the past three years, including 2011, is 95.5%, with very conservative reserving. So a big round of applause for Brian and OdysseyRe, which accounts for almost half our business. I discussed OdysseyRe in last year’s Annual Report and called it ‘‘the jewel in our crown’’ – well, the jewel was shining a little brighter in 2013!

While you have your hands together, Zenith had an excellent year in 2013 as it once again made an underwriting profit (the first time since we purchased it in 2010), with a combined ratio of 97.1% on a premium base of $700 million – much higher than the $430 million it wrote in 2010. You will remember that Zenith had shrunk its volume from $1.2 billion in 2005 to $430 million in 2010 because rates were grossly inadequate. In the past two years, companies that had expanded significantly in workers’ compensation in the 2005 – 2010 period have been falling like dominoes, allowing rates to rise again to adequate levels. Jack Miller and his team at Zenith have navigated the treacherous waters of the California workers’ compensation market exceptionally well. We expect, in time, that Zenith will write more than the $1.2 billion it wrote in 2005.

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Last year, for the first time since we began 28 years ago, we appointed a President at our head office. Given the size and scope of our operations, and the outstanding contributions of Paul Rivett to Fairfax’s growth, we named him President of our holding company. Since he joined us ten years ago, Paul has been intimately involved in all of our head office functions, including acquisitions, financing and succession planning. Also, as Chief Operating Officer of Hamblin Watsa Investment Counsel, our investment management subsidiary, and a member of our Investment Committee, he has been involved in our investments, particularly private placements like the Bank of Ireland and The Brick Furniture Stores and private investments like Sporting Life and William Ashley. More recently, Paul has led our expanding investments in the restaurant business – more on that later. Most importantly, Paul epitomizes our culture of being hard working and team oriented, with no ego. Paul works very closely with all our officers at Fairfax and Hamblin Watsa as well as with Andy Barnard.

At our annual meeting last year, Andy said that his objective was to have Fairfax become as well known for its  underwriting operations as for its investment results. Well, 2013 was a great start! He is now having a very significant  impact on all our underwriting operations worldwide. Under Andy, the Executive Leadership Council, which  consists of our Presidents, Peter Clarke, Jean Cloutier and Paul Rivett, continues to work well in coordinating our
diversified operations and getting the best from all of them. The working groups established by the Executive
Leadership Council across all our companies – all chief claims officers, all chief actuaries, all chief legal officers, etc. –
continue to explore and take advantage of best practices. A very important subgroup that I mentioned last year is our
Talent and Culture Development Working Group. It is making great strides in fostering our ‘‘fair and friendly’’
culture, with a special focus on outstanding customer service. Our special culture – nurtured and preserved over our

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Prem Watsa on Blackberry

No sooner had the ink dried (almost!) after I wrote to you in last year’s Annual Report about BlackBerry, than  BlackBerry became a daily headline. The Board of Directors of BlackBerry decided to form a Special Committee to  look at all options for the company. As we were the biggest shareholder in the company (almost 10%) and were
potentially conflicted by my being on the Board, I decided to resign as a director so we could review all our options.  On September 23, 2013, Fairfax made an offer to take BlackBerry private at $9 per share, subject to a six-week due  diligence period. To do our due diligence, we hired a very experienced team led by Sanjay Jha, who ran Motorola,  Sandeep Chennakeshu, who was President of Ericsson Mobile Platforms, and John Bucher, who was Chief Strategy  Officer at Motorola Mobility. Briefly stated, their conclusions were simply: 1) the company had excellent assets,

2) the management teams had made many mistakes along the way, and 3) the company could not afford high cost LBO debt. For the first time in our history, our due diligence resulted in our not being able to complete an announced deal. After discussions with the Special Committee, led by its Chair Tim Dattels, instead of continuing with a go-private transaction, we proposed to raise $1.25 billion for BlackBerry in the form of 6% seven-year convertible debentures (convertible at $10 per share into BlackBerry stock) and proposed that John Chen be concurrently appointed as Executive Chairman of BlackBerry.

John Chen has an extraordinary background. After immigrating to the U.S. from Hong Kong at the age of 16, John  gained a Bachelor’s degree in electrical engineering from Brown and a Master’s from Caltech. He then trained at  Burroughs (Unisys), turned around Pyramid Technology Corp., and then very successfully resurrected Sybase and ran  it profitably for about 15 years. When John took over Sybase in 1998, it had lost money for four years, its stock price was down 90% (ring a bell?) and most analysts were predicting bankruptcy within six months. Within a year, Sybase was profitable and in 2010, 12 years later, SAP came knocking to buy it at $65 per share, more than ten times the $5 – $6 per share it sold at when John took it over! John has also been on the Board of Wells Fargo for eight years and Disney for ten years.

Since his appointment as Executive Chairman at BlackBerry in November 2013, John has bolstered the management  team (mainly with people he has worked with), done a joint venture with FoxConn to manufacture low cost phones
for emerging markets, brought back the ‘‘BB Classic’’ phone (the Q20) and publicly said that BlackBerry would break  even by the fourth quarter of fiscal 2015 (i.e., the quarter ending January 2015). John is on his way – and all  BlackBerry shareholders are fortunate that he decided to take the job of saving Canada’s iconic technology company.

I must also say, BlackBerry would not have survived if not for the extraordinary leadership of Tim Dattels as Chair of the Special Committee. You may understand why I say this if you read the recent book on Nortel’s bankruptcy ‘‘100 Days: The rush to judgment that killed Nortel’’, by James Bagnall.

We purchased $500 million of the BlackBerry convertible debentures and have said that we would sell some of our  common shares over time to rebalance our position (we have sold 5 million shares at about $10 per share as of this  writing). The rest of the convertible debentures were purchased by six contrarian long term investors, of whom four  were Canadian.

Interestingly, Twitter went public, just after BlackBerry announced its convertible debt issue, at $26 per share, giving it a market value of $18 billion. It had revenues of $665 million and losses of $645 million, and most investors could not get a single share unless they were very good clients of the major houses underwriting the issue. On that day, BlackBerry traded in excess of 100 million shares at $6 per share, giving it a market value of $3 billion. BlackBerry had revenues of approximately $8 billion with cash of $2.6 billion and no debt other than the new convertible debt to be issued. If you thought that Twitter was grossly overvalued at $26 per share, it promptly doubled and currently is selling at $55 per share, with a market value of $39 billion.

Twitter is no exception – please see the recently compiled table below to see the extraordinary speculation in high  tech companies. This sort of speculation will end just like the previous tech boom in 1999 – 2000 – very badly!

 

Prem Watsa
Prem Watsa

 On China

There is a monstrous real estate and construction bubble in China, which could burst anytime. It almost did   in 2011 but China increased its credit growth significantly since then.

In the last few years we have discussed the huge real estate bubble in China. In case you continue to be a skeptic, here are a few observations from Anne Stevenson Yang, an American who has been in China for over 20 years and is the founder of JCapital Research in Beijing:

1.     China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of

more than 50 Manhattans – in just five years!

2.     In 2012, China completed about 2 billion square metres of residential floor space – approximately

20 million units. For perspective, the U.S. at its peak built 2 million homes in a year.

3.     At the end of 2013, China had about 6.6 billion square metres of new residential space under construction,

around 60 million units.

4.     Yinchuan, a city of 1.2 million people including the suburbs, has 30 million square metres of available

apartments – roughly 300,000 units that could house 900,000 people. This is in addition to the delivered but unoccupied units. The city of Guiyang, capital of Guizhou Province, has roughly 5.5 million extra units for a city of 5 million.

5.     In almost every city Anne has visited, pretty much the whole existing housing stock has been replicated and

is empty.

6.     Home ownership rates in China are estimated to be over 100% versus 65% in the U.S. Many cities report

ownership over 200%. Tangshan, near Beijing, is one.

7.     This real estate boom could only be financed through unrestrained credit growth. Since 2009, the Chinese

banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP.

8.     The real estate bubble has resulted in companies extensively borrowing and investing in real estate or

lending on real estate in the shadow banking system. This is exactly what happened in Japan in the late 1980s.

9.     And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive

growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China.
The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where  speculators have borrowed at low rates across the world and invested in China, almost always backed by real  estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is
estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly  enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or  approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China,  watch out!

These observations remind me again of the following quote from Michael Lewis’ essay in Vanity Fair, ‘‘When Irish Eyes are Crying’’, which I wrote to you about in our 2010 Annual Report: ‘‘Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.’’ Amen!

As they say, it is better to be wrong, wrong, wrong and then right than the other way around!

For those of you who believe a picture is worth a thousand words, please watch the recent BBC documentary ‘‘How China Fooled the World’’.

Finally, in our 2007 Annual Report, we quoted Hyman Minsky, the father of the Financial Instability Hypothesis,  who said that history shows that ‘‘stability causes instability’’. Prolonged periods of prosperity lead to leveraged  financial structures that cause instability. This quote was in relation to the U.S. in 2007. It applies in spades to China  in 2013!

Any credit event in China will have very significant ramifications for the world economy

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