Nuggets from Prem Watsa

GuruFocus.com

- By Robert Abbott

Every March, Prem Watsa (Trades, Portfolio) of Fairfax Financial Holdings Ltd. (FFH.TO) releases his annual letter to shareholders.


In it, he addresses the successes and failures of the companies within the Fairfax portfolio, along with other issues all investors face, including asset bubbles and economic circumstances. And, with those comments there are usually some quotable quotes and sprinklings of humor.

The normally publicity-shy Watsa got a good dose of attention in late 2016, when he took drastic action in response to the election of Donald Trump as president of the U.S. He sold much of the hedging he had had in place since 2010 and upped his equity holdings. In selling off the hedging, Fairfax Financial took a $1.2 billion loss, giving it one of the few losing years it has had in the past 30.

Despite the loss, few shareholders will want to dump their stock; over the past three decades Watsa has given them exceptional returns. As he reported in the 2017 letter, "Since we began 31 years ago, our book value per share has compounded by 19.4% (20.2% including dividends) per year, and our stock price has followed suit at 18.6% per year."

This article offers a number of Watsa nuggets, quotable quotations that provide insight into investments and a guru investor's mind. They come from the last four letters, which are identified here by their years of publication (not the fiscal years they reviewed). The full texts of all his letters are available here.

For those investors who have scratched their heads and banged their fists when the prices of their stocks did not keep up with book valuations, Watsa said (in the 2014 letter) you must keep your eye on the long game.


"In the short term, there is no correlation between growth in book value and increase in stock price. You will note periods when our book value grew substantially faster than our stock price and vice versa. More recently, we think the intrinsic value of our company has grown much more than its underlying book value. In 2013, our book value dropped by 10% for the reasons discussed earlier while our stock price increased 18%, some of it due to the declining Canadian dollar. However, it is only in the long term that book values and stock prices compound at similar rates."



Watsa is often compared with Warren Buffett (Trades, Portfolio), and for several reasons, including decisions to build their empires on a foundation of insurance companies. In his 2016 letter, Watsa boasted:


"Our book value per share has compounded at 20.4% (21.2% including dividends) per year and our stock price at 19.4% per year. The compound rate of growth in our stock price over 30 years is the best in the property and casualty industry (there are only 12 public companies with a 30-year track record), second best among all companies in Canada and in the top 10 companies in the Standard & Poor's 500."



Although Fairfax Financial has significant holdings in technology, primarily through BlackBerry (BBRY), he expressed his frustrations about tech valuations in the 2014 letter.


"As discussed earlier, the high tech stocks were soaring - particularly those with no earnings and very little revenue. Tesla (TSLA), for example, sold 22,477 cars in 2013 but commands a market cap of $31 billion, while Fiat (FCAM), which we like, sold 4.4 million cars but has a market cap of only $14 billion. Amazon (AMZN) has a market cap of $167 billion but has not earned more than $1.2 billion in any one year since it went public in 1999. Facebook (FB) has recently made a $19 billion offer for WhatsApp - a company with approximately 50 employees and $20 million in revenue. This is the poster child for the excesses that prevail in the tech world!"



Watsa returned to the tech-bubble overvaluation theme in his 2015 letter.


"So Uber has a valuation of $41.2 billion as compared to the cumulative equity capital raised of $2.8 billion - i.e., the valuation is a hefty 14.7 times all of the money that was raised by the company.

"We're confident that most of this will end as other speculations have - very badly!"



In the 2016 letter, he discusses a bad ending in another sector; commodity prices took another big hit in 2015, and he lists five big companies that have seen their share prices drop dramatically, between 62% and 98%, from their 2011 highs,


"Interestingly enough, all of the above companies [Rio Tinto (RIO), Anglo American (AAL.L), BHP (BHP), Glencore (GLEN.L), Teck (TECK) and Cliffs (CLF)] made major acquisitions in 2011 and loaded up their balance sheets with debt! They are trying to clean up their balance sheets by selling subsidiaries at very low prices - and at huge losses from their purchase price. Unfortunately, we have seen this movie many times over our 40-year career."



Few investors focus as much on risks as Watsa, who worries about everything from tech bubbles to consumer spending. Writing in 2016's letter, he says:


"I have purposely given you a quick summary of all the problems/challenges that the world faces right now. The potential for unintended consequences, and therefore of pain, is huge. This is why Ben Graham said if you were not bearish in 1925 - yes, 1925 - you had a 1 in 100 chance of surviving the depression - really the 1930 to 1932 crash in the stock market that resulted in an 86% loss from the high in 1930. We continue to protect you, our shareholders - and our company - as best we can from the potential problems that we see. As we have said, it is better to be wrong, wrong, wrong, wrong, wrong and then right, than the other way around! We remember it took 89 years for AIG (AIG) to build $90 billion of shareholders' capital, and only one year to lose it all!"



In the 2017 Letter, Watsa wrote:


"Since we fully hedged our common stock portfolio in 2010, we have been frequently asked, as we have constantly asked ourselves, under what circumstances would we remove the hedges. Obviously, a huge selloff in the financial markets, such as that of 2008-2009, would have led to that result, as the hedges would have performed the purpose for which they were established."



He has hedged Fairfax Financial's stock holdings for years, often with negative results. But, every so often he is vindicated, and Watsa said in the 2014 letter that he planned to continue with safety first:


"We had to endure years of pain before harvesting the gains of 2007 and 2008. While we hope the world economy muddles through, we continue to protect our company from the significant unintended consequences that prevail today."



As we know now, he dramatically reduced his hedging positions in late 2016, anticipating a Trump administration would stimulate the economy (and the stock market).


"What actually happened with the U.S. presidential election on Nov. 8 was the arrival of a new administration focused on dramatically reducing corporate taxes (35% to 15% - 20%), rolling back a myriad of regulations large and small which unnecessarily impede business, and very significantly increasing much needed infrastructure spending. In our view, this should light up 'animal spirits' in America and result in much higher economic growth than what has prevailed in the last eight years."



And, he added:


"When the U.S., a $19 trillion economy, does well, the world tends to do well!"



One of the keys to Watsa's success has been the ability to see what his company does in broader context, as expressed in the 2016 letter.


"Very simply, we think of business as a good thing. By providing outstanding service to customers, looking after and nurturing employees, providing a return for shareholders and then reinvesting a portion of the profits in the communities we serve, we think business can be a calling. The key, we think, is to be focused on the long term and never compromise honesty and integrity in any relationship. Our Guiding Principles have served us well over the past 30 years and are the rock on which our company is built. They will never change!"



Many are envious of early hires at tech companies, employees who become millionaires because they took some of their pay in stock instead of cash. Fairfax Financial has an employee share ownership program that didn't require quite the same sacrifices of its early employees, but has created millionaires nevertheless,


"If an employee earning $40,000 Canadian ($29,669) had participated fully in this program since its inception, he or she would have accumulated 3,162 shares of Fairfax worth $1.3 million Canadian at the end of 2013. I am happy to say we have many employees who have done exactly that!"



The guru has a somewhat complex relationship with Fairfax Financial, based on the multiple-voting share structure that allows him, and his family, to control the company. At the same time, he has kept a lid on his own salary and secondary compensation.


"I have agreed that through 2025, I will continue not to receive any remuneration by way of bonus, equity incentive or pension entitlement, and my annual salary will remain at $600,000 Canadian, where it has been since 2000 at my request."



And in an expression of pride, Watsa reported on the charitable giving of his company and employees, in the 2014 letter.


"Imagine - our entire company was worth less than $2 million when we began 28 years ago, and last year alone we donated over $12 million."



Conclusion

That last nugget captures much of what drives Watsa. He sees himself as a steward of shareholders' money, and someone who can use their capital to help them and to help the world as well.

Investors would do well to consider how the gurus manage to be both bold and cautious at the same time, investing in value stocks while often hedging against losses they might sustain. Watsa has paid dearly on occasions for his hedging, but those hedges have made a major contribution to his long-term results and his status as one of the world's investing gurus.

Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.