In the first in a series for Master Investor Magazine, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
As they say, it is better to be wrong, wrong, wrong and then right than the other way around.
I start this series of articles about top investors that are featured in my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors with a lesser-known investor: Prem Watsa. Watsa is the founder and CEO of the Canadian insurance holding company Fairfax Financial Holdings (FFH). Under his leadership FFH’s book value per share compounded at 22% a year between 1986 and 2014. This puts him in the same league as Warren Buffett. Hence, his nickname “the Canadian Warren Buffett.”
Unlike most other investors that are discussed in my book, Prem Watsa integrates macro calls in his investment process. Over the past decades he repeatedly demonstrated his skill in taking advantage of imbalances in the economy. As an illustration I highlight here how he managed to make money out of the credit crisis of 2008-2009.
Prem Watsa was actually pretty early in detecting the dangers that lurked in the US economy after the technology crash of the early 2000s. He warned in 2003 of the danger of asset-backed securities. Between 2004 and 2008 he repeatedly expressed his concerns about the lax credit standards, growing debt and rising real estate prices in the USA. He even expressed his fear for a 1 in 50, 1 in 100 year financial crisis that could be triggered by these excesses.
As a result he steered clear of structured products like the infamous Collateralized Debt Obligations (CDOs) that were all the rage in the years leading up to the financial crisis. Even more, he started to protect himself against the fallout of a possible financial storm five years before it actually broke out. Indeed, in 2003 Watsa bought some protection against financial institutions through so-called Credit Default Swaps (CDS). In 2004 he also got cold feet about the stock market as he opined that the market collapse of the early 2000s had only partially eliminated the exuberance of the late 1990s. So, he started to hedge about half of his equity portfolio against a market drop.
In subsequent years the excesses in the US economy continued to grow, which prompted Watsa to gradually add to his CDS positions. The figure below clearly shows that Prem Watsa exhibited supreme confidence as he added to his CDS position in 2004, 2005 and 2006 in spite of mounting losses. He also held on to his loss-making equity hedges, and actually increased them to 80% in 2007. Be aware that these were clearly contrarian moves at that time as economists, central bankers and most other investors felt that there was little to worry about!
Then in 2007 the CDS investment finally paid off massively. Problems started to arise in the American housing market, which rattled some investors. Nevertheless, most observers played the housing problems down, and portrayed them as a temporary glitch in a strong economy. This complacency in the market enabled Prem Watsa to buy even more CDS contracts at attractive prices. Early 2008 while very few economists were concerned about the global economy, Prem Watsa warned that the American housing problems were likely to spread to the rest of the world. His investment portfolio therefore remained fully in defensive mode.
Finally, in the summer of 2008, the financial crisis that Watsa had warned about for years arrived. But contrary to some perma-bears at that time, Watsa demonstrated that he was willing to turn around when the market valuations reflected the severity of the economic problems. He actually removed the equity hedges after the stock market crashed in September and October. By the end of 2008 and in the first months of 2009 he was pretty busy adding to his stock portfolio and picking up distressed debt and distressed structured products.
Prior to and during the credit crisis Prem Watsa exhibited typical characteristics of top investors: patience, courage to go against the crowd, willingness to challenge the conventional wisdom, and tolerance for losses in contrarian positions. In addition, although critics may say that Watsa was much too early in anticipating the credit crisis, intelligent investors like him know that being early is part of the game as market timing is an exercise in futility. Next up in the series is a former friend of Watsa, John Templeton.
Figure: Prem Watsa and the credit crisis of 2008-2009.