Friday, March 07, 2008

Fairfax's 2007 Shareholder Letter

To Our Shareholders:
2007 was the best year in our history. For the first time in 22 years, we earned in excess of $1 billion* after tax ($1.096 billion to be exact) or $58.38 per diluted share. Mark-to-market book value grew by 48.7% to $230.01 per share and we ended the year with almost $1 billion in cash and marketable securities in our holding company. We like lumpy but this was as lumpy as we have ever had!

Book value per share has compounded at 26% over the past 22 years and our common stock price has followed at 23% per year. While we are excited about these results, we have some way to go to make up for the biblical seven lean years that you have suffered.

In last year’s Annual Report, we discussed the change in our financial objectives going forward from a return on shareholders’ equity objective to a 15% compounding over time of our mark-to market book value. I mentioned the favourable impact on our rate of compounding of holding some common stock positions for the very long term. I am pleased to say we have identified one position that we feel very comfortable holding for a very long time because of its excellent track record, wonderful culture and decentralized structure of operations.

Johnson & Johnson has perhaps the best long term track record we have come across. They have compounded sales and earnings for the last 100 years in excess of 10%per year. The growth prospects for their products on a worldwide basis are unlimited.We own 5.9 million shares at a cost of $62.29 per share with amarket value of $370 million.We think in the next few years, Mr.Market may give us many more opportunities like Johnson & Johnson that we can purchase at attractive prices for the long term. Ifwe choose properly, you may be pleased with our rate of compounding of book value in the future.


2007 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami and Sam Mitchell.

The very significant risks that we identified for you in the past few years have now materialized with a vengeance. In the past year, we have seen a major decline in housing prices and its collateral impact on asset backed bonds, CDOs and other instruments. As the U.S. economy heads into a recession, risk is now being identified and repriced in structured investments based upon automobile loans, commercial real estate loans, credit card receivables, leveraged buyout debt and bank loans.

Hyman Minsky, the father of the Financial Instability Hypothesis, said that history shows that “stability causes instability”. Prolonged periods of prosperity lead to leveraged financial structures that cause instability. We are witnessing the aftereffects of the longest economic recovery (more than 20 years) in the U.S. with the shortest recession (2001). Regression to the mean has begun – but only just begun!

We have witnessed credit spreads widen dramatically for mortgage insurers, bond insurers and junk bonds, reflecting mainly the problems of the housing market. We remain vigilant for the spreading of these risks into all credit markets, because the same loose lending standards and asset backed structures have been applied to these markets. Also, as we have mentioned in the past, we remain concerned about the potential decline in record after-tax profit margins in the U.S. and its impact on stock prices. Of course, the potential impact of the U.S. economy and stock prices on the rest of the world’s economies and stock prices, particularly given that most of the
world’s stock markets are trading at close to record highs, is why we continue to protect our portfolios from a 1 in 50 to 1 in 100 year financial storm.

Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record low interest rates and record high fiscal deficits, Japan went through years of mild deflation. The feelings at the time in Japan were that they were different and would not allow stock prices and land prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!

The assumption in the marketplace that “structure” would eliminate or significantly reduce all risks collapsed as thousands of mortgage structures were downgraded, some from AAA to CCC in a single day. After five years where the average downgrades were less than 1%, in 2007 S&P downgraded nearly 16% of the 36,000+ residential mortgage backed securities it rated. In the marketplace, the prices of many of these asset backed bonds declined significantly in the second half of 2007 and have continued to decline since then. Currently, some AAA subprime mortgage
backed bonds are trading at 60¢ on the dollar and some similar AA issues are trading at 25¢ on the dollar. Please remember that there are approximately $3.8 trillion in asset backed and non-Agency mortgage backed securities where the same structuring techniques and “good times” assumptions have been employed to create “highly rated” securities. Only time will tell, but our expectation is that few of these securities will remain unscathed.


Anonymous said...

Just one question. What is the holding company cash and other resources of Fairfax? What can they spend to meet holding company obligations?

In what ways do the conference call numbers differ from the annual report?


Anonymous said...

Hey Nick,

Cardboard on Sanjeev Microsoft board has nailed down the cash position - which was not as it seemed at the conference call.

Perhaps you could fill the baord in.