A mere three days after publishing my brief rant about The Folly of Risk Management we learned that Fairfax Financial Holdings lost a chunk of money on their investments because of the hedges in place. To be fair, these same hedges (based on expectations of a market collapse) were effective at turning the company’s shares into one of the few winners throughout the financial crisis.
Below is a quote about the news from Reuters Feb 16, 2012 – 6:09 PM ET:
The Toronto-based company lost US$771.5-million, or US$38.47 a share, in the fourth quarter of 2011. That compared with a year-before loss of US$494.4-million, or US$24.77 a share.
Net losses from investments rose to US$914.9-million from US$887.9-million, which Fairfax attributed to a “non-correlation between the performance of the company’s equities and its equity-related hedges,” which Fairfax said should reverse in future periods. Watsa hedged the company’s equity position in 2010 and took investment losses in that year’s fourth-quarter because stock markets rose.
In my previous commentary I discussed why attempting to manage risk after-the-fact can be very dangerous (see The FOLLY of Risk Management). The result is not just missing good returns when the market bounces back, but losing money as the derivative securities used for the hedges decline in value on paper.
There is also additional risk introduced (despite efforts to ‘manage’ risk) when successful hedges are not unwound or “cashed in.” Fairfax benefited immensely from these same hedging strategies that are now are hurting profits. Investors fell in love with shares of the company as the rest of the market tumbled. In the case of Fairfax, management did not put on these hedges after-the-fact. Chronically risk averse, Prem Watsa almost always anticipates the worst and this time it finally came to be. Every money manager finds it harder to sell stocks or bonds (or unwind a good hedge) when he/she has profited from them.
It’s not unusual for an investor to personally identify with a successful stock pick. His/her ego then prevents the person from selling the stock – it went up because he/she picked it, so it will continue to go up simply because he/she owns it.
After being right for several years, perhaps Prem has simply been reluctant to change course, as he insists:
“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.” (Toronto Star, Feb. 16th.)
I’ve always made it a habit to scrutinize statements like ‘we remain very concerned’ because they often mean ‘I refuse to accept that I’m wrong after being right for so long.’ I am especially worried about such statements when they come from my own mouth. Am I not just being stubborn (like that mule in the above photo)?
For some time now I’ve continued to predict a strong (U.S. leading the world) equity market despite the negative sentiment since the bottom in 2009 (fyi the S&P 500 is UP 50% since then). I’m not prescient by a long shot – I just pay attention to the evidence (cited here over the past many months), ranging from rebounding corporate profits in 2010, poor consumer sentiment mid-2011 (coinciding with market troughs), and insitutional investors getting way offside yet again last September (see Asset Allocation points to RALLY!) – they are always underweight equities immediately prior to strengthening markets….these are just a few of the indicators I’ve come to trust.
Hedging is a dangerous and usually expensive exercize. When I was managing natural resource-oriented portfolios, I’d always pay attention to what company boards were approving when doing their commodity price hedges. Most of the time, their ‘bets’ or hedges were dead wrong, influenced by the prevailing ‘mood’ rather than good business sense. PetroCanada was one of my favourites for predicting natural gas pricing. When natural gas prices were extremely high (normally a good time to hedge) the company would hedge virtually nothing….irrationally expecting the price to go even higher – God forbid they should lock in healthy profits and miss more upside? When gas prices were low, and the expectation was they’d go to zero, then lots of hedging at terrible prices would occur. Of course, the company would then lose $$ unwinding those hedges as natural gas prices rocketed up. As you can guess, I’d overweight natural gas stocks (with minimal production hedges in place) in portfolios when PetroCanada had hedged alot of its production at low prices. When the company wasn’t hedging production, I’d sell all my gas stocks. After all, when the board and management all agree that the commodity price must go higher, they are generally mistaken.
The point is that hedging strategies are bets, and bets are risky. Unless there’s a clearly defined purpose to hedging, such as locking in a profit margin or cashflows required to run a business (mining company needs a definitive amount of cashflow to pay for project financing; pension payments need to be paid out for example) then the hedge is simply a bet most likely biased by recent emotional experience rather than reasoning. Frequently it can be a leveraged bet, meaning it would have been altogether less risky and costly to simply sell the underlying asset rather than do the hedge.
2012 is likely to be the best year for stocks we’ve had in many years….provided governments around the globe continue to keep interest rates low. I for one believe that it makes perfect sense for central banks to keep rates low in order to eventually devalue (let inflation come when it comes) their currencies – after all inflation transfers wealth from borrowers (government) to those that did the lending (private sector). As long as we let them get away with it, they’ll continue to do it. As long as they do it, stock markets will rock.