Fairfax Financial’s Hedges Shelter Insurer from Financial Crisis

By | October 13, 2011

Toronto-based Fairfax Financial, which raked in billions during the 2008 financial crisis by using market hedges, is once again a go-to stock for shaken investors.

Although the company has been criticized by some for its opaqueness and complicated structure, its stock has risen 2.8 percent since the beginning of July, the strongest issue in the Toronto Stock Exchange’s financials sector, which has fallen nearly 10 percent over the same period.

Since mid-2006, Toronto’s benchmark S&P/TSX composite index has risen just over 10 percent, while Fairfax stock has nearly quadrupled. Analysts say its go-to status should last as long as the recent market volatility continues.

“Fairfax’s strong balance sheet, steady underwriting performance, and defensively positioned investment portfolio… combine to make Fairfax a solid defensive pick through the ongoing market turmoil,” said Jeff Fenwick, an analyst at Cormark Securities.

Fenwick has a “buy” recommendation on the stock and a C$460 [US $450] target for its price in a year’s time. The stock closed at C$396.47 [US $388] Wednesday.

While technically a property and casualty insurer, the Canadian company is better known for its investment portfolio, run by founder and Chief Executive Prem Watsa, who has been described by some as “Canada’s Warren Buffett” because of the way he played the 2008 crisis.

“It’s the great-man theory of stocks. You’re betting on Prem Watsa, and the rest of the company’s completely opaque,” said David Baskin, portfolio manager and president of Baskin Financial Services in Toronto.

As the equity market crumbled in late 2008, Fairfax notched a $2.7 billion investment gain on the year, due to equity hedges and the use of credit default swaps as a bet against the U.S. housing market. Watsa then removed the equity hedges and rode the market higher through 2009.

In late 2010 and early 2011, as equity prices were rushing to multiyear highs, Watsa was again sounding the alarm on markets, due to concerns about financial system debt. He hedged 100 percent of the Fairfax’s stock portfolio in mid-2010.

The move forced Fairfax to take a loss in the fourth quarter of 2010, but has paid dividends in 2011 as markets have retrenched.

The company recorded net gains on investments of $119.6 million in the second quarter of 2011 even as equity markets sold off during the period, and investors have kept the stock close to decade highs.

CIBC World Markets analyst Paul Holden, who has a C$450 [US $440] a share target on Fairfax, said he expects its third-quarter results to benefit from the company’s large U.S. bond holdings.

“U.S. bond yields have come down significantly over the last quarter, so we expect them to book a large gain,” he said.

Meanwhile, Watsa has kept up his habit of surprising the market with his moves, diving into the heart of the European debt crisis with the purchase of a 9 percent stake in struggling Bank of Ireland, one of a number of acquisitions Fairfax has made as many others in the market have retrenched.

“It certainly shows he’s a contrarian investor,” said Todd Johnson, a portfolio manager at BCV Asset Management in Winnipeg, which holds Fairfax bonds.

Johnson said the investment was “a long-term investment in Ireland, and an eventual recovery in the economy and in banking.”

Fenwick believes Fairfax may leverage its strong financial position — the company has a cash position of more than $1.1 billion — to make more acquisitions of companies whose shares are trading at depressed levels.

(Figures are in U.S. dollars unless noted)
(Reporting by Cameron French; editing by Peter Galloway)

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