Prem Watsa is worried about the stock market. In fact, the famed value investor and CEO of Fairfax Financial has hedged his company's stock portfolio against a market downturn.
When an investor as successful as Mr. Watsa adopts such cautious measures, should ordinary investors follow his lead? Let's take a look to see if investing in value stocks while selling, or "shorting," the broad market has worked – either as a permanent technique or as a temporary measure when the markets are due for a decline.
To hedge its portfolio against the possibility of a bear market, Fairfax takes out short positions against the S&P500 and Russell 2000, selling the broad market indexes so the company will benefit if they decline.
Although the hedge is of the same size as Fairfax's stock portfolio, it does not specifically cover the value stocks that Mr. Watsa owns (or as the pros say, is "long" in). As a result, it is not an exact hedge. There is a slight mismatch.
The accompanying graph gives some idea of how a similar long-short strategy might work. It shows the returns that come from going long in value stocks and shorting the broad U.S. stock market.
The value side of the equation is represented by the returns of the second lowest 10 per cent (or decile) of stocks in terms of price-to-book-value (P/B). Stocks with low P/B ratios are considered classic value stocks. The second lowest P/B slice also happens to be the top performing decile over the long-term.
The market is represented by the returns of the largest 30 per cent of stocks by market capitalization. This approximates the S&P 500.
The data show that value stocks have outperformed over the long term. A simple strategy of investing in value stocks would have provided 12.4 per cent average annual returns.
Sticking to a hedging strategy through thick and thin would have hurt your results. Going long value stocks while shorting the market yielded only 3.5 per cent average annual returns.
But can shorting the market at least help protect your wealth in downturns? The second graph addresses that question. It shows periods when the long-short portfolio declined from its prior peak in comparison to similar periods for buy-and-hold value investors.
The numbers say the long-short strategy did provide some protection against the big value crashes of the past. Most notably it muted the crash of 1929. It would have also helped during the 2008 debacle.
However, it isn't a surefire technique because it still suffered a 50 per cent decline in the 1930s. As a result, most investors should probably avoid complicated hedging strategies and simply hide out in cash during such periods. To make a shorting strategy pay off, you have to be able to spot bear markets ahead of time. As a Fairfax shareholder, I hope that Mr. Watsa's crystal ball has maintained its clarity.
Norman Rothery, PhD, CFA is founder of StingyInvestor.com
Norman Rothery