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Watsa wisdom: Fairfax’s (latest) bet on a market correction

Fairfax Holdings CEO Prem Watsa speaks at the annual general meeting for shareholders in Toronto, April 9, 2014.

Mark Blinch/The Globe and Mail

Monday's widespread market tumult prompted calls that lofty stocks were overdue for a correction in many parts of the world.

But few have been foretelling a downturn for as long as Prem Watsa, chief executive officer and founder of investment and insurance company Fairfax Financial Holdings Ltd.

A long-time value investor, Mr. Watsa has warned about risks in the global markets in recent years, as his company fully hedges its equity portfolio to protect against "permanent capital loss from the many potential unintended consequences that abound in the world economy."

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"In this crisis that we're going through last week and this week, this is what we've been worried about for a few years now," Mr. Watsa said in an interview on Monday. "And the problem with all of this is you can never say when it will happen."

In recent years, Mr. Watsa has highlighted concerns about weak economic growth in the Western world, deflation and a real estate bubble in China.

Fairfax waited patiently to profit from its last big bearish prediction, too.

"Remember the credit-default swaps? We were worried about the housing crisis in 2003 and 2004, it took place in 2008. So the timing is always very tough," he said.

Fairfax benefited from bets made before the credit crisis that some major financial firms would run into difficulty. The position made the company hundreds of millions of dollars. Fairfax's decision to short the S&P 500 prior to the financial crisis of 2008 also paid off, as did removing the hedges on its stock portfolio near the low point for the market in 2009.

"So, you can see the signs and all you can do is protect yourself and stay away from harm," Mr. Watsa said.

The full hedging position the company has on its equity holdings now mirrors its position from 2003 to 2008. But this time around, Fairfax has been concerned about deflation rather than the U.S. housing market, and is looking to consumer price index-linked derivatives for profits.

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The equity hedges are puts on the S&P 500 and the Russell 2000, meaning the company has taken a position that these indexes will decline. Both are down about 8 per cent since December, 2014. Thanks to the market movements of the recent few days the company's deflation floors are also popping in value.

But Fairfax has also paid dearly to maintain those positions amid more bullish markets, the same way it did with credit-default swaps (CDS), until all of a sudden the positions became valuable.

"While the deflation derivatives are very volatile, if we are right, these derivatives may become as valuable as our CDS derivatives became in 2007/2008," Mr. Watsa wrote in the company's last annual letter to shareholders released in March this year.

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