Prem Watsa's 2007 Shareholder Letter - Fairfax Financial

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 a market 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. If we choose properly, you may be pleased with our rate of compounding of book value in the future.

...

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. Ben Graham 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.!!