Fairfax Financial chairman Prem Watsa likes to prepare early for possible market meltdowns.
Fairfax began hedging its stock portfolio and buying credit default swaps years before the crash of 2008-'09, and for a long time it lost money on them. But when the debacle came, it hit the jackpot.
For the past five years, Fairfax has hedged again and bought derivatives to protect from deflation, and it has profited as markets have begun to crack. As he said in his annual letter to shareholders: "It is better to be wrong, wrong, wrong, wrong, wrong and then right, than the other way around!"
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Here's how Watsa has explained his moves since 2006.
March, 2006: "Animal spirits are alive and well and downside risks have long been forgotten."
March, 2007: "Some of you have wondered—sometimes loudly—why we bother with these hedges and credit default swaps. Besides our comfort in having this protection, we continue to think that this insurance policy may pay dividends—perhaps sooner than you think!"
March, 2008: "The very significant risks that we identified for you in the past few years have now materialized with a vengeance."
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March, 2009: "We had to endure years of pain before harvesting the gains in 2007 and 2008."
March, 2010: "Our reading of history—the 1930s in the U.S. and Japan since 1990—shows in both periods nominal GNP remained flat for 10 to 20 years with many bouts of deflation."
March, 2011: "Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!"
March, 2012: "Ben Graham's observation that 'only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925' continues to ring in our ears!"
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March, 2014: "While it is very painful and costly waiting, we think your (and our!) patience will be rewarded."
March, 2015: "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."
March, 2016: "We have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals. These risks may be coming to a head in early 2016, as I write this Annual Report to you—right out of the blue!"