Watsa: Well Europe, to put it in perspective, I think you might have seen something that I spoke to one of our local newspapers, the Globe & Mail, about. In the story I laid out some of my concerns, and my primary concern, if I can just put it broadly and then come to Europe, is to say that we think we're in a very difficult environment right now, might last for 3-5 years, so it's a longer term deal. It comes from the United States with the austerity program, 0% interest rate, basically the idea that there's no ammunition either with the Fed or with the Treasury, because we've got these huge deficits, larger debt, and 0% interest rates.
So if you go to Europe, it's the same thing. There's austerity programs across the continent, from Germany down to Greece, and Ireland and Portugal. Italy just came out with a 50-60 billion euro austerity program, which means they're raising taxes and they're cutting government spending. So, if you think that the last few years is a recovery from the 2008-2009 recession, the "Great Contraction," if you think this is a normal recovery, then you might be quite positive on stocks and perhaps bonds, corporate bonds.
But we think of this as a one-in-fifty, one-in-a-hundred year event. We think it could be like Japan in the last 20 years or the U.S. in the ‘30s. we think those are the two events that need to be studied, not to say that history will repeat itself, but those are the two events that need to be studied, and there are quite a few similarities in terms of too much debt in the system in the U.S. today and interest rates which are at 0%, so there's no ammo left to get the economy going while individuals particularly are deleveraging and paying back debt. And now governments are doing the same, in a time of deleveraging, in the U.S. and in Europe. So we're prepared for a tough environment.
Watsa: In our annual meeting, I showed the Schiller P/E, I showed the Schiller real estate index too. But the point there on the price/earnings is a good one. Right now, people look at the S&P 500 and think it's cheap, they think earnings will be at $100 selling at 12x earnings, perhaps less, and the worry of course is that the earnings will not be at 100, that they could be significantly less for the second half of this year and next year, so this environment is one that we worry quite a bit. That's why for ourselves, our stock positions are almost 90% hedged, we have a lot of Treasury bonds and municipal bonds, and we have those deflation contracts. It's amazing to us how after 2008, 2009, when the spreads widened dramatically between corporate bonds and government bonds, they've come down a month, month and a half ago to levels that existed in 2007 and 2008. Now they've started going back up again, so we have very little in corporate bonds, because we basically figure that we're not being paid for taking risk, so if we're not getting paid, we just like owning Treasury bonds, and that's what we've done.
GuruFocus: You mentioned the earnings of the S&P 500. Of course, we know the earnings have been high because profit margins are extremely high from a historical point of view. What do you think about the profit margin? Do you think it will come back to the historical mean?
Watsa: Yes, you know that regression to the mean, that concept, so things going way beyond the mean eventually come down. We saw house prices took off and now they're coming down, and they're still 15-20% off where they have been historically, real house prices adjusted for inflation. So yes, the margins in a tough economic environment will come down again, quite significantly. I mentioned in that article in the Global and Mail that China is also an area that you have to be a little careful because in China they have this construction boom that's going on. There's quite a bit of real estate speculation that's taken place there.
Watsa: So you might have experienced that, have you been recently to Shanghai or Beijing? I was there just six months ago, and ordinary people, making 65k - 75k, which is a good amount of money/salary in Shanghai, owned four apartments, and their friends owned three-four apartments, and I said, "How high has it gone up?" and he said, "It's gone up three or four times in four years." But if they would just sell one apartment they could re-coup their cost, they'd have $1 million, but unfortunately there's no way they will be convinced to sell because of the current psychology and an overwhelming belief that China's a big country with 1.3 billion people and there are all sorts of reasons why a property price decline won't happen. That reminded me of all sorts of real estate markets, including the one in Dubai that has fallen flat now and of course the U.S. markets, some time back the UK market, some time back in Canada we had the same thing, so these bubbles do break. But in China, it's such a big economy that if it breaks, it will affect the rest of the world, particularly in commodities.
Watsa: We've never hedged before, we've only hedged in the last five or six or seven years, and it's this worry that Ben Graham suggested years ago that this current economic environment is different, this is different from any recession we've had. The real estate speculation in America was massive, the destruction of wealth when house prices came down 30-50% was massive, and you have to be very careful. So we operate in a mark-to-market world in terms of our capital. If the insurance business one of these days will turn, and we don't want to be restricted in the ability of our insurance businesses to write more business because the capital's gone down, because of mark-to-market hits. Mark-to-market declines this time may last for some time, as opposed to 2008-2009 when it lasted it seemed for a few months.
Watsa: Yes, we removed that hedge when the markets went down 45-50% and with the gains we made on the hedge we bought more stock. And we had a lot of government bonds at the time, corporate spreads had opened up dramatically and we sold government bonds and bought corporate bonds, distressed bonds and municipal bonds. We had a very good 2008 and a very good 2009.
Watsa: We are hedging not for 5-10% declines, we are hedging big market risk. We're worried about the markets coming down significantly. It might not happen, but we are just very downside protection oriented. We look at downside protection, we worry about that, and we have to live within our means. I keep telling our team, we don't have the Federal Reserve or the Bank of Canada to help us. We always keep a $1 billion + in cash and marketable securities in the holding company. Our financial position is very strong, we have very little maturities in the next five years, that's significant. We don't count on having access to the bond markets and the preferred markets, (we do have access to them and can issue them at any time, but in 2008 and 2009 it was very difficult to issue anything), so we always keep a lot of cash, that's a policy statement for us and of course in our insurance companies too, 25-30% in cash (which is earning very little by the way). So sometime we expect the insurance market to turn and we'll benefit from it.
Watsa: If you were running a pension fund, you might not hedge, and if you were running a mutual fund, you might not hedge, because those are relative returns. So a pension fund money manager would look at it, if they drop 20% but the market dropped 50%, he's a hero. We solely focus on absolute return because of the fact that it affects our capital. And there might be a time that our capital is so huge that we don't have worry about it, but at the moment we continue to worry about fluctuations, big fluctuations, not small fluctuations. And given what I told you before, that we think this economic environment that we just came through in the last few years is worrisome to us because we think of it as either Japan or the 1930s.
If you are managing your own money, as we are with the insurance company portfolios, you will want to be hedged because we do not want to incur impairments or the loss of capital, whereas mutual funds and pension funds are more focused on performing relative to their peers.
Watsa: John Templeton was my mentor, I'll tell you, I've known him for 30 years, he passed away a few years ago, but John Templeton was always a long-term investor in common stock. I remember in 1999-2000 he said to me, "Prem, buy bonds, forget about common stock, they're too risky." Then, more recently, four-five years ago, he always hedged, and he said "In this environment, what I like to do is buy the best things I like, and I short the things I really don't like."
But I try to be neutral, sometimes more short than long, but that's John Templeton. So John, one of the key lessons he taught me was to be flexible. His investment philosophy was always value oriented, long term, buy at the point of maximum pessimism, but be flexible in your thinking, and that's what we try to apply.