Prem Watsa from the FFH conference call – some interesting macro thoughts – Watsa’s views have not changed over the years, but we thought readers would nonetheless, find them of interest.
In the third quarter OdysseyRe again had an excellent combined ration of 88.3%, while Zenith had a combined ratio of 83.8%. As shown on Page two of our quarterly release, we have realized gains on our investment portfolio of $16 million during the third quarter, excluding all hedging gains and before mark-to-market fluctuations in our investment portfolio, we earned $138 million in pre-tax income. Including all hedging, losses and gains, and mark-to-market fluctuations in our investment portfolio we reported pre-tax income of $616 million, and after-tax income of $475 million in the third quarter of 2014. Our third quarter has continued to trend to the first half of 2014. You will note investment portfolios went up to $26.9 billion, almost $27 billion in the third quarter in spite of being 79% hedged, 23% in cash and short-term investments, and little exposure to corporate bonds.
How did this happen? Long US government bond rates continued to drop and our common stocks did much better than the Russell index, which dropped 7.7%. We have yet to significantly benefit from our hedges, and are approximately $108 billion in deflation swaps. And of course our cash position gives us great optionality. At our Annual Meeting we made the point that while we are protecting our capital on the downside, our investment portfolios could also do very well. The first nine months of 2014 are a case in point. Our common stock portfolios continue to be hedged at approximately as I said 79%. We selectively bought more stocks but we did not add to our hedges. Our common stocks outperformed the index. We continue to be soundly financed with year-end cash and marketable securities in the holding company of $1.4 billion.
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Also, please remember that it took five years in Japan before deflation set in for the next 18 years. When you review our statements, please note that when we own more than 20% of a company, we equity account, and above 30% we consolidate. So that mark-to-market gains in these companies are not reflected in our results. As you can see on page 11 of our quarterly report, the fair value of our investment in associates is $2.17 billion, with a carrying value of $1.81 billion, an unrealized gain of $356 million not on our balance sheet. Also, Thomas Cook and Ridley, which are consolidated in our financial statements are doing very well compared to our original purchase price.
We continue to be concerned about the prospects of the financial markets and the economies in North America and western Europe accentuated as we have said many times before, by the potential weakness in China and the emerging markets. We have said and now we have said it for some time, we believe there continues to be a disconnect between the financial markets and the underlying economic fundamentals. As of September 30th, 2014 we have $5.9 billion in cash and short term investments, which is approximately 23% of our total investment portfolio, to take advantage of opportunities that come our way. As a result in the short-term our investment income will likely be reduced.
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Jeff Fenwick – Cormark Securities – Analyst
Hello. Good morning. I just want to follow up on you have been pretty consistent in your commentary about the macro risks that you are seeing there, and the potential impact on investments, but when I look at the way you’re deploying some of your funds here, it looks like the amount of cash and marketable securities, the balance there has been gradually trending lower for the last few quarters, I think it was about 30% of the portfolio at the start of the year, down below 25% now, and I was wondering how are you balancing that view of the risk, and does this imply you’re seeing some areas where you are seeing value, and where you feel the risk/reward is attractive to you?
Prem Watsa – Fairfax Financial Holdings Limited – Chairman, CEO
Yes. Jeff, it’s our cash position whether it’s 30% or 25% is not a top down view. It’s looking for opportunities, and when we don’t see them, it’s parked in cash. What we have seen selectively, Jeff, is opportunities that work for us, and so the cash has come down. It’s come down some from 30% to as you said, a little below 25, but we are still very concerned. We sort of look at this whole time period as a 1 in 100 year event, so if you remember in the liability side, catastrophes were very low this year in 2014, so there were no windstorms to speak about in Florida, but that doesn’t mean that we don’t protect ourselves from a Category 5 coming into Miami, right? It hasn’t come ever, but we want to survive that. So in a similar sense, we look at the left hand side of the balance sheet, the investment portfolios, and we always have to protect ourselves from the markets coming down, we use a 30%, 40%, 50% drop in the markets, interest rates going up, all sorts of permutations and combinations, but broadly speaking we’re looking at protecting ourselves from worst case events on the left-hand side of the balance sheet, and at the moment, it doesn’t seem to worry too many people, but that doesn’t mean we don’t protect ourselves. But the fact that our cash position has gone from 30% to 25%, small we have seen some positions, we have taken a position in Eurobank, for example, that’s public, that’s the new one that we disclosed, but otherwise our position hasn’t changed in any significant way.
Jeff Fenwick – Cormark Securities – Analyst
Okay. And I guess that feeds into my follow-on question there around the CPI contracts. You continue to add here to the notional value, is there some target in terms of just how big you would like that exposure to be, or is it just a question of these contracts you can acquire them at attractive pricing today, and it’s just giving you more cover, and you’re happy to sit on them?
Prem Watsa – Fairfax Financial Holdings Limited – Chairman, CEO
Jeff, that’s a good question. We have accumulated, and when I say it’s got some similarity to our credit default position, I meant like when we bought it, you will remember the credit default position it dropped quite significantly, and we averaged down, and that’s what we basically have been doing with our deflation swaps. They’re long-term contracts, and we are averaging down, and we have got a very good position now, where I have said in the last few quarters that plus minus we’re where we want to be. We might use a little money, just to refresh the CPI indices, get them back to where they are today, but we see in sort of worst case events, and right now as I said in my prepared comments, deflation in six or seven countries in Europe, I mean actual de police station.
China there’s, China’s economy is weak, no one knows how weak, but you do know that commodity prices, the price of oil has done recently from $100 to $80. The price of iron ore has collapsed from $190 to less than $80 a ton, and price of copper has trended down, so you are seeing commodity prices come down significantly. China’s real estate prices are coming down. We have talked about that before, and so if anything happens in China, Jeff, you have got a very significant deflationary factor, and in that environment, if that happens, some may say when that happens, these contracts are, even though they have got seven or eight years to go, they are marketable contracts. They react to sentiment about inflation or deflation, so if you think inflation these contracts will be worthless, and that means we would lose $110 million over some time period. So there’s very little downside in our book value for that $110 million, but if the sentiment changes towards deflation, these contracts will respond pretty significantly, and we keep that because in a deflationary environment, and Japan is a great case, it’s very difficult to make any money, because everything is going down. Stock prices are going down, and interest rates are going down, credit spreads widen significantly, so it’s very difficult to make any money, and perhaps one of the few places you will make money is on the deflation swap, so we’ve got that in the back of our mind, and we are very happy with the position that we’ve acquired, and it’s been acquired over a few years as you know, but mark-to-market it’s down like 80%. More than 80%.
Paul Holden – CIBC World Markets – Analyst
I wanted to ask you about the position you have in US Treasuries, and other fixed income products outside of the, munis which we know you’re going to hold to maturity. In the past when rates have dropped to extremely low levels such as this, we have seen you sell some US treasuries, I’m not sure you did the same this quarter. Maybe your updated thoughts on your holding the fixed income?
Prem Watsa – Fairfax Financial Holdings Limited – Chairman, CEO
Yes. So US Treasuries is another case as to happens in the marketplace. We’ve had QE3, I don’t know about a year-ago or so, or a little longer and most people expected interest rates to go up and Treasuries didn’t go up. When they started tapering, which most people would have expected interest rates to go up, long Treasuries to go up further, they started tapering, meaning they were no longer buying Treasuries, Treasury rates have come down. Long Treasuries ended the year 2013 at close to 4%, and they have been trending down every quarter. They ended the September quarter at 3.20% and now they’re at 3.05% or something, to the surprise of many.
So that’s another possibility of deflation being in the air, because if you have deflation in the United States, or very low rates of inflation, then of course you would gravitate towards the most secure bonds, which is US Treasuries, and we continue to have some, we have sold in the past at the 2.50 area I think, Paul, and we keep our options open as to where we would sell them, but our long Treasuries we have sold at approximately 2.5, but I must say that Van Hoisington, who we have quoted before, came out with an excellent third quarter, for our shareholders, I want you to make sure that you read that, because it’s an excellent third quarter report. He’s the only guy that we know of in any, among money managers who’s got it right in the last ten years, and he’s been very positive on long Treasuries.
And he’s made the point that the velocity of money which impacts how an economy does, in the United States has been trending down significantly, but it’s been trending down in Europe even more, and in Japan even more in absolute rates, and it’s worth looking at those figures, because it does make some very good points. So we continue to like the Treasury position. It’s not huge, but it can be significant in terms of making some money for us, but Jeff, it’s interesting to me when I watch the fact that QE3 came in, and interest rates, QE3 what it did was buy bonds and other things which you would expect the interest rates to come down. It did the opposite. When they stopped, the Feds stopped, interest rates came down. So thank you for that, and what’s your, anything else that you had, Paul?
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MIkel Abasolo – Solo Capital Management – Analyst
Thank you and good morning. My question is on Eurobank. I think that yours is better on the Greek economy, restoring balance, avoiding structure of deflation, and ultimately remaining the Euro. And my question is, why do you trust Greece’s macro economy to be as resilient as Ireland’s, allowing you to score similar success with Eurobank perhaps as you had with Bank of Ireland (ADR) (NYSE:IRE). And if i may on your other Greek investments, particularly Mytilineos this year stands now that this structure prices have collapsed again in Greece? Thank you very much.
Prem Watsa – Fairfax Financial Holdings Limited – Chairman, CEO
Thank you. In Greece, first of all, we have always have been long-term investors, we like the leadership of the country, we think it is pro business. We think Greece has suffered greatly, in terms of its economic position, and its bottoming out, and in fact, increasing, economically increasing. We think Eurobank, the banking industry in Europe, in Greece there were about 20 to 25 banks, five six seven years ago, where there are only four now, and Eurobank is one of the four. They were approximately the same size, and Eurobank is very well-run, so we like that. The like the management team of Eurobank, and we feel very confident that over the long-term, Eurobank will do well, as well as the Bank of Ireland has done for us in Ireland. If you just take Ireland for two years, in 2011 it’s difficult to think how Ireland, the prospects for Ireland were two years ago or three years ago in 2011, and today it’s so different. So it’s very difficult to tell how Greece’s position will be a few years from now. We think it will be good. As far as the prices that are coming down, those are the fluctuations they go up, they go down. We don’t pay too much attention to them. We look at the long-term, and in the long-term we think our Greek investments will do very well. So thank you for your question, Mikelo.
