Tickers in this Article: FFH, BRK.A, PG, HPQ, BRK.B
It's official. The world is in recession, a global economic quagmire that could spell disaster for many companies, including Fairfax Financial (NYSE:FFH). According to its CEO Prem Watsa, the recession will be deep and painful. Because we failed to learn the lessons of the 1990s about greed and excess, the time has come to pay the piper.

While it's impossible to side-step current events, there are ways to limit your personal hell. One such method is to invest defensively with experienced managers like Prem Watsa, whose investment portfolio grew 19.5% annually for 15 years to the end of 2007, compared with 10.4% for the S&P 500. The Canadian master of capital allocation knows his stuff and, as a result, is often compared to Berkshire Hathaway's (NYSE:BRK-A, BRK-B) Warren Buffett.

A Storm Brewing
Fairfax is a holding company that owns property, casualty and reinsurance businesses. Like Buffett, Watsa takes the float from his insurance companies and invests wherever he sees fit. Generally conservative, the recent market crisis has shaken even him. Seventy percent of Fairfax's investment portfolio was in cash or government securities as of June and hedging the company's equities 100%. Thus, Watsa believes the time has come to hunker down and protect assets during what is turning out to be a long and painful drought.

Sensing in 2003 that times were getting frothy, Fairfax began buying credit default swaps to protect its balance sheet. Meant as a defensive posture, the move generated impressive profit. In the third quarter, Fairfax made $575 million from selling a $3.22 billion notional amount of credit default swaps. Since beginning this program five years earlier, the company has made $1.65 billion from a $8.87 billion notional amount of credit default swaps. (To learn more about credit default swaps, be sure to read Credit Default Swaps: An Introduction.)

Money Maker In Good Times And Bad
Since the beginning of the market decline in August 2007, Fairfax's investment portfolio has grown $2.3 billion to $19.55 billion. In 2007, it wrote $4.5 billion in net insurance premiums, adding fuel to the investments fire. As for the swaps, Watsa reasons that Fairfax paid $425 million for $22 billion in credit default swaps. However, if the wrong decision was made, the company could lose up to $425 million. The people who sold the swaps, however, exposed themselves to the entire $22 billion, which gives favorable odds.

Operating businesses earned $1.13 billion, or $59.89 per diluted share, in the first nine months of 2008. This is an increase of $532.2 million, or $28.27 per diluted share, over the previous year. The large gain was partially a result of the $1.24 billion in gains from credit default swaps. In addition, revenues were $2.16 billion, up from $1.87 billion the year before. Hurricanes Ike and Gustav affected the operating income of Fairfax's insurance operations. Otherwise, profits would have been even higher.

Fairfax's Assets
Hedge funds are taking a beating this year, but Clarium Capital seems to have done well through the first part of September. As of mid-September, it was still up 27.8% year-to-date, a gain that can be partly attributed to the bet that commodities would fall. However, one of the investments in Clarium Capital's portfolio at the end of the second quarter was none other than Fairfax, along with Procter & Gamble (NYSE:PG) and Hewlett-Packard (NYSE:HPQ). Thus, it's not hard to see why Clarium is holding.

Fairfax's return on equity is 36%, much higher than the industry average of 11%. Further, its net margin of 18.7% is almost three times higher than the industry average of 6.8%. Add to these indicators an earnings-per-share increase from $5.6 in 2003 to $58.54 in 2007 and you can see why its stock is up 1% over the past 52-week period in comparison to the S&P 500's decline of 37%. (To learn more about the return on equity measure, don't miss Keep Your Eye on the ROE.)

Creative Accounting
Until 2002, Fairfax maintained a program to lend money to directors and officers whereby a trustee holds the shares until fully paid for. Fairfax pays the prime, plus one-half percent interest. Currently, there are $17.4 million in loans outstanding, with the value of the stock underlying those loans worth $52.5 million (minus any dilution to existing shareholders). As an aside, internal lending practices of this kind were squashed by U.S. regulations.

Bottom Line
I'm not a big fan of the insurance business, but Watsa's and Buffett's abilities to allocate capital so skillfully is fascinating. Monitoring the moves of these market gurus could help you determine the strategy to take with your portfolios. Thus, you may want to take Watsa's defensive position under consideration.

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