November is here and discussing any form of foliage or shrubbery is a little bit odd. So why this talk of trimming hedges early? It's a bit late now, isn't it? Well, hedging is defined differently in the investing world, as you may have guessed. Hedging in the simplest of terms means investing in an investment vehicle that should offset losses incurred in the rest of your portfolio. There are a number of ways to do this, such as through derivatives, buying options or even holding commodities like gold. The different ways to hedge all have different costs associated with them as well as a range of returns.
Done properly, hedging can reduce the risk of your portfolio by limiting downside or providing you with an appreciating security that you could sell for a capital gain during bad times. "Why would I buy something only to hedge against it?" you may ask. It acts as a form of insurance. With investments that you hold long-term, it gives you a cushion that you can take advantage of during times when your portfolio may have contracted. The other important thing is that a hedge isn't very useful if you try to implement it after you have already lost value on your investment.
This brings us to an interesting hedge that has been publicized in media—a hedge against deflation, by Fairfax Financial Holdings (TSE:FFH). The status quo of an economy is one of a moderate inflation rate. In Canada, the Bank of Canada regulates prime interest rate and quantitative easing (QE) with the goal of having between 1 - 3% inflation per year. Ideally, it would be exactly 2% per year. Inflation is measured by a pre-determined "basket of goods" index that approximates the average Canadian citizen's consumption, called the Consumer Price Index (CPI). For there to be deflation, the CPI has to be a negative number, meaning goods and services are actually getting cheaper. This is an unusual situation that would likely be the case only in a shrinking economy.
A shrinking economy would be defined by increasing unemployment, stagnant wages and reduced spending. If you think about the effects, it makes sense. Fewer people working means fewer people can afford to buy things. Companies would need to therefore lower prices to keep sales consistent, but that would reduce profits unless cost cutting was done—which often comes in the form of layoffs. Since the crash of oil prices, unemployment in Canada has risen, and the only job growth appears to be coming from part-time jobs, meaning in general, people will have less money to spend. The effects will be slow and steady, but deflation is definitely a possibility if things don't improve quickly.
Fairfax Financial made a large bet on deflation some time ago through derivatives against CPI totaling $650 million that you could probably call a super-hedge. Due to the effect of leverage, the total bet against inflation amounts to about $109 billion. The latest quarterly earnings report by Fairfax Financial, released yesterday, was not rosy due to investments (including the bet on deflation) having substantial paper losses as markets and economies have stayed relatively stable so far. That being said, with the cost of housing shooting well past wage increases for quite a few years and what I predict to be higher unemployment than today, I think it is just a matter of time.
Fairfax Financial made a large bet against equities before the recession of 2008 that you could almost call a super-hedge. This bet not only let Fairfax Financial Holdings completely avoid having half its share value erased like most of the world, but ended up almost doubling during the same period of time! In the graph above, you can see that there was a time frame where Fairfax did suffer a bit while the hedge was not successful (in 2006) until 2007 when the hedge started finally paying off. But even then, the full effect of the recession was not felt until 2008, when the hedge really paid off and pushed the share price to new highs.
What this shows is the power of hedging, and the power of it even if you have it too early. Like car insurance, it will only pay off in the worst of situations, but is a small price to pay for a lot of security. Consider if you want protection from deflation; becoming a shareholder of Fairfax Financial could be the easiest and most profitable way to have that protection!
Disclosure: I own shares of Fairfax Financial Holdings (TSE:FFH) at the time of this writing.