When the Crash Comes, Will You Be Ready?
Editor's note: Prem Watsa is the greatest investor you've never heard of.
The "Warren Buffett of Canada" is a noted contrarian... routinely netting billions of dollars by betting against the investment herd.
In today's Masters Series – adapted and updated from the November issue of Stansberry's Big Trade – Porter explains how he's using Watsa's strategy to potentially make huge gains as the next crisis begins to unfold...
When the Crash Comes, Will You Be Ready?
By Porter Stansberry, editor, Stansberry's Big Trade
Prem Watsa stood at the podium and delivered the most prescient warning the crowd would hear...
There's a one-in-50- or a one-in-100-year storm coming... When the music stops, it stops very quickly.
It was April 2007, just six months before the S&P 500 hit its peak. He was speaking at the Ben Graham Centre for Value Investing at the Richard Ivey School of Business. He reminded the audience what really happens when a specific trade gets too hot... Generally, that trade collapses.
And Watsa was right.
Two years later, just a few months after the market bottomed in early 2009... Watsa had booked a 489% profit from a bet on the great recession... Essentially, he'd gone short on real estate. It was a $2.1 billion payday.
And this wasn't his first correct call on a bubble... nor the first time he'd profited massively. He's probably the most successful investor you've never heard of...
Watsa moved from his hometown in India to Ontario, Canada in 1972. At the time, he had just a few dollars to his name.
He sold air-conditioning units door to door to pay for an MBA at the University of Western Ontario. After graduation, he worked at insurance firm Confederation Life for almost a decade.
He left to form his own asset-management firm, and in 1985 he took control of a company that would become the Toronto-based investment firm Fairfax Financial.
His investment results are simply outstanding.
From 1986 to 2015, he grew book value at Fairfax Financial at 20% per year on average (compounded annual growth rate). The company's stock price has grown at 19% per year on average over the same period. Today, Fairfax Financial's market cap sits at around $11 billion. He has turned every $10,000 invested in his company in 1985 into more than $2 million today.
Many call him the Warren Buffett of Canada. The comparison goes beyond how much money he has made... Like Buffett, he built a financial giant with property and casualty insurance at its foundation. Unlike Buffett... Watsa isn't afraid of a little risk. Wade Burton at investment firm MacKenzie Cundill Investment reportedly said "Buffett doesn't like trouble... Prem doesn't mind mucking about in the mud, so long as the price is right."
And he's a natural contrarian...
He famously sold half the stocks in his portfolio just before the Black Monday market crash in October 1987 – when the Dow Jones Industrial Average dropped 22.6% in a single day. He predicted the Japanese bubble in 1990. He bought put options on the S&P 500 right before it tanked in 2000.
But probably his biggest success so far was his bet before the 2008 crisis... which he predicted in his April 2007 speech.
Today, we're going to show you how Prem Watsa pulled off one of the most profitable bets we've ever seen... and how we can do the same thing. We're going to use our Big Trade strategy to set ourselves up for massive profits in the collapse we see coming now... And we're going to do it with insurance...
The Big Trade Strategy
As early as 2003, Watsa was targeting big American banks and bond insurers exposed to the housing boom.
He had been buying large amounts of credit default swaps (CDSs). These swaps are effectively insurance. The buyer pays to transfer the risk of default for a bond to someone else (who "insures" against a default). Then the CDS buyer profits when the underlying security suffers a default.
At one point in 2006, he was down $87 million – 74% on his position. But he knew the crisis was just around the corner. So he kept buying. Altogether, Watsa bought more than $430 million in CDSs.
When the global financial crisis hit in 2008, Bear Stearns, Lehman Brothers, and AIG all failed. Within the year, the $433 million bet Watsa had placed was now worth more than $2.5 billion... He made $2.1 billion on the deal – almost five times his original investment.
Watsa saw the bubble forming and knew that it must eventually collapse. So he made his bet by buying insurance on the companies he knew would suffer the most.
Here in Stansberry's Big Trade, that's exactly what we aim to do...
First, and most important, we also see a storm coming – only this one will be far more damaging than the credit crisis in 2008-2009.
We're eight years into a bull market... one that has been driven by artificially low interest rates and debt. Corporate debt issuance has grown over the past five years at a pace we've never experienced before. More than $9.5 trillion in global corporate debt is coming due over the next five years. About $1.6 trillion of that debt is below investment grade, or "junk."
Yet the market is pricing little risk into the equities that hold it. The "market's fear gauge" – the Chicago Board Options Exchange (CBOE) Volatility Index, or "VIX" – remains at near-record lows. No one is paying attention.
It won't last. Because it never does.
Banks are already starting to tighten credit. According to Federal Reserve data, the outstanding amount of corporate loans is now contracting for the first time in six years. As you can see below, the amount of lending in the $2 trillion market for commercial and industrial loans has plunged at a 5.4% annualized rate over the past three months...
In general, banks are more concerned with repayment than bondholders. They tend to demand more restrictive terms than the corporate bond markets.
Thus, just as the bond market can be a "canary in the coalmine" for the equity markets, stress in commercial lending can serve as an early warning of problems in the broader credit markets.
There is no doubt this credit cycle is nearing an end. When it finally rolls over, many investors holding the shares of weaker credits – aka "junk" rated companies – are going to see the value of their stocks plummet. Some will go to zero.
Just as they did in 2007, investors remain complacent about the underlying problems in the credit markets. No one listened to Watsa when he said the collapse was coming. They believed that the results would be different.
Our bet is that this time, nothing's changed.
Here's the second important point of this story: Watsa used insurance to bet against the 2008 meltdown. Instead of simply shorting stocks he knew would have big downward moves, he used CDSs to take the trade even further. He wasn't just betting that these companies would go down, he was betting that they wouldn't be able to pay their debts at all.
We think the same thing will happen this time, and we plan to profit in a similar way.
The only difference between his strategy and ours is the instrument we'll use. We want to protect our portfolios and speculate on the pending collapse. But it's not easy for small retail investors to buy CDSs. So instead, we're using long-dated put options. The mechanics are different. But the outcome will be the same.
Don't let the idea of trading options intimidate you. Put options are simply contracts you hold with your broker that allow you to sell a stock at a specified price at a specified time.
We stand to make huge 500% gains just like Watsa. But to succeed with this strategy, you must remember...
At one point, Watsa faced substantial losses on his bet. He was down 74%... But he stuck to his conviction. He built a position over several years. Then he waited.
We, too, could face some stress in our positions. And some puts will expire worthless. Which is why we'll be building out a diversified portfolio over the next 12-36 months. And we must exercise patience. These factors are critical to our success with this strategy.
Remember, Stansberry's Big Trade is not a typical investment newsletter... We aren't making safe bets that you can buy and hold forever. We're making speculations. These aren't positions that you bet the rent money on. They carry a lot of risk... But they have the potential to return outsized gains.
Editor's note: You may not believe this at first. You may not want to believe it. But right now, America is in the middle of a secret civil war. And we're quickly approaching the most dangerous period in our country's political history since the Great Depression. What happens next is going to affect everything... your money, your retirement, even where it's safe to live. On April 5, Porter is hosting an emergency briefing where he'll share all of the details. Reserve your spot right here.