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Still Bearish on the Market? Then Buy Fairfax Financial Holdings Ltd.

It’s been an interesting few days in the markets.

After the TSX Composite Index slid last week, we woke up on Monday morning to what appeared to be a bloodbath in progress. At one point, the market was down more than 700 points, as investors panicked and told their brokers to sell. But cooler heads prevailed, and as I type this, the benchmark Canadian index is barely below where it closed on Friday.

Now, it seems like investors are pretty evenly divided between two possible outcomes. Either you’re in the camp that says that Monday’s lows are the bottom and that stocks are heading higher, or you think other economic issues are bound to push markets lower. China is the big issue on investors’ minds, as the Shanghai markets continue to implode.

I’m on the side of the bears. I think the market has further to go down, as China’s stock market meltdown affects other parts of the nation’s economy. This could have interesting repercussions for Canada as well, since so much money from China is finding refuge in our real estate and stock markets.

If you share my opinion, just how can you invest in a market that’s poised to get even rockier? There are all sorts of ways, but one of my favourites right now is buying shares of Fairfax Financial Holdings Ltd. (TSX:FFH). Here’s why I’m bullish on the company.

The man in charge

If you’re a veteran investor in the market, you’re familiar with Prem Watsa, the man in charge of Fairfax. He’s been successful enough that he’s commonly referred to as the Warren Buffett of Canada.

Since Watsa took over in 1985, he’s managed to grow Fairfax’s book value by 20% per year. Yes, he’s had some missteps, but for the most part he’s gotten the big bets right. He made shareholders a lot of money investing in undervalued stocks, but also by placing huge bets on macro events like the U.S. mortgage meltdown in 2008. Watsa ended up making billions for Fairfax shareholders when just about every other financial company on the planet was reporting huge losses.

These days, Watsa is nervous about China, and has positioned Fairfax’s portfolio accordingly. The company’s stock portfolio is completely hedged, meaning this latest market decline is hardly keeping Watsa up at night.

Watsa also has Fairfax making a different bet, one that isn’t quite a bet on China, but looks to pay off if China really falls off a cliff.

A bet on deflation

Essentially, Watsa’s thinking goes like this.

When China inevitably slows down, it’ll take down the price of commodities with it, since it was a major consumer of oil, coal, steel, and the like over the past few years. Beijing will respond to this by devaluing the yuan, trying to export its way back to growth. The combination of these two factors will lead to deflation, since both commodities and finished goods will end up cheaper.

At least so far, it looks to be working.

As of the end of 2014, Watsa has a massive bet on deflation happening in the U.S., U.K., European Union, and France. Altogether, through CPI-linked derivative contracts, Watsa’s total bet could potentially be worth $111.8 billion if he’s proven to be correct. And it’s not like deflation needs to happen tomorrow for the bet to be successful either. The contracts had a weighted average duration of 7.4 years at the end of 2014.

The bottom line? Not only is Fairfax Financial an interesting bet on China’s continued weakness, but investors are also getting Watsa and his proven ability to pick undervalued stocks for a valuation of only a little above book value. Combine all of that, and it’s easy to see why Fairfax has been an investor favourite for years.

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Fool contributor Nelson Smith owns Fairfax Financial preferred shares.

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