Description

I recommend the purchase of Fairfax Financial Holdings common stock.  Fairfax trades at 66% of March 31, 2020 book value and approximately 7.6x normalized earnings, a cheap entry price with the tailwind of a hardening insurance market.

Fairfax is a financial services holding company with subsidiaries primarily engaged in property and casualty insurance and reinsurance.  Fairfax also controls the publicly-traded investment holding companies Fairfax India Holdings and Fairfax Africa Holdings.  Prem Watsa, the chairman and CEO, controls 43% of the voting interest.

Fairfax has been written up six times on VIC, most recently in early 2019.  The 2019 write-up provides a good overview of Fairfax's various components, and a comprehensive sum-of-the-parts analysis.

From year end 1986 through year end 2019, Fairfax compounded book value per share at the rate of 15.4% per annum, an admirable record by most any standard.  However, from year end 2009 through year end 2019, book value per share compounded at only 2.8% per annum.  During its glory years, Fairfax combined mediocre (or worse) underwriting with excellent (though lumpy) investment returns.  This culminated in 2008 and 2009 when Fairfax realized huge gains on credit default swaps and equity market short positions.  From 2010, this dynamic has reversed – Fairfax has generated ten years of solid underwriting performance (combined ratio of 98%) paired with mediocre to poor investment results.  Investment results have improved, however, since 2016, and I believe that Fairfax is well positioned to generate decent investment returns going forward.  At the current share price, decent investment results are all that are needed.

Insurance Operations.  Fairfax's principal insurance subsidiaries are as follows:

• Northbridge Financial, based in Toronto, Canada, provides property and casualty insurance in Canada – approximately 9.4% of 2019 net premiums earned.

• Odyssey Group, based in Stamford, Connecticut, provides insurance and (primarily) reinsurance globally – approximately 24% of 2019 net premiums earned.

• Crum & Forster, based in Morristown, New Jersey, provides commercial property and casualty insurance (principally specialty coverages) in the United States – approximately 16.6% of 2019 net premiums earned.

• Zenith National, based in Woodland Hills, California, writes workers compensation insurance in the United States – approximately 5.6% of 2019 net premiums earned.

• Brit, based in London, England, is a global Lloyd’s of London specialty insurer and reinsurer acquired by Fairfax in 2015 – approximately 12.4% of 2019 net premiums earned.

• Allied World, based in Bermuda, provides property, casualty, and specialty insurance and reinsurance globally, and was acquired by Fairfax in 2017 – approximately 17.7% of 2019 net premiums earned.

The balance of Fairfax's insurance operations (14.3% of net premiums earned) include Fairfax's interests in various Asian, Latin American, and European insurance operations, and Fairfax's run-off operations.

Hard Market.  Fairfax reported a hardening insurance market in 2019 continuing into the first quarter of 2020 (pre-pandemic), and this is reflected in Fairfax's 2019 and 1Q 2020 operating results.  Fairfax's management believes that the pandemic will exacerbate this trend, and that insurance markets will continue to harden for the foreseeable future.  Fitch and WillisTowersWatson are each projecting a hard market in most commercial lines through at least 2021.

Valuation.  Fairfax trades at 66% of March 31, 2020 book value (1.4x tangible book value).  March 31 book value is depressed due to mark-to-market losses in Fairfax's investment portfolio, some of which have reversed with the current market rally.  Fairfax also trades at approximately 7.6x my estimate of normalized earnings.  An estimate of normalized earnings is below (all figures in US$ millions except per share amounts and number of shares).  The assumptions made in estimating normalized earnings are summarized in the notes following the earnings table.

Notes on normalized earnings:

• Net premiums earned are based on 2019 premiums.  Hardening insurance markets should result in material premium increases.

• Fairfax's combined ratio has averaged approximately 98% since 2010.

• Portfolio investments include (1) the investments held by the affiliated investment holding companies Fairfax India and Fairfax Africa and (2) Fairfax's interests in non-insurance associates (i.e., non-insurance operating businesses in which Fairfax owns an interest).

• Investment income includes interest and dividend income and gains on portfolio investments.  Fairfax's investment returns have averaged 8% since 1985 and, after Fairfax's struggles in the earlier 2010's, averaged 5.6% from 2017-2019.

• Interest expense is for holding company and insurance subsidiary debt only; interest on debt owed by non-insurance associates is not included.  Interest on debt owed by non-insurance associates is a (negative) component of investment income and is subsumed in the 5% assumed return.  Debt owed by non-insurance associates is all non-recourse to Fairfax.

• Income taxes are calculated based on the Canadian corporate tax rate of 26.5%.  Fairfax has substantial operations in the United States, the UK, and Bermuda, where corporate tax rates are lower.  The cash taxes paid by Fairfax in 2018 and 2019 imply a materially lower effective tax rate.

Investments.  From 1985 to year end 2019, Fairfax earned an average return of 8% on its investments.  However, investment performance has been poor since 2010.  The poor results can be attributed primarily to (1) expensive hedges (via total return swaps) on Fairfax's equity portfolio, which Fairfax continued to carry after the financial crisis until lifting them in 2016 and (2) poor stock selection, with BlackBerry being the headline example.  The poor returns on Fairfax's equity investments, exacerbated by its expensive equity hedges, led to poor overall investment results notwithstanding the strong performance of Fairfax's fixed income investments, which performed well throughout the decade.  Fairfax's long-term investment record is strong, and from 2017 to 2019 Fairfax has earned 5.6% on its investments.  I believe a 5% return is achievable going forward.

Impact of Coronavirus on Insurance Operations.  During 1Q 2020, Fairfax reserved approximately $84 million for Covid-19 losses (primarily at Odyssey and Brit), consisting almost entirely of incurred but not reported losses.  Management obviously expects an impact on insurance claims from the pandemic, but is optimistic that Fairfax will earn an underwriting profit in 2020.  Management has identified the following issues:

U.S. Business Interruption Insurance.  The insurance industry consensus view is that, for a claim to be triggered under standard U.S. business interruption coverage, there must be physical damage to property.  Fairfax has stated that its business interruption coverage is typically industry-standard coverage.  Nonetheless, the U.S. insurance industry is facing political pressure to pay business interruption claims regardless of what the relevant policies actually say.  This pressure may ultimately result in one or more U.S. states mandating, either legislatively or administratively, the payment of business interruption claims regardless of policy language.  These mandates, if imposed, will be contested in the courts.  Fairfax is confident, as is the industry in general, that they would prevail in any litigation, believing the courts would not re-write insurance contracts.  This bears close watching, however.

Related to this issue, Fairfax has provided no disclosure on whether (and, if so, to what extent) its business interruption policies contain express exclusions for losses caused by viruses or pandemics.

Miscellaneous Claims.  Fairfax has identified exposure to event cancellation insurance claims (primarily Brit) and exposure to claims on directors and officers (D&O) insurance (financial distress typically results in increased D&O claims).  In both cases, Fairfax believes its exposure is small in relation to the size of the company.  Fairfax has also identified exposure from certain of its European insurance, where coverage differs from the American standard.  Again, Fairfax believes its exposure is small in relation to the size of the company.

Zenith.  Zenith, Fairfax's workers' compensation subsidiary, is pressured by Covid-19 in two ways.  First, Zenith will almost certainly experience declining premiums because premiums are generated off payroll.  Second, several states, including California, have for certain classes of employees created a presumption that, if the employee contracts Covid-19, it will be deemed to have been contracted in the course of employment (in contrast to most illnesses which are not deemed to be workplace injuries).  Being only a presumption, the employer can rebut it, but I expect that will be difficult.  In any event, Fairfax expects Zenith to experience material premium declines, but believes its Covid-19 claims exposure is limited, notwithstanding the change in presumption.  It is worth noting that Zenith represents only 5.6% of Fairfax's premiums.

Litigation.  Regardless of ultimate claims liability, management expects and is prepared for a substantial amount of litigation regarding Covid-19 claims.  Litigation is not cheap, and this will obviously cause a drag on Fairfax's underwriting results.

Deflation Hedges.  In the aftermath of the financial crisis, Fairfax purchased derivative contracts referenced to selected consumer price indexes.  The contracts are structured to increase in value in the event of decreasing CPI index values, with most of the contracts based on either the United States CPI index or the European Union CPI index.  The notional amount of these CPI-linked derivative contracts is $87.4 billion (compared to Fairfax's common shareholders' equity of $11.3 billion), and have a remaining weighted average life of 2.9 years.  The contracts are carried on Fairfax's books at $54.6 million.  These contracts will probably expire worthless.  However, in the very low (but not zero) probability event that the U.S. or European economy suffers a deflationary collapse in the next three years, an investment in Fairfax provides a hedge.

Risks.

Catastrophe Losses.  Like most property and casualty insurers, Fairfax is exposed to potentially large claims from catastrophe losses resulting from earthquakes, hurricanes, tornadoes, and other severe weather events.

Covid-19.  The insurance risks resulting from Covid-19 are still highly uncertain.  It is conceivable that one or more U.S. states will mandate the payment of business interruption claims regardless of underlying policy language and that, notwithstanding the consensus view to the contrary, the courts will uphold the mandate.

Poor Investment Performance.  It is possible that Fairfax's investment results from 2010-2016 provide a more reliable forecast of Fairfax's future investment results than do Fairfax's overall long-term results and its more recent 2017-2019 results.

Poor Associated Company Performance.  Fairfax owns substantial interests in various non-insurance operating businesses, including a large Canadian restaurant group.  These interests represent over 10% of Fairfax's investments (not including associates held through Fairfax India and Fairfax Africa).  Sustained economic weakness could lead to losses in Fairfax's portfolio of associated companies.

Catalyst

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