Description

The common stock of Fairfax Financial Holdings (FFH CN) is an attractive investment today trading around 75% of fair value. If Fairfax henceforth became very average, the downside would be less than 20%. If Fairfax repeated the investment performance and combined ratios of its first 26 years, the upside would be over 40%.  Something close to the latter is far more likely. The following evaluates the investment merits in more detail. 

I. A Simple business to understand

The key drivers of profits and business value are (a) investment returns and (b) the cost of borrowing from insurance policyholders (float). Shareholders keep nearly 100% of investment returns in excess of the cost of the insurance float, which typically finances 40-50% of the investment portfolio.  Over the past 26 years, investment returns have averaged 9.6% and cost of float has averaged 2.8%.* The result is ROEs averaging 12-13%. Oversimplifying the financial model: investments return 9.6% while float costs 1.4% (0.5 x 2.8%) yielding 8.2% pretax and 5.7% after tax, but since the investments are twice shareholders’ equity, the return on shareholders’ equity is closer to 11-12%.  Growth in book value per share of 23.6% has been superior to the average ROE of 12-13% primarily because management has issued stock above book value and repurchased stock below book value. 

See table at end for detailed data on Fairfax’s investment returns.

(*In the 2011 annual report, Fairfax implies that its cost of float will be less in the future than in the past.  Management does this by presenting the 2002-11 average of combined ratios for each of Fairfax’s four main insurance operations.  The averages were: 96.4%, 100.3%, 93.6%, and 87.4%, which equates to an underwriting profit and no cost for the float.  Management’s point is that the 2.8% long-term cost of float is disadvantaged by decisions underwriters made before Fairfax acquired them, in many cases.  Since the businesses have been part of Fairfax, the underwriters have been encouraged to turn away unprofitable business, so the cost of float has fallen.)

We have 85 years of base rate data for the key drivers, in addition to 25+ years of Fairfax specific data. The long-term returns from bonds and stocks are described by various academics (see below for one source).  Since 1928, US Treasury Bonds have returned about 5.25%, US Treasury Bills 3.5%, and US stocks 10%. Also, in 57 of the past 86 years (for which I have the data), the underwriting margin for the US property/casualty industry has been -2.1%. Given the typical relationship between premiums and total float, this suggests a cost of float for the industry equal to about 1.5%.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histret.html

The risk of significant and permanent capital loss seems remote.  Fairfax’s CEO is the chief risk officer. He founded the company and has spent 30 years building a reputation he is unlikely to want tarnished.  He owns more than 5% (may be 9%) of the stock (~95% of his net worth) and has hardly ever sold shares.  On the investment side, he has repeatedly avoided bubbles and served as an admirable steward of capital.

Over the past twenty seven years at Fairfax, investment returns have been negative in only 1990 and 1999, both from unrealized losses, and down only 4% and 3%.  On the insurance side, the CEO’s aim is to keep catastrophe losses to less than one year’s earnings.  When the company models the worst possible scenario, which is a series of catastrophes each costing the industry $50-100 billion for a total annual industry loss of $250 billion, the aggregate after tax loss for Fairfax is still just 15% of shareholder’s equity.

The insurance operations have experienced many years of favorable reserve development.  A decade ago, like many insurance companies (including Wall Street darling WR Berkley which was insolvent), Fairfax was under-reserved.  The company struggled. But the problems emanated primarily from underwriting that occurred before its insurance subsidiaries had been purchased.

The company’s policy is to underwrite a profit and to pick loss estimates that will prove conservative as actual losses develop.  In 2001, the CEO wrote: “As you know, it is our policy to have our reserves set at a level that results in redundancies in future years.”  In the 2011 letter to shareholders, the CEO presented the average annual reserve redundancies from 2002-10 for the four main insurance operations: 8%, 8%, 9%, and 6%.  Since 1985, Fairfax has had external actuaries (in some cases two sets) reviewing the company’s reserves.

Management prioritizes financial strength over returns.  As early as 1991, management emphasized the importance of financial strength. “We will always sacrifice returns if it endangers our financial health.” In practice, some of the company’s internal safeguards are the following. First, management seeks to maintain $1 billion or more of cash and short term investments at the holding company in order to cover three to four years of administrative, interest, and preferred dividend expense with no dividends from insurance subsidiaries. This is referred to internally as the “management survival ratio.” Also, holdco cash flows from dividends, interest income, and management fees should cover holding company administrative, interest and preferred dividend expense by 1-2x.  Second, net debt/equity is not to exceed 50% (currently 24%).  Net long-term debt is not to exceed 3x the company’s normal earnings base.  And management refinances obligations well ahead of maturity. For example, maturities in the next three years total $283m, or less than 10% of all long-term debt. Third, the company maintains an unsecured, committed, long term credit facility and typically reports that no amounts have been drawn (possible the company uses intra-quarter).  Finally, the company’s main insurance subsidiaries are registered with the SEC providing Fairfax with the financial flexibility to issue non-control stakes if necessary.

II. Capable and trustworthy management team

Various objective factors suggest giving management the benefit of the doubt (which we will not do). Book value per share growth has been 23.6% since the company was formed in 1985.  The 10-year CAGR of book value per share has not fallen below 9%, though the 5-year CAGR reached -1% in 2005.  The earnings growth picture is not as appealing, however.  Earnings have been volatile, but management has stated upfront and repeatedly that it prefers higher volatile growth to lower smooth growth.

Management interests are closely aligned with shareholders.  The CEO’s total compensation has been about $600,000 for many years. For comparison, compensation for the CEOs of Markel and Arch Capital has been $970,000 and $8,880,000 each year over the past three years. Even the founder’s son at W.R. Berkley made $4,384,000 on average, which wasn’t quite as good as his dad’s $19 million per year.

In his first letter to shareholders’ as CEO back in 1985, the CEO praised the company’s other managers, articulated his investment philosophy: “the value approach as laid out by Ben Graham and practiced by ... Buffett,” and provided the criteria by which to judge management’s success: an ROE of 20% (subsequently lowered to 15%).

Subjective factors garnered from annual reports and annual general meetings likewise point to a high quality management team.  Five of the key investors at Fairfax have worked together for over 35 years (predating Fairfax). Management has faced several tests of character throughout its tenure, but in each case, management addressed the problems openly and discussed them with other shareholders.

A) In the late 1990s, management endured years of investment performance below the indices before vindication in 2000-01. 

• After 1996, the CEO stated: “we are now finding it very difficult to identify long term values in both markets [U.S. and Canada].” The company sold equities to make them the smallest portion of the investment portfolio in a decade, and began investing outside North America. 
• After 1997, the CEO stated: “we feel compelled to change the warning flashing lights to red alert.” He noted that GE’s market cap exceeded the combined equity market value for Malaysia, Indonesia, Thailand, Philippines and South Korea. Moreover, he called out two risks. First, considerable sums of money had left the banking system for mutual funds (shadow banking). Second, yield spreads had declined significantly, and he was especially worried about bonds collateralized with consumer debt. 
• After 1998, the CEO stated: “speculation is rampant in the U.S. markets as demonstrated by the ‘internet’ stocks...the U.S. equity market is ‘priced for perfection.’ There is virtually no margin of safety should there be any negative developments.” 
• After 1999, he wrote: “We have been very wrong over the past three years as the S&P 500 has done very well – but we will not speculate and buy things that don’t make any economic sense. We do not believe in ‘New Eras’ and feel that most participants in today’s equity markets will suffer significant permanent loss. It is very likely that the high price for the S&P 500 and Dow Jones reached in this cycle (which may have already taken place) will not be seen again in the next ten years.”

Management didn’t just observe the bubble, however. They purchased equity puts on both the S&P 500 Index (and a basket of technology stocks) for $163 million and by 2000 had written off $115 million.  In the next two years Fairfax realized gains of $120m on these puts.

B) In 2001, management discovered that insurance loss cost estimates (reserves) at two subsidiaries that Fairfax had acquired recently were far too low.  So the CEO wrote a special letter to shareholders. He called the situation “very embarrassing” but also noted that much of the industry was experiencing the same problem and that most of the underwriting mistakes occurred before Fairfax acquired the businesses.  Concluding the letter, he stated: “we have not performed for you, our shareholders, in the past three years.” After 2001 had concluded, he wrote the annual letter and stated: “I am shocked at our atrocious results over the last three years and I sincerely apologize to you, our shareholders...As always, we have disclosed the past, studied it and learned from it."

C) Management has survived (so far) an energetic bear raid which lasted from 2002-2006.  The company’s lawsuit against its attackers can be found at the following link. http://securities.stanford.edu/1037/FFH_01/200695_o01n_064197.pdf

D) By 2004, management had observed a bubble in U.S. home prices and had purchased credit default swaps. They took further steps to protect against a 1 in 50 or 1 in 100 year event in the financial markets, including building cash and buying equity puts. Fairfax continued to purchase credit default swaps in 2005, 2006, and 2007.  By then, the company had lost 74% of its $276 million investment.  Management stayed resolute, however, and remarked after 2006: “We see an explosion coming [from collateralized bonds, mortgages and loans] but unfortunately cannot predict when.”  The explosion arrived and gains from Fairfax’s investment in CDS totaled $2.4 billion during 2007-08.  “We had to endure years of pain before harvesting the gains in 2007and 2008."

III. Industry is Unlikely to Change Much, but Two Tough Businesses with Okay Long-Term Growth

The investing and insurance markets are unlikely to disappear or change significantly.  While investing and insurance are both highly competitive and mature markets, they are unlikely to undergo much change.  People will continue to spread risk using insurance.  Investment markets will continue to allocate capital.  Key success factors in both will continue to be hard work and emotional discipline.

Cycle management is the key to achieving opportunistic spurts of growth.  Demand for insurance has been pretty stable over the long term.  Supply has been more cyclical and has periodically experienced shock declines.  When undisciplined underwriters sustain losses that reduce their underwriting capacity, their more disciplined competitors absorb their lost market share.  The key is to avoid losses.

Fairfax’s management has understood this dynamic from the company’s founding.  After 1988, the CEO wrote to shareholders: “We have always said that our insurance companies would not write business unless there was the prospect of an underwriting profit. 1988 tested that resolve.” Recently, the supply of insurance capacity has exceeded demand and caused rates to decline.  Inadequate rates caused Fairfax to cut back. At the workers compensation insurer Zenith, management cut premiums by 50% from $1.2 billion in 2005 to $600m in 2008 during which time shareholders’ equity increased by 50% from $700m to over $1 billion.

As a result, Fairfax has significant capacity today to increase the size of its float once rates and profitability improve.  A crude illustration of this opportunity is a comparison of the net written premiums-to-surplus ratio today of 0.67x versus the company’s 2002-05 average of 1.5x.  Collecting more premiums is just like borrowing more from insurance customers, and the funds are invested which increases Fairfax’s ratio of investments-to-shareholders’ equity. Between 1998 and 2006, the ratio of investments-to- equity was nearly 6x; today it is under 3x).

Over the long term, there is room for both Fairfax’s investment and insurance portfolio to grow at GDP or slightly better.  The investment portfolio is $24 billion, and the mix has typically been ~50% bonds, ~25% common stocks, and ~25% cash and short term investments.  The insurance float is $14 billion, including nearly $3 billion in run-off.  That leaves growth potential considering Berkshire Hathaway hit $70 billion in float before declaring that further growth would be tough. Fairfax’s float per share has increased at a 3-5% CAGR over the past 10 years. For reference, premiums paid by policyholders to P&C insurers have increased by 7% per year since 1960.

Differentiated investment approach has driven ROEs better than 150% of industry.  Fairfax’s ROEs have handily beaten the P&C industry over various periods.  Since inception, the ROE has averaged 12-14% versus 8% for the P&C industry, or about 1.6x.  Over the past ten years, the ROE has averaged 10%, or 1.3x the industry.  Fairfax’s results have been more volatile, however.  And the company has posted losses in three years: 2001, 2005, and 2011.

IV. A Solid and Multi-pronged Margin of Safety

The Margin of Safety is primarily based on management’s risk aversion.  The best way to derive conviction about the safety of this investment is to review the company’s historical annual reports. Of particular interest are the letters to shareholders and the investments sections (if anyone wants highlights I can post some in the Q&A section).  The investment team has averted nearly every financial bubble over the past 30 years, documenting their path along the way since 1986.  As noted, the CEO owns over 5% of the company and has a substantial reputational investment as well.

While this is public information, I doubt whether many investors have reviewed the data and commentary about investments since 1986. Given the undemanding valuation of the stock today and the power of the business economics, the investment return does not rely on improvement in investor psychology, Market perception of the stock, or multiple-expansion.

Compared to a range of fair values ($315-550), the stock has less than 20% downside and over 40% upside. Tables below depict three scenarios to evaluate Fairfax’s earning power and value.  The first scenario uses base rates for the key assumptions.  The ROE is 8% and EPS are $30.  This is what to expect if Fairfax achieves industry average results.  In fact, the long-term average ROE for the P&C industry is 8%.  For earnings from investments (debt and cash) funded by float, fair value is based on a 15x P/E multiplier because the earnings stream is relatively certain and requires less capital for growth.  The multiplier for the earnings from investments funded by shareholders’ equity is only 8x.  In total, the fair value estimate is $315.

The second scenario uses Fairfax’s historical results for the key assumptions.  The ROE is 14% and EPS are $50. Utilizing the same P/E multipliers as in the first scenario, the fair value estimate is $550. While Fairfax will struggle to repeat the 10% and 14% returns from investments in bonds and stocks, the cost of float will likely be considerably lower than the firm’s 2.8% historical result.  Fair value is still $510 if the returns on cash, bonds, and stocks are 2.5%, 7%, and 10%, provided that the cost of float falls to 0.0%.

The P/E is not enticing given recent results, but looks better on longer-term data.  The company’s results are volatile, by choice: “we will accept short term volatility in our earnings for better long term results” (1999 ARS).  Fairfax broke even in 2011, which makes the LTM P/E less useful and doesn’t reflect the long-term history or the businesses future earning power.

Trying to look longer term, using the 5-year and 10-year average EPS, the earnings yield is 11% and 6%.  Applying the 5-year and 10-year average ROA to current assets per share yields similar yields of 12% and 6%.  These 5-year earnings yields are near the highest since 2001, which is as far back as I calculated.

Using base rate assumptions, earning power is $30 per share, or a 7% yield (see Scenario #1 below).  Using management’s long-term historical results, earning power is $50 per share, or a 12% yield (see Scenario #2).

The price is 110% of book value. While the 24% growth in book value per share since 1985 is almost certain not to be repeated, growth of 10-15% is probable.

 The mispricing of Fairfax’s stock stems from the Market’s focus on short-term results, which have been lackluster.  Fairfax strikes me as a dull but not flawed story.  Return on equity was 0% in 2011 and 5.5% in 2010, well below the company’s target of 15% and peer results (~3% in 2011 and ~6% in 2010). Moreover, returns on equity will hover around 0% until management changes the current investment posture (see Scenario #3 below).  These low returns result from the investment team’s cautious outlook and investment positioning.  But the team’s track record is long enough so that there is sufficient evidence to suggest they have been skilled and not lucky.

Today, the investment portfolio consists largely of cash & short term investments at 40%, while the 28% invested in stocks is 100% hedged.  Like always, the investment team is focused on preservation of capital. They fear inflation rather than deflation. In fact, they have made a small ($421m) investment that could pay off big in the event of deflation or a deflationary scare.

Fairfax has underperformed financial peers and the market recently, so sellers are likely to include investors under pressure to report consistent monthly or quarterly outperformance.

Buyers of Fairfax are not paying much to share in a big bet with an asymmetric payoff.  Fairfax will benefit substantially from deflation.  Nearly two years ago, the company purchased ten year derivative contracts with a notional value of $47 billion linked to the CPI in four different regions: European Union ($27b), United States ($18b), France ($1b), and the United Kingdom ($0.9b).  Fairfax paid $423m in cash, and has already recognized a loss of $278m.  The maximum remaining pre-tax loss is $145m.  If there has been no deflation at the end of ten years (8.4 years remain on average), the contracts expire worthless.  If there has been deflation, counterparties will owe Fairfax the product of the cumulative change in the CPI and the notional amount of the derivatives. For example, if the CPI index for the European Union is 1.0% lower after ten years, then Fairfax is owed $270 million (0.01*$27b).

Few investors are worried about inflation, which is one reason Fairfax was able to purchase a derivative with payoffs that could be such a high multiple of the cost.  But deflation is part of our history, both in the US during the 1930s, and in Japan during the past decade.  After four straight years of annual deflation, by 1933 the US had experienced cumulative deflation in excess of 20%.  Although deflation abated, the cumulative 10 year deflation starting from 1929 still exceeded 10%.  And Japan has experienced deflation in 11 of the past 12 years, also accumulating deflation in excess of 10%.

If the EU and France experienced 5% inflation each, then Fairfax would earn over $1.4 billion.  More likely, however, the counterparties would repurchase the derivatives sooner once they feared such large losses.

V. Supporting tables and charts

Catalyst