Description

Thesis:

I recommend the purchase of shares of Fairfax Financial.  I think that the Muddy Waters’ short report is not credible, the stock is very undervalued, and will increase substantially on Friday, once the fourth quarter results are released after the close on February 15^th.

Let’s assume that MW is correct and take the write-downs that it proposes.  Then, let’s adjust all assets to fair market value, including the stake in Bangalore airport and Eurobank, add in the profits and increase in book value generated in Q4 2023, and profits generated in the first six weeks of 2024.  Then, the stock at USD 1000 per share is trading at a discount to “true” book value of at least $1050 per share and at five times my estimate of 2024 net income. 

Description of the business

Fairfax has been written up a few times on VIC.  It is a property and casualty insurer and reinsurer, with an excellent underwriting track record that has grown strongly over the years. 

Muddy Waters’s short report

MW’s thesis is that a $4.5bn downward adjustment to book value is necessary, and it claims that Fairfax routinely overstates its book value and books illusory gains.  MW makes a lot of accusations that are hard to disprove, however, here is why I don’t believe that MW is correct.

1. MW ignores disconfirming evidence.

1. The sale of the pet business – carried on the books for $200MM, company launched a sale process in 2021 and sold for $1.4bn in 2022.  
2. Undervaluation of Indian investments, particularly the stake in Banglore airport (please see rajpgokul’s write-up on Fairfax India from December 13^th 2023.)  If the stake in Bangalore airport were written up to fair value, that would provide a multibillion dollar increase in book value. 
3. The fact that are number of marketable securities were carried below market value on 09/30/2023 and marking them to market as of today – Eurobank, Poseidon and Thomas Cook India would result in $1.5bn increase in book value. 

2. IFRS 17 adjustment argument does not hold water.  First, outlier does not mean wrong.  More importantly, there is a good reason why the company would benefit more than its competitors from IFRS 17.  According to the EY report, most insurance companies incurred write-downs on their bond portfolios under IFRS 17 partially offset by write-downs of insurance liabilities driven by the increase in interest rates.  However, Fairfax had much shorter bond portfolio duration than the competitors (1.2 years vs 4+), so while its liabilities dropped as much, its assets did not decline as much when interest rates rose since it had shorter duration, hence the impact of IFRS 17 was more favorable.  By the way, the increase from IFRS 17 in book value varied between 1 and 30% with one insurer reporting 65%, so why is 15% from Fairfax not credible?
3. MW is flat out wrong when it discusses Exco Resources and Grivalia Property. 

1. MW says that the stake in EXCO resources is overstated by $245MM.  May be, but Chou funds commissioned a third party valuation (Kroll) to value the company as of 12/31/2022, and the value was $21.08 per share, meanwhile Fairfax carried its position at $12.59 on 12/31/2022. 
2. Grivalia was merged into Eurobank, and the market value of the Eurobank stake exceeds 09/30/2023 carrying value by more than USD 700MM. 

4. MW deliberately does not discuss the Q4 2023 results that are to be released on Feb 15^th after the close, a week after MW released the short report, since the results will, in my opinion, be spectacular and very detrimental to MW’s thesis.  I estimate that the company will earn at least $50 per share and increase book value by $2.5bn-$5bn or $100-200 per share. 
5. MW never discusses the earnings power of the business.  Why?  Because it makes a mockery out of the short thesis.  In my opinion, the company, helped by higher interest rates and a hard insurance market, will be able to generate north of $200 per share in EPS per annum for at least the next three to five years. 

Muddy Waters never states what the company is worth and why.  It ignores all disconfirming evidence and ignores the elephant in the room – the earnings power of the business.  When a company is trading at five times net income, MW must expect earnings to collapse, and if they don’t how will the short work?

Operating performance

Underwriting

Fairfax has historically had excellent underwriting results, with combined ratio under 100 on average since inception, and for the past 1, 5, 10 and 15 years.

Investing

Mediocre.  The company was superbly positioned into the GFC with long CDS positions, however it stayed bearish for far too long, making very low investment returns during a decade long bull market.  However, it deserves an A for refusing to reach for yield and keeping its fixed income portfolio in mostly T-bills and short-term treasuries with duration of less than 1.25 years.  The company extended the duration of its fixed income portfolio in October of 2023. 

A few years ago, it promised that it will no longer engage in macroeconomic driven bets and will just stick to value investing on the equity side.

Forecasts of performance

I expect the company to earn $200 per share per annum, or more than $4bn per annum.  This assumes $1bn per annum in underwriting profit per year, roughly $1.3bn of share of income from associates, $3.5bn of interest income and dividends, offset by $800MM of interest expense & corporate overhead, $800MM of tax and $120MM of non-controlling interest. 

Based on my conversations with insurance participants, (insurance brokers and insurance companies), it seems that the hard market will last for several more years at least.  Interest income is unlikely to decline for the next several years for the company given 4+ year duration on the bond portfolio.

Capital Allocation

Historically, it primarily bought other insurance companies, bought back stock when it was cheap and paid dividends.  Created a lot of value via investments in India (Fairfax India.)

Valuation

Trading at 20% discount to book value and 5x net income if we ignore MW’s adjustments, and 5% discount to book value and 5x net income if one assumes that MW is 100% correct. 

Risks

It is an insurance company, so it is very dependent on top management, and will obviously get hurt if there are several extreme catastrophic events in one year (Cat 6 hits Florida, 9.0 earthquake hits California, etc…)

Mistakes in reserving.

I don’t like the swap on 1.9MM of its own shares that the company has.  It adds additional risk, and in case of several massive catastrophic events will drastically increase risk.

Conclusion

This is an opportunity to buy well run insurance company at below book value and probably 5x forward earnings. 

Catalyst

Catalyst

Q4 2023 results to be released on February 15^th post close.