Maverick47

Fair enough, @Marco Van Basten! We know that there are points in the history of the company when the company performed admirably on the investment side of the business model and points when their performance was msignificantly subpar. And as was probably the case with Berkshire Hathaway, it may well be the case that the stretches of significant outperformance for the company on a per share book value basis occurred earlier on, when the company was quite a bit smaller so history is not likely to be the best guide to the future. What will really matter to us is how we expect them to perform in the near to intermediate future if we have included them in our own investment portfolios. My simple way of looking at it is that if the company is able to earn 5% on their total investments, which are leveraged bout 3 to 1 for investments to shareholder equity, also earns positive returns from underwriting profits, and doesn’t have too much of a drag from corporate overhead, interest expense and taxes, that a 15% or greater return on equity is eminently achievable. If they earn closer to their long term historical return on total investments of 7.7%, then even if underwriting profits were to completely disappear, we’re still sitting at around the 15% ROE level. Only if interest rates plummet and the total investment return drops well below 5% do we have a situation where a 15% ROE would appear to be out of reach without dramatically higher underwriting profits to act as an offset. I don’t think we need to assume stellar equity performance (or even outperformance relative to the index) to make it likely that the company will produce good results for its shareholders. But if anyone does wish to include in their estimate of intrinsic value the expectation that the current stable of equity investments will match or outperform the index going forward, that would in my opinion lead them to believe that an even greater margin of safety exists at the current market price. My personal rough expectation is that there is a greater than 50% probability that the company will meet or exceed a 15% ROE over the next five years, and I believe the downside probability is quite limited. Sort of a heads I win, tails I win a bit less and almost a zero chance of loss compared to current market price over the next five years.

Excellent point. The prospect of double digit returns without a sizable risk of loss of capital is an ideal investment for me personally. For more than ten years now I have set my personal expectations for investment returns at somewhere in the range of 6 to 8% annually. That’s the level that should allow me to reach my reasonable goals for income in retirement. I would be well satisfied with that result. Finding a candidate for inclusion in my portfolio that has outpaced this target for the last five years, with a realistic prospect of doing so for the future five years as well, is already “icing on the cake” for my personal needs, and as you note, the business model of Fairfax and current store of unrealized gains may well produce results skewed to the upside. Fairfax under Prem’s stewardship for 40 years has produced stellar annualized returns of roughly 19%. I don’t need Fairfax to produce anything like this for the next 40 years in order to achieve my personal wealth goals, and in fact, even the achievement of their current target of 15% would be far in excess of what I would hope for. I am reminded of Charlie Munger’s comment regarding Berkshire Hathaway and Warren Buffett’s stewardship thereof, made sometime near the turn of the century:

God bless AI!

Agreed.

I think you’re directionally on the right track with trying to approximate the equity returns by backing them out of the total investment returns. One caution I would make is to be clear in differentiating between an arithmetic average return and a geometrically compounded return. My guess is that the S&P 500 11.2% return is the CAGR over the period, meaning the geometric average. Meanwhile, the 7.7% Fairfax investment return looks to me as if it might just be the simple arithmetic average of the individual years. The geometric average is what we’d want to have in order to compare with the equity index, but I don’t them we have that here. And generally speaking, when you take into account the possibility of negative return years, which have occurred four times in the Fairfax history, then the geometric return, which is what we want for comparison purposes to the index, is always going to be less than what appears to be an arithmetic average return of 7.7%. My guess is that Fairfax’s equity returns on a geometrically compounded basis probably have still exceeded those of the index over 40 years, but that they likely may not have not been quite as high as 18.2% annually.

I think you are correct in identifying challenges with aging, sclerotic leaders. He’s not going to change for the better, and as he ages, instead of getting lazy, he just loses whatever filters and checks on his bad impulses that he might possibly ever had.

Food for thought, @Blake Hampton! As someone who loves reading, I’d like to think that you’re not altogether wrong in pointing out the challenges with the apparent disinterest in it on the part of either the average American or many of our leaders. And a love of reading and lifelong learning can probably be connected somewhat to an above average level of personal intelligence while not being a reader might be correlated with a below average level of intelligence. But I’m also reminded of Buffett’s comments about what characteristics he looks for in an ideal employee: energy, integrity and intelligence. And if a candidate is missing one characteristic in particular (integrity) he really didn’t want him (or her) to have either of the other two. I guess what I’m saying is, given his lack of personal integrity, I’m not terribly upset that the President lacks an interest in reading. I do wish, however, that our dear leader would spend much more of his time sleeping or playing golf than he already does….

I agree. I think the company was just trying to ensure it didn’t die, so that it would be able to keep a string of annual results moving forward in the future. In a series of annual performance figures, the only thing worse than a number of subpar or negative years would be a zero, meaning the company had died. I can think of a number of value investing phrases that are apropos in this regard, such as “to finish first, one must first finish.” A company is an artificial person, with one significant advantage over the human beings who manage it: it can be immortal as long as its managers don’t allow it to be killed. Charlie Munger was known to share the thought that “All I want to know is where I’m going to die, so I’ll never go there”. I appreciate the fact that the human beings who manage Fairfax think about how and where their company might die, and try to manage its affairs so that it doesn’t go there. In doing so, they increase the likelihood that it will survive and continue to compound value for its shareholders well beyond their own lifespans. Sometimes they purchase insurance against catastrophes that happen, such as buying CDS’s in advance of the GFC, or keeping bond durations low in periods of historically low interest rates so that mark to market losses won’t hinder the company’s financial strength and solvency when rates began to rise again. Other times they purchase insurance against catastrophes that didn’t occur, such as global deflation after the GFC. These were all decisions to purchase insurance against events that could kill or severely injure the company. Since the company is still alive and thriving, I consider them all to be successful, whether the feared for events occurred or not.

I didn’t have a clue what a CDS was at the time, but had a coworker who was involved, not with buying them, but creating and selling them to other companies on behalf of the property casualty company I worked for. We used to have quarterly q and a sessions with employees being allowed to ask senior management about the quarterly results. A few quarters in a row we recorded some losses from the part of the company that he was working in, which involved investing in and selling derivatives such as CDS’s. I was sort of the lone employee gadfly who was willing to ask questions about negative items to management, and I believe I’d been influenced by Buffett’s comment that derivatives were financial instruments of mass destruction, so a few quarters in a row I asked the leadership why we were involved in creating and selling financial instruments that we were losing money on, in an area we had no specific expertise in. Sometime later, but before the GFC in 2008, the company announced that they were shutting down that department and my coworker had to find a job elsewhere. All by way of noting how unusual it was at the time for someone like Francis Chou to be working with an insurance company, understanding what a credit default swap was, how valuable they would be in certain economic environments, and encouraging Fairfax to purchase substantial amounts of them. I was happy the company I worked for simply avoided a major problem and a near death experience such as AIG with their Financial Products division experienced by not selling credit default swaps to other parties. But I’m not aware of any insurance company other than Fairfax that took the right side of that trade…. Kudos to Francis!

Based on the track record of previous announcements by Trump I think it would be optimistic to even apply Churchill’s WWII comments to the situation: ”Now this is not the end. It is not even the beginning of the end. But it is perhaps the end of the beginning.”

Whose troops are we talking about? Can’t be US since total service members across all branches amount to 1.35 million and latest estimates are that only 10 to 20% of that total actually serve in combat roles. Taking the high end of the estimate puts the current number of US combat soldiers worldwide at 270,000, far short of 1 million. And this includes combat members in all branches including the navy and the Air Force, meaning the available number of ground troops has got to be less than that. We could always reinstitute the draft and build up the combat force to a million, but that would take years and trillions of dollars to quadruple the current force and then send them all over to the Iran Iraq border. There’s a reason we only have 50,000 troops in the area. We can’t afford to send many more without denuding force levels elsewhere in the world. If the air and naval war doesn’t do the trick, I don’t think we have any good options to put significant numbers of boots on the ground in a country of 90 million.

Excellent summary and overview of the “lost decade” for Fairfax @Viking! The discussion of trust between a company and its shareholders was apt as well. I think it was Richard Feynmann who said that the first principle of scientific analysis is “not to fool yourself”, and that one must also keep in mind that “you are the easiest person to fool”. It’s too easy as human beings and investors to remember evidence of our own superiority and outperformance and to ignore evidence of mediocrity and failure in assessing our own capabilities. I really enjoyed the juxtaposition of the two posts, first cheering the CDS episode with over a $2 billion positive return, followed by the decade long foray into shorting equity indexes and buying protection against the possibility of global deflation which resulted in a loss of more than twice the CDS gain, even before considering the opportunity cost connected with having to sell equities earlier than would have otherwise been the case. Had the $5 billion loss over a decade not occurred, and if the company had not been forced to leave over a billion of additional equity gains on the table by selling shares early, then we might consider that the purchases of companies such as Allied World and Brit could potentially have been funded by the lost profits and potential positive investment returns on those lost funds instead of requiring the issuance of about 7 million of common shares. We have all been happy that the repurchase of shares has essentially returned us to the same share count as before the Allied World acquisition, but imagine if those shares hadn’t needed to have been issued in the first place…. But if no mistakes had ever been made, the opinion of Mr. Market on the relative valuation of Fairfax shares would likely have been sky high…at nosebleed level prices for the entire period up until this very day, leaving me and others on this board with precious little opportunity to purchase shares again and again over the last 5 years or so at quite attractive prices. So as painful as the lost decade was, it sowed the seeds of a solid investment for me personally in the years since. I don’t have to bemoan the fact that I wasn’t around to buy Fairfax in 1986. Instead, I can be happy that I was able to buy it at reasonable prices for the most recent 5 years or so….

I’m not an expert in solvency regulation or insurance portfolio strategies, but an internet search did provide some indication that there may be perceived value in convertible bonds for insurer investment portfolios: https://aamcompany.com/wp-content/uploads/2022/08/Convertible-Bonds-A-Compelling-Investment-for-Insurers.pdf I don’t personally recall the insurers I worked for in my career having a significant (or indeed ANY) investments in convertible bonds. I do think that with Fairfax we see the benefits of long term relationships between management and the folks they partner with for investment purposes. What kinds of convertible bonds have we seen with Fairfax? Orla, Poseidon? Off hand I can’t think of other examples. But these are probably deals made directly between Fairfax and the companies themselves as opposed to convertible bonds that are publicly traded and which any investors, including ourselves, could purchase on the open market. The only other significant use of this sort of creative financing that comes to mind is with Berkshire when they provided investment support to companies after the Great Financial Crisis. With Bank of America, for example, I think Buffett provided something like $5 billion in capital structured something like a preferred stock earning a fixed dividend rate at 6% annually, but which was convertible into common equity at the then market price of $7.14 per share. At some point years later, when the dividend rate on the common stock had risen to roughly equal the $300 million per year that Berkshire had been enjoying on their preferred, they exercised their conversion rights, and they now hold $28 billion or so worth of BAC common shares earning $560 million per year of dividends. But other insurers and investors did not have the same ability as Berkshire to make these sorts of investments, which depended solely on the credibility Buffett and Berkshire had to make a financing deal directly with Bank of America. This is one more reason why I am happy to own shares in Fairfax, which has been run by Prem Watsa for over 40 years now. He has been building relationships with investment partners all over the world and thus has opportunities to make the sorts of creative financing agreements and investments with those partners that I can participate in vicariously as a shareholder.

I was just thinking that sometimes Fairfax gets involved in deals with partners who need capital, and sometimes they provide that to their partners in the form of an equity investment, while other times they do so in the form of debt instruments and sometimes they do both, with an equity investment alongside convertible debt. If the investments were made at the insurance subsidiary levels, then perhaps the debt portion of the financing would be viewed by regulators similarly to (and a replacement for) corporate or government bonds without running the risk of adversely impacting regulatory assessments of the risk levels. And since the bond portfolio is large and of relatively short duration, the insurance subs would appear to have a steady stream of maturing bonds that might be sources of debt financing. I don’t claim to understand the details of the Kennedy Wilson transaction, but the SEC proxy statement regarding the proposal indicates that Fairfax has provided an equity commitment letter promising to purchase “equity or debt securities, or provide debt financing” in an aggregate amount of $1.650 billion to allow the transaction to take place. Presumably, whatever portion of the total $1.650 billion is provided in the form of debt financing could easily be supplied by principal repayments of existing bonds already held at the insurance subsidiary level as they likely mature at the rate of perhaps $2 billion a month. Dozens of pages in the proxy statement list all of the entities at Fairfax involved in the proposal, including management and board members of numerous Fairfax insurance subsidiaries including Odyssey, Allied World, Brit, Northbridge, Crum & Forster along with the Holding Company. So I think @SafetyinNumbers was on the right track in suspecting that much, if not all, of the funds required for financing this transaction will be provided at the insurance subsidiary level.

Good point, @SafetyinNumbers. This has been a blind spot in my thinking about the company’s investment options. I’ve tended to think that they can only really afford to spend/invest what they earn plus what they can raise in the debt markets in any given year…perhaps $5 or $6 billion or so, with investment options spread out between buying out minority partners, paying dividends, buying back stock and making new equity investments. I’ve completely forgotten about the $50 billion or so of fixed income float investments, most of which is held at the insurance subsidiaries, and which is turning over at about $25 billion a year if duration is short and at around 2 years. This can be a source of debt-like funding (other than only equity) which can be used to help finance purchases and deals as you note above. And when that is not enough, it helps to have partners like OMERS who are willing to front money for larger purchases, receive preferred equity, and provide Fairfax with future dated options to buy back their interests. And of course, as @Viking has noted, the operating subsidiaries have the ability to raise debt on their own to help fund bolt-on acquisitions or refinancings that they may be interested in doing.