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.

Where am I from? Currently I live in Seattle in the US. However, originally my ancestors came from your part of the world, in Northwestern Germany, arriving in the US sometime in the late 1800’s. Grandparents on both sides of my family could still speak German, but my own parents could not, nor can I. Here in Seattle, the folks I encounter who are interested in talking about investing are focused almost exclusively on Tesla, or Nvidia, or Bitcoin, or electric plane manufacturers or small pharmaceutical companies that may win the lottery with the next blockbuster drug, none of which I know anything about. They may have heard of Warren Buffett and know a bit about Berkshire Hathaway, but even when I worked in the insurance industry, it was rare to come across someone who had even heard of Fairfax or Markel or Charlie Munger and Benjamin Graham. And my experience here in the US was the same as yours, with no opportunity to learn about investing in school. I presume the same is likely true in much of the world, and I admire the efforts of folks like @Viking for his work in setting up an educational website on investing, targeted at young folks in Canada.

Kind words Crip — thank you! In my corner of the world, I just haven’t found many folks, either among family or friends, who seem to enjoy investing as much as I do. I do come across a good number of folks who enjoy speculation, but that’s a whole different kind of person I refuse to “learn” from…. I’d been a longtime lurker on this forum, but joining it shortly after I retired has been one of the best decisions I’ve ever made. Some of the most powerful lessons I glean here are those that reinforce the appropriate, measured response a value investor ought to have after viewing seemingly irrational market pricing of the businesses we own part of. This online community helps me maintain a steady approach in the face of market volatility. Glad to hear your son is approaching things the same way…it’s an impressive lesson to learn at such an age!

She did treat me to a great dinner or two over the years! But to be fair, she also had the temperament to leave her portfolio alone even when things may not always have looked as though they were trending steadily upwards and to the right. For the first couple of years before Valeant imploded, her spouse second guessed the decision to dispose of Valeant, as it continued to outperform the replacements. And even her Fairfax investment was underwater about seven years after it was first purchased (right around the time that Prem signaled how undervalued he thought it was by purchasing $150 million for his own account). She didn’t give me any grief when we sold some other names and purchased more Fairfax around the same time. I am glad I never got involved with short selling, as I would have discovered with regard to Valeant the truism that “ the market can remain irrational longer than you can remain solvent.”

Good point, @patterson. I think the market overreacted to the Q1 earnings. The current price is an attractive entry point for those looking to acquire a solid long term investment, as well as a great opportunity for continued retirement of shares by the company itself. Thanks for the comparison with Chubb as well. I am currently quite happy to own more Fairfax, with just a bit of CB via Berkshire’s investment in same…

One comment of his that hasn’t aged well since Thorndike’s Google talk was the inclusion of Mike Pearson of Valeant on his shortlist of potential future outsiders. Just a lesson to myself and folks such as Bill Ackman that it can be difficult to ensure one is partnering with a true Outsider who belongs on the all time great list. My sister actually was working in cost accounting for Valeant shortly before the company imploded. She had left with a lot of company stock and options, after being emotionally exhausted by the high pressure of the work, and called asking me for advice of what to do with her investments. I looked into some of the financials of the company and couldn’t understand how they were viewed so positively by the market. They would continually turn negative GAAP earnings into adjusted operating profits as far as I could tell, and I wasn’t impressed with Pearson’s on camera interviews when he was touting his attempt to take over Allergan. I wasn’t seeing what Ackman thought he was seeing when he described Valeant as the next Berkshire Hathaway. Maybe that’s why I’m skeptical of Ackman’s latest attempt to create his own Berkshire like vehicle. My sister transitioned into a less stressful though also less remunerative position and also converted her Valeant investments and options into investments in Berkshire, Fairfax and Markel among others, with Fairfax alone making up about 50% of the total these days.

@Viking — very opportune overview of Thorndike’s work. I couldn’t help notice that perhaps an additional reason Buffett makes the list in part is that as a capital allocator, he allocated some of Berkshire’s capital to companies headed by two others on the list — Katherine Graham and Tom Murphy. It certainly doesn’t hurt to allocate some of one’s own capital to other masters of capital allocation.

Thanks for the links @SafetyinNumbers. As an armchair historian, I have to say I appreciated the Crum and Forster overview of their company history. I like to see a current manager spending time learning about the mistakes of the past to help ensure that they are not revered in the future. And it was a kick to see that one of the original investors in the company back in 1822 (William Adee) had the same last name as the current CEO…and found a short interview online with Marc Adee in which he confirmed that he discovered this previously unknown connection himself upon reviewing the company archives.

Kudos to you, @Hamburg Investor! First time I can recall in decades that I had to look up the definition of a word used by someone else! (“scissions”). But that single observation aside, I really appreciate the entire post. Well done!

All valid points @Hamburg Investor, and I agree with you that Fairfax is not likely to dilute their insurance powerhouse as quickly as happened with Berkshire. And premium to equity is a very rough and inexact measure of leverage, while float leverage is indeed more important to us as owners. The point I was trying to highlight was just that very few other insurance companies appear willing to expand their capital allocation menus to wholly owned subsidiaries outside of insurance, such as Sleep Country Canada, Recipe, etc. Over time if these operating subsidiaries grow, I may be wrong, but I think the book value recorded on Fairfax’s balance sheet may end up being understated, while ideally their reported profits may grow to be a larger portion of the overall earnings stream at Fairfax. In my opinion, this will likely make Fairfax less risky than a pure play insurance company without other such earnings streams that are likely to be uncorrelated with the insurance cycle and whose book values may not be similarly understated. I think we’re getting massive benefits with Fairfax’s high float leverage generated at a negative cost along with some sources of financial stability and risk mitigation that most other insurance companies don’t have via the non-insurance operating subsidiaries. Everything else you highlighted — global footprint, decentralized operations, culture, openness to expanding insurance ops to other countries are all great reasons to expect Fairfax to have a longer runway with the current high powered business model in place than was the case with Berkshire. And I really like seeing how effective the company has been at repurchasing their stock. I think I recall Buffett and Munger praising Henry Singleton’s share repurchases with Teledyne years ago, but then not seeing much action on that front for a long time with respect to their own shares. When Prem similarly highlighted Singleton, I thought I’d seen this movie before and wasn’t holding my breath for a lot of activity, but I’m happy to have been completely wrong in that regard.

Spot on @Viking. I got my start in the insurance business in 1990. For the entirety of my career, it was a mistake to confuse Berkshire with any competitors of the insurance company I worked for. In fact, quite often metrics for the US or global insurance industry had to be adjusted to exclude Berkshire lest they distort things and give too rosy a picture of how well the industry was doing. Berkshire simply had much more capital supporting its insurance premium writings than any other insurance company because of its wholly owned subsidiaries and the outsized growth of its investments in equities. A typical pure play insurance company will “lever” its shareholder equity/policyholder surplus such that each dollar of it supports the writing of $2 or even $3 of premium. Every dollar of Berkshire equity nowadays supports much less than a dollar of premium volume. If we look at Fairfax today its premium volume is about $33 billion, and its shareholder equity is probably just a few billion shy of that…but as Prem reminded us, there is almost a $4 billion of fair market value to carrying value cushion that doesn’t yet appear on the balance sheet. So the Fairfax ratio is probably a 1 to 1 now…which makes comparisons with other pure play insurance companies much less appropriate. Fairfax is indeed metamorphosing before our eyes. It’s already a mistake to consider it only an insurance company, and ten or twenty years from now we are likely to consider it more as a conglomerate with a strong insurance business, even more immune to the vicissitudes of the insurance cycle than companies that are solely insurers than it already is today. Berkshire has normalized operating earnings of over $40 billion a year now. Who cares if they might occasionally wipe out a quarter’s worth of earnings in the event of their $10 billion share of a massive $300 billion industry catastrophe? Likewise, with $5+ billion of normalized annual operating earnings for Fairfax, who cares if they might experience a $1 or $2 billion catastrophe event? Large future catastrophes that could be balance sheet events for the typical insurance company are likely to be merely quarterly earnings/income statement events for companies like Berkshire and the new Fairfax. Folks who are even high level execs in the insurance industry simply don’t understand Fairfax well enough to understand that insurance cycle observations or rules of thumb about how well the industry is likely to perform in a soft market are not as applicable to Fairfax as they are to other insurers. Nor does Morningstar yet appear to understand that viewing Fairfax solely through the lens of an insurance company investment is increasingly less helpful to consumers of their research.