Maverick47

I don’t have an estimate of how much could be deployed from fixed income to equities, but I think it’s not uncommon for insurance company managements to choose to hold their insurance loss, and expense reserves (and unearned premium reserves) in the form of relatively secure fixed income instruments. The amount of float held by Fairfax might be a reasonable approximation for such a lower bound on fixed income — roughly $35 billion? I’d be surprised if they chose to hold fixed income investments in an aggregate amount less than that. I think they currently hold over $40 billion in bonds? in addition, there may well be some regulatory or rating agency constraints on investments in equities. There’s often an implicit trade off between underwriting and investment risk for a company. When a company expands its premiums written such that they become sizeable relative to supporting surplus or equity, then they generally have less of an ability to accept risk on the investment side of the house by moving into equities. A company such as Progressive, with premiums to surplus/equity ratios in the high 2+ area (sometimes close to 3.0) takes much of its risk on the underwriting side, so not surprisingly will not hold a sizable investment in equities. Fairfax has written premiums of about $29 billion, and equity including both preferred and common of about $24 billion. So they can be heavier into equities than a company like Progressive, and they are…with about $15 billion invested in equity-like instruments, associates, etc. If they anticipated opportunities to grow premiums dramatically, then they’d probably hold off on a further move from fixed to equities. But if they anticipated a soft market in which they even saw premiums shrinking, they might well choose to offset a reduction in insurance related risk with an increase in investment risk via a shift from bonds to equities.

From an economic standpoint, as long as Fairfax continues to prefer to hold equity investments for the long term and allow the gains to compound on the balance sheet unrealized, there should be no dramatic reduction in reported after tax income. But if as you’ve noted, the deferred tax liability would increase by $18 per share, the book value ought to drop by an equal amount. However, in my opinion, that is a somewhat misleading effect. A deferred tax liability is an interest free loan from the government which has to be paid back only when gains are realized. And a deferred tax asset is an interest free loan to the government that only is paid back to the company as future income is generated and able to be shielded from taxes because of the prepaid tax asset. Neither of these are present valued on the balance sheet. An asset that earns no interest is not worth as much in my opinion as a similar amount invested in 5% government bonds. Similarly, a no interest loan that might not have to be paid off until years in the future is not as large a liability as a similar amount borrowed by means of a 6% interest 10 year bond issue. Fairfax has about a $1 billion net deferred tax liability (interest free loan from the taxing authority) on the balance sheet at year end 2023. That is a sign of a savvy insurance company in my opinion, and if the liability grows to $1.4 billion after a tax change, it just makes the comparison with peer insurance companies that often record net deferred tax assets on their balance sheets that much more favorable.

I got a look at a prior report of Brett’s and noticed that he projects Earnings per diluted share…so presumably he converts actual book value per share at year end 2023 to a book value per diluted share instead. I think diluted shares are about 8% higher than actual shares. That may well explain the disconnect between his report and the reality that I care about personally.

Agreed! Thanks to @John Hjorth for reaching out to Andy!

I’m not an expert on surety bonds, but it can help to understand that these are probably quite different from a typical insurance risk transaction. I believe the provider of the appeal bond has to guarantee payment of the cash amount of the bond plus any accrued interest in the event that the appeal is lost. Generally speaking, the insurer wants a source of liquid collateral from the client at least equal to the amount they might have to pay. They basically just provide guaranteed liquidity to a client. It is the appellant who is supposed to pay the amount of any financial judgement, and an insurance company isn’t interested in providing coverage for the full amount of the award in exchange for a premium smaller than that. This is different from catastrophe reinsurance where the insurer accepts a relatively small premium compared to the total payout required against the risk of a catastrophe and so has to have an opinion on the probability of the event. As Greenberg’s letter noted, the surety bond provider does not actually assess the likelihood of the success of the appeal. Unfortunately, commercial real estate, which may or may not be unencumbered, is not viewed by surety providers as a desirable source of collateral. If an appeal fails, and the insurer has to pay the face value and accrued interest on the bond immediately, then they are stuck with having to collect on the collateral. Foreclosure on real estate is not high on the list of things that insurance companies want to deal with. The Chubb bond by contrast was secured with readily liquidated brokerage investments.

@Thrifty3000 : I’m not aware of how Fairfax’s share-based plans work. Is this something you can educate me on? Are they based on options grants or are shares given directly? Many companies do purchase sufficient shares to offset dilution resulting from share-based compensation, but Fairfax has been reducing share counts outstanding, and given the highlighting of Henry Singleton’s example of reducing Teledyne’s share count outstanding by something like 90% over his tenure, I think we can safely assume that the only way share counts might increase would be if additional shares were issued to help pay for an acquisition like Allied World in the future. Absent that possibility, I’m not personally worried about diluted per share earnings.

Appreciate the update @Viking, and I like the historical data as well. As I scan the years columns from left to right, I appreciate the growth in interest rate and dividend income relative to underwriting results as well as the share of profits of associates and gains on investments. Rough mental math indicates it would take quite a severe worsening of underwriting results to offset completely the expected normalized income from the other sources given current expectations for them. Something like a Combined Ratio of 115 or so might result in no income (but also no loss) for a future year. Given attention to managing cat exposure, and the fact that a good portion of the premium volume is related to reinsurance, which ought to be able to react somewhat faster to poor underwriting results than a typical primary insurer, as well as the global spread of exposures among a number of independent insurance providers, it’s unlikely in my opinion for that kind of underwriting result to occur, but I do like to get some sense of how bad something might get for the companies I invest in, and a 115 CR is about a 20% worsening from the ideal target of 95. That’s a pretty poor underwriting result, not very likely in my opinion, but a reasonable worst case scenario, and it comes nowhere near to damaging the future viability of the company. I continue to believe we have significant upside for the company, and limited downside

@MMM20 Your point about float appearing on the balance sheet in an overstated manner that an analyst ought to adjust does, I think, also apply to the difference between deferred income tax liabilities and assets. Fairfax has about $1 billion more deferred tax liabilities than assets on their balance sheet. That net liability is akin to an interest free loan from the tax authorities. Not as valuable as float generated at a negative cost with positive underwriting profits, but more favorable than debt or preferred stock issuances.

Thanks for the update @Viking! I feel pretty good about the results relative to expectations. Regarding share count, I’ve got to believe this is a critical denominator for per share estimates. Last time I checked Brett Horn’s Morningstar report, he was projecting roughly 25.5 million shares outstanding for 2023 through 2025. That may be part of the reason he projects earnings per share close to $100 for the next few years. Nice to hear Prem indicate that he’s comfortable with the run rate on interest income for the next four years…

The 18.9 figure does include dividends for all prior periods while 17.8 excludes them. The comparable 37 yr CAGR including dividends is 18.5. Using the same sort of calculations I’m estimating a 34.6% gain in book value in full year 2023, not far off the 33.3 non annualized value through Q3. So maybe an $884 book value per share when we see the full year report Thurs evening?

@Viking Maybe the inclusion of dividends or not? Paragraph 2 of the 2022 letter refers to a 37 year book value including dividends CAGR as being 18.5%. Still a good jump from there to 18.9 by adding one more year, but not as incongruous as moving from 17.8 to 18.9. Likely an early read on how helpful 2023 was….

@Viking Love the football analogy, especially since I missed this game and didn’t know the details of the comeback! To extend the analogy a bit, it strikes me that besides the offensive comeback, part of the reason for the victory might be attributed to the Patriots’ defense that held the Falcons scoreless after they had scored 28 points (could have been Falcons’ offensive ineptitude as well I suppose). Insurance analog? Fairfax defensively protects their balance sheet from massive unrealized losses when they kept their bond durations short in advance of interest rate increases. At worst they were in perhaps an aggregate $1 billion shortfall on the market value of their bonds relative to cost? By contrast, a number of competitors with similar sized bond portfolios but longer durations (Travelers, Chubb, Liberty Mutual, Hartford come to mind) had bond portfolios with market values $5 billion or more below their cost at the same time. So Fairfax’s strong defense in the second half of the latest 4 years of the insurance Super Bowl allows their insurance premium growth and interest rate income offense to shine, while competitors poor balance sheet management takes the wind out of their offensive sails.

We’ll put @dealraker! It reminds me of a comment that I believe Charlie Munger made a few years ago at a Daily Journal meeting… talking about the temperament an investor needs to have in the face of market fluctuations. I think he was talking about his own stake in Berkshire Hathaway, and in his own inimitable phrasing said something like “you have no business investing in individual stocks if you can’t face the possibility of a 50% decline in market value with equanimity”. He then went on to elaborate that two times in his personal ownership of Berkshire Hathaway he had faced that sort of situation….

Thanks @Spekulatius, for the report. I do appreciate the opportunity to see some of the per share projections for 2023 and the two years thereafter. He shows a 2021 EPS of $122, and though the first 9 months of 2023 have come in at $129, his projection for the full year is at $113, with the next two years lower than that. As a likely net acquirer of the stock for the next two years, I would be more than happy if the market valuation takes time to react and respond to what (based on Prem’s expectations and supported by @Viking and the work he has done) are more likely to be EPS results closer to $150 than under $100. As Graham would say, in the short term, the market is a voting machine, in the long run it’s a weighing machine. If the company is able to produce three back to back years with the sort of earnings we think are likely, then we can begin to focus on what the company will do with the $9+ billion of cash added to the corporate coffers in that time frame. If the market provides opportunities for share repurchases, that might be one thing to keep an eye on. There certainly didn’t appear to be any long term expectation in Horn’s model for material investment income reported from the shares of earnings of associates, and he doesn’t seem to have increased the dividend rate to $15 yet. He only projects modest share count reductions. I did just notice that his outstanding share count for 2023 was listed as 25.9 million, whereas I expect we’ll learn next week that the share count is closer to 23.2 million or less. So his EPS modeled estimates are understated by a minimum of 10%. If I’ve gotten this wrong, please correct me. It does seem to be a rather material error in the work when one is advising readers of your analyses what sort of market price per share they should target as a fair valuation… All in all, I’m happy to have his model as a more pessimistic view of the future than I would hold, and if it, along with the Muddy Waters thesis help to keep the overall market valuation from reacting to likely future earnings power while allowing me to add to my position at more favorable prices, then I’m more than willing to be patient.

Thanks @Viking. The only thing I was sorry about was that I didn’t have any dry powder in my personal accounts to do the same. However, I was able to pick up some shares for a family member’s account that I manage.

Chapter 2 of William Thorndike's "The Outsiders" is probably all you need to read to find out about Henry Singleton and Teledyne. Given the Fairfax stock buyback at $500 and the Total Return Swap homerun, it's clear that Prem has gleaned the correct lessons from Henry Singleton's example at Teledyne.

https://archive.org/details/distantforcememo0000robe

Thanks, @glider3834! This was an extremely valuable conversation for me to learn from. It clarified for me the value of corporate culture, family ownership/long-term control, and I appreciated learning some more about how the duration decision on fixed income gets made (at the Investment Committee level, with heavy involvement by Prem and Brian Bradstreet). The value of the decentralized nature of the business, avoiding the sclerotic nature of large corporate bloat, was also good to learn some more about. Much appreciated!

@Viking, When I read your posts about Fairfax, I can’t help but hear the voice of my van pool driver from 30 years ago. He was sharing with his passengers the story of his summer job driving a delivery truck with a more experienced driver who would yell instructions to him from the loading dock as he was tasked with backing up to it. The instructions he recalled hearing were always the same: ”Keep comin’, Keep comin’, Keep comin’!!!’” CRASH! Hokayyy!!!!”

Viking — Thanks so much for sharing your thoughts in this latest post. And I think it dovetails well with musings of others regarding how large a position Fairfax should make of one’s portfolio. Temperament/patience are areas where small individual investors might well have an advantage over professional traders/portfolio managers. Fifteen years ago when I had a much smaller non retirement portfolio, I made the mistake of treating my investments as if they were bets in a casino. When two of my small investments began to perform well I sold off half when they had doubled, telling myself I was now “playing” with house money. I did keep the half stakes — one has turned into a 10 bagger after 15 years, while the other is a 14 bagger. But neither decision would have made a material difference to me now since the initial amounts were rather small. I would only be concerned personally with Fairfax or other investments making up a large portion of my current portfolio if I believed there was a reasonable chance it might go to zero, like Enron. Part of Prem’s history makes me think that is unlikely. The struggles against short sellers when he faced a concerted attack betting that the company would go to zero or thereabouts in the early 2000’s had the benefit for me now, I believe, of making Prem more cautious about a financial situation that would ever put the company in such a position again. I think he and his investment folks really hit the ball out of the park with their credit default swaps at the time of the 2008 financial crisis. The profits on that allowed them to buy back the portions of their subsidiaries that they had to sell off to make it through the short selling attacks (was that both Odyssey Re and Northbridge?). I only got into the stock myself around the 2010 time frame. Then the lesson they learned from that macro bet was that they should make another one (the lost years thereafter betting on deflation, and hedging their equity investments). I think you have laid out very well that the latest lesson they have learned is not to make such huge macro bets in the future, and for roughly the last 4 or 5 years their actions have matched what they have said in that regard. I think one sign that an insurance/investment platform company is taking the long view, allowing compounding to work its exponential magic, can be seen by examining whether they have a net deferred tax liability on their balance sheet or not. Those only get built up with years of unrealized capital gains, generally on equity investments. It takes a lot of patience and a long term view on the part of a CEO to do this. The power of compounding of this deferred tax liability only makes a material difference after about 25 or 30 years. Berkshire is a shining example of this — basically they are allowing an interest free loan of well over $10 billion from the government compound on behalf of their owners. Companies with net deferred tax assets are actually doing the reverse — making an interest free loan to the government. Fairfax has a net deferred tax liability of about $1 billion. Other US companies with net deferred tax liabilities are Markel and Cincinnati Financial, which is why I have some positions in those companies as well. I like companies that make decisions that pay off over the same long term that I have in mind for my retirement time frame of 30 years or so, and that’s what I see in all of these companies.

The way I interpreted the $84B reference was that the journalist was referring to the assets of the company, which is just over that amount on the 2023 Q3 balance sheet.

Am I missing something in the FIH chart you included? To me it seems to indicate a 12.0% CAGR for BIAL. The 12.8% figure seems to apply to Seven Islands….

Sheer pleasure to be educated by your post, Viking. I enjoy the question and answer format. I have to admit I’ve tended to focus on the equity investments myself, and my understanding of bond portfolio management is rudimentary at best. I appreciate the comparison with other companies.

These days I give a decent amount of credit to Prem for his capital allocation decisions and opportunities. Buying back stock like Singleton of Teledyne, at book value or below, is something that few other CEOs are willing or able to do in a rational, shareholder friendly fashion. He also has the ability to buy back portions of associates that he has sold off to OMERS to raise the capital needed for previous buybacks (10% of Odyssey). The longer term focus on shareholder value, and maintaining franchise value of the insurance subs by not laying off staff in times of crisis (COVID) is also a differentiator from competitors. I used to work for a competitor that wasn’t able to maintain capital levels sufficient to support the writings of premium levels when they rose from the inflation shock of the last few years, and their capital levels dropped because they were reaching for yield on their bond portfolio. I got laid off recently as the staff cuts began, in an effort to return to profitability so that capital levels could be rebuilt. (I am able to view the early retirement with equanimity because I have over 70% of my retirement assets in Berkshire and Fairfax.) The less experienced staff that has been retained will be cheaper, but most of the value I added over the years was in using my experience to help the company avoid self inflicted wounds through poor business decisions. Fairfax’s insurers will have a continuing and expanding advantage over the company I used to work for because they have a solid balance sheet, and a growing insurance business, which gives them the best of both worlds — experienced staff and opportunities for professional growth for the newer employees that are added each year. Don’t underestimate the value of the corporate culture that has been created at Fairfax. That can be part of a company’s enduring moat just as much as more easily understood business model advantages can be….

To be fair, the estimates through 2024 are an average of 6 analysts, while for the years thereafter, only one analyst provided EPS estimates.