ap1234

I have been looking at Fairfax’s historical investment results recently. Given the importance of the investment returns to the company’s BV/share growth (historically accounted for 100%+ of the growth ), I’m interested in getting a sense for what is a reasonably expectation (rough ball park figure) for the company’s investment returns over the next 5-10 years? It appears this figure is extremely important because it is what will drive whether BV/share growth ends up being 3%/annum, 5%/annum, 10%/annum or 15%/annum (the company's LT objective). The historic returns are phenomenal. Since 1985, the total (unlevered) return on the investment portfolio has been 9.4%/annum. Over the past decade, the total return on the portfolio has been 9%/annum. Even if you exclude the CDS gains, the total return on the portfolio was approx. 8%/annum over the past decade. Since inception, the company has only had two negative years (-4% in 1990, -2% in 1999). On an asset class basis, the company’s equity portfolio (with hedging) has returned 13.5%/annum over the past 15 years (beating the market by 9%/annum) and the taxable bond portfolio has delivered 10.8%/annum (beating the market by 4.4%). The problem I have is the investment environment for bond investors over the past 30 years is unlikely to look anything like future. This could be a material headwind for all insurers if int. rates stay low for a long time. I'd love to hear thoughts from members of the board on the following questions: 1. What do you think the pre-tax total return on the investment portfolio will be over the next 5-10 years? How do you arrive at that figure (i.e. what asset mix and returns are you assuming)? 2. Historically, it looks like approx. 75% of the portfolio was invested in cash/bonds. The past 25+ years have been an amazing time to be a bond investor. Going forward, the tailwind from int. rates is gone. What is a reasonable return on Fairfax’s bond portfolio over the next 5-10 years assuming int. rates stay low? 3. Does anyone know any specific details about Fairfax’s fixed income portfolio. The returns of Brian Bradstreet and his team are out of this world. What % would be high yield or distressed? What kind of bond investments do they own? What is classified as 'taxable bonds'? For example, if Fairfax lends money to the Brick or Megabrands, are these investments counted in the bond returns? If anyone has thoughts on any of these questions, I’d love to hear a discussion about what is a reasonable expectation for Fairfax’s investment returns over the next 5 or 10 years.

Thank you for the replies. That is very insightful and provides me with a lot more insight on how to think about their historical results. Tommm50 - I have two follow-up questions. You seem to be very knowledgable about the P&C space so I'd love to hear your thoughts. 1. I understand your concerns re: the results of Crum as their transition to a specialty insurer (discussed at the recent AGM) sounds interesting but the results have yet to show up in their underwriting results. In terms of Zenith, why are you concered about their results? According to mgmt., their loss ratios are amongst the best in the industry and it is the expense ratios that are elevated. The level of premiums are clearly down from the peak of the hard market. Do you not believe that their CR will drop significantly during a hard market as volumes & price go up? 2. You mentioned that "showing the 10 year numbers puts them in the best light but they only look good due to "hard market" results from earlier in the period." Over the past 10 years, we have had a hard market from 2003-2005, a soft market from 2006-2010 and some modest hardening in 2011-2012. Do you think that the past 10 years is not a good indication for an average insurance cycle (i.e. capturing peak and trough experiences)?

Thank you for sharing your insights!! That makes a lot of sense. Is there any reasson NOT to use the 10 year averaged accident year data below (pg. 13 of the annual report) as a gauge for the company's underwriting going forward (i.e. assuming they don't acquire any more troubled insurers)? I assume the past 10 years is a reasonable proxy for a full insurance cycle as it captures a very hard market following 9/11 and a prolonged soft market from 2006 onwards. Northbridge: 97.4% Crum & Forster: 101.5% Fairfax Asia: 87.1% Odyssey Re: 92.8% Consolidated: 95.8%

I recently attended the Fairfax AGM. Aside from the typical discussion on investing which is usually insightful, I was intrigued by some of the remarks by Andy Barndard (and the presidents of the insurance subs) suggesting that they believe they can generate an underwriting profit over a full cycle. I used to think of Fairfax as a mediocre insurer who would write at 102-105 and use the cheap float to invest. I decided to take a look at Faifax’s underwriting record over the past decade. I noticed a considerable discrepancy between the reported results (calendar year data) and the accident year combined ratios. I'd be interested to hear thoughts from members of the board on how to interpret the historical underwriting data. The following data is the 10 year average combined ratio on a calendar year basis (GAAP reporting). Northbridge: 99.1% Crum & Forster: 104.6% Fairfax Asia: 87.6% Odyssey Re: 100.3% Reinsurance/other: 111.4% Consolidated: 101.8% The following data is the 10 year average combined ratio on an accident year basis (pg. 13 of the annual report); Northbridge: 97.4% Crum & Forster: 101.5% Fairfax Asia: 87.1% Odyssey Re: 92.8% Consolidated: 95.8% The calendar year combined ratios don't appear that impressive. The accident year ratios on the other hand look quite good especially given the prolonged soft market since 2006. For example, Odyssey Re has a 100% average calendar year CR and a 93% average accident year CR. I assume the calendar year combined ratios are higher because they include the legacy books from Fairfax's prior acquistions (ex. C&F). In other words, prior to 2003, there were policies that were underreserved (ex. asbestors liabilities) that resulted in negative reserve developments that impacted the Fairfax's calendar year CRs from 2003-2008. The accident year CRs would not be impacted by business written prior to 2003. My questions for members of the board are: 1. Fairfax provides the annual calendar year CR for each sub and on an consolidated basis. Is there any way I can find the same data on an accident year basis? In other words, I want to be able to get the annual data that the table on pg. 13 of the annual report is using (i.e. annual data rather than just taking the 10 year averages). I notieced Fairfax provides accident year reserve development triangles in their notes but I can't find the initial accident year CRs for 2003,2004,2005, etc. to be able to get the data I am looking for. 2. Do people believe that the 96% average accident year CR over the past 10 years is more representative of the company's future results? in other words, if the company does not acquire any more troubled insurers, is their any reason not to look at the accident year results as opposed to the calendar year results? 3. If the accident year results are the best guage of the company's underwriting record, when will the improved results show up in the calendar year CR? As far as I can tell, the pace of negative reserve developments from pre-2003 business has slowed down dramatically.

With regards to Fairfax's investment portfolio, I'm not sure if there would be any restrictions in their ability to invest in Berkshire Hathaway. After all, Markel invests in both BRK (their largest position) and Fairfax in their common equity portfolio.

The annual report was great! I have a question regaring one of Buffett's calculations (return on unlevered net tangible assets). On page 13 he says: “Viewed as a single entity, therefore, the companies in this group are an excellent business. They employ $22.6 billion of net tangible assets and, on that base, earned 16.3% after-tax.” Based upon the balance sheet for the Manufacturing, Service and Retailing Operations (pg. 12), how does Buffett calculate the $22.6 billion of net tangible assets??

Gio, I will try and touch on some of your questions below. I apologize in advance if this too lengthy of a reply but I hope the additional color will help in your analysis of the company. 1) On a quarterly basis, Onex provides disclosure of their invested capital along with a breakdown of their net asset value (NAV). Unlike GAAP book value, NAV is non-GAAP measure and there is no standardized approach to arriving at the figure. One of the potential concerns is that several of the businesses are privately held and as such are difficult for an outside investor to value. Onex does not provide “fair value” disclosures on the individual companies but rather a lump sum valuation for an entire fund (ex. Onex Partners III). As such, an outside investor is not aware if some companies have experienced permanent impairment whereas as other companies have increased materially in value (we only know that the entire private portfolio has appreciated by X% on a quarterly basis). That said, there are a lot of reasons to believe that Onex is not reporting an inflated NAV. I have provided some of the reasons below: 1. The marks that Onex publishes to shareholders are the very same marks that Onex provides to their LPs on a private basis. 2. Onex has no incentive to overstate their valuations on a quarterly basis. The company generates carried interest upon the sale of an asset not on the quarterly valuations they provide. 3. Onex has a very sophisticated client base (LPs) that consists of pension funds and sovereign wealth funds. It is not in their interest to overstate the fair values from quarter to quarter as over time they would lose the integrity/trust of their client base. 5. When Onex sells an asset, it is typically well in excess of the mark that they were previously carrying it on their NAV calculation. 6. Onex does not disclose the valuation of the individual holdings because they would then have a hard time selling it for a higher price in the future. Why would another investor pay 1.25x for a company that Onex has stated they think is worth only X. 7. Onex has generated a 28% IRR on their realized sales since inception. This track record is based upon dispositions and not their internal fair value markings. 2) From 1984 until 2000 proprietary capital showed a gross IRR of 27%: do you know what growth in NAV/share it translated into? Onex has never provided this information which I alluded to in my earlier post. That said, I have spoken with Onex management in the past and I believe they mentioned at the time there was approx. 11% leakage (ex. Onex generated 29% IRR and shareholders earned 18%) as a result of the cash drag + expense burden that shareholders previously paid for. On a side note, I should caution that the 28% IRR that Onex reports is not the same as a typical mutual fund earning a 28% annualized return. Firstly, the 28% IRR is based upon investments that Onex has sold (i.e. does not incorporate unrealized gains/losses). Secondly, the company has a significant cash drag at the parent corp. level of 20-30%. Imagine if you ran a mutual fund and only reported performance of companies you sold and did not report the returns on the cash drag in your portfolio! I would hazard a guess taht your performance would look a lot better than your actual reported returns. However, one of the most interesting aspects of the Onex investment thesis today is that the expense burden is no longer a drag on shareholder returns. Onex manages $2 of 3rd party capital for every $1 of internal capital. The fees from 3rd party capital more than offset the costs of running their internal capital. As such, if Onex generates a 15% IRR going forward, shareholders should actually receive in excess of 15% if we exclude the cash drag. 3) I understand that the comparison with FFH’s portfolio of investments might not be applicable. But what about Mr. Buffett? Onex's investment universe and philosophy is quite different from Berkshire. They are both value-oriented investors with fantastic track records. However, Onex is a P/E investor with the focus on acquiring an assets, unlocking value and selling the business several years later. The company uses more leverage in their acquistions (although less than the typical P/E firm) than Buffett. The comparison is not clear as Buffett's business model is based upon leverage (a permanent source of leverage). When Buffett buys a company he is a passive investor (i.e. he doesn't advice management on how to run the business with the exception of capital allocation). Onex is an active investor who takes control of a business and brings about change (ex. cost cutting, etc.). When Buffett buys a private company, his holding period is forever. Onex has a fund life (typically 10 years) and needs to sell the companies and return the capital/profits to their LPs. 4) Finally, on succession: has Mr. Schwartz ever communicated his plans to shareholders? Do you see him retiring soon? If that were the case, is there someone younger, who has already proven himself, and who could replace Mr. Schwartz at the helm of Onex? I believe that succession planning is a significant concern in any asset management business and in particular in the case of Onex. Very few asset management firms have successfully transitioned to the 2nd generation of employees. Gerry has had a profound influence on the company’s success in terms of investment performance, client relationships, culture, etc. However, there are several mitigitants that make me feel more comfortable with successfion planning. Over time, the company has evolved as they have built out a diverse team of investment professionals which now consists of over 30 members and 8 Managing Directors. The management team behind Gerry is very strong. These are seasoned private equity professionals who have decades of experience and have been immersed in the Onex investment approach. The senior management team has been at Onex for an average of 16 years and collectively the team has over 166 years of experience in private equity investing. Of the eight managing directors, the most recent hire joined the firm in 2004. At the top level, the company has had extremely low turnover which is remarkable considering the competitveness of the industry. It is not clear who the heir apparent will be but some analysts have suggested that Seth Mersky or Bobby Leblanc are the most likely candidates. In terms of business development, Onex will begin fundraising for a new flagship fund (Onex Partners IIII) in early 2013. The LP investors (pension funds, etc.) will be committing capital for a minimum of 10 years. These are sophisticated investors are willing to commit capital to another organization with the understanding that Gerry is likely not actively involved in Onex at the end of that period. Despite this, it appears that clients are still willing to give Onex their money as they believe in the philosophy, process and ability to generate above-average returns over the long-term. It is impossible to quantify the impact on company culture if Gerry Schwartz leaves. However, I do get the sense that Onex is well prepared for that eventually and have made significant efforts to institutionalize both the investment process and culture to strive after he is gone. The experienced management team, low staff turnover and unique ownership structure and incentives should help Onex maintain their business even after Gerry leaves. I think it is safe to say that Gerry's influence on Onex is significantly less than Buffett's contribution to Berkshire. I hope these answers help in your analysis. AP

Gio, I have been a shareholder in Onex for several years. The company has performed well (i.e. solid NAV/share growth) and the discount to intrinsic value has narrowed (i.e. multiple expansion) over time. That said, before you dig a little further, I want to clarify a few of your points below: 1) Onex has not historically grown NAV/share by 22% as mentioned below. I think it's important to understand the history of the company. Prior to 2000, the company managed their own proprietary capital as opposed to 3rd party capital. As such, the company had no annual revenue stream (i.e. management fees and carried interest) to offset the costs of running the business (salaries, bonuses, travel, etc.). Prior to 2000, if Onex generated a 28% IRR on their investments (even if we assume they were 100% invested), the shareholders in Onex Corp. would not receieve a 28% return as a result of leakage (i.e. the shareholders paid for Gerry and his team's salary, bonuses, etc.). One of the issues facing investors is that the company has only recently provided disclosures regarding their growth in proprietary capital. 3) I do not think the comparison to Fairfax is that applicable. As you mentioned, Fairfax has a $24 billion investment portfolio. However, this is largely a public investment portfolio consisting of bonds and equities. With the exception of small positions in credit and real estate, Onex is a private equity investor and their investment universe is very different from Fairfax. I think Onex is an interesting investment vehicle for long-term investors. You get exposure to a high quality P/E firm as well as a small but growing asset management business. In the long-term, the argument could be made that the company deserves to trade at a premium to their reported NAV/share if they can continue to deliver strong investment returns and the asset management business provides an additional source of value. That said, there are many risks. As you noted, there are concerns surrounding succession planning. The P/E market has evolved and there is a lot of competition for deals (ex. Onex has recently been acquiring companies from other P/E firms). Size is an anchor on performance. Onex is growing their business in credit which has historically not been a core competency. The company's ability to fundraise is dependent on maintaining strong investment results, etc. In any case, I remain a long-term shareholder but I wanted to provide some additional background if you decide to do further analysis on the company. AP