SafetyinNumbers

Actually, this might be the catalyst for a multiple rerate. The thinking is that a big cat year like that would harden the market and trigger big growth in gross premiums written. The same momentum investors that have been selling since June flood back in to the stock except, there are a lot less shares available as passive indices and the company have reduced supply while they were chasing returns elsewhere.

Last year wasn’t that benign, the California wildfires were a big hit in Q1. Cat losses were 4.8 points this year vs 4.5 last year. Cat has shrunk as part of total premiums so I don’t think the risk of a loss in underwriting on a full year basis is very high. If it does happen, they are very well positioned to take advantage of the hard market to follow. I’m looking forward to an update of the climate report graph.

Anecdotally, I have noticed the combined ratio of an acquisition goes up after Fairfax acquires them. I think this is because they are much more conservative on reserving so there is some padding required. The street seems to assume it means they did a bad deal but I think it’s classic Fairfax income deferral.

The financing cost of the TRS is captured in equity exposures but I don’t think it needs to adjusted for. The adjustment is to reduce the share count by 1.76m shares and increase debt by $3b. The long term debt financing would be more expensive vs the TRS but the difference is negligible.

They don’t want control because they would be forced to consolidate the debt which might increase the cost of capital as it will screen worse. I guarantee you they are well protected in the shareholder agreement. I don’t this is about chasing yield as much as real returns and above average collateral.

We have to pay employees. If we paid them cash and they bought the stock directly it would be the same thing except here there are longer vesting period which promotes long term thinking. CSU, SCR, GFR all pay cash and senior executives have to maintain a stock position and they decide when to buy the stock. In some ways that’s better as they might be able to market time and provide signal for investors. With this methodology, over time, I think FFH picks up extra shares in treasury that like the float may never get paid out. I think we’ll see the number of shares issued each year decline over the next 5 years as the stock price has probably gone up faster than growth in the program and compensation combined.

I don’t think a sum of the parts valuation is useful. The non-insurance companies are the equity investments of the insurance subsidiaries. It’s easier to think about the range of returns for the $75b investment portfolio. Historically it’s been ~7%+. We know leverage is ~3:1 and with two thirds of the portfolio earning 5%, it means the equity portfolio has to put up an 11% return to hit the 7% bogey. That’s a 21% pre-tax ROE before underwriting income and head office expenses/financing costs. 10% for the equity portfolio is a 15%+ ROE after tax for the company assuming underwriting is profitable. It’s not important what the current income of the equity portfolio is when trying to understand the difference between fair value and carrying value. If we start with the biggest position and work our way down, we can quickly see that big parts of the portfolio are earning returns well above 10%. In fact our biggest position which is over 10% of the equity book, Eurobank, earns ~20% on our carrying value which means the rest of the portfolio has a lower hurdle rate to achieve 10% and that increases the probability it’s achieved.

On a side note, this is helpful to defer earnings.

He doesn’t make the value estimate, Morningstar’s computer does. He is responsible for the terrible estimates and moat evaluation.

No, they expect a 15% return if it keeps its multiple. I think the key is the investments:equity leverage. If they sacrifice that, then ROE expectations probably come down. That’s the position BRK is in. Too much success and not enough high return opportunities to reinvest. Fairfax has high return investment options for now including buying back shares and buying in minority interests.

This all makes sense to me. I think the value of the investment portfolio or about 3x BV is a fair multiple. Investors would pay full value for an equity etf and a bond etf so I think it’s fair to argue the same for FFH. It’s actually better as we get paid to own it because underwriting income exceeds holding company and interest expenses. BVPS growth over the past 5 years is > 20% for the next 5 years. If it can stay above 15% for the next 5 which seems like a low bar, then maybe we’ll test 3x BV. The higher BVPS compounds the better the chance the P/B multiple gets silly and goes well beyond 3x. It’s nice to get the right tail for free.

Using low expectations instead of realistic expectations has kept investors out of the stock or encouraged them to sell too soon for years. Good for the rest of us, I suppose.

Regular marking up of BIAL provides some predictable book value growth for FIH. That might make it easier to own thus shrinking the discount.

I wouldn’t think of it as 1% dilution because they buy all of the shares contemporaneously with the grant. They could give them extra cash but instead they buy shares and stick them in treasury.

Just a separate bet. I guess it would be a hedge since you are long the stock.

I like Annie Duke’s idea about putting it in terms of bets. So the question is how much would you bet on FRFHF NOT doubling over the next 5 years? That is, if total return hits 100% within 5 years, the bets over and you lose.

The yield curve might also get steeper which means higher long term rates. Credit spreads could widen. They could invest more with KW and get higher mortgage rates or invest more in real property at higher cap rates. It also takes time for lower rates to work their way through the portfolio given duration. If the average coupon falls from 5% to 4%, then the equity portfolio has to do 12%. That still doesn’t seem like a high hurdle given how low carrying value is vs fair value for big chunks of the equity portfolio.

You may not appreciate how 3:1 investments:equity leverage works when interest rates are normal like they are now. With fixed income book (two thirds) doing 5%, if only takes a 10% return on the equity book (one third) to get to a 20% pre tax return on equity as long as underwriting is offsetting head office costs including financing costs which it is more than doing now. Meanwhile the equity book might do much better than 10%. Eurobank is over 10% of the portfolio at carrying value but contributes at a 20% return on investment because it’s marked at 5x earnings. That means the hurdle rate for the rest of the portfolio is lower.

They issued a lot more equity for operating companies after that including Dairy Queen, Net Jets, Gen Re and BNSF. I think we’ll only see FFH issue stock for insurance acquisitions or if they need to fortify the balance sheet. Both seem unlikely in the foreseeable future given the valuation and fortress like balance sheet, respectively.

That’s probably true but as @Vikinghas pointed out, it also reduces the volatility of earnings and increases the earnings. They can also restructure the balance sheet to improve ROI without as much reflexivity risk.

Exactly right and it’s all explained by the IFRS accounting rules and Fairfax’s own conservatism. Fairfax didn’t start buying 20%+ positions until 2012 from what I can tell. The nature of the accounting is that mistakes are written off quickly. If they ultimately recover the returns look outstanding on a lower cost base. For the successes, we only get to accrete the net earnings in the book value. We don’t get the benefit of the multiple of those earnings or expansion in the multiple in book value until it’s sold but once again the returns look great. The accounting suppressed this flywheel until the last few years but now it’s in swing. Combine this with 3:1 leverage and you can see why I’m so bullish on forward ROE.

I think this is another generalization that is providing an opportunity to buy back stock cheap. First, the street is selling the stock on lower GWP but they are using less reinsurance so NWP is growing faster. That’s important for returns which is what Fairfax is focused on as long term investors. It’s ironic that guys like Bloomstran don’t like Fairfax because they use reinsurance but now it allows them to grow NWP/share in a soft market without writing bad business. Fairfax’s diversification and decentralization helps with this. Asia is uncorrelated to other insurance markets and Fairfax has traditionally passed through a lot of the risk to reinsurers. Lately they have been ceding less. Second, they are very conservative on reserving so underwriting profit should be buffeted by strong reserve releases for years to come. Excess reserves are just future equity masquerading as a liability. Third, they can buy in minority interests at very low valuations which is very accretive and has the same effect as growing net premiums/share. Consolidating Digit starting in Q1 will also help with this,

It also boosts future ROE all else being equal as the earnings power is unchanged when current earnings are used for buybacks. Further, I think it’s better to think of ROE as a range as opposed to static. 15-25% average ROE over the next 5 years has a 90% confidence inferval in my mind given what we know about the leverage and gains that will make their way into income over the next 5 years.

For the most part yes. They cannot use insurance subsidiaries investment portfolio to buyback stock as some seem to think they can. It sounds like you rather they keep more excess capital at the insurance subs to make equity investments when they already seem to be overweight fixed income and avoid buybacks.

This strategy requires very good stock picking to achieve outsized returns as there is less leverage over time. Fairfax’s strategy doesn’t but it might achieve them nonetheless.