T-bone1

Thats perfectly fair Tiddman, and the recent results suggest you are correct, I just wanted to make sure we are on the same page. I think its worth more than book, but only because I think the insurance side (leverage, bonds, mega cats) is worth a LOT . . . I completely agree with you though. I would not pay more than book value to have Hamblin Watsa manage money for me in a hedge fund or mutual fund vehicle, regardless of whether or not they employed leverage

The Fairholme fund fell about 30% in 2008. If they had been levered 3 to 1 or 4 to 1 shareholders would have been completely wiped out... the leverage works both ways. You can't just say that a great manager is more great if you apply leverage. That only works during the good times. Gee I don't remember saying anything of the sort :). Fairfax's insurance operations, exclusive of investments, are approximately average in terms of long term results and will probably remain so. Average insurance operations with average investment results are worth book value or slightly less (look at WTM at 78% of book for example). What differentiates Fairfax is the investment returns. The results from Watsa & team are fantastic. But I am not willing to pay a 50% premium to book for that, because if I did, their fantastic results would lead to average results for me. I would rather pay book value, and get the fantastic results for myself. If you aren't willing to pay more than book value, wouldn't you rather that they just ran a hedge fund or mutual fund?

I think Speicher's calculation is too complicated to be useful. I would suggest it is more useful to either separate the "book value" or "hedge fund" portion of FFH (worth about $8 Billion) and the "insurance side" with about $16 billion of assets and liabilities. I think the "hedge fund" side is worth the same as any other good fund, NAV, or in this case Book Value. I think this is roughly equal to Seth Klarman's fund . . . great long term performance, usually holds a lot of cash, and makes conservative long-term investments along with opportunistic short-term ones with a large margin of safety. I think the insurance side should be viewed as a kicker of sorts . . . what percent of book value (the "hedge fund") will this entire operation add each year (dividends and capital appreciation of assets minus cost of float, on an after-tax basis). Right now it is probably around 2% (I assume a 5% return, 2% cost of float, and 33% taxes) of $16 Billion or 4% per year on the book value of $8 Billion. . . Maybe this is only worth paying an extra .25 of book to have (but I think this implies that hamblin watsa will return a steady 16% on the rest, since a 4% return is worth only 0.25 of book and everyone seems willing to pay book value for the "hedge fund" side of the business. We know that expense ratios are at least 5% too high because they aren't writing much insurance. I think it's safe to assume that at some point they will write twice as much insurance as they are writing now - Prem has said they have the capacity to do so. Without any improvement in the loss ratio or asset return (bonds mostly) This will take the after-tax return on the insurance side to about 5% - but 5% of $32 billion is 20% of the "hedge fund" . . . what is this worth? Is it that unrealistic to think that a harder market would lead to a lower loss ratio AND higher bond yields? What is the posibility of owning this asset worth today?

Yes I would. If Bruce was levered 4 to 1 or 3 to 1. Maybe not Bruce, but if Pimco's Bill Gross had 4 to 1 leverage on a bond portfolio I would pay 2x book for it. Maybe if Pimco somehow had long-term low-cost leverage so he wouldn't be at the mercy of market movements . . . and at a minimum I think thats the value of the insurance business, it provides long-term low cost leverage. I think the insurance side (a.k.a the business) will turn out to be an incredibly profitable enterprise regardless of hamblin watsa, but until that happens, at a minimum I think everyone has to admit that the insurance side provides leverage for a bond portfolio at less cost than the yield on that bond portfolio . . . adding a couple percentage points a year to the "pure" investment side of surplus, and warranting a premium to book value. If someone devised a derivative that paid me the annual return on Berkowitz' portfolio plus 6% every year, I would be willing to pay 1.5 times book value for that.

Tiddman, Fairfax is a great insurance company which is temporarily experiencing mediocre results due to a soft market and artificially high expense ratios (due to being sized to write much more business, when doing so becomes profitable). You are essentially saying that you would like FFH to get out of the insurance business, fire everyone, sell-off the runoff insurance liabilities and associated assets, and run a hedge fund for below-market compensation levels. Do you really think the insurance business is worth zero? Would it make no difference to you if they handed the entire insurance business over to bruce berkowitz and just managed the surplus capital that remained?

From the latest issue of Value Investor Insight: What environment are you positioned for today? PW: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out. The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time. So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left. Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession. With that cheery prognosis, what’s an investor to do? PW: What we’ve done is position ourselves not to give back the significant gains we’ve had. We like the stocks we own, such as J&J, Wells Fargo [WFC] and U.S. Bancorp [uSB]. But while we’re holding on to those, we’ve increased our equity hedge ratio as of June 30 to 90%. Those hedges are almost exclusively in the form of shorts on the S&P 500 and Russell 2000 indexes. We’ve trimmed our corporate bond portfolio significantly and have added some to our municipal bonds, which provide a nice stream of income for us. We tend to focus on bonds that support essential government services, say funding the Los Angeles airport, where we’d expect the U.S. government to step in if there was a problem. Our cash position in the insurance-subsidiary portfolio is now about 15%, and is building up again. What we’re basically doing is battening down the hatches and just being very careful here. If the stock market takes off and interest spreads come down even further, our performance might lag for a year or two. But in the spirit of building our company over the long term, we’re willing to take that risk. Are you at all concerned about inflation and rising interest rates? PW: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time. What advice would you give policymakers confronting the environment you fear? PW: There are no easy answers, but I generally believe that the more we allow the economy to naturally adjust, the faster we come out of it. In the U.S., housing starts have gone from 2.2 million per year to 500,000, which is the type of thing that has to happen for the excess inventory of homes to ever be digested. When you’re working off way too much debt in the system, there are no short term fixes for that. I’m not a long-term pessimist. The U.S. and all of us are going to survive and the economy will come back. But I do think we’re on dangerous ground here.

I think it's a total return swap, not put options, so they don't pay for volatility

txlaw, I think the fact that Whitman, Berkowitz and Buffett are on different sides of this argument suggests to me that these stocks go in the too hard pile - at least for me. I think they are really a political question. Whitman recapitalized MBIA and the government allowed the bond insurer to steal the money from the parent for political reasons. This is what the fraudelent conveyance lawsuit is about. AIG went bankrupt and the government kept them alive, which is the only reason they have a market cap right now. I readily admit, I am a US taxpayer, and maybe I am too upset about these situations to see the investment merits clearly. But if the rule of law still applies, I don't think these are good investments. Whitman should win his lawsuit in any reasonable courtroom . . . this will kill the public subsidiary, but even if the government props it up, there is no reasonable reason for a recovery on the equity. The same is true of AIG . . . if they survive it will be because the government propped them up for long enough to do so . . . and the rewards should go back to the goverment (taxpayers), not some random shareholders in a bankrupt company. I didn't start commenting on these companies to pick a fight. If there is an opportunity here, I would like to get over my bias and understand it. I just don't see it. Any return to shareholders in these companies seems to me like a gift from the US taxpayer, and I don't understand who in government is motivated to make that gift. I am interested because I repect Berkowitz . . . these compnies are so hated (by myself among others) that if he is right, it will be one hell of an investment. I really have a tough time trying to guess what he could be right about though . . .

Book of $382. I think this was a great quarter considering the insurance and investment environment!

Teledyne

first question: do you have enough industry insight to sit on the board of White Mountains? Second: Are you intimately familiar with the business of insuring munis? Third: Have you poured over MBIA recent SEC documents for days on end and hired consultants do a forensic analysis of the accounting? NO? take it easy there Peter . . . rough day? I have nothing but respect for Bruce Berkowitz, I just don't understand these investments that he has made. I have followed most of his investments and when he has spoken about them I have found his analysis to be very insightful. However, with AIG, MBIA, MS etc. I have a hard time understanding what he sees there. Maybe I am blinded by hatred for financials or biased because these companies needed to be saved from death with taxpayer money a few months ago. This is why I said "I still don't get it . . ." rather than "Bruce Berkowitz is an idiot, who here will defend his honor?" Smart people don't generally get stupid overnight and Bruce has a lot more experience and resources than I do so I would assume that this will somehow work out for him, I just don't understand how . . . from where I'm standing it looks like MBIA and AIG are insolvent and MS seems to have lost a good deal of franchise value. I was hoping someone on the board might also like these investments or have some insight into Bruce's thinking beyond his brief public comments. Considering that AIG is owned and propped up by the government right now, I think being a member of congress would give you more insight into its ultimate value than being on the board of WTM. WTM is a great company, but that doesn't make its board members experts on the value of AIG. I would say that I'm pretty familiar with the business of insuring munis (we haven't been intimate yet though). I understand that even defaulted munis require very little upfront cashflow from the insurer, but MBIA is arguably bankrupt - maybe you should take a look at Marty Whitman's lawsuit against them for the other side of the argument. Warren Buffett is arguably an expert in insuring Munis and he decided to get out of the business. I don't understand why Berkowitz is investing in a company that could be insolvent pending a serious lawsuit, in a business Warren Buffett won't touch, but again, this is probably a failure to understand on my part - I'm just curious what Berkowitz knows or understands that I don't. Do you have anything to say on the merits of these investments? NO?

great interview! thanks

I still don't get it . . .

Lets say FFH is 35% off (should trade at 1.5 times book) and will grow at 15% per year (Prem's own public target). Do you think JNJ is cheaper than this? What about Dell or GE? If FFH can grow after-tax book value at 15% per year, how is this different from trading at a FCF yield of 15%? FFH might not be as big and safe as JNJ (or just as big as GE or Dell, which I don't think are as safe), but this is also a positive as they can grow at a higher rate for much longer. How many investments has Warren Buffett ever made that would have performed better than buying his own stock? Has KO or AXP outperformed BRK since 1970? I agree that managers/owners shouldn't take their eye off the ball (as some say Lampert did) and make buying back their own stock a primary business activity, but I think FFH is cheaper than any of FFH's large investments, and will have a better return, so I think allocating $400MM to buybacks along with $400MM to WFC makes sense. I realize that they recently had to issue shares, but what's done is done and it shouldn't change the math on what the best decision is right now. This company is trading at roughly tangible book value (after ICICI adjustments). This means you are paying nothing for an insurance company that I think will be the next AIG (in a good way - pre 2000). Most people on this board don't seem to want to own this insurance company, but I do, and I know Prem Watsa does. Every share they buy back at book value give them more of this insurance company for free. Maybe none of you believe the insurance company can have an average CR under 100 over time and grow all over the world, but I do, and Prem says they wouldn't run the business if they couldn't get good underwriting results. I think FFH is cheaper now at book value - due to its quality - than it was at $100 a share when I started buying, at roughly 85% of book if I remember correctly. I don't understand why a group that was so bullish on this company at higher valuations doesn't think it is cheap now. Prem says that when the market turns they will write twice as many premiums at better loss ratios and dramatically lower their expense ratio. Does everyone think he is senile or wildly optimistic? I think he won't buy back shares because he is saving the capital for the insurance business, but I would rather own FFH than any of FFH's large equity investments. What would BRK be worth today if Warren bought back 10% of the shares in 1970?

My understanding is that the hedge is an inverse total return swap . . . the equivelent of being short the S&P 500 to the tune of 30% of the March 31 equity portfolio. They put this hedge on at a level of 1060, so it hurt them as the market rose above this level, but will help them on the way back down. I think Viking is about right on BV, or at least as accurate as we are going to get. I would be encouraged by buybacks, but wouldn't count on it.

I haven't seen any mention of dividends or similar payments. I assume he was taking money out of the business over this time, which could dramatically change the IRR

I'm not sure, but I believe that buying in-the-money (or maybe at-the-money) puts stops the clock with regard to a stock holding going long-term. If this I correct my recollection is that you can get around this by taking some risk and buying a put a strike or two lower than the current stock price. I'll try to check on this

I think Arena shareholders vote on the 16th of this month, and the "go shop" period for Arena to solicit other offers expired yesterday Also, SD sold deap rights to part of its Oklahoma properties today (or at least signed an LOE to do so) for $140MM . . . This is an asset with no reserves associated with it and no value ascribed to it, yet they are selling part of it for $140MM, which is about $0.33 of value for the combined SD/ARD company on a fully diluted basis.

someone put out a report (I don't have it) that the Financial Regulation bill as currently written would force BRK to put up $8 Billion or so in collateral for its derivatives. Buffett has argued against this for existing contracts and you can pretty much gurantee that the big banks won't be posting margin on their positions (probably a loophole somewhere or a change coming), but still would be a pain in the neck for BRK if this actually happens

I haven't seen anything, but offshore (and particularly deepwater) natural gas is less and less important with the growth in shale-gas production in the US. At this point even hurricanes that shut down production in the gulf don't have much of an effect on natural gas prices, and Lousiana has become a net importer of gas due to the decline in Gulf production (although the Haynesville shale will change that over time). I'm not sure of the exact number, but I believe Gulf production is 10-15% of total US gas production at this point. Down from 25-30% ten years ago.

good find Dazel. If the SEC ever decided it wanted to go after SAC (doubtful), smaller players involved in a RICO lawsuit with them getting caught for other crimes is a good start!

that is pretty much exactly what the "relieve wells" will do. These aren't really wells (in the sense that they won't extract oil), they will pump heavy mud into the formation at the bottom of the existing well, and the oil will push the mud up the riser towards the seafloor until the pressure equalizes due to the weight of the mud. Then they will pump in cement and start fighting back against the US gov't

I have read that deepwater oil rig insurance rates are up 50% and shallow water up 20% already. I would bet with the increased scrutiny and regulatory focus the chances of a (non-hurricane) disaster is down a great deal. I wonder if FFH will increase its exposure here.

Myth, I agree that there is a lot of uncertainty regarding BP, but I think there is much less with RIG. Unlike the financial companies, we know what is on their balance sheets . . . The ultimate size of BP's liability is unknown, but I think its quanitifiable at $5-$20 Billion. This is a lot different that not knowing the value of the assets at a levered financial company (where a 5% overvaluation of assets means the company is insolvent). BP has lost $60 Billion in market cap . . . I don't think anyone thinks their liability will reach that level, but even if it somehow does, its already priced in (and ultimate liability will be down the road and will need to be discounted to today). I think a $60 Billion hit to the company is pricing in an ultimate liability of $100 Billion. As for RIG, I'm not sure they have any liability, as I have read that BP indemnified them from liaibility for a spill or other event, and they have made money on the insurance settlement for the rig. I think the danger to RIG is from a ban on offshore drilling, but I don't think there is much of a possibility of this happening. Even if the US congress bans deepwater drilling (dumber things have been done, think nuclear energy policy after 3 mile island), there is no way that Brazil, China and africa will do the same. One accident every 25 years is a pretty good safety record (although this accident was preventable and I don't think an accident of this magnitude should ever be risked). I'm sure new regulations will be put in place, but even if you have to put in an extra blow-out-preventer on top of the first and take more time for cementing and pressure testing, drilling will continue. The US might be willing to kill a $25 Billion per year industry (an estimate I heard for deepwater gulf drilling and associated support services) but no other country can afford to do so.

Oldye, I agree that a fair amount of the money will be spend on interest and drilling, but they currently have IRRs over 100% in their permian oil wells, so they will have substantial FCF if they want to. As far as oil going to $30 . . . right now inventories are very high worldwide and it is possible, but longer term there is no way that demand will decline at a faster annual rate than the "$30 breakeven" oil production will. The BP spill (disaster that it is) also hurts the long-term supply outlook as there will be less offshore drilling and it will be more expensive. I agree with you that ARD is a slightly better deal as you get about a 2% discount, but I prefer SD. I'm bullish on gas so if the deal falls through I'll take SD and the breakup rather than own ARD.