Viking

@treasurehunt For the past 3 years I have been writing pretty extensively on Fairfax (putting it mildly). I have compiled my writings into a 330 page document called 'Hiding in Plain Sight'. I will attach a copy of the updated PDF file to this post (and also the companion Excel file). I have not seen anything today that suggests I need to change anything in my PDF file. Anything I might want to say is in there. That is all I am going to say about what has been going on today. If you have a family member who believes in UFO's or Sasquatch do you argue about it with them? I don't. It is energy draining and it accomplishes nothing. Peter Lynch has one golden rule when it comes to investing: 'understand what you own'. Education is the key. When a stock I own goes down and I panic it usually means I don't understand what I own. The answer? More education is needed. Hence why I am posting an updated version of my PDF file. I was not panicking about my sizeable Fairfax position today. I was surprisingly calm. And I was adding. Buffett tells us 'Price is there to serve you not to inform you'. He is one smart dude. Fairfax Feb 8 2024.pdf Fairfax Jan 31 2024.xlsx

So let me get this straight… you are shorting a company that is earning a record amount of ‘good’ earnings? Thats not in dispute. And you know they will be aggressive with share buybacks. You also know the stock has had a monster run and there are likely lots of shares in ‘weak hands’ - shareholders who are easily panicked. When is the best time to release your ‘report’? A week before earnings. When Fairfax is in a blackout period - and can’t respond properly or can’t buy back stock. What do you think is likely to happen next week? Think we might see some buybacks? So what is the play? Short a week before earnings. Make a quick 12% on the downside. Before earnings come out, flip to a long position and make another 12% as the stock recovers. Make 24% return over a month or two. Add a little leverage. That is a pretty good trade. This looks an awful lot like what used to happen to Fairfax back in 2003-2005 when it still traded on the NYSE. Back then it happened a couple of times a year. I made a lot of money over the years playing the big swings in Fairfax’s stock price. Is anyone else experiencing deja vu?

+1. i am with you on this one.

Ok… what an interesting thing to wake up to (i live on the West Coast and am a night owl). So let me get this straight. He shorted Fairfax primarily because the company has not hit is 15% CAGR for growth in book value over the past decade? Just 9%. And because some people stupidly say that Prem is the Warren Buffett of Canada? Well, yes, Fairfax hasn’t hit its 15% CAGR over the past decade. That is true. And Prem is not the Warren Buffett of Canada. But who says that anymore? Only dummies of people looking using it as clickbait. Not anyone who understands Fairfax. So if he is getting his information from these people he might want to expand who is talking to. And his smoking gun is Recipe? That is the first example he brought up so i have to assume it is his best example. Seriously? Riverstone AVLN’s are complex? Yup. We then take a crazy trip into the past. He says he thinks Fairfax ‘might have’ owned some credit default swaps during the great financial crisis. That is an example of solid research? You don’t know that? Governance: 2 kids on the board? True. (If he thinks that is a big problem he might want to check out a company called Berkshire Hathaway - that one is probably much easier to short). Auditor: Former head of PWC Canada on board? True. Problem if PWC Canada is your auditor? ‘Lulling them to sleep’? That is such a precise accusation. Was he with his grandkids when he thought up that line? Oh, and the best part… the P&C insurance business is good. After listening to the interview i feel like the old lady in the Wendy’s commercial… ‘This is all fluff… where’s the beef’.

Yes. Tax free compounding is the 9th wonder of the world. Much better than the 8th (compounding that is taxxed). In Canada we have so many good options: TFSA, RRSP, LIRA, LIF RESP to pay for kids education. And now FHSA for first time home buyers. Time + tax free compounding, and pretty soon you are talking about real money. Young kids in Canada have never had it so easy to get financial independent. I suspect most will largely miss it - by not getting on it early.

CFP.TO Back under C$15. Canfor is trading at about $250/1,000 board feet of capacity. West Fraser recently made a purchase at C$900/1,000 board feet. Not really an apples to apples comparison but i think it is at least a little instructive. Time to dust off my old files on lumber companies. US just increased duties on Canadian softwood lumber. Canfor was hit especially hard; that is likely what is causing the stock to sell off more than peers. Higher duties just might cause the permanent closer of capacity in central BC to accelerate - which would be supportive of higher prices down the road. Something to monitor. It is pretty much a given that central banks will be cutting rates, likely around mid year. What sector should benefit the most? Housing. Demand: Canada has a serious housing shortfall. My guess is the US also will need to increase the amount they are currently building in the coming years. Supply: lumber production will continue to decline in BC. Yes, it will continue to increase in the US South. Higher imports of lumber from Europe could be a risk; something to monitor. But an increase in new housing starts might start to tighten the market. It will depend on how much new home starts increase as rates start to come down. Why Canfor? It looks to me to be the cheapest of the big boys. West Fraser is the best managed (IMHO). This is a trade for me; not a long term hold. The problem? No near term catalyst. Might be dead money for a while. And the stock could continue to fall. I view it as a 6-12 month hold/trade. I am in no hurry. The payoff? Lumber is one of the most volatile commodities. Up and down. If a catalyst shows up the whole sector will rocket higher. Interfor releases earnings after close of business Feb 8. Probably will not be great.

Great news. Below is an update of the math. Eurobank headlines the dramatic improvement we have seen in the quality of Fairfax’s total equity portfolio over the past 5 years. This bodes well for future earnings at Fairfax from their equity holdings: - higher dividends - higher share of profit of associates - higher investment gains For associate/equity accounted holdings like Eurobank, this means excess of fair value to carrying value will continue to widen (pretty dramatically in Eurobank’s case). Which just means book value at Fairfax will become more understated. I think Eurobank is hoping to announce the re-instatement of their dividend when they report Q4. If they do, i think Fairfax’s share could be meaningful. Perhaps as much as $80 to $100 million per year.

Multiple expansion - a deep dive This post is broken into the following parts: Part 1 - Introduction: Drivers of a share price Part 2 - Multiple Part 3 - Turnarounds Part 4 - The turnaround is complete - the caterpillar has transformed into a butterfly Part 5 - Narrative change and multiple expansion Part 6 - Multiple expansion - What does the math look like? Appendix - Is growth in book value a good measure of quality? ————— Part 1 - Introduction Three things drive a share price: Earnings Multiple Share count In buying a stock, an investor is buying a stream of future earnings. The multiple is simply the price an investor is willing to pay for the stream of future earnings. These are called ‘fundamentals’. Understanding the change in each of these items gives an investor great insight into the future path of a stock. It’s like being able to predict the future. Of course, the perfect sep-up for an investor is to find a company that is: Growing earnings Experiencing multiple expansion Reducing its share count Finding a company where one of these things is happening is usually pretty good. Finding a company where two are happening at the same time - that usually leads to market-beating returns. Finding a company where all three things are happening at the same time - well, that is how the big money is made - or multi-baggers in Peter Lynch parlance. Theory is great. But is it actually possible for an investor to find a stock that is poised to do all three at the same time? Aren’t markets supposed to be pretty efficient? Well grasshopper, let’s pivot to the real world and look at an unloved, scrappy P/C insurance company called Fairfax Financial. Yes, it is still unloved... we will show you why in this post. A real life example: Fairfax Financial Buybacks Let’s start with share buybacks because they are the easiest. Over the last 4.75 years Fairfax has spent $1.94 billion and reduced effective shares outstanding by 4.12 million or a total of 15.1% (3.2% per year). This is a material reduction in share count. The average cost was $470/share. With shares closing Friday at $1,030, the shares were purchases at an average cost well below their intrinsic value. This is an example of great capital allocation on the part of management at Fairfax. Share count has been materially coming down for the last 4.75 years at Fairfax. We can check off box three from our list above. Earnings Let’s move now to earnings. Earnings at Fairfax have spiked over the past 3 years. And because of the significant reduction in shares, per share earnings are up even more. When analyzing P/C insurance companies, analysts prefer to look at operating income. It removes the volatility tied to ‘icky’ investment gains. Ok, let’s play be their rules and only look at the ‘good stuff’ - operating income. Operating income at Fairfax averaged $1 billion ($39/share) per year for the 5-year period from 2016-2020. Over the next 3 years (2021-2023) it was like a goat going straight up a mountain. For 2023 my estimate is operating earnings will come in around $4.4 billion ($190/share). This is a 387% increase per share. My forecast is for operating income to come in around $4.6 billion ($202/share) in 2024. This higher level is durable and growing. Bottom line, we are seeing a significant increase in earnings at Fairfax. We can check off box 1 from our list above. Multiple What about multiple? Share count and earnings are relatively easy to understand - they are largely based on numbers. Multiple can be a more difficult nut to crack. Yes, it is based on numbers. But it is also steeped in psychology. To better understand multiple we are going to do a deep dive. First we will zoom out and look at the big picture. And then we will zoom in and apply what we have learned to Fairfax. Let’s get started. Part 2 - Multiple What is the multiple for a stock? A multiple is a quick and easy way to value a company. It is best used to compare valuations of companies in the same industry. A low multiple (when compared to peers) suggests a stock may be undervalued - a high multiple suggests the opposite. What determines the multiple a stock trades at? Two things primarily drive the multiple: Past results and events. The facts. We all know the axiom: “The best predictor of future behaviour is past behaviour.” Well, it appears the same holds true for financial results. Narrative. This is ‘the story,’ or how the facts have been interpreted. A large part of narrative is driven by psychology. Most companies are pretty predictable animals. They tend to have the same management team. Future earnings tend to follow in an arc consistent with their historical trend. A narrative - that is reasonably accurate - settles in over time for most companies. And it tends to remain largely the same, sometimes for decades. As a result, most companies tend to trade at a pretty stable multiple over the years (within a stable band). Let’s steer this discussion back to Fairfax. To do this we need to bring turnarounds into the picture. Part 3 - Turnarounds As part of his investment framework, Peter Lynch classified all stocks into six broad categories - one of which was turnarounds. With turnarounds, past results/events usually have been pretty bad. This usually results in a narrative that is quite negative. Lower earnings and a poor narrative tends to compress the multiple - often to extremes. This set-up usually causes the share price to crater. Why did Lynch like turnaround plays so much? Lynch loved turnarounds because of their potential to become big winners - sometimes 5 and even 10 baggers. Another benefit is the returns are usually not correlated with the overall market. Why are successful turnarounds so lucrative for investors? When investing, your starting point matters. Buy low. The stocks of lots of turnaround plays have been left for dead by investors - often you can buy them at crazy low prices. For successful turnarounds, two things happen. But usually along two very different time-frames: Short term (1 to 2 years): earnings turn. Medium term (3 plus years): multiple expansion. Of course, higher earnings tends to lead to a higher stock price. Facts are facts. But multiple expansion? This usually takes years to happen. Why? The multiple is largely driven by the looking through the rear view mirror - a narrative that has been constructed from past events. For successful turnarounds it often takes years for the narrative to get updated. Why does it take so long? There are a couple of reasons. Most turnarounds are under-followed. For the most part these are companies that have disappointed investors for years. Analysts? Investment professionals? Losing your clients money year after year by recommending a shitty stock is never a good career move. As a result, most turnarounds become hated companies. Lack of coverage results in an information disadvantage. Of course, some turnarounds actually turn around. And guess what? Pretty much no one notices - because no one is following the company anymore. And if no one is following the company it is impossible for the old narrative to change - even after the fundamentals have turned. There is a second reason it takes a long time for narratives to change and it is very powerful. Holding on to an old (wrong) narrative requires no work. After all, people are busy. Updating a narrative? Now that is hard. It requires a lot of work. And in the beginning almost everyone around you is going to think you are an idiot. But over time (sometimes years in length), as it becomes obvious to more and more people that the turnaround has actually happened, the ‘story’ around a stock gets to an inflection point. And those clinging to the old narrative are the ones who start to sound like idiots. And do you want that ‘crazy uncle’ managing your money? (Darwin at work on Bay and Wall Street.) Eventually, the narrative does get updated. And as that happens, we see multiple expansion. So what does all this have to do with Fairfax? Fairfax is a turnaround play. That has turned around. It actually started to turn around all the way back in late 2016 when it removed all the equity hedges (Trump getting elected was a great event for Fairfax shareholders). It picked up steam in 2018 and 2019 when the company got to work fixing its poor quality equity portfolio. We probably could say the turnaround was largely done at the end of 2020 when Fairfax covered its last short position. For sure, the turnaround was done by the end of 2021 - that is when all the positive changes from the previous years started to show up in much higher (record) operating income. Bottom line, the turnaround at Fairfax was completed years ago. Yes, I know… shocker! Fairfax has transformed itself over the past 6 years into a high quality insurance company. And that matters a lot when it comes to multiple. This is what we are going to explore next. Part 4 - The turnaround is complete - the caterpillar has transformed into a butterfly How do we know Fairfax has transformed itself into a high quality insurance company? To help us answer this questions we are going to look at something called return on equity (ROE). Return on equity (ROE) Return on equity is a measure of how profitable a company is. The bigger the number - the higher the quality. We are also going to look at operating income ROE (which I will call OI-ROE). This is viewed by the P/C industry as being a higher quality measure of ROE. Operating Income ROE at Fairfax For the 5-year period from 2016-2020, the OI-ROE averaged 9%. For the 3-year period from 2021-2023, the OI-ROE averaged 19%. My estimate for 2024 is 20%. OI-ROE has doubled from 9% to 19%. That is a massive increase. OI-ROE of 20% is top-tier performance among P/C insurers. Fairfax is tracking in 2024 to deliver its 4th year in this range. That is exceptional performance and a material increase from what it delivered in the past. I can hear the naysayers yell out as they are reading this post… “Ya, but it’s not sustainable!” To which I would answer: 3 years in a row at an average OI-ROE of 19.5% is in the books (well, should be when Fairfax reports Q4 results). A 4th year at 20% looks likely. Is 4 years in a row not the beginning of a trend? Maybe not 20%. But even something in the high teens range over the next 5 years would put Fairfax among the top tier of P/C insurers. I could also bring up investment gains. This is something we have completely ignored but is a clear strength of Fairfax (when compared to peers). Pet insurance? Sold in 2022 for a $1 billion after-tax profit. The FFH-TRS position (providing exposure to 1.96 million Fairfax shares) is up $1.3 billion (pre-tax) over the past 37 months. I could go on. Volatile? Yes. But smoothed out over a few years, the average number is a significant contributor to Fairfax’s regular ROE calculation. Just something to keep in mind. But to help us answer the question of whether or not the high OI-ROE is sustainable, let’s peel the onion back one more layer. What is the best predictor of long term results for a company? The best predictor of long term results for a company is the management team and their capital allocation skills. This is especially true for P/C insurance companies because of something called float (which can be larger in size than shareholder’s equity). The quality of the capital allocation decisions being made by management is likely the best leading indicator for future ROE for a P/C insurer. Of course, it takes years for good capital allocation decisions to show up in higher earnings and higher ROE. Especially for a turnaround like Fairfax. But that is exactly what we have been seeing in each of the past three years. But the story gets better. I wrote a very long post last week where I went into great detail on Fairfax’s capital allocation record over the past 6 years or so. The conclusion? Fairfax looks best-in-class in the P/C industry. If you have one of the best capital allocation teams in the industry, and they have been hitting the ball like Ted Williams over the past 6 years, what do you think ROE will look like in the coming years? Above average for sure. And probably even better than that. As a result, I think the facts and evidence points to Fairfax being a high quality insurance company. How is Mr. Market valuing Fairfax? Finally, we get to our answer! ROE and P/BV Return on equity (ROE) and price to book value (P/BV) are the preferred metrics used by investors to value P/C insurance companies. Looked at together, they tell investors a story about the company. Over time, a high and sustainable ROE inevitably results in a high P/BV multiple. The opposite is also true: a low ROE generates a low P/BV multiple. Return on equity Earlier we learned that OI-ROE at Fairfax is tracking to overage 20% from 2021-2024. That is top tier performance. Let’s now compare that to P/BV. Price to book value (P/BV) This measure tells us what Mr. Market thinks about the future prospects of the company. Or put another way, is ROE sustainable? Fairfax’s P/BV is about 1.11 (if we use estimated 2023 YE book value). Compared to peers, Fairfax’s P/BV is at the very bottom. A P/BV near 1 suggests the P/C insurer is both poorly run and has poor prospects. Fairfax has a very high ROE (with solid prospects). The company is high quality. Yet, its P/BV multiple is very low. This suggests Fairfax is very undervalued. What about PE? I know PE is not supposed to be used to value a P/C insurance company. But it is a useful measure for most companies so let’s see what it has to say. If we use Yahoo Finance’s current earnings estimate for Fairfax for FY 2023, we can see Fairfax is currently trading at a PE of 6x. That is crazy low. Both when compared to peers and the market in general. Summary Fairfax is a high quality company delivering top-tier ROE. Trading at what looks to be crazy cheap valuation as measured by both P/BV and PE. Is there anything that can explain this disconnect? Yes. The narrative surrounding the company is in need of an update. The part driven by psychology. Thanks for hanging in there. We’ve come full circle. Let’s finish connecting the dots. Part 5 - Narrative change and multiple expansion “Although expectations of the future are supposed to be the driving force in the capital markets, those expectations are almost totally dominated by memories of the past. Ideas, once accepted, die hard.” Peter Bernstein Fairfax and narrative Fairfax had one analyst attend their Q3 conference call. Tom MacKinnon/BMO, you get a gold star from the teacher. The lack of interest in Fairfax in the analyst community suggests to me that the old narrative is still firmly in place. After all, it is Fairfax. That shitty little Canadian insurance company. Right? Even Rodney Dangerfield would be surprised at the lack of respect Fairfax still gets today - even though it is a top 20 global P/C insurer and now one of the top 30 Canadian companies in terms of market cap. Yes, but the stock is a dog! Woof! Right? Fairfax has probably been one of the best performing large cap stocks in Canada over the past three years (the best?). But, hey, don’t let the facts get in the way of a good narrative. To be fair, the quality of the research on Fairfax has been getting better, especially over the last year. I recently read Jaeme Gloin/National Bank’s Q4-2023 earnings preview for Fairfax and i had to wipe the tears from my eyes when i was done - it was that good. And not because he upped his price target to $C2,000. It was because of the facts and logic he provided readers - the detailed build - which he used to arrive at his conclusions (final earnings estimate, multiple and price target). It was clear Jaeme has actually put in the work to understand the Fairfax as it exits today (that doesn’t mean he is ignoring the past). But there is also, IMHO, still one piece of simply terrible stuff out there. ‘Crazy uncle’ bad. This one is so steeped in the past it reads like it was actually written 10 years ago. (Maybe it was…. I better check the date.) Anyone who follows Fairfax closely knows the report that I am referencing. Now when you can go unnamed - and yet people know who you are? Well, that’s pretty impressive. But is it really? The good news is the old narrative around Fairfax will eventually be laid to rest. And that’s because you can only ignore the facts and the fundamentals for so long. Multiple expansion My view is 2024 could well be the year when we get to an inflection point in the narrative for Fairfax. In fact it looks like it might have started as we begin 2024. In January the P/BV multiple has expanded from 1.0 to 1.1. As the narrative gets updated, Fairfax will shift from being valued as a poorly run company delivering poor results to being valued as a well run company delivering very good results. In turn, this should result in multiple expansion. Yes, Fairfax will need to do its part - and continue to deliver solid results. So with Fairfax today, it looks like we have a situation where: 1.) earnings are growing 2.) multiple is expanding 3.) share count is falling And all three happening at the same time? That is when the big money is made. Part 6 - Multiple expansion - What does the math look like? The example below is not intended to be a forecast. Rather it is intended to demonstrate to investors the power of multiple expansion (when it happens). Readers can overlay their own assumptions as they see fit. To keep our analysis simple we are going to use Dec 31, 2023 as our starting point. Let’s be conservative and assume Fairfax only earns $150 in 2023 (instead of the forecast of $170). Let’s also assume Fairfax continues to pay a $15 dividend. Let’s be conservative and assume Fairfax grows earnings at 6% per year. Now for the fun part. Let’s assume the P/BV multiple expands from 1x at Dec 31, 2023 (where it was) to 1.3x at Dec 31, 2026. A multiple of 1.3x would get Fairfax to the lower band when compared to peers - I think it is a conservative number. Given the inputs above, what is the return for investors over 3 years? The total increase is 100%. A double over 3 years. Of the total increase, about 50% is driven by earnings. And 50% is driven by multiple expansion. Yes, multiple expansion is rocket fuel to a stock. ————— Appendix - Is growth in book value a good measure of quality? I wasn’t able to find a good place to insert this into my post above. But I think it is important so I am including it here. The growth in book value over time is another way to assess the quality of a P/C insurance company. In some ways, it might be the best way. Because it includes all the ‘messy’ stuff that might not be included in ROE (like unrealized losses in bonds). How does Fairfax stack up when compared to peers like Markel, WR Berkley and Chubb? Over the past 5 years Fairfax’s has grown book value at a CAGR of 16.6%. None of the other 3 companies come close to that performance. It should be noted, Fairfax, WR Berkley and Chubb all pay a modest dividend. Markel does not. Yes, change in book value is just another important measure that points to Fairfax being a very high quality P/C insurance company.

Fairfax's total return swap position (giving it exposure to 1.96mn $FFH.TO shares) is up $250 million so far in 2024. And up $1.3 billion (before carrying costs) in a little over 3 years. Outstanding capital allocation. Opportunistic. Creative. Concentrated position. A needle mover for Fairfax and its shareholders. “We think this will be a great investment for Fairfax, perhaps our best yet!” This is what Prem said in his letter in the 2020 annual report when first describing this investment. Clearly, Fairfax was thinking big when they made this investment. My guess is the return from this investment so far has exceeded their lofty expectations. When you combine this decision with the buyback of 2 million Fairfax shares in late 2021 at US$500/share... Wow!

What we are learning is Fairfax WAS building considerable value from 2010-2020. It was masked by all the one-time losses (primarily the equity hedges/short positions and later by poorly performing equity holdings). The one-time losses ended. Headwinds became tailwinds. Since 2018, Fairfax has been on a capital allocation hot streak. Weave it all together - Fairfax became a coiled spring that got released in October of 2022. The crazy thing is we are still learning what ‘normalized earnings’ looks like. Because fundamentals just keep getting better. And there are lots of catalysts lurking (Digit IPO, Anchorage IPO, equity revaluations - where CV is well under FV, what they are going to do with $4 billion/year in earnings etc).

Capital Allocation - Is the Management Team at Fairfax Best-In-Class? Of all the posts that I have done on Fairfax over the past year, this one on capital allocation is the most important. Below is an update with some new material. My view is over the past 6 years, the management team at Fairfax has delivered best-in-class results. Do you agree? Please share your thoughts. ————— Capital allocation is the most important responsibility of a management team. Why? Capital allocation decisions are what drive the long-term performance of a company and important metrics like reported earnings, growth in book value and return on equity. These metrics in turn drive the multiple given to the stock by Mr Market - and finally the share price and investment returns for shareholders. Capital allocation is especially important for P/C insurance companies. And that is because of something called float – which provides low cost (sometimes free) leverage (see Chapter 4 of my PDF called ‘Fairfax-Hiding in Plain Sight’ for more information on float). https://thecobf.com/forum/topic/20253-fairfax-financial-60-of-the-best-posts-all-in-one-document/#comment-526661 When done well, capital allocation does two important things: Delivers a solid return. Improves the quality of the business. Therefore, the fundamental task of an investor is to determine if management, over time, is making intelligent decisions regarding capital allocation. What is capital allocation? Capital allocation is the process of determining how capital is raised, managed and disbursed by a company. Capital allocation decisions often play out with a lag, sometimes years in length. Recognizing this, an investor needs to take a multi-year approach with their analysis. What are the sources of capital for Fairfax? Fairfax has three sources of capital: equity, debt and float. The largest bucket is its $31 billion in float (as of Dec 31, 2022) which has a cost of less than zero - because they earn an underwriting profit (over the past 10 years they have averaged a CR of 95.6%). Fairfax also utilizes some debt, which has an average cost of about 5%. All together Fairfax has total capital of about $58.1 billion working for shareholders, or about $2,500/share. This capital has been obtained at a very low average cost. How does Fairfax do capital allocation? Internal capabilities: Capital allocation at Fairfax is managed by the senior leadership team, led by CEO Prem Watsa. Insurance: Since 2011, the insurance business has been led by Andy Barnard. In early 2023, Brian Young was promoted and now shares oversight responsibilities with Andy Barnard over all of Fairfax’s insurance and reinsurance operations. Brian is also still CEO of Odyssey. Investments: The investment business is managed by the large team at Hamblin Watsa. The fixed income team is led by Brian Bradstreet, who has been with Fairfax from the beginning. The equities team is led by Wade Burton, who joined Fairfax in 2009 from fund manager Cundill Investments, and Lawrence Chin, who also joined from Cundill in 2016. In India, Fairfax has Fairbridge, a boots-on-the-ground investment team. Fairfax also leverages the knowledge of the many CEO’s who manage their vast collection of equity holdings across the globe. “Since 1985, investments have been centrally managed for all of the Fairfax group companies by Hamblin Watsa Investment Counsel Ltd. (www.hwic.ca), a wholly-owned subsidiary of Fairfax. Hamblin Watsa emphasizes a conservative value investment philosophy, seeking to invest assets on a total return basis, which includes realized and unrealized gains over the long-term.” Fairfax web site Fairfax has a large internal team with expertise across many different asset classes and geographies. They are a long-tenured group with experience managing through many different market cycles. They are also a battle tested team. They have established a strong long-term track record of success. Below is a slide from the AGM (April 2023) that summarizes Fairfax’s internal investment team. External capabilities: Fairfax has been actively cultivating relationships with a large network of individuals/companies in the investment world for decades. The company has established partnerships and expertise across many different asset classes (real estate, private equity, commodities) and geographies (India, Greece, Africa, the Middle East). These external partnerships have been an important source of ideas and diversification while also delivering solid returns to Fairfax over the years. This important external capability allows Fairfax to leverage the knowledge and skills of a much larger group of people and organizations. Summary: Over decades, Fairfax has built out a large team and network of highly skilled internal and external capital allocators. In a world where active management is back, this has become a significant competitive advantage. Fairfax is well positioned at exactly the right time. In general, what are the basic capital allocation options available to management? Reinvest in the business - grow organically: support the slow and steady growth of existing operations. Acquisitions/mergers - higher risk, but can be transformative. Asset sales - lower risk, opportunity to take advantage of Mr Market’s mood swings. Pay down debt: the most predictable option, as the cost of repaid debt is known. Pay dividends: although tax-inefficient, usually indicates a financially healthy, shareholder-friendly company. Share buybacks: impactful, if purchased below intrinsic value, by improving per-share financial metrics like earnings per share and book value per share. What has Fairfax done? The management team at Fairfax has been extremely active on the capital allocation front. Every year they typically make between five to ten meaningful decisions. So much has been happening on the capital allocation front in recent years it is hard for shareholders to keep up - especially understanding the impact on current and future business results. Below we are going to take a quick look at 16 of Fairfax’s bigger decisions made in recent years to see what we can learn. Reinvest in the business: 1.) 2019-2023, hard market in insurance. Net premiums written have increased 79% over the past four years from $13.3 million in 2019 to an estimated $23.7 million in 2023, a CAGR of 15.5% per year. Fairfax is poised to deliver an estimated record underwriting profit of $1.37 billion in 2023 (CR of 94%). 2.) In 2017, seeded start-up Go Digit in India at a cost of $154 million and a fair value today of $2.3 billion. This investment has turned into a home run, with a possible IPO coming in 2024 (bringing more potential gains). Acquisitions/sales: insurance: 3.) In 2017, purchased Allied World, with the help of minority partners, for $4.9 billion (at 1.3 x book value). The price paid was not an overpay. Net written premiums have increased from $2.37 billion in 2018 to $4.46 billion in 2022, an increase of 88% in 4 years. With the onset of hard market in 2019, the timing of this purchase was perfect. 4.) In 2017/2019, sold ICICI Lombard for $1.7 billion: realized a $1 billion pre-tax investment gain. Due to regulations in India, Fairfax had to sell down its position in ICICI Lombard to be able to invest in Digit. This action was a brilliant strategic shift of Fairfax’s insurance business in India. 5.) In 2020/2021, sold Riverstone UK (runoff) for $1.3 billion (plus $236 million CVI). At a time when they needed the cash, Fairfax sold their UK run-off business at a much higher price than expected at the time. By shrinking the size of the runoff group, this sale also improved the overall quality of the remaining P/C insurance businesses. 6.) In 2022, sold the pet insurance business to JAB Holding Co. for $1.4 billion. This action resulted in a $1 billion after-tax gain. This sale was a home run for Fairfax as the business was sold for a much higher price than anyone thought possible (most people didn’t even know Fairfax owned this business). 7.) In 2023, purchased KIPCO’s 46% stake in Gulf Insurance Group for $740 million fair value consideration, as it is payable over 4 years. Fairfax paid a premium to get a control position in a quality business. This is a great strategic purchase that will solidify Fairfax’s presence in MENA region for insurance. This deal closed in late December 2023. Acquisitions/sales: investments: 8.) In 2018, made initial investment in Poseidon/Atlas/Seaspan. Fairfax partnered with David Sokol (formerly Buffett’s heir apparent at Berkshire). Today Fairfax owns a 45.5% stake in this company valued at $2 billion. Poseidon will see significant growth in 2024 as it takes delivery of a large number of container ships and completes the final leg of its multi-year new-build strategy. 9.) In late 2018, purchased 13% of Stelco for $193 million. Fairfax partnered with Alan Kestenbaum. This investment has already delivered more than $300 million in in total gains (as of Dec 31, 2023). Today, Fairfax now owns 23.6% of Stelco (having invested no new money). 10.) In 2020/21, initiated a total return swap position giving them exposure to 1.96 million FFH shares at an average cost of $372/share. With Fairfax’s stock closing at $1,013/share (Jan 26, 2024), this investment has already delivered a cumulative gain of about $1.26 billion (before carrying costs). This action was very creative and opportunistic and has become in three short years one of Fairfax’s best investments ever. 11.) In Dec 2021, reduced the average duration of its $37 billion bond portfolio to 1.2 years (as interest rates bottomed). This action saved the company billions in bond losses, protected the company’s balance sheet and allowed the insurance subs to be aggressive in growing their business in the hard market. 12.) In Oct 2023, increased the average duration of its $41 billion bond portfolio to 3.1 years (as interest rates were peaking). This locks in record interest income, currently running at about $2 billion annually, for the next 3 or 4 years. The string of decisions executed by the fixed income team over the past 24 months was brilliant and has delivered billions in value to Fairfax’s shareholders with much more to come. 13.) In 2020 and 2023, expanded partnership with Kennedy Wilson. Phase 1, in 2020, was the establishment of a $3 billion real estate debt platform. Phase 2, in 2023, was the purchase of $2 billion of PacWest loans yielding a fixed rate to maturity of 10%. Fairfax, through long term partner Kennedy Wilson, took advantage of a temporary market dislocation. 14.) In 2022, sold Resolute Forest Products for $626 million (plus $183 million CVR) at the top of the lumber cycle. Fairfax opportunistically sold at a premium price what had been one their large chronically underperforming equity holdings. This sale also improved the overall quality of the remaining basket of equity holdings. 15.) In 2023, sold Ambridge Partners for $379 million, delivering a $259 million pre-tax investment gain. Dividend: In January 2024, Fairfax increased their annual dividend 50% to $15/share. It had been $10/share going all the way back to 2011. Share buybacks: Effective shares outstanding have decreased an estimated 17.1% over the past six years from 27.8 million in 2017 to an estimated 23.0 million in 2023, an average decline of 2.9% per year. 16.) in 2021, re-purchased 2 million shares at $500/share. This was 7.6% of shares outstanding at the time. Fairfax’s share price recently closed at $1,013. Fairfax’s significant share purchase was done at an incredibly attractive price - which makes it very beneficial for the company and shareholders. This was another financial home run. The list above captures only the largest capital allocation decisions made by Fairfax in recent years. We could easily add another 15 smaller examples of transactions that are also proving to be of a material benefit to Fairfax. --------- For a comprehensive list of many of Fairfax’s capital allocation decisions going back to 2010 (sorted by year) go to the Appendix in my PDF called ‘Fairfax-Hiding in Plain Sight’. https://thecobf.com/forum/topic/20253-fairfax-financial-60-of-the-best-posts-all-in-one-document/#comment-526661 ---------- The importance of properly sizing your bet A lesson from Stan Druckenmiller: position sizes really matter https://moneyweek.com/investments/investment-strategy/605020/stan-druckenmiller-position-size-really-matters “Sizing is 70% to 80% of the equation. Part of the equation is seeing the investment, part of the investment is seeing myself in a good trading rhythm. It’s not whether you’re right or wrong, it’s how much you make when you’re right and how much you lose when you’re wrong,” says Druckenmiller. Position size matters. A lot. If you don’t believe Druckenmiller, just ask Buffett. Now take a close look at the 16 examples I cited above. What jumps out? The size of gain from each of the decisions. My math says 9 delivered a $1 billion or more gain to Fairfax and its shareholders over time. In recent years, Fairfax has been not only making very good decisions - it has been sizing them exceptionally well. The benefits to the company and shareholders have been massive - with much more to come. Fairfax’s market cap is only $25 billion. A $1 billion gain is a needle mover for the company. A bunch of them stacked one on top of the other? That is called ‘escape velocity’ for operating earnings. More on this point later in the post. Asset sales Asset sales is one part of capital allocation that separates Fairfax from its peers like Berkshire Hathaway and Markel. In selling an asset, Fairfax is essentially trading a stream of future cash flows for a lump sum today. Why should a company sell an asset? Sometimes another company - who is willing to pay up - values an asset at a much higher value than you do. The sale of the pet insurance business is a great example of this. There also can be important strategic reasons to sell an asset. For instance, if a sale allows the company to better focus on other parts of its business, selling an asset can lead to improved financial results. Selling APR to Atlas is perhaps a good example of this. Selling lower quality assets is also a good way to improve the overall quality of the remaining holdings. Selling Riverstone UK (runoff) and Resolute Forest Products are two good examples of this. Put simply, asset sales have been a very important part of Fairfax’s capital allocation framework, realizing significant value for Fairfax and its shareholders over the years. Improving the quality of the two businesses - insurance and investments Over the past 6 years Fairfax has done a great job of improving the overall quality of both its insurance and equity holdings. Equities was where the heavy lifting needed to be done - and after years of effort Fairfax has made considerable progress with many underperforming holdings (sales, mergers, take-private). Other holdings, like Eurobank, always well managed, have been greatly assisted by external events (economic pivot in Greece). Higher quality businesses are able to deliver higher and more stable earnings. And that is what we are starting to see. Analysts have been slow to recognize this change, which is one reason why their estimates were usually too low in 2023. Is Fairfax’s capital allocation record perfect? No, of course not (no company is perfect on this front). I see two notable misses: Taking until late 2020 to exit the last short position (and not exiting earlier). Not finding a way to unload Blackberry during the WallStreetBets mania that caused the share price to spike for a very short period of time in 2021. Fairfax says they were unable to act due to being in a blackout period at the time. Looking at everything they have done over the past five or so years, it is clear that Fairfax has been executing exceptionally well. "In this business if you're good, you're right six times out of ten. You're never going to be right nine times out of ten." Peter Lynch Looking at Fairfax’s track record over the past five years, I would argue that the company has been right with their capital allocation decisions at a rate much higher than 6 out of 10. In Druckenmiller parlance, Fairfax has been on a multi-year “hot streak”. Or in Buffett parlance, Fairfax has been hitting the ball like Ted Williams for the past couple of seasons. Has Fairfax simply been lucky? Did Prem give the team at Fairfax a sip of ‘liquid luck’ back in 2018? Some luck likely has been involved. But I like this definition of luck: “Luck is what happens when preparation meets opportunity.” Roman philosopher Seneca What have we learned? Here are the words I would use to describe Fairfax’s approach to capital allocation: Flexible - use the full suite of options available. Opportunistic - take advantage of dislocations/opportunities as they arise. Countercyclical - act contrary to prevailing investment trends. Speed - act quickly when necessary. Conviction (position sizing) - go big when risk/reward is highly compelling/asymmetrical. Creative - be open minded during the process. Long term focus – goal is to generate above-market returns. Accepting of volatility. Strategic - make the company stronger - both insurance and investments. Rational - capital goes to the best (risk adjusted) opportunities. Equally capable in executing across both insurance and investment businesses. What has been the financial impact of Fairfax’s capital allocation decisions? Operating Income: Let’s start by looking at operating income given it is viewed by analysts as the most important part of an insurance company’s total earnings. Operating income at Fairfax is the sum of three things: underwriting profit, interest and dividend income and share of profit of associates. For the 5-year period from 2016-2020, operating income at Fairfax averaged $1 billion per year or $39/share. Compared to the 5-year averaged from 2016-2020: in 2021, operating income doubled to $1.8 billion or $77/share. in 2022, operating income tripled to $ 3.1 billion or $132/share. in 2023, operating income is on track to quadruple to $4.4 billion or $190/share. in 2024, operating income is estimated to quintuple to $4.6 billion or $202/share. The run rate for operating income per share in 2023 ($190/share) is 4.9 times larger than the average from 2016-2020 ($39). What is the reason for the spike higher? The dramatic increase is due in large part to the exceptional capital allocation decisions made by the management team at Fairfax over the past 6 years. Importantly, the gains in operating income are durable as they have been driven by improving fundamentals (not one time items). Investment Gains: The other important part of earnings is investment gains. This lumpy part of earnings has historically been a strength for Fairfax - the pet insurance and Resolute sales in 2022, and the Ambridge Partners sale in 2023, being three recent examples. We should expect Fairfax to continue to deliver solid (but lumpy) investment gains moving forward. My current estimate has Fairfax on track to deliver record earnings of around $170/share in 2023. Return On Equity: For the 5-year period from 2016-2020, ROE averaged about 6.0% per year. For the period 2021-2024, ROE is tracking to average 16.6%. That is a marked improvement. Important: I have use 'average equity' to calculate ROE. Some P/C insurers (like WRB) use 'beginning year equity' in their calculation. If I used 'beginning year equity' my ROE for Fairfax would be higher. Driven by strong capital allocation decisions, all important financial metrics at Fairfax have been materially improving in recent years. This strong performance looks set to continue in 2024. How is the strategic positioning of Fairfax’s businesses? Insurance: Significant expansion by acquisition 2015-2017 - build out of global platform is complete. Significant expansion by organic growth 2019-2023 - hard market Ongoing bolt-on acquisitions, like Singapore Re, has further strengthened the business. Ongoing buy-out of minority partners, like Eurolife in 2021 and Allied World in 2022, and majority partner KIPCO (GIG) in 2023, has further strengthened the business. The quality of the insurance businesses has rarely looked better. The business is delivering record net premiums written and record underwriting profit. Investments - fixed income: 2021: shortened duration of portfolio to 1.2 years and shifted to primarily government bonds in late 2021, to protect the balance sheet. 2023: extended duration to 3.1 years in October 2023, to lock in much higher rates. 2023: capitalizing on dislocations in financial markets to lock in even higher rates - with KW, purchased $2 billion in PacWest real estate loans yielding a total return of 10%. The positioning of fixed income portfolio has rarely looked better. The portfolio is delivering record interest and dividend income. Investments – equities: Total return swaps, giving exposure to 1.96 million Fairfax shares, looks well positioned. Eurobank - balance sheet is fixed, earnings are strong. Greece is expected to be a top performing economy in Europe in the coming years. Purchase of Hellenic Bank will be a catalyst in 2024. Poseidon / Atlas - is currently in rapid growth mode. Investments in India (Fairfax India/BIAL etc) look well positioned given India is expected to be a top performing global economy in the coming decade. The rest of the company’s portfolio looks well positioned. The quality of the portfolio of equities owned has rarely looked better. The portfolio is delivering record share of profit of associates and sold investment gains. Summary: The strategic positioning of each of Fairfax’s three economic engines (insurance, fixed income and equities) has been steadily improving for the past five years. Conclusion Fairfax has a strong management team. They have been executing exceptionally well over the past 6 years. They are now delivering record financial results. Both businesses - insurance and investments - appear very well positioned. Fairfax is delivering on the dual core objectives from capital allocation: Deliver good/great returns on capital deployed Improve the quality of each of the businesses (insurance and investments) over time As a result, I think we can fairly conclude that the management team at Fairfax have demonstrable best-in-class capital allocation skills, and not just within their peer group in P/C insurance. And with the company producing record operating earnings (and an estimate of around $4 billion in earnings) this best-in-class team is going to get the opportunity to deploy billions each year moving forward into new opportunities. Record, sustainable and growing earnings + exceptional capital allocation + compounding + time = exponential growth ---------- Fairfax is trading today at a P/BV of about 1.05 (using my estimated 2023YE BV). That is a very low valuation - it suggests Fairfax is a poorly run P/C insurer with poor prospects. If Fairfax is best-in-class at capital allocation how can it also be poorly run with poor prospects? The answer is simple - it can’t be both at the same time. If Fairfax is above average at capital allocation then future earnings growth should be solid. This will lead to an above average ROE. As Mr Market comes to understand Fairfax better - and that the company is an above average P/C insurer, then we should see multiple expansion. The trifecta for a stock: Growing earnings + growing multiple + lower share count = much higher share price. 'Time is the friend of the wonderful business.' Warren Buffett

@Maverick47 i always appreciate your comments. You have areas of expertise that are different from mine. Thank you for sharing your thoughts on the tax liability. I will file that away. I think there is merit to your comments about Fairfax going through adversity. And learning the right lesson on the other side. I agree with you - Fairfax has been making much better decisions in recent years - i put it at about 6 years (since about 2018). It looks to me like Fairfax has been slowly improving the quality of their businesses over the years. - insurance seems to have always been moving in that direction since Andy Barnard took over in 2011. I liked the sale of Riverstone UK (runoff) in 2020/21 although it appeared to be well run. More recently, Fairfax has talked about how they have reduced property cat exposure at Brit (who had been underperforming in recent years). - equities is where you can really see the improvement in quality the last 5 years. Having higher quality insurance and equity holdings should also provide some buffer should adversity strike. ————— I continue to believe that something changed internally at Fairfax around late 2017 or early 2018 with how they were managing the equity bucket at Hamblin Watsa. It’s almost like someone very senior said ‘enough of this bullshit’. And from that day equity holdings were told: 1.) they had to stand on their own two feet financially. Fairfax hold co was no longer going to be piggy bank for poorly run operations 2.) they had to run themselves. Fairfax HO did not have the resources to be a turnaround shop. Two other things were decided: 1.) New money would only go to the best opportunities. 2.) New equity purchases must have very strong CEO’s/management/leadership. The amount of (good) change that has happened at Fairfax since 2018 has been breathtaking. The quality of the equity holdings (looked at as a group) has improved dramatically. And i don't think Fairfax is done.

How does an investor make the big money? To state the obvious, outperforming the market averages is very difficult. Especially over a longer timeframe like 10 or 20 years. So why manage your own investments? Investors usually do it for the opportunity to make the big money - to materially outperform the market averages. How can an investor do that? That is what we are going to explore in this post. The post has been broken into the following sections: 1.) Learning from the master: how did Buffett do it? 2.) Time, compounding and exponential growth 3.) What do investors actually do? 4.) How to make the big money 5.) Berkshire Hathaway shareholders - a special breed? 6.) Fairfax Financial ————— Warren Buffett - Berkshire Hathaway 2022AR “In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so… “Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years. “The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. And, yes, it helps to start early and live into your 90s as well.” ————— Part 1: Learning from the master: How did Buffett do it? Warren Buffett has been able to significantly outperform the market averages since 1965. Over the past 58 years (to YE 2022), Berkshire Hathaway stock has had a CAGR of 19.8%, which is about 2 times the CAGR of the S&P 500 of 9.9% (including dividends). Yes, Buffett has earned ‘big money’ for Berkshire Hathaway shareholders. But here is what is really interesting. Buffett readily admits most of his capital allocation decisions over this 58-year time period were ‘so-so.’ He goes on to explain that his significant outperformance was driven by a small number of ’truly good decisions’. Buffett puts the number at 12, or one about every 5 years. This looks like it could be important. Let’s explore this further. What is Warren Buffett’s greatest attribute? Yes, this is kind of dumb thing to ask. Let’s do it anyway. What is it about Warren Buffett that has allowed him to consistently generate such outstanding results over the past 58 years? Intellect? Work ethic? Thirst for knowledge? Temperament? Character? Self awareness? Management skills? Obviously, all of the above attributes are important and will help investors achieve success. But lots of investors have many of these attributes - and yet they still underperform the market averages over time (let alone outperform to the degree that Buffett did). Is there something else, not listed above, that perhaps explains Buffett’s significant outperformance? I think there is something else… I think Buffett’s greatest strength might be his patience. Before you throw your phone/tablet in disgust, let me explain. We need to peel the layers back. Buffett’s holding period is not months. Or years. For his ‘truly good decisions,’ the investments that become needle movers for Berkshire Hathaway, his holding period can be measured in decades. And that is very different from almost any other investor out there. That is something Buffett does than pretty much no one else does. (Please name another successful investor who did it this way… i can’t think of another one.) After patience, i think Buffett’s next greatest strength might be how he sizes his positions, especially his best ideas. And not just at the time of purchase - but also over time. How to size a position is exceptionally difficult to do and is a topic that requires its own post - so we will not explore it further here. There are a couple of lessons here. Really, really good investment opportunities are exceptionally rare. Over his lifetime, Buffett points to 12 that worked out for him - or one about every 5 years. But finding a great investment is not enough on its own. Great patience is also required. It can take a decade or more for some investments to fully bloom. Of the two skills (finding a great investment and having great patience with it) the second is the one that is incredibly rare today. Part 2: Time, compounding and exponential growth What is the greatest advantage of an investor? It is time. Why time? Time is what allows compounding to work its magic. Compounding is simple to explain but wicked difficult for most people to actually understand. I like the description below. It is ‘boring’ for years and then very ‘exciting’. Given enough time, compounding inevitably results in exponential growth. Or at least the is what one would think. More on this later. The goal of all investors is to get their portfolio to the ‘exciting’ part of compounding curve (the hockey stick part) - because it is life changing when it happens. Buffett’s genius? It is understanding that patience and time are two sides of the same coin. Together, they allow an investor to fully maximize the benefits of compounding. This in turn, can lead to exponential growth. Patience: this is how the big money is made. Compound Interest (drawing by Carl Richards) ————— Let’s take a quick trip into the archives One of my favourite all time books on investing is Reminiscences of a Stock Operator. It was first published all the way back in 1923 (in serial form over two years in The Saturday Evening Post). Of all the memorable quotes in this book the following might be my favourite: “And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine - that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money…” The lesson: Finding a great investment is hard. Holding the investment for years, perhaps decades - that is much more difficult. Should we be surprised that Buffett is in a league of his own? ————— Part 3: What do investors actually do? “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” Peter Lynch. Warren Buffett liked this quote so much he contacted Peter Lynch and asked him if he could use it. What is the average holding period for retail investors? I think it is around 5.5 months. And falling over time. Retail investors are like Edward Scissorhands. The flowers in their garden don’t stand a chance. Actually, we probably need to update Peter Lynch’s quote: these days, retail investors are so active buying and selling stocks in their portfolio - it’s like they completely raze their garden every year or two. What’s the chance the flowers are getting cut? Probably 100%. Should we be surprised that most retail investors achieve such poor results over time? What about the professional/smart money? The performance of professional/smart money is measured by investors quarterly… so they can’t be patient with their holdings. Sub-par results over a couple of quarters and retail investors start to pull the plug. The professional/smart money has to chase short-term performance if they want to stay in business (or get paid their bonus) - which usually means owning whatever are the most popular stocks at a given time (the list of which is always changing). The bottom line, ‘patience’ is not a word that is part of retail and professional investors vocabulary or in their toolbox. Patience is primarily the stomach part of investing. Not the brain part. This also probably tells us something… Ben Carlson has a good article on the subject of holding period Buy & Hold is Dead, Long Live Buy & Hold (Feb 2023) https://awealthofcommonsense.com/2023/02/buy-hold-is-dead-long-live-buy-hold/ (As an aside, ‘The Compound’ has become one of my favourite podcasts to listen to. Ben, Josh, Michael and guests are great. They have a bunch of different formats depending on what you are interested in.) Taking profits Why do retail investors turn their portfolio over so much? Lot’s of reasons. To buy something they think is better. To get rid of a mistake. To try and time the market. Macro call. Hot tip. I could list another +20 ‘good’ reasons. Let’s be optimistic. We are told taking profits is a sensible thing to do. Yes? But remember, in this post, we are trying to learn how to make the big money. Here is another great quote from the book ‘Reminiscences of a Stock Operator’: “They say you never grow poor taking profits. No. you don’t. But neither do you grow rich taking a four point profit in a bull market.” When investors sell their best ideas they are cutting the flowers in their portfolio. And because the really good ideas (that actually work out) are exceptionally rare (Buffett found one about every 5 years), the proceeds are recycled back into inferior ideas - investors water their weeds. This is like throwing sand in the gears of the compounding machine we discussed earlier. And hurts investment results. Investors get stuck in the ‘boring’ stage (from the napkin drawing above). As a result, many investors never get to the ‘exciting’ stage - the hockey stick part of compounding that becomes life changing. What does the investment industry have to say on this topic? I find it is helpful to follow the money. Incentives matter. A lot. How does everyone in the industry get paid? Fees. And fees generally come from activity. Action. Churn. Chasing short term performance. The exact opposite of patience. Part 4: How to make the big money Buffett’s very simple model: Step 1: identify a ‘truly good’ investment and size the position appropriately. Step 2: exercise great patience and let it grow undisturbed for decades. Truly great investments (the needle movers) are exceedingly rare. When you discover one, you need to size it appropriately. And then you hang on to it. For a long, long time. Do we have any real-life examples of ‘patience’ actually working out for a retail investor? Yes. A company named Berkshire Hathaway. Part 5: Berkshire Hathaway shareholders - a special breed? Investors have known for decades that Berkshire Hathaway was run by one of the best capital allocators of all time. All an investor had to do was buy shares and watch the Buffett flower continue to bloom year after year… bigger, brighter and more beautiful. Importantly, investors had years to watch (learn) and get their position sized right. How many investors followed Berkshire Hathaway over the decades? Lots. How many investors never bought shares? Lots. How many investors bought shares and then sold them after a small gain? Lots. How many investors bought shares and then held them for a decade or longer? Very few. But the few who did so built great wealth over time. These investors exercised great patience - and were richly rewarded. These investors had a ‘truly great idea’ - buy Berkshire Hathaway stock. But their real genius - what separated them (and their returns) from all other investors - was their patience. They held the stock for the long-term. Why didn’t these investors sell out? That is a great question. I don’t know. Because I sold my Berkshire Hathaway every time i ever owned it (after what i thought was a nice gain). With hindsight, i was an idiot. I was happy making a small profit. And i completely missed the big move - when it was staring me right in the face. So what does all of this have to do with Fairfax? Maybe nothing. Maybe everything. Part 6: Fairfax Financial Similar to Berkshire Hathaway, Fairfax has an outstanding long-term track record. Fairfax has significantly outperformed the S&P 500 over the past 38 years (since the company was founded in 1985). However, unlike Berkshire Hathaway, Fairfax had a pretty big stumble from about 2010-2017. The investing side of the business messed up (the insurance side of the business continued to perform well). Business results suffered. However, from about 2016 to 2020 the company got to work correcting its past mistakes. By 2021, the turnaround was largely complete. Operating income has increased from a run rate of $1 billion/year from 2016-2020, to $1.8 billion in 2021, to $3.1 billion in 2022, to an estimated $4.4 billion in 2023. And it is poised to increase again in 2024 (my current estimate is $4.6 billion). Since around 2018, Fairfax’s capital allocation decisions have been very good - best-in-class among P/C insurers. I have written about this extensively in other posts so i am not going to rehash things here. Bottom line, the set-up at Fairfax today - with both insurance and investment businesses - has never looked better. Now i generally hate comparing Fairfax with Berkshire Hathaway because they are such different companies. But i am going to break my rule in this post. Here is what i am wondering - and i would love to hear your thoughts. Does Fairfax today look like a much younger Berkshire Hathaway? Here are some of the similarities i see between Fairfax today and a Berkshire Hathaway from 30 years ago: Business model: built squarely on the P/C insurance / float model (Berkshire Hathaway has more of a conglomerate business model today) Capital allocation: master capital allocator (Fairfax has been hitting the ball out of the park in this regard since 2018 - that is a pretty good timeframe to use to evaluate the current management team) Significant, sustainable earnings: current estimates have Fairfax earning a record of more than $4 billion in 2023. And the future outlook is promising. Size: Fairfax is still small in size - good capital allocation decisions move the needle in terms of financial results (earnings and book value growth) All of the above + the power of compounding = opportunity for exponential growth over the next decade. ‘Time is the friend of the wonderful business’ to quote Warren Buffett. Valuation: Fairfax’s stock is trading today at a very low valuation - both compared to P/C insurance peers and the overall stock market. The set up today for Fairfax looks - to me - an awful lot like a much younger Berkshire Hathaway. Fairfax is poised to become a compounding machine in the coming years. If that happens, Fairfax would become what Buffett would call a ‘truly good decision’ for investors. Is Fairfax, once again, a buy and hold type of stock? I am warming to this idea. I think 5 years is a good amount of time to evaluate a management team - and the team at Fairfax has done an exceptional job over the past 5 years. This topic is important - let’s give it the attention it deserves in a future post. ————— Full quote by Warren Buffett from Berkshire Hathaway 2022AR “At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. (Remember our escapes from near-disasters at USAir and Salomon? I certainly do.) “Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire. Let’s take a peek behind the curtain. The Secret Sauce “In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire. “The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow. “American Express is much the same story. Berkshire’s purchases of Amex were essentially completed in 1995 and, coincidentally, also cost $1.3 billion. Annual dividends received from this investment have grown from $41 million to $302 million. Those checks, too, seem highly likely to increase. “These dividend gains, though pleasing, are far from spectacular. But they bring with them important gains in stock prices. At yearend, our Coke investment was valued at $25 billion while Amex was recorded at $22 billion. Each holding now accounts for roughly 5% of Berkshire’s net worth, akin to its weighting long ago. “Assume, for a moment, I had made a similarly-sized investment mistake in the 1990s, one that flat-lined and simply retained its $1.3 billion value in 2022. (An example would be a high-grade 30-year bond.) That disappointing investment would now represent an insignificant 0.3% of Berkshire’s net worth and would be delivering to us an unchanged $80 million or so of annual income. “The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. And, yes, it helps to start early and live into your 90s as well.”

Other than when i owned a home and had a mortgage, i have never used leverage. I don’t think that using leverage is a stupid idea. I probably read too much Buffett early on. However, i have always had a pretty concentrated portfolio - and that has definitely helped my returns over the years.

@SafetyinNumbers that was very informative. Thank you for taking the time to lay it out in some detail. What if investors decide Fairfax is a buy and hold type of stock again? And not just a trade? When i read reports like National Bank (well done) i think we are getting to a sentiment inflection point. We will see. Fairfax’s AGM this year is setting up to be quite the event.

I would love to hear other board members thoughts: how do you handle position sizing? Especially when the winning/oversized position is likely just getting started? @MMM20 that is a great question. I also have a friend who is looking for an answer. Position size has two components: 1.) when you buy 2.) what happens over time Position sizing is exceptionally difficult. Probably because it is more art (gut) than science (brains). Unlike the ‘brain’ type, the ‘gut’ type of decisions can’t easily be explained. My comments in earlier posts today were meant to be quite general in nature. As an example, i have owned Berkshire Hathaway stock many times over the years. I always sold it after a decent move higher. With hindsight, i should have simply held my position. And been adding to it on weakness. Now there is another situation… and i think this is what you are getting at… i am going to make up some number. What if you backed up the truck with Fairfax a year ago and made it 33% of your total portfolio. Concentrated, but not a crazy number. Today, Fairfax might now be 50% of your total portfolio. At what point does it get too big? I’m a big believer in the ‘sleep well at night’ rule of position sizing (that you reference). If your weighting is keeping you up at night, that is telling you something. I suspect there are a few people on this board in this boat. Yes, great problem to have. Another way to look at it might on a risk / return adjusted basis: - What do you think Fairfax is going to return over the next couple of years? - What will the index averages return over the next couple of years? - What is the chance something is going to happen to materially impact Fairfax’s valuation (a 30% or more permanent drawdown) over the next couple of years? My view is you only want to be highly concentrated if the opportunity is materially better than putting the money in a broad based market index (you expect 1.5x or better outperformance). But you have to be wired the right way for this to work (to hold a very concentrated position). My guess is quite a few Berkshire Hathaway shareholders have achieved generational wealth holding the stock for decades. What did these shareholders do when confronted with the same question? My guess is the ones who built the greatest fortunes didn’t sell a share.

Here is what Prem said in the 2020AR after they put the position on: “We think this will be a great investment for Fairfax, perhaps our best yet!” My view is the FFH-TRS is a ‘punch-card’ type of investment for Fairfax. A ‘truly good decision.’ Exceedingly rare. One that comes along perhaps once every 5 years or so. And Fairfax knows how to value this investment. Why would you sell something that is likely going to compound at a high rate for the next 5 years? You would be a dummy to sell it even at fair value. And Fairfax is nowhere near fair value today. Cutting your flowers and watering your weeds is never a smart thing to do. Inevitably, the proceeds go into an inferior idea. Most people sell because they think they can find something as good or better. That isn’t what happens when you sell the ‘truly good decisions’. I think it is mental flaw that lots of investors have. And it leads to sub-par returns. i know this because i see a guy in the mirror every day who has repeatedly made this mistake over the years

Valuation will likely be the driver of what they do with the TRS position. Of all the analyst reports I have read over the past 18 months National Bank has consistently been the best - and by the best I mean they get into the weeds and provide a very thorough and thoughtful build of all of their assumptions. Their estimate 12 months ago was the most accurate. I don't think it was luck. Today? They have updated their models and have upped their price target to C$2,000. This is not a crazy number. It is based on Fairfax trading at a 1.3 multiple which is reasonable. Fairfax is still cheap. And it would be easy to argue that it is crazy cheap. Why would they exit the TRS when the set-up is so favourable (not just valuation but also the near-term outlook)? Buffett said 12 'truly good decisions' made over 60 years (one every 5 years) is what generated his significant outperformance versus the S&P 500. You make the big money by holding your best ideas for years - decades in Buffett's case. My guess is Fairfax is holding the TRS to make the big money. “They say you never grow poor taking profits. No. you don’t. But neither do you grow rich taking a four point profit in a bull market.” Reminiscences of a Stock Operator

WR Berkley just released results. I like listening to their conference call to get an update on where the US P/C insurance market is at. WRB is a traditional insurer focussed on the US market. Here are my key take-aways: 1.) the hard market continues with no signs of ending any time soon. 2.) P/C insurer returns - for some companies like WRB - are very good. ‘Record setting financial results.” 3.) The outlook is even better. Sceptics continue to question how this can be possible. The simple answer is lots of insurers are not experiencing ‘record setting financial results’. Some lines, like auto, were beyond terrible for years. Investments - the current book yield on fixed maturity holdings is about 4.7%. - new money yield is over 5% - average duration is 2.4 years, about the same as last quarter. WRB would like to extend duration WRB missed out on extending duration when rates peaked out in October of 2023. It is exceptionally difficult to time the market. This just further highlights the exceptional job the team at Fairfax has done with their fixed income portfolio over the past 2.5 years - extending the average duration from 1.6 years to 3.1 years in 2023 is a big, big deal. We will get clarity on all the puts and takes when Fairfax reports Q4 results (and more when they release the AR). It looks to me like WRB got caught ‘thumb sucking’ in Q4 when rates spiked. Returning money to shareholders WRB returned more than $1 billion to shareholders in 2023: dividends, special dividend and buybacks. Well done. Importantly, this is capital that is leaving the P/C insurance industry. Other - Rate increase in Q4 = 8% and still exceeding loss cost trend. Q4 of 2022, rate increase was 6.9%. Yes, rate was up modestly YOY. - Top-line growth of 12% in Q4: seeing nothing today to suggest growth rate is slowing in Q1. - Interest rate outlook: stay the same or maybe higher. See pressure on inflation in coming years driven by high government spending (supported by both Biden and Trump) and limited ability to raise taxes. - ‘Alternative investments’ opportunities not compelling today given what is available in fixed income today (on a risk adjusted basis).

@petec sorry, i missed that your comment was specific to Eurobank. From my perspective, the ‘stumble’ at Poseidon has been their inability to come close to hitting their financial targets set out in the recent past. Interest expense appears to be the culprit. The CFO resigned in July 2023. 2024 will be a big year for Atlas, given all the new-builds that are getting completed. The issues in the Red Sea - if they persist - might help at the margin (driving shipping rates higher). The fact interest rates have come down significantly over the past 3 months might also help a little. I am not concerned about Poseidon/Atlas. I view it more as a missed opportunity (in the near term). I do expect the ship to right itself over time. Going private was the right move for Atlas.

@dartmonkey yes, great start to the year for two of Fairfax’s largest equity holdings. And if the big boys are performing well, that usually means good things for the performance of the equity group as a whole.

@petec “I think they've been making great decisions for a decade” 1.) On the insurance front, i agree. 2.) On the investments - fixed income front, i am neutral (looking at the decade as a whole). 3.) On the investments - equities front, the period 2014-2017 was a stinker (Eurobank 1st purchase, Fairfax Africa, APR, EXCO bankruptcy, AGT take private, Farmers Edge, Boat Rocker etc). Notwithstanding the recent stumble at Poseidon/Atlas, decisions made 2018 to present has been great (in aggregate). 4.) On the derivates front, the equity hedges/shorts were a catastrophe from 2010-2020 mostly (2010-2016). The FFH-TRS has been better than great. The question i have is did all the equity hedge/short losses and the losses from the poor equity purchases from 2014-2017 significantly warp the book value we see today? I wonder if it is significantly understated. The main reason i think it might be significantly understated is the fact the insurance business has increased in size by 350% from 2014-2024E. Book value has increased much less over this same timeframe. That is probably why i prefer to use a bottom-up earnings estimate as my primary valuation tool for Fairfax as opposed to book value. I trust the informational value of one much more than the other.

@Haryana If Fairfax's stock went up 20% each of the next 4 years then we would see a price of US$2,000. Three things drive a stock price: 1.) earnings 2.) multiple 3.) shares outstanding My view is much of the increase we have seen in Fairfax over the past three years is being driven by much higher earnings and much lower share count. The P/BV multiple has not expanded much from its historical range - one could argue the multiple is actually below its historical average. If we get multiple expansion in the coming years then I think investors will be very happy. Solid earnings + lower share count + multiple expansion = very happy shareholders.

@LC great point. To come up with a ‘fair value’ for Fairfax shares, i think it is helpful to use a number of different methods. And of course, ‘fair value’ is going to be a range. My previous post was done kind of tongue in cheek and not meant to be rigorous. One of my big mistakes in the past was using price as my primary tool when exiting a position (that sucker went up a lot so it is time to sell). That (flawed) logic lead me to sell my big Apple stake in 2015/16 (after a big gain) Sometimes when i write my posts i am talking to myself… As an investor I think it is very easy to get anchored in the past. I think many people are anchored in the past when they value Fairfax. Part of the problem is Fairfax is a turnaround… it was under-earning for almost a decade. So its past results are not a good input for investors to use today to value the company looking forward (although the past 2 years are much better). Getting anchored on faulty numbers is even worse. A question. I think with the following comment you were thinking interest rates might come down. Am i correct? “For example performance on the fixed income portfolio are dependent on interest rates. It may be difficult to project that component.” Do you see lower interest rates as a risk? Because they were lower in the past? What about higher interest rates? Would that then be opportunity for Fairfax? I find when investors look at Fairfax it is not done in a balanced way. Only one scenario is considered (usually anchored by past events) and it usually leads to lower earnings. The other scenario, which might be just as likely and would lead to higher earnings, is not considered. It is presented as being conservative but i don’t see it that way. Both risk and opportunities need to be equally considered when valuing a company. Probabilities then need to be assigned to each. And then folded into a valuation framework. - what is the probability rates move lower in the coming years? - what is the probability rates move higher in the coming years? Based on what i know today, my current assessment is the risks are probably petty balanced. At least close enough. (Yes, trying to predicting macro is pretty much impossible… but that is a topic for another day). Fairfax business results are in uncharted territory. They have been for the past three years. But investors keep expecting a return to the mean (lower historical numbers). I am not oblivious to the risks. But i am also not ignoring the opportunities. I am trying to find the middle ground (i think). What we are slowly learning is a great deal of intrinsic value had been building at Fairfax over the past 10 years. Until recently, it remained hidden (from earnings). But that is changing. It will likely take another couple of years for the true earnings power of the company to become clear to investors (including me).

@Dinar My estimate for underwriting profit for 2024 is a little lower than 2023 because of my assumptions with the combined ratio (CR). 2023 has been a low cat year (big ones) so i am forecasting a full-year CR of 94%. For 2024, i am using 95% as my CR estimate as i expect ‘big catastrophes’ to normalize (come in higher than this year). I think that is a reasonable assumption. Of course, one of these years, we are going to get a really bad year for catastrophes. There is also a chance we could learn that Fairfax is a better underwriter than previously thought. I think they have been slowly improving the quality of their insurance operations - most recently Brit and reducing its catastrophe exposure. If true, this suggests my CR assumption might prove to be too conservative. We will see. PS: if you go to the 'Premiums' tab in my Excel spreadsheet (attached) you can see the build. You can adjust the CR (or any estimate) as you like to make the estimate your own. Fairfax Jan 10 2024.xlsx