StubbleJumper

The issuer bid circular has been posted to SEDAR (attached). Paid-up capital is US$252/sh. So, if the tender goes through at the high-end of the bracket there will be a deemed dividend of US$500-$252=$248/sh. SJ fairfax.pdf

Yeah, when FFH announced it entered into a TRS on their own shares, I was quite surprised that it was even possible to do so from a regulatory perspective. SJ

Because at a certain point, you have exceeded any reasonable financial capacity that might be available to actually conduct a buy back. So, in this case FFH seems to be levering up by "borrowing" some money from OMERS to fund the SIB. Once they've levered up a billion through this transaction, they are even tighter on financial capacity to conduct future buybacks. If you cannot foresee in the reasonably near future enough financial capacity to actually conduct a buyback, what are you actually doing? SJ

That's a solid argument. But, where does it take you? In my view, it takes you to the viewpoint that FFH did not undertake the TRS for the purpose that was originally stated, which was to lock in an attractive re-purchase price. It takes you to the view that FFH instead opportunistically speculated on the price of its own shares. Is that the type of risk management you want to see from an insurance company? Given the industry's history of occasionally seeing a company enter a death-spiral (FFH may have narrowly avoided that 20 years ago), do you want to see a management team exposing the company cash flow risk from TRS compounded on top of whatever other events in the insurance industry or financial markets that trigger a reduction in the company's share price? It's just one more way of taking on a great deal of additional leverage (which can work for you or it can work against you). I would say that if FFH's intention was to speculate on its own share price, we should be a little uncomfortable. It's even worse than the macro speculation of 5 years ago. I guess the only saving grace is that the position size is not as ridiculous as some of the past debacles. SJ

No, I don't believe that it can be marked to market. I believe that it's the actual amount that the original shareholders paid for their shares. The shares from 1986 were issued for peanuts, while the shares from 2015 were much higher. So what will be the weighted average? I'm guessing that it will be pretty low. But I guess we'll see tomorrow or Friday when the filing becomes available. SJ

Do not forget about the Canadian withholding tax.... ***EDIT*** If the deemed dividend is US$300+ as I am guessing, the withholding tax would be US$45+/sh. SJ

I have attached the issuer bid circular for Home Capital Group, which came out with their SIB announcement a few days before Fairfax. Go down to page 32 and read the tax treatment, both domestic and foreign. The numbers will be different for Fairfax, but the tax law should be roughly the same. ***EDIT*** The Home Capital SIB has an odd-lot privilege, so there's some easy beer money to be made by a Canadian taxpayer who has enough space in his RRSP to buy 99 shares... SJ homecapital.pdf

Worse. So, suppose that my suspicion is correct that there will be a deemed dividend of, say US$300/share. Right off the bat, there's a foreign income withholding tax by Revenue Canada (maybe 15% if you live in a country that has a tax treaty with us). And then when you file your income tax, you get to pay your local dividend tax on that foreign income. Ouch. SJ

No, I hope they use at least some of the proceeds for their NCIB. They should have lots of space remaining on that. SJ

My opinion is that they don't want to actually sell Odyssey. In five years, when we look back, we will probably recognize this as a debt-like transaction. They are likely paying a significant annual "dividend" (9% or 10%) to their partner and there is probably a repurchase privilege that effectively guarantees a 9% or 10% return. Usually I am not a happy shareholder when I see FFH seeking outside capital with that kind of hurdle, but if you can use the proceeds to buy back your shares at 20-25% less than book, it's not a terrible thing to do as long as you can "repurchase" the position within a few years. SJ

That's exactly what I think. There's money to be made if you've got some RRSP space. ***EDIT*** We'll have a better idea of just how tax punitive this SIB is when the issuer bid circular is posted in the next few days. The more tax punitive, the less likely it will be fully subscribed. SJ

I appreciate the sentiment, but I would caution you to temper your enthusiasm. It is likely that this SIB will be undersubscribed due to the hella tax bill that tendering would cause for many shareholders. Under Canadian tax law, the difference between the ultimate tender price per share and the paid-up capital per share is treated as a deemed dividend. I have not yet pulled the issuer bid off SEDAR, but I am guessing that when it is published we will see that the paid-up capital will be some trivial amount, perhaps CAD$200/sh or something, which would end up triggering a massive deemed dividend of something like CAD$400/sh. Do the song and dance of grossing it up by 45% and then claiming your dividend tax credit, and you end up with a considerable tax bill if you tender shares that are not held in some sort of tax privileged vehicle (eg, RRSP or TFSA). If somebody wanted to dispose of FFH shares, he'd likely be better off just selling them on the market, realising a capital gain, applying the 50% inclusion rate and then cutting a small cheque to Revenue Canada. So, what's the school-boy arithmetic on this one? Prem owns ~9% of the shares and he's not tendering. Anyone holding them in a taxable account won't likely be tendering. So, what's left is basically the shares held in tax advantaged accounts. Realistically, how many shares can even be rationally tendered? I am guessing that there's not a large percentage of those 25.88 million shares that are rationally available, and that a good portion of the rationally available shares will be retained by shareholders who know that they are worth more than US$500. My take is that this substantial issuer bid will be undersubscribed and the buybacks through the normal course issuer bid will be more realistic. Still, it's nice to see the SIB. SJ

Odyssey is not a Canadian reinsurer. I wouldn't expect Odyssey to have any more than its traditional "share" of a typical North American catastrophe. Northbridge *is* a Canadian insurer, so we should expect to see NB take it on the chin from this weather event. What remains unclear to me is just how the economic damages of this storm get divided. In general, you cannot get insurance for over-land flooding in Canada. Presumably you can get an indemnity if your house is wiped out by a mudslide, or if flooding triggers business interruption indemnities, or if your car ends up going for a swim. My guess is that the Canadian federal government will be in this for 10-digits of dollars, but I'm not entirely certain how it will stack up for the insurers. SJ

Anybody got any ideas about what the Paid-up Capital will be for this transaction? Presumably it will be relatively low, which will trigger a large deemed dividend? If the deemed dividend is significant, I wonder whether this offer will even be fully subscribed? SJ

Well, this will be interesting to see. The TRS were described as a measure to lock-in a buyback price. What was announced today *is* the buyback. So, do they close out the TRS following the auction? Or was it really the case that the TRS were intended for speculation in FFH's own shares, in which case we shouldn't expect to see the position closed? SJ

When FFH took ORH private, we shareholders were effectively offered 1x book. And now this is 2x book? I'd say that the buyout was ridiculously undervalued, and this is now ridiculously overvalued. SJ

So is FFH "borrowing" US$900m from OMERS at 9% to fund a US$1b repurchase of FFH stock? Give the discount at which FFH shares trade, I guess that would work as long as they "repay" OMERS within a few years. ***EDIT*** I wonder whether FFH will close out some of the TRS following the repurchase. The TRS were intended to lock-in a repurchase price, not to speculate in the market price of FFH, right? SJ

The trigger for re-rating will be 3 or 4 years of *good* ROEs. None of this chaotic +23% followed by -12% followed by + 7%. Nope, 3 or 4 years of double-digit, positive ROE will likely garner some serious attention. This year, 2021, is a fabulous start. Another couple years of modestly good returns will change the narrative. Eurobank and Altas share prices are not marked to market, so only the people doing a deeper-dive will ever realise the value from those positions. The income from those outfits won't hurt, but we need to see reliable operating and investment returns from FFH for a few more years. But, whatever. Even if FFH "only" re-rates to 1x BV in the next couple of years, that will be a fully acceptable return (ie, a reversion to 1x BV is 40% plus the gain in book, which would be ~60% over a couple of years). If it reverts to 1.1x or 1.2x in four years, that will be fully acceptable too. It's cheap. SJ

Guys, let's not overthink this. It's not necessary to do a Tilson-style or a Bloomstran-style analysis to obtain a valuation estimate down to the penny. As WEB once said, "You don't need to know a man's weight to know that he's fat." And so it is with FFH, you don't need an elaborate valuation model to know it's cheap. If the stock price increases by, say, another 40% or so, that's the time to start the navel gazing about precisely how much it's truly worth. That being said, the easiest valuation method for an outfit like Fairfax is a simple multiple of BV. The issue is what level the multiplier ought to be (ie, 1x, 1.2x, 1.4x, something else). So let us start with two broad scenarios: the first is that Prem's stretch-goal of a 15% ROE is actually the future reality, and the second being that historical ROE is representative of future reality. So, just for giggles and farts, I've ripped off a chart of Return on Common Equity from tikr.com which I've attached below: As Viking noted, it's a chaotic, hell of a mess but in complete fairness to Prem, there were never any promises of stable returns. Ignoring the volatility, if I've done the arithmetic correctly, the geometric mean of that chaotic mess is about 6.7%. So, I'd say that Viking has nailed the issue quite nicely, which is that the 17-year mean ROE has been underwhelming, while Prem's stretch-goal of 15% ROE has only been attained on 5-of-17 years. It is what it is. Returning to the two-scenario approach, what would be an appropriate book-value multiple for an outfit that kicks out a 6.7% ROE and what would be appropriate for an outfit that kicks out a 15% ROE? I would say that the former is worth approximately 1x book, and the latter would easily be worth 2x book. Given that the shares trade at a considerable discount to book, current valuation is bat-shit crazy in either circumstance. I don't blame the market for being skeptical of FFH because there has been chronic over-promising and under-delivering. I would say that FFH is in a "show me" period when it comes to valuation. The market will pay for true value generation, but it will take a few years to repair the damage done by that chaotic, hell of a mess of a ROE chart. But, when it trades at like 0.7x BV, who gives a shit? If it takes two years to get back to book and two more to reach an "appropriate" multiple based on the next few years of results from re-aligned strategy, it will provide a handsome return. At this point, there's no need at all to over-think this. SJ

Rates have already shown a modicum of improvement. I'm not sure what the bond team is thinking these days, but I wonder whether they are biting on 2-yr treasuries, which still provide inadequate interest rates, but are better than zero and don't lock you in for the long-term. I'd be surprised if they were planning to allocate much of the bond portfolio to the 5-yr, 10-yr or longer because there just isn't enough yield there at this point. But, as one other poster noted this week, FFH seem to be fans of Van Hoisington, and their outlooks is still lower for longer, so who knows... But that's just the interest rate aspect. Inflation also impacts on indemnities, particularly those which take 2, 3, or 10 years to resolve. One of my observations about the Q3 report was that there wasn't as much favourable development as I had expected to see. I had anticipated that the 2019 and 2020 accident year CRs would have had a fair bit of cushion built into them because the pricing environment was favourable. If that were true, in 2021, that should have resulted in healthy reserve releases -- maybe we'll see them when the reserves are assessed in Q4? We didn't see that favourable development in the first three-quarters. Is it possible that inflation is eating into our favourable development (eg, some guy's house gets obliterated in a hurricane in 2020, but the re-build cost 10% more than was expected when the claim was originally made)? To what extent does this occur and is it material (I'm talking general inflation, not social inflation)? SJ

I don't belly-ache about the dividend too much, but I would offer a few observations. For the past decade (or two?) FFH has been a serial acquirer, and has aggressively purchased insurance and non-insurance subs whenever the financial capacity was available. We have questioned the wisdom of a few of the acquisitions, but on the whole, the aggressive growth strategy has served shareholders well. But, the result of this is that FFH has been chronically short of capital and occasionally leveraged to a greater extent than some shareholders might like. This chronic shortage of capital has resulted in significant new issuances of shares, sometimes at valuations favourable to existing shareholders and sometimes at valuations that are disappointing to existing shareholders. These successive share issuances ultimately triggered the desire by the Watsa family to re-weight the multiple voting shares to sustain family control of FFH. This shortage of capital has also required FFH to partner with other deep-pocketed organizations such as OMERS to complete certain acquisitions, or to refinance certain assets with the goal of bolstering holdco cash levels. The share issuances, the re-weighting of the multiple voting shares, and the numerous murky collaborations with OMERS probably have not served shareholders well. In the first instance, dilution was the outcome, and in the second and third instances, the company's reputation has suffered, which probably has a negative impact on the marketability of FFH's shares today. I have not done the arithmetic about the magnitude of common dividends that FFH has paid out since it initiated the dividend, but I am guessing that it was US$3B+ that has been paid (maybe even US$4 billion?). So, do the counterfactual analysis. If FFH had not had a dividend and had instead retained that US$3B, what would the company's capital structure currently look like, would would the sharecount be, would we have seen that reweighting of the multiple voting shares, and would we be paying OMERS seemingly guaranteed dividends of 9% (this is one of the poignant measures of the cost of the dividend policy because shareholders are giving OMERS 9% dividends so that we can get our US$10/sh)? All other things being equal, that ~US$3 billion of capital would probably have been better to be retained. I would say that the dividend policy might have been appropriate for executive compensation, but it was very much poorly aligned with FFH's broader corporate strategy and had a number of undesirable consequences. Management could have margined their shares to fund their lifestyle or we could have simply paid them a couple million bucks per year more. Going forward, are the concerns of the past relevant? Prem claims that he's done adding major insurance subs, and perhaps the serial-acquisitions are over? Maybe the chronic shortage of capital will become a reliable and predicable annual surplus of capital? I guess we'll see. But the current opportunity to repurchase shares is just one more downside to a dividend policy that mostly has not served us well. SJ

Yes, Prem could have passed that dividend question to Jen Allen instead. Capital allocation and distribution is right in the CFO's wheelhouse, and she seems to be a solid communicator. He should have let her explain the capital allocation strategy and the resulting dividend policy, then Prem could have added his two-bits at the end. SJ

Q3 conference call transcript can be found here: https://seekingalpha.com/article/4466036-fairfax-financial-holdings-limited-frfhf-ceo-prem-watsa-on-q3-2021-results-earnings-call

I would say that the evaluation of the Toys purchase remains ambiguous. They sold the operations and retained the real estate, which IMO was an excellent move. But, just to be clear, they did not get any cash from selling the operations. They instead created an intangible asset to plunk onto the balance sheet and booked a healthy paper gain on the sale! If you are a believer in Toys' future success in the Canadian market place, you will hold the view that the intangible asset will yield annual sales royalties (cash) for a great many years and all is well. On the other hand, if you are like me and suspect that Toys' days are numbered and that the competition will eat its lunch in short order, then you fully expect that Putnam will close shop in a couple of years and FFH will end up writing off that intangible asset. That is neither here nor there when it comes to evaluating the success or failure of the Toys purchase. If Putnam closes up shop it is quite likely that FFH will sell the real estate, and that will be the time when we can assess whether it was a good cigar butt or just a soggy mess. But, my guess is that the booking of a gain in 2021 will end up being just smoke and mirrors because I don't expect a couple of decades of cash royalties to follow. Setting aside my cynicism, dumping the Toys operation on Putnam was masterful. If I am correct and Toys gets squeezed out of the market in a few years, at least it will be Putnam making the decision about whether to pull the plug and fire thousands of people rather than FFH. All FFH need to do is sit back and collect a rent cheque for the buildings, and any royalty cheque that comes in will be just gravy. After the business folds, we'll see whether the real estate has risen in value sufficiently to declare the original purchase to be a success. SJ

Just looking at the numbers, ORH increased its net written by 17.5% which is pretty good! Strip out the cats, and their Q3 2021 pre-cat CR was 90.7 compared to 89.5 last year. That's a bit of a deterioration but almost all of it was attributable to lower favourable development this year. The profitability of their underwriting is virtually identical, even after they grew their book by 17.5%. That looks like a win to me. SJ