StubbleJumper

One of the most interesting bits that FFH publishes every year is a table depicting FFH's financing differential that appears in Prem's annual letter. In the early years, he provided the table in its entirety, but over the past 15 years or so, he's only provided an excerpt. A number of months ago, I went through the annual letters and constructed the long term series to the best of my ability (see attached). The table shows how CRs and long term Canadian fixed income rates have evolved. The long and the short of it is that the financing differential (long-term bond rate less cost of float) has typically been in the low single digits, with only occasional years higher than 5%. The unfortunate thing is that the table uses long Canadian bonds, which made a great deal of sense 25 years ago when FFH was mainly a long-tail Canadian insurer. But, at this point, FFH is effectively a US insurance company with the lion's share of its fixed income investments in shorter-term US treasuries. A more instructive table would therefore replace the Canadian long-bond return with a 2 or 3 year US treasury, or perhaps a 5 year US treasury. But, in any case, suffice it to say that when you can easily find a 5% treasury bond, you don't usually also see a -6% cost of float (ie, a 94 CR). We are currently seeing a financing differential of about 11 percent, which is outstanding...and likely unsustainable. That enormous financing differential is likely to be competed away as capital enters the industry and companies get a bit more aggressive about growing their book. That leads me to yet another interesting observation about FFH shareholders. Allied, Odyssey and Northbridge all have plenty of capital to enable an underwriting expansion. It's fascinating to me that shareholders have not been haranguing Prem during the conference calls to grow those books more aggressively. SJ FFHfloat.xls

Well, it's true that a stock is worth the present value of future cashflows. If you hold the view that FFH's fair value is much higher than BV, you pretty much need to make the argument that there is some hidden value on the balance sheet, that FFH is a best in class underwriter, or that management is so talented that it will be able to obtain a return on equity that far exceeds market return. Hidden value can definitely exist, and it probably does in assets such as the Bangalore airport and possibly a few undervalued investments like Eurobank. But, most of the other portfolio assets that FFH holds and most of its investments in associates have fair value that is pretty close to reported book. And that's the nature of an insurance company. The most valid argument in favour of FFH being worth more than the book value of its assets is its investing prowess. That argument definitely does hold water, but you need to be very thoughtful of just how significant that advantage is. An insurer is inescapably constrained to holding a large percentage of fixed income investments. If FFH can get some alpha on its investment in equities and associates, it is definitely worth more than book. But, there are limits to that. Even Berkie only trades at 1.5x, and Berkie has a significantly undervalued railroad on its books among other long-held operating businesses that are worth far more than book. SJ

It's not a worst case scenario. It's merely a more normal scenario. What we are seeing today is not normal. It's a top of the cycle underwriting situation. And with respect to interest rates, who really knows? All we know is that the fed has engaged in a tightening stance for a particular reason, and if the economy slows, the fed will likely reverse that stance to some extent. All that to say, we are living nearly perfect operating conditions for a well capitalized P&C insurer right now, and if you project that forward very far, you do so at your own risk and peril. That is a possibility. It's always possible that Hamblin Watsa shoots out the lights for the next 20 years and we will see truly extraordinary investment results. The question is whether it's wise to make that kind of assumption. It could happen. But, if you have a business model that requires you to keep roughly two-thirds of your investments in fixed income and preferreds, you need a particular set of circumstances to get you 6-8% returns overall. You can definitely get there right now when you can average 4.5% on the fixed income component because means you only need ~9% on your investments in equities/associates to get your overall 6% return. But, again, you might want to be a little cautious about projecting that sort of thing forward because we are likely near the end of a tightening phase. We are seeing a truly amazing set of circumstances right now. SJ

Mr. Market likely doesn't believe that EPS of $150 is sustainable. Your EPS of $150 contains $60 of underwriting income which can disappear pretty quickly if capital flows into the industry, and the $100 of interest can turn into $75 by 2027 if the fed moves away from it's tightening process and instead adopts a loosening posture. FFH will almost certainly have 2 or 3 good years of income and its share price likely has some distance left to go, but we need to attenuate our long-term expectations. Ignore the PE ratio entirely when you are at the top of the insurance cycle. Instead develop a forecast of BV for December 2025 and select what you believe is an appropriate multiple of book for a company that is selling a commodity product (insurance policies) in an industry with minimal barriers to entry. That BV multiple should likely be one of 0.8x, 0.9X, 1.0x, 1.1x or 1.2x. As a point of interest, CAD$1375 is roughly 1.2x... SJ

On that point, historically they would be correct. The insurance cycle is self-correcting to the extent that attractive profits have always attracted new capital which subsequently made the attractive profits disappear. I will write once again what I wrote in January. If you give one of FFH's subs an extra $1 of capital, they can use it to write $2 of premium. That $2 of premium will earn 12-cents underwriting profit for the sub (Q2 CR=94). As we all know, the sub collects the premium long before it pays out an indemnity, so it gets float for a year of probably roughly $1 from writing those $2 of premium. The incremental $1 plus the original $1 of capital that you gave the sub can be invested today in a boring 12-month US treasury which closed Friday at 5.29%. So, in total, that incremental dollar of capital that you gave the Fairfax sub can earn about 22.58 cents of operating income. The profitability is ridiculous. A 20%+ margin will eventually attract new capital to the industry. As it always does, new capital will eventually push down underwriting profitability. There's a reason why Prem expressed a degree of surprise during the conference call that this hard market has endured as long as it has, and that new capital does not seem to be flowing into the industry. That being said, FFH has a few years of strong profits baked in. There will be at least 2 or 3 good years of profits, but understand that it will not continue forever. I see some truly enthusiastic valuation levels being proposed on this board for a company that sells a commodity product with few barriers to entry. There's still room for the price to run, but that will be mainly from the earnings that will be retained over the coming 2 or 3 years rather than some marked increase in fundamental valuation. SJ

No. He's likely not part of an old shorting club, but more likely an analyst who is trying to intelligently publish opinions on 40 or 50 different stocks and cannot do a credible job of any of them. The investment losses that preoccupy him are a nothing as they are mainly unrealized losses on bonds that will be held to maturity, and thus will reverse over the next 2 or 3 years, irrespective of what happens to interest rates over that time. The other thing to ignore are the IFRS 17 discounting issues as they too will reverse over a few years (there is no economic significance to them). And then the Farmers Edge charge is the third thing to ignore as that reflects a bad decision made five years ago or so. None of those things make a whit of difference about the economic value of the company on a going-forward basis, but I understand how an analyst who cannot invest adequate time in the company might view those items as significant. SJ

They actually list several of the reasons for not maxing out the divvy in the AR. Supporting growth is one reason, but there are others. Irrespective of their motivation, they haven't been sending regular dividends of more than ~$400m per year to the holdco. My take is that they currently have about $600m of true liquid assets at the holdco (but, who knows, maybe the $358m of derivatives are more liquid than I think, and maybe those derivatives are not serving any risk management purpose or any strategic investment purpose). So, from a cash sources perspective, that puts the holdco cash sources at about $1B, and then from a cash uses perspective, holdco interest, Gulf consideration payable, and preferred and common divvies will make up most of a billion. It's not a crisis, but they will either need to make an extraordinarily large dividend from one or more sub, float $500m or $750m of bonds, or make use of the revolver for general operating purposes. I would prefer that they float some bonds, but I guess we'll see how they choose to manage it. SJ

Yes, they could always sell an entire subsidiary or a portion of a subsidiary to raise cash. You don't really want to do that because you don't generally get a great price from a forced sale. And you definitely wouldn't do that until you tapped out your revolving credit and exhausted any possibility of floating more debt. But, just to be clear, you can't just take $5b of bonds from Odyssey and give them to the holdco to sell. You can trigger dividends from the subs to the holdco to the extent that the regulators have approved, but you can't just transfer capital willy-nilly. In a hard market, if you dividend too much money from your subs to the holdco, it might end up constraining your premium growth. SJ

Well, yes, the Q2 does say that the holdco has $1B. But, when you look at the components of "cash", $358m are actually derivatives rather than cash equivalents, and another $147 are pledged for derivative obligations. So, if you look at the actual short term assets that the company could realistically use for its operations, there's roughly $600m that could be easily liquidated. The revolver is extremely important to maintain. The question is whether you want to see the companies you invest in being reliant on revolving credit for general operations. Maintaining it is a very good idea because it can be invaluable for the proverbial black swan or to opportunistically acquire a major asset. But, it is a basic philosophical question of whether you want to see revolving credit being used for general operations. FFH does have scads of operating income flowing every month, but it does not generally flow to the holdco, but rather the insurance subs. The insurance subs do have dividend capacity to flow money to the holdco, but the most significant dividend capacity is in Allied, Odyssey and Northbridge. The first two are competing where the market seems to be hardest, so how much of a dividend they would want to draw is an open question. Over the next six months, the holdco will have cash outflows of $177 for Gulf, about $230 for the common divvy and about $25 for preferred divvies, plus whatever interest that needs to be paid on holdco debt. With ~$600m of true liquid assets, I found the statements about liquidity to be a little odd. If they float another $500m or $750m of debt, everything is good, but it does strike me that they are not as liquid as I would like to see. SJ

I'm a bit surprised that there has been no comment on holdco cash. It looks to me like there is currently only about $600m of cash and short term investments that FFH could realistically use to meet its liquidity requirements. They will either need to float some bonds pretty soon or begin to use the revolver for operational purposes. The actual numbers are a bit at odds with the statements in the Q2 and on the call about having plenty of liquidity and being soundly financed. SJ

No. My sense is that Prem was being sloppy in that comment. The argument is that at some point in 1986 market price was "fair" and that since then BV has increased by a ridiculous amount and sometimes the stock price has tracked BV and sometimes it hasn't. But if market price had tracked BV perfectly, then somehow CAD$1375 would be a "fair" price today. Okay, the point is interesting, but I doubt very much that Prem holds the view that IV is $1375, and I doubt very much that he would approve of a share re-purchase during 2023 at a price as high as CAD$1375. But, sloppy or not, it certainly was what he said. More broadly, I liked Prem's approach to the Q&A on today's call. In the past, analysts would pose a question, and in response they would get what I call the "Prem fuddle" as he didn't really answer the question and nobody would gain any insight at all from the question. I have stated on several occasions that I wished he would pass the question to one of the other conference call participants to answer and then perhaps after the answer, Prem could chip in his own two-bits. Well that's pretty much exactly what he did today, and we generally heard cogent and clear replies to the questions being asked. Unfortunately, he should have relied on Jen Allen or someone to respond to the buyback question rather than replying the way he did. SJ

Cigarbutt, as always, thanks for the insight. I will endeavour to write fewer posts with which you disagree. SJ

If you want to think about what normalized earnings are, I would strongly encourage you to take another read through Prem's annual letters over the history of FFH. Every year he includes a table with an excerpt of FFH's historical cost (or benefit) of float, the prevailing long bond rate and a calculated financing differential. For 2023, some of us think that the benefit of float will be about 5% (ie, a CR of 95, maybe even lower!) and it's likely that a garden variety treasury bond will yield ~4%, for a net financing differential of +9%! FFH's 10-year average financing differential reported in last year's AR is 4.2%. Looking at that annual table that Prem publishes, you can go back a couple of decades and you will see that you won't find a better year than what we expect in 2023! So, where does that leave us? Well, FFH's reported float from Thursday's release was $29.6 billion. We expect to see gold falling from the skies in 2023 because that financing differential might be ~9%. If you want normalized income, you need to haircut that from 9% and instead use a 10-yr average or 20-yr average which captures the financing differential over multiple insurance cycles because, clearly, we are near the peak of the current cycle. If you simply take the reported float and apply the 10-yr financing differential instead of the ~9% that we expect for 2023, it will give you an idea of where normalized earnings might be situated. In short, during 2023, FFH might earn about $60/sh above normalized earnings (ie, $29.6B x (9% - 4.2%)/ 23m shares). Enjoy it while it lasts, but don't pencil it in over the long-term. SJ

There does exist a downside that we can't just wish away. Effectively, duration is the sensitivity of the value of your bond port to a change in interest rates. So, if you have a duration of 1.6 and there was an overnight 100 bps upward shift in the yield curve, the value of your bond port would decrease by about 160 bps. In the case of FFH's $28 billion bond port, that type of situation would give you an overnight haircut on your bond port of about $450m. Okay, that's not the end of the world. Now, Prem has signalled that FFH intends to shift to a duration of 2-ish during 2023. So, once again, taking a hypothetical 100 bps increase across the term structure of interest, FFH's $28B bond port would be haircut by about 200 bps, or $560m. TwoCities has expressed a preference for a duration of about 3, so the hypothetical 100 bps increase in rates would haircut the $28B bond port by about $840m. It's worth noting that if you hold your fixed income instruments to maturity as FFH usually does, there is no economic significance to those valuation changes as they will reverse themselves as the instruments progressively approach maturity. Where it does matter is for the insurance subs' underwriting capacity. Even if you plan to hold that fixed income port to maturity, you still need to mark those bonds to market which flows through the subs' balance sheets. Their underwriting capacity is a direct function of their capital level. For some of them, this is of no consequence while for others, like C&F, capital has been tight for a few years and hair-cutting the bond port could result in an actual underwriting constraint. To compound matters, if you get an interest rate increase, what else is happening at the same time? So, the type of scenario that Jen Allen should be concerned about is the situation where the Fed engages in an evangelical fight against inflation and elects to continue the aggressive tightening during 2023. Should that occur, what happens to equity prices? We've seen a recent stock market rally that might be attributable to investors believing that the Fed's tightening process is largely complete, that we will soon see a pause, and then maybe even a modest cut late in 2023. But, what happens if that's not what the fed does? Equity prices likely drop in that scenario which once again results in marking those $5B of securities to market and reducing the subs' capital levels. If you are thinking about Prem's 1-in-50 year scenario, it's not too hard to imagine the Fed going all out into Volker mode, interest rates rising another 200 bps during 2023 and the stock market plummeting 10-20% as a result. That type of scenario would be a pretty significant hit to the subs' statutory capital levels and underwriting capacity. When it comes to risks to the subs' capitalisation, the principal risk management tools that Prem and Jen Allen have are essentially portfolio allocation (ie, $5b of equities vs $28b of fixed income) and duration. While many of us think that duration should have been pushed out a bit more during Q4, we shouldn't pretend that there's no risk or no downside. SJ

Yes, and now you are positing that it will drop from 4.50 to zero in 9 months, despite the fed having a posture of increasing or, at worst, pausing. So, in essence, you are suggesting that the decline will approximate that which we saw during the Great Financial Crisis, which was the worst credit crisis since the great depression. And even at that, in the GFC it took more like 15 or 16 months to drop to zero from rates similar to what prevails today. As you suggest, it might very well get bad if the economy heads into a recession during 2023 or 2024, but let's try to keep the situation in context. Headline inflation is still significant and will likely remain so until May or June when the year-over-year comps for energy prices and food prices become more favourable (there was a notable spike last spring). I cannot envision the fed adopting a cutting posture until mid-year at the very earliest. If interest rates do decline, then interest income will follow a few years later. That's the reality. Current duration is 18 months, and Prem suggested during the conference call that it will likely be pushed out to 2-ish years during 2023. So, you are right, perhaps by 2026 there could be a significant impact on interest income. But, then again, by 2026 lots of things could happen. Even with your proposed 3-yr duration instead of the 2-yr that Prem has signalled, you could still get the same outcome, only delayed by another 12 months. If you are worried about interest rates being low in a secular sense, an additional 12 months is of limited value. Labour has been strangely resilient. It's unfathomable. But, I would suggest that most of the indicators that are at 2008-type levels can be safely ignored. What happened in 2008 was not just a recession like all of the others that we've seen. What happened was that the financial system almost broke (or maybe it did break). The issue was not principally an increase in unemployment, but rather that the entire financial system came close to collapse. Personally, I don't expect to see that in 2023 or 2024. I don't doubt that unemployment will nudge higher (how could it not!?!), but it is unlikely to be a reprise of 2008 where the fed was trying to keep the financial system from completely falling apart. Oh, I didn't say that 0% was extreme. I did say that 0% by Q4 2023 was extreme when you are sitting at 4.5% in February and the fed has a tightening posture. In the current context it would be a drastic change to hit zero in 9 months. Of course, nothing is impossible, just highly improbable. The reason why we spent much of the past 15 years near zero is that we had the worst credit crisis in nearly a century followed by the biggest public response to a pandemic in nearly a century. In the end, each of us needs to understand what camp we are in. It could be the "higher for the foreseeable future" camp, which would suggest that a shorter duration is probably okay. Or it could be the Hoisington/Hunt "secular decline towards zero" camp which would suggest that we all ought to be piling into 30-yr treasuries at the moment. SJ

If the Fed cuts its rate back to zero in Q4? It's what 4.5% at the moment? Your scenario is pretty extreme....like Great Financial Crisis extreme. And even then it took more like a year. SJ

I was a little surprised about that too. But, one the other hand, with the curve inverting, any of the Tbills or short term treasuries that they roll over the next 6 or 12 months will likely be rolled into much higher interest rates. The run-rate for interest and dividend income has grown considerably, and strangely, there is still a bit of runway on that. I get your point about potentially being subject limited interest income, but that is unlikely to occur in 2024 although it does become a risk in 2025 and 2026. In a more general sense, I would observe that it is unreasonable for shareholders to expect that FFH will nail the evolution of the yield curve perfectly, by going long at the perfect moment to get a peak rate for a cycle. What we need is not perfection, but thoughtful competence. And, I would say that so far in 2022 and 2023 Bradstreet has given us exactly that. FFH has done very well due to the thoughtful positioning of its fixed income port. I never particularly like the release of the Q4 financials because it isn't immediately accompanied by a detailed and verbose report. I guess we'll see in a month exactly what has been done with the maturity profile and the extent to which FFH has (or hasn't) reached for yield by buying bonds from sub-national governments or corporate bonds. SJ

It's not that investors lacked imagination. It's just that we also saw Toronto Star and Farmers Edge, amongst others. It's been a mixed bag. Happily, the winners are a larger magnitude than were the losers over the past few years. And the poor execution on Blackberry certainly didn't help as FFH could have easily recovered half the of capital invested in BB by selling the equities and then they could still be holding the converts. To be honest, it's been a bit of a mixed bag on the investments. SJ

Your best bet would be to read Prem's annual letters and possibly the fixed income section of the annual reports. In a general sense, it's probably worthwhile to read Prem's annual letters to get an overview of the evolution of FFH. SJ

Oh, I don't believe that I ever suggested it was easy. Rational, disciplined, opportunistic and creative, yes. But easy? I don't think anyone ever suggested that it was easy. There's a reason why most insurance companies don't have anything close to FFH's fixed income investment track-record. SJ

That's what I would hope to see. I don't expect a large move into corporates, as the market wasn't paying for risk last fall. FFH tends to be very rational and very opportunistic on these things. When risk is underpriced, they eschew corporate bonds, but when the market is paying for people to take risk, they deploy capital in a big way. A couple other examples of Brian Bradstreet seizing opportunities occurred when the market went bonkers coming out of the financial crisis and FFH picked up a shitload of relatively high yielding municipal bonds 100% insured by Berkshire Hathaway! FFH made out like bandits on that one. And then, more recently in April/May 2020 they piled into corporates when spread blew out during that initial covid panic. Rational and opportunistic. SJ

@glider3834Yes, Bradsteet has one of the best fixed income investment records that I have seen. That being said, I would not describe FFH's fixed income investment strategy during 2022 as an active, value oriented program. They quite rightly kept things simple during 2022 by rolling over government bonds and bills into other government bonds and bills and the big innovation was not primarily climbing the risk ladder into corporates, but rather a moderate extension of average duration (some of us think they could have been more aggressive on this). The losses on that bond port during 2022 were not primarily realised losses attributable to some bond investment going bad or an unexpected rotation of the yield curve, but rather they were simple unrealised M2M losses that resulted from a general rapid, upward shift of the yield curve. In 2023 it is likely that those losses unwind as the short-term fixed income instruments age. Those M2M losses during 2022 and subsequent reversals expected during 2023 have nothing to do with good decisions or poor decisions made by HWIC during 2022 and 2023 and everything to do with an historically rapid upward shift of the yield curve, followed by what we think will be a drastic slowing of that upward shift in 2023. Having said that, Bradstreet definitely has created considerable value for FFH over the years through active management of the fixed income port. Going long in the early 2000s was a conscious decision that worked out well (actually it was more of a barbell strategy than long, but the long bonds made us the money). Going into corporates when the market was actually paying for risk during the financial crisis also worked out well and made us a tonne of money. And, in the years leading up to the the financial crisis, Bradstreet earned a mountain of money for us by recognizing that the market wasn't paying for risk, so that the CDS were ridiculously underpriced. But, not much of that sort of thing occurred during 2022, as the opportunities were not there. SJ

People should ignore this. Three or four years ago, I expressed caution about quality of earnings when Fairfax cobbled together some paper gains from reorganizing certain holdings. I reassert that caution about the quality of losses for 2022 and the quality of some of the gains in 2023. FFH has demonstrated every intention to hold the bulk of its fixed income portfolio to maturity. Therefore, we would be well served to completely ignore the M2M losses that we saw in 2022 and the M2M gains that we will probably see from the fixed income port in 2023. It's a nothing. The one thing that we might get from the M2M losses/gains on the fixed income port is that sometimes Mr. Market responds to headline EPS numbers. Last fall, Mr. Market hated FFH's EPS numbers and the stock traded off to US$450ish. That was a very attractive buying opportunity. Will we shoot the other direction in 2023? Will the M2M gains result in Mr. Market giving us an attractive selling opportunity? As a shareholder, the bond gains and losses are pretty irrelevant from an economic perspective, but maybe stupidity will reign in the opposite direction in 2023? If it happens, I'll take it. Just remember, M2M gains/losses on bonds for Fairfax are not real or relevant in any way. SJ

The over-earning part comes in due to having both strong underwriting income AND solid investment returns. Think of it this way: If somebody adds $1 of capital to an insurance company right now, what's the return on that? Well, with a $1 investment you can write $2 of premium. If they are decent underwriters, that will provide 10 cents of underwriting income, and then you get to invest the original dollar plus your incremental float, which probably amounts to about $2 altogether (ie, $1 of new capital, plus maybe $1 of float averaged over the year). Slap those $2 into any old short term treasury bill/bond at 4+% and you'll have 8 cents of investment income. So, your annual return on investing an incremental dollar into the industry is what, about 18-ish percent? As it always does, that will attract new capital! Some smart guys will say, let's throw some money into the industry, and even if we have to discount prices and can only write a 99 CR, that's still a plenty good return. But if too much capital gets thrown into the industry, it won't be a CR of 99, but maybe it'll be 102 (suddenly you've gone from benefit of float back to having a cost of float). This article is a good read as a blast from the past: https://money.cnn.com/magazines/fortune/fortune_archive/2002/06/10/324523/ On equities, I am reasonably optimistic about FFH's prospects, but then again that's subject to much uncertainty. A down market or a sideways market is probably a pretty good place for FFH to play. The private equity returns have been lumpy and will continue to be lumpy. The market will discount that element of earnings (but it is definitely of great value to long-term shareholders). Don't get me wrong here. I am optimistic about the next few years for FFH. But, I would encourage you to look at their historical ROE for the past 10 or 20 years. It goes up, and it goes down. We think that 2023 will be one of the "up years" and should exceed 15%, but that is unlikely to endure. SJ

Well, I hope you are right. In the past, what has happened is that profitability has attracted a flood of new capital and that has created pricing pressure. FFH is reasonably disciplined and just lets business go if it cannot be underwritten profitably, but that drives both a volume and a pricing impact on the P/L. We can hope that most of the premium growth will be sticky, but it really varies from sub to sub. Working from memory, both Odyssey and Zenith are examples where net written has dropped in the past due to unfavourable pricing. Your question about the amplitude of earnings across the cycle is a good one. In 2023 we expect to see a strange thing, which is highly profitable underwriting, solid returns on fixed income and probably a positive return from equities. With that, maybe EPS will be $100? Take one or two of those away, and maybe you are looking at $40 at the bottom of the cycle? If you want to use PE as a valuation tool then, you need to normalize your EPS for a cycle rather than accepting that the EPS at the top of the cycle will be your average! A ROE of 15% has been the exception over the past few decades, not the rule. It's much easier to use a multiple of book. SJ