ERICOPOLY

Please don't misrepresent my position. I haven't. I said that if they are indeed value investors, and if they indeed have a portfolio of stocks and bonds that is marked-to-market below intrinsic value.... then it must be the case that FFH itself should not be trading at intrinsic value. You disagreed, saying that we must DCF those future capital gains -- therefore, the only way for that to be the case is if the market puts the "magic hat" premium on FFH such that the current market price reflects the intrinsic value of the stocks and bonds that they currently hold. It's okay though if you don't even realize the implications of what you said, but it's not a misrepresentation. Sorry, where did I say that I think they're going to have six-sigma returns? You alluded (in a hypothetical) to paying a DCF for expectations of six-sigma returns. You stated that if you believed that they were going to make 1,000% per year then it would be appropriate to value their expected six-sigma returns using DCF. Is it an exaggeration to mark 1,000% a year as "six sigma"? Is it only two sigma? How many sigmas is 1,000% a year? It was in an example you provided. I was still referring to the Fairfax of your example. You said it would be appropriate to discount the future cash flows if you expected them to make 1,000% a year.

Please don't misrepresent my position. I haven't. I said that if they are indeed value investors, and if they indeed have a portfolio of stocks and bonds that is marked-to-market below intrinsic value.... then it must be the case that FFH itself should not be trading at intrinsic value. You disagreed, saying that we must DCF those future capital gains -- therefore, the only way for that to be the case is if the market puts the "magic hat" premium on FFH such that the current market price reflects the intrinsic value of the stocks and bonds that they currently hold. It's okay though if you don't even realize the implications of what you said, but it's not a misrepresentation.

"We don't formally have discount rates. Every time we start talking about this, Charlie reminds me that I've never prepared a spreadsheet, but I do in my mind. We just try to buy things that we'll earn more from than a government bond - the question is, how much higher?" -WEB I believe him when he says he doesn't write them out. Can he do them mentally? 1) We're talking about a man who can calculate compound annual return figures in his head; I think the mental math ability is there. 2) I am not suggesting the DCF is done with precision. He's noted before that others would be surprised at just how imprecise he is. The more I do these DCF calculations in Excel the more mental shortcuts I find. With enough practice I don't think doing these without Excel is so far fetched. Example... It's 2011 and he is sitting in his bathtub thinking about how even with a middle-of-the-road management team BAC will earn a consistent 13% ROTCE in a few years. He only has to multiply 0.13 times $14 and he's got $1.82 in earnings. That's a 26% yield on $7 price tag. Does he need a spreadsheet? No, this is basic math stuff that can be approximated in your head even if you can't calculate $1.82 precisely. He knows that there might be no yield for 3 years (going to cleaning up the mess), so he knows that $1.82 is still a fine yield on $9.50 stock (approximating a 10% return for the first few years before earning the yield on top of that). It takes more effort to dig up Moynihan's phone number.

These fuel cells look interesting: http://www.redoxpowersystems.com/ They claim that they will cost about $1K/kW, so these 25kW models that are coming out soon should be about $25K. I wonder how cheap they are to run and how long they will last. Certainly a lot quieter than a generator. Not the right device for me. I never have anything close to a 25kW load. I need a 20 kWh battery pack on my garage wall that is charged by the grid at night between midnight and 6am for 9 cents per kWh, and depleted during the day when it would be offsetting 49 cents per kWh (between 10am and 6pm), and 31 cents per kWh the rest of the hours. This would save me roughly $5,000 annually on my utility bill. The battery would very quickly be paid off (less than 2 years), leaving me with a tax-free imputed income stream for the remaining life of the battery (probably another decade).

Exactly! We have spent two days on something we simply disagree… People disagree on a whole range of topics every day… Without necessarily making all this fuss… Right?! ;) Gio BTW, I don't disagree with your 6%-7% returns for them. That's not what I'm disagreeing about. I only stated that to value the company, you need to value it based on investment returns that are more average (because people shouldn't pay a magic hat premium). Based on the "average" return expectations for HWIC (market-matching returns), FFH seems merely fairly priced.

I am not talking about repricing FFH!!! How can I explain this??? I am only talking about what I think they could achieve during the next 2-3 decades. You don't believe the could? Fine! We simply disagree. Gio Gio, I don't disagree that HWIC is the secret sauce. I just disagree when somebody complains about the low PB multiple, because I think it's actually a fair arms-length price for Fairfax for the reasons I listed.

Eric, if I had said that, I would have predicted an expansion in the multiple FFH will be priced tomorrow. Have I said that? No! Yeah, sorry. Richard said it. Richard believes the appropriate valuation is to DCF their future six-sigma returns. Perils of multitasking with you guys. I apologize if I misrepresented your position for Richard's.

Eric, if I had said that, I would have predicted an expansion in the multiple FFH will be priced tomorrow. Have I said that? No! Only thing I have said is: if at the end of the 25-30 years period PW is working for he turns out to be very successful, then and only then the market might reward FFH with an higher multiple. What’s wrong with that? Gio Everybody knows that if they earn 7% on their investment portfolio the returns will be terrific. However, not everyone knows that their returns will be 7%, and so not everyone is as enthusiastic as you. That's basically the crux of it as I see it.

But he also has repeated many times how results of the insurance business in particular depend on good management! Hasn't he? Gio The market is already pricing in Fairfax's good management of it's insurance businesses. It is asking for the same multiple that the owners that sold to Fairfax asked for -- somewhere in the 1.3x range. The market has not discounted the value of those businesses after they came into the Fairfax fold. So there is no "bad manager" discount. The only thing that is missing is the "seer of the stock and bond market future" premium. Well, that's a tall ask.

That's the key thing. You want to be with good managers. Preferably great managers. Avoid terrible ones no matter what. That's not where it ends though. When you are speculating for a higher market multiple, as people here are doing with Fairfax, you need to understand what drives the high multiples at a company like Coca Cola -- and then ask if what HWIC has is of the equivalent nature that would command a similar multiple. Even if HWIC can turn out such great investments as to earn the same ROEs (historically) as Coca Cola, you still need to ask if you could personally sell your Fairfax shares face-to-face with the average investor in the Mr Market crowd on the grounds that the investors at HWIC essentially are so incredibly likely to deliver Madoff-like returns that you can just go ahead and DCF them right now. I mean, you need to tell them that future six-sigma investment outperformance is a slam dunk. Think about how hard that conversation would be, versus describing how the globally recognized brand and distribution at Coca Cola points to future incredibly high ROE. You can't kid yourself Gio -- you simply cannot make the first conversation as convincing to the crowd as the second one. Take that to it's logical conclusion -- people aren't going to pay "intrinsic value" for Fairfax when that value depends on them being six-sigma "seers" of the stock and bond markets. It's a ludicrous expectation to hold for Mr. Market.

Ah! Here it comes! I guess BAC instead isn’t supposed to depend on management, right? Even after what Mr. Lewis has been able to do with just a couple of very stupid decisions some years ago, right? --Charles Munger It is always both: good people and good business. One without the other is the only true optical illusion! ;) Gio There are lots of examples of banks that earn returns at least as good as BofAs. The current management only needs to remain conservative. That was the whole beauty of that investment -- they only needed to be mediocre in order to get us outlandish returns. Yet you compare Fairfax to BAC. How many insurance companies have investment teams that earn returns anywhere near as good as HWIC's? So implicitly, you think HWIC only needs mediocre performance in order to be worth the multiple you want the market to assign them. That was implied by the comparison with BAC, because that was the BAC thesis. And that's also what is implied by my comparison to Coca Cola -- the enduring qualities of the globally recognized consumer brand enable them to earn very high returns on equity even if management is relatively mediocre. Average management is fine -- you don't need a Brian Bradstreet running the show at Coca Cola. Fairfax's secret sauce at HWIC is entirely dependent on the employee superstars. You take them away, and suddenly you are trying to sell the magic hat but you don't have any seers left.

The double counting comment was targeted at your continually claiming that 1.15x book was too low... that you needed a bigger premium. Yet the bigger premium is already there -- it's really 1.35x. So to biggie size the premium (ignoring that it's already biggie-sized) is double counting. Thus, my recommendation to strip out the goodwill and so you can clearly see the size of the premium. It does nobody any good to continually tell the board that 1.15x is too little without clarifying that it's not really 1.15x... it's actually roughly 20% more than that. And you weren't being "mathematical" in your exclamations about 1.15x... it was more emotional based on the diminutive size of the number. Thus my comment about the optical illusion going on due to the size of the goodwill.

Okay, so to cut through the confusion. Here's the Cliff's Notes version: 1) I have steadily argued that the marked-to-market assets in their securities and bonds portfolio should be valued at market. Even the accounting standards board people agree with me here 2) I have steadily argued that their insurance float has value and should be assigned a premium accordingly. It has value because they can invest it for returns, it can be grown, and it can be associated with an underwriting profit. I then stated that the market currenly prices FFH for 1.3x tangible asset value, which is basically the same premium that FFH has been snapping up quality insurers for. In other words, that seems to be the going rate for a private party transaction. So I then further argued that private party arms-length transaction price is about the top you can expect from Mr. Market. So I feel like FFH is basically trading for what it's component parts (operating insurance companies) were purchased for... based on recent valuations of the quality insurers that Fairfax themselves have purchased (not talking here about the broken crappy ones they bought in the distant past). Then there is this other side-argument going on where Richard believes that Mr. Market should know as a fact that Fairfax's investors are going to crush the market in the future and should therefore be assigning a DCF based premium on that. That's a side show.

It all boils down to the following dilemma... Why is it that Mr. Market just doesn't know that HWIC's investors will crush the market in the future? I mean seriously... try to find a guy on the street and tell him that there are these people you know about who have the secret sauce to beat the market and that you can sell them your shares today for the discounted value of all those future gains -- but act now, while supplies last! I guarantee some eyebrows will be raised. You'd sound like a con man selling snake oil. It's very different from explaining how a recognizable consumer brand like Coca Cola will ensure that terrific returns on equity will continue far out into the future. The latter is far easier to swallow and Coca Cola's enduring advantages trade at a significant premium and have done so very consistently. Just imagine yourself delivering the first sales pitch versus the second one. Try it out on an EMT professor. I believe the ease at which those two sales pitches roll off the tongue... is responsible for the unreliability of the Fairfax HWIC premium, versus the reliability of the Coca Coca enduring advantages premium.

Richard, I responded that I hire managers that I respect and where I trust their process. Your example was of a company where that was not the case. In your little world, if I would pay 1% performance fee for a manager, then I would pay ANY manager 1%. Not so. I don't hire managers that put it all on short-term SPY options and you know that. No, I don't think you're a jerk... that's not what I had in mind as a label for you.

You invest with a manager that you trust and you like his process. You pay him for managing the money. Perhaps you pay a fee as percentage of assets. Perhaps you pay a salary. Perhaps you pay him a percentage of gains as they come in after a hurdle rate is met. Richard pays them upfront for the future gains, discounted to the present. He even knows how to discount this properly because he knows their future gains. Maybe Richard has the magic hat too! We all have our favorite ways of paying people. I have mine, he has his.

Put them on Fairfax's balance sheet and suddenly you are overbidding what Black Scholes dictates. Because of the magic hat, Black Scholes is wrong and you confidently bid it higher. A good example (on topic of derivatives) is the deflation hedges. They were purchased out of the money. You are overbidding the market because they have the magic hat.

I mean... paying a discounted present value for the future excessive gains that are to be reaped from HWIC's abilities to see a future that nobody else sees. That truly is seer-stone stuff (in the eyes of most people). Are you really surprised that the market isn't going to value the magic hat for a premium?

The metric isn't about beating the market. It's about beating your longevity. Don't run out of money before you die. That's the bogey.

It's the way of determining what economic goodwill the market is currently assigning to FFH. Current market cap is a reflection of that economic goodwill. Has nothing to do with liquidation value -- I have no interest in valuing a company on it's liquidation value.

You are dead right. Just toss out the accounting goodwill. Recreate the "true" goodwill by looking at the size of the float, the anticipated rate of increase of the float, and the underwriting profit. That's all worth a premium for sure and it's economic goodwill. The accounting goodwill is just a subset of the economic goodwill. Nothing gets missed by tossing out the accounting goodwill -- it all gets recaptured when looking at economic goodwill.

The double counting is when you are fixated at the low P/B... yet the "low" P/B isn't that low at all. So by looking at something that makes the premium invisible, your mind is being tricked by an optical illusion. You are then trying to put a premium on something that has already had a premium put on it... without regard for measuring the premium that is already there (that's the double counting).

Fairfax is one of those stocks that makes me think of the Buffett comment about making sure you are buying a business that even an idiot could run. My point in saying that is the HWIC portion is clearly not of the "idiot proof" type. It does not have lasting "special" value beyond the current management. So it is not to be valued accordingly. In other words, not at it's intrinsic value. The "magic hat" is not where the value is, the value is in the seer. You can't purchase a person, but you can pay them for their services. Pay for the seer, not the magic hat. The seer is not a perpetuity. Think of the employees of a company -- any company. They are paid for their labor, and hopefully paid fairly. They are not purchased at a capitalized DCF premium to the expected value of all their future labor.

That's exactly right. Double counting.

;D ;D Gio The Dhandho pay model is better. He gets paid for performance. This idea of yours to pay HWIC via a huge premium is broken -- because when you pay a premium for the stock, it doesn't go into HWIC's pocket. You are paying the wrong people. Good management should be paid. Mohnish isn't getting paid simply because he has a magic hat with a "seer stone" in it. Sure he has one, but he'll be paid for the results it produces. So he will be paid directly in line with the value he adds.