Time to buy Fairfax again?

[RichardGibbons]

This is a hilarious response, because it doesn't address any of the counterexample at all.  It's like "Oops, I was just proved wrong.  Umm, let's wave my hands, talk about option pricing, paying managers money, and hope that people don't notice I was just proven wrong."

 

OK, now I'm going to shut up, because I'm being a bit of a jerk.  It's not nice to call people on these sorts of things.

[ERICOPOLY]

This is a hilarious response, because it doesn't address any of the counterexample at all.  It's like "Oops, I was just proved wrong.  Umm, let's wave my hands, talk about option pricing, paying managers money, and hope that people don't notice I was just proven wrong."

 

OK, now I'm going to shut up, because I'm being a bit of a jerk.  It's not nice to call people on these sorts of things.

 

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.

 

 

[ERICOPOLY]

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.

[Rabbitisrich]

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?

 

 

The conversation has been difficult to follow, but you previously seemed to argue that you would only value a company based on its current asset values. I and others responded that you can never be neutral with respect to management quality, and that a current market valuation holds under certain management behaviors, while under or overvaluing others. That's why I mentioned liquidation, which is a scenario in which it makes sense to "ignore" management. Except that you aren't ignoring anything; you are just assuming a behavior in which your sum of the parts analysis is valid. The same analysis would be hugely optimistic if the CEO were the dumbest, yet most ambitious, man in the world.

 

But now your argument seems more specific; that you don't think FFH warrants a premium. That's very different from the more extreme claim that you are literally paying for the assets of company despite being an outside passive minority investor.

[innerscorecard]

Eric, thanks for being so patient and writing your thought processes out. I learned a lot from your responses to this thread, and I really appreciate your effort (quite an effort, as this thread was in fact quite exhausting for the reasons you stated).

[ERICOPOLY]

The conversation has been difficult to follow, but you previously seemed to argue that you would only value a company based on its current asset values.

 

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.

 

 

[giofranchi]

That’s all I am doing. Where is the double counting?

 

Gio

 

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).

 

Eric,

I told you the exact math I use. I am not putting any multiple on top of any number. I am just trying to understand what shareholders truly own today. How that could reasonably grow in the future. Then, discount it back to the present. It is only math, so if wrong it should be mathematically proven incorrect. Not philosophically... Your philosophical response doesn’t help me in the least.

 

PW every quarter reports to shareholders BVPS, not BVPS less goodwill and intangibles. Therefore, he feels it is BVPS that we own as shareholders. And I believe him.

 

I call it BVPS0.

 

Then, I make an assumption for a rate of compounded growth of what we own today. To make no assumption for the future, obviously, is not possible, if you want to understand what IV really is. I think 15% is achievable, because it entails a return from their portfolio of investments of about 6%-7% annual. You might say that is no small feat, but it is way below their average of 9% until now.

 

But you can choose whatever compounded growth you think is most reasonable to expect.

 

This way I calculate BVPS30.

 

Finally, I discount BVPS30 back to the present.

 

As my example of Zenith proves, I don’t see where I am mathematically double counting. But, if I am actually double counting, I hope you can show me… mathematically!

 

Btw, in year 1:

BV = $8,194.1 million

Portfolio of investments = $25,461.6

6% of portfolio of investment = $1,527.7, which is 18.64% of BV…

 

A return of 4.83% on their portfolio of investments is actually enough to increase BV by 15% in year 1.

 

Gio

 

 

[giofranchi]

So I then further argued that private party arms-length transaction price is about the top you can expect from Mr. Market.

 

Of course! How could it be different?! Other insurance companies cannot even dream of compounding BV at 15% for many years to come! How could the market allow them an higher multiple?!

 

Listen, it is very easy: either you are right about FFH future, or you are wrong. Period.

 

If I am right, FFH today is very cheap. If I am wrong, FFH today is priced like Mr. Market prices any other insurance company. Great upside if I am right. Small downside if I am wrong.

 

Gio

 

[ERICOPOLY]

As my example of Zenith proves, I don’t see where I am mathematically double counting. But, if I am actually double counting, I hope you can show me… mathematically!

 

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.

 

[giofranchi]

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. 

 

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?

 

It is said that an institution is often the lengthen shadow of a single man.

…

At Blue Chip we are in part engaged in the business of trying to invest in the lengthened shadow of the right sort of people.

--Charles Munger

 

It is always both: good people and good business. One without the other is the only true optical illusion! ;)

 

Gio

 

[giofranchi]

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.

 

I don't think so.

 

If I am right about FFH future compounded growth, it doesn't matter if it is 1.15 or 1.30... It doesn't matter at all! It will be a very satisfactory investment anyway. As I have said I was not putting any multiple on top of anything.

 

On the other hand, if I am wrong, 1.15 or 1.30 won't matter either. It won't be a very satisfactory investment anyway.

 

Gio

[giofranchi]

Great presentation that I think might fit very well within this thread! :)

 

https://gallery.mailchimp.com/443e8872e35ccdde12b72e8cd/files/BAM_YPO_Presentation_Sep_14_.pdf

 

Gio

[giofranchi]

Either I am right that we as shareholders own BV, or you are right that we as shareholders own BV less goodwill and intangibles, I guess we might agree on the following:

 

Today, anyone can pay $448.5 and get $1,200 in investments supervised by someone of the caliber of Watsa and Bradstreet.

Investments that will probably grow thanks to the increasing float generated by an insurance global conglomerate whose operations are supervised by someone of the caliber of Barnard.

 

Gio

 

[giofranchi]

Or let’s look at it another way:

 

Supposing these two ratios don’t change in the future, Investments / BV and Investments / BV less goodwill and intangibles, an annual return from investments of 4.83% (or whatever it is, taking interests and taxes into consideration, but hopefully also some underwriting profitability) will be required to compound BV at 15% annual, while a return of 4% will be required to compound BV less goodwill and intangibles at 15% annual. If at the end of the 25-30 years period Mr. Market still values FFH 1.15 x BV or 1.3 x BV less goodwill and intangibles, shareholders return will obviously be 15% compounded annually.

 

Therefore, the only interest we might have in those two multiples, 1,15 x and 1.3 x, is to answer the question: how likely is it that Mr. Market might grant those same multiples to FFH in the future? In other words, is there a risk of multiple contraction, or not?

 

Imo not only there is no risk of multiple contraction, but there is also the possibility of multiple expansion! Because, if FFH truly achieves those annual returns on its portfolio of investments for such a long time, it will be most probably regarded by the market like BRK is today.

 

Gio

 

[giofranchi]

You might say this doesn’t mean anything and the repurchase of Subordinate Voting Shares is very limited indeed… Yet, it strikes me as an odd circumstance FFH declares the intention to repurchase some of its shares just 2 days after I asked if it were a good idea to buy FFH again… ;)

 

Gio

PRFFH-Sept-23-2014-Normal-Course-Issuer-Bid.pdf

[A_Hamilton]

You might say this doesn’t mean anything and the repurchase of Subordinate Voting Shares is very limited indeed… Yet, it strikes me as an odd circumstance FFH declares the intention to repurchase some of its shares just 2 days after I asked if it were a good idea to buy FFH again… ;)

 

Gio

 

They refile this every year.

[giofranchi]

They refile this every year.

 

Well, but they have to approve it each time, don't they? Or is it utterly automatic? If so... ok, just a coincidence!! ;D

 

Gio

[ERICOPOLY]

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. 

 

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?

 

It is said that an institution is often the lengthen shadow of a single man.

…

At Blue Chip we are in part engaged in the business of trying to invest in the lengthened shadow of the right sort of people.

--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.

 

[giofranchi]

Yet you compare Fairfax to BAC. 

 

No, I do not compare Fairfax to BAC. I only say that in any investment I always look for good people, a good business, and a good price.

If you are fine with BAC being led by a mediocre team, well then ok! Maybe the price is wonderful enough to justify that…

I am more comfortable with a good price and a good management, rather than a wonderful price and a mediocre management.

 

Gio

 

[premfan]

No opinion on this topic. I would suggest to learn from eric. His track record is out of this world.

[merkhet]

I think you can break things down in the following way:

 

Good management is always the best bet for both (A) good companies and (B) bad companies.

 

Mediocre management is probably okay for (A) good companies and terrible for (B) bad companies.

 

Terrible management is bad for both (A) good companies and (B) bad companies.

 

For instance, Coke is a pretty damn good company, but if the CEO started buying a King Digital a month, well, it wouldn't stay a good company for long... Ken Lewis falls under "terrible management."

[merkhet]

Yet you compare Fairfax to BAC. 

 

No, I do not compare Fairfax to BAC. I only say that in any investment I always look for good people, a good business, and a good price.

If you are fine with BAC being led by a mediocre team, well then ok! Maybe the price is wonderful enough to justify that…

I am more comfortable with a good price and a good management, rather than a wonderful price and a mediocre management.

 

Gio

 

I believe what Eric is saying is that insurance is a pretty bad business most of the time. And Buffett has a saying about what happens when good management tackles bad business.

 

It's a rarity that good management can turn a bad business good. Berkshire is one such gem w/ its insurance operations. It's currently unclear whether Fairfax can be the same.

[giofranchi]

I would suggest to learn from eric. His track record is out of this world.

 

I would suggest never to chase track records out of this world. Save as much as you can, and invest with good people, in good businesses, at good prices.

 

Gio

 

[giofranchi]

And Buffett has a saying about what happens when good management tackles bad business.

 

But he also has repeated many times how results of the insurance business in particular depend on good management! Hasn't he?

 

Gio

[ERICOPOLY]

I think you can break things down in the following way:

 

Good management is always the best bet for both (A) good companies and (B) bad companies.

 

Mediocre management is probably okay for (A) good companies and terrible for (B) bad companies.

 

Terrible management is bad for both (A) good companies and (B) bad companies.

 

For instance, Coke is a pretty damn good company, but if the CEO started buying a King Digital a month, well, it wouldn't stay a good company for long... Ken Lewis falls under "terrible management."

 

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.