Fairfax nears deal to buy Allied World for $4.9B

[Viking]

From one of the quotes above, it looks like Fairfax is in the process of doing a complete 180 in terms of positioning of the investment portfolio. My guess is what remaining equity hedges they had may have been sold and it would not surprise me to see them scale back they deflation hedge.

 

Fairfax has underperformed the past 5 years primarily because their hedging has not worked out and this has led to poor returns in their investments. The good news is they are performing well with underwriting. If they can once again start generating decent investment returns then earnings have lots of upside.

 

What they do with the investment portfolio of Allied will be key. Prem has lost credibility the past 5 or 6 years due to decisions made in the investment portfolio. Can they get their investing mojo back?

[StubbleJumper]

I like how the deal is structured in a way that lets FFH pay cash if they discover that they've bought a plum or pay in shares if they discover that they've bought a lemon.  Prem's a pretty slick operator.

 

SJ

 

It doesn't make much difference how you pay for it - if you've overpaid, you've overpaid, whether you decide to use cash or your own shares to finance the purchase.

 

The flexibility that I like is that it gives Watsa the opportunity to use FFH shares if their value rebounds a bit, or if raising more cash suddenly becomes more difficult, or he can use cash if FFH shares stay at low prices or if he has no worries about Fairfax's balance sheet.

 

dm

 

 

No, actually it does matter how you pay for it.  If you think your shares are fully valued or overvalued, existing shareholders are clearly better off to pay using shares (it's the same thing as issuing new shares when the price is high...if intrinsic value is $100/sh and I issue additional shares at $500/sh, then existing shareholders are better off).

 

If over the next 75 days FFH discovers that it has bought a turd which will impair its share value, then the share exchange price of ~Cdn$614 will likely be higher than intrinsic value and the share exchange is better for existing shareholders.  On the other hand, if it is discovered over the next 75 days that Allied is a plum, then pro-forma intrinsic value might well be higher than Cdn$614, meaning that a cash purchase would be better for existing shareholders.

 

The cash purchase is probably better from an intrinsic value perspective, but it is largely a question of whether financing can be obtained and whether the increased financial risk (ie, debt to asset ratio) results in an adverse response from the ratings agency.  And it does call into question how they would manage their debt repayment schedule such that they do not have a couple of large slugs of debt maturing in particular years (there is already a large slug of debt maturing in 2021, it wouldn't be helpful to have another billion or so maturing in, say, 2023).

 

 

SJ

[rb]

What they do with the investment portfolio of Allied will be key. Prem has lost credibility the past 5 or 6 years due to decisions made in the investment portfolio. Can they get their investing mojo back?

I don't know. This doesn't really seem like value investing. Make an acquisition at a price that like Ben Hacker said doesn't seem great. Talk about reason to change strategy and for the acquisition is an election in the US. This just feels like more top down macro stuff as opposed to bottom up analysis/buy at a discount/margin of safety value investing.

[maxthetrade]

Here are a couple of interesting quotes from Prem regarding the rational for the purchase:

 

“The recent election . . . has a strong potential to make the business climate for growth great again,” he said. “We believe the US may see significant growth in GDP and our business in the US will benefit from any such positive development.”

 

Mr Watsa suggested that there could be more US deals in the future: “When the biggest economy in the world is on the way up we think the downside is significantly reduced and it becomes a value-oriented, stockpickers’ market. In the last few years we’ve played defence. We expect to play offence.”

 

https://www.ft.com/content/da6d1b3a-c5f5-11e6-9043-7e34c07b46ef?ftcamp=traffic/partner/feed_headline/us_yahoo/auddev&yptr=yahoo

 

He sounds like a cartain manic depressive fellow I want to sell some shares to... really strange.

 

[TwoCitiesCapital]

Here are a couple of interesting quotes from Prem regarding the rational for the purchase:

 

“The recent election . . . has a strong potential to make the business climate for growth great again,” he said. “We believe the US may see significant growth in GDP and our business in the US will benefit from any such positive development.”

 

Mr Watsa suggested that there could be more US deals in the future: “When the biggest economy in the world is on the way up we think the downside is significantly reduced and it becomes a value-oriented, stockpickers’ market. In the last few years we’ve played defence. We expect to play offence.”

 

https://www.ft.com/content/da6d1b3a-c5f5-11e6-9043-7e34c07b46ef?ftcamp=traffic/partner/feed_headline/us_yahoo/auddev&yptr=yahoo

 

He sounds like a cartain manic depressive fellow I want to sell some shares to... really strange.

 

Yea - This is getting bizarre. I don't have any issues with the acquisition in and of itself, but the 180 degree turn on the U.S. markets as the result of the election with no commentary on rising rates, falling liquidity, strengthening dollar, declining corproate profits, levered corporations, and valuations that appear excessive certainly seems strange.

 

 

[Viking]

Prem has had a close long term relationship with Wilbur Ross; given his role in the new Trump administration I wonder if this is providing Prem with a little more conviction regarding what will likely be happening in the US in the next couple of years.

 

A couple of comments from  the conference call held earlier today:

1.) perception that Prem underpaid; will be interesting to see if another competitor enters with a competing bid

2.) likely Fairfax gets significant cash infusions from outside investors to cover a majority of the shares required (similar to Brit transaction); this would allow the cash part of the offer to increase significantly

 

[John Hjorth]

FFH will be going head to head against BHSI. Jain/Eavis have big ambition. We'll see who's got legs.

 

Duly noted, longinvestor. Certainly worth some consideration, as both a BRK and FFH investor.

[Txvestor]

Here are a couple of interesting quotes from Prem regarding the rational for the purchase:

 

“The recent election . . . has a strong potential to make the business climate for growth great again,” he said. “We believe the US may see significant growth in GDP and our business in the US will benefit from any such positive development.”

 

Mr Watsa suggested that there could be more US deals in the future: “When the biggest economy in the world is on the way up we think the downside is significantly reduced and it becomes a value-oriented, stockpickers’ market. In the last few years we’ve played defence. We expect to play offence.”

 

https://www.ft.com/content/da6d1b3a-c5f5-11e6-9043-7e34c07b46ef?ftcamp=traffic/partner/feed_headline/us_yahoo/auddev&yptr=yahoo

 

 

The risk of course being that they played defense(when they should've been playing offense) and will now play offense when they should be playing defense!

The first part of this is now undeniable. The money in the hedges, the deflation swaps etc was all lost. Their long investments have significantly under performed with even a few bankruptcies e.g. Sandridge energy and many others RFP, BBRY, Eurobank, XCO significantly under water. Prem's comment about the deflation swaps like as if they are a foot note now, says all you need to know that he has thrown in the towel on that trade.

 

A major geopolitical even handled badly by Trump next year could make everything slide in reverse in the still fragile, highly leveraged  environment.

[Viking]

Tx, I agree with everything you have said. Trump seems to want to pick a fight with China and I am not sure how this ends well. I am happy that FFH is moving on from an investing standpoint. IF inflation is indeed picking up and the US economy continues to improve then FFH will benefit.

[giofranchi]

It is undeniably true that lots of things have changed. And I am considering what to do with my FFH shares.

I would like to know where people see the most downside risk today:

1) Valuation: I don't think so, FFH shares are not expensive.

2) Balance Sheet risk: lots of cash, manageable debt, I don't see a great cause for concern here.

3) Investment performance: it seems to me that a lot of pessimism is already priced in.

4) Uncertanty regarding this new acquisition: Allied has an average 90.5% CR since inception (15 years), and an average ROE of 12.4%. 1.3x BVPS doesn't look too expensive a price for a company with such a good and long track record. Am I wrong?

5) Has Watsa lost his mind? Is this where the most downside risk lies? Do people think Watsa will lose the trust of FFH employees and as a consequence of FFH shareholders?

6) Other reasons? Would you elaborate?

 

Cheers,

 

Gio

[Spekulatius]

Well guys, have to say, kind of seems real strange to me.

 

Fairfax is on a rollup spree in insurance... but unlike a rollup they aren't doing anything strategic to get synergies.  They are running a decentralized rollup and paying prices that don't seem great, and funding from sources where they also don't have a cost advantage (debt or equity).

 

I think there are few charitable explanations of their recent actions, but there are a few bad explanations.

 

Hate to reign on the parade, but doesn't seem right to me. 

 

I'm out of my position here.  Will revisit and decide whether to re-enter.  Been an interesting >10 year hold for me... but I think the thesis has changed too much, and the negatives have accumulated too much for me to continue to hold.

 

Cheers,

 

I understand your rationale and I agree that this deal makes Fairfax a more difficult stock to hold. I just recently entered a position on the price weakness and intend to hold a bit. I also think the recent price weakness in Fairfax shares was due to Mr Market "knowing" something about this deal coming. This is a pretty large acquisition, meaning that a lot of investment bankers must have known about this, plus there was a debt offering that made no sense unless there was an acquisition being planned.

[gary17]

It is undeniably true that lots of things have changed. And I am considering what to do with my FFH shares.

I would like to know where people see the most downside risk today:

1) Valuation: I don't think so, FFH shares are not expensive.

2) Balance Sheet risk: lots of cash, manageable debt, I don't see a great cause for concern here.

3) Investment performance: it seems to me that a lot of pessimism is already priced in.

4) Uncertanty regarding this new acquisition: Allied has an average 90.5% CR since inception (15 years), and an average ROE of 12.4%. 1.3x BVPS doesn't look too expensive a price for a company with such a good and long track record. Am I wrong?

5) Has Watsa lost his mind? Is this where the most downside risk lies? Do people think Watsa will lose the trust of FFH employees and as a consequence of FFH shareholders?

6) Other reasons? Would you elaborate?

 

Cheers,

 

Gio

 

Gio

i think a company that has not much down side risk but at the same time not shown significant ability to grow is in itself at risk of under performing the market-- i think some call this a value trap

 

amazon is expensive but look at how much it has grown.  same with facebook.

[Uccmal]

Well guys, have to say, kind of seems real strange to me.

 

Fairfax is on a rollup spree in insurance... but unlike a rollup they aren't doing anything strategic to get synergies.  They are running a decentralized rollup and paying prices that don't seem great, and funding from sources where they also don't have a cost advantage (debt or equity).

 

I think there are few charitable explanations of their recent actions, but there are a few bad explanations.

 

Hate to reign on the parade, but doesn't seem right to me. 

 

I'm out of my position here.  Will revisit and decide whether to re-enter.  Been an interesting >10 year hold for me... but I think the thesis has changed too much, and the negatives have accumulated too much for me to continue to hold.

 

Cheers,

 

Interesting Ben.  I came to this conclusion a while ago as you know. 

 

I dont understand why more insurance?  To get more float?  Why not just invest the float in really good companies, and increase it through cash flow? 

 

Prems economic comments scare me.  Is he just trying to justify selling off the hedges?

 

I dont believe it, for one second.  US markets, and the world at large have gone this long without a bear market, precisely once, before.  When Trump takes over and the markets realize he cant deliver on his promises, and that his economic advisors are incapable of operating in government this is going to get really bad. 

 

It scares me when everyone thinks sunny days are here again. 

 

And Prems economic comments just scare me more.

[Shane]

I struggle with nearly any deal which increases the share count, particularly when it is (potentially) done almost entirely with shares that aren't clearly overvalued.  It is also frustrating to read that so many decisions appear to be based on macro viewpoints which are notoriously difficult to get right.  I usually try to take the viewpoint of a 5+ years holding period while trying to not to second guess investment decisions from 'jockey stocks', but It has been hard to do this with Fairfax. 

 

I added to my position prior to this announcement viewing this as a company which had done a great job improving the underwriting and investment returns are likely to improve with the reduction in hedging.  Only time will tell.

[giofranchi]

Gio

i think a company that has not much down side risk but at the same time not shown significant ability to grow is in itself at risk of under performing the market-- i think some call this a value trap

 

amazon is expensive but look at how much it has grown.  same with facebook.

 

Gary,

downside risk is important imo, because in this market I don’t see many good bargains as FFH is right now. If downside risk is somewhat mitigated from the current share price level, I can keep my shares until some good bargain comes along. Then I might decide to sell some FFH shares and invest the proceeds elsewhere.

Not so if there are good reasons why FFH’s multiple should compress further, or FFH should start posting unexpected losses.

Therefore I would like to know if someone sees threats that might have escaped me.

 

Cheers,

 

Gio

 

[gary17]

Gio

i think a company that has not much down side risk but at the same time not shown significant ability to grow is in itself at risk of under performing the market-- i think some call this a value trap

 

amazon is expensive but look at how much it has grown.  same with facebook.

 

Gary,

downside risk is important imo, because in this market I don’t see many good bargains as FFH is right now. If downside risk is somewhat mitigated from the current share price level, I can keep my shares until some good bargain comes along. Then I might decide to sell some FFH shares and invest the proceeds elsewhere.

Not so if there are good reasons why FFH’s multiple should compress further, or FFH should start posting unexpected losses.

Therefore I would like to know if someone sees threats that might have escaped me.

 

Cheers,

 

Gio

 

i tend to not think i'm buying a stock but rather buying a business.  the best defence is offence.  so a business that can grow for a sustained period of time should prove to be a better investment over the long term.  just my view

[benhacker]

I understand your rationale and I agree that this deal makes Fairfax a more difficult stock to hold. I just recently entered a position on the price weakness and intend to hold a bit. I also think the recent price weakness in Fairfax shares was due to Mr Market "knowing" something about this deal coming. This is a pretty large acquisition, meaning that a lot of investment bankers must have known about this, plus there was a debt offering that made no sense unless there was an acquisition being planned.

 

Oh, i think it's far from expensive, so you will likely be rewarded.  You now have a lot of investments working for you sans hedge.  So far in Q4, mostly that hasn't helped a ton, but I like the heavy international focus.

 

Don't take my selling as that I'm now shorting.  I just think the thesis has changed.  Need some time away to see if and how much I want to own.

[chrispy]

I have been appreciating everyone's thoughts and have two questions probably due to my lack of experience:

 

1) Isn't increasing the amount of insurnace that can be written in the future at ratio~0.9 a substantial tailwind to the potential for investments moving forward? If equities are well priced right now and interest rates are rising, more insurance is a good place to be putting one's cash, right?  It sounds like many respected insurers like Markel were interested in this company recently but at a cheaper price. Even Gayner will say that if you want to continue working with a company and have their respect, you cant beat the snot out of them on a low ball price everytime. 

 

2) I also have trouble digesting Prem's public reasoning for this drastic change at FFH and it is a concern that he may be buying high right now by removing the hedges...  I hope he will say something in the annual letter about this ...  But, doesnt Prem have good reason to hold his cards close to him and not publicly state what his team thinks and what they are planning on doing right now?  After re-thinking about my own question, maybe I am just trying to justify his lack of willingness to admit to his own mistakes and should re-think my position..

 

I am interested what you guys think regarding these questions as all of these developments are new and of great interest to me.

 

[giofranchi]

i tend to not think i'm buying a stock but rather buying a business.  the best defence is offence.  so a business that can grow for a sustained period of time should prove to be a better investment over the long term.  just my view

 

Of course I agree, Gary!

Just look at my portfolio: they are all businesses and/or industries which have grown a lot in the past and which imo still have much room to grow in the future.

The fact is also FFH could grow! If only Prem & Company would make the right decisions...

And this I am interested in talking about: which decisions are they making NOW (not 6 years ago... we all know the bad decisions they made 6 years ago) so bad that could sink the boat even from these already depressed levels?

 

Cheers,

 

Gio

[Luckyone77]

It appears that Ray Dalio has the same opinion as PW about future US economic prospects. I share their sentiment that things have changed 180 degrees. Doesn't mean there won't be bumps on the road but, FWIW, I haven't seen this many people this hopeful and optimistic in a very long time.

 

https://finance.yahoo.com/news/dalio-trump-could-ignite-animal-spirits-and-it-could-be-huge-for-markets-104253070.html

 

 

More detailed comments:

 

https://www.linkedin.com/pulse/reflections-trump-presidency-one-month-after-election-ray-dalio?trk=prof-post

 

[racemize]

The presentation has pro forma BVPS at $421, but I can't tell if that includes the divs out to Allied World shareholders.  Does anyone know?

 

Also, there isn't a email address for fairfax investor relations?

[giofranchi]

The presentation has pro forma BVPS at $421, but I can't tell if that includes the divs out to Allied World shareholders. 

 

Joel,

if I have understood correctly, Allied shareholders will receive $5 in cash per share as a special dividend from Allied + $5 in cash from FFH. Those $10 per share won't stay inside the combined company and therefore should not be included in its BVPS calculation.

Of course, I might have misunderstood!

 

Cheers,

 

Gio

[Partner24]

Oh my,

 

Prem is still making these macro forecasts? No lesson learned from these huge losses? He's bearish when the market is low and bullish when the market is high?

 

For the first time in 13 years, I will seriously consider reducing or eliminating my position in FFH. I can handle a lot, but this is difficult.

[racemize]

The presentation has pro forma BVPS at $421, but I can't tell if that includes the divs out to Allied World shareholders. 

 

Joel,

if I have understood correctly, Allied shareholders will receive $5 in cash per share as a special dividend from Allied + $5 in cash from FFH. Those $10 per share won't stay inside the combined company and therefore should not be included in its BVPS calculation.

Of course, I might have misunderstood!

 

Cheers,

 

Gio

 

I'm hoping that's the case, but it says proforma as of September of this year (not after combination) and the footnote doesn't mention whether it accounts for the dividends.

[Uccmal]

I have been appreciating everyone's thoughts and have two questions probably due to my lack of experience:

 

1) Isn't increasing the amount of insurnace that can be written in the future at ratio~0.9 a substantial tailwind to the potential for investments moving forward? If equities are well priced right now and interest rates are rising, more insurance is a good place to be putting one's cash, right?  It sounds like many respected insurers like Markel were interested in this company recently but at a cheaper price. Even Gayner will say that if you want to continue working with a company and have their respect, you cant beat the snot out of them on a low ball price everytime. 

 

2) I also have trouble digesting Prem's public reasoning for this drastic change at FFH and it is a concern that he may be buying high right now by removing the hedges...  I hope he will say something in the annual letter about this ...  But, doesnt Prem have good reason to hold his cards close to him and not publicly state what his team thinks and what they are planning on doing right now?  After re-thinking about my own question, maybe I am just trying to justify his lack of willingness to admit to his own mistakes and should re-think my position..

 

I am interested what you guys think regarding these questions as all of these developments are new and of great interest to me.

 

1) It depends.  If the combined ratio is kept below 100%, everything works fine.  In a rising interest rate environment they can invest in bonds that pay more, but we have to consider after tax returns on these bonds and inflation.  We have not had a significant rising interest rate environment since the 1970s, early 80s.  If policy payouts rise more rapidly than interest rates then the combined ratio will turn negative. 

 

There is also the effect of rising interest rates on competition.  Prem himself had a chart where he showed that combined ratios in the industry improved when interest rates where low.  Now, your guess is as good as mine as to what the actual level of rates needs to be at which competition heats up, and combined ratios drop. 

 

And then there is the aspect of a major claims event, which seem to come in waves, and are generally unpredictable.  Granted FFH has worldwide diversity which they didn't have when Katrina and the Twin towers hit.  Buffett has had periods with his insurers when he would rather have not heard the numbers, for years at a stretch. 

 

2) Prem has never admitted his mistakes.  He is an incredibly good salesman.  Had I invested according to FFHs doctrine of the last 6 years I would have had an investment return of zero, or less.  I simply dont believe that we are going to get all the tail winds everyone expects, without a major hitch along the way.  We dont know what the achilles heel is yet but its somewhere. 

 

Markets, and popular sentiment indicate that everyone is 'happy' right now.  The wall of worry is suddenly gone.  There is a con man who will be running the US shortly.  We dont really know how this is going to play out.  I dont get why everyone is suddenly so optimistic right now.  And I have never been a perma bear, in fact, more the other way around.