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Terrific new article on Prem in Reactions magazine!  Cheers!


Prem Watsa: The man who made a killing from the crisis


24 November 2009


After years of fierce criticism, Prem Watsa’s long-term value investing approach has been fully vindicated. His firm Fairfax has made billions from the financial crisis.


Prem Watsa has played the financial crisis beautifully. The chairman and chief executive officer of Canadian financial services firm Fairfax is one of the few people to have made money from the worst economic collapse since the 1930s.


While everyone watched in horror as the value of their investments tumbled, Watsa was racking up the profits. Fairfax has made billions through clever use of hedging and credit default swaps.


The past two years have provided a resounding vindication of Watsa’s approach. Following what Watsa describes as a “biblical seven lean years” between 1998 and 2005 – when Fairfax made no money in aggregate despite hard market conditions for most of that time, and withstood a barrage of reserve increases, restatements and fierce criticism – his firm is now firing on all cylinders.


It had net earnings of $2.8bn after tax between 2006 and 2008, and its book value more than doubled in that time.


Fairfax began life in 1985 with total assets of $30m and common shareholders’ equity of $7.6m. Those figures have increased 1,000-fold in the 24 years since. At the end of the third quarter of this year it had $30bn of assets and $7.5bn of common shareholders equity. Fairfax’s book value has compounded at an annual rate of 25% and its common stock price by 23%.


Having made a killing off the financial crisis, Watsa has been busy in the past year taking back full control of his biggest subsidiaries, and making strategic investments in insurers and reinsurers around the world. While other firms have been licking their wounds, Fairfax has built up considerable momentum.


“Our strategy right through the piece has been to focus on underwriting profit, with good reserving, and manage the float a little better than everybody else,” Watsa told Reactions in an exclusive interview. “That combination has resulted in our return.”


The method sounds simple. Watsa’s triumph has been an unwavering commitment to it. Watsa’s focus on the value of investing the float from insurance companies has drawn comparison with Berkshire Hathaway’s Warren Buffett, and earned him the nickname The Buffett of Canada.


Watsa describes this year’s third quarter as a “key milestone” in Fairfax’s history. It had net earnings for the quarter of $562m, up from $468m in the third quarter of 2008. This pushed net earnings for the first nine months to $777m, down from $1.13bn in the first nine months of 2008.


In addition it brought US reinsurer Odyssey Re fully back under its wing in the third quarter, buying back the 27.4% of the firm it did not own. To do this, it raised $1bn of equity, as well as completing a $250m offering of preferred shares.


Fairfax is now in a very strong financial position, with a cushion of more than $1bn of cash and marketable securities in the holding company, and increased annual dividend capacity.


Crisis management


Not only did Watsa call the impending financial crisis, he nimbly and decisively responded to it. Acting on his fears, Watsa was willing to take an ultra-conservative approach to investing in the years leading up to the financial crisis.


“From 2003 we have expressed concern about the US in terms of residential markets, in terms of its real estate markets and in terms of the mortgage-backed securities – the fact that there were thousands of AAA-rated structured product bonds and there were less than 10 fully-fledged companies that were rated AAA.


It just didn’t make too much sense for us,” says Watsa. Fairfax held about 75% of its investment portfolio in government bonds and cash. To protect against a possible fall in equity prices, Fairfax hedged its stock holdings against the S&P 500.


“We wanted to hedge the fact that stock prices could go down, so in 2004 and 2005 we hedged 25% to 30% of our stock portfolio,” says Watsa. “In 2008 all of the problems became more serious in our minds so we hedged 100% of our common stock portfolio.”


The hedges cost Fairfax $296m between 2004 and 2007. Fairfax also bought $341m of credit default swaps, and sat tight as their value fell to $198m at of the end of the second quarter of 2007.


Watsa said in his annual letter to shareholders in early 2007 that some people had wondered loudly why the firm was bothering with the costly hedges and credit default swaps. He wrote: “We continue to think that this insurance policy may pay dividends – perhaps sooner than you think!”


He was not wrong. The conservative approach paid off handsomely when all hell broke loose in the housing market and eventually triggered the financial crisis. The hedges protected Fairfax from tumbling stock prices and the credit default swaps exploded in value. They were worth $2.1bn by February 2008.


The firm posted earnings of $1.1bn in 2007, and bettered that with earnings of $1.5bn in 2008. Fairfax made investment gains of $2.72bn for the whole of 2008, up from $1.6bn in 2007. In 2008, Fairfax boasted by far the biggest change in book value among property/casualty companies analysed by research firm Dowling & Partners. Its book value was up 23%, with HCC trailing far behind in second with 11%. Most firms saw their book values dive.


“In 2008 our book value per share went up 23% whereas most companies in the industry – with of course AIG being the biggest – lost a ton of capital,” says Watsa. “By not reaching for yield, and protecting ourselves from a stock market downturn that we had identified for many years, we came through the financial crisis very well.”


From bull to bear


Fairfax did not just sit back, however. While others panicked, Watsa shifted quickly to bull mode from bear mode. He set to work, throwing off the shackles of Fairfax’s hedges and scooping up stock and bonds at bargain prices. It opportunistically bought $2.3bn of common stocks, and sold its government bond holdings and moved into municipal bonds.


At the end of the third quarter, $4.7bn of Fairfax’s $10.9bn bond portfolio was in municipal and tax-exempt bonds, up from just $965m a year before. It moved from government bonds with a pre-tax 2.5% yield to muni bonds with 5.75% yield after tax, and with the added security of 85% of them being guaranteed by Berkshire Hathaway. This change has greatly boosted Fairfax’s tax-equivalent yields and after-tax retention of its interest and dividend income.


At the end of the third quarter, Fairfax had about $5.9bn-worth of equities in fair value terms. This is about 25% of Fairfax’s overall portfolio. A lot of this was acquired in the fourth quarter of 2008 and first quarter of this year when the S&P 500 index was between 700 and 900. The index was up to around 1,100 in early November of this year.


“In the last six months, many of the stocks we have bought have gone up 50% or 60% from the bottom and now there is a slug of interest and dividend income in our portfolios that will last us for some time, for the next five or 10 years, because we acquired these bonds at very good yields,” says Watsa.


Fairfax’s interest and dividend income was up 36% in the third quarter compared with the same period in 2008, and the nine-month figure was up 12.5%.


Ending seven lean years


The past three years have proved a triumph for Fairfax. The firm – and Watsa in particular – have received a lot of praise for their handling of the financial crisis.


It was not always thus. Watsa has a less attractive parallel with Buffett than his strategy of making profits by investing the float of insurance companies.


Fairfax enjoyed a fast rise between 1985 and 2000. But then, like Buffett did with Gen Re, Watsa made a number of acquisitions that ran into serious reserving problems.


Fairfax – whose name stands for fair, friendly acquisitions – busily snapped up insurance companies in the 1990s. Two of those, US insurers Crum & Forster and TIG, were snapped up at big discounts in 1998 and 1999. They soon revealed themselves to have hidden woes.


Fairfax had to increase reserves at the two firms by $600m in the third quarter of 2001. This, coupled with losses from the September 11 terrorist attacks, led to Fairfax’s first ever annual loss, of $346m.


That was just the start of the problems. In 2002, most of TIG was placed into run-off, and more reserve increases followed. To raise funds, parts of Odyssey Re were spun off in 2001 and Fairfax bundled four Canadian insurance units together as Northbridge and floated part of that in 2003. In addition, Fairfax listed its shares in the US at the end of 2002.


Grave concerns were raised by observers. Analysts and short sellers accused Fairfax of being greatly under-reserved and some even implied the firm could be a candidate for bankruptcy.


In 2003, rating agency Fitch highlighted worries about Fairfax’s liquidity and drew attention to inter-company reinsurance deals, which it said were hiding the real state of the company.


Around the same time, John Gwynn, a Morgan Keenan equity analyst, claimed that Fairfax’s reserves were $5bn short. After Fairfax reacted with outrage to the claim, the analyst revised the figure to $3bn a few weeks later.


The hits kept coming, with Fairfax lurching from one problem to another.


In September 2005, Fairfax found itself caught up in New York attorney general Eliot Spitzer’s investigation of finite reinsurance, and was placed under investigation.


Fairfax’s problems cumulated in 2005 with a $498m loss and Watsa declaring it the toughest year in Fairfax’s history. Record industry catastrophe losses from hurricanes Katrina, Rita and Wilma pushed its combined ratio for 2005 to 107.6%. To make matters worse, in July 2006 Fairfax announced it was restating its results because of the discovery of various noncash accounting errors. It then restated them for a second time in August that year, after errors were found in the entry of a $1bn contract with Swiss Re that it was commuting.


Part II...

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Part II...


But, since 2005, the smoke has cleared from around the firm. Watsa says the period between 1998 and 2005 was tougher than the firm could have imagined. Underwriting losses wiped out $2.9bn in investment income and $2.4bn in realised gains during that period.


“In those seven lean years we basically didn’t make much money,” he says. “We made two major acquisitions – TIG and Crum & Foster – and we did them in 1998 and 1999 in the throes of the soft market. It took us longer than expected to turn them around. We thought we could turn them around in three years and it took us more like five or six years. But despite what our detractors might have said, we eventually accomplished our goals.”


Watsa says all the firm’s problems of that time are now behind it. He says reserves are strong at Fairfax. He is also is quick to point out that the firm has not lost a single leader from its units in that time.


“I try my best to think of that time period as a character building experience for our team because we are trying to build our company over the next 20 years, over the long term. The whole group has been through these turbulent times together so our thinking is focused on the positives now and how in some ways the experience has made us stronger,” says Watsa.


Some good news came in June this year, when it was revealed that Fairfax had been cleared in a Securities and Exchange Commission investigation of its use of finite reinsurance. This could help it in its fight against its detractors. In 2006, Fairfax hit back at its accusers. It filed a lawsuit against the hedge funds and the Fitch analyst that had attacked it, claiming it had been the victim of a share price manipulation scheme so that short sellers could profit. Fairfax is seeking $5bn in damages. The case is still winding its way through a New Jersey Court.


Taking back control


The turnaround in Fairfax’s fortunes since the hard times of 2005 is symbolised by two deals it has done this year. In February, Fairfax completed the acquisition of the 37% of Northbridge that it did not own for C$686m ($650m). It followed this up with the acquisition of the 27.4% Odyssey stake, which cost $1bn. Fairfax initially offered a price of $60 a share for Odyssey but increased it to $65.


Fairfax now has complete control over its three main insurance subsidiaries: Northbridge, Crum & Forster and Odyssey Re. In 2008, these subsidiaries’ net earned premiums came to $1.01bn, $878m and $2.03bn, respectively.


In the past year, Fairfax also acquired the 33.3% of Advent that it did not already own in a deal that valued the Lloyd’s insurer at around ?94m ($157m), bought all the outstanding shares of Polish reinsurer Polskie Towarzystwo Reasekuracji Spo?ka Akcyjna, and acquired a 15% interest in Alltrust Insurance Company of China for $66m.


Watsa says he was eager to seize back full control of Northbridge and Odyssey Re. But the firm is maintaining a cautious approach to its insurance and reinsurance operations, given the market conditions. Fairfax’s combined ratio for the first nine months of 2009 was 99%, basically break even.


Fairfax’s gross written premiums fell 3.7% in the third quarter and its net premiums fell 6%. Andy Barnard, president and chief executive officer of Odyssey Re, says the firm is not afraid to shrink premiums further.


“Odyssey is a good illustration of Fairfax’s underwriting discipline in the soft market, where we are going to be less aggressive than many other companies. We are prepared to shrink our business,” he told Reactions.


But he adds that the flipside of that strategy is a willingness to expand when the markets harden. “The only way you are in a position to expand like that is when you have kept your powder dry when the market is soft so that you are able to focus on the opportunities rather than [making] corrections and changes because you were too aggressive in the soft market,” says Barnard.


He concedes that it is a tough market, and gives a gloomy forecast for the medium term.


“We see the market today as a fairly competitive place,” he says. “The turn in the market is probably still several years away so we are maintaining a position of caution. We are preparing for several more years of very tight underwriting policy and reduction in our premiums.”


Barnard says being a public company helped forge Odyssey’s identity, after being formed in the late 1990s through combining Fairfax’s acquisitions of Skandia America, Compagnie Transcontinentale de Reassurance and TIG’s reinsurance business. But he says being privatised will help Odyssey maintain its discipline, away from the short-term demands of shareholders.


“We at Odyssey are very happy to come back under the Fairfax umbrella and return to a private company status within the larger Fairfax group. It helps reinforce the message throughout the company that, as long as the market remains soft, we should be prepared to cut premiums and reduce market share. That is what we have been doing and at this point what we expect to be doing throughout 2010,” he says.


A contrary path


Watsa and Barnard’s talk of discipline, focusing on underwriting profits and shrinking premiums when pricing is soft sounds just like that peddled by most other executives in the industry. But they believe Fairfax has a unique approach that sets it apart.


“We have never focused on operating returns in the same way that almost all other public companies do,” says Barnard. “There are many times when we have sacrificed operating earnings in order to have a superior long-term value investing strategy.”


He says this means maintaining large percentages of the firms’ investment portfolios in cash when the investment markets are not offering good opportunities. This enables the companies to put that cash to work when opportunities do arrive.


Watsa quotes figures for a selection of reinsurance companies to back up the claim that a total return approach is best. He says between 2002 and 2008 the reinsurers’ average investment income return was about 4% to 4.5%, which is higher than Fairfax’s figure of 3.4%. However, Fairfax did much better on realised gains. Fairfax had a return of 6.1% from realised gains, compared with the average portfolio, which had realised gains of zero to -0.5%. This means on average Fairfax produced a total return of about 9.5%.


“It is very much a contrary path,” says Watsa of his strategy. “By focusing on total return using a value-oriented approach we have been able to build shareholders capital more significantly than the rest of the industry.”


Barnard says other companies struggle to take a long-term view because of pressure from investors and rating agencies.


“Our objective is to grow book value on a compound basis 15% a year,” says Barnard. “Most [companies in] the industry – driven by Wall Street and, to some extent, the rating agencies – struggle with capital gains as a metric that doesn’t easily fit into their formulas. There is a lot of conventional, orthodox thinking that pushes you to focus on just operating returns.”


Staying cautious


In stark contrast to the situation five years ago, analysts are now asking what Fairfax will do with all its money. Watsa is remaining cautious.


“We have got significant amounts of cash in the holding company and we have the ability to invest the money,” says Watsa. “But what the capital in the holding company does is provide us with protection from the unexpected, because who knows what will happen in the next few years?


“When we take advantage of opportunities it will not be at the expense of our financial position. So we don’t expect to take our cash down to $500m from the more than $1bn that it is today.”


Watsa does not rule out more acquisitions, but says the firm does not need to make any large buys. He says Odyssey Re operates worldwide so does not have a pressing need for an acquisition, and Crum & Forster and Northbridge are already national firms.


“We are open to acquisitions but only if they make sense,” he says. “So, yes, we could do another tuck-in acquisition.”


Meanwhile, Watsa is confident book value will continue to grow. In the conference call for the company’s third-quarter results, he predicted that five years from now Fairfax’s book value will have soared because of the high-quality common stocks it bought in the last quarter of 2008 and first quarter of 2009.


“We expect to hold them at least five years,” he says. “[Considering] the price that we bought a company like Johnson & Johnson at, we think we might hold it for a long period time because it is a compounding machine. We have looked at a lot of companies but we have not come across a company like Johnson & Johnson in terms of the number of years – literally 40, 50 years – that it has been compounding at close to 15%. Very high quality companies were available and we plan to hold them for some time.”


The hedges are now back, however, with the firm hedging about 25% of its equity portfolios. This is indicative of the cautious approach that positioned Fairfax so well during the financial crisis. The benchmark worst case that Fairfax looks to protect itself against is a 50% drop in the stock market, combined with a severe natural catastrophe such as a category 5 hurricane hitting Miami or a California earthquake of magnitude 7 or 8.


“We are very downside oriented. We look at the worst case,” says Watsa. “Our guiding principle is that we will never bet the company on any acquisition, project or common stock.”


Watsa remains cautious about the US economy, especially the amount of public spending. He expects the recession to be prolonged and says the only comparable periods are the debt deflation seen in the US in the 1930s and Japan’s economic difficulties since 1989 that last until today.


“We are very strong financially with the cash in the holding company, with our investment portfolios and with that 25% investment hedge,” he says. “But we are concerned about the economy, and we constantly monitor economic indicators, because in the US the government and government stimulus represents only about 20% of the entire US economy, and the remaining 80% of the economy is private – dependent on the spending patterns of businesses and individuals. The test is will the 80% start spending and we will not know that for some time.”


But Watsa’s firm is now well set to deal with anything the market throws at it. The company’s long-term approach has paid off enormously. He says Fairfax will keep performing for investors who have a similar long-term view.


“Of course anyone can buy our stock,” he says. “But the investors that gravitate to Fairfax are ones that take a long-term view and that is who we are trying to perform for.”


By Michael Loney - mloney@euromoneyny.com

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Very interesting indeed. Looks like he's answering some questions here...


“We have never focused on operating returns in the same way that almost all other public companies do,” says Barnard. “There are many times when we have sacrificed operating earnings in order to have a superior long-term value investing strategy.”


Watsa quotes figures for a selection of reinsurance companies to back up the claim that a total return approach is best. He says between 2002 and 2008 the reinsurers’ average investment income return was about 4% to 4.5%, which is higher than Fairfax’s figure of 3.4%. However, Fairfax did much better on realised gains. Fairfax had a return of 6.1% from realised gains, compared with the average portfolio, which had realised gains of zero to -0.5%. This means on average Fairfax produced a total return of about 9.5%.


“It is very much a contrary path,” says Watsa of his strategy. “By focusing on total return using a value-oriented approach we have been able to build shareholders capital more significantly than the rest of the industry.”




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