Fairfax Valuation - $430

[watsa_is_a_randian_hero]

Call BV $300 after adding in ICICI but subtracting out current losses on equities at 12/31/08.  Lets say the equity portfolio is undervalued by $1.5 billion at that point, and the current market were not as a result of changes in the intrinsic value of any of the holdings.  And lets assume FFH could grow the stock portfolio at 15% from its current intrinsic value (significantly less than long run average of 25%).  On the bond side, lets assume the current market value is the current intrinsic value, and assume hamblin watsa can achieve a 10% return (long run bond average of Hablin-Watsa).

 

That means FFH's portfolio has a current intrinsic value of $20 billion, or $1000 per share after accounting for minority interests.  The average return above translates into an 11.1% return on the portfolio.  This means 111 in earnings, pre tax $72 after tax.

 

As for underwriting, assume their insurance operations have a CR of 102, and that means after tax the eps affect is $5.37.  However, given FFH carries its policy holder liabilities undiscounted, the present value of this is probably $4 per share. 

 

Finally, you must subtract the cost of debt capital.  The interest expense on debt and dividends on preferreds will be around $6.00 per share annual cost, after accounting for tax effect & minority interest impact on debt interest. 

 

This results in long run, normalized EPS levels of $72 (investment revenue) - $4 (underwriting loss) – $6 (debt and preferred cost).  This means FFH has normalized earnings capacity of $62 per share.  Apply a 15% required rate of return to that, or a 6.66x multiple, and you get to a fair value of $413.  Add in ICICI Lombard and you get to $430.

 

Holding every other assumption constant, the current share price of 300 implies that FFH will only return 8.5% on average for the portfolio going forward.  This is well below their long run average of 10% on bonds and 25% on stocks. 

 

Looking at it another way, holding every other assumption except the require rate of return constant, the current share price implies expected returns of 20%.

 

[Orientinvestor]

This would be a good sticky thread -- a dynamic valuation exercise (or at least annually).

 

Now that Fairfax is about 16% down since the peak achieved last 26March, and is in about 7-month low any valuation exercise for Fairfax?

 

I've gotten anchored by the USD500 entry point and that price has been broken in the last few days, so i would be interested in what the veteran of these forum think Fairfax's fair valuation is, particularly if it accounts for the Brit acquisition.

 

 

[giofranchi]

This would be a good sticky thread -- a dynamic valuation exercise (or at least annually).

 

Now that Fairfax is about 16% down since the peak achieved last 26March, and is in about 7-month low any valuation exercise for Fairfax?

 

I've gotten anchored by the USD500 entry point and that price has been broken in the last few days, so i would be interested in what the veteran of these forum think Fairfax's fair valuation is, particularly if it accounts for the Brit acquisition.

 

Well, imo basically no valuation can be done without defining:

1) The minimum return you require for an investment in equity for the next let’s say 20 years

2) The rate FFH will compound equity for the next let’s say 20 years

 

I tell you what I do:

1) The minimum return I require for an investment in equity for the next 20 years is 9%

 

If FFH compounds equity at:

a) 9% annual: its IV is at least BVPS = 395 USD

b) 10% annual: its IV is at least 1.2 x BVPS = 474 USD

c) 11% annual: its IV is at least 1.44 x BVPS = 569 USD

d) 12% annual: its IV is at least 1.72 x BVPS = 679 USD

e) 13% annual: its IV is at least 2.06 x BVPS = 814 USD

 

What will be FFH's CAGR in BVPS for the next 20 years? No one knows. You pick your number! ;)

 

Cheers,

 

Gio

 

[mcliu]

Shouldn't you try to assign a probability from a to e and calculate an expected value?

[giofranchi]

Shouldn't you try to assign a probability from a to e and calculate an expected value?

 

Not easy…

For what I know, they might even be able to compound at 15% annual… But, as soon as I express that view, people jump at me! ;)

And 20 years is a very long time…

You might try to assign a probability to each scenario, but don’t really expect it to be anything more than an educated guess!

 

Gio

 

[frommi]

Since no one knows the future, i valued it a bit different.

 

Book value: 395$

Unrealized gains not included in book value: ~39$

Float: (Long term interest rates - cost of float) * Float Per Share * 10= (2.6%-0.3%) * 711 * 10 = ~163$

------

Fair Value: ~598$

[klarmanite]

Ok taking a crack at this. Might have some faulty assumptions, so feel free to correct me...numbers are in USD.

 

Whether Fairfax is a good investment depends on how you see the normalized investment returns going forward, in my opinion.

I'm making quite a few assumptions here that people may not agree on, e.g. that the cost of float is essentially zero going forward in perpetuity.

I also assume that FFH will generate at least 6% over the long term, but over the next few years, wll that's anyone's guess.

 

Hopefully this post can stimulate some discussion, I don't pretend to be an authority on FFH or on insurance companies generally.

 

I will venture to say though that I think these valuation levels are attractive from a long term point of view.

 

 

 

 

[vinod1]

 

Whether Fairfax is a good investment depends on how you see the normalized investment returns going forward, in my opinion.

 

 

Agree. Investment returns are really what would drive book value growth for Fairfax.

 

So you have to ask what rate did they earn in the past? What was their return compared to the relevant benchmark i.e. the value add? What are the benchmarks likely to yield in future? Is the value add likely to be less, more or about same as in the past?

 

This is what I tried to do in this blog post.

 

http://vinodp.com/blog/?p=34

 

Vinod

[frommi]

 

Whether Fairfax is a good investment depends on how you see the normalized investment returns going forward, in my opinion.

 

 

Agree. Investment returns are really what would drive book value growth for Fairfax.

 

So you have to ask what rate did they earn in the past? What was their return compared to the relevant benchmark i.e. the value add? What are the benchmarks likely to yield in future? Is the value add likely to be less, more or about same as in the past?

 

This is what I tried to do in this blog post.

 

http://vinodp.com/blog/?p=34

 

Vinod

 

So following your logic, FFH is worth ~0.7*bv? And every insurance company is worth a lot less than bookvalue because stock and bond returns are lower going forward? :)

[vinod1]

 

Whether Fairfax is a good investment depends on how you see the normalized investment returns going forward, in my opinion.

 

 

Agree. Investment returns are really what would drive book value growth for Fairfax.

 

So you have to ask what rate did they earn in the past? What was their return compared to the relevant benchmark i.e. the value add? What are the benchmarks likely to yield in future? Is the value add likely to be less, more or about same as in the past?

 

This is what I tried to do in this blog post.

 

http://vinodp.com/blog/?p=34

 

Vinod

 

So following your logic, FFH is worth ~0.7*bv? And every insurance company is worth a lot less than bookvalue because stock and bond returns are lower going forward? :)

 

Assuming stock market returns are going to be 5% and FFH returns 7%, even adjusting for risk, why would it be worth less than book value?

 

Vinod

[frommi]

Assuming stock market returns are going to be 5% and FFH returns 7%, even adjusting for risk, why would it be worth less than book value?

 

Vinod

 

Because when i discount everything with 10%, a RoE of 10% means fair value is around bv. But maybe i just misunderstood your post in this regard, we are probably talking about different things.

[watsa_is_a_randian_hero]

This was my posting 6 years ago. 

 

after it reached my fv in the 2010 to 2012 timeframe i sold most of my holdings - it had approached my FV estimate and also my expectations for the future had soured based on Prem's 100% hedging of the equity portfolio and RIMM investments.  I did by the FFH long-dated bonds though with some of the proceeds - my IRR on the bonds has been 13.75% since that time period, exceeding that of the stock.  (in USD terms).

 

I recently sold some more stock near $700 CAD.  Its at a fairly rich P/B multiplle given the returns we've seen the past few years (Since dec 2010, over 4.25 years, BV is only up about 18% adjusted for dividends). 

[Jurgis]

Assuming stock market returns are going to be 5% and FFH returns 7%, even adjusting for risk, why would it be worth less than book value?

 

Vinod

 

Is 7% return-on-book or return-on-current-price?

 

Even if stock market returns are going to be 5%, 7% return-on-whatever is nothing to be excited about. So, if FFH is expected to return 7%-on-whatever, I'd only pay 0.50-of-whatever for it, so I'd have 14% return. Someone wanting 10% return, would pay 0.7-of-whatever.

[benhacker]

I think many folks here are using imprecise language and are thus talking past each other.

 

The 7% references above are on the "portfolio" of FFH investments.  This is much different than assuming a 7% ROE or growth in book equivalent.

 

Not arguing for one or another being the right number, just trying to help the communication barrier.

[Jurgis]

The 7% references above are on the "portfolio" of FFH investments.  This is much different than assuming a 7% ROE or growth in book equivalent.

 

OK.

 

But then the question

 

Assuming stock market returns are going to be 5% and FFH returns 7%, even adjusting for risk, why would it be worth less than book value?

 

Vinod

 

does not make sense to me, since you need more info than just return on portfolio investments to evaluate the worth.

 

Perhaps Vinod will clarify what he meant.

[thepupil]

 

does not make sense to me, since you need more info than just return on portfolio investments to evaluate the worth.

 

Perhaps Vinod will clarify what he meant.

 

Vinod was calculating the rate of book value growth. His estimate is 5-12%, with a base case of, call it, 7%. His base case calls for stock market returns of 5% (not unreasonable by any measure).

 

His base case says Fairfax will grow at a greater rate than the market and is therefore "worth" at least book to "the market".

 

What it is worth to frommi or Jurgis or vinod is an entirely different story. What something is worth to the market under reasonable assumptions under today's conditions is different than what something is worth to any one of us with an XX% hurdle.

 

My takeaway from Vinod's thorough analysis is in order to own FFH today, you either must have higher compounding rate expectations (like Gio does, not trying to argue with you Gio, I just know you expect greater things from FFH than 5 or 7%) or pretty low return requirements. I have no strong opinions either way and have never owned FFH.

[Jurgis]

OK, I agree with what thepupil said.

[vinod1]

 

does not make sense to me, since you need more info than just return on portfolio investments to evaluate the worth.

 

Perhaps Vinod will clarify what he meant.

 

Vinod was calculating the rate of book value growth. His estimate is 5-12%, with a base case of, call it, 7%. His base case calls for stock market returns of 5% (not unreasonable by any measure).

 

His base case says Fairfax will grow at a greater rate than the market and is therefore "worth" at least book to "the market".

 

What it is worth to frommi or Jurgis or vinod is an entirely different story. What something is worth to the market under reasonable assumptions under today's conditions is different than what something is worth to any one of us with an XX% hurdle.

 

My takeaway from Vinod's thorough analysis is in order to own FFH today, you either must have higher compounding rate expectations (like Gio does, not trying to argue with you Gio, I just know you expect greater things from FFH than 5 or 7%) or pretty low return requirements. I have no strong opinions either way and have never owned FFH.

 

This is exactly what I meant. Thanks for explaining it better than I could.

 

Vinod

[TwoCitiesCapital]

I agree with the comments regarding the income generated by their investment portfolio.

 

Fairfax has $1240 per share in investments. If they can achieve just 3% returns on this amount, that would amount to a 7% return post-tax. Not stellar, but reasonable outcome based on a very low performance bar. 3% is hard for them to achieve with 50% of the portfolio hedged/cash with the rest being in bonds, but the portfolio won't resemble that forever. Also, this analysis totally excludes any gains generated by underwriting and the consolidated affiliates which have the potential to impactful in any given year.

 

Ultimately, in a normal environment, I'd envision Fairfax being able to easily generate $85 per share on it's current assets/insurance business. We're currently far from a normalized environment, but I see these working out one of three ways:

 

1) Fairfax is right and there is deflation in western economies. Bond portfolio pays off hugely with Fairfax recognizing billions in gains. The hedges and deflation derivatives quite literally mint money and give Fairfax large upfront gains which would be subsequently deployed into assets classes that now have attractive forward valuations. We get a large bump in earnings on the front side and then very volatile earnings afterwards with the inevitable ups-and-downs associated with the value assets purchased. Fairfax likely manages to make greater than my $85 per share per year over an economic cycle during this period. 

 

2) U.S. economic growth picks up and inflation with it. Fairfax waits for another 2-3 years (maybe shorter) in the face of strengthening U.S. data before determining that their deflationary thesis has been invalidated. Fairfax re-risks their portfolio for a more normalized outlook and begins generating the $85 per share that I believe they can earn.

 

3) Economies continue to muddle on with some quarters validating Fairfax's cautionary stance and others making them absolutely wrong. Earnings will be hard to predict and will be entirely dependent on underwriting results and alpha generations. Earnings per share are more likely to be in the $25-30 per share range but will be extremely bumpy due to the constant shift in asset prices back and forth between positive and negative sentiments.

 

It's hard for me to say which one of these scenarios is most likely, but scenarios 1 and 2 don't end up so badly for investors other than being volatile or requiring additional patience.

 

Option 3 would be moderately troublesome from current prices, but I also think that it's the least likely. We've muddled through for the last 7 years, but without any significant slowdown and with trillions in liquidity and support pledged from central banks along with zero-bound interest rates. The seeds of the next crisis have likely been sown and something will happen somewhere to re-awaken volatility and the concept of loss at some point in the next few years. I have a hard time imagining a muddle through scenario if we see severe asset price correction or a recession in the major economies - either one could easily happen after 7 years of relative calm.

[bluedevil]

Vinod,

 

I think it is incorrect to assume that Fairfax's CR will be 100 going forward AND interest rates will remain at very depressed levels.  Both of those are independently reasonable assumptions, but together they fail, in my view, to account for the relationship between these two metrics.  If interest rates remain at very depressed levels, then all P&C insurers will see their ROE's plummet as higher yielding bonds mature and the proceeds are plowed into new bonds at the reduced rates.  Ultimately, this will bear itself out in lower CRs as companies, in writing business, demand higher prices to offset the lowered value of the float they are underwriting.  I believe that Prem has said a 95% CR is needed by the industry at current interest levels to achieve even a single digit ROE.  With Fairfax's ability, hard earned through time, to write at better rates than the industry, i think it would be very reasonable to assume some $500 million a year in underwriting profits if the low interest rates continue -- a sum that would obviously move the needle  considerably in your valuation. 

[giofranchi]

 

does not make sense to me, since you need more info than just return on portfolio investments to evaluate the worth.

 

Perhaps Vinod will clarify what he meant.

 

Vinod was calculating the rate of book value growth. His estimate is 5-12%, with a base case of, call it, 7%. His base case calls for stock market returns of 5% (not unreasonable by any measure).

 

His base case says Fairfax will grow at a greater rate than the market and is therefore "worth" at least book to "the market".

 

What it is worth to frommi or Jurgis or vinod is an entirely different story. What something is worth to the market under reasonable assumptions under today's conditions is different than what something is worth to any one of us with an XX% hurdle.

 

My takeaway from Vinod's thorough analysis is in order to own FFH today, you either must have higher compounding rate expectations (like Gio does, not trying to argue with you Gio, I just know you expect greater things from FFH than 5 or 7%) or pretty low return requirements. I have no strong opinions either way and have never owned FFH.

 

This is exactly what I meant. Thanks for explaining it better than I could.

 

Vinod

 

As far as I am concerned, this goes well beyond my future expectations for FFH’s business results. It has lots to do with the business I am in, which is not buying and selling securities… Instead it is:

 

1) Generating cash;

2) Finding a business led by an owner/operator with a solid and long track record, a business that I understand and that is not subject to obsolescence;

3) Using the cash I generate to keep buying that business at fair/good prices;

4) Finding new ways to generate cash, should it become too small a fraction of my firm’s equity.

 

Therefore, my perspective is not really “at which CAGR will FFH be able to compound BVPS in the future”, instead it is more like “which other business fits the description in 2) better than FFH, so that I could keep buying it instead of FFH with my cash”. As I have always said, show me a better alternative, and I will be very glad to take it into careful consideration!

 

Because, irrespective of the CAGR I might think FFH could compound in the future, I am confident that, as long as I do sensible things (1, 2, 3, and 4), with the discipline to keep doing them for a long time, satisfactory outcomes should follow… with maybe some pleasant surprises along the way! ;)

 

This being said, as I have already told Vinod, I think that simply saying “well, the indices have returned X for the past 30 years and FFH has returned Y… the indices are going to return X2 for the next 20 years, therefore FFH is going to return Y2” might be greatly misleading.

Instead, to judge the future prospects for any business, you should think hard about what that business has been in the past, and about what that business could become in the future. And imo FFH is becoming a much better business than it has ever been.

 

Cheers,

 

Gio

 

[steph]

Fairfax is very attractive as an investment because they are quite different from other insurers/companies. It is a nice company to own in a portfolio because its stock price (and the intrinsic value) will behave in a very different manner than most other holdings of your portfolio. They like to make directional 'bets' and are patient investors. Sometimes it works out, sometime it doesn't. It is therefore very difficult to put a price on FFH today. This is not a Coca-Cola type of investment with steady, predictable cashflows.

But they are smart people, with a growing and improving insurance business.  Paying 1.25 times book is a very reasonable price for what FFH has to offer.

[klarmanite]

I agree Steph. It's one of the main reasons I bought the stock (yesterday).

 

Low correlation to my other holdings

Reasonable valuation

Fairly low risk of large negative return over a multi-year horizon

Great management with skin in the game

 

 

All things considered an attractive bet. The most reasonable (and common) bearish argument is that it could be dead money for a while. But I'm fine with that.

 

[thepupil]

 

This being said, as I have already told Vinod, I think that simply saying “well, the indices have returned X for the past 30 years and FFH has returned Y… the indices are going to return X2 for the next 20 years, therefore FFH is going to return Y2” might be greatly misleading.

Instead, to judge the future prospects for any business, you should think hard about what that business has been in the past, and about what that business could become in the future. And imo FFH is becoming a much better business than it has ever been.

Cheers,

Gio

 

 

Agreed. Vinod's quantitative approach would certainly miss an inflection point in the quality of the business and large chunky gains. I don't know Fairfax well but there does seem to be a lot of optionality and growth (and risk!) in the form of the the insurance businesses in emerging markets, being the GP of FIH, wholly owned businesses, distressed workouts, etc that would certainly be close to impossible to model in a spreadsheet.

 

Also, to add a little bit of quantitative finance modern portfolio theory mumbo jumbo (otherwise known to some value investors as quasi-science bullshit) to the conversation, Fairfax does exhibit strong diversification benefits to a stock portfolio over time and has periods of very low or negative correlation to general markets. Fundamentally we know this because they have lots of hedged and made beaucoup money on the CDS contracts, but if I knew nothing about that and just looked at the monthly returns of the stock, I'd agree with those saying "I like FFH for its diversification benefits"

[klarmanite]

What is the blue and what is the green line?