Fairfax 2018

[petec]

 

My only quibble is that I don't believe it is as easy to increase the leverage as your post may imply.  They need to find profitable insurance to write (100% or less CR) or acquire.

 

If Fairfax does increase book value by 15% (straight book value, not per share), it seems to me as though it will be a challenge to maintain the current leverage.  If they grow 15%/share/year, and some of that is through share buybacks, that should be a little less difficult.  That is one of the reasons why I like opportunistic buybacks. It helps alleviate some size/growth problems.

 

I think I have that right.  Any reason you think maintaining the leverage won't be an issue?

 

StevieV

 

Hi StevieV.

 

My post was just an explanation of the theory in response to a question about the pref/warrant deals. I didn't actually meant to imply that leverage would grow. But it's a good question.

 

First, there's every reason to believe that premiums will grow in line with nominal GDP or faster and therefore float ought to do the same. If you don't believe that then you must believe either that insurance premiums will shrink as a % of GDP or that Fairfax will lose share. Yet insurance is materially under-indexed in developing parts of the world so it is likely to grow faster than GDP globally - and Fairfax will capture more of that than many north American insurers because it does a material amount of business in those developing areas. Also, my base case would be that well run, disciplined underwriters might take share over time because they'll have equity when others are struggling. Fairfax has a good history of finding niches and growing in them, and I won't be surprised if Fairfax take share in places where existing business is small (LatAm, Eastern Europe) and in India, where Digit is a startup and could grow very fast.

 

Second, we know they can write a LOT more premiums in a hard market - possibly as much as double. That obviously doesn't double float immediately, but it does grow it.

 

Third, we know they will buy the stubs of Brit, Eurolife, and AWH. That will add to float. And while big acquisitions may be off the table, I fully expect continued tuck-ins.

 

In the long run that may not be enough to maintain leverage - Fairfax's mix may shift towards operating buisnesses - but that hasn't been too bad for Berkshire!

 

 

[petec]

The big multi-variable equation question about Fairfax capacity to grow profitably is one I am wrestling with.

Historically, FFH has shown an incredible capacity to grow float and more recently to grow it profitably.

Isolating the residual room to grow variable going forward, here's an excerpt from Berkshire Hathaway 2017 edition:

 

Here’s the record:

(in $ millions)

Volume Float

1970 39    1980 237    1990 1,632    2000 27,871    2010 65,832    2017 114,500

 

Fairfax year-end float (2017): 22,700

 

If you go back in time for Berkshire Hathaway, in 1998, year-end float was 22,800

Question:

From the perspective of 1998, did BH have an opportunity to grow float?

Float has grown at 8.9% (CAGR).

 

FFH is not BH but even if the rate of potential growth in float has come down, IMO, the variable, in itself, is not a major limiting factor in terms of the return objective that they describe going forward.

And indeed, opportunistic buybacks, given the right environment, could help with float per share.

 

+1 Ultimately I think good, motivated underwriters can grow float by spotting opportunities less capable people don't. Berkshire is one of the best underwriters around - and Fairfax, thee days, is also superb.

 

[StevieV]

Thanks petec and Cigarbutt.  Those are very helpful thoughts about the insurance float.

 

I would also expect changes to the investment leverage to be gradual (though perhaps lumpy).  Meaning, Fairfax isn't going to go from 2x leverage to 1.5 or 3x leverage overnight.  That would play out over a number of years.  On the lumpiness side, it could go into a decline until a harder market, and then reverse.

[Cigarbutt]

Speaking of lumpiness. the uncertainty of future returns for Fairfax revolves a lot around investment returns.

Comments by petec and StevieV triggered the following.

Hat tip to Brooklyn Investor (note 22/11/17) vs the concept of matching invested assets and insurance reserves.

https://brooklyninvestor.blogspot.ca/

 

My numbers are not audited and may not be perfectly exact; exercise done for conceptual reasons.

 

So for Fairfax, in 1998 (all numbers in billion, expressed in CAD $), float was 8,15, cash was 1,15 and bonds at cost were 9,86.

Ratio of (cash + bonds)/float=1,35

Fast forward to 2017 (USD $), float is 22,7, cash is 18,5 and bonds at cost are 8,76, for a ratio of 1,20

Conclusion for FFH: cash is king (now).

 

The real reason for this post is the following:

For BH, in 1998, float as estimated by Brooklyn Investor was 26,3, cash was 13,58 and bonds were 21,25, for a ratio of 1,32.

For BH, in 2017, float as estimated by Brooklyn Investor is about 120, cash is 103,98 and bonds are 21,35, for a ratio of 1,04

For BH, float has been multiplied by about 5, bonds have remained the same and cash has been multiplied by 8.

Mr. Buffett is said to hate cash. What then, are his feelings about bonds now?

 

Fairfax' profile in terms of the composition of float coverage is comparable, to some degree, to Berkshire Hathaway and IMO that may not be a bad thing.

 

 

 

[Dazel]

 

 

The credit markets are getting strained...3 month Libor is now 2.26%! This is the kind of market that Fairfax wants to deal in....would expect deal flow to get larger...its likely that Bradstreet will stuff the portfolio full of higher yielding corporates...this is what Fairfax has waited for. There will not be a calamity but in a leveraged finance world there will be forced liquidation’s which happened 1994 which is where I think we are (a flat stock market year becoming a stock pickers market but credit markets become wild)..the tide is heading out in the credit markets...many are now scrambling for their suits. Cash is king.

[Dazel]

 

Hosington is right...long term US treasuries yields  will fall...but all other interest rates will rise substantially....flat yield curve for treasuries.

 

Any better way to play it than Fairfax...other than having cash to buy high yielding debt? Fairfax gets the magic of the float so they have an advantage on that strategy.

[Dazel]

 

 

3 month Libor has been up 32 days in row.

[StubbleJumper]

Let's just hope that they are making maximum use of the normal course issuer bid while the stock price is still bouncing around BV.

[ourkid8]

https://finance.yahoo.com/news/fairfax-announces-pricing-offering-senior-200820172.html

 

Fairfax is issuing 600 million euro debt with a coupon of 2.75% per year and due 2028.  This is extremely cheap euro denominated debt and looks to be used to refinance higher yielding debt. 

 

"Fairfax intends to use the net proceeds from this offering to refinance or repay outstanding debt or other corporate obligations of Fairfax and its subsidiaries and for general corporate purposes. This may include the redemption or repurchase of certain of Fairfax’s previously issued senior unsecured notes. "

[petec]

Its likely that Bradstreet will stuff the portfolio full of higher yielding corporates...this is what Fairfax has waited for.

 

Why would he buy corporates when spreads are still near all time lows? Or am I wrong?

 

I would think he might be pulling the trigger on 2y treasuries at 2.3% with little duration risk. But I don't think you're getting paid for risk in HY corps yet. This isn't what Fairfax has been waiting for - yet.

[petec]

https://finance.yahoo.com/news/fairfax-announces-pricing-offering-senior-200820172.html

 

Fairfax is issuing 600 million euro debt with a coupon of 2.75% per year and due 2028.  This is extremely cheap euro denominated debt and looks to be used to refinance higher yielding debt. 

 

"Fairfax intends to use the net proceeds from this offering to refinance or repay outstanding debt or other corporate obligations of Fairfax and its subsidiaries and for general corporate purposes. This may include the redemption or repurchase of certain of Fairfax’s previously issued senior unsecured notes. "

 

Good spot. They seem to be refinancing quite a bit at the moment although I haven't calculated the impact. These bonds actually yield 3% as they were issued below par but still, I'll take it!

[Dazel]

 

 

Petec,

 

I just told you that 3 month USD Libor is 2.26%....it depends who you are and where you are what type of spread you get see Seaspan etc. Money is tightening as is liquidity hence the U.S and European banks are all down around 10% plus this week. No one has really discussed libor going straight up because they don’t want to...tight money means rolling over debt will become harder and commercial paper programs will have significantly higher costs.That’s why to buy the “right” corporates hopefully with warrants if the opportunity presents its self.  Fairfax-Bradstreet has made a lot of money on corporates in the past....by having tons of cash and liquidity when it was needed. This is turning into one of those times.

 

As for Fairfax euro offering...awesome move...and it becomes a natural hedge for Greek investments.

[Dazel]

 

 

Petec,

 

Hope I did not come across the wrong way...in summary this is the type of market that The Fairfax investment team does very well in....volatility and value are coming back into vogue. Cash is king and they are loaded with it....I think the credit markets are a lot tighter than people think...and Bradstreet is the bond king. Interest rates in treasuries do not matter in times of panic...will we get more I am not sure but it feels like the season has changed.

[petec]

Dazel

 

I may have misinterpreted the comment I was replying to. I thought you meant Bradstreet would be hoovering up corporate bonds in the market right now. I'll be surprised if that is true - corporate spreads are still tight and ultimately it is only when they widen that you get disproportionate opportunity in corporates.

 

However, if you're saying that as conditions tighten specific opportunities will present themselves for Fairfax, then I agree entirely.

 

Ultimately I suppose what I am saying is that while a dislocation might be starting, it is only starting. Fairfax didn't spend the last 10 years worrying in order to get sucked in at the first hint of trouble. They are extraordinarily well positioned and they will be patient and wait for fat pitches.

 

P

 

[FairFacts]

good conversation going on here......a few things come to mind.....

 

Jeremy Seigel on CNBC yesterday worried about the Fed Forecasting a fund rate of 3.6% by 2020 when the current 10 year is at 2.8% - 'ever since the 2nd WW an inverted curve has presaged a recession.

 

Bill Gross weighed in yesterday saying he sees a 10year at about 3% for 2018 AND he doesn't see the fed going beyond 2 increases. He says that the US and global economies are too leveraged and won't stand a fed funds rate above 2% in a 2% inflationary world.

 

In Dec'17 Oxford University (UK) raised STG750k (about $1bil) at 2.54% on a 100 year bond!

 

Fairfax is refinancing existing debt at 200-300 bps lower than the existing rates.

 

They say the bond market (10x bigger than the stock market) is a far better signal of what is actaully going on in the economy.

 

SOOOOO.....I think lower for longer is here to stay for longer......

 

How does this affect the FFH thesis?

 

 

 

 

[Cigarbutt]

-So Oxford issues a century bond with a higher credit rating than the UK government.

-The Libor is moving up more than government bond yields.

-Investment grade spreads move up less than risk-free bonds and high yields barely notice.

-The curve is flattening as the death of long term bonds may have been exaggerated.

-The conundrum that Mr. Greenspan alluded to in 2005 is still looking for an explanation.

 

Opinion: not a bad time for Fairfax to have some dry powder.

There is definitely room to grow for the corporate credit spread.

[Dazel]

 

 

Lower long term interest rates only happen if there is a pot hole hit...have we hit one now?

 

If we hit a pot hole corporate spreads blow out...longer term treasury yields fall...the opportunity is in a spreads blow out and refinancing problems with the massive global debt load reaching maturity.

 

When the 30 year treasury hit 2.5% in 2008....Bradstreet sold most of Fairfax long term treasuries at a huge profit and bought I believe $5b in Berkshire guaranteed tax free Muni’s yielding 7%. Maybe the bond trade of the century...

This will not happen again obviously but when the credit market tightens- freezes...opportunities come quickly to those with ready cash. Libor’s rise is causing funding problems so who knows what the credit market will serve up Fairfax! 2.3% in  3 month money is a pretty good start.

 

If rates continue to ride higher the opposite of a blow up Fairfax wins as well....

 

My bet is a rise that gets high enough to cause a credit event...where Fairfax buys both corporates at great prices and higher yielding treasuries at good yields...brings a nice yield to the portfolio for many years and adds billions in capital gains....as rates come back down.

[Dazel]

 

 

Having said that...the best investment Fairfax can make right now...is in their shares. Hoping they are actively looking for block share purchases from those want to get out of the AWH buyout and those that need to raise cash. If we stay here in price or drop below these levels for awhile it will be very beneficial to get a boat load of stock purchases. I have not seen Fairfax this cheap since 2003 at that time they were unable to take advantage of the price with big buy backs. Excited.

[ourkid8]

https://www.bloomberg.com/news/articles/2018-03-26/berkshire-hathaway-says-knauf-made-offer-for-usg-at-42-a-share

 

Fairfax can sell their position in USG for a nice little gain...

 

 

[Txvestor]

I believe they sold down most of that converted equity stake in 2012 at around $20. They more recently picked up a smaller $60M position in the low $30s area but their irigibal stake was much larger.

[ourkid8]

Yes, they picked up a small position on Q4 2016 /Q1 2017 for ~$30 /share so they can exit the position with a nice gain. 

 

I believe they sold down most of that converted equity stake in 2012 at around $20. They more recently picked up a smaller $60M position in the low $30s area but their irigibal stake was much larger.

[petec]

SOOOOO.....I think lower for longer is here to stay for longer......

 

How does this affect the FFH thesis?

 

Depends what you mean by lower for longer. If you mean rates won't go back to historical norms you're probably right - there's too much debt and the world could not survive it. Amazing to think that the 2y was at 6.5% in 2000. Those days are gone, and all else equal that must slow Fairfax's rate of compounding because earning 6.5%, levered by float and with no credit or duration risk, is a very nice way to make money.

 

However, current rates still provide a very nice tailwind of 2.25% on near-cash (2y treasury) while they wait for better opportunities. That tailwind has not been present for a decade.

 

Those better opportunities will either come along one by one as they did last year or, as Dazel says, if rates or spreads spike then a lot will come at once. Either scenario is positive for Fairfax.

[Cigarbutt]

Given the underwriting and investment landscape, potential to reinvest in FFH is reconsidered.

 

In the past, I’ve occasionally backed up the truck with FFH and even if my conclusion is no (not now anyways), the post is respectfully submitted as Fairfax has been a major factor leading to financial independence.

 

-Underwriting side opportunity

 

Have reviewed a lot of end of year reports including from Lloyd’s just recently. What Lloyd’s reports is typical of the global environment:

 

-2017 was a tough year for catastrophes, CR at 114%.

-A hard market (except for some “exposed” areas) is simply not happening.

-The market is still characterized by a very unusual amount of capacity and “alternative” capital.

-At this point, even slight increases in price result in major loss of market share.

-Underlying combined ratios (with cat losses removed), in general, show relatively weak underlying trends, with Lloyd’s underlying CR at 98,4%.

-Except for 2017, catastrophes have been quite benign for quite some time.

 

AM Best recently released some preliminary 2017 data for the P/C industry as a whole.

 

-The industry’s combined ratio for the year came in at 103.8, a three-point deterioration versus what it was in 2016. The 103.8 ratio was the worst of the last five years.

-A.M. Best estimates that the catastrophe losses account for 10.0 points on the P/C industry’s combined ratio, up from an estimated 4.9 catastrophe points in the prior year.

 

IMO FFH is not immune to the environment (unusually soft and benign) but is relatively well positioned (underwriting culture/discipline, reserve profile, capitalization at the subs level and +/- overall financial flexibility) to thrive in this market AND to profitably grow global float going forward. This is a risk business but IMO the underwriting posture is WAY better than it has been when I invested before in FFH.

 

Transition note to the next topic:

 

Before writing this, went back to the “Time to buy Fairfax again?” thread started in 2014. A lot of discussion on the “premium” to book value (what is book value anyways for FFH?). IMO, best to buy low but the value of long term profitable growth in float warrants a significant premium. I would suggest that, for an insurer like Fairfax, if you can define a profitable path going forward, it may be reasonable to buy at a multiple of normalized earning power.

 

Next topic: Investing side opportunity (fixed income side)

 

No comment here about the equity exposure and this may be eventually discussed separately.

 

Agree that this has been a stellar component. But I’m scratching my head at this point.

 

Have recently spent a considerable time looking at the bond market and here are some facts/opinions.

 

Potential bias: I don’t like it. Will use top and bottom examples.

 

-Corporate debt as a % of EV looks relatively OK but corporate debt as a % of BV or GDP looks very high, in the sense of cyclically high.

 

-The fraction of BBB bonds over all investment-grade bonds has been rising:

-1990’s: +/- 25%

-2009: 32%

-now: about 50%

 

-Now, the face value of BBB bonds is larger than all BB bonds (unusual and suggests the possibility that some BBBs belong in the BBs?). To be fallen angels?

 

-CVS (context of buying Aetna) recently (in a pre-emptive fashion) issued a government-sized BBB offering that offered what I consider to be very limited margin of safety spreads and the issue was met by yield-hungry investors with a bid to cover ratio of 2,7. CVS may eventually realize the transformational aspect of the transaction. I just find that the risk reward is not favorable to the bond investor.

 

-Who knows about junk bonds but a lot of stuff will continue to mature, possibly in a rising short term rate environment?

 

-Recently looked at Revlon and found that investors in the high yield area may be looking at increasing spreads on top of being exposed to evolving “holes” in the covenants as it has been suggested that the majority investor may consider "pulling a J. Crew" on Revlon.

 

-Even if volume of issuance of high yield bonds is decreasing, the segment has been taken over by leveraged loans in a very interesting way. These are very popular these days, are typically used to finance mergers, acquisitions and buybacks, typically have floating yields tied to LIBOR and are expected to do well in a rising rate environment. These loans are felt to be safe and secured but, because of the size it now occupies in the fixed income space (vs capital structure), because of the very real decline in covenant quality and because many are packaged into CLOs, the structure of this segment has changed (the risk profile has changed). These specific CLOs have historically done well before under many circumstances and many still get a AAA rating but the underlying securities are non-investment grade securities which, IMO, may behave in a more correlated way, given recent circumstances that now drive this market.

 

Bottom line: I find that, for some time and even more recently, fixed income investors have accommodated less creditworthy companies with lower spreads and this will be recognized somehow.

 

So, potential opportunity for the cash deployment at Fairfax into expected larger credit spreads?

 

To answer the previous question about FFH’s ability to grow intrinsic value for a significant amount of time and the relevance of paying a premium or not, important to identify potential opportunities where FFH could benefit AND TO UNDERSTAND the rationale/analytical framework behind the investment decisions.

 

The investment stance that FFH has defined has been that they have switched to the offense and expect interest rates to increase and the global economy to grow because of the USA-led locomotive. This scenario and investment mindset would however go along a maintenance and even an elevation of present trends in the fixed income market. What gives?

 

I’m still uncomfortable with the sudden and IMO incompletely explained change in investment stance. After reading last year’s BH annual report, I can clearly define the fundamental principles behind investment decisions. In my limited mind, for FFH, this is no longer the case.

 

Respectfully submitted, this investment rationale uncertainty combined with the tone of the last annual report pointing to perhaps a transition in the composition and functioning of the investment team prevents me from investing in Fairfax now.

 

FFH may do very well and that’s great but I will jump in the train only if I understand where the train is going.

 

 

 

[petec]

Cigarbutt

 

Very interesting post and one I agree with to a very great degree.

 

Where I differ is on the interpretation of Fairfax's investment moves.

 

First, hedges. We can debate the hedges ad nauseam but I've come to the conclusion that they simply decided the cost - financially but I suspect also to the morale of the investment team working below those who were making the macro calls - was too great. Trump provided a catalyst and an excuse. Like that or loathe it, that was the right call: 2017 would have been a horrible year with the index hedges (they still lost $400m on the individual ones!). Plenty on here have voiced outrage at the bet taken, the sizing, the explanations, etc. I take the view that it is a lesson learned, and what matters is that the hedges are gone and are not coming back and that makes it much easier to see into the future.

 

Second, "playing offence" - sorry but as a Brit I need to spell it properly ;). I have actually come to the conclusion over time that Prem is not good at communicating to the market and this is a prime example. Sitting in cash, which is what they have done, is not playing offence, and that phrase should never have been used. They have been clear about the risks that they still see, but with a pro-business government in the US driving global GDP they may not come to pass soon and hedging them is too costly. That doesn't mean they are bullish on equities or bonds - in fact they've been explicit that they don't necessarily expect equity indices to do well, and you can tell that they agree with you on corporate bonds by looking at how many they own (not many). What they do expect is for individual opportunities to arise ("stockpicker's market"), and cash on hand is helpful when opportunities appear.

 

I also differ on needing to know where the train is going before hopping on. What I need to know is that there is a high probability of a decent destination, a low probability of an awful one, and a ticket price that doesn't reflect those probabilities. I think that's where we are here.

 

Supporting my view of a high probability of a decent destination are all the things that have gone right over Fairfax's history. The hedges tend to cloud over everything at the moment but when you look at the history of compounding, the transformation of the underwriting, the ability to build businesses from scratch, the acquisitions of amazing insurers (Zenith etc.), the phenomenal performance in India, and the extent to which Fairfax seems to have become a talent magnet, I tend to think more good things will happen than bad.

 

 

 

[Cigarbutt]

Thanks for the solid rebuttle. :)

 

As far as the spelling…no offence.

 

For the record (3 years of Latin leaves an imprint) the root of the word is offensus and the initial meaning had an unpleasant connotation. Playing offence is seen as a potential positive nowadays but was seen more as an insult in times past particularly in places where social decorum had precedence over human qualities. ;)

 

BTW, my unconscious mind wants to be convinced that FFH is a good investment.

Keep it coming.