Fairfax 2018

[StubbleJumper]

Obtuse, the big risk I see is FFH loads up with GE type value plays right before the US enters a recession and a big stock market correction. A second risk is they use all their freecashflow to buy out minority shareholders in companies like Brit which are underperforming. Thanks nstead of using free cash flow to buy back shares that look undervalued. From a corporate governance perspective Prem seems more focused on his kids and keeping control than driving shareholder value.

 

 

It's a legitimate concern.  FFH has demonstrated poor risk management on a recurring basis by taking inordinately large position sizes in some of its investments.  I personally am not even looking at GE for my portfolio, but I wouldn't be up in arms if FFH conducted some analysis and decided to drop $50m or $100m on GE.  My concern is that it might not stop there.  IMO, the problem is that it would not be a shocker to see FFH take a $1 billion position in a company like GE, which is the sort of thing that exposes shareholders to the risk of a permanent loss of capital.

 

As I have opined on previous occasions, FFH really just needs to execute a simpler plan.  Continue the solid underwriting, roll the short-term treasuries into higher interest rates as they mature, and the operating income will appear.  Focus the equity investments on large cap value in plain sight, and limit the position sizes of some of the riskier investments.  There should be no problem at all to reliably generate eps of $80/sh in a few years. 

 

But, to get to the promised land, Prem needs to find the discipline to manage risk better through appropriate position-sizing.  How much has the inappropriate position sizes of Blackberry and the equity shorts cost shareholders?  There was nothing wrong with throwing a few bucks into Blackberry, but the position size was clearly inappropriate for the riskiness of the investment.  Similarly, there's nothing wrong with using equity hedges if you are nervous about markets, but in which parallel universe does it make sense to hedge your entire portfolio (or, in FFH's case, on occasion, the shorts were more than 100% of their long position)?  Even Seaspan strikes me as being at the limit of what would be considered to be an appropriate position size.  At a certain point, the word "reckless" comes to mind.

 

On a going-forward basis, let's hope for a focus on execution and risk management.  The earnings will be there if FFH stops shooting itself in the foot.

 

 

SJ

[Viking]

Seaspan is a good example... listen to Prem talk about the aquisition and all he does is talk about how wonderful David Sokol is and what a great track recod he had at mid-American and BRK (it is all about the jockey). This is the same guy that BUffett had to fire for lack of ethical behavior. Now FFH has $1 billion tied up. My point is Sokol has his warts and Prem is all promotion when he talks about him. How about talking about Seaspan’s business (moat), what it is specifically that FFH loves about the company that warrants a $1 billion investment for FFH shaareholders. Yes, the jockey is i portant but surely there are 3 or 4 other things that FFH loves about Seaspan.

 

FFH is not a private company; shareholders should get the straight goods with a minimum of hyperbole or promotion.

[petec]

Seaspan is a good example... listen to Prem talk about the aquisition and all he does is talk about how wonderful David Sokol is and what a great track recod he had at mid-American and BRK (it is all about the jockey). This is the same guy that BUffett had to fire for lack of ethical behavior. Now FFH has $1 billion tied up. My point is Sokol has his warts and Prem is all promotion when he talks about him. How about talking about Seaspan’s business (moat), what it is specifically that FFH loves about the company that warrants a $1 billion investment for FFH shaareholders. Yes, the jockey is i portant but surely there are 3 or 4 other things that FFH loves about Seaspan.

 

FFH is not a private company; shareholders should get the straight goods with a minimum of hyperbole or promotion.

 

Well, Prem’s no longer the one doing the talking so you won’t have to listen to him so much any more.

 

On Seaspan specifically he does talk a lot about Sokol (who was once so respected by Buffett, don’t forget, that many considered him to be the likely next CEO of Berkshire) because Seaspan is primarily a capital allocation story. I’ve written about how much cash it is generating on the Seaspan thread, if you’re interested. Prem has also talked about the value they see there. He’s not going to talk about the moat because it hasn’t got one, but then nor really did Midamerican. At heart FFH aren’t moat investors when it comes to equities (although I would argue they generally are when it comes to operating businesses). If that puts you off, I’d advise buying Markel or Berkshire instead.

 

More broadly a lot of Fairfax’s investments are fundamentally jockey businesses. There are some incredibly impressive people running even some of the smaller subsidiaries. I like that, and for all Prem’s mistakes I think he’s done a good job of assembling a brain trust and creating a culture in which they stay.

 

As for position sizing, as I’ve said before it’s important to distinguish between what’s convert and what’s equity. From an equity downside perspective Blackberry is under half a billion. That may still be too high for some tastes, but it’s not a billion. Same goes for Seaspan, even after the coming warrant exercise.

 

I don’t see a risk in an oversized position in value cyclicals because they’ve been so clear that they still see macro threats. They didn’t go all in in the February sell off and I doubt they’re doing it now. I hope I’m right.

 

As for catalysts, I haven’t a clue. But they own a lot of cheap stuff (I’m trying to find a platform that will let me buy Grivalia) and I didn’t foresee the value reveal/creation at Quess, ICICIL, First Capital, etc. One of the things I like about Fairfax is the value creation is so lumpy and untrusted by the market that it never seems to get priced in and you can buy it for free. But I accept you have to trust that it’s here. You can’t model it.

 

[gary17]

Petec

What’s your thought about all the share based compensations?

[StubbleJumper]

Seaspan is a good example... listen to Prem talk about the aquisition and all he does is talk about how wonderful David Sokol is and what a great track recod he had at mid-American and BRK (it is all about the jockey). This is the same guy that BUffett had to fire for lack of ethical behavior. Now FFH has $1 billion tied up. My point is Sokol has his warts and Prem is all promotion when he talks about him. How about talking about Seaspan’s business (moat), what it is specifically that FFH loves about the company that warrants a $1 billion investment for FFH shaareholders. Yes, the jockey is i portant but surely there are 3 or 4 other things that FFH loves about Seaspan.

 

FFH is not a private company; shareholders should get the straight goods with a minimum of hyperbole or promotion.

 

 

As for position sizing, as I’ve said before it’s important to distinguish between what’s convert and what’s equity. From an equity downside perspective Blackberry is under half a billion. That may still be too high for some tastes, but it’s not a billion. Same goes for Seaspan, even after the coming warrant exercise.

 

I don’t see a risk in an oversized position in value cyclicals because they’ve been so clear that they still see macro threats. They didn’t go all in in the February sell off and I doubt they’re doing it now. I hope I’m right.

 

 

 

I don't at all buy the argument that the position size is mitigated because part of the position is on the higher portion of the capital structure (ie, debt).  For both Blackberry and Seaspan, if operations should happen to deteriorate, how does FFH exit their debt position?  The obvious answer is that the bonds will come to maturity and they'll simply be repaid, right?  So where does the cash come from?  Let's get real.  For Seaspan in particular, if FFH hadn't loaned them money, *nobody* would have loaned them money.  For FFH to be repaid in cash, Seaspan or BB need to float new debt to somebody else and use the proceeds to write a cheque to FFH.  So, who is going to loan $500m or $1b to either of those companies so that FFH can repatriate its capital?  IMO, the current answer is nobody.  If nothing changes between now and when that debt comes due, FFH will likely end up having to roll it.

 

If you want to go down the extreme road of financial distress, being slightly higher on the capital structure is better, but then again, recovery prospects are still typically only pennies on the dollar.

 

So, let's hope that everything goes well with the investments that constitute a large position size!

 

 

SJ

[Viking]

Petec, You said “More broadly a lot of Fairfax’s investments are fundamentally jockey businesses”. This is true. But some purchases like Blackberry were complete dogs; i was invested in Blackberry when FFH was just getting started and by the third conference call i understood that Baisilie was a complete ding dong. He was great for Blackberry when it was getting started and when they dominated but when the market was pivoting to Apple/Samsung he was completely lost. (Fortunately i sold my complete position at a loss of 15%,i think, which would have been closer to 80% if i had not sold and instead drank the Kool Aid Blackberry management was serving). Not only did FFH not sell, they then kept doubling down when it was clear management was terrible. My point is if I was able to identify that Blackberry was being run by a ding dong after 3 conference calls why was FFH not able to come to the same conclusion? It was not difficult. A year or so later Apple was selling for $60 a share. With what FFH had learned a out the cell phone business (after owning a big chunk of Blackberry for a year) why were they not able to capitalize on Apple trading at $60? If they have a choice of doubling their money with a quality name like Apple or tripling it with a dog like Blackberry something in their DNA makes them want to pick the dog (just to prove how smart they are because even a dummy could make the Apple pick and they need to show how smart they are).

 

I think what i am finally understanding is i have evolved over the past 10 years as an investor. I am more in Buffett’s camp in terms of buying quality. Whereas FFH has remained in the Graham camp of buying statistically cheap companies regardless of how stinky the business is. So when i look at buying FFH i am quite often disappointed with the decisions they are making on the investment side of the business (which stops me from buying the shares).

 

There is a simple answer. Fairfax is not going to change :-) So i need to move on and stop being disappointed in what they are doing. They obviously feel the Graham approach is best and i hope it works out for the company and shareholders.

[petec]

Hi all

 

@Gary: not sure yet. If it's because FFH have stepped up options issuance in a structural way then I'm disappointed. If it's related to the Brit deal, which is what I suspect, then it's a one off. What concerns me more is why they don't talk about diluted book value per share on the calls. If there isn't a good reason for that then it's very disingenuous. I need to do more work here.

 

@SJ: Obviously you're right that being up the cap structure doesn't necessarily mean being safe. And where I have come to think you are 100% correct is on the sizing of the hedge. But I do wonder if you're looking at the same two stocks I am in Blackberry and Seaspan. Blackberry is heavily net cash and has turned FCF positive. The only way it's not going to be able to repay that loan, which matures in less than 2 years, is if it does a bad acquisition, which is possible, but FFH hand-picked the CEO and have seats on the board so they have at least some influence. Seaspan has a bit over $4bn of net debt (not including prefs) but it's fairly well laddered and from q3 of this year SSW is generating $500m a year of FCF, which was predictable when FFH made the first loan. I'm actually astonished that Seaspan had to give away so much equity to get the money they did from FFH - SSW had zero capex from May out and were quite clear about that. They will make huge inroads into their debts over the next few years. I regard the odds of Fairfax getting trapped into rolling loans to both companies as being functionally pretty close to zero. If they roll it's because they want to.

 

@ Viking: I'm certainly not defending the Blackberry investment - the equity portion of it has been a complete dog and the debt part didn't come at a great price. I just don't view it as a $1bn equity position like SJ does. As for Apple, well done you if you made that call. I didn't, and I feel pretty silly about that, but then I did think Microsoft was an absolutely easy win at $25 in 2010 when everybody was telling me it was going to be outcompeted on all fronts and Ballmer was a ding dong (I like that phrase). My point is simply that what's obvious to one person isn't obvious to another, and that doesn't necessarily make the other person a dummy except in the cold glare of hindsight, which can go both ways. There are other investments that have done very well that never seem to come up in these conversations, like Quess, not to mention the businesses they've built and surfaced value from. Ex-hedges, book value would have done OK these last years, and they've said they won't hedge like that again. That's important.

 

I agree with your characterisation of their equity investment style when it comes to minority/disposable stakes, but not for operating companies nor, arguably, control stakes like Grivalia. This makes sense to me: take advantage of silly market prices for things you don't want to own forever but buy quality at a reasonable price for things you do. And I agree with you: if you don't like it, there's no point being disappointed, just don't buy it. I do like it. I like the operating businesses, the brain trust, the record of building businesses internally (which I do think is under-recognised), and the value mindset, which won't always work, but when it works it works well. And I like the current price, which doesn't seem to me to offer much risk of permanent capital loss.

 

Ten years ago the prevailing thesis was that FFH were great investors but terrible underwriters. Funny how things change. I expect that over the next five or ten years they will get the opportunity to go long at great prices and one of those impressions will change again - but only one. That might provide a great exit valuation.

 

As an aside I invest for two things: returns and sleep. I could have made more money in other things over the last decade, but I wouldn't have slept as well. Others don't feel the same way. That's the nature of the game. I'm not trying to persuade you into FFH. Don't buy it if you won't sleep. There's plenty of other stuff out there.

 

[StubbleJumper]

 

@SJ: Obviously you're right that being up the cap structure doesn't necessarily mean being safe. And where I have come to think you are 100% correct is on the sizing of the hedge. But I do wonder if you're looking at the same two stocks I am in Blackberry and Seaspan. Blackberry is heavily net cash and has turned FCF positive. The only way it's not going to be able to repay that loan, which matures in less than 2 years, is if it does a bad acquisition, which is possible, but FFH hand-picked the CEO and have seats on the board so they have at least some influence. Seaspan has a bit over $4bn of net debt (not including prefs) but it's fairly well laddered and from q3 of this year SSW is generating $500m a year of FCF, which was predictable when FFH made the first loan. I'm actually astonished that Seaspan had to give away so much equity to get the money they did from FFH - SSW had zero capex from May out and were quite clear about that. They will make huge inroads into their debts over the next few years. I regard the odds of Fairfax getting trapped into rolling loans to both companies as being functionally pretty close to zero. If they roll it's because they want to.

 

@ Viking: I'm certainly not defending the Blackberry investment - the equity portion of it has been a complete dog and the debt part didn't come at a great price. I just don't view it as a $1bn equity position like SJ does. As for Apple, well done you if you made that call. I didn't, and I feel pretty silly about that, but then I did think Microsoft was an absolutely easy win at $25 in 2010 when everybody was telling me it was going to be outcompeted on all fronts and Ballmer was a ding dong (I like that phrase). My point is simply that what's obvious to one person isn't obvious to another, and that doesn't necessarily make the other person a dummy except in the cold glare of hindsight, which can go both ways. There are other investments that have done very well that never seem to come up in these conversations, like Quess, not to mention the businesses they've built and surfaced value from. Ex-hedges, book value would have done OK these last years, and they've said they won't hedge like that again. That's important.

 

 

 

Pete, we are definitely looking at BB and SSW differently.  You seem to looking at them from a base case perspective based on some sense of probable free cash flow.  It's facile to say it, but it's obvious that if everything goes well then everything will go well.  I rather look at them as businesses that have a wide range of potential outcomes.  Some of those potential outcomes are good, and some are not.

 

With BB, we can take cold comfort in the fact that there's a pile of cash on the balance sheet.  That's great.  So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash?  The history of the tech industry is littered with the carcasses of companies that made value destroying acquisitions in a vain attempt to maintain/regain market position (the RedHat acquisition comes to mind!).  Cash in the tech industry can disappear very quickly.  The value of the tech that a company holds can also shift very quickly.  The basis upon which FCF is generated is mere intellectual property that can be (and often is!) supplanted by a superior offering from some other company.  If you put money into an outfit like BB, you need to handicap it's potential outcomes.  Is there a 10% likelihood that it'll be a home run, 40% likelihood that they'll muddle through and a 50% likelihood that there'll be no enterprise value in 10 years?  Or is it a 20% likelihood of a home run , 60% likelihood of muddling through, and a 20% likelihood of a permanent loss of capital within 10 years?  However you handicap it, history of the tech industry and BB's current positioning in the industry demand that you assign a non-trivial likelihood to the permanent loss of capital.  And that's the problem with an inappropriate position size for that type of investment.

 

Turning to Seaspan, I understand your hypothesis for considerable FCF in the foreseeable future.  That's why I like the fact that FFH dumped some capital into the outfit.  The reason why I view their $1b position as being on the frontier of what would be wise is that the nature of the shipping industry is that it is subject to considerable risks too, and Seaspan itself has relatively high financial risk due to its capital structure.  That's okay, but then you need to do the mental handicapping exercise again.  So, taking into account all of the bad things that have happened in the industry over the years, what's the likelihood that Seaspan blows up?  I'd say there's a real possibility of this becoming a permanent loss of capital.  Is it a 60% likelihood of a good outcome, 30% of muddling through, and 10% likelihood of a permanent loss of capital?  It's hard to say, but when you pile $1b into an outfit like Seaspan you absolutely must remain cognizant about that negative scenario.  I certainly would not want to see FFH dump $2b into Seaspan (ie basically full ownership).

 

Over the past number of years, I have been beating a dead horse on this.  But, my sense is that nobody will pay an appropriate BV multiple for FFH as long as Prem keeps making wacky decisions without heed for the management of risk.  FFH is in a position to kick out considerable EPS in the next few years through strong underwriting and making plain-Jane investments.  If they stop taking such daring positions, maybe the market will finally recognize that the company is worth 1.3x BV.

 

 

SJ

[gfp]

Really good posts guys.  Thanks

 

I found it funny re: blackberry that as soon as I read your post about the primary risk being that they do an unwise acquisition, I flipped over to the news wire where they had just announced a $1.4 Billion all cash acquisition.  Not saying it's unwise, I haven't the faintest idea.

https://www.cnbc.com/2018/11/16/blackberry-to-buy-cybersecurity-firm-cylance.html

[petec]

Really good posts guys.  Thanks

 

I found it funny re: blackberry that as soon as I read your post about the primary risk being that they do an unwise acquisition, I flipped over to the news wire where they had just announced a $1.4 Billion all cash acquisition.  Not saying it's unwise, I haven't the faintest idea.

https://www.cnbc.com/2018/11/16/blackberry-to-buy-cybersecurity-firm-cylance.html

 

Ha ha - yes great timing. This has been coming for a while. I've seen a lot of speculation.

 

If the target company has no debt, BBRY will still have net cash after this by my maths.

[StubbleJumper]

Really good posts guys.  Thanks

 

I found it funny re: blackberry that as soon as I read your post about the primary risk being that they do an unwise acquisition, I flipped over to the news wire where they had just announced a $1.4 Billion all cash acquisition.  Not saying it's unwise, I haven't the faintest idea.

https://www.cnbc.com/2018/11/16/blackberry-to-buy-cybersecurity-firm-cylance.html

 

 

I hadn't seen that presser when I drafted my post.  It's a bit embarrassing to be musing about the possibility of burning cash when the truth was that the cash had already been burned a few hours earlier.  :-[

 

 

SJ

[petec]

 

Pete, we are definitely looking at BB and SSW differently.  You seem to looking at them from a base case perspective based on some sense of probable free cash flow.  It's facile to say it, but it's obvious that if everything goes well then everything will go well.  I rather look at them as businesses that have a wide range of potential outcomes.  Some of those potential outcomes are good, and some are not.

 

With BB, we can take cold comfort in the fact that there's a pile of cash on the balance sheet.  That's great.  So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash?  The history of the tech industry is littered with the carcasses of companies that made value destroying acquisitions in a vain attempt to maintain/regain market position (the RedHat acquisition comes to mind!).  Cash in the tech industry can disappear very quickly.  The value of the tech that a company holds can also shift very quickly.  The basis upon which FCF is generated is mere intellectual property that can be (and often is!) supplanted by a superior offering from some other company.  If you put money into an outfit like BB, you need to handicap it's potential outcomes.  Is there a 10% likelihood that it'll be a home run, 40% likelihood that they'll muddle through and a 50% likelihood that there'll be no enterprise value in 10 years?  Or is it a 20% likelihood of a home run , 60% likelihood of muddling through, and a 20% likelihood of a permanent loss of capital within 10 years?  However you handicap it, history of the tech industry and BB's current positioning in the industry demand that you assign a non-trivial likelihood to the permanent loss of capital.  And that's the problem with an inappropriate position size for that type of investment.

 

Turning to Seaspan, I understand your hypothesis for considerable FCF in the foreseeable future.  That's why I like the fact that FFH dumped some capital into the outfit.  The reason why I view their $1b position as being on the frontier of what would be wise is that the nature of the shipping industry is that it is subject to considerable risks too, and Seaspan itself has relatively high financial risk due to its capital structure.  That's okay, but then you need to do the mental handicapping exercise again.  So, taking into account all of the bad things that have happened in the industry over the years, what's the likelihood that Seaspan blows up?  I'd say there's a real possibility of this becoming a permanent loss of capital.  Is it a 60% likelihood of a good outcome, 30% of muddling through, and 10% likelihood of a permanent loss of capital?  It's hard to say, but when you pile $1b into an outfit like Seaspan you absolutely must remain cognizant about that negative scenario.  I certainly would not want to see FFH dump $2b into Seaspan (ie basically full ownership).

 

Over the past number of years, I have been beating a dead horse on this.  But, my sense is that nobody will pay an appropriate BV multiple for FFH as long as Prem keeps making wacky decisions without heed for the management of risk.  FFH is in a position to kick out considerable EPS in the next few years through strong underwriting and making plain-Jane investments.  If they stop taking such daring positions, maybe the market will finally recognize that the company is worth 1.3x BV.

 

 

SJ

 

I agree entirely about the need to probability-weight. But I suspect I do weight the probabilities for these two stocks differently than you do. That's partly due to current business momentum, which can change but is currently improving in both businesses. In Seaspan's case it is partly to do with the existing contract durations and the global order book, which is basically zero in the ship classes where they have uncontracted time - together these make high FCF for the next few years not probable, but highly probable. In both cases it's partly to do with management. FFH skew the probabilities strongly in their favour, in my view, by partnering/picking good CEOs. In Seaspan's case, for example, I find it notable that they do not intend to order new ships simply to maintain the fleet as ships age. They will only do it if they can get decent returns. In other words they'd rather run the business off than invest at poor returns. I suspect, although I cannot prove, that the same is true of John Chen at BBRY. That dramatically improves the probability of the debt being money good.

 

To be clear I'm not advocating an equity position in either, although I am long SSW. I'm simply saying I think the debt portion of both investments is highly likely to be safe and one has to take that into account when debating position size.

 

A $1bn position is 2.5% of the portfolio and 5.5% of equity (I am assuming one should include minorities in this calculation, but obviously that does depend on where the positions are held). I think this overstates equity exposure for reasons given above. As a resut I am comfortable with these position sizes (but they are close to the limit, for me). What would you consider to be acceptable position limits?

 

Finally you may well be right about the p/bv. I don't care. I'm not in this hoping it will rerate, although it is a nice option. I'm in it because I don't have to pay a premium to book value for an asset that I think will compound nicely over the long term. If their investing style holds back the p/bv multiple so I can keep adding as I earn, great.

 

[petec]

Really good posts guys.  Thanks

 

I found it funny re: blackberry that as soon as I read your post about the primary risk being that they do an unwise acquisition, I flipped over to the news wire where they had just announced a $1.4 Billion all cash acquisition.  Not saying it's unwise, I haven't the faintest idea.

https://www.cnbc.com/2018/11/16/blackberry-to-buy-cybersecurity-firm-cylance.html

 

 

I hadn't seen that presser when I drafted my post.  It's a bit embarrassing to be musing about the possibility of burning cash when the truth was that the cash had already been burned a few hours earlier.  :-[

 

 

SJ

 

No, it's been spent. We will find out whether it has been burned over the ensuing few years. I have no opinion on this currently although I look forward to JC's explanations.

 

Incidentally, we haven't discussed one other risk with BBRY, which is that FFH chooses to convert and doesn't sell. Then I would worry about the position size.

 

[StubbleJumper]

Really good posts guys.  Thanks

 

I found it funny re: blackberry that as soon as I read your post about the primary risk being that they do an unwise acquisition, I flipped over to the news wire where they had just announced a $1.4 Billion all cash acquisition.  Not saying it's unwise, I haven't the faintest idea.

https://www.cnbc.com/2018/11/16/blackberry-to-buy-cybersecurity-firm-cylance.html

 

 

I hadn't seen that presser when I drafted my post.  It's a bit embarrassing to be musing about the possibility of burning cash when the truth was that the cash had already been burned a few hours earlier.  :-[

 

 

SJ

 

No, it's been spent. We will find out whether it has been burned over the ensuing few years. I have no opinion on this currently although I look forward to JC's explanations.

 

Incidentally, we haven't discussed one other risk with BBRY, which is that FFH chooses to convert and doesn't sell. Then I would worry about the position size.

 

 

Okay, you don't like the term "cash burn".  Fair enough.  It's a pretty commonly used term to denote the usage of cash.  Like all cases where companies use cash, it's not immediately clear whether it'll end up being a good thing or a bad thing.

 

I would say that the risk that FFH chooses to convert and then elects to not sell, or simply continues rolling the debt is a virtual certainty.  As I have opined in the past, the fact that Prem holds a seat on BB's board of directors makes it very awkward for FFH to dispose of its investment in BB.  Frequent open market sales of 50,000 shares here and 50,000 shares there would require recurring insider filings and would likely be frowned upon by BB.  So, as we've discussed in the past, that really leaves only a few outlets for exiting the BB position:

 

 

1) BB gets taken over by some other company and all shareholders, including FFH, dispose of their position through a cash tender offer;

 

2) Some large institutional shareholder suddenly gets a hankering to own a large slug of BB and makes an offer to buy FFH's block;

 

3) At some point in the future, BB is rolling in cash and elects to make significant buybacks.  As part of the buybacks, it offers to buy FFH's block for a shade under market price;

 

4) Prem resigns from his BB BOD position and FFH dumps the BB shares on the market, come what may.

 

 

Some of those possibilities could be good outcomes, but it certainly strikes me as a situation characterized by a lack of flexibility for FFH.

 

 

SJ

[StubbleJumper]

 

Pete, we are definitely looking at BB and SSW differently.  You seem to looking at them from a base case perspective based on some sense of probable free cash flow.  It's facile to say it, but it's obvious that if everything goes well then everything will go well.  I rather look at them as businesses that have a wide range of potential outcomes.  Some of those potential outcomes are good, and some are not.

 

With BB, we can take cold comfort in the fact that there's a pile of cash on the balance sheet.  That's great.  So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash?  The history of the tech industry is littered with the carcasses of companies that made value destroying acquisitions in a vain attempt to maintain/regain market position (the RedHat acquisition comes to mind!).  Cash in the tech industry can disappear very quickly.  The value of the tech that a company holds can also shift very quickly.  The basis upon which FCF is generated is mere intellectual property that can be (and often is!) supplanted by a superior offering from some other company.  If you put money into an outfit like BB, you need to handicap it's potential outcomes.  Is there a 10% likelihood that it'll be a home run, 40% likelihood that they'll muddle through and a 50% likelihood that there'll be no enterprise value in 10 years?  Or is it a 20% likelihood of a home run , 60% likelihood of muddling through, and a 20% likelihood of a permanent loss of capital within 10 years?  However you handicap it, history of the tech industry and BB's current positioning in the industry demand that you assign a non-trivial likelihood to the permanent loss of capital.  And that's the problem with an inappropriate position size for that type of investment.

 

Turning to Seaspan, I understand your hypothesis for considerable FCF in the foreseeable future.  That's why I like the fact that FFH dumped some capital into the outfit.  The reason why I view their $1b position as being on the frontier of what would be wise is that the nature of the shipping industry is that it is subject to considerable risks too, and Seaspan itself has relatively high financial risk due to its capital structure.  That's okay, but then you need to do the mental handicapping exercise again.  So, taking into account all of the bad things that have happened in the industry over the years, what's the likelihood that Seaspan blows up?  I'd say there's a real possibility of this becoming a permanent loss of capital.  Is it a 60% likelihood of a good outcome, 30% of muddling through, and 10% likelihood of a permanent loss of capital?  It's hard to say, but when you pile $1b into an outfit like Seaspan you absolutely must remain cognizant about that negative scenario.  I certainly would not want to see FFH dump $2b into Seaspan (ie basically full ownership).

 

Over the past number of years, I have been beating a dead horse on this.  But, my sense is that nobody will pay an appropriate BV multiple for FFH as long as Prem keeps making wacky decisions without heed for the management of risk.  FFH is in a position to kick out considerable EPS in the next few years through strong underwriting and making plain-Jane investments.  If they stop taking such daring positions, maybe the market will finally recognize that the company is worth 1.3x BV.

 

 

SJ

 

I agree entirely about the need to probability-weight. But I suspect I do weight the probabilities for these two stocks differently than you do. That's partly due to current business momentum, which can change but is currently improving in both businesses. In Seaspan's case it is partly to do with the existing contract durations and the global order book, which is basically zero in the ship classes where they have uncontracted time - together these make high FCF for the next few years not probable, but highly probable. In both cases it's partly to do with management. FFH skew the probabilities strongly in their favour, in my view, by partnering/picking good CEOs. In Seaspan's case, for example, I find it notable that they do not intend to order new ships simply to maintain the fleet as ships age. They will only do it if they can get decent returns. In other words they'd rather run the business off than invest at poor returns. I suspect, although I cannot prove, that the same is true of John Chen at BBRY. That dramatically improves the probability of the debt being money good.

 

To be clear I'm not advocating an equity position in either, although I am long SSW. I'm simply saying I think the debt portion of both investments is highly likely to be safe and one has to take that into account when debating position size.

 

A $1bn position is 2.5% of the portfolio and 5.5% of equity (I am assuming one should include minorities in this calculation, but obviously that does depend on where the positions are held). I think this overstates equity exposure for reasons given above. As a resut I am comfortable with these position sizes (but they are close to the limit, for me). What would you consider to be acceptable position limits?

 

Finally you may well be right about the p/bv. I don't care. I'm not in this hoping it will rerate, although it is a nice option. I'm in it because I don't have to pay a premium to book value for an asset that I think will compound nicely over the long term. If their investing style holds back the p/bv multiple so I can keep adding as I earn, great.

 

 

Pete,

 

Position sizing is about managing risk.  I actually don't mind large-ish positions as long as they are in investments that have a reasonably narrow range of outcomes, have a very small likelihood of realizing a permanent loss of capital, and are easily exited.  As an example, if FFH decides to invest 10% of shareholder capital in a Canadian bank, I don't have a particular problem with that.  The risk of a permanent loss of capital is very small, and when you want to exit, dumping $2b of Royal Bank or Bank of Nova Scotia shares on the open market is relatively easy (could you do it over a 10 days or two weeks without much impact on share price?).

 

 

SJ

[Cardboard]

"There is a simple answer. Fairfax is not going to change :-)"

 

No it isn't and it has not changed after its near death experience in 2002/2003. That is when my confidence eroded completely. Ok sure, more cash was then carried at holdco or around $1 billion since then doing squat.

 

I made money with it again in 2006 and with the Odyssey Re take-out in 2009 but, these were trades.

 

I have said for I don't know how long that the structure is wrong: too much recurring costs such as interest while carrying too many investments earning too little.

 

It is easy to see. Look at shareholder equity and true investments/businesses excluding treasuries and cash. Then you have a lot of debt to support all that. Makes it near impossible to earn that 15% return over time.

 

And it has happened yet.

 

Cardboard

[petec]

 

Okay, you don't like the term "cash burn".  Fair enough.  It's a pretty commonly used term to denote the usage of case.  Like all cases where companies use cash, it's not immediately clear whether it'll end up being a good thing or a bad thing.

 

Agreed. FWIW I wasn't trying to be pedantic - I've only heard the term cash burn in the context of a company that is operating cash lossmaking and only has a finite amount of cash to keep itself alive. I've not heard it used in reference to  investment activities except in hindsight when it is known an investment was a bad one.

 

I agree that FFH is limited in its flexibility, but I would draw the outcomes differently:

 

1) BBRY operating performance deteriorates and FFH is forced to roll the loan to protect its equity investment because BBRY needs the cash and no-one else will lend. This is the situation in which you are 100% correct about the position sizing. I currently think it is a low probability but I may be wrong.

 

2) BBRY is still net cash and is generating FCF but the convert is out of the money. In this case I see no reason why having Prem on the board reduces the likelihood of the loan being repaid. FFH is under no obligation to extend and the loan can be paid with cash - or, another lender could be found. The only reason Prem would extend is to maintain the conversion right if he thinks the shares are undervalued, and if he does he might push for better terms (higher coupon, lower strike).

 

3) the convert is in the money when the loan expires (2020). Then Prem has to convert, and the position size is too big, and it's tricky to sell while Prem is on the board - but we have made good money from today's starting point. In this case PC readily agrees with SJ that the position size is too big, until the company gets sold for $40/share and then with the benefit of hindsight we all agree Prem is a misunderstood genius.

 

OK, maybe not that last bit - although having listened to JC discussing BBRY I think his endgame is a sale.

 

Useful discussion although I'm busy for the rest of the day so can't contribute much more.

 

[petec]

 

Pete,

 

Position sizing is about managing risk.  I actually don't mind large-ish positions as long as they are in investments that have a reasonably narrow range of outcomes, have a very small likelihood of realizing a permanent loss of capital, and are easily exited.  As an example, if FFH decides to invest 10% of shareholder capital in a Canadian bank, I don't have a particular problem with that.  The risk of a permanent loss of capital is very small, and when you want to exit, dumping $2b of Royal Bank or Bank of Nova Scotia shares on the open market is relatively easy (could you do it over a 10 days or two weeks without much impact on share price?).

 

SJ

 

Noted & fair. I tend to view these big positions as very long term. What FFH is trying to do here is build value by appointing excellent management, so I worry less about liquidity but I acknowledge the risks of this can be higher under some circumstances. So long as those risks aren't correlated, though, I don't mind large, carefully-structured (debt/equity/warrant) investments. I prefer SSW to BBRY, but that's because I think FFH got a genuinely good deal on SSW while what they've been doing with BBRY is trying to save an old, failed investment. The psychology of that bothers me more than the pure risk/reward/size dynamic.

[Uccmal]

"There is a simple answer. Fairfax is not going to change :-)"

 

No it isn't and it has not changed after its near death experience in 2002/2003. That is when my confidence eroded completely. Ok sure, more cash was then carried at holdco or around $1 billion since then doing squat.

 

I made money with it again in 2006 and with the Odyssey Re take-out in 2009 but, these were trades.

 

I have said for I don't know how long that the structure is wrong: too much recurring costs such as interest while carrying too many investments earning too little.

 

It is easy to see. Look at shareholder equity and true investments/businesses excluding treasuries and cash. Then you have a lot of debt to support all that. Makes it near impossible to earn that 15% return over time.

 

And it has happened yet.

 

Cardboard

 

I agree, Its one of the biggest investment disappointments I am aware of.  I would never touch it.  I have been out since about 2012 and nothing they do could convince me to be back in it. 

[doc75]

The Global, TorStar and Sandridge investments were some of the biggest head-scratchers for me.  And I recall Prem being quite enthusiastic about the Sandridge CEO...

 

 

[petec]

So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash? 

 

I don't mean to restart this debate (useful though it was) but I forgot to mention something that people might find interesting.

 

I don't know if there are such indentures in the BB debt issue. But there are at least two useful protections in the SSW one. First, SSW can't increase the dividend without compensating FFH for the value thus detracted from its debentures. And second, the price of getting FFH to agree to early exercise of the warrants (which is what took the commitment to $1bn) was that Fairfax got the option to ask for the debentures to be repaid within a year. As such they have been reclassified as ST debt (although FFH has waived its option for this year, so they're back in LT for now). In effect this option means SSW can't do anything that imperils its liquidity or FFH would have them over a barrel. It's not quite a capital allocation veto, but it's useful nonetheless.

[StubbleJumper]

So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash? 

 

I don't mean to restart this debate (useful though it was) but I forgot to mention something that people might find interesting.

 

I don't know if there are such indentures in the BB debt issue. But there are at least two useful protections in the SSW one. First, SSW can't increase the dividend without compensating FFH for the value thus detracted from its debentures. And second, the price of getting FFH to agree to early exercise of the warrants (which is what took the commitment to $1bn) was that Fairfax got the option to ask for the debentures to be repaid within a year. As such they have been reclassified as ST debt (although FFH has waived its option for this year, so they're back in LT for now). In effect this option means SSW can't do anything that imperils its liquidity or FFH would have them over a barrel. It's not quite a capital allocation veto, but it's useful nonetheless.

 

 

Yes, the main risks currently faced by SSW are not internal to SSW, but rather external (fuel costs, counter-party risk on contracts, the demand for shipping as manifested through GDP/trade growth, environmental regulations, risk/security of transit in international waters, state sponsored competitors, etc).  SSW currently doesn't have scads of cash to burn, so the internal decisions have limited scope to cause FFH grief.  On the other hand, once FCF starts to really roll in, that's when the cash allocation decisions become really important -- repay debt, buy a bunch of new ships, buy a subsidiary, buy back shares, etc.  Hopefully FFH will have an exit strategy to repatriate its capital in a profitable way as the FCF rolls in!

 

 

SJ

[petec]

So, is there an indenture in the debt that FFH holds which prevents BB from burning that cash? 

 

I don't mean to restart this debate (useful though it was) but I forgot to mention something that people might find interesting.

 

I don't know if there are such indentures in the BB debt issue. But there are at least two useful protections in the SSW one. First, SSW can't increase the dividend without compensating FFH for the value thus detracted from its debentures. And second, the price of getting FFH to agree to early exercise of the warrants (which is what took the commitment to $1bn) was that Fairfax got the option to ask for the debentures to be repaid within a year. As such they have been reclassified as ST debt (although FFH has waived its option for this year, so they're back in LT for now). In effect this option means SSW can't do anything that imperils its liquidity or FFH would have them over a barrel. It's not quite a capital allocation veto, but it's useful nonetheless.

 

 

Yes, the main risks currently faced by SSW are not internal to SSW, but rather external (fuel costs, counter-party risk on contracts, the demand for shipping as manifested through GDP/trade growth, environmental regulations, risk/security of transit in international waters, state sponsored competitors, etc).  SSW currently doesn't have scads of cash to burn, so the internal decisions have limited scope to cause FFH grief.  On the other hand, once FCF starts to really roll in, that's when the cash allocation decisions become really important -- repay debt, buy a bunch of new ships, buy a subsidiary, buy back shares, etc.  Hopefully FFH will have an exit strategy to repatriate its capital in a profitable way as the FCF rolls in!

 

 

SJ

 

Agreed. I happen to think all those risks are low given some are passthrough (fuel costs and environmental regulation costs) and given where we are in the cycle (we have had 10 years of low rates, supply overhang, slower-than-expected growth, and stress testing counterparty risks; now the order book is tiny and capital is getting more expensive). The main risk I see is a trade recession which I find very hard to forecast, but I'd worry a lot more if the contracts weren't there or there was a supply overhang. NB the cash has started to really roll in ($130m FCF in q3). My guess is FFH gets those debentures repaid when they mature and exits its equity at a higher price at some point - or, if Sokol is building a diversified asset-based company as seems to be his strategy, maybe FFH are long term partners in that. Will be interesting to see how it plays out. FWIW one option that seems unlikely is buying new ships - from call commentary sounds like consolidating the industry and adding different asset types is more likely than newbuild at the moment.

 

Worth pointing out if they exercised all the warrants today they'd book a gain of over $250m.

[petec]

Eurobank and Grivalia have just announced that they will merge. Fairfax will own 33% of the newco.

 

The merger creates a much better capitalised banking group - in effect it is an equity issue by Eurobank in return for a cheap asset. It's accretive (for what that's worth) to earnings and capital ratios but dilutive to Eurobank's bvps.

 

The merger also gives Grivalia's excellent management team operating control over the big Eurobank real estate portfolio.

 

Eurobank has also announced plans to speed up bad loan reductions by securitising them and spinning the securities out to shareholders. This cleans the bank's balance sheet but allows shareholders to participate in any upside.

 

Fairfax controls Grivalia and has seats on both boards so this isn't happening without their approval.

 

Links:

 

https://www.eurobank.gr/-/media/eurobank/omilos/grafeio-tupou/etairikes-anakoinoseis/2018/etairiki-anakoinosi-26-11-18/etairiki-anakoinosi-26-11-18-eng.pdf?la=en

 

https://www.eurobank.gr/-/media/eurobank/omilos/grafeio-tupou/etairikes-anakoinoseis/2018/etairiki-anakoinosi-26-11-18/investor-presentation.pdf?la=en

[wondering]

https://www.chicagofed.org/publications/chicago-fed-letter/2018/405

 

This is a nice introduction to Catastrophe Bonds (CAT).  Others may know better than me, but I think this is one of the reasons that the insurance industry has been in a soft market for so long.