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2017 Annual Letter


ValueMaven
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Best letter in a very long time!

Prem finally admits that hedging was a mistake and that the equity selection was very poor over the last years.  They will do no hedging anymore and there will be a change in the equity team.

Mistakes are human, we all make them.  But it is important to admit them, learn out of them and move on.  It seems that Prem was finally able to do this and it is very important for the future of Fairfax. 

 

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I too liked the expansion of the investment team and the additional responsibilities of the younger members.

 

PW restated the investment goals and 15% increase in BV target.

 

'With $40 billion in investments, a current run rate of $11.5B in net premiums written and $12.5B in common shareholders equity, we need an investment return of approximately 7% in order to achieve an annual increase in 15% in BV per share, assuming a consolidated combined ratios of 95%"........."We have drilled deeper and by analysing each of our 21 insurance companies we have estimated the investment return needed for each company in order to achieve our 15% target. We have delegated investment responsibility for each of our insurance companies to one member of our investment team".

 

 

 

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I too liked the expansion of the investment team and the additional responsibilities of the younger members.

 

PW restated the investment goals and 15% increase in BV target.

 

'With $40 billion in investments, a current run rate of $11.5B in net premiums written and $12.5B in common shareholders equity, we need an investment return of approximately 7% in order to achieve an annual increase in 15% in BV per share, assuming a consolidated combined ratios of 95%"........."We have drilled deeper and by analysing each of our 21 insurance companies we have estimated the investment return needed for each company in order to achieve our 15% target. We have delegated investment responsibility for each of our insurance companies to one member of our investment team".

 

If they get the 15%, I would expect some multiple expansion.  That would give shareholders a somewhat better than 15% return.  Certainly could double in 3-4 years if they get 15% BVPS growth over that time. 

 

Of course, actually achieving the 15% is the key.

 

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I worry that they are bullish at the wrong time ( market and valuation at highs). I think their portfolio of companies and operating performance is better than their earlier years, but their investing performance has been sub par .

 

I think that is a fair concern, but if forward returns for the market are low, that could still mean significant outperformance for Fairfax.

 

Let's say they add and subtract no value in their investing.  If the market returns 7% CAGR over the next 5 years (and Fairfax matches the market), Fairfax thinks they can grow at 15%.  I don't think 7% is unreasonable, but the market may very well fall short of that.  Let's say the market returns 3% (and, again, Fairfax matches).  Fairfax wouldn't hit 15%, but could do very well on a relative performance basis against the 3% market.

 

Lots of assumptions baked in.  Just saying that Fairfax might be a good relative performer in a challenged equity market.

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I worry that they are bullish at the wrong time ( market and valuation at highs). I think their portfolio of companies and operating performance is better than their earlier years, but their investing performance has been sub par .

 

They are not bullish. They still hold lots of cash. That is why they will never be able to achieve 15% with yields as low as they are today.  But if they even achieve 10% priced at book value today, and hoping for a rerating at one point in time to 1,5 times book, that would still be a great investment.

Investment performance has been poor on the equity (and hedging) side, but on the bond portion of the portfolio they are amazing.  The fact that they sold everything just before Trump got elected when long term yields were at 1,5% is a master stroke.  For an insurer the fixed income part of the portfolio is essential, and with Fairfax you have the best.

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Reading the letter, it appears to me that Prem is less promotional and more fact oriented. Nice to see.

 

Can someone explain to me what impact the following transaction will have on Thomas Cook India and also Fairfax?

 

From page 9: “Quess has had a phenomenal run since we acquired our interest in it in 2013. Thomas Cook India invested $47 million in Quess in 2013, sold 5.4% last year for $97 million and retains 49%, which is currently worth over $1 billion. Because of Quess’ great success, Thomas Cook India intends to spin its holding in Quess out to its shareholders during 2018 so that Quess can be run independently as a public company under the leadership of Ajit Isaac. A big thank you to Madhavan Menon for nurturing Quess under the Thomas Cook India umbrella as it became large enough to be a freestanding company. Today, Quess is India’s leading integrated business services provider. With over 250,000 employees, the company has a pan-India presence with 65 offices across 34 cities, along with an overseas footprint in North America, the Middle East and South East Asia. It serves over 1,700 customers across five segments – Industrials, Global Technology Solutions, People and Services, Integrated Facility Management and Internet Solutions.”

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"Can someone explain to me what impact the following transaction will have on Thomas Cook India and also Fairfax?"

 

I think that it goes like this:

 

FFH owns 66% of Thomas Cook India

Thomas Cook owns a majority of Quess, I think it might be down to 49% now.

If TC spins out Quess it will no longer own, nor consolidate Quess in its numbers.

FFH will now own 66% of the 49% of Quess Stock which means FFH wil have a direct holding of 32.3%.

 

FFH will not consolidate Quess and thefore the gain will be recognised which until now was an unrealized gain in Thomas Cook.

 

Also, FFH can directly sell off Quess shares as and when it pleases.

 

We would see and imediate uptick in Book Value if this goes ahead.

 

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I worry that they are bullish at the wrong time ( market and valuation at highs). I think their portfolio of companies and operating performance is better than their earlier years, but their investing performance has been sub par .

 

They are not bullish. They still hold lots of cash. That is why they will never be able to achieve 15% with yields as low as they are today.  But if they even achieve 10% priced at book value today, and hoping for a rerating at one point in time to 1,5 times book, that would still be a great investment.

Investment performance has been poor on the equity (and hedging) side, but on the bond portion of the portfolio they are amazing.  The fact that they sold everything just before Trump got elected when long term yields were at 1,5% is a master stroke.  For an insurer the fixed income part of the portfolio is essential, and with Fairfax you have the best.

 

Steph, yes, FFH has absolutely excelled with their bond portfolio decisions over the past 18 months. Their total portfolio is about $40 billion. Only $9 billion is currently in bonds; of this amount only $1 billion is 5-10 year duration and $2 billion is more than 10 year duration.

 

It will be very interesting to watch where US interest rates go in 2018. If the long end (10 year plus) continues higher then bond losses will start to hit insurance companies book value when they report Q1 earnings. In a rising rate environment the size and average duration (years) of bond portfolios will become very important metrics for investors moving forward. Fairfax’s investment portfolio is ideally positioned for a rising rate environment.

 

If long bond yields increase enough, and spreads widen on junk debt, it may hit book values enough to support a harder market in insurance pricing.

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I too liked the expansion of the investment team and the additional responsibilities of the younger members.

 

PW restated the investment goals and 15% increase in BV target.

 

'With $40 billion in investments, a current run rate of $11.5B in net premiums written and $12.5B in common shareholders equity, we need an investment return of approximately 7% in order to achieve an annual increase in 15% in BV per share, assuming a consolidated combined ratios of 95%"........."We have drilled deeper and by analysing each of our 21 insurance companies we have estimated the investment return needed for each company in order to achieve our 15% target. We have delegated investment responsibility for each of our insurance companies to one member of our investment team".

 

 

Could someone check my math:

 

95% combined ratio on $11.5B = $575M underwriting profit

7% return on $40B investments = $2800M return

 

Underwriting + investment return = $3.375B pretax or say $2.36B after-tax assuming 30% tax rate

 

After-tax ROE = 2.36/12.5 = 18.9% >> 15%?

 

 

I think it's difficult to have 95% combined ratio (including catastrophes) over long-term.  In fact, page 17 says their combined ratio since inception is 100%.  They may have gotten better over the years though.  On the other hand, 7% return on a mostly-bond portfolio may not be so easy either in the medium term given rising but still low interest rates.

 

 

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Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

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Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

Vinod,

 

Thanks for correcting my calculations.  Seems to me it's a tall order to get to 7% return in this kind of market (high stock AND bond valuations).

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Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

Vinod,

 

Thanks for correcting my calculations.  Seems to me it's a tall order to get to 7% return in this kind of market (high stock AND bond valuations).

 

My earlier post on this should be ignored.  I was reading and posting too fast.  7% for the equity portion of the portfolio and 7% for a blended portolio is much different.  A 14-16% return for the equity portion isn't plausible.

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Prem touched on many topics that have been talked about here. Share buybacks, the consequences of selling JNJ WFC USB, changes in their equity investment approach, and his sons $50m investment fund. It appeared to me he is a little humbled by the way things have gone over the past few years...

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Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

Vinod,

 

Thanks for correcting my calculations.  Seems to me it's a tall order to get to 7% return in this kind of market (high stock AND bond valuations).

 

My earlier post on this should be ignored.  I was reading and posting too fast.  7% for the equity portion of the portfolio and 7% for a blended portolio is much different.  A 14-16% return for the equity portion isn't plausible.

 

I need to look more closely at this later today.  The numbers below are a little hasty.

 

It looks to me as though the book value is about $12.5B US.  A little under $10B CAD.  (most I see are per share; so perhaps I have this total book value incorrect).

 

If there are $40B in investments, at a 95% combined ratio, why would they need a 7% return to grow book at 15% (about 1.8B USD)?

 

Anyway, I've gotten myself confused here and need to take a fresh look.

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