Fairfax Valuation

[jfan]

Hey everyone,

 

Fairfax is a pretty complex beast to value with all its moving parts but thought I would give it an amateurish attempt.

 

Just wondering if all you nice people on this board won't be opposed to provide me with some criticism and feedback to my simple dcf model.

 

Thanks for your time.

 

Jerome

FFH_simple_DCF_model.docx

[Spekulatius]

Hey everyone,

 

Fairfax is a pretty complex beast to value with all its moving parts but thought I would give it an amateurish attempt.

 

Just wondering if all you nice people on this board won't be opposed to provide me with some criticism and feedback to my simple dcf model.

 

Thanks for your time.

 

Jerome

 

It seems that you tax investment earnings twice - one time by putting a tax on investment earnings (1/3) and the second time, but assuming a company tax rate of 27%.

[jfan]

The 2/3 discount on the investment income was just a margin of safety that was imposed in order to be conservative. I recognize that it will be quite difficult to forecast their future investment returns as it will be dependent on the skill of the team, market sentiment changes to revalue their stock picks, the weighted average interest rate changes, global macroeconomic Dynamics, ever changing capital shifts in their portfolio, etc. I just reasoned that given the uncertainty and the complexity of all the variables, trying to predict a precise estimate would be fool's game and that the central tendency would be the most least error prone value.

[jfan]

I've attached an updated FFH valuation model spreadsheet for everyone.

 

I've included some historical data, estimated yield on their bond portfolio, estimated current investment portfolio yield, as well as their geometric total return portfolio (historically). I assumed a 2% GDP related growth of the float.

 

I realize everything here is a rough approximation and most likely everyone here will have a more precise model.

 

For what I gather, there are a few interesting points (at least to me):

1) The current investment portfolio likely will hover around the range of 4.5% given its cash, bond, stock composition. To get their investment returns to 7% will require a common stock return of >20% to achieve this level or much higher interest rates.

2) It seems they have been quite dependent on growing their share of profits/losses from their equity accounted investments over time (especially their non-insurance side, Fairfax AFrica and India fall here as well) to make up for their portfolio returns. This portion has been growing 33% yearly over the past 10 years.

3) Also getting to a 95% Combined ratio is likely a stretch as well. Their 11 year average CR is about 98.6%.

 

 

 

FFH_Valuation_Model.xlsx

[omagh]

Insurance companies are usually modelled using a sum of the parts (SOTP) and book value (BV) multiple.  So, something like WRB is at the top range of valuation (approaching 2x BV) while Fairfax (sub 1x BV; use US$ as financials are US$) is at the bottom range of valuation.  Your view on BV growth and a range of BV multiples is probably more meaningful than DCFs which are a trickier model to get 'right'. 

 

Fairfax is saddled with a 1xBV valuation because their portfolio management has been atrocious for years.  They play the Templeton-style deep value game, in the small percentage of their portfolio dedicated to equities, which hasn't worked for ages.  The bulk of their portfolio is in cash and bonds which was great during the bond bull market but tremendously limits their upside going forward.  At best, Fairfax will grow their book value by xx% and possibly get a 1.2 or 1.3xBV bump when one of their deep value plays finally pays off.  There are easier ways to make money.

 

DCFs are more appropriate for predictable cash-gushing businesses than insurance companies which have catastrophe years where cash is needed for payouts.  Even still, favorable assumptions in DCFs lead to a large tail value which is quite probably wrong.  Caveat emptor.

 

Hey everyone,

 

Fairfax is a pretty complex beast to value with all its moving parts but thought I would give it an amateurish attempt.

 

Just wondering if all you nice people on this board won't be opposed to provide me with some criticism and feedback to my simple dcf model.

 

Thanks for your time.

 

Jerome

[jfan]

Insurance companies are usually modelled using a sum of the parts (SOTP) and book value (BV) multiple.  So, something like WRB is at the top range of valuation (approaching 2x BV) while Fairfax (sub 1x BV; use US$ as financials are US$) is at the bottom range of valuation.  Your view on BV growth and a range of BV multiples is probably more meaningful than DCFs which are a trickier model to get 'right'. 

 

Fairfax is saddled with a 1xBV valuation because their portfolio management has been atrocious for years.  They play the Templeton-style deep value game, in the small percentage of their portfolio dedicated to equities, which hasn't worked for ages.  The bulk of their portfolio is in cash and bonds which was great during the bond bull market but tremendously limits their upside going forward.  At best, Fairfax will grow their book value by xx% and possibly get a 1.2 or 1.3xBV bump when one of their deep value plays finally pays off.  There are easier ways to make money.

 

DCFs are more appropriate for predictable cash-gushing businesses than insurance companies which have catastrophe years where cash is needed for payouts.  Even still, favorable assumptions in DCFs lead to a large tail value which is quite probably wrong.  Caveat emptor.

 

 

Thanks Omagh for your comments. Much appreciated and very helpful. I just want to paraphrase so that I truly understand.

 

So it seems that premium/discount on book value for an insurance company is quite dependent on the current liquidation value + estimated book value growth. In turn, the book value growth is dependent on float growth from net premiums written annually and underwriting discipline as well as the return on the investment portfolio.

 

So with the current interest environment, and ASSUMING they can mean revert back to historical 10.9% common stock return, their total return on equity/minority interest would be 8.5% (including common dividends), meaning that they would be deserving to have a valuation around 1x book. Given that their book value CAGR over the past 10 years, has only been 4.5%, this suggests that the market is already giving them the benefit of the doubt despite their recent underperformance.

 

However, for those that are optimistic about FFH's future, they would be counting on the following optionalities to be recognized:

1) a hard insurance market with the chance to increase float size

2) continued success in FAH and FIH to help generate fees and increase in market value from revaluation and/or book value growth

3) repurchasing of common shares (which is a bit nullified by their options issuance) at a fair price

4) re-evaluating the effectiveness of their current deep value/turnaround investment philosophy and portfolio sizing

 

To the last point, FFH is very different than BAM which also invests in turn-arounds. It seems to me that FFH has much less operational expertise to turnaround businesses unlike BAM. Given this limitation, it appears to me that strategically it makes more sense to move up the quality chain (especially given the float size) or consider much smaller position sizes with more rapid turnover to minimize the sunk cost fallacy and  future opportunity costs. It also appears to me, that their aversion to technology and growth companies should also be re-examined since all investing is a probabilistic exercise (even in deep value situations) anyways.

 

Would this be a fair assessment of their future?

 

 

[steph]

Management says that they aim for 15% growth of book by achieving a 95% combined ratio and 7% return on their portfolio.  I assume they will do 98% combined and closer to 5% on their portfolio due to low interest rates.  If they get close to 10% growth in book value I am perfectly happy.  I am not sure there are that many companies out there that will achieve this. 

And being today at close to book value , you may even hope that at one point investors will like FFH again and price goes back to 1.5 times book.  Then you get 10% growth in book plus a rerating which would give a very decent return. 

[investmd]

Management says that they aim for 15% growth of book by achieving a 95% combined ratio and 7% return on their portfolio.  I assume they will do 98% combined and closer to 5% on their portfolio due to low interest rates.  If they get close to 10% growth in book value I am perfectly happy.  I am not sure there are that many companies out there that will achieve this. 

And being today at close to book value , you may even hope that at one point investors will like FFH again and price goes back to 1.5 times book.  Then you get 10% growth in book plus a rerating which would give a very decent return.

Do you have a time frame for expected re-rating to 1.5x book? 3-5 years? Have been thinking of similar returns for past decade. Hasn't played out yet.

[steph]

No, no time frame.  It will only happen if they make some pretty smart investment decisions which will bring confidence back regarding their investment skills or if interest rates start to rise again.  But timing of these is difficult to predict.  But I just see it as a bonus. But a bonus which will most probably eventually happen.

[nickenumbers]

All,

 

I am performing a DCF valuation on FRFHF.  I have completed it, but I need to update some of my inputs with you guys that know a little more about this firm.

 

Revenue Growth Rate Assumptions-  Over next 5 years, and then remaining 5 years?  [Or however you want to provide it to me.]

 

Tax Rate Assumptions- What do you think tax rate on it is going to be over the next 10 years?  I don't need super precision.

 

BS Investments- Are the Bonds, Preferred Stocks and Common Stocks quality and liquid? 

 

 

Thank you in advance. 

[petec]

I’ve watched FFH for 15 years now and I sincerely have absolutely no sodding idea. Sorry.

[nickenumbers]

I’ve watched FFH for 15 years now and I sincerely have absolutely no sodding idea. Sorry.

 

Baaahhhhhhhh......... ;) ;) :P

 

 

Maybe some brave soul will hazard a guess.

[obtuse_investor]

Lol! There is so much truth in that.

 

FFH’s business returns are highly variable year to year. Over medium (3-10yr) term they can range from terrible to outstanding. Effectively, as a long term shareholder you’re in for a ride. It will occasionally move like a rocket and other times it is a dud for years. The only reason to stay attached to the business is trust in management, which itself ebbs and flows.

 

Frankly, I don’t know why I do it. :-)

 

I also know that when I feel incredibly down about this firm it’s a time to buy rather than sell.

 

In short, I don’t do a DCF on this firm because I am not smart enough. It would be garbage in and garbage out. 

[Jurgis]

Isn't DCF - or just valuing on CF basis - for insurance companies inherently wrong approach?

[StubbleJumper]

Isn't DCF - or just valuing on CF basis - for insurance companies inherently wrong approach?

 

Yep.  It's worth doing as a secondary approach to supplement a BV based metric, but it's not the best choice as a sole approach.  This is particularly true with FFH over the past few years with its lumpy earnings and with the varying quality of earnings (some years assets gained value which never hit the books, while other years gains were booked on assets without those assets having necessarily added much value in that particular year). 

 

Multiple metrics are a good idea, but a BV based metric is essential.

 

 

SJ