Is this patient investor flogging a dead horse with FFH? I Sell side discipline

[TwoCitiesCapital]

Good points vinod1.

 

My own reservations regarding Fairfax are as follows:

 

1. Leverage: FFH has roughy $3 in insurance liabilities for $1 of common equity and another $0.50 mostly in debt. With so much insurance liability leverage, I think they are forced to keep most of the float in fixed income or cash. Obviously when it works, leverage produces great results but the reverse is true also. One major CAT loss, a huge portion of common equity will be wiped out. I really don't like the way annual letter shows underwriting results with and w/o CAT losses as if CAT losses were not supposed to happen and are highly unusual. It is as if management wants shareholders/readers to ignore these insurance losses when they are normal part of being in the insurance business.

 

2. Invested Assets: Just the fixed income portion of assets is larger than common equity. And it is highly unlikely that FI portfolio will produce great results going forward. And common stock selection has been awful during the last 10+ years. As others pointed out, they like to go for the crappy stuff all the while completely avoiding quality long term investments.

 

3. Macro Calls: A big negative in my book. One can easily see them making a 2020 US election macro bet for example if past is any indication.

 

4. Sub-optimal capital allocation: The dividend policy doesn't make any sense especially because they immediately issued more stock many times in the past right after declaring dividends. If they need more capital why not retain earnings? Why force shareholders to pay tax on dividends and immediately dilute them with new stock issuance?

 

5. Board governance: Too much Watsa family involvement without a clear benefit to the company or shareholders.

 

Out of those five items, only really the macro calls affected performance.  Their equity positions overall have done reasonably well since 2008, excluding the puts and derivatives.  That's what really killed about $2B in gains.  As for the Watsa family involvement, Ben has only been involved for the last 3 years, while Christine has been involved for one year...are you going to tell me that was the reason Fairfax underperformed for the last decade?

 

Ben Graham must be turning over in his grave. Do not blame value investing or indexing.

 

What happened over the past decade is that earnings for companies that fall in the value spectrum have not grown as much as they have historically done. Why that is so is a separate topic of discussion. Where as for the growth stocks they are pretty much in line with history. See attached table from philosophical economics blog. Pay attention to the earnings growth rate of value.

 

This earnings slowdown for value stocks is what is causing the under-performance. Market is paying attention to fundamentals. That is in line with what Ben Graham has been teaching. Stocks. Long Run. Weighting Machine.

 

Fairfax portfolio and Fairfax itself performed poorly because the earnings of their portfolio companies and itself were below par. Are we really blaming indexing for Fairfax's portfolios poor returns? Should Blackberry be worth $100 because Fairfax first paid what $45 a share several years back?

 

Vinod

 

 

 

Fairfax is not buying the market...be it value or growth.  So that's not an excuse, nor the reason why it underperformed.  We all know clearly from the letters that the macro calls since after 2009 offset about $2B in gains.  And that extremely conservative position left them holding a ton of cash and a ton of bonds, when equities were priced at 50 year lows.  So if shareholders want to blame anything, I would say they should be blaming the macro calls on what might happen.

 

- Going back to shareholders holding the stock or considering buying...if you think that Fairfax has learned their lesson on macro calls, Fairfax will probably do well in the future. 

- If you think that Fairfax will continue to try and make these macro bets, then yes, it is possible Fairfax will be out of step. 

 

I personally am betting on the former, but at the same time, I manage a considerable amount of my own portfolio and only a portion is in Fairfax.  Cheers!

 

I'm not convinced they have learned. It was only 3 years ago that they dumped 100% of their long bond portfolio in response to Trump winning the election.

 

It was a smart move in the short term, but they failed to start re-adding to that position and have now missed out on additional gains from the duration rally while being stuck in short-bonds while we cut rates.

 

Macro calls will continue. Sometimes they'll be right. Sometimes they'll be wrong. They need to get better about the risk management when the latter occurs. 

[Fat Pitch]

I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

 

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

[EricSchleien]

I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

 

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

 

On the latter point, I spoke for about 2 hours in depth about this at my annual meeting this year in NY. I think you're exactly on point here :)

[Packer16]

I think the change to many industries from on-line businesses is real.  The end state will be close to what the disrupters describe but there are many ways to get there and the timing is uncertain.  In some industries, the new disrupter will win however for many of the incumbents will adopt the innovation and either defeat the disrupters or delay the time of disruption to long into the future.  Given the uncertainty here you have IMO many smart marketers that can raise money for businesses that either in the end will not disrupt, become a less advantaged competitor (despite a high multiple today) or the timing for the disruption is so long they will run out of money.  The current low interest rate environment has led to a proliferation of these types of firms IMO.

 

This IMO leads value investors to dig deep & estimate the growth of their businesses going forward.  The should lead to a discussion of the growth implied in the share price versus what the value investor thinks the growth rate should be.  The growth rate debate is one place where IMO value investors will make their money going forward.  One interesting observation is that as interest rates decline the "premium" for growth increases.  One way to quantify this is via Grahams 8.5 + 2g.  What this formula implies is 0 growth is equal to an 8.5 multiple and the growth multiplier is 2.  LT interest rates has declined by 1/3rd since this formula was derived, so, the current 0 growth multiple is 13 (7.7% yield) & the growth multiplier is 3.

 

Packer

[petec]

I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

 

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

 

On the latter point, I spoke for about 2 hours in depth about this at my annual meeting this year in NY. I think you're exactly on point here :)

 

How does software "destroy", for example, Stelco? Or is the thesis just that software companies have higher ROICs and can therefore grow faster, provided demand is there? Because if it's the latter, you're right, but that doesn't mean you can't make an amazing return on a Stelco if you buy at the right price. And it may be easier/lower risk to make money that way vs investing in software, because 1) everyone is looking at software and ignoring the likes of Stelco and 2) it's not always easy to predict the winner software winners before the market does.

 

FD: Microsoft is one of my biggest positions so I have drunk the Kool-Aid - but only to a point.

[cwericb]

New article on Fairfax in Seeking Alpha:

 

https://seekingalpha.com/article/4295352-time-trade-fairfax-financial?dr=1

[Fat Pitch]

I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

 

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

 

On the latter point, I spoke for about 2 hours in depth about this at my annual meeting this year in NY. I think you're exactly on point here :)

 

How does software "destroy", for example, Stelco? Or is the thesis just that software companies have higher ROICs and can therefore grow faster, provided demand is there? Because if it's the latter, you're right, but that doesn't mean you can't make an amazing return on a Stelco if you buy at the right price. And it may be easier/lower risk to make money that way vs investing in software, because 1) everyone is looking at software and ignoring the likes of Stelco and 2) it's not always easy to predict the winner software winners before the market does.

 

FD: Microsoft is one of my biggest positions so I have drunk the Kool-Aid - but only to a point.

 

It just comes down to opportunity costs and redeploying capital. Less decisions you have to make the better. Would you rather chase Stelco like opportunities (5% ROIC) and redeploy into another after you get your pop or focus on companies that can endlessly redeploy capital on your behalf at ridiculous ROIC?

 

Tech based companies can scale to the masses in a blink of an eye vs traditional businesses. There's roughly 2.5 billion people (it's growing too) with a smart phone and they are all 1 click away from using your product/service. Your time is better spent angel seeding smart developers with sensible ideas and going for that 100x-1,000x than over analyzing some steel company that maybe might double your money in 3-5 years. The beauty of this is you only have to win once and your life and future generations are forever changed. I feel blessed in living such a world that affords these opportunities to anyone.

[KFS]

This thing is trading at around 90% of book value.  I understand the concerns and frustrations and I'd probably agree if this was at 1.4x book, and folks on this site could argue all day long whether the intrinsic value should be 1.1x book or 1.5x book, or whatever.  I just do not see how we reach 0.9x book.

 

Compare this to other insurers (Markel at 1.56x, CB at 1.35x, TRV at 1.47x, WRB, etc...) 

 

At "peak optimism" in 1996, FFH traded at 3.3x book, and this turned out to be a terrible time to buy.  Today, the pendulum has swung pretty far in the opposite direction.

 

On the investments, instead of rear-view mirror driving, the question is where do we go from here.  Prem has stated that it's extremely unlikely he will resort to macro hedges or significant short selling in the future.  His long term investment performance is not bad.  He has placed Wade Burton in charge of the investment team, and Wade supposedly has a very good track record (it would be interesting to see more detail/clarity on his past investments...).  In any case, I don't think it's safe to assume the future investment performance will resemble the recent past.  At the current stock price, I don't need their investments to be brilliant.

 

Their insurance business has drastically improved.  I keep going back and re-reading Ben Comston's article on this (link below).  If someone has an argument to make against the sustainability of this improvement, I'd love to hear it.

https://seekingalpha.com/article/3974653-fairfax-financials-meaningfully-improved-underwriting

 

With the stock trading at book value, you essentially get the float per share for nothing, and below book value, you essentially get a discount on the investments, correct?  Please explain if I'm going crazy. 

 

 

[petec]

It just comes down to opportunity costs and redeploying capital. Less decisions you have to make the better. Would you rather chase Stelco like opportunities (5% ROIC) and redeploy into another after you get your pop or focus on companies that can endlessly redeploy capital on your behalf at ridiculous ROIC?

 

Tech based companies can scale to the masses in a blink of an eye vs traditional businesses. There's roughly 2.5 billion people (it's growing too) with a smart phone and they are all 1 click away from using your product/service. Your time is better spent angel seeding smart developers with sensible ideas and going for that 100x-1,000x than over analyzing some steel company that maybe might double your money in 3-5 years. The beauty of this is you only have to win once and your life and future generations are forever changed. I feel blessed in living such a world that affords these opportunities to anyone.

 

a) If I buy Stelco at the right price and trust management to allocate capital I can compound very nicely, not just pop. Just requires discipline.

 

b) The kind of companies you're looking at can't endlessly redeploy capital at a ridiculous ROIC. The very fact that they have a ridiculous ROIC tells you they can't deploy capital in the business. That's why they end up with tons of cash and doing deals at silly valuations, both of which depress ROIC.

 

c) App development is becoming commoditised and it's viciously competitive. Picking winners is nigh impossible so while 100x is possible, 0x is probable, and I don't have access to nearly enough opportunities to offset that risk (do you, and if so how?).

 

d) Summary: I'd rather invest in what I know and understand than punt in what I don't. I'm happy to have my life changed slowly, but surely.

 

Just my view :)

[Spekulatius]

 

 

a) If I buy Stelco at the right price and trust management to allocate capital I can compound very nicely, not just pop. Just requires discipline.

 

 

I think over time, Stelco is a zero, it’s just a matter of time. Blast steel mills in NA don’t work economically any more, as the mini mills over time eat their lunch, breakfast and dinner.

[Fat Pitch]

It just comes down to opportunity costs and redeploying capital. Less decisions you have to make the better. Would you rather chase Stelco like opportunities (5% ROIC) and redeploy into another after you get your pop or focus on companies that can endlessly redeploy capital on your behalf at ridiculous ROIC?

 

Tech based companies can scale to the masses in a blink of an eye vs traditional businesses. There's roughly 2.5 billion people (it's growing too) with a smart phone and they are all 1 click away from using your product/service. Your time is better spent angel seeding smart developers with sensible ideas and going for that 100x-1,000x than over analyzing some steel company that maybe might double your money in 3-5 years. The beauty of this is you only have to win once and your life and future generations are forever changed. I feel blessed in living such a world that affords these opportunities to anyone.

 

a) If I buy Stelco at the right price and trust management to allocate capital I can compound very nicely, not just pop. Just requires discipline.

 

b) The kind of companies you're looking at can't endlessly redeploy capital at a ridiculous ROIC. The very fact that they have a ridiculous ROIC tells you they can't deploy capital in the business. That's why they end up with tons of cash and doing deals at silly valuations, both of which depress ROIC.

 

c) App development is becoming commoditised and it's viciously competitive. Picking winners is nigh impossible so while 100x is possible, 0x is probable, and I don't have access to nearly enough opportunities to offset that risk (do you, and if so how?).

 

d) Summary: I'd rather invest in what I know and understand than punt in what I don't. I'm happy to have my life changed slowly, but surely.

 

Just my view :)

 

All I just read are excuses not to adapt to the changing environment that tech is bringing to the global economies. Very much reminds me of Plato's allegory of the cave when you mention tech to a "value" investor  ;)

[petec]

It just comes down to opportunity costs and redeploying capital. Less decisions you have to make the better. Would you rather chase Stelco like opportunities (5% ROIC) and redeploy into another after you get your pop or focus on companies that can endlessly redeploy capital on your behalf at ridiculous ROIC?

 

Tech based companies can scale to the masses in a blink of an eye vs traditional businesses. There's roughly 2.5 billion people (it's growing too) with a smart phone and they are all 1 click away from using your product/service. Your time is better spent angel seeding smart developers with sensible ideas and going for that 100x-1,000x than over analyzing some steel company that maybe might double your money in 3-5 years. The beauty of this is you only have to win once and your life and future generations are forever changed. I feel blessed in living such a world that affords these opportunities to anyone.

 

a) If I buy Stelco at the right price and trust management to allocate capital I can compound very nicely, not just pop. Just requires discipline.

 

b) The kind of companies you're looking at can't endlessly redeploy capital at a ridiculous ROIC. The very fact that they have a ridiculous ROIC tells you they can't deploy capital in the business. That's why they end up with tons of cash and doing deals at silly valuations, both of which depress ROIC.

 

c) App development is becoming commoditised and it's viciously competitive. Picking winners is nigh impossible so while 100x is possible, 0x is probable, and I don't have access to nearly enough opportunities to offset that risk (do you, and if so how?).

 

d) Summary: I'd rather invest in what I know and understand than punt in what I don't. I'm happy to have my life changed slowly, but surely.

 

Just my view :)

 

All I just read are excuses not to adapt to the changing environment that tech is bringing to the global economies. Very much reminds me of Plato's allegory of the cave when you mention tech to a "value" investor  ;)

 

I must look up Plato's cave, but FWIW I wouldn't describe myself as a value investor. In general I'm a value-aware growth investor with a weakness (I use that term deliberately) for a few deep value stocks. More broadly, as a personal investor I own both tech and startups (but not tech startups so far as I haven't found any good ones yet) and as a professional investor I would say I spend 75% of my time thinking about what impact tech will have on a given industry/company and how to benefit from it. That thinking has driven huge shifts in my portfolios over time. So I am moderately confident that you're wrong, although there's always room for improvement.

 

The point is, none of that stops me from investing in an old-industry business if I think it has certain characteristics - for example a high (say, 20%) sustainable free cash flow yield, a solid balance sheet, and a management team that can allocate capital. (For clarity, I am not saying Stelco has these things. I'm interested but haven't done enough work. I was using it as a hypothetical example.)

 

So, a question: leaving aside the general impression my comments gave you, what did I say above that was actually wrong?

[Fat Pitch]

It just comes down to opportunity costs and redeploying capital. Less decisions you have to make the better. Would you rather chase Stelco like opportunities (5% ROIC) and redeploy into another after you get your pop or focus on companies that can endlessly redeploy capital on your behalf at ridiculous ROIC?

 

Tech based companies can scale to the masses in a blink of an eye vs traditional businesses. There's roughly 2.5 billion people (it's growing too) with a smart phone and they are all 1 click away from using your product/service. Your time is better spent angel seeding smart developers with sensible ideas and going for that 100x-1,000x than over analyzing some steel company that maybe might double your money in 3-5 years. The beauty of this is you only have to win once and your life and future generations are forever changed. I feel blessed in living such a world that affords these opportunities to anyone.

 

a) If I buy Stelco at the right price and trust management to allocate capital I can compound very nicely, not just pop. Just requires discipline.

 

b) The kind of companies you're looking at can't endlessly redeploy capital at a ridiculous ROIC. The very fact that they have a ridiculous ROIC tells you they can't deploy capital in the business. That's why they end up with tons of cash and doing deals at silly valuations, both of which depress ROIC.

 

c) App development is becoming commoditised and it's viciously competitive. Picking winners is nigh impossible so while 100x is possible, 0x is probable, and I don't have access to nearly enough opportunities to offset that risk (do you, and if so how?).

 

d) Summary: I'd rather invest in what I know and understand than punt in what I don't. I'm happy to have my life changed slowly, but surely.

 

Just my view :)

 

All I just read are excuses not to adapt to the changing environment that tech is bringing to the global economies. Very much reminds me of Plato's allegory of the cave when you mention tech to a "value" investor  ;)

 

I must look up Plato's cave, but FWIW I wouldn't describe myself as a value investor. In general I'm a value-aware growth investor with a weakness (I use that term deliberately) for a few deep value stocks. More broadly, as a personal investor I own both tech and startups (but not tech startups so far as I haven't found any good ones yet) and as a professional investor I would say I spend 75% of my time thinking about what impact tech will have on a given industry/company and how to benefit from it. That thinking has driven huge shifts in my portfolios over time. So I am moderately confident that you're wrong, although there's always room for improvement.

 

The point is, none of that stops me from investing in an old-industry business if I think it has certain characteristics - for example a high (say, 20%) sustainable free cash flow yield, a solid balance sheet, and a management team that can allocate capital. (For clarity, I am not saying Stelco has these things. I'm interested but haven't done enough work. I was using it as a hypothetical example.)

 

So, a question: leaving aside the general impression my comments gave you, what did I say above that was actually wrong?

 

We are still in the early innings of tech disrupting the global economies so we haven't seen anything yet. I tend to fish around in the frontier tech (AI, blockchain) so I'm very confident we'll be shifting to a p2p world where commerce can bypass nation borders at the micro level and also give birth to a virtual economy (100% digital, detached from analog world).

 

So with that lens the ROIC of the next ecosystems will surprise many as capital formation and coordination can be bootstrapped from literally nothing. The joint stock company formula that powered capitalism for the last several hundred years is about to get disrupted. What's great about digital is that it's not bound to the same physics of analog based companies (supply chain, distribution channels, etc). It may sound sci-fi, but I'm witnessing the building blocks being laid and there's a nascent digital economy already forming.

[petec]

 

We are still in the early innings of tech disrupting the global economies so we haven't seen anything yet. I tend to fish around in the frontier tech (AI, blockchain) so I'm very confident we'll be shifting to a p2p world where commerce can bypass nation borders at the micro level and also give birth to a virtual economy (100% digital, detached from analog world).

 

So with that lens the ROIC of the next ecosystems will surprise many as capital formation and coordination can be bootstrapped from literally nothing. The joint stock company formula that powered capitalism for the last several hundred years is about to get disrupted. What's great about digital is that it's not bound to the same physics of analog based companies (supply chain, distribution channels, etc). It may sound sci-fi, but I'm witnessing the building blocks being laid and there's a nascent digital economy already forming.

 

The only thing I disagree with here is the ROIC part. Some ROICs will be very high; but we might be surprised at how accessible some of these technologies and how competing ecosystems drive down returns. That's not a prediction, but it is a risk. I think I am already starting to see it in some spheres of activity.

 

Incidentally, if you have any recommended reading on this I'd love to see it.