Fairfax 2020

StubbleJumper · October 30, 2020

What can you say? It was a pretty good quarter, all things considered. Can't complain about EPS of $4/sh and a 101 CR on an accident year basis. A few observations:

1) Double-digit growth in Net Written is encouraging. What is more perplexing is how light the cats were compared to some of the other players in the industry (RenRe, Arch, etc). Seriously, the Atlantic basin ran out of English alphabet letters for this hurricane season and the meteorologists have had to revert to naming storms after Greek letters. Add to that the wildfires in the Western US and the mid-west derecho, it is interesting how few non-covid cat points that FFH registered. After all of that, the accident year CR was 101 for the quarter? Not too shabby.

2) How are losses from short equity exposures continuing to overwhelm gains from the long? What shitty selection of securities drove that result? It's hard to believe how poorly the equity portfolio has performed.

3) The holdco repaid a large chunk of what was drawn on its revolver during Q3. Was that due to the commercial paper having come to term and the absence of acceptable short term investments to replace it? It looks to me as if FFH has just enough equity to draw the entire $2B revolver without violating its covenants. A decent result in Q4 would make things a bit more comfortable. They will probably want to float another bond offering early in the new year.

4) This is not new in Q3, but it's nice to see a considerable chunk of the bond holdings in the 1 to 5 year category, because prospects for rolling maturing bonds during 2021 don't look great. Maybe 2023...

5) FFH bought the rest of Brit for $220m in August. Didn't Prem tell us that it would be about $100m? Maybe all of those business interruption covid claims made Brit more valuable ;D ? Interesting that Brit paid a $20.6m dividend to the minority interest back in April and FFH bought that interest out for $220m. What the hell kind of arrangement was that?

Better than I had expected....

SJ

Viking · October 30, 2020

Fairfax is a three legged stool:

1.) insurance / underwriting - solid

2.) investing part 1: fixed income - solid

3.) investing equities / op co’s - a mess

The way to make very good money with Fairfax for the past 20 years is to wait for the turn in stool leg 3. (Mr Market was always slow to catch on so the shares became $20 bills lying on the ground in plain sight for all to see.) The problem for Fairfax investors is stool leg 3 has underperformed for the last 7 years (more than offsetting the gains made in stool legs 1 and 2).

The good news for new investors in Fairfax is with shares trading at US$266 they will likely do well moving forward if Fairfax simply stops losing money with bucket 3. Crazy thing to say... but i think it is true (posters think i am only hard on Trump :-)

And that is how out of favour this company is today... People do not want to own it because they expect Fairfax to lose more money in bucket 3. There are lots of legacy dogs still barking in the shadows: Toys R Us, Recipe, Blackberry to name a few that quickly come to mind...

Now having said all that i might reestablish a position tomorrow. Because, to Sanjeev’s point, if they ever start to make a positive return from stool leg 3 the stock will rock.

The other potential catalyst for shares is Prem’s creativity in surfacing value.

Parsad · October 30, 2020

Fairfax from this base forward will probably do better than Berkshire long-term. Just based on the discount it is trading at, and the size advantage it holds in terms of the universe of investments it can look at. I think WFC will do nearly as well over the next 4-5 years as FFH. Cheers!

petec · October 30, 2020

No.

The insurance subs are in a hard market. They would absolutely ooze cash (which could be dividended to the holdco) if they stopped growing.

What we need to worry about is that Fairfax has somehow contrived to arrive at a place where it can’t fund growth in a hard market or buy back many shares at bargain levels without taking on more debt. The sequence of bad decisions that caused us to arrive at this point is staggering.

petec · October 30, 2020

OMERS always got paid its dividends in cash. I'm not sure whether that was a preferential arrangement, or whether Fairfax opted to capitalise Brit to grow by taking stock instead.

I need to revisit the disclosures on Brit over the years. I think OMERS have done quite well.

StubbleJumper · October 30, 2020

Well, yes, that was the second part of my observation. Not only did the buyout cost rise compared to guidance that I recall Prem providing during earlier teleconferences, but also it seems that OMERS was on the receiving end of a 9% dividend? WTF?

It doesn't really make me feel better about any of the other existing partnerships that FFH has established with OMERS.

SJ

bearprowler6 · October 30, 2020

The lack of transparency/full disclosure around the various funding that OMERS has provided over the years is all you need to know. Prem continues to play up what a great partner Fairfax has in OMERS....great for OMERS and not so great for Fairfax shareholders.

I continue to believe that Fairfax got way ahead of itself and could not internally fund the organic growth of its insurance companies, the share buybacks that Prem had promised and the various acquisitions that it made. OMERS was more than willing to "help" out and provide the capital needed.

Although the cash level at the holdco remained essentially flat during the first 9 months of 2020: $1.153 billion at Sept 30/20 versus $1.099 billion at Dec 31/19 this only occurred because Fairfax drew $700 million on its line of credit, received $599.5 million on the sale of a portion of its Riverstone European Runoff business (to ....you guessed it.....OMERS) and completed a 10 year senior note offering of $650 million at 4.625%.

To summarize----cash level essentially flat, insurance hard market supported and Brit's minority interest bought out however at a cost of approx $1.950 billion in 9 months.

bearprowler6 · October 30, 2020

Hi Viking...I agree with your 3 legged stool analogy concerning Fairfax with one exception. To date Fairfax's fixed income investing has been very solid---in my view the real strength of the company over the last many years. My concern is that given the ultra low interest rate environment we are in and will likely remain in for a very long time I am not at all optimistic going forward that Fairfax will enjoy the lift that it has from its fixed income investments in the same way that that it has over the last 30 years. Sure it can fund some private debt deals and achieve some yield enhancement in the corporate market but the bulk of its fixed income investments will be in governments bonds and hence return virtually nothing for the foreseeable future. This will put even more pressure on its equity investments and on this point point I could not agree with you more---- this part of the 3 legged stool is a total mess. So although a few posters on here are saying that all Fairfax needs to do is achieve a 3% return on its investments in order to achieve a 15% long term compound on its shares from this point forward I am not so sure this is as much of a slam dunk as some others on here seem to think it is. Your thoughts/comments and those of others would be appreciated.

drzola · October 30, 2020

They Just need to Green Slklate and actually hire an 21 st century equities purveyor simple is what simple does duh!

Cardboard · October 30, 2020

Well.... After being out for maybe a decade, I bought some today.

Obviously, the market likes results considering the rest of the market today.

I believe it is justified since they have managed a decent combined ratio with a pretty nasty hurricane season, fires and Covid related losses.

Investment wise, these guys must be defensively positioned with their take on Nasdaq and now that they will reverse their stance on U.S. with a pro-taxation government likely coming in.

To keep it simple, I received recently my auto and home insurance renewals and prices are going up. Not much I could do either trying to negotiate lower with current company or competitors.

This trend should continue and if they can only avoid losing money on portfolio side, I believe that they will be better off than competitors.

Price is right or well below book. Seems right to me.

Cardboard

StubbleJumper · October 30, 2020

Well, then create your own pro-forma income statement for 2021. It might look a little like this:

1) UW profit

Net Written Premiums $16B (up 6.5% over 2020)

Consolidated Ratio: 94% (take the YTD CR, strip out the 10 cat points for 2020 and replace with 4 cat points for 2021)

UW profit = $960m

2) Investment returns

Investment portfolio $40B

Investment return 2% (bond duration is strangely favourable for this assumption)

Inv profit = $800m

3) Overhead = $200m (just grab the number from 2018)

4) Interest = $500m (run rate the first three-quarters of 2020)

Earnings before taxes = $960m + 800 - 200 - 500 = $1,060m

Taxes = $281m (tax rate 26.5%)

Earnings after tax = $779m

Sharecount: 26.2 milion

EPS = $779/26.2 = $30

Is there anything outrageous about that bit of school-boy arithmetic? The current stock price is US$268, so a basic EPS of $30/sh would be an 11% earnings yield, which is not reliant on much of an investment return and makes no assumption of further price increases. The 15% target would be left in the dust if FFH actually got a 3% investment return.

SJ

Cigarbutt · October 30, 2020

^Reasonable time to retrospectively evaluate the Brit acquisition so far.

-Price paid in summer of 2015 for 97.0% interest = 1,656.6M (including 575.9M in shares (price per share about 500-501(!)).

100% inferred price for 100% = 1,707.8M

-----

a look at OMERS

-in late June 2015, they got 29.9% interest for 516.0M

-since then

-57.8 paid back by Brit in August 2016

-251.8 paid back by parent in July 2018

-206.4 paid back by parent in Q3 2020

-57.8+251.8+206.4=516.0M

-the return obtained by OMERS is related to dividends received over time: 45.8 (2017), 45.8 +12.8 (2018), 20.6 (2019) and 20.6 + 13.6 (2020)

-total div. = 159.2 which results in an about 9% compound return over time.

So that part of the initial transaction was financed by debt-like characteristics with an approximate 9% coupon, non-tax deductible.

Opinion: From Omers' point of view, i would say a satisfying risk-reward proposition, assuming they had some kind of downside protection.

-----

Of course, the future is where the money is but let's take a retrospective look from FFH's point of view.

Since acquisition: cumulative pre-tax income = 165.7M

Book value of Brit at end of Q3 2020 estimated at about 1.85B

Outside of holdco capital contribution to Brit to fund payments (capital and dividends) to OMERS, FFH parent contributed a net 196.6M

Brit, itself, paid OMERS (capital and dividends) 190.6M

Difference in book value from acquisition to end of Q3 2020 = about 140M

Average combined ratio since acquisition: 103%

The return (average net pre-tax earnings over book value) so far from both the underwriting and investment points of view has been very low (about 1.5 to 2.0% CAGR).

Other aspects to consider:

-NPW at end of first complete year of operations (2016): 1,480.2M; at end of Q3 2020: about (annualized) 1,800M

-reserves development is still positive, slightly overall better in 2020 in a declining trend and lower in Q3 year over year.

bearprowler6 · October 30, 2020

SJ---your "school boy arithmetic" seems reasonable for 2021. My question however related to the potential for long term compounding for the shares at the 15% level. Your 2% investment return assumption which produces $800m in your analysis for 2021 seems high post 2021(note the drop off in interest and dividend income from 2019 to 2020). If my concern is correct on this point than an investment return well in excess of the 3% target is needed to achieve the 15% overall earnings yield. Expecting Prem (and team) to produce this level of long term investment returns on a sustainable basis is simply not reasonable based on either the results of the last 10 years nor the longer term prospects for the company's current equity holdings.

StubbleJumper · October 30, 2020

The 2% is already very conservative. Of the portfolio, about $10b is corporate bonds yielding about 3.5% with a 3-yr duration, ~$17B is governments bills and bonds yielding about 0.5%, plus another ~$13B is equity-like investments (preferreds, common stocks, investments in associates). There should be no trouble at all to make 2% until the end of 2022 when the corporates will mostly need to be rolled. When you weight it all out, getting a weighted 3% might require about a ~6% return on the equity-like investments, which is not a particularly outrageous hurdle.

After 2022, who the hell knows? It could go a couple of different ways. Either the risk-free rate remains at 0.5% in the "lower for longer" scenario, in which case you should expect to see tighter underwriting practices and higher insurance prices, or the risk-free will return to a more "normal" level which makes the 3% return easily attainable. But, over the longer term, capital will leave the industry if there is not some acceptable combination of underwriting and investment profit.

SJ

bearprowler6 · October 30, 2020

Very reasonable---thank-you!

Seems like a good time however to remind everyone of the compound total annual investment returns actually achieved by Fairfax over the last 10 years or so:

2011-2016: 2.3%

2017-2019: 5.6%

And yes I know that we need to look forward and not focus on the mistakes of the past however Prem seems unwilling to address several losing equity positions (both private and public markets) which account for a significant portion of Fairfax's current equity holdings. Combine this with the ultra low interest rates which in my view will be around for a very long time and we have a perfect storm which will work against Fairfax achieving the overall investment return it requires to achieve the 15% earnings yield.

For what its worth...I hope my concerns are not valid and Fairfax shares soar however we are dealing with Prem so I believe a healthy dose of skepticism is warranted!

TwoCitiesCapital · October 30, 2020

So what this is saying, is even over past decade where investment returns were dismal and outweighed by short TRS and deflation swaps, they still managed the +2-3% compounded that is the benchmark for a 15-20% ROE going forward? And we don't have a hedged equity portfolio any more and many of their investments are off 50% or more from peaks at the end of 2019 period so seems to me that it doesn't take much to get this shop moving in that 2-3% direction.

Xerxes · October 30, 2020

Excellent posts by everyone; not much else that i can add. I haven't listened to the conference call yet.

maybe just a comment on sharecount.

Q3 2020 outstanding: 26.3 million

Q3 2019 outstanding: 26.8 million

Q3 2018 outstanding: 26.7 million

Q3 2017 outstanding: 27.6 million

Q3 2016 outstanding: 23.1 million

About 5% reduction in share count since the purchase of Allied World in mid-2017, which ticked up the share count by about 4 million. So while the volume bought back has not been staggering, my yardstick is look at the issuance in 2017. Back in the day the share price was trading at a 1.25 price to book, and FFH has been buying a cumulative 1+ million shares or so since. For reference, in 2019 price to book was around 1.0 and in 2020 at a 0.65 price to book. So Allied World which was bought at a premium when it was at its absolute highs in 2016-17, in retrospect was bought cheaply, given the deteriorating value* of FFH share price. If one can say Allied World was hugely accretive (i am no expert in insurance) than that is even better.

I am prepared to declare half-victory when share count goes back to 23 million, bought mostly below to which they were issued.

*Of course one hopes that values does go up.

Xerxes · October 30, 2020

We just need some of the heavy hitters on page 17 in the link below start throwing their weight around.

That ought to help to get 2% or more.

https://s1.q4cdn.com/579586326/files/doc_downloads/2020/FFH-2020-Q3-Interim-Report-(Final).pdf

Crip1 · October 30, 2020

Umm...seriously, that jumped off the page at me. Saw it earlier this year but figured (or hoped) that with the overall market returning to levels reasonably close to what they were at the start of the year that we'd see better equity results. The days of "With their investing prowess, if they can just get their insurance business in line, this will be magnificent investment" are long gone. Good insurance quarter considering the environment, but we're several years into probelmatic equity investing and it's absolutely killed the value of the company.

-Crip

bearprowler6 · October 30, 2020

TwoCitiesCapital---that is certainly one interpretation of what has been presented. Another way to look at it---despite the higher yields offered by bonds between 2011 and 2019 and the gains realized on their massive bond portfolio during that same time frame due to falling rates they were only able to realize average overall investment returns of 2.3% for the period 2011-2016 and 5.6% for 2017-2019.

As SJ pointed out earlier....Fairfax currently holds $10B in corporate bonds yielding 3.5% for another 2 years, $17B in government bonds yielding 0.5% and approx $13B in equity like investments (preferreds, common stock and investments in associates). Unless interest rates rise (in my view this is not likely) then $27B in overall bonds will earn next to nothing within 2 years which means the overall investment return will be solely dependent on the equity holdings which I believe is a very scary prospect for any investor into Fairfax who is looking to achieve a long term earnings yield of 15% or better.

TwoCitiesCapital · October 31, 2020

I certainly understand this concept. That was precisely why I sold the stock back in early 2019. It was clear interest rates weren't rising anymore and Fairfax wasn't locking in long term gains and future income/rates were at risk. I figured Fairfax couldn't get decent returns on bonds with rates halted and that equities would prove difficult and that @ $550-600 US that the bar was too high for returns.

2-years later we're at less than 1/2 the price (much lower bar) and there are certain sections of the equity markets still dislocated. It's pretty easy to get a 4-7% yield - AT&T, Royal Dutch Shell, China Mobile,

any European financial, REITS, auto companies, etc. Let's nor forget their fast growing investments in Digit in India and Fairfax India being roughly half of NAV. It should be relatively easy to accomplish 2-3% returns in equity markets with low multiples to earnings, low multiples to book, and high dividends currently available.

And while bond markets are at zero, thats probably closer to the lower end of their range. The time to be paranoid about rates was 2018/2019 when they were at their local highs - not when they're near their local lows. While they can always go lower near term, I'd imagine there will be opportunities to pick up some bonds at higher rates and higher spreads with localized disruptions over the next year or two while Fairfax hides in cash. Also, they've proved themselves to be willing, and semi-adept, traders which means they can make capital gains here too.

bizaro86 · October 31, 2020

I agree low to mid single digits on equities should be easy, but it would have been easy to do a lot better than they did on equities the last 10 years as well.

If they changed their approach to buying "easy singles" and just bought the low multiple large caps you mention their returns would almost certainly be fine. Is there evidence they will stop doing their "swing for the fences on structurally distressed" style of investing?

TwoCitiesCapital · October 31, 2020

Even if the don't, I have to imagine that in the environment where those same distressed investments are down 50-75% from their peaks it'll be easier to make 2-3% on them going forward.

My only point is the opportunity set for them in 2018/2019 was scarce IMO and they traded at 2x where they do today.

Now opportunities abound and Fairfax is undeniably cheap. Maybe they fail to capitalize on it. It's possible. But the decision for me to buy today is way easier than the decision was for me to sell in 2018/2019.

Viking · October 31, 2020

I do see some improvement in decision making with equities/hold co’s the past few years. Like selling (for shares) APR to Atlas. Selling Fairfax Africa to Helios for shares in the new venture. Bottom line, there seems to have been a realization at Faifax HO that they were ill equipped to support operating companies that were turn around situations. Fairfax seem to slowly be cleaning things up.

Fairfax appeared to be trying to make more of these moves (and outright sales) but the pandemic has likely put a hard stop on that for now.

I think they have also said they will not be throwing more money at operations like Recipe (forcing them to stand on their own two feet) which is nice to finally see. Stop watering the weeds.

As they continue to deal with the problem children that also will allow the quality in the portfolio stand out more. I am watching Atlas the closest given its position size and how it appears to be handling the pandemic well.

Xerxes · October 31, 2020

Listened to the conference call; some comments. Good overall. But not great. I thought Q2 conference was better than this one. Just the overall tone. Lots of questions from retail investors, and fewer and fewer from institutional investors. I am not a fan of when he goes off tangent talking about high multiple on technology names (he mentions Zoom) and virtues of value investing. I feel that he is keep digging his heels on his view.

I thought his comment interesting in the prepared remark and Q&A on monetization. He certainly has been keeping his word on this in the past few years. So more to come and that is great. Just hope the monetization is not giving up family jewel because we need the cash at hold-co. Said differently, we are not selling because we need, rather because it is advantageous to trade the value.

-----------------

Now I want to tell you this is just the start. Various initiatives are underway, including taking some of our other private investments public in the New Year. We have built significant value, as I mentioned before, which our shareholders will soon see.

Q&A:

But we are planning, we've got some private investments I can't talk about them of course, till it goes public. But yeah, we think they'll be worth a lot and they're good companies. And mostly their books had very low values compared to where we take them public. And we can build very significant companies we think over time, just like Horizon North will be over time.

-----------------

Here is what i really didn't like or maybe not understanding. I am not sure how the unwinding of short works, shorts were being removed at the time Trump election. That was 4 years ago. Based on the conference call, Watsa keep saying that these are the remnants being removed. Does it take 4 years to remove shorts ? I understand if one needs to be strategic on covering the shorts, but i think if there was any short covering to be done, it could have all been done in March-April this year or during the Dec 2018 market plunge.

Just the fact that they didn't cover these shorts in March-April 2020 when they had a chance, tells me that these are NEW 2020 shorts probably against high-flyers.

Some data points:

Q1: $248 realized losses in shorts (??? was that front-loaded)

Q1: $122 unrealized gain in shorts (ok fine that make sense)

Q2: $0 realized in shorts

Q2: $96 unrealized losses in shorts (guessing a partial reversal of $122 unrealized gain in Q1 ??)

Q3: $79 realized losses in shorts (guessing realizing a portion of the $96 unrealized loss in Q2 ??)

Q3: $89 unrealized losses in shorts (huhhh where this came from ? did the unrealized exposed delta between $96 million (Q2) and $79 million (Q3) just expanded into a giant $89 million loss ?? was it Zoom )

I am guessing based on comment below in Q&A, we should expect unwinding of the remaining $89 million shorts in Q4. The fact that the total of realized and unrealized shorts in Q3 is far larger than $96 million in Q2 tells me that there are new shorts within even in Q3. Frankly, the company can barely adds to BV based on its long equity position, it shouldn't be toying around with shorts.

-----------------

Here some excerpts:

Mike Bill

Thank you. Prem, could you give us a little more color on this short equity exposure? Exactly, what are we short? And the notional or size relative to our portfolio? So just the strategy in general there, that that that is a pretty big number. And I don't mean to Monday morning, or Friday morning quarterback because the third quarter was a strong one. But $168 million in losses on short equity exposure, I think deserves a little more explanation.

Prem Watsa

So Michael, we don't talk about individual names as you know, till we buy them or cover them. And on the shorts, let me assure you that it's over. This is just a remnant. And unfortunately, as you pointed out has gone up. But, not too long in the future we'd be out of it.

It's all marked to market of course so you see it. And we reduced it quite significantly in the third quarter. And relatively soon, I just don't want to fix a time, but relatively soon that will be gone. And then as we've said publicly, we will not short the TSE and not short the indices, meaning we've samples or any of them, so we will not do that. And we won't short companies at all ever. And so rest assured there will be no more of those.

Mike Bill

Okay. So exactly broadly, what where are we short? You just said we don't short individual companies and we don't short The TSE or I guess the S&P. So I still don't understand what with this hedge is designed - what it's about?

Prem Watsa

Yeah. So Michael, basically what it was a position that we've had in the past. So it's not a new short to position an individual position that we've had in the past that we've covered and covered and covered. And this is the last remnants of it.

------------------------

Question about dividend; not exactly answered by i guess he means the cash will be there for dividend

------------------------

Tom MacKinnon

Question on the [indiscernible] cash at $1.1 billion. I think you've always said you'd like it to be at least $1 billion there. Just trying to gauge you're comfortable with us where it sits right now. Just in - are you expecting some dividends from the operating companies in the fourth quarter because you do have a $275 million dividend that you're going to be - common dividend that you'd be paying in January? So just trying to gauge how comfortable we are with the whole cash position as it stands right now $1.1 billion?

Prem Watsa

Yeah, Tom, we basically want to keep an excess of $1 billion. So we expect to get some dividends and some other payments. And we have a huge credit facility that we paid back, as you know, from $2 billion down to $1.3 billion. So there's about $700 million that we've used. And over time we'd pay that back also to zero which it was at the end of last year.

So yeah, so that's - Tom, we're very focused on keeping $1 billion plus in cash. We're focused on having enough money to support our insurance companies in this hard market that we're witnessing. And finally the extra money we were taken buyback our shares. So that's the order we'll look at it.

Tom MacKinnon

And if I could quickly squeeze in another, the equity hedge losses seemed a little bit higher than I would have expected. Could you get 266 notional, which is unrealized losses were $89 million. I mean, that's seems high relative to the notional. Is there anything I'm missing here?

Prem Watsa

Yeah, no, that's right, Tom. It's the remnants of what we've covering. So I told you that before and I guess in the first quarter, second quarter, and we've slowly but steadily covering it then it's gone. So it's on the way to - it's on the way out.

---------------------------

Fairfax 2020

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