Fairfax 2023

[UK]

I think it is very healthy when we still have such opinions from analysts, especially when they are obviously wrong:). If you read only COBF, these days consensus on FFH almost worryingly too cheery. But when I speak about FFH with some other investors, I am still getting a lot of push back and/or very low interest. These views are usually because of expierence of the decade from 2010 and they just do not want to dig deeper, or to change the old opinion, or to dig at all, but also maybe because FFH is quite complex and in the insurance business. Anyway, if or when this Morningstar analyst will upgrade FFH to some 'medium moat' and a price with the multiple of 1.3 or 1.5 BV in the next 3 years, he probably will be another 50 or 100 per cent to late and at that time expected returns will be much lower:)

[Luke]

1 hour ago, UK said:

These views are usually because of expierence of the decade from 2010 and they just do not want to dig deeper, or to change the old opinion, or to dig at all, but also maybe because FFH is quite complex and in the insurance business. 

Yep, friends of mine who also invest say they don't and cant understand insurance (fair enough, its a blackbox) and the history doesn't look appealing to them which stops them from digging deeper. I shared a lot of things from the board, but skepticism is strong against future underwriting (climate change), they still think rates will come down hard soon and that the interest income leg will fall away for fairfax (they know they locked in rates but are still skeptical)+their equity portfolio is not something where one immediately sees value. 

 

Hence the opportunity.

Edited August 6, 2023 by Luca

[longlake95]

1 hour ago, Luca said:

Yep, friends of mine who also invest say they don't and cant understand insurance (fair enough, its a blackbox) and the history doesn't look appealing to them which stops them from digging deeper. I shared a lot of things from the board, but skepticism is strong against future underwriting (climate change), they still think rates will come down hard soon and that the interest income leg will fall away for fairfax (they know they locked in rates but are still skeptical)+their equity portfolio is not something where one immediately sees value. 

 

Hence the opportunity.

I have noticed a pattern over many years - people react slowly to good news and quickly to bad news. Combine that with the heard mentality and you get the Morningstar’s of the world. 

[StubbleJumper]

3 hours ago, Luca said:

they still think rates will come down hard soon

 

On that point, historically they would be correct.  The insurance cycle is self-correcting to the extent that attractive profits have always attracted new capital which subsequently made the attractive profits disappear.

 

I will write once again what I wrote in January.  If you give one of FFH's subs an extra $1 of capital, they can use it to write $2 of premium.  That $2 of premium will earn 12-cents underwriting profit for the sub (Q2 CR=94).  As we all know, the sub collects the premium long before it pays out an indemnity, so it gets float for a year of probably roughly $1 from writing those $2 of premium.  The incremental $1 plus the original $1 of capital that you gave the sub can be invested today in a boring 12-month US treasury which closed Friday at 5.29%.   So, in total, that incremental dollar of capital that you gave the Fairfax sub can earn about 22.58 cents of operating income.

 

The profitability is ridiculous.  A 20%+ margin will eventually attract new capital to the industry.  As it always does, new capital will eventually push down underwriting profitability.  There's a reason why Prem expressed a degree of surprise during the conference call that this hard market has endured as long as it has, and that new capital does not seem to be flowing into the industry.

 

That being said, FFH has a few years of strong profits baked in.  There will be at least 2 or 3 good years of profits, but understand that it will not continue forever.  I see some truly enthusiastic valuation levels being proposed on this board for a company that sells a commodity product with few barriers to entry.  There's still room for the price to run, but that will be mainly from the earnings that will be retained over the coming 2 or 3 years rather than some marked increase in fundamental valuation.

 

 

SJ

Edited August 6, 2023 by StubbleJumper

[Viking]

The key to forecasting is getting the ‘big rocks’ right. From an earnings perspective, there is no more important item to Fairfax today than ‘interest and dividend income.’ This one ‘bucket’ now represents about 40% of Fairfax’s total pre-tax earnings. Next year it could be as high as 45% of pre-tax earnings. So, if we can get can get our estimates for this part of earnings modelled properly we should be well on our way to coming up with a quality earnings estimate for the company as a whole.  

 

When looking at ‘interest and dividends’ for Fairfax, dividends represent about 7% of the total. Interest income represents about 93% of the total, so that is what we are going to focus on. 

 

Two items drive interest income: 

• The size of the fixed income portfolio
• The average yield earned on the investments held in the portfolio

It is quite simple. It is relatively easy to calculate. It is not volatile quarter to quarter. And it is predictable, looking out a couple of years. This is why ‘interest and dividend income’ is considered the highest quality source of earnings for an insurance company.

 

So, let’s look at Fairfax and see what we can learn.

 

How big is the fixed income portfolio at Fairfax and how fast is it growing?

 

The fixed income portfolio at Fairfax is about $40 billion today. In 2016, it was $20.3 billion. Over the last 7 years, the size of the portfolio has doubled, which is growth of about 10% per year. 

 

Growth in 2024 should be similar (at 10%, or $4 billion). The GIG acquisition will add around $2.4 billion to investments when it closes later this year. Earnings are coming in strong and we are still in a hard market, which should also support modest growth of the fixed income portfolio in 2024. 

 

Next, let’s review the average yield. 

 

From 2016 to 2022, Fairfax earned an average of about 2.4% on its fixed income portfolio (see chart below). Yes, that is a low number. Fairfax has been very conservative with the positioning of their fixed income portfolio over the past 7 years (low duration and high-quality holdings). 

 

What about 2023? The average yield in 2023 is estimated to be about 4.5%. 

What about 2024? The average yield in 2024 is estimated to be about 4.8%.

 

The average yield that Fairfax is earnings on its fixed income portfolio has doubled. 

 

This is important:

1. The size of Fairfax’s fixed income portfolio has doubled over the past 7 years. 
2. At the same time, the rate of return that Fairfax is earnings on its fixed income portfolio looks like it is also poised to double. 

Investors are getting served up a double-double with Fairfax’s fixed income portfolio (that line will only make sense to Tim’s coffee drinkers). 

 

What does it mean for Fairfax?

 

Interest income is poised to increase from $514 million in 2016 to an estimated $2.1 billion in 2024. That is a 300% increase over 8 years. Exactly what you would expect when the size of the portfolio doubles and the rate of return also doubles. 

 

Average duration

 

In the first quarter we learned that Fairfax had materially extended the average duration of their fixed income portfolio and as of June 30, 2023, it was at 2.4 years (from 1.6 years at Dec 31, 2022, and 1.2 years at Dec 31, 2021). This is important because it locks in the rate of return on a large part of the portfolio for a couple of years making the earnings stream more durable.

 

What does this mean for investors?

 

The most important bucket of earnings for Fairfax (for a P&C insurer), interest and dividend income, is poised to deliver a record amount in 2024. And 2025 looks promising as well.  

 

Efficient Market Theory

 

Of course, everything I have written above is from publicly available information. So, it is priced into the share price of Fairfax’s stock today. Right? 

 

Fairfax’s Price Earnings Ratio = 5.6 = $843 / 2023 $150E per share (as of Aug 4, 2023)

 

My current estimate (another word for guess) is Fairfax could earn about $150/share in both 2023 and 2024 (that will be the topic of a future post). Given my analysis of interest income above, I trust my earnings number (please note, that doesn’t mean you should!). 

 

So, the appropriate question for me to ask: “is 5.6 an appropriate multiple to pay to get $150 in estimated earnings from Fairfax.” Mr. Market thinks so. I disagree. I think the multiple is too low. My guess is Mr. Market does not yet fully grasp the significance of what a fixed income double-double means for the future earnings of Fairfax. 

 

 

Dividends

• Extending its close partnership with Kennedy Wilson (KW), Fairfax also invested $200 million in preferred shares of KW with a 6% dividend. This will deliver an incremental $12 million in dividend income to Fairfax each year. 
• Eurobank would like to start paying a dividend, likely in 2024. As a result, I have added $40 million in dividends to my forecast for 2024.

Interest & dividend income = interest income + dividend income - investment expenses.

 

 

—————

Interest rates are once again moving higher

 

Interest rates have moved higher in recent months. As a result, Fairfax will have the ability to continue to re-invest maturing bonds at higher yields. This suggests interest income has not peaked. 

 

Edited August 6, 2023 by Viking

[StubbleJumper]

33 minutes ago, Viking said:

So, the appropriate question for me to ask: “is 5.6 an appropriate multiple to pay to get $150 in estimated earnings from Fairfax.” Mr. Market thinks so. I disagree. I think the multiple is too low. My guess is Mr. Market does not yet fully grasp the significance of what a fixed income double-double means for the future earnings of Fairfax. 

 

 

 

Mr. Market likely doesn't believe that EPS of $150 is sustainable.  Your EPS of $150 contains $60 of underwriting income which can disappear pretty quickly if capital flows into the industry, and the $100 of interest can turn into $75 by 2027 if the fed moves away from it's tightening process and instead adopts a loosening posture.

 

FFH will almost certainly have 2 or 3 good years of income and its share price likely has some distance left to go, but we need to attenuate our long-term expectations.  Ignore the PE ratio entirely when you are at the top of the insurance cycle.  Instead develop a forecast of BV for December 2025 and select what you believe is an appropriate multiple of book for a company that is selling a commodity product (insurance policies) in an industry with minimal barriers to entry.  That BV multiple should likely be one of 0.8x, 0.9X, 1.0x, 1.1x or 1.2x.   As a point of interest, CAD$1375 is roughly 1.2x...

 

 

SJ

[Viking]

2 hours ago, StubbleJumper said:

 

On that point, historically they would be correct.  The insurance cycle is self-correcting to the extent that attractive profits have always attracted new capital which subsequently made the attractive profits disappear.

 

I will write once again what I wrote in January.  If you give one of FFH's subs an extra $1 of capital, they can use it to write $2 of premium.  That $2 of premium will earn 12-cents underwriting profit for the sub (Q2 CR=94).  As we all know, the sub collects the premium long before it pays out an indemnity, so it gets float for a year of probably roughly $1 from writing those $2 of premium.  The incremental $1 plus the original $1 of capital that you gave the sub can be invested today in a boring 12-month US treasury which closed Friday at 5.29%.   So, in total, that incremental dollar of capital that you gave the Fairfax sub can earn about 22.58 cents of operating income.

 

The profitability is ridiculous.  A 20%+ margin will eventually attract new capital to the industry.  As it always does, new capital will eventually push down underwriting profitability.  There's a reason why Prem expressed a degree of surprise during the conference call that this hard market has endured as long as it has, and that new capital does not seem to be flowing into the industry.

 

That being said, FFH has a few years of strong profits baked in.  There will be at least 2 or 3 good years of profits, but understand that it will not continue forever.  I see some truly enthusiastic valuation levels being proposed on this board for a company that sells a commodity product with few barriers to entry.  There's still room for the price to run, but that will be mainly from the earnings that will be retained over the coming 2 or 3 years rather than some marked increase in fundamental valuation.

 

SJ

@StubbleJumper i agree that the insurance market will soften at some point in the future. I also think the investment side of Fairfax is being underestimated. Investors don’t know what they are going to do with all the cash that will be rolling in so they are very conservative with their return estimates from investments. My big miss with Fairfax the past couple of years is how well they are executing on the capital allocation front and the impact that is having on earnings. As a result my past earnings estimates (looking foolishly high when made) have been too conservative. I expect Fairfax will continue to allocate capital well in the coming years. My guess is increasing returns from investments will more than offset any slow down in underwriting profit looking out a few years.

[Viking]

12 minutes ago, StubbleJumper said:

Mr. Market likely doesn't believe that EPS of $150 is sustainable.  Your EPS of $150 contains $60 of underwriting income which can disappear pretty quickly if capital flows into the industry, and the $100 of interest can turn into $75 by 2027 if the fed moves away from it's tightening process and instead adopts a loosening posture.

 

FFH will almost certainly have 2 or 3 good years of income and its share price likely has some distance left to go, but we need to attenuate our long-term expectations.  Ignore the PE ratio entirely when you are at the top of the insurance cycle.  Instead develop a forecast of BV for December 2025 and select what you believe is an appropriate multiple of book for a company that is selling a commodity product (insurance policies) in an industry with minimal barriers to entry.  That BV multiple should likely be one of 0.8x, 0.9X, 1.0x, 1.1x or 1.2x.   As a point of interest, CAD$1375 is roughly 1.2x...

 

SJ

@StubbleJumper i have enormous respect for your knowledge about all things insurance. So please keep the comments coming. I agree there is a risk that the hard market could quickly reverse and become a shit show - which would hit underwriting income. But what is the probability of that actually happening? My understanding is when the last hard market ended things went sideways for 3 or 4 years - it did not deteriorate into a shit show. My point is risks need to be considered. And probabilities attached. 
 

Insurance companies are laser focussed on generating an acceptable return for shareholders. Pricing (rate increases) look like it actually accelerated a little higher in Q2. 
 

With my estimates/forecasts i lean heavily on what i think i know. That is why i only like to look out about 2 years. As new information becomes available i will make updates. 

[LC]

Fair points from @StubbleJumper re: potential for future combined ratio increases and NII decreases.

Appreciate the pushback - nobody should feel comfortable in an echo chamber.

 

One has to weigh the probability of those two negative occurrences (i.e. the timing of a softening market and timing of Fed rate reductions) against growth in premiums written and growth in the bond portfolio. 

 

Perhaps we don't see as much reduction in 150/sh earnings that Viking estimates, due to growth in business and size of the bond portfolio. 

[Tommm50]

14 hours ago, Parsad said:

 

It's because of guys like this that make the markets so efficient!  Cheers!

Parsad, you know I have deep suspicions surrounding the hedge funds market manipulations. They have before and likely now have analysts in their pockets. This analysis of Fairfax is so far off it simply seems to be there to justify a short campaign.

[Matthew Lembo]

Agree the hard market may reverse but at that point the insurance subs would no longer need the capital and Prem said on the conference call that that is the time FFH would increase the volume of share repurchases price dependent of course. So sorta tho not exactly a bit of a built in hedge / outlet for incremental capital allocation. 
 

is that a plausible scenario? 

[Munger_Disciple]

1 hour ago, StubbleJumper said:

 

 

Mr. Market likely doesn't believe that EPS of $150 is sustainable.  Your EPS of $150 contains $60 of underwriting income which can disappear pretty quickly if capital flows into the industry, and the $100 of interest can turn into $75 by 2027 if the fed moves away from it's tightening process and instead adopts a loosening posture.

 

FFH will almost certainly have 2 or 3 good years of income and its share price likely has some distance left to go, but we need to attenuate our long-term expectations.  Ignore the PE ratio entirely when you are at the top of the insurance cycle.  Instead develop a forecast of BV for December 2025 and select what you believe is an appropriate multiple of book for a company that is selling a commodity product (insurance policies) in an industry with minimal barriers to entry.  That BV multiple should likely be one of 0.8x, 0.9X, 1.0x, 1.1x or 1.2x.   As a point of interest, CAD$1375 is roughly 1.2x...

 

 

SJ

 

 

There is no way FFH or any other insurer can maintain a 94 CR over the long term. The best one can hope is 100 CR over a full cycle. Insurance is too much of a commodity business to expect anything else. That's why BRK's goal is to have cost free float. Having said that, it is quite possible for FFH to do quite well in the next 2-3 years in a hard market. 

Edited August 6, 2023 by Munger_Disciple

[Red Lion]

7 hours ago, Luca said:

Yep, friends of mine who also invest say they don't and cant understand insurance (fair enough, its a blackbox) and the history doesn't look appealing to them which stops them from digging deeper. I shared a lot of things from the board, but skepticism is strong against future underwriting (climate change), they still think rates will come down hard soon and that the interest income leg will fall away for fairfax (they know they locked in rates but are still skeptical)+their equity portfolio is not something where one immediately sees value. 

 

Hence the opportunity.

The funny thing is climate change should be bullish for insurance in the long term since it implies much larger risks and higher premiums which means more float and hopefully underwriting profit. 

[MMM20]

5 hours ago, StubbleJumper said:

I see some truly enthusiastic valuation levels being proposed on this board for a company that sells a commodity product with few barriers to entry.

I’ve yet to see anyone arguing FFH should trade at even a market multiple. Have you? Half that would be a ~2x!  
 

What if the board actually skews too cautious - too quick to tamp down enthusiasm and assume there is a shoe to drop, or that we’ll revert to some worst case scenario for underwriting profitability and investment returns? Maybe we are still too anchored to 2010-18 and not believing the new reality, because we as value investors reflexively blanch at anything that sounds like “this time is different.”

 

Maybe there really has been the fundamental transformation in through-cycle earnings power (even assuming breakeven underwriting) that many of us think we see here, and Mr Market has just been slow to react b/c he is anchored to the recent past.

 

Frankly, I could argue that the stock is easily worth $3,000+ USD to a permanent owner right now — with slightly better than breakeven underwriting through cycles, more historically normal interest rates and equity returns, and great capital allocation — if  Prem and team prove to be great capital allocators for another decade or two or three. 
 

Wait until Mr Market starts doing the math again on what ~6-8% investment returns translate to for shareholders when sustainably levered ~1:1 - ~2:1 with the best possible type of leverage. I think many people are still afraid to get laughed at for doing that math. But what if that’s reality?

 

And BTW Charlie Munger tells us that he welcomes downturns because great businesses take share when their competitors are in distress. Does that not look like Fairfax right now? And in large part b/c they were willing to look stupid and not reach for yield… b/c of a sustainable structural advantage.
 

I assume I’ll be laughed off the board for that but there’s your enthusiastic valuation level

 

 

Edited August 6, 2023 by MMM20

[MMM20]

4 hours ago, StubbleJumper said:

Ignore the PE ratio entirely when you are at the top of the insurance cycle.  Instead develop a forecast of BV for December 2025 and select what you believe is an appropriate multiple of book for a company that is selling a commodity product (insurance policies) in an industry with minimal barriers to entry.  That BV multiple should likely be one of 0.8x, 0.9X, 1.0x, 1.1x or 1.2x.   As a point of interest, CAD$1375 is roughly 1.2x...

I could not disagree more with this approach or characterization.
 

The ability to underwrite profitability and operate for long term shareholder value creation and not short term optics is a massive moat in this industry full of bureaucrats and hired-gun MBAs who nearly blew up their collective balance sheet by simply matching duration risk and sticking with long terms bonds even though interest rates were at 5,000 year lows — human nature and principal agent problem, misaligned incentives. You can’t afford to risk looking dumb for a decade if you dont have an incredible 25 track record and huge personal ownership. That more than any cost advantage is what makes a moat in this business. That will not change anytime soon, even when capital re-enters and drives underwriting profitability down.

 

Prem did what was right from a risk/reward perspective of a permanent owner and it has structurally transformed the cash flow power of the business going forward. This is far from reflected in book value right now and an output of it may very reasonably be, with conservative assumptions around underwriting and investment returns, that book value triples over the next decade.  Because the cash flows and incremental return on those retained are what matters. 
 

And a stock is worth the net present value of future cash flows, not what the accountants say it is worth based on historical artifacts. Accounting book value almost completely misses the point in this case at this point in time, and nearly all others.  Respectfully, investors are totally missing what is going on here if you they are focused on that metric. It is useful just to understand how the stock may trade in the short run, I agree on that much.
 

Anyway, sorry, this gets me fired up, and maybe I’m wrong. I’ve been dead right on this for 2.5+ years now on my biggest position by ~3x in the face of skepticism bordering on derision so maybe I’m just riding high and overconfident. “What do I know?” — Montaigne

 

I guess this is what makes a market!

 

Edited August 6, 2023 by MMM20

[Haryana]

 

My math is very easy.

 

I can take my $1000 to the treasury market and get treasuries worth $1000.

 

OR

 

I can take my $1000 to the Fairfax stock and get treasuries worth $2000.

 

 

Not even expecting any profits from their underwriting or equity investments.

 

Please criticize.

 

[StubbleJumper]

5 hours ago, MMM20 said:

What if the board actually skews too cautious - too quick to tamp down enthusiasm and assume there is a shoe to drop, or that we’ll revert to some worst case scenario for underwriting profitability and investment returns? Maybe we are still too anchored to 2010-18 and not believing the new reality, because we as value investors reflexively blanch at anything that sounds like “this time is different.”

 

 

It's not a worst case scenario.  It's merely a more normal scenario.  What we are seeing today is not normal.  It's a top of the cycle underwriting situation.  And with respect to interest rates, who really knows?  All we know is that the fed has engaged in a tightening stance for a particular reason, and if the economy slows, the fed will likely reverse that stance to some extent.  All that to say, we are living nearly perfect operating conditions for a well capitalized P&C insurer right now, and if you project that forward very far, you do so at your own risk and peril.

 

 

5 hours ago, MMM20 said:

Frankly, I could argue that the stock is easily worth $3,000+ USD to a permanent owner right now — with slightly better than breakeven underwriting through cycles, more historically normal interest rates and equity returns, and great capital allocation — if  Prem and team prove to be great capital allocators for another decade or two or three. 

 

That is a possibility.  It's always possible that Hamblin Watsa shoots out the lights for the next 20 years and we will see truly extraordinary investment results.  The question is whether it's wise to make that kind of assumption.

 

5 hours ago, MMM20 said:

Wait until Mr Market starts doing the math again on what ~6-8% investment returns translate to for shareholders when sustainably levered ~1:1 - ~2:1 with the best possible type of leverage. I think many people are still afraid to get laughed at for doing that math. But what if that’s reality?

 

 

It could happen.  But, if you have a business model that requires you to keep roughly two-thirds of your investments in fixed income and preferreds, you need a particular set of circumstances to get you 6-8% returns overall.  You can definitely get there right now when you can average 4.5% on the fixed income component because means you only need ~9% on your investments in equities/associates to get your overall 6% return.  But, again, you might want to be a little cautious about projecting that sort of thing forward because we are likely near the end of a tightening phase.

 

We are seeing a truly amazing set of circumstances right now.

 

 

SJ

[StubbleJumper]

5 hours ago, MMM20 said:

And a stock is worth the net present value of future cash flows, not what the accountants say it is worth based on historical artifacts. Accounting book value almost completely misses the point in this case at this point in time, and nearly all others.  Respectfully, investors are totally missing what is going on here if you they are focused on that metric. It is useful just to understand how the stock may trade in the short run, I agree on that much.

 

Well, it's true that a stock is worth the present value of future cashflows.  If you hold the view that FFH's fair value is much higher than BV, you pretty much need to make the argument that there is some hidden value on the balance sheet, that FFH is a best in class underwriter, or that management is so talented that it will be able to obtain a return on equity that far exceeds market return.  Hidden value can definitely exist, and it probably does in assets such as the Bangalore airport and possibly a few undervalued investments like Eurobank.  But, most of the other portfolio assets that FFH holds and most of its investments in associates have fair value that is pretty close to reported book.  And that's the nature of an insurance company.

 

The most valid argument in favour of FFH being worth more than the book value of its assets is its investing prowess.  That argument definitely does hold water, but you need to be very thoughtful of just how significant that advantage is.  An insurer is inescapably constrained to holding a large percentage of fixed income investments.  If FFH can get some alpha on its investment in equities and associates, it is definitely worth more than book.  But, there are limits to that.  Even Berkie only trades at 1.5x, and Berkie has a significantly undervalued railroad on its books among other long-held operating businesses that are worth far more than book.

 

 

SJ

[StubbleJumper]

8 hours ago, Viking said:

@StubbleJumper i have enormous respect for your knowledge about all things insurance. So please keep the comments coming. I agree there is a risk that the hard market could quickly reverse and become a shit show - which would hit underwriting income. But what is the probability of that actually happening? My understanding is when the last hard market ended things went sideways for 3 or 4 years - it did not deteriorate into a shit show. My point is risks need to be considered. And probabilities attached. 
 

Insurance companies are laser focussed on generating an acceptable return for shareholders. Pricing (rate increases) look like it actually accelerated a little higher in Q2. 
 

With my estimates/forecasts i lean heavily on what i think i know. That is why i only like to look out about 2 years. As new information becomes available i will make updates. 

 

 

One of the most interesting bits that FFH publishes every year is a table depicting FFH's financing differential that appears in Prem's annual letter.  In the early years, he provided the table in its entirety, but over the past 15 years or so, he's only provided an excerpt.  A number of months ago, I went through the annual letters and constructed the long term series to the best of my ability (see attached).

 

The table shows how CRs and long term Canadian fixed income rates have evolved.  The long and the short of it is that the financing differential (long-term bond rate less cost of float) has typically been in the low single digits, with only occasional years higher than 5%.  The unfortunate thing is that the table uses long Canadian bonds, which made a great deal of sense 25 years ago when FFH was mainly a long-tail Canadian insurer.  But, at this point, FFH is effectively a US insurance company with the lion's share of its fixed income investments in shorter-term US treasuries.  A more instructive table would therefore replace the Canadian long-bond return with a 2 or 3 year US treasury, or perhaps a 5 year US treasury.  But, in any case, suffice it to say that when you can easily find a 5% treasury bond, you don't usually also see a -6% cost of float (ie, a 94 CR).  We are currently seeing a financing differential of about 11 percent, which is outstanding...and likely unsustainable.  That enormous financing differential is likely to be competed away as capital enters the industry and companies get a bit more aggressive about growing their book.

 

That leads me to yet another interesting observation about FFH shareholders.  Allied, Odyssey and Northbridge all have plenty of capital to enable an underwriting expansion.  It's fascinating to me that shareholders have not been haranguing Prem during the conference calls to grow those books more aggressively. 

 

 

 

SJ

FFHfloat.xls

[Tommm50]

2 hours ago, StubbleJumper said:

That leads me to yet another interesting observation about FFH shareholders.  Allied, Odyssey and Northbridge all have plenty of capital to enable an underwriting expansion.  It's fascinating to me that shareholders have not been haranguing Prem during the conference calls to grow those books more aggressively. 

 

I hope our shareholders understand It's not that simple.

 

I've been managing underwriting operations for over 30 years and you are a;ways walking on a razor's edge trying to balance growth and profitability. It's been said on this board that Fairfax is in a commodity business but that is not exactly true. Where that concept is most true is in U.S. personal lines and small commercial business, less so in reinsurance and specialty casualty business. Fairfax's portfolio is more tuned to the latter, as well as global and emerging markets. Crum & Forster went from a "main street" insurer (read commodity insurer) when Fairfax bought them to much more of a specialty casualty insurer now. Their results reflect this.

 

In every case in the U.S. market even the largest insurer has a very small market share, you have very little leverage in obtaining your price and terms. You have better conditions in lines of coverage that fewer insurers write. Even here your opportunities are contingent on market conditions. In a hard market you have a better shot at getting your terms but if you are not very disciplined on managing your growth you'll find in a few years your combined ratios will climb as you wrote "middlin' opportunites" rather than the best opportunities. Your combined ratios will revert to 100 or worse.

[Viking]

@StubbleJumper and @Tommm50 , great comments. I have said many times, i am not an insurance guy. So i really appreciate hearing from those who work(ed) in the industry. I appreciate the colour. And please point out the flaws in my logic in my posts… otherwise i will just keep repeating my mistakes. Thank you. 

Edited August 7, 2023 by Viking

[steph]

I also do agree that expecting 94 combined ratios long term is not realistic.  97-98 would be nice.  On the other hand I hope to see some nice surprises on the equity side in the coming years: Digit, Eurobank, Atlas,....whatever....and not much credit is given to this possibility. 

In the meantime FFH still trades at what is a historical very low valuation compared to book even though it has never been as solid: great insurance activities (used to be very average) and a AAA bond portfolio.  A 1.5 times book seems acceptable today.  This would be more in line valuation compared to the past and compared to competitors.  And FFH is today better, stronger and more interesting growth profile than ever before. 

[MMM20]

@StubbleJumper the fact that you see it that way makes me think I’m missing something. That's a good thing and I am grateful for that too.

 

Seems like the big vectors are lining up as if we are still in the early-middle innings, which is clearly not consensus! Of course 1100 bps of spread between investment returns and borrowing costs is unsustainable in the long run. Maybe the counterpoint is we could easily end up with 3 more years of wide spreads and then some reversion to the mean, which could easily mean $4-5B+ annual cash flow thereafter through the cycle if we get good to great capital allocation. I don’t know. In other words, even if the current state of things *is* more like a windfall than a new normal, well, it seems like a windfall of such magnitude that with good capital allocation it should permanently transform the earnings power either way. That is not priced into the stock. 

 

“To date, 2023 has been a significant catastrophe year with some estimates suggesting that U.S. insurer losses have already surpassed $25 billion this year. The events this year had been broadly felt with 44 states affected by 43 events. At the company level, these events have added 4.5 points to our combined ratio year-to-date, which is 1.7 points higher than the impact catastrophe events had on our combined ratio for the first half of 2022. Our property business has been most affected by catastrophes, adding almost 46 points to the property loss ratio so far this year, which is about 16 points more when compared to this time in 2022."

- Progressive CEO Susan Griffith

 

My underlying point is this.  What if Fairfax has proven to be a truly world class company on both the underwriting and investment side of things?  What are the implications? 

 

Edited August 7, 2023 by MMM20

[Xerxes]

If ever there is a CoBF coffee mug dotted with the handles of the top ten-fifteen posters in the Fairfax thread, I would definitely buy a mug as a memorabilia 

[Viking]

Fairfax just reported Q2-2023 results. The surprise for me? Underwriting profit, interest and dividend income and share of profit of associates all came in higher than I expected. 

 

As a result, I decided it was time to update my earnings estimates for Fairfax for 2023, 2024 and 2025. I have the highest confidence level in my 2023 forecast. My 2025 forecast is largely an educated guess. A lot can change in 2 years (both good and bad). Please keep this in mind as you are reading. 

  

Conclusion:

Let's skip ahead to the conclusion. My rough estimate is Fairfax will earn about $160/share in 2023. This is up from my last estimate which was $145/share (made in early July). The increase reflects the better-than-expected operating earnings Fairfax reported for Q2. 

 

For 2024, my new estimate is $166/share and for 2025 it is $174/share. 

 

The big ‘miss’ with my estimates in 2024 and 2025 is likely capital allocation. We don’t know what the management team at Fairfax is going to do with all the earnings (around $3.6 billion) that is likely coming in each of the next 2.5 years. Looking at the last 5 years, the management team has been outstanding with capital allocation. My guess is they will continue to make good decisions (on balance) and this will benefit shareholders - providing a possible tailwind to my forecasts.

 

I am also assuming interest rates remain roughly at current levels. Of course, this will not be the case. But if rates rise - or go lower - Fairfax will have lots of puts and takes. 

 

Below is an 8-year snapshot for Fairfax. It communicates in a concise manner dramatic transformation that has happened at this company, beginning in 2021. It is a pretty amazing story.

 

 

What are the key assumptions?

 

1.) underwriting profit: Estimated to increase to a record $1.3 billion in 2023. 

• I am forecasting Fairfax’s combined ratio (CR) to remain flat at 94.5 in 2023 (the same as 2022).
• When the Gulf Insurance Group transaction closes in 2H-2023, Fairfax should get a nice boost to its insurance business. I think GIG will add about $1.7 billion to net written premiums, which should drive low double-digit top-line growth in 2024.
• The hard market will end at some point. But do things quickly turn ugly? Probably not, but I am not sure.

2.) interest and dividend income: Estimated to increase to a record $1.9 billion in 2023. 

• The average duration of the fixed income portfolio was increased to 2.4 years in 1H-2023.
• GIG should add about $2.4 billion to the total investment portfolio.
• PacWest loans will deliver incremental interest income (of $80-$90 million?), with half coming in 2H-2023 and the other half in 1H-2024. 
• Eurobank: the plan is to start paying a dividend in 2024. If this happens, we might see dividend income increase by $40 to $50 million.
• Potential headwind: Short-term treasury rates might come down in 2024. If this happens, interest income on cash/short term balances could fall.

3.) Share of profit of associates: Estimated to increase to a record $1.1 billion in 2023. 

• Earnings at Eurobank, Poseidon/Atlas, EXCO, Stelco and Fairfax India, in aggregate, should continue to grow nicely.
• 2023 headwind: Sale of Resolute Forest Products - Contributed $159 million in 2022.
• 2024 headwind: I estimate GIG will contribute $100 million in 2023. When Fairfax’s purchase of Kipco’s stake is approved the financial results for this holding will be reported with Fairfax’s insurance operations. In anticipation of this deal closing later in 2H-2023, I removed $100 million from my 2024 estimate. 

4.) Effects of discounting and risk adjustment (IFRS 17). Interest rate changes drive this bucket. My estimates here could be a little messed up. Given I am forecasting interest rates to remain about where they are today, I am leaving this number the same over the forecast period (at my estimate for June 30, 2023).

 

5.) Life insurance and runoff. This combination of businesses lost $167 million in 2022. I am forecasting this bucket to lose $200 million in each of the next three years.

 

6.) Other (revenue-expenses): improving results from consolidated holdings.

 

In the near term, we could get write downs in both Boat Rocker and Farmers Edge. With Covid in the rear-view mirror, earnings at Recipe could move higher ($100 million per year?). Earnings at Dexterra are growing again. AGT is a sleeper holding. Grivalia Hospitality is in its peak investment phase; earnings could grow nicely looking out a year or two. This bucket is poised to grow nicely for Fairfax in the coming years.

 

7.) Interest expense: A slight increase.

8.) Corporate overhead and other: A slight increase.

 

9.) Net gains on investments: Estimated to come in around $900 million in 2023.

• My estimates assume (this is very general):
• Mark-to-market equity holdings of about $7.8 billion increase in value by 10% per year, or $800 million.
• A small bump of $200 to $250 million per year for additional gains (equities and fixed income).

----------

My estimated total return on the investment portfolio for each year is as follows:

• 2023 = 8.0%    = $4.5bn / $56bn
• 2024 = 7.6%    = $4.5bn / $59bn
• 2025 = 7.8%    = $4.7bn / $61bn

What is the math? For each year, add the following line items: 2.) + 3.) + 6.) + 9.) and divided the total by the estimated value of Fairfax’s investment portfolio. These estimated annual percent returns, while high compared to recent years, are driven largely by the spike in interest and dividends and share of profit of associates.

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10.) Gain on sale/deconsol of insurance sub: This is a wild card.

 

This is where I put the large asset sales. In 2022, it was the sale of pet insurance business. In 2023, it was the sale of Ambridge and the pending purchase of GIG (resulting in a write-up of the existing holding).

 

For 2024 and 2025, I estimate no gains from sales/write up of assets. There could be something:

• Perhaps we get a Digit or AGT IPO.
• Perhaps Fairfax sells another holding for a large gain.

This ‘bucket’ is perhaps where I will be most wrong with my forecast. Developments here will likely have a material positive impact to Fairfax’s reported results (earnings and book value). 

 

11.) Income taxes: estimated at 19%

12.) Non-controlling interests: estimated at 11% (not really sure)

 

13.) Shares Outstanding: Estimated that effective shares outstanding is reduced by 500,000 per year. This is in line with a normal year from Fairfax. 

 

Notes:

• Underwriting profit: Includes insurance and reinsurance; does not include runoff or Eurolife life insurance.
• Interest and dividends: Includes insurance, reinsurance and runoff.

 

Edited August 7, 2023 by Viking