StubbleJumper Posted August 12, 2023 Posted August 12, 2023 31 minutes ago, Viking said: At the time, many laughed at Prem for making this comment. I don’t think these same people are laughing at Prem today. I believe that I likely expressed more disdain than anyone for Prem's comment in the 2018 annual letter. My argument at the time was that for most of 20 years, FFH had been chronically short of capital and, nonetheless, had chronically acquired both insurance and non-insurance subsidiaries. It did this by issuing large amounts of debt and by repetitively increasing its share count. My argument at the time was that, as a serial acquirer, Prem would be unable to make a meaningful reduction in the share count because the capital/cash at the holding company level required to do so would never be there because there would always be another business to buy. Well, I was wrong....mostly. FFH has meaningfully reduced its share count since 2018, and it was mainly done in a very rational and opportunistic manner. The largest buybacks were conducted at objectively significant discounts to any reasonable notion of FFH's fair intrinsic value. But, how was it done? Well, it was done principally by increasing FFH's corporate debt-level, selling subsidiaries (Riverstone and Pet Health), and by issuing what I consider to be "quasi-debt," which are the recurring transactions with partners like OMERS where FFH "sells" part of an asset and then "repurchases" it a few years later at a price that always seems to give the partner a predetermined 8-10% return. Effectively, the share repurchases and the operations of the holdco have been largely financed by issuing debt (including quasi-debt) and selling assets. I don't have a particular problem with that, provided that the terms that FFH receives for the sale of its subsidiaries and for the issuance of debt are broadly acceptable, and if FFH is being rational and opportunistic about its buyback prices. The strategy of continuing to lever up after the 2018 letter has mostly worked out very well, mainly because the asset side of the balance sheet has exploded over the past two years. Having said that, the risk of that strategy became palpable during the first wave of covid (Q2 2020) as M2M losses on equities and corporate bonds and covid cat losses pushed the company uncomfortably close to its debt ceiling as defined by the revolving credit facility's debt covenants, and debt markets dried up which impeded FFH's ability to float bonds as an alternative to using the revolver. In the end, it worked out, but in Q2 2020 it was not at all obvious how FFH would fund its operations if equity markets were to continue to decline and/or covid cat losses grew appreciably. This sort of situation is the potential downside of levering up and leaving yourself reliant on bank credit (ie, a revolver). I can happily say that FFH's share repurchases to date have been an unmitigated success. The prices paid were such a significant discount to book that it's hard to envision a scenario where the decision could be declared a failure, ex post. That being said @Viking, there is a line missing from the table analysing the buyback profitability, and that line is cost of financing the repurchases. That line item would include the cost of "dividends" that Odyssey is paying to OMERS and the ultimate cost of "repurchasing" the Odyssey position (it will be "bought back" by FFH in 5 or 6 years, at a price that will guarantee OMERS it's 8-10% return, right?) and the cost of maintaining the TRS. If the Odyssey quasi-debt is repaid in a relatively short period, the fall 2022 repurchase will be an overwhelming success as the discount was so large it will easily exceed any cost of financing, but if the quasi-debt languishes for a prolonged period the analysis might be a bit more ambiguous (8-10% per year for a decade or more would be a little painful). Similarly, if the TRS continue to increase in value at a pace that drastically outstrips the cost of the swap, it will be an unambiguous win for FFH, but if the share price growth should flatten (or, gasp, go negative!) and FFH continues to pay the juice for a number of years the outcome could become less obvious. In any event, the odds are overwhelmingly in favour of this working out very well for shareholders over the long-term, but always keep in mind that financing was not free and it was not without risk. All of this brings us to today. The FFH holdco is once again a little light on cash and management seems to understand that large dividends from the insurance subs during a hard market might be undesirable because it could impede growing the subs' books during the virtuous part of the insurance cycle when both underwriting and investments are providing strong returns. Buybacks slowed to $80m during the first 6 months of 2023, likely because the holdco had limited cash available. The company has pushed out the "repurchase" of the minority position in Allied for a few years to give itself time to make a pile of money before it ultimately shrinks its books of business (it bought back 0.5% for $30.6m so repurchasing the remaining 16.6% will require about $1B of cash). As much as I don't like seeing FFH increase its debt load, I would say it's probably time that they float some bonds to fund the holdco's operations for a little while. If they can fund the holdco's requirements for the next couple of years until the hard market is over, FFH will make a pile of money and can spend the 2026-28 period releasing a few billion dollars of excess capital from the subs to "repurchase" some of the outstanding minority positions and possibly complete the share buyback that was initiated through the TRS position. They have made some pretty large moves over the past couple of years that are not yet fully digested. SJ
SafetyinNumbers Posted August 12, 2023 Posted August 12, 2023 (edited) 1 hour ago, valuesource said: I’m struggling to understand Morningstar’s motivation. This isn’t Sell Side research, where they would look to capture investment banking business. We could use that to explain the bullish bias by NBF, Cormark, CIBC and BMO. I’d have to guess Morningstar is being compensated directly by some entities rather than by a soft dollar arrangement. I can tell you exactly how something like Morningstar happens. They are paid directly by discount brokers who by settlement post the dot com bubble have to provide research. Morningstar having a good brand name adds a new business line selling equity research. Because they are quants, they use their models to come up with target prices and earnings estimates. The analyst then just has to write a narrative to support the “AI” valuation. With ChatGPT, maybe AI is writing that too. Every analyst covers a lot of companies and probably gets paid very little. He covers a lot of companies. He can’t be an expert. At the crux of it, quants can’t value a lumpy 15% very well. They don’t understand the business model and the structurally high ROE. All they do is look at history and weigh the recent history extra because that’s what works for the rest of the stocks in their universe whose businesses are more predictable. It doesn’t matter by the way that it’s bad at valuing Fairfax in particular. I think regulators should look at banning this type of research because individuals read it and think that it’s Fairfax specific research when in fact it’s a snippet of a big data project that is being shared with an individual in a more personalized way via the analyst narrative. A fund managed based on that quant strategy might still beat the market! It’s a big reason why an obviously cheap liquid company like Fairfax can stay so obviously undervalued when everybody has the same information. The number of active managers has diminished significantly in the past 20 years and the ones left for the most part are good at hugging the index and/or using quant screens to pick stocks. They might as well be following Morningstar research because their quant screen knocked Fairfax out of consideration. None of this should be surprising. If passive and quant based funds are taking all of your assets it makes business sense to mimic your peers. It’s a very hard job. I know I would find it very difficult to make money with those constraints. That’s a big reason why I don’t do it but if I found myself needing a job I might give it a shot! I would try to find an unconstrained seat first of course! Frankly, I don’t think there has been a better time for unconstrained investors in decades. It’s one of the reasons I’m so bullish on Fairfax. They are an unconstrained investor with the potential to make 10%+ returns on the equity portfolio while the fixed income portfolio is making 5%. That all translates to 20%+ ROE potential. Viking’s brilliant well written post above spells out how easily that can happen. Buying insurance subsidiaries at < 10x earnings is also a 10%+ return on investment. I think selling 10% of Odyssey at a premium valuation to fund the SIB was a Singleton move. When I talk to investors about Fairfax, the focus is still on the downside and I fear that’s why there is selling at these prices on a daily basis. People are worried about a near term drawdown which could absolutely happen and likely will but that has nothing to do with intrinsic value. I know a lot of people are hoping for more buybacks but I hope Fairfax keeps making buying what they know (Stelco could be next) and making the company more durable. That will make it easier for shareholders to hang on and worry less about drawdowns. That will gives Fairfax a much better chance of a premium valuation as the index huggers and momentum quants keep buying which I’m sure Prem will use to issue equity (Singleton!) and increase book value that much more When I was in UBS Equity Sales as a desk analyst, one of my bosses clients gave me the nickname “The Dream”. My boss actually said he gave me the nickname but as a 27 year old kid at the time I remember thinking it was awesome that a hedge fund manager running billions of dollars knew who I was. He didn’t know my name though which is why he called me The Dream. My ego took it like I was at a Hakeem Olajuwon level but in reality he was just referring to my propensity to figuring out the narrative where everything goes right. At the time we were trading a lot of risk arbitrage and event driven trades so some creativity was helpful and paid off big time as there was a lot of money to be made in 2004. To that end, I’m clearly focusing on what could right for Fairfax. I think that’s an important part of the expected returns and focusing on the downside might make me let shares go too early which I will almost certainly will regret doing. Edited August 12, 2023 by SafetyinNumbers Typo
Redskin212 Posted August 12, 2023 Posted August 12, 2023 Stelco - what are the chances Kestenbaum takes the company private with some assistance from Prem in the next 12 months? He clearly is a great operator and capital allocator, so likely a perfect fit for Fairfax.
SafetyinNumbers Posted August 12, 2023 Posted August 12, 2023 (edited) 1 hour ago, Redskin212 said: Stelco - what are the chances Kestenbaum takes the company private with some assistance from Prem in the next 12 months? He clearly is a great operator and capital allocator, so likely a perfect fit for Fairfax. The best part about is that they could do it without putting any new cash in using Stelco’s cash on hand and some term debt. Edited August 12, 2023 by SafetyinNumbers
Viking Posted August 12, 2023 Posted August 12, 2023 (edited) 4 hours ago, StubbleJumper said: I believe that I likely expressed more disdain than anyone for Prem's comment in the 2018 annual letter. My argument at the time was that for most of 20 years, FFH had been chronically short of capital and, nonetheless, had chronically acquired both insurance and non-insurance subsidiaries. It did this by issuing large amounts of debt and by repetitively increasing its share count. My argument at the time was that, as a serial acquirer, Prem would be unable to make a meaningful reduction in the share count because the capital/cash at the holding company level required to do so would never be there because there would always be another business to buy. Well, I was wrong....mostly. FFH has meaningfully reduced its share count since 2018, and it was mainly done in a very rational and opportunistic manner. The largest buybacks were conducted at objectively significant discounts to any reasonable notion of FFH's fair intrinsic value. But, how was it done? Well, it was done principally by increasing FFH's corporate debt-level, selling subsidiaries (Riverstone and Pet Health), and by issuing what I consider to be "quasi-debt," which are the recurring transactions with partners like OMERS where FFH "sells" part of an asset and then "repurchases" it a few years later at a price that always seems to give the partner a predetermined 8-10% return. Effectively, the share repurchases and the operations of the holdco have been largely financed by issuing debt (including quasi-debt) and selling assets. I don't have a particular problem with that, provided that the terms that FFH receives for the sale of its subsidiaries and for the issuance of debt are broadly acceptable, and if FFH is being rational and opportunistic about its buyback prices. The strategy of continuing to lever up after the 2018 letter has mostly worked out very well, mainly because the asset side of the balance sheet has exploded over the past two years. Having said that, the risk of that strategy became palpable during the first wave of covid (Q2 2020) as M2M losses on equities and corporate bonds and covid cat losses pushed the company uncomfortably close to its debt ceiling as defined by the revolving credit facility's debt covenants, and debt markets dried up which impeded FFH's ability to float bonds as an alternative to using the revolver. In the end, it worked out, but in Q2 2020 it was not at all obvious how FFH would fund its operations if equity markets were to continue to decline and/or covid cat losses grew appreciably. This sort of situation is the potential downside of levering up and leaving yourself reliant on bank credit (ie, a revolver). I can happily say that FFH's share repurchases to date have been an unmitigated success. The prices paid were such a significant discount to book that it's hard to envision a scenario where the decision could be declared a failure, ex post. That being said @Viking, there is a line missing from the table analysing the buyback profitability, and that line is cost of financing the repurchases. That line item would include the cost of "dividends" that Odyssey is paying to OMERS and the ultimate cost of "repurchasing" the Odyssey position (it will be "bought back" by FFH in 5 or 6 years, at a price that will guarantee OMERS it's 8-10% return, right?) and the cost of maintaining the TRS. If the Odyssey quasi-debt is repaid in a relatively short period, the fall 2022 repurchase will be an overwhelming success as the discount was so large it will easily exceed any cost of financing, but if the quasi-debt languishes for a prolonged period the analysis might be a bit more ambiguous (8-10% per year for a decade or more would be a little painful). Similarly, if the TRS continue to increase in value at a pace that drastically outstrips the cost of the swap, it will be an unambiguous win for FFH, but if the share price growth should flatten (or, gasp, go negative!) and FFH continues to pay the juice for a number of years the outcome could become less obvious. In any event, the odds are overwhelmingly in favour of this working out very well for shareholders over the long-term, but always keep in mind that financing was not free and it was not without risk. All of this brings us to today. The FFH holdco is once again a little light on cash and management seems to understand that large dividends from the insurance subs during a hard market might be undesirable because it could impede growing the subs' books during the virtuous part of the insurance cycle when both underwriting and investments are providing strong returns. Buybacks slowed to $80m during the first 6 months of 2023, likely because the holdco had limited cash available. The company has pushed out the "repurchase" of the minority position in Allied for a few years to give itself time to make a pile of money before it ultimately shrinks its books of business (it bought back 0.5% for $30.6m so repurchasing the remaining 16.6% will require about $1B of cash). As much as I don't like seeing FFH increase its debt load, I would say it's probably time that they float some bonds to fund the holdco's operations for a little while. If they can fund the holdco's requirements for the next couple of years until the hard market is over, FFH will make a pile of money and can spend the 2026-28 period releasing a few billion dollars of excess capital from the subs to "repurchase" some of the outstanding minority positions and possibly complete the share buyback that was initiated through the TRS position. They have made some pretty large moves over the past couple of years that are not yet fully digested. SJ @StubbleJumper Yes, i did not discuss where the money came from to fund the $6.2 billion buying spree. I thought the post was already long enough Here are some quick thoughts: 2020-2021 - FFH TRS purchase has been a home run. Yes, at the time, Fairfax did not have the cash. Hence, the genius of this investment. And with Fairfax shares today trading at 5.3 x 2023E earnings i think this investment has much further to run. Yes, there is a cost to hold this position. But I trust that Fairfax is laser focussed on this and they will exit the TRS at an appropriate time. With the significant earnings coming in each of the next three years Fairfax has the ability to help the share price get closer to what they believe is intrinsic value (by cranking up buybacks). My guess is Fairfax holds this position for a couple more years. Late 2021 - Dutch auction taking out 2 million shares at $500 million was also a home run. At the time Fairfax did not have the cash. Another very good investment with book value today at $834/share and likely on its way to $900 by year end. To fund it, yes, they had to sell 10% of Odyssey in a funky deal with partners (OMERS) who i think get a fixed return of around 8%. However, in return i think Fairfax is able to buy back the stake at a fixed price (set when the deal was struck). And (i believe) Fairfax keeps 100% of the growth in value of the underlying business, including the 10% owned by the minority partners. So the 8% ‘cost’ is likely much less (as long as the business grows in value). Not really sure - just my guess. 2022 - The sale of the pet insurance deal will do down as one of the biggest heists in the insurance industry in recent years. So yes, Fairfax ‘sold an asset.’ But that was a criminally good deal for Fairfax investors. The sale of Riverstone UK is a little more nuanced. I think it was a very well run operation. However, a run off business is never going to be valued anywhere close to an appropriate level by Mr Market. Bottom line, i also like this sale given what Fairfax was able to do with the proceeds. I think i look at things a little differently than you. When looking at the individual transactions it is always through the lens of Fairfax as a whole. Is their total level of debt today ok? Yes. Especially considering the likely trajectory of operating earnings (2023-2025). Are they reducing ‘minority interest’ in insurance subs? Yes. As you point out, with some puts and takes. I expect this trend to continue in the coming years - Fairfax will continue (on balance) to take out more of its minority partners. Insurance asset sales (pet insurance, Riverstone UK, Ambridge) are delivering significant value to shareholders. This is not a negative, this is a big positive. Non-insurance asset sales are the same (Resolute Forest Products). I expect this to continue. The net/net of all the moves over the past 3 years is Fairfax is a much, much stronger company today than it was June 30, 2020. Were all the decisions perfect? No, of course not. But taken as a whole, they have hit the ball out of the park. They are delivering a clinic in value investing. Now where the Fairfax story gets really interesting is right about now. In the past, Fairfax was capital constrained. Not anymore. My current forecast is for Fairfax to deliver net earnings of around $11.3 billion in 2023, 2024 and 2025 (total over these three years - after minority interests). For reference, my past estimates have been on the low side and i think that could well be the case here too. Today, being short of capital is not a concern for me for Fairfax. Edited August 13, 2023 by Viking
MMM20 Posted August 12, 2023 Posted August 12, 2023 5 hours ago, valuesource said: I’m struggling to understand Morningstar’s motivation. This isn’t Sell Side research, where they would look to capture investment banking business. We could use that to explain the bullish bias by NBF, Cormark, CIBC and BMO. I’d have to guess Morningstar is being compensated directly by some entities rather than by a soft dollar arrangement. Never attribute to malice that which can be adequately explained by stupidity. Hanlon’s razor. 1
Parsad Posted August 12, 2023 Posted August 12, 2023 5 minutes ago, MMM20 said: Never attribute to malice that which can be adequately explained by stupidity. Hanlon’s razor. LOL! +1! Cheers!
UK Posted August 14, 2023 Posted August 14, 2023 (edited) On 8/7/2023 at 3:15 AM, StubbleJumper said: 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 10.5 kB · 25 downloads Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK! ffh brk float.pdf ffh brk float.xlsx Edited August 14, 2023 by UK
StubbleJumper Posted August 14, 2023 Posted August 14, 2023 (edited) @UK That is quite interesting. I knew that BRK was concerned that Geico had not been keeping up with Progressive, but I would not have guessed that BRK's benefit of float including GenRe had been trending downward for a decade. Edited August 14, 2023 by StubbleJumper
SafetyinNumbers Posted August 14, 2023 Posted August 14, 2023 58 minutes ago, UK said: Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK! ffh brk float.pdf 124.81 kB · 7 downloads ffh brk float.xlsx 37.75 kB · 3 downloads Float to market cap and float to BV would also be an interesting comparison over time and currently vs peers.
UK Posted August 14, 2023 Posted August 14, 2023 https://www.wsj.com/articles/wildfires-and-thunderstorms-are-throwing-insurance-market-into-turbulence-2c62ab7b?mod=hp_minor_pos19 Not only have reinsurers in some cases raised the cost of coverage, but they have also moved up the starting point for when they will begin to absorb losses. Thus, the amount of losses that primary insurers have to take before reinsurance kicks in is in many cases getting larger. Reinsurers are now typically seeking to start at the level of catastrophe losses that occur around once every 10 years, rather than the more typical starting point of one-in-three-year or -five-year events, Gallagher Re said in its January report. Clearly, the insurance industry as a whole needs to keep adjusting to worse events, more often. That won’t happen without cost.
treasurehunt Posted August 15, 2023 Posted August 15, 2023 16 hours ago, UK said: Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK! ffh brk float.pdf 124.81 kB · 9 downloads ffh brk float.xlsx 37.75 kB · 3 downloads Nice work! I checked the BRK data for the past ten years and your chart looks correct. Even accounting for differences in the lines of business, I am surprised that Fairfax's underwriting has been noticeably better than Berkshire's in recent years. I mean, Buffett is very proud of the quality of Berkshire's insurance business, but Fairfax has had better underwriting results for the last six years or so. Very impressive.
ValueMaven Posted August 15, 2023 Posted August 15, 2023 @treasurehunt big issue there has been GEICO - so not really comparing apples to apples imho
treasurehunt Posted August 15, 2023 Posted August 15, 2023 2 hours ago, ValueMaven said: @treasurehunt big issue there has been GEICO - so not really comparing apples to apples imho It's true that the comparison is not apples to apples, but GEICO by itself does not explain the difference. 2022 was the only bad year for GEICO with an underwriting loss of -$1.9 billion. In the four years prior, GEICO's underwriting profit totaled over $8.6 billion, or almost $2.2 billion per year.
Viking Posted August 20, 2023 Posted August 20, 2023 (edited) Fairfax and the Transition from Good to Great: The Flywheel Effect Warning: Mr Market might be right. And I might be completely wrong. This post is not intended to be financial advice. It is intended to educate and entertain. Please contact your financial advisor before making any stock purchases. Fairfax’s stock trades today at a PE of 5.2 (to my estimate of 2023 earnings). Of course, it is not normal for a stock to trade at a PE of 5.2. The PE multiple for the S&P500 is currently 20. So Fairfax’s stock could double in price and it would still be trading at a 50% discount to the S&P500. Fairfax’s PE of 5.2 screams that one of two things is clearly wrong: 1.) the price of the stock is way too low. 2.) the estimated earnings are way too high (and not ‘durable’) Let’s take a look the stock price first. Fairfax has been one of the best performing stocks over the past 31 months (since Dec 31, 2020). Over this time period, Fairfax is up 143% while the S&P500 is up 16%. Fairfax has outperformed the S&P500 by 127%. That is stellar outperformance. After a run like that, Fairfax’s stock price must now be fairly valued - in fact, it might even be overvalued. Looks like we might have our answer to our question above. If the stock is fairly valued then that means the earnings estimate must be way too high. Let’s take a look at earnings estimates. After Fairfax released Q2 earnings, I updated my three year earnings estimate for Fairfax and came up with the following: 2023 = $160/share 2024 = $166/share 2025 = $174/share My forecast is for earnings to go up each of the next 3 years. Clearly, my estimates must be too high. Right? I actually think they might prove to be conservative. Why? Because every forecast I have done for Fairfax for the past 30 months has proven, in hindsight, to be too conservative and usually by a lot. Why have my estimates been too low? Because i have been consistently underestimating the management team at Fairfax and the earnings power of the collection of assets they have today. So i trust my earnings estimate looking out three years. A lot. So what explains Fairfax’s current PE of 5.2? Despite a 143% gain over the past 31 months, the stock price of Fairfax is still dirt cheap. Yes, that probably sounds like crazy talk. How can a ‘still dirt cheap’ stock price be explained? Operating earnings are the holy grail for insurance companies because it is made up primarily of predictable items. And these items tend to be durable. Let’s focus on this bucket of earnings at Fairfax and see what we can learn. The average for total operating earnings at Fairfax from 2016 to 2020 was $1 billion per year ($39/share). But this dramatically changed beginning in 2021. in 2021, operating earnings doubled to $1.8 billion or $77/share (from 2016-2020 average) in 2022, operating earnings tripled to $3.1 billion or $132/share (from 2016-2020 average) in 2024, operating earnings are forecasted to quadruple to $4.3 billion or $185/share (from 2016-2020 average) The increase in operating earnings at Fairfax has been like a goat climbing straight up the steep side of a mountain. Let’s now do some historical comparisons to see what we can learn. From 2016 to 2020, Fairfax’s stock price averaged about $500/share (I am ignoring the covid drop in 2020). Over this same 5-year period, operating earnings at Fairfax averaged about $1 billion per year ($39/share). So investors over this 5 year period thought $1 billion in operating earnings (let’s call that baseline earnings) at Fairfax was worth a stock price of about $500. Back then, Fairfax’s stock was considered to be fairly valued. In 2023, operating earnings at Fairfax will be about $4.3 billion ($185/share). Operating earnings for 2023 are up 330% compared to the old 5-year baseline trend from 2016-2020, or 374% on a per share basis (the share count has come down over the past 5 years). Fairfax’s stock price closed Friday at $828. Fairfax’s stock price is up only 66% compared to the 5-year trend from 2016-2020. So operating earnings per share at Fairfax have increased a staggering 374% over the 2016-2020 trend while the share price has increased a modest 66%. I think we just learned something useful. The increase in Fairfax’s stock price has not kept up with the increase in operating earnings. And ‘not kept up’ is a big understatement. What is Mr Market missing? Mr Market clearly is not understanding the new trajectory for operating earnings at Fairfax. This is likely because Mr Market is still looking at Fairfax’s financial performance through the rear view mirror - focussing primarily on past reported results. That approach makes sense for most companies. But it makes no sense for Fairfax today. Because it completely misses (ignores) all the significant positive changes that have been happening at Fairfax over the past 5 or 6 years - the benefits of which are only just now fully flowing through to reported results. The good news is Mr Market will eventually figure things out at Fairfax. Earnings are the key. And as Fairfax keeps reporting stellar results quarter after quarter, Mr Market will price Fairfax’s shares appropriately. What is causing the massive increase in operating earnings? What we are seeing today, with record operating earnings at Fairfax, is the cumulative effect of slow, organic (internal) change that has been happening at Fairfax for many years - a process of continuous improvement. It is the result of the conscious choices and actions being taken at all levels of the organization - senior management, the insurance operating companies, the investment team at Hamblin Watsa and the CEO’s of the various equity holdings. All parts of the organization are working in a disciplined way towards the same end purpose - the consistent delivery of solid results leading to the improvement of the long term performance of the company. It is the slow methodical process of doing what needs to be done. For Fairfax the process also involved some soul searching - there were lessons that needed to be learned. Fairfax stopped doing the things that were not working (like the equity hedges and short positions). It got better with its new equity investments. The improving operating earnings are also not due primarily to circumstance. But active management (taking advantage of circumstance) is an important part of Fairfax’s business model. The record operating earnings we are seeing at Fairfax today is simply the end result of years of good decisions and hard work. What is the new baseline for operating earnings at Fairfax today? The level of operating earnings at Fairfax have likely reached an inflection point - a breakthrough of sorts - given their size. Significant sums are now being reinvested every year (billions). The seeds that are being planted will grow new streams of operating earnings for Fairfax in both insurance and investments in the coming years. Compounding will work its magic. Fairfax looks like it is now in that virtuous circle where success begets more success. My estimate for operating earnings for 2023 is $4.3 billion and I think that is a reasonable number to use a new baseline for Fairfax moving forward. Why? Because all the inputs I use are reasonable and mildly conservative. How durable is $4.3 billion in operating earnings? My guess is it is quite durable. At least as durable as operating earnings at other insurance companies like WR Berkley, Markel or Chubb. Why wouldn’t they be? In fact, the management team at Fairfax has been best-in-class in terms of overall management of the business in recent years - this suggests that we should have more confidence in Fairfax’s future results than that for peers. I know, that is a very non-consensus view. But it is where logic takes me. As I like to say, the once ugly caterpillar called Fairfax has magically transformed itself into a beautiful butterfly. What thing happened to cause the transformation? There was no one thing. It was a bunch of things. From the butterfly’s point of view, what happened was perfectly natural. Only to the outsider does it look like magic. ————— Jim Collins, in his book Good to Great, has a concept called the ‘flywheel effect’ that describes very well what has been happening ‘under the hood’ at Fairfax for the past 5 or 6 years that has got the company to where it is today. The flywheel effect: “The Flywheel effect is a concept developed in the book Good to Great. No matter how dramatic the end result, good-to-great transformations never happen in one fell swoop. In building a great company, there is no single defining action, no grand program, no one killer innovation, no solitary lucky break, no miracle moment. Rather, the process resembles relentlessly pushing a giant, heavy flywheel, turn upon turn, building momentum until a point of breakthrough, and beyond.” https://www.jimcollins.com/concepts/the-flywheel.html ————— What are some of the decisions/actions made by Fairfax in recent years that have caused the Fairfax 'flywheel' to pick up more and more speed? To provide some context, we are going to separate the decisions/actions into Fairfax’s three economic engines: insurance investments - fixed income investments - equities/derivatives Each on its own is driving earnings for Fairfax. Together, they help illustrate why Fairfax is delivering record operating earnings - and why the Fairfax flywheel has now likely reached ‘breakthrough’ speed. Economic engine 1: insurance Turn 1: 2015-2017: rapid growth - driven by international expansion by acquisition Turn 2: 2017: strategic pivot in India - sold ICICI Lombard for significant gain ($950 million) and seeded Digit with an investment of $154 million that is now worth $2.3 billion.. Turn 3: 2019-today: rapid organic growth - driven by hard market. Turn 4: 2022: increased ownership in Allied World from 70.9 to 82.9% Turn 5: 2023: increasing ownership in Gulf Insurance Group from 44% to 90%. Strategic; secures Fairfax’s position in MENA. Turn 6: ongoing: methodically improving quality of the insurance businesses. Resulting in improving CR. Net written premiums have increased from $8.1 million in 2016 to an estimated $24.1 billion in 2023, an increase of 198%. At the same time, the combined ratio has improved from an average of 98 from 2016-2020 to an average of 95 the past three years. Much higher net written premiums and a lower CR has resulted in much higher (record) underwriting profit. Underwriting profit averaged $191 million per year from 2016-2020. It was $801 million in 2021, $1.1 billion in 2022 and is forecasted to be $1.3 billion in 2023. This increase is sustainable (with some volatility in both directions). Economic engine 2: investments - fixed income Turn 7: Dec 2021: average duration of fixed income portfolio was reduced to 1.2 years. In 2021, sold $5.2bn in corporate bonds at a yield of 1% for a realized gain of $253 million (most were purchased in March/April 2020). Avoided billion in unrealized losses on $40 billion fixed income portfolio as interest rates spiked higher in 2022 and 2023 (protected the balance sheet). Turn 8: 1H 2023: average duration of fixed income portfolio extended to 2.4 years. This locks in more than $1.5 billion in interest income for each of the next three years (this estimate is low). Turn 9: 2020 and 2023: real estate debt platform partnership established with Kennedy Wilson. $4 billion portfolio is delivering an average return of about 9% total = $360 million, mostly in interest income. Driven by the significant increase in the insurance business, the size of the fixed income portfolio at Fairfax has doubled in size from $20.3 billion in 2016 to $40 billion today. From 2016-2022, the average yield of the fixed income portfolio was 2.4% and today the average yield is 4.8%. As a result of the two doubles (portfolio size and rate of return), interest income is spiking higher. Interest income averaged $650 million per year from 2016-2021. It was $874 million in 2022 and is forecast to come in at $1.8 billion in 2023 and $2.1 billion in 2024. This increase is sustainable (with some volatility in both directions). Economic engine 3: investments - equities / derivatives Turn 10: 2016: ending the ‘equity hedge’ in late 2016. Turn 11: 2020: closing out the final short position in late 2020 These two programs cost Fairfax an average of $494 million per year on average from 2010-2020. Ending these two programs eliminated what was essentially a $494 million annual expense for the company (meaning Fairfax became $494 million more profitable). Fairfax has also said multiple times that they have learned their lesson and that they will no longer short indices or individual stocks. Turn 12: 2014-2017: poor equity purchases - Fairfax made a string of poor equity purchases from 2014-2017. Turn 13: 2018-today: very good new equity purchases - Fairfax has been hitting the ball out of the park with their more recent new equity purchases. Turn 14: 2020- present: Fairfax also have been taking advantage of recent bear market low stock prices by adding significantly to many of the equity holdings they already own. Fairfax has done a great job over the last 5 years fixing their poor equity purchases from 2014-2017. These holding were burning about $200 million per year in cash (losses/write downs/restructuring etc) and now they are all largely fixed and delivering solid returns for Fairfax shareholders. Eurobank is the shining star in this group. The equity purchases from 2018-today have been performing well. And Fairfax has been aggressively adding to positions in equities they already own - buying at bear market low prices. Share of profit of associates at Fairfax averaged $151 million per year from 2016-2021. It was $1 billion in 2022 and it is forecast to come in at $1.1 billion in 2023. This number should grow nicely in the coming years (with some volatility in both directions). The quality of Fairfax’s total portfolio of equity holdings has likely never been better than it is today. Turn 15: late 2020/early 2021: purchase of total return swap giving Fairfax exposure to 1.96 million FFH shares at an average cost of $372/share. This one investment has delivered to Fairfax an unrealized gain of more than $900 million since inception. Asset sales: Turn 16: 2020/2021: sold Riverstone UK (runoff business) for $1.3 billion (plus $230 million contingent value instrument). Turn 17: 2022: sale of pet insurance business delivered a $1 billion after tax gift to Fairfax shareholders. Turn 18: 2022: sale of Resolute Forest Products for $626 million (plus $183 million CVR) at top of lumber cycle. Asset sales (insurance and investments) have always been an important part of the capital allocation framework at Fairfax and have delivered significant value to shareholders over the years. Stock buybacks: Turn 19: 2021: dutch auction - Fairfax purchased 2 million shares at $500/share. Turn 20: 2018 to present - via NCIB, Fairfax has bought back about 2.5 million shares via the NCIB at about $490/share. Share count at Fairfax peaked at 27.75 million in 2017. Since that time Fairfax has reduced effective shares outstanding by 4.55 million or 16.2%. Share count has returned to about where it was in 2016 fully offsetting the dilution caused by the Allied World acquisition. As a result, shareholders today enjoy the full benefit of the significant growth Fairfax has achieved since 2016. As well, all 4.5 million shares were repurchased at a very attractive average price of around $490. Fairfax shares closed today at $828 (BV is $834). Conclusion: As you can see from the list above there is no one thing (action, event, luck) that is driving record operating earnings at Fairfax. Rather, it is the cumulation of many, many things that have happened over the past 5 or 6 years. But it is only now that the impact of these many actions are becoming fully visible to outsiders - because now they are all together ‘all of a sudden’ showing up in record underwriting profit, record interest and dividend income and record share of profit of associates. The flywheel has achieved breakthrough. And Fairfax as a company has made the leap from good to great. Is Fairfax’s stock fairly valued at a PE of 5.2 (to 2023 estimated earnings)? You decide. ————— The Benefits of active management: Above is a list of 20 actions taken by the management team at Fairfax in recent years. A significant number of the actions mentioned have on their own delivered $1 billion or more in value to Fairfax shareholders. Each on its own is an impressive accomplishment. But when you put them all together… well that is simply an amazing collection of accomplishments. And a big reason why i am so confident Fairfax’s new baseline for operating profit is likely around $4.3 billion. It clearly demonstrates the huge impact active management, when done well, can have on a company like Fairfax. Edited August 20, 2023 by Viking
petec Posted August 20, 2023 Posted August 20, 2023 57 minutes ago, Viking said: The record operating earnings we are seeing at Fairfax today is simply the end result of years of good decisions and hard work. Viking your work is usually excellent but this statement is wrong. Fairfax have absolutely done excellent work - I have argued this for a long time, and actually think it goes back decades, notwithstanding clear mistakes regarding the big short. However, what's really driven the increase in operating earnings is the big shift in the macro backdrop - covid stimulus and then rising rates helped (in rough order) Atlas, then the broader economy, float income, and underwriting profits (because CRs are directly linked to interest rates, which control the amount of capital flowing into the industry). Eurobank's recovery is not entirely unrelated to this either. Don't get me wrong: Fairfax's management made some great decisions in the down market to grow by acquisition (not writing more policy) and put themselves in a position to write record amounts of business and generate record amounts of float in the up market. They got roundly criticised for some of those decisions on this board (the Brit and Allied deals were evidence of Prem's towering ego, not his ability to make different decisions at different points in the cycle). I agree with almost every example you've given of good decisions on their part. But the fact is that if rates were still at 2019 levels, which they might well have been without covid, Fairfax's operating earnings wouldn't be at this level. That said, I do think Fairfax's next 2-3 years look strong, and by then they will be so large in float terms that operating earnings will be far higher than historic levels regardless of rates. And I think the stock looks fairly cheap on that basis. It's my largest holding, but I trim on spikes these days.
Viking Posted August 20, 2023 Posted August 20, 2023 (edited) 41 minutes ago, petec said: Viking your work is usually excellent but this statement is wrong. Fairfax have absolutely done excellent work - I have argued this for a long time, and actually think it goes back decades, notwithstanding clear mistakes regarding the big short. However, what's really driven the increase in operating earnings is the big shift in the macro backdrop - covid stimulus and then rising rates helped (in rough order) Atlas, then the broader economy, float income, and underwriting profits (because CRs are directly linked to interest rates, which control the amount of capital flowing into the industry). Eurobank's recovery is not entirely unrelated to this either. Don't get me wrong: Fairfax's management made some great decisions in the down market to grow by acquisition (not writing more policy) and put themselves in a position to write record amounts of business and generate record amounts of float in the up market. They got roundly criticised for some of those decisions on this board (the Brit and Allied deals were evidence of Prem's towering ego, not his ability to make different decisions at different points in the cycle). I agree with almost every example you've given of good decisions on their part. But the fact is that if rates were still at 2019 levels, which they might well have been without covid, Fairfax's operating earnings wouldn't be at this level. That said, I do think Fairfax's next 2-3 years look strong, and by then they will be so large in float terms that operating earnings will be far higher than historic levels regardless of rates. And I think the stock looks fairly cheap on that basis. It's my largest holding, but I trim on spikes these days. @petec you are a night owl! My view is the true anomaly was the period 2010-2020 and zero interest rates. Interest rates appear to be normalizing. This is causing the investment world to return to a more normalized environment… one where active management, when done well, matters (can deliver serious outperformance). Something Fairfax has historically been very good at. So i give the management team the benefit of the doubt for the very good decisions they have made in recent years. The part of your comment i do not understand is: “And I think the stock looks fairly cheap on that basis.” My estimate is the stock is trading at 5.2 x 2023 earnings. That is not ‘fairly cheap’… that is crazy cheap. Do you not think $4.3 billion is a reasonable estimate for operating earning for 2023? Or is it more a weighting issue… where Fairfax is getting too big and you want to lighten up to rebalance your overall portfolio? Regardless of fundamentals or what the stock might actually be actually worth? Edited August 20, 2023 by Viking
SafetyinNumbers Posted August 20, 2023 Posted August 20, 2023 3 hours ago, petec said: Don't get me wrong: Fairfax's management made some great decisions in the down market to grow by acquisition (not writing more policy) and put themselves in a position to write record amounts of business and generate record amounts of float in the up market. They got roundly criticised for some of those decisions on this board (the Brit and Allied deals were evidence of Prem's towering ego, not his ability to make different decisions at different points in the cycle). I agree with almost every example you've given of good decisions on their part. But the fact is that if rates were still at 2019 levels, which they might well have been without covid, Fairfax's operating earnings wouldn't be at this level. I think this take on Brit and Allied ignores that Fairfax issued stock at 1.3x book plus and issued preferred at tight spreads to partially fund these acquisitions. Singleton is a legend not only for the buybacks below book but for issuing stock early on well above book to grow the earnings power of the business. Call it towering ego if you like, I call it accretive capital allocation.
StubbleJumper Posted August 20, 2023 Posted August 20, 2023 2 hours ago, Viking said: @petec you are a night owl! My view is the true anomaly was the period 2010-2020 and zero interest rates. Interest rates appear to be normalizing. This is causing the investment world to return to a more normalized environment… one where active management, when done well, matters (can deliver serious outperformance). Something Fairfax has historically been very good at. So i give the management team the benefit of the doubt for the very good decisions they have made in recent years. The part of your comment i do not understand is: “And I think the stock looks fairly cheap on that basis.” My estimate is the stock is trading at 5.2 x 2023 earnings. That is not ‘fairly cheap’… that is crazy cheap. Do you not think $4.3 billion is a reasonable estimate for operating earning for 2023? Or is it more a weighting issue… where Fairfax is getting too big and you want to lighten up to rebalance your overall portfolio? Regardless of fundamentals or what the stock might actually be actually worth? I'm not Pete, but I'll take a run at this. If you want to value a security using PE as a metric, you need to do so on the assumption that earnings are neither unusually high nor unusually low and that they are sustainable for a prolonged period. A PE is essentially a mental short-cut for assessing the value of a perpetuity. To make the argument that a 5.2 PE is cheap and that the company should have a PE of, say, 12, you need to assume that the current excellent operating conditions for an insurance company will persist for many years on end. To do this, you need to argue that FFH has some sort of special sauce that enables it to write a 94 CR while buying US treasuries yielding 5%, but nobody else can/will do so. So, in essence, the argument needs to be that $1 of capital in Crum or Odyssey can be used to write $2 of premium, the underwriting earnings will be 12 cents (94 CR) and riskless investment income will be 10 cents (a US Treasury yielding 5%), providing a slick return of 22% on that equity, BUT no other company can replicate that. No other company will see this, obtain new capital, expand their book of business, and competition will not push the CR rate up and squeeze FFH's books of business. If you can hammer out this argument in your own mind why FFH can do this and nobody else can/will, then your earnings are sustainable and you can simply slap some sort of market average PE onto current earnings to arrive at a valuation estimate. Setting aside the argument about the sustainability of earnings, the comment saying, "And I think the stock looks fairly cheap on that basis" is in my view a reasonable and valid comment. You have quite rightly pointed out that FFH has locked in some fairly attractive investment returns for the next few years. You've done the arithmetic through to develop pro forma earnings estimates going forward 2.5 years and shown that there will be big earnings coming down the pipe, even if a guy gives a moderate haircut to underwriting profitability for 2024 and a massive haircut to underwriting profitability for 2025 (but, hey if they actually continue to write a 94 CR, so much the better!). If you do this, it is difficult to envisage a scenario where adjusted BV (after accounting for the excess of market over book for certain associates) doesn't hit $1,100 by Dec 31, 2025. If operating conditions in the insurance market continue to be as wonderful as they currently are, with a CR of 94 and a treasury of 5% being SIMULTANEOUSLY available, that Dec 2025 BV could be higher, but it seems to be a no-brainer that they'll make the $1,100 BV given that the returns on the fixed income portfolio are largely locked in. So, someone who doesn't buy the argument that FFH ought to currently trade at PE12x$180EPS=US$2,000+ can quite reasonably believe that it could trade at somewhere between 1x and 1.2x BV on Dec 31, 2025. With the shares currently trading at ~US$830, a price on Dec 31, 2025 of $1,100 to $1,300 is quite plausible and is fully consistent with the observation, "And I think the stock looks fairly cheap on that basis." It really amounts to a bit of a differing view of just how far into the future you are comfortable to predict outstanding insurance results. I am assuming that we are at the peak of the insurance cycle and that conditions will deteriorate as capital enters the industry and companies competing to expand their books of business push the CRs higher (probably to slightly above 100 before it's all said and done). If it actually does work out that FFH can routinely obtain a 22% return on an incremental dollar of capital, so much the better. But, personally, I am unwilling to assume that today's wonderful insurance conditions will persist for a prolonged period. I would be happy in 10 years if I am wrong today! SJ
SafetyinNumbers Posted August 20, 2023 Posted August 20, 2023 13 minutes ago, StubbleJumper said: I'm not Pete, but I'll take a run at this. If you want to value a security using PE as a metric, you need to do so on the assumption that earnings are neither unusually high nor unusually low and that they are sustainable for a prolonged period. A PE is essentially a mental short-cut for assessing the value of a perpetuity. To make the argument that a 5.2 PE is cheap and that the company should have a PE of, say, 12, you need to assume that the current excellent operating conditions for an insurance company will persist for many years on end. To do this, you need to argue that FFH has some sort of special sauce that enables it to write a 94 CR while buying US treasuries yielding 5%, but nobody else can/will do so. So, in essence, the argument needs to be that $1 of capital in Crum or Odyssey can be used to write $2 of premium, the underwriting earnings will be 12 cents (94 CR) and riskless investment income will be 10 cents (a US Treasury yielding 5%), providing a slick return of 22% on that equity, BUT no other company can replicate that. No other company will see this, obtain new capital, expand their book of business, and competition will not push the CR rate up and squeeze FFH's books of business. If you can hammer out this argument in your own mind why FFH can do this and nobody else can/will, then your earnings are sustainable and you can simply slap some sort of market average PE onto current earnings to arrive at a valuation estimate. Setting aside the argument about the sustainability of earnings, the comment saying, "And I think the stock looks fairly cheap on that basis" is in my view a reasonable and valid comment. You have quite rightly pointed out that FFH has locked in some fairly attractive investment returns for the next few years. You've done the arithmetic through to develop pro forma earnings estimates going forward 2.5 years and shown that there will be big earnings coming down the pipe, even if a guy gives a moderate haircut to underwriting profitability for 2024 and a massive haircut to underwriting profitability for 2025 (but, hey if they actually continue to write a 94 CR, so much the better!). If you do this, it is difficult to envisage a scenario where adjusted BV (after accounting for the excess of market over book for certain associates) doesn't hit $1,100 by Dec 31, 2025. If operating conditions in the insurance market continue to be as wonderful as they currently are, with a CR of 94 and a treasury of 5% being SIMULTANEOUSLY available, that Dec 2025 BV could be higher, but it seems to be a no-brainer that they'll make the $1,100 BV given that the returns on the fixed income portfolio are largely locked in. So, someone who doesn't buy the argument that FFH ought to currently trade at PE12x$180EPS=US$2,000+ can quite reasonably believe that it could trade at somewhere between 1x and 1.2x BV on Dec 31, 2025. With the shares currently trading at ~US$830, a price on Dec 31, 2025 of $1,100 to $1,300 is quite plausible and is fully consistent with the observation, "And I think the stock looks fairly cheap on that basis." It really amounts to a bit of a differing view of just how far into the future you are comfortable to predict outstanding insurance results. I am assuming that we are at the peak of the insurance cycle and that conditions will deteriorate as capital enters the industry and companies competing to expand their books of business push the CRs higher (probably to slightly above 100 before it's all said and done). If it actually does work out that FFH can routinely obtain a 22% return on an incremental dollar of capital, so much the better. But, personally, I am unwilling to assume that today's wonderful insurance conditions will persist for a prolonged period. I would be happy in 10 years if I am wrong today! SJ What if the equity portfolio returns 5-10% per year on average for an indefinite period of time? Wouldn’t an ROE of 15-20% be achievable then even if combined ratios inevitably go higher?
MMM20 Posted August 20, 2023 Posted August 20, 2023 (edited) On 8/20/2023 at 8:10 AM, SafetyinNumbers said: What if the equity portfolio returns 5-10% per year on average for an indefinite period of time? Wouldn’t an ROE of 15-20% be achievable then even if combined ratios inevitably go higher? It seems like the stock just hasn’t come close to adjusting to a more normalized environment for investment returns b/c of an anchoring / recency bias. If if fact ~5% risk free rate and ~6% underwriting profit = ~11% spread turn out to be persistent for the decade or more, the stock might literally be worth $4,000 per share right now. I don’t think anyone is saying that. Even with half or a quarter of that, the stock is worth a whole lot more than $820 b/c of the value of a large and well managed investment operation generating even 60/40 beta-like returns, and an insurance operation generating roughly costless float to leverage that up without risk of a margin call. IMHO. You all have done a great job showing that it’s likely somewhere in the middle - really meaningful structural changes leading to durably higher earnings power through cycles, and that we are in a particularly favorable operating environment right now. To be clear I am not saying the stock is worth $4000. Even I am not that bullish. But I do think there is now a totally plausible upside case in which you could pay $4000 today and make ~10% returns long term from there. Who would’ve said that 5 years ago? Definitely not THIS random guy on the internet… Thanks again all for the great FFH forum. Best thing on the internet Edited August 21, 2023 by MMM20
John Hjorth Posted August 20, 2023 Posted August 20, 2023 @SafetyinNumbers, From the Markel Topic in the Investment Ideas forum a few years ago : and Just to elaborate on the basis return calculations in the considerations above, where cost of float in period n isen't 1-CRn.
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