Fairfax 2023

Munger_Disciple · September 15, 2023

18 minutes ago, ValueMaven said:

Grants Interest Rate has a very compelling piece on the reinsurance industry and the hard pricing market current occurring. While FFH is not specifically mentioned, there are some interesting nuggets in the article.

Can you please provide a more detailed summary? Thanks

Viking · September 16, 2023

Like Indiana Jones, today we are going to set out on an adventure in search of long lost treasure. Something that most investors appear to have forgotten about. What do the legends tell us? Does it really exist or is it just a myth?

What am i talking about?

P/C insurance float (I’ll just call it ‘float’ moving forward).

Float is such a big (and important) topic we are going to tackle it in two posts. The first post (below) will focus on the theory - what it is and why P/C investors should care. The second post will then apply the theory to today using a real company - Fairfax Financial. My plan is to have the second post completed and out on Sunday.

Ancient history

Thirty years ago, talking about float was all the rage for P/C investors. Read old articles on investing in P/C insurance companies and a discussion of float will usually be front and center. And the champion of float from that era was, of course, Warren Buffett and his company Berkshire Hathaway.

So what happened?

Why has float apparently settled into into the dustbin of history and become a relic of the past?

Due to competitive insurance markets, industrywide underwriting profit has remained illusive for the past decade. At the same time, top line organic growth slowed to a crawl.
Returns on investments fell: P/C insurers put most of their investments into fixed income instruments. In their battle with deflation, global central banks took interest rates all the way into negative territory. The US 10 year treasury traded at a yield below 0.60% in August of 2020 and traded with a yield below 1.5% for much of 2021.

S&P Global: US P&C Insurance Market Report

Float lost its value

Breaking even on underwriting for a decade while returns on investments plummeted made having float far less valuable than at any point in recent history.

Another smaller factor: over the years, P/C insurance has become a much smaller part of Berkshire Hathaway’s business model. What did Buffett have to say about float in his 2022 letter to shareholders? Float is mentioned 4 times in one short paragraph - telling investors to go somewhere else if they wanted to learn more. Does this sound important to you? So ‘float’ also lost its biggest cheerleader.

Does this mean… Float is dead? Long live float?

No, of course not. Just because float is no longer appreciated (or followed) doesn’t mean it doesn’t matter. In fact, for those paying attention, the world has changed again. The conditions that made float a big deal 30 years ago have returned:

Insurance has been in a hard market since about Q4 of 2019 - above average insurance companies are seeing improving underwriting results (cost of float) and significant top-line growth (supply of float) over the past four years.
Global central banks now have an inflation fight on their hands - and ‘higher for longer’ is becoming the new mantra for interest rates. Fixed income yields have spiked higher across the curve. The 10 year US treasury closed today with a yield of 4.32%, a level where it last traded at in 2007. As a result, returns on float are improving greatly.

Both of these developments make having float today extremely valuable.

Except remember… pretty much everyone has forgotten about float.

What’s old will be new again.

Well, my guess is this is about to change. I think investors are going to get interested in float again.

What is going to cause the change?

A new generation of investors are about to discover something Warren Buffett hit on when he bought National Indemnity back in 1967: float, under certain conditions, can be a license to print money. Those ‘certain conditions’ have returned. And in recent years some insurance companies have started up the printing presses and are now starting to print money. More than anyone imagined possible.

==========

P/C insurance float: the basics

Let’s first do a quick review of float. Float is deceptive. It is kind of like compound interest as a concept. It is easy to define but very hard to actually understand.

Who better to teach us about P/C insurance float than the old master, Warren Buffett himself.

Float: the basic building block to use to evaluate a P/C insurance company

Back in the 1990’s, Warren Buffett was using P/C insurance as the core engine to drive Berkshire Hathaway’s profit growth. GEICO was purchased in 1996 and General Re was purchased in 1998. Given P/C insurance’s importance to Berkshire Hathaway shareholders, Buffett provided the following as a guide to help them understand P/C insurance as an investment.

BRK 1998AR: “With the acquisition of General Re — and with GEICO’s business mushrooming — it becomes more important than ever that you understand how to evaluate an insurance company. The key determinants are:

1.) the amount of float that the business generates;

2.) its cost; and

3.) most important of all, the long-term outlook for both of these factors.”

Well, Warren appears to be saying float is the most important thing to understand when evaluating an insurance company. Interesting, given how little press float gets today from analysts and investors.

What is float?

BRK 1998AR: “To begin with, float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years.”

Float is money a P/C insurer has that it can use to invest. It is an asset but it is a liability (not equity). It is kind of like a very sticky deposit at a bank (a deposit is also a liability for the bank).

Because float is a liability, it is also leverage. Like all leverage (i.e. debt), float can be both good or bad - and this depends on the cost paid over time to hold the float.

What is the cost of float?

BRK 1998AR: “Typically, this pleasant activity (the insurance business) carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss," which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”

Underwriting determines the ‘cost’ of float.

This point is critical. Over time, if an insurer can produce an underwriting profit on its insurance business that means the cost of its float is actually a benefit - that is better than free. That means the insurer is actually getting paid to hold the float. This is far better than ‘the cost the company would otherwise incur to obtain the funds.’

Float is a pile of money that an insurance company can actually earn two income streams from: underwriting (if float is obtained at a benefit) and investing.

Sounds like Buffett was on to something.

To summarize: according to Buffett, a good P/C insurance company:

Has a large amount of float
Is a good underwriter - is able to generates the float at a favourable cost (ideally a benefit)
Has a good long term track record - of both growing float and as a solid underwriter

Buffett’s secret sauce: P/C insurance float

Buffett’s genius has really been two pronged:

Use P/C insurance float as an ever-increasing low cost (free) source of capital/leverage used to push profits even higher.
These growing profits were then continuously reinvested into great companies/equities (outside of insurance) that have also become compounding machines over time and pushed profits even higher.

OK. So there is a quick review of float, explained with the help of Warren Buffett.

To help us understand float even better, let’s look at it now from a balance sheet perspective.

==========

Float and the balance sheet

Let’s create an imaginary insurance company - called Random P/C Insurance Co - and create a fictitious balance sheet.

Our company has $80 billion in assets, with $60 billion in liabilities and $20 billion in common shareholders’ equity. Of the total liabilities of $60 billion, float is $30 billion. The summary of the balance sheet is below:

We are also going to assume common shareholders’ equity = book value.

We are going to make up more numbers below. We are using numbers that make our calculations easy. Please don’t focus too much on the exact numbers. Instead, focus on the information they are trying to convey - especially about leverage.

Cost of float

Let’s assume our insurance company is a slightly above average underwriter with a combined ratio (CR) of 96 - this translates into a ‘benefit’ of float (better than free - our company is actually getting paid to hold their float).

Return on investments (which includes float)

Let’s assume our insurance company is above average in terms of the return it earns from its total investments (which includes float) - let’s assume it earns 8% on average.

We are also going to assume there are no taxes.

The return of Random P/C Insurance Co

When we put the two together we get:

Benefit of float (CR of 96)
Return on investments = 8%

Let’s assume Random P/C Insurance Co earns a total return of 10% on its float.

This means our insurance company is earning the following:

$30 billion float x 10% = $3 billion.

Can we calculate the actual leverage provided by the float?

Yes. Total earnings from float of $3 billion will flow though the income statement and increase retained earnings, which will then flow though to the balance sheet and increase both assets and common shareholder equity by $3 billion.

So a return from float of 10% results in an increase in common shareholders' equity of 15%.

The leverage can be calculated as follows: total float / common shareholders' equity.

In our example

float of $30 billion / common shareholders' equity of $20 billion = 1.5 x leverage

Common equity, debt and total investments

The above increase in common shareholders' equity was driven solely by float. A company is also going to generate earnings from its common shareholders’ equity - the funds provided by shareholders. Perhaps it also uses a little debt to generate more earnings. Any returns generated by its other investments (those other than float) need to be added to the numbers above.

==========

Below Buffett summarizes how float fits into the big picture

Berkshire Hathaway 1995AR: “In more years than not, our cost of funds has been less than nothing. This access to "free" money has boosted Berkshire's performance in a major way.

“Any company's level of profitability is determined by three items:

1.) what its assets earn;

2.) what its liabilities cost; and

3.) its utilization of "leverage" - that is, the degree to which its assets are funded by liabilities rather than by equity.

“Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly - to a degree that is not generally well-understood - because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage.

“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn't belong to us. Nevertheless, let's assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result - more shares, equal assets and lower earnings - would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business - if it is obtained at a low cost.”

Float is better than equity?

This question is a bit of a mind bender. Because of its unique ‘cost’ (i.e. low cost or even a benefit), in the past Buffett has said that he views float as being better than equity.

BRK 1997AR: “Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

Well, suggesting float is better than equity is perhaps a bridge too far. However, I think we can conclude that float matters a great deal. Especially today (in a high interest rate world).

Conclusion

OK. So now we know what float is and the key metrics to use to evaluate P/C insurers. Who should we start with? That is an easy question to answer. In our next post (coming Sunday), we will do a deep dive on float at Fairfax Financial to see what we can learn.

==========

How Warren Buffett Achieves Great Returns Every Year - Advantages of Insurance Float

Edited September 16, 2023 by Viking

UK · September 16, 2023

17 hours ago, SafetyinNumbers said:

Just a reminder that consensus is much lower and if you are wondering which analyst has the low estimate for the next 5 years (only for the last three), it’s our friend at Morningstar. The declining earnings estimates (and historical volatility in earnings) basically makes it unownable for quants and for active institutional investors who use the same screens as quants in order to compete with them.

Wow, what a passimism from 2025, never saw this, what is the source of this table?

dealraker · September 16, 2023

8 minutes ago, UK said:

Wow, what a passimism from 2025, never saw this, what is the source of this table?

Morningstar's analysts have cycled through euphoria and despair as to their insurance underwriters, the re-insurers longer tail float types particularly. They seem to have either forgotten or fully upended their past "float is equity" presentations with and gone to another model. As interest rates change it would seem some sort of adaptation to their somewhat current model of "float don't count no more" would evolve.

But anyway in the long ago they had the better insurers valued at investments per share which at the time was about 3x book value for some.

UK · September 16, 2023

9 hours ago, Viking said:

Like Indiana Jones, today we are going to set out on an adventure in search of long lost treasure. Something that most investors appear to have forgotten about. What do the legends tell us? Does it really exist or is it just a myth?

What am i talking about?

P/C insurance float (I’ll just call it ‘float’ moving forward).

Float is such a big (and important) topic we are going to tackle it in two posts. The first post (below) will focus on the theory - what it is and why P/C investors should care. The second post will then apply the theory to today using a real company - Fairfax Financial. My plan is to have the second post completed and out on Sunday.

Ancient history

Thirty years ago, talking about float was all the rage for P/C investors. Read old articles on investing in P/C insurance companies and a discussion of float will usually be front and center. And the champion of float from that era was, of course, Warren Buffett and his company Berkshire Hathaway.

So what happened?

Why has float apparently settled into into the dustbin of history and become a relic of the past?

Due to competitive insurance markets, industrywide underwriting profit has remained illusive for the past decade. At the same time, top line organic growth slowed to a crawl.

Returns on investments fell: P/C insurers put most of their investments into fixed income instruments. In their battle with deflation, global central banks took interest rates all the way into negative territory. The US 10 year treasury traded at a yield below 0.60% in August of 2020 and traded with a yield below 1.5% for much of 2021.

S&P Global: US P&C Insurance Market Report

Float lost its value

Breaking even on underwriting for a decade while returns on investments plummeted made having float far less valuable than at any point in recent history.

Another smaller factor: over the years, P/C insurance has become a much smaller part of Berkshire Hathaway’s business model. What did Buffett have to say about float in his 2022 letter to shareholders? Float is mentioned 4 times in one short paragraph - telling investors to go somewhere else if they wanted to learn more. Does this sound important to you? So ‘float’ also lost its biggest cheerleader.

Does this mean… Float is dead? Long live float?

No, of course not. Just because float is no longer appreciated (or followed) doesn’t mean it doesn’t matter. In fact, for those paying attention, the world has changed again. The conditions that made float a big deal 30 years ago have returned:

Insurance has been in a hard market since about Q4 of 2019 - above average insurance companies are seeing improving underwriting results (cost of float) and significant top-line growth (supply of float) over the past four years.

Global central banks now have an inflation fight on their hands - and ‘higher for longer’ is becoming the new mantra for interest rates. Fixed income yields have spiked higher across the curve. The 10 year US treasury closed today with a yield of 4.32%, a level where it last traded at in 2007. As a result, returns on float are improving greatly.

Both of these developments make having float today extremely valuable.

Except remember… pretty much everyone has forgotten about float.

What’s old will be new again.

Well, my guess is this is about to change. I think investors are going to get interested in float again.

What is going to cause the change?

A new generation of investors are about to discover something Warren Buffett hit on when he bought National Indemnity back in 1967: float, under certain conditions, can be a license to print money. Those ‘certain conditions’ have returned. And in recent years some insurance companies have started up the printing presses and are now starting to print money. More than anyone imagined possible.

==========

P/C insurance float: the basics

Let’s first do a quick review of float. Float is deceptive. It is kind of like compound interest as a concept. It is easy to define but very hard to actually understand.

Who better to teach us about P/C insurance float than the old master, Warren Buffett himself.

Float: the basic building block to use to evaluate a P/C insurance company

Back in the 1990’s, Warren Buffett was using P/C insurance as the core engine to drive Berkshire Hathaway’s profit growth. GEICO was purchased in 1996 and General Re was purchased in 1998. Given P/C insurance’s importance to Berkshire Hathaway shareholders, Buffett provided the following as a guide to help them understand P/C insurance as an investment.

BRK 1998AR: “With the acquisition of General Re — and with GEICO’s business mushrooming — it becomes more important than ever that you understand how to evaluate an insurance company. The key determinants are:

1.) the amount of float that the business generates;

2.) its cost; and

3.) most important of all, the long-term outlook for both of these factors.”

Well, Warren appears to be saying float is the most important thing to understand when evaluating an insurance company. Interesting, given how little press float gets today from analysts and investors.

What is float?

BRK 1998AR: “To begin with, float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years.”

Float is money a P/C insurer has that it can use to invest. It is an asset but it is a liability (not equity). It is kind of like a very sticky deposit at a bank (a deposit is also a liability for the bank).

Because float is a liability, it is also leverage. Like all leverage (i.e. debt), float can be both good or bad - and this depends on the cost paid over time to hold the float.

What is the cost of float?

BRK 1998AR: “Typically, this pleasant activity (the insurance business) carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss," which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”

Underwriting determines the ‘cost’ of float.

This point is critical. Over time, if an insurer can produce an underwriting profit on its insurance business that means the cost of its float is actually a benefit - that is better than free. That means the insurer is actually getting paid to hold the float. This is far better than ‘the cost the company would otherwise incur to obtain the funds.’

Float is a pile of money that an insurance company can actually earn two income streams from: underwriting (if float is obtained at a benefit) and investing.

Sounds like Buffett was on to something.

To summarize: according to Buffett, a good P/C insurance company:

Has a large amount of float

Is a good underwriter - is able to generates the float at a favourable cost (ideally a benefit)

Has a good long term track record - of both growing float and as a solid underwriter

Buffett’s secret sauce: P/C insurance float

Buffett’s genius has really been two pronged:

Use P/C insurance float as an ever-increasing low cost (free) source of capital/leverage used to push profits even higher.

These growing profits were then continuously reinvested into great companies/equities (outside of insurance) that have also become compounding machines over time and pushed profits even higher.

OK. So there is a quick review of float, explained with the help of Warren Buffett.

To help us understand float even better, let’s look at it now from a balance sheet perspective.

==========

Float and the balance sheet

Let’s create an imaginary insurance company - called Random P/C Insurance Co - and create a fictitious balance sheet.

Our company has $80 billion in assets, with $60 billion in liabilities and $20 billion in common shareholders’ equity. Of the total liabilities of $60 billion, float is $30 billion. The summary of the balance sheet is below:

We are also going to assume common shareholders’ equity = book value.

We are going to make up more numbers below. We are using numbers that make our calculations easy. Please don’t focus too much on the exact numbers. Instead, focus on the information they are trying to convey - especially about leverage.

Cost of float

Let’s assume our insurance company is a slightly above average underwriter with a combined ratio (CR) of 96 - this translates into a ‘benefit’ of float (better than free - our company is actually getting paid to hold their float).

Return on investments (which includes float)

Let’s assume our insurance company is above average in terms of the return it earns from its total investments (which includes float) - let’s assume it earns 8% on average.

We are also going to assume there are no taxes.

The return of Random P/C Insurance Co

When we put the two together we get:

Benefit of float (CR of 96)

Return on investments = 8%

Let’s assume Random P/C Insurance Co earns a total return of 10% on its float.

This means our insurance company is earning the following:

$30 billion float x 10% = $3 billion.

Can we calculate the actual leverage provided by the float?

Yes. Total earnings from float of $3 billion will flow though the income statement and increase retained earnings, which will then flow though to the balance sheet and increase both assets and common shareholder equity by $3 billion.

So a return from float of 10% results in an increase in common shareholders' equity of 15%.

The leverage can be calculated as follows: total float / common shareholders' equity.

In our example

float of $30 billion / common shareholders' equity of $20 billion = 1.5 x leverage

Common equity, debt and total investments

The above increase in common shareholders' equity was driven solely by float. A company is also going to generate earnings from its common shareholders’ equity - the funds provided by shareholders. Perhaps it also uses a little debt to generate more earnings. Any returns generated by its other investments (those other than float) need to be added to the numbers above.

==========

Below Buffett summarizes how float fits into the big picture

Berkshire Hathaway 1995AR: “In more years than not, our cost of funds has been less than nothing. This access to "free" money has boosted Berkshire's performance in a major way.

“Any company's level of profitability is determined by three items:

1.) what its assets earn;

2.) what its liabilities cost; and

3.) its utilization of "leverage" - that is, the degree to which its assets are funded by liabilities rather than by equity.

“Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly - to a degree that is not generally well-understood - because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage.

“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn't belong to us. Nevertheless, let's assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result - more shares, equal assets and lower earnings - would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business - if it is obtained at a low cost.”

Float is better than equity?

This question is a bit of a mind bender. Because of its unique ‘cost’ (i.e. low cost or even a benefit), in the past Buffett has said that he views float as being better than equity.

BRK 1997AR: “Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

Well, suggesting float is better than equity is perhaps a bridge too far. However, I think we can conclude that float matters a great deal. Especially today (in a high interest rate world).

Conclusion

OK. So now we know what float is and the key metrics to use to evaluate P/C insurers. Who should we start with? That is an easy question to answer. In our next post (coming Sunday), we will do a deep dive on float at Fairfax Financial to see what we can learn.

==========

How Warren Buffett Achieves Great Returns Every Year - Advantages of Insurance Float

Thanks!

Viking · September 16, 2023

2 hours ago, UK said:

Wow, what a passimism from 2025, never saw this, what is the source of this table?

US P&C Insurance Market Report: Profitability to remain elusive in 2023

- https://www.spglobal.com/marketintelligence/en/news-insights/research/us-pc-insurance-market-report-profitability-to-remain-elusive-in-2023

MMM20 · September 16, 2023

2 hours ago, Viking said:

US P&C Insurance Market Report: Profitability to remain elusive in 2023

- https://www.spglobal.com/marketintelligence/en/news-insights/research/us-pc-insurance-market-report-profitability-to-remain-elusive-in-2023

Doesn't sound like it's worth starting my new P&C insurer yet then.

Is that good for FFH? Asking for a friend.

Viking · September 16, 2023

1 hour ago, MMM20 said:

Doesn't sound like it's worth starting my new P&C insurer yet then.

Is that good for FFH? Asking for a friend.

Food for thought for those who are convinced the hard market in insurance HAS to end soon. Imagine a world where Fairfax continues to grow top line insurance by 8% in both 2023 and 2024 (further increasing float). And interest rates remain higher for longer. That is probably a reasonable base case today.

Edited September 16, 2023 by Viking

Viking · September 16, 2023

Comments on status of hard market from CEO of Arch Capital on their Q2 call (July 27):

“We often refer to the insurance clock developed by to help illustrate the insurance cycle. You can find the clock on the download cap for this webcast or on our corporate website. If you can't do the clock right now, just picture a traditional clock dial. For some time, we've been hovering at 11:00, which is one we expect most companies in the market to show good results as rate adequacy improves and loss trends stabilize.

“Last year, a popular topic on earnings calls was whether rate increases were slowing or what the rates were even decreasing. These are classic signs of the clock hitting 12 when returns are still very good, but conditions begin to soften. Yet here we are in mid-2023 and conditions in most markets remain at 11:00. We've even checked the batteries in the clock and they're just fine. The clock isn't broken. It's just that the current environment dictates an extended period of rate hardening.

“So what's sustaining this hard market? Well, I believe it's a relatively simple combination. Heightened uncertainty is driving an imbalance of supply and demand for insurance coverage. Since this hard market inception in 2019, we've had COVID to war in Ukraine, increased cat activity and rising inflation, all of which create significant economic uncertainty. Underwriters have had to account for more unknowns. Beyond those macro factors, industry dynamics also play a role in sustaining the hard market. Generally, in adequate pricing and overly optimistic loss trend assumptions during the soft market years of 2016 through 2019 have led to inadequate returns for the industry.

“The impact of these factors should cause insurers to raise rates and purchase more reinsurance in a capacity-constrained market with limited new capital formation. Put it all together, and it may be a while before the clock strikes 12 and we begin to move beyond this hard market.”

Edited September 16, 2023 by Viking

SafetyinNumbers · September 16, 2023

8 hours ago, UK said:

Wow, what a passimism from 2025, never saw this, what is the source of this table?

The source of the analyst estimates is Koyfin.

TwoCitiesCapital · September 16, 2023

2 hours ago, Viking said:

Food for thought for those who are convinced the hard market in insurance HAS to end soon. Imagine a world where Fairfax continues to grow top line insurance by 8% in both 2023 and 2024 (further increasing float). And interest rates remain higher for longer. That is probably a reasonable base case today.

We can hope, but I just don't have the confidence interest rates will be at their current levels in 12-18 months.

I know what the Fed is saying. I know what they're currently doing. But this is also the same Fed that has forecasted interest rates to stay low through 2022 and then ran into 9% inflation with a ton of egg on their face.

I don't have any confidence in their projections of rates beyond a 3-month time horizon.

Viking · September 17, 2023

7 hours ago, TwoCitiesCapital said:

We can hope, but I just don't have the confidence interest rates will be at their current levels in 12-18 months.

I know what the Fed is saying. I know what they're currently doing. But this is also the same Fed that has forecasted interest rates to stay low through 2022 and then ran into 9% inflation with a ton of egg on their face.

I don't have any confidence in their projections of rates beyond a 3-month time horizon.

Because Fairfax has extended duration to 2.4 years I don't think where interest rates go in 12-24 months matters all that much anymore. My view is the management team will navigate their way though it - just like they have since 2018. Extreme volatility has been very good for the team at Hamblin Watsa and Fairfax shareholders. Active management is able to take advantage of the extreme dislocations when they happen. The $2 billion PacWest loan purchase (expected to deliver a total return of 10%) being the most recent example.

Viking · September 17, 2023

Fairfax Financial and Float - A Deep Dive

In my last post i reviewed P/C insurance float, largely through the writings of Warren Buffett - a pretty knowledgeable guy on the subject. In this post we are going to pivot and apply what we learned to Fairfax Financial.

Fairfax and Float: Summary of the topics we will explore:

A short review of financial leverage
Size of float
Leverage provided by float
Growth of float
Cost of float
Returns achieved on float
Summary

----------

A short review of financial leverage

Balance Sheet: Assets = Liabilities + Equity

To grow (increase assets) a company can issue a liability like debt (borrow) or equity (shares).

Borrowing (a liability) is simply a way to use ‘other peoples money’ to finance growth / business activities. Using borrowed money to grow/invest is a financial strategy referred to as leverage.

Why use leverage to grow? To increase the return on equity. If equity stays constant but a firm can grow assets, which in turn grows earning, that will result in higher return on equity.

What is the rub? There is a cost to borrow, which is the interest rate charged on the loan. And today, with interest rates elevated, the cost is very high.

What does this have to do with P/C insurance companies?

P/C insurance companies are unique animals. Through the course of their business operations they generate something called float. Float is the money held by insurance companies when they receive premiums that has not yet been paid out to claimants.

Like debt, float is ‘other peoples money’ so it is technically a liability. Like debt, float can be used to purchase investments on the asset side of the balance sheet. The investments purchased with float will then grow total earnings, which results in a higher return on equity for the company.

Growing float (L) = growing investments (A) = growing earnings (E) = higher return on equity (ROE).

What is the rub? There is a cost to float and it is determined by underwriting (combined ratio). If an insurer is able to generate an underwriting profit over time, the cost of float is free (actually better than free… the ‘cost’ is a benefit).

So P/C insurance companies have the ability to use float (leverage) as a low cost way to boost return on equity (ROE).

Let’s now see how all of this applies to Fairfax.

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How much float does Fairfax have?

At December 31, 2022, Fairfax had $31.2 billion in total float.

However, to make our analysis more meaningful, we need to make 2 adjustments to this number:

Remove float from runoff - Fairfax separates runoff when reporting underwriting results so to be consistent we will remove runoff float from our analysis. So in this post we will only be looking at float for insurance/reinsurance at Fairfax.
remove minority interests - small amounts of Allied World, Odyssey, Brit and International are owned by minority shareholders. We also adjust float to account for this. By removing the share of float that accrues to minority shareholders we are left with the amount of float that accrues to Fairfax’s common shareholders, which is really the number we care about.

After making the 2 adjustments outlined above, at December 31, 2022, Fairfax had $26.8 billion in float working for common shareholders (i am going to call this ‘adjusted float’ in the remainder of this post.) Adjusted float was $1,150/share. Given the growth in Fairfax’s insurance business in 2023, ‘adjusted float’ today is likely well over $1,200/share. Of interest, Fairfax’s share price closed at $846 on Friday (Sept 15).

Now that we know the size of Fairfax’s float, let’s now look at it in relation to Fairfax’s total balance sheet.

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What is the leverage provided by Fairfax’s adjusted float?

Common shareholders’ equity at Fairfax was $17.8 billion at Dec 31, 2023. As we just learned above, adjusted float is $26.8 billion. Float is 1.5 x bigger than common shareholders’ equity.

The leverage is 1.5 times (adjusted float of $26.8 / common shareholders’ equity of $17.8). That means every 1% gain just from float will result in a 1.5% gain in common shareholders’ equity (ROE = 1.5%)

So if float delivers an 8% return to Fairfax that will boost common shareholder’s equity by 12% (deliver an ROE = 12%) all by itself.

How does Fairfax’s adjusted float and leverage compare to other P/C insurance companies?

Fairfax (at 1.51 times) has more leverage from float than Markel (at 1.26 times). For interest, I also included Berkshire Hathaway. Leverage is much smaller for Berkshire Hathaway (at 0.35 times) compared to Fairfax and Markel and this makes sense given the significant growth of BRK’s non-insurance businesses over the years.

Note: my float number for Markel above is an estimate. Markel does not provide a float number. Float isn’t even mentioned in their annual report, which seems strange given its importance to the returns of the company.

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How much has total float grown in recent years at Fairfax?

Please note, in this section we will use the float numbers for insurance/reinsurance (runoff is excluded). However, i did not separate out minority interests. It would have been a lot of work and it wouldn’t have materially changed the conclusions (the growth numbers) - which is what we care about here.

The float of insurance/reinsurance at Fairfax has been growing rapidly for many years:

2014 to 2022 (8 years): total float grew 155% or at a compound growth rate of 12.4% per year.
2015-2017 growth was fuelled primarily by acquisitions (Brit, international, Allied World).
2020-2022 growth was fuelled primarily by organic growth (hard insurance market).
2023 and 2024 should see solid growth in float driven by continuation of the hard market and the GIG acquisition.

The management team at Fairfax has done a fantastic job of growing float over the past 8 years. And the prospects for continued growth are strong.

What is the cost of float? What is the trend?

Like borrowing money, float is a liability. Like all leverage (i.e. debt), float can be both good or bad - and this depends on the cost paid over time to hold the float.

The ‘cost’ of float is measured by looking at underwriting results and the combined ratio. Fairfax excludes runoff when it reports underwriting results and the combined ratio (CR) so we can use their numbers in this section.

Summary:

From 2014-2022 the CR averaged 95.7
From 2018-2020 the CR ticked higher and averaged 97.3
From 2021-2022 the CR ticked lower and averaged 94.7
For 2023 my current estimate for the CR is 94.5

Fairfax has consistently earned an underwriting profit on its adjusted float. That is a big deal. It means that is has been able to secure $26.8 billion in adjusted float on very favourable terms. In fact the ‘cost’ of float is better than free - it is a benefit. I know, that is crazy - but it is true.

This is why Buffett has said in the past that he views float as being more valuable than a similar amount of equity. That statement is a real mind bender.

What is driving the improvement in the combined ratio?

My guess is two factors are driving the improvement:

The hard market in insurance (that began in Q4, 2019) resulting in higher prices and better terms and conditions.
Slow incremental improvement in the quality of Fairfax’s collective insurance businesses (resulting in better underwriting) driven by Andy Barnard and the leaders of the various insurance companies.

So float has been growing at 12.4% per year for the past 8 years. And the ‘cost’ has actually been better than free - a ‘benefit’ - over the same time frame.

But the story gets even better. Why? Return.

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What is the return Fairfax has been earning on its float?

Fairfax has $26.8 billion in adjusted float that is fully invested and earning a return for Fairfax shareholders.

For reference, the total investment portfolio at Fairfax was about $55.5 billion at Dec 31, 2022. Adjusted float of $26.8 billion represents 48% of total investments. It is significant.

In this section we are going to look at Fairfax’s return on total investments (a number we have a fair bit of confidence in). We are not going to try and break out Fairfax’s returns specific to float (which is a part of total investments). Again we are coming at this analysis at a very high level. If we subscribe a lower than average return to float (by assuming it is more skewed to short term fixed income investments) we would then need to attach a much higher return to Fairfax’s non-float investments to get to the correct average number. Instead, we are going to keep our analysis simple and use Fairfax’s average return on total investments as a very rough estimate for what is being earned on adjusted float.

From 2018-2022, Fairfax’s return on total investments averaged about 5.1% per year. Not surprisingly, the big drag was the fixed income portfolio. Fairfax’s interest and dividend income (a reasonable proxy for the return on the fixed income portfolio) delivered an average return of about 2.3% from 2014-2022.

Today? In 2023, Fairfax is tracking to earn an 8.6% return on its total investment portfolio. That is 69% more than the average of 5.1% of the past 5 years (2018-2022). That is a meaningful increase (big understatement!).

What are the biggest drivers of the increase in total return?

Interest and dividend income, which is estimated to deliver a return of 4.5% in 2023. My current guess is interest and dividend income will increase to about 5% in 2024, which is more that double its run rate from 2014-2022.
Equity markets have also rebounded YTD in 2023.
Since 2018, very good capital allocation decisions - with the benefits increasingly showing up in reported results.

What about future returns?

Fairfax has extended its fixed income portfolio from 1.2 years at Dec 31, 2021 to 2.4 years at June 30, 2023. This locks in higher interest rates for the next couple of years. It seems reasonable to expect the management team at Fairfax to continue to make good capital allocation decisions.

Bottom line, Fairfax looks well positioned to continue to deliver strong investment returns moving forward. My current estimate has Fairfax earning a return of more than 8% on its investments in each of 2023, 2024 and 2025.

Ok. Let’s try and summarize everything.

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What have we learned about Fairfax and its float?

‘Adjusted float’ is $26.8 billion. It has been compounding at better than 10% per year for the past 8 years.
‘Cost’ of float is actually a benefit and the benefit has increased in recent years.
The average return Fairfax is earning on its total investments is currently tracking to be 8.6% in 2023, up from an average of 5.1% from 2018-2022.

When looking at float, all three of the most important metrics are moving to the benefit of Fairfax and its shareholders. It is large and increasing in size. It is being obtained at a very favourable cost - better than free. And the return being achieved on its investments has spiked and the higher number looks sustainable.

So how does float fit into Fairfax’s valuation today?

This is where things get interesting.

Fairfax’s stock is trading today at $846 which is about the same as book value ($834 at June 30, 2023). Mr. Market is saying that Fairfax is worth a little more than book value = common shareholder’s equity = $19.4 billion at June 30, 2023.

Mr Market appears to be assigning little value to the adjusted float that Fairfax has of $26.8 billion ($1,150/share) at Dec 31, 2022. Assigning a very low value to adjusted float might have made some sense when interest rates were very low. But in the current environment, where interest rates are high and likely to stay high, this makes no sense.

This perhaps explains why Fairfax trades at a PE of 5.3 x 2023E earnings (my current estimate of $160/share).

Perhaps Mr Market does not yet appreciate how large the increase in earnings from adjusted float is likely to be in the coming year(s) and the impact that will have on ROE at Fairfax (at 1.5 x leverage).

What did Fairfax have to say about float in its most recent annual report?

Fairfax 2022AR: “For our stock price to match our book value’s compound rate of 17.8%, our stock price in Canadian dollars should be $1,375. And our intrinsic value exceeds book value, a principal reason being that our insurance companies generate huge amounts of float at no cost. This is the reason we continue to buy back our shares as we continue to think they are very cheap.”

Fairfax has resumed buying back stock in August and September.

Edited September 17, 2023 by Viking

MMM20 · September 17, 2023

Great posts @Viking

Here is the long and short of it for me:

Buffett's methodology = per share investments + per share pretax operating earnings (from businesses other than insurance and investments) * ~10-13x pretax
- Buffett has also told us he thinks a dollar of float equates to a dollar of intrinsic value
For Fairfax, this equals ~$3,000+ intrinsic value right now
- This does not even consider
  - (1) some level of consistent underwriting profitability which IMHO should be capitalized
  - (2) any expected future growth in per share float
- Intrinsic value might therefore be closer to ~$4,000

Edited September 17, 2023 by MMM20

steph · September 17, 2023

My reasoning is quite simple. Market Cap is 21 billion. Total portfolio is 55 billion (equity and float). If float is for free (combined ratio = 100) and they average 6% on the portfolio for the coming years…that is 3,3 billion before interest expense on debt and corporate costs. But let’s assume we roughly arrive at 12-14% return on actual market cap. If you then assume a combined of 98 for the coming years instead of 100, you can add a 2-3% return a year.

So from here (with the higher interest rates) I expect they will ‘easily’ achieve the 15% return on book. Therefore at book I estimate it is much too cheap. 1,3 to 1,5 times book would be a very decent price. Margin of safety when buying today is very interesting.

Malmqky · September 17, 2023

The great thing about Fairfax is it's pretty easy to determine it's undervalued by some amount, but it's tough to figure out exactly what that amount is. Some people will complain this "black box" just makes things complicated, but if you're willing to be comfortable with not having an exact number, you have the opportunity to buy something that could be discounted by 20% or 200%. I'll take that set-up any day.

Munger_Disciple · September 17, 2023

Somewhat Conservative Valuation of Fairfax

I know several members on this board are posting super high valuations of FFH. I wanted to independently estimate for myself a very crude, somewhat conservative (but not a totally low ball estimate) earnings power of Fairfax.

Assumptions:

Combined ratio of 100%. So float is cost free but there is no underwriting profit. I know people are throwing around way better numbers for CR but let us keep in mind that the goal of the best insurer on the planet (Berkshire) is to underwrite at 100CR over the cycles.
As of Q2, Fairfax had cash+fixed income securities of $40.6B. Given the short duration of FI portfolio, I assume that this bucket earns 4.5% for the next few years.
Fairfax has $2.4B of preferred stocks. Let us also assume that this bucket earns 7% (remember this is a crude+conservative estimate).
Fairfax also has a total of $13B of equity securities+investment in associates+stake in Fairfax India. Let us assume that this bucket earns 10%.
Fairfax has $8.8B of debt costing $520mm in interest payments & annual corporate overhead of $400mm.

I ignored everything else (remember this is a crude estimate) and assumed 20% corporate tax rate. So I get an earnings figure of $1.9B after tax. So that gives a P/E ratio of roughly 10 for Fairfax. Pretty decent value but not as ridiculously cheap as others claim.

Edited September 18, 2023 by Munger_Disciple

dealraker · September 18, 2023

So I've owned Fairfax for somewhere around 30 years, I got in before the super-duper run up when Watsa was (not his choice but the media) making a run on Warren Buffett's reputation. It isn't unfathomable that the stock price could get as fully/over-valued as it did back then- I think in the mid to late 1990's or whenever it was. 3-4 times book as I remember? Some of you have more access to charts and data than I do, too many miles on me to be anywhere close to right with memory.

I appreciate the work Viking has done, I do enjoy reading it and I read all of it. With experience all of you here will be able to program all of this in generalist form within your mind without doing any math much or writing detailed lengthy reports. It becomes literally obvious enough to get close enough to make investment decisions

That said I wasn't much thinking about Farifax until Parsad, Viking, and others began posting and in the last couuple of years I've simply added to the stock when funds show up and that's about 30 times now. I appreciate this forum, it gives me the energy I need not to fade away in mental lethargy - what I see most my age do.

But anyway, some probably get tired of me writing about the past or my connection to it but I do this here to relay what I think it by far more important than the basic math or number awareness that you need to determine whether you invest in these insurance entities. Yes, it does start with the numbers but by far the most important things after some basic "this is a good or decent time and/or a good valuation" or "this isn't a good time or valuation" - but beyond that I'd say the following:

Don't ever invest in an insurance entity based on numbers only.

Invest only if you have knowledge of managment and their habits, history, and how they have evolved over time.

Invest only when and in entities you trust management to underwrite over time well.

Invest only when and in entities you trust management to invest well.

Poor pricing can come quickly and at the same time as a poor investing climate

And finally don't be surpised if, particularly in the short run (which can be a couple of years) both the business and stock price does completely the opposite of what you expect. And be aware of political attacks on the insurance industry should some crappy thing happen (I've lived through these both on the underwriting and broker side).

Anyway that's my experience with 45 plus years, and I began in 1977 with McDaniel Lewis and Co in Greensboro NC as a bank and insurance analyst.

Edited September 18, 2023 by dealraker

Viking · September 18, 2023

9 hours ago, Munger_Disciple said:

Somewhat Conservative Valuation of Fairfax

I know several members on this board are posting super low valuations of FFH. I wanted to independently estimate for myself a very crude, somewhat conservative (but not a totally low ball estimate) earnings power of Fairfax.

Assumptions:

Combined ratio of 100%. So float is cost free but there is no underwriting profit. I know people are throwing around way better numbers for CR but let us keep in mind that the goal of the best insurer on the planet (Berkshire) is to underwrite at 100CR over the cycles.

As of Q2, Fairfax had cash+fixed income securities of $40.6B. Given the short duration of FI portfolio, I assume that this bucket earns 4.5% for the next few years.

Fairfax has $2.4B of preferred stocks. Let us also assume that this bucket earns 7% (remember this is a crude+conservative estimate).

Fairfax also has a total of $13B of equity securities+investment in associates+stake in Fairfax India. Let us assume that this bucket earns 10%.

Fairfax has $8.8B of debt costing $520mm in interest payments & annual corporate overhead of $400mm.

I ignored everything else (remember this is a crude estimate) and assumed 20% corporate tax rate. So I get an earnings figure of $1.9B after tax. So that gives a P/E ratio of roughly 10 for Fairfax. Pretty decent value but not as ridiculously cheap as others claim.

To help investors value a stock, Warren Buffett tells the story of Aesop: "a bird in the hand is worth two in the bush."

According to Buffett, investors need to determine 3 things:

How many birds are in the bush?
When are you going to get them out?
How sure are you?

The prevailing interest rate is also important:

If interest rates are 15%, then two birds out in 5 years makes sense.
If interest rates are 3%, then two birds out in 20 years makes sense.

-----------

@Munger_Disciple Thanks for taking the time to put together an earnings estimate for Fairfax. It is great to get different perspectives.

When I read your estimate above I immediately thought: "two birds in the hand are worth one in the bush." Of course, I know this was not what you are trying to say. But that was my take-away from your estimate.

Let me explain. Let's start with your estimate:

Now let's pivot to my current estimate for 2023. My current estimate is Fairfax will earn $160/share in 2023. We are almost 9 months into the year. Yes, something bad could happen. But something good could also happen. My view is the tail risks to my forecast (too high or too low) are about equally distributed. So I think $160 is a reasonable number.

What about 2024? I am at earnings of $166/share for 2024 and $174 for 2025. I think my 2024 and 2025 estimates are mildly conservative.

Let's compare out two numbers: You are at $84/share and I am at $160/share. You are 1/2 of my number. That is a big difference.

So what explains the difference?

Let's compare our estimates.

1.) Underwriting: Your CR is 100 and mine is 94.5 for 2023 and 95 for 2024.

Your rationale: You say Warren Buffett's goal is 100.

My rationale: That is where Fairfax is currently tracking (the last 3 years).

Yes, we likely are late in the hard market. But everything I read suggests the hard market is likely to continue into 2024. Reinsurance (property cat) just started its hard market.

Will Fairfax's CR trend higher in the coming years? Probably. I am modelling 94.5, 95 and 95.5 from 2023-2025. Over time, as I get new information I will adjust accordingly.

Bottom line, Fairfax is tracking to earn $1.27 billion in 2023. Taking that to zero today and every year into the future just seems bizarre to me.

PS: Warren Buffett also thinks float is better to have than an equal amount of equity.

2.) Fixed Income: $40 billion earning 4.5%. We are pretty close here.

The difference is compounding. My guess is the fixed income portfolio will grow in total size at 8-10% per year the next couple of years:

Top line growth: increased premiums (currently running at 8%) will grow float
GIG acquisition will boost total investments
Earnings: 4.5% yield will deliver earnings of $1.8 billion pre tax

My point is the $40 billion will likely be $50 billion by the end of 2025. I also think the yield will be closer to 5% in 2024.

Bottom line, ignoring the power of compounding gives you a lower number here.

3.) Preferred stock $2.4 billion = $170 million. I don't break out preferred stock as a separate line item. Let's assume we are on the same page here (it is a small number)

4.) Equities/derivatives. You are $13 billion at 10% = $1.3 billion. We are off quite a bit here. My tracker has this bucket with a value of $16.9 billion today. This includes some preferred stock ($850 million). I also value the FFH-TRS at notional ($1.6 billion).

For this bucket I am at $2.4 billion for 2024 and growing in future years:

Mark to market gains on portfolio of $8 billion = $800 million (10%). The FFH-TRS is driving this bucket (every $100 move in FFH = $200 million).
Dividends = tracking around $140 million per year (includes preferred stock)
Share of profit of associates on portfolio of $6 billion = tracking around $1.15 billion. Yes, close to 20%. This is a build of the current trend of the companies included in this bucket, driven by Eurobank.
Associates - YOY change in fair value vs carrying value = $100 million. Although not captured in book value, this is value creation for shareholders.
Operating companies (Recipe, TCI, Dexterra etc) pre-tax earnings: $150 million.
Investment gains (sales/revaluation) = $250 million (lumpy)

Let's take $170 million off my number to account for preferred stock already counted in 3 above. That brings my equity number to $2.23 billion. What will cause my number to fall by $900 million to your number of $1.3 billion? An economic depression?

I think my equity/derivative number is going to grow by 10% per year. Like underwriting, we are miles apart here.

5.) Corporate + Interest expense = $400 + $520. We are the same here.

Summary:

Two buckets explain most of the difference in our forecasts:

Underwriting: you are $1.2 billion below me
Return equity/derivative portfolio will deliver: you are $900 million below me

It looks to me like you are also assuming Fairfax stops growing today: assets, liabilities, equity.

Fairfax will likely grow its assets significantly in the coming years (organic growth + earnings reinvested). Growth in float will also increase liabilities. And shareholders equity will be increasing (earnings). The power of compounding at Fairfax could be significant the next couple of years (larger in size than anything we have seen).

My current estimate has Fairfax earning $3.7 billion in 2023 and a total of $11.3 billion 2023-2025. That is more than 50% of current shareholders equity. It is a huge number. This is likely coming in the next 10 quarters (2 have already been delivered) - not the next 10 years.

How many birds are in the bush? $3.7 billion per year and growing.
When are you going to get them out? One is coming every year (a little plumper).
How sure are you? Its in line of sight.

Today, Fairfax shareholders currently have one bird firmly in one hand (2022) and the second bird is just about to land in the second hand (2023). The third one is getting ready to take flight. It looks to me like your analysis assumes away 1/2 of the birds - it just pretends they don't exist. Hence my analogy of "two birds in the hand are worth one in the bush" kind of logic.

What is the major flaw with my estimates?

Am I being way too optimistic? Perhaps. But my problem the past 3 years is I have been way too pessimistic with my forecasts - they have consistently been way too low.

I lean heavily on what I think i know today. I only go out max 3 years with my forecasts. And I admit my year-3 forecast is not as clear as my year-1.

As new news comes in I update my forecasts. Quickly. If bad news starts to pour in I will take down my estimates. Same if the opposite happens and good news comes in - I'll take up my estimate. So far, I have only been making upward revisions.

Another flaw with my forecasts is I do not incorporate compounding in very well. So my estimates in 2024 and 2025 for asset growth is too low. Higher assets likely means higher earnings. This is a big reason I think my forecasts are mildly conservative (overall).

20% growth in ROE is a double in 3.6 years (about). I think Fairfax might be able to do that. Looking out 4 years, a double in shareholders equity should result in much higher earnings - Fairfax's track record with capital allocation has been excellent since 2018.

Soft market in insurance? Bear market in stocks? Of course both will happen at some point in the future. Just like they have in the past. And good companies will benefit. And bad companies will fall by the wayside. P/C insurance was in a soft market from 2014-2017. In the last 6 years we have had 3 bear markets in stocks and the biggest bear market ever in bonds. Over the past 3 years Fairfax has thrived. And they didn't have the earnings/cash flow they do now. My guess is Fairfax will be just fine. But I remain open minded.

Edited September 18, 2023 by Viking

StubbleJumper · September 18, 2023

@Viking There's nothing particularly wrong with your earnings estimates for the current year and the next two. A guy could quibble with an assumption or two and shave 10 bucks per share off or add 10 bucks on, but really that doesn't much change the story.

The difference between your two-year forecast and what @Munger_Disciple posted is that you have developed a pro forma forecast for 2024 and 2025 based on your current best estimate of operating conditions for those two years, while he seems to have developed an estimate of normalized earnings, meaning an average earnings level that could reasonably be obtained over the course of an entire insurance cycle (you used the term normalized earnings differently back in January, but typical usage is to essentially average out earnings over a cycle for companies operating in a cyclical industry). You will note that @Munger_Disciple's financing differential (the fixed income return minus cost/benefit of float) is about 4.5% which is what one might expect over a lengthy period.

The advantage of normalizing earnings is that it does enable you to take a mental short-cut and slap a PE ratio on the result. So, the outcome of that thought process suggests that FFH is currently selling at roughly 10x normalized earnings, and those normalized earnings will experience growth over time. In short, that metric shows that FFH is currently cheap without all of the noise associated with the temporary unusual market conditions that currently offer the company an 11% financing differential (ie, ignore the silly current year PE multiples of 5 or 6 or whatever because they is not sustainable over a cycle, and PE analysis assumes long term cash flows).

As I have suggested in the past, over the shorter term, your earnings estimates are more useful to evaluate short-term cheapness. Take current adjusted-BV, tack on your earnings estimates for the next couple of years, subtract off the $10 divvies and you'll have a decent estimate of adjusted-BV as at Dec 31 2025. Slap your preferred p/BV ratio on the result and, voila, you suddenly have a plausible stock price forecast going out two years. If you are conservative like me, you might hair-cut the earnings for 2024 a bit and 2025 a bit more out of an abundance of caution, and you might be circumspect about your p/BV ratio (ie, do you select 1.0x or do you go all out and declare that its worth 1.5x?). But, based on the current stock price and a reasonable estimate of accumulated earnings over the next couple of years, FFH appears to be cheap.

Ten years from now, we might end up looking back and declaring that FFH wasn't just cheap in Sept 2023, but that it was outrageously cheap in retrospect. I am willing to run that risk of retrospectively declaring it outrageously cheap and regretting that I didn't choose a larger position size. But, on a prospective basis, I am unwilling to declare it outrageously cheap because the other side of the insurance cycle will eventually come and sizing up my position beyond where it currently sits is an enormously risky thing in that context (ie, if something is outrageously cheap and one is relatively certain about that analysis, what does the Kelly Criterion instruct us to do?).

Anyway, on this board, we are all very likely to make a pile of money from FFH over the next few years and our preoccupation during 2023 has been arguing about precisely how large our winnings will be...

SJ

Edited September 18, 2023 by StubbleJumper

MMM20 · September 18, 2023

I think these frameworks need to be combined.

The cash flows over the next few years could be so large relative to the current market cap that it's really not fair to wave them away as overearning. If we find ourselves with 50% of market cap in cash flows to the equity over a few years, well, with good capital allocation, that fundamentally changes the normalized earnings power.

This is not some procyclical oil management team that'll plow it all back into some $100 breakeven projects at the peak and burn all that capital. So we might be looking at +$1B to normalized earnings power over a few years from this "windfall" (if it turns out that way).

What's our NPV if we use a ~10-15x multiple on normalized earnings after our base resets 50% higher?

I think this properly bridges the two and by my math still gets us to a $2500-3000+ intrinsic value.

That's not to say you never get a 50% drawdown!

Edited September 18, 2023 by MMM20

nwoodman · September 18, 2023

25 minutes ago, MMM20 said:

If we find ourselves with 50% of market cap cash flows to the equity over a few years, well, with good capital allocation that fundamentally change the normalized earnings power.

Exactly this, I don’t want to dumb down the conversation but what they do with the windfalls of Bradstreet’s genius is key to a sensible P/B multiple. Is the equity allocation machine functional and rational as the bond machine? On balance I see somewhere between sensible to “it was great to be invited”. Deal flow is key.

Nice to see Mr Market appreciating some of the great unwashed though.

@viking apart from the minor quibble of whether P/Es are relevant you have been incredibly helpful. Also glad to see you are confident in your own analysis to stop trading in and out. If IRC this is your main gig, so you are doing your family proud

Viking · September 18, 2023

50 minutes ago, StubbleJumper said:

@Viking There's nothing particularly wrong with your earnings estimates for the current year and the next two. A guy could quibble with an assumption or two and shave 10 bucks per share off or add 10 bucks on, but really that doesn't much change the story.

The difference between your two-year forecast and what @Munger_Disciple posted is that you have developed a pro forma forecast for 2024 and 2025 based on your current best estimate of operating conditions for those two years, while he seems to have developed an estimate of normalized earnings, meaning an average earnings level that could reasonably be obtained over the course of an entire insurance cycle (you used the term normalized earnings differently back in January, but typical usage is to essentially average out earnings over a cycle for companies operating in a cyclical industry). You will note that @Munger_Disciple's financing differential (cost/benefit of float minus the fixed income return) is about 4.5% which is what one might expect over a lengthy period.

The advantage of normalizing earnings is that it does enable you to take a mental short-cut and slap a PE ratio on the result. So, the outcome of that thought process suggests that FFH is currently selling at roughly 10x normalized earnings, and those normalized earnings will experience growth over time. In short, that metric shows that FFH is currently cheap without all of the noise associated with the temporary unusual market conditions that currently offer the company an 11% financing differential (ie, ignore the silly current year PE multiples of 5 or 6 or whatever because they is not sustainable over a cycle, and PE analysis assumes long term cash flows).

As I have suggested in the past, over the shorter term, your earnings estimates are more useful to evaluate short-term cheapness. Take current adjusted-BV, tack on your earnings estimates for the next couple of years, subtract off the $10 divvies and you'll have a decent estimate of adjusted-BV as at Dec 31 2025. Slap your preferred p/BV ratio on the result and, voila, you suddenly have a plausible stock price forecast going out two years. If you are conservative like me, you might hair-cut the earnings for 2024 a bit and 2025 a bit more out of an abundance of caution, and you might be circumspect about your p/BV ratio (ie, do you select 1.0x or do you go all out and declare that its worth 1.5x?). But, based on the current stock price and a reasonable estimate of accumulated earnings over the next couple of years, FFH appears to be cheap.

Ten years from now, we might end up looking back and declaring that FFH wasn't just cheap in Sept 2023, but that it was outrageously cheap in retrospect. I am willing to run that risk of retrospectively declaring it outrageously cheap and regretting that I didn't choose a larger position size. But, on a prospective basis, I am unwilling to declare it outrageously cheap because the other side of the insurance cycle will eventually come and sizing up my position beyond where it currently sits is an enormously risky thing in that context (ie, if something is outrageously cheap and one is relatively certain about that analysis, what does the Kelly Criterion instruct us to do?).

Anyway, on this board, we are all very likely to make a pile of money from FFH over the next few years and our preoccupation during 2023 has been arguing about precisely how large our winnings will be...

SJ

@StubbleJumper Yes, i agree that @Munger_Disciple and i are both coming at this from very different perspectives. But sorry, i can’t reconcile the two estimates - they are simply too far apart. They both can’t be right (or even close).

If Fairfax earns $160/share each of the next three years there is no way the shares are worth anything close to $845/share today.

Anyways, i love the debate. But time to get some sleep

Edited September 18, 2023 by Viking

glider3834 · September 18, 2023

3 hours ago, Viking said:

5.) Corporate + Interest expense = $400 + $520. We are the same here.

just on corporate overhead

1. 2020-2022 avg was 317M - but first 6m23 was around 196M so I guess that would put us higher and closer to 400M annualised.

2. $92M or around 30% of the 2022 corporate overhead was amortization of customer & broker relationships - looks like a non-cash expense and purchase accounting requirement - given the premium and earnings growth in Fairfax's businesses post acquisition, it would be difficult to argue that this charge off reflects reality

Edited September 18, 2023 by glider3834

glider3834 · September 18, 2023

just on the subject of the hard market & expectations around underwriting - not sure if this article has been posted

https://www.insurancebusinessmag.com/asia/news/breaking-news/arch-ceo-compares-hard-insurance-market-to-tennis-final-454585.aspx?e=dXNlckBleGFtcGxlLmNvbQ&utm_content=&tu=&utm_campaign=Editorial-IBAP-NS&utm_medium=social&utm_source=twitter&hss_channel=tw-728383287090020352

'During the company’s latest earnings call, Grandisson – whose camp writes more business when the market is hard – said: “This hard P&C (property and casualty) market is proving to be one of the longest we’ve experienced, and we are in an enviable position as we look to 2024 and beyond.

“We often refer to the insurance clock developed by Paul Ingrey to help illustrate the insurance cycle… For some time, we’ve been hovering at 11:00, which is when we expect most companies in the market to show good results as rate adequacy improves and loss trends stabilise.

“Last year, a popular topic on earnings calls was whether rate increases were slowing or whether rates were even decreasing. These are classic signs of the clock hitting 12:00, when returns are still very good but conditions begin to soften. Yet here we are in mid-2023 and conditions in most markets remain at 11:00. We’ve even checked the batteries in the clock and they’re just fine. The clock isn’t broken; it’s just that the current environment dictates an extended period of rate hardening.”

Fairfax 2023

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