Fairfax 2023

[Viking]

At the end of the day the key for any investor is fit. In terms of positioning of their bond portfolio, Fairfax has nailed it over the past 18 months: 

- in 2021 they shortened duration to 1.2 years. 
- in 2022 they extended duration to 1.6 years.

- on the Q4 conference call Prem said the plan is to extend the average duration to 2 years in 2023. 
 

Fairfax has a very good long term track record in managing its fixed income portfolio. Perfect? No, of course not. Am i happy with how they are positioned as we begin 2023? Yes. 
 

Now we will see what happens with bond yields moving forward. And what Fairfax does with its fixed income portfolio (and the rest of its business). As the Fairfax story evolves i will manage my holdings accordingly. 

[maxthetrade]

37 minutes ago, Viking said:

Fairfax has a very good long term track record in managing its fixed income portfolio. Perfect? No, of course not. Am i happy with how they are positioned as we begin 2023? Yes. 

 

I agree. If there is one area where I really trust the guys at Fairfax then it is how they mange the fixed income portfolio. They have an excellent track record and expecting perfection is crazy. I'm also beginning to trust their underwriting more. If they stay on this path and don't revert to the old ways of making macro bets and buying crappy value traps/turnarounds the next couple of years should be pretty good.

Edited February 17, 2023 by maxthetrade

[TwoCitiesCapital]

35 minutes ago, MMM20 said:

I get the critical importance of their fixed income investing and duration positioning, so not trying to poo poo that conversation, but at risk of sounding like a broken record, even if interest income goes to ~0 by '25/'26, the stock should *still* have a low teens ROE long term driven by profitable underwriting, something like high single digit long term returns on their equity investments, and a shrinking share count w/ FFH telling us they'll look hard at large buybacks (and at ~50% or less of IV unless the stock really pops this year). A lot of this comes down to the sheer size of their float, which again is equivalent to negative interest rate debt, relative to peer levels. If they can create borrowing at negative 2% or maybe even negative 5% interest, then even ~0-1% interest income on cash/fixed income earns us shareholders a decent spread given the sheer size of the insurance operations.

 

I'm copying this chart from Trevor Scott again b/c it perfectly illustrates how much of a crazy outlier FFH still is on a reasonable estimate for the near year or two, despite now being a ~2x over the past couple years. If you think through the size/strength of their insurance ops and public+private equity portfolio, I just don't get how FFH is worth less than 1.5x BV even in in a worst case scenario where interest income is down huge by '25/'26. Closer to 2x BV, still less than a market muliple of earnings, looks more fair now.

 

 

 

I agree on the current undervaluation. Fairfax is my largest holding. But its ONLY significantly undervalued if you believe current earnings are recurring.  A portion of them could be if we locked in rates. Insurance is always at the whim of catastrophes. And equities? Well, if the Fed cuts to zero, it's for a reason and that reason us unlikely to be supportive of positive returns at that time. 

[TwoCitiesCapital]

13 minutes ago, maxthetrade said:

 

I agree. If there is one area where I relly trust the guys at Fairfax then it is how they mange the fixed income portfolio. They have an excellent track record and expecting perfection is crazy. I'm also beginning to trust their underwriting more. If they stay on this path and don't revert to the old ways of making macro bets and buying crappy value traps/turnarounds the next couple of years should be pretty good.

 

Nobody is expecting perfection. I'm expecting them to take risk off the table after knocking the ball out of the park instead of doubling down and expecting another home run.

 

I'm not upset they didn't go all in on 10-year treasuries in October. I'm upset that they didn't even extend duration even 0.25 years in an environment that saw rates heading higher even while the economic environment was/is clearly deteriorating. 

 

3-years duration is still a massive large macro call on rates and inflation relative to their insurance liabilities. It's still wholly consistent with their inflationary outlook. It just reduces the risk of giving back all of the benefits of having been short duration like we did in 2018-2020. 

Edited February 17, 2023 by TwoCitiesCapital

[MMM20]

2 hours ago, TwoCitiesCapital said:

 

I agree on the current undervaluation. Fairfax is my largest holding. But its ONLY significantly undervalued if you believe current earnings are recurring.  A portion of them could be if we locked in rates. Insurance is always at the whim of catastrophes. And equities? Well, if the Fed cuts to zero, it's for a reason and that reason us unlikely to be supportive of positive returns at that time. 

I think this just gets at the fact that returns will certainly continue to be lumpy… not the structural drivers of returns and what a fair multiple of normalized earnings should be.
 

If combined ratio is 95-98% and equity returns 8% over the next decade - which I think would be below 10-year estimates from Research Affiliates on a global equity index portfolio - then this is a US$1000 stock right now even if cash+fixed income is only 1-2% for the next decade (in large part b/c of the power of the float) b/c from that point shareholders would still make a low teens  long term CAGR. 

 

So I think the key question is really what normalized earnings are right now at their current size and capabilities. I agree with @Vikingthat US$100/share might be low. 

 

Edited February 17, 2023 by MMM20

[gary17]

i get confused with if people are using CAD and USD in their messages.  I think this company should be around $1500 cad- $2000 per share 

[giulio]

On IFRS17: I found this article helpful https://www.footnotesanalyst.com/prudent-versus-unbiased-ifrs-17-insurance-liabilities/

 

On Ffh: this discussion on rates, the fed cutting, portfolio duration etc is so boring.

Fairfax was cheap in 2020, cheap in 2021 and cheap in 2022. I agree with what  @MMM20  said.

To own FFH as an "interest rates play" is ok but it misses the point. Earning power is there irrespective of the fed. Same for management, culture and capital allocation.

 

G

 

 

[Parsad]

13 hours ago, Xerxes said:

So if you had bought FFH at the same time as Prem did and held it, you would have beaten all the FANGs, and market indices. 

 

I did.  Actually bought well before he announced the $150M purchase.  Put 30% of my portfolio in it. 

 

Still makes up about 25% of the portfolio after doubling and me right sizing the position over and over.

 

Enjoying a nice slice of strawberry rhubarb pie tonight to celebrate! 

 

Cheers!

[Parsad]

8 hours ago, gary17 said:

i get confused with if people are using CAD and USD in their messages.  I think this company should be around $1500 cad- $2000 per share 

 

Ok...I know you guys are all pumped up right now.  Fairfax should continue to do well going forward for many years if they've truly changed the quality of their underwriting, investing and hedging on a permanent basis.  I'm long on the company and also feel things are different going forward.

 

But let's not get crazy carried away with the price.  Yes, I would expect at some point with consistent performance, P/B could expand to 1.5 times book on a long-term basis similar to what MKL has enjoyed.  It should continue to grow from here and hit its ROE target of 15% annualized.  

 

My point is that I was spending an inordinate amount of time defending Prem and FFH over the last three years, and now everyone is suggesting that they can do no wrong and throwing around crazy-ass numbers on the high side. 

 

High expectations are fine...but temper it with real-world potential problems.  Reinsurance is a lucrative business when done right, but it can also be extremely volatile because of huge cat losses.  Cheers!

[gary17]

Thx Sanjeev

I was buying Fairfax in 2021 and 2022.  I just kept quiet but have been following the story and Atco too.  

 

i owned Allied World for years before Prem bought them out 

 

I had the $1500 per share in mind when I was buying last summer. it’s not that i all the sudden got excited about this. just thought i clarify that

Edited February 18, 2023 by gary17

[gary17]

i don’t have sophisticated analysis or in depth knowledge like many here - so many thx especially to Viking. and petec. 

i have always thought they had some good records. got an interesting bag of business.  for me the big one was if Prem & co acknowledged their earlier mistakes and willing to course correct. i think i heard that quite clearly from him in a conf call and that’s when i decided to buy shares. 

i don’t  like his kids on the board etc. but i think i will watch out for that.  

Edited February 18, 2023 by gary17

[Xerxes]

59 minutes ago, Parsad said:

 

I did.  Actually bought well before he announced the $150M purchase.  Put 30% of my portfolio in it. 

 

Still makes up about 25% of the portfolio after doubling and me right sizing the position over and over. 

 

Cheers!

And very well earned !!

[This2ShallPass]

11 hours ago, TwoCitiesCapital said:

I'm upset that they didn't even extend duration even 0.25 years in an environment that saw rates heading higher even while the economic environment was/is clearly deteriorating. 

Yes, don't know why they couldn't even increase duration from 1.6 to 1.8. What's the downside, you miss the opportunity to make $1.7B and have to settle for $1.5B?? Locking rates (not 10 yr but more than 1.6 when you already hit the home run) provides the stability. More importantly, the certainty on income stream is what will help increase the multiple.

 

They are always swinging for the fences, either spectacularly right or wrong. When wrong, it wipes out a decade of returns. No one is going to give them a high multiple after what they did the last 10 years. I do really hope for it as this is by #1 position by a mile..

 

The other head scratcher is not doing a SIB in Q4 with the pet insurance sale, what did they do with that cash?

 

[gfp]

So from the conference call transcript I have Prem saying this:

 

And in 2022, our interest and dividend income went up significantly, and they're running today at $1.5 billion, and we are slowly increasing duration to 2, which means that '23, $1.5 billion, '24, $1.5 billion. That's probably more than we've ever had in the past, interest and dividend income of that amount.

 

So it sounds like this is the plan - slowly move that average from 1.5 -> 2 years.  Too slow for you guys I guess, but I have no idea why so many people are assuming that the 10yr peaked at 4.3% back in October.  That was the rate priced in when "everyone" was sure we were having a recession imminently.  The US 5Y peaked at 4.4% back in October and is already back to 4.03% looking like it wants to go higher.  The US 3Y peaked at 4.65%, October, and it already back to 4.31%, again looking like it (the rate) is going higher.  There is no reason to assume they have already missed some great opportunity to lock in low 4's for a long time.

 

I think what they are doing is smart and they have shown that managing this part of the portfolio is one of their greatest strengths.  I'm not disappointed at all.  The sweet spot for where I would park my money (if I had any not invested in equities) would have a 5-handle on it.  I'll bet we see the same avg. duration posture when Berkshire reports.  

[MMM20]

On 2/17/2023 at 11:09 PM, Parsad said:

 

I did.  Actually bought well before he announced the $150M purchase.  Put 30% of my portfolio in it. 

 

Still makes up about 25% of the portfolio after doubling and me right sizing the position over and over.

 

Enjoying a nice slice of strawberry rhubarb pie tonight to celebrate! 

 

Cheers!

I made this a big position at $360 in Jan 2021 after doing a deep dive for the first time b/c of Blackberry becoming a meme stock, of all things. I still have the crazy $BB $100 scenario in my model but realized it was screaming cheap even if BB went to 0. And made it 50%+ of net worth for a week or so in Dec 2021 from US$460 -> $500 into the auction buyback. Hindsight 20/20 but should’ve kept more of it.
 

I got a lot of pushback at the time for suggesting IV then was easily US$800+ if you marked their assets to market and thought hard about intrinsic value. I was called naive but I was convinced a fresh pair of eyes for a deep dive was an advantage and stuck to my guns b/c this was squarely in my circle of competence, having spent many years focused on asset managers / fund investing professionally.

 

I think I am just doing the same now and getting to $1500+ as IV has arguably doubled over the past two years with great capital allocation decisions, mainly short duration fixed income protecting capital and expanding aggressively into the hard market, putting them in a huge position of strength now imho.

 

Amazingly, the valuation on earnings (which don’t seem to be at a cyclical peak, but structurally higher as they’ve protected capital and intelligently taken insurance share by competition weakened by big bond losses) hasn’t really changed as the stock has roughly doubled.
 

I take your point that sentiment has shifted (from depths of hell levels imho) and there is a lot of risk and uncertainty in the business. But as far as I can tell, Fairfax is still such an outlier that I would be surprised if that 50-100% valuation gap persists as more eyes take a fresh look and see the turnaround and great setup.

Respectfully, those that have lived and breathed all the ups and downs might still be underestimating how much has changed and what this is worth going forward after some major structural changes.

It is looking to me like a potential lollapalooza scenario with earnings growth + multiple expansion from insanely cheap to just fair value at 1.5-2x BV. With setbacks and lumpiness in returns along the way, inevitably. 
 

That said, still open to the idea that I’m way too bullish as there was a lot of good luck involved with how rates played out, and no one went broke taking some chips off the table after a stock rerated from 0.6x to 1x BV.

 

I am still inclined to add and held back only by epistemic humility and "sleep well" risk management.

 

Anyway, I am grateful for all the knowledge and wisdom of all the long time FFH followers here.

 

 

 

Edited February 21, 2023 by MMM20

[StevieV]

9 hours ago, Parsad said:

Fairfax should continue to do well going forward for many years if they've truly changed the quality of their underwriting, investing and hedging on a permanent basis. 

 

I like anything with a high probability of double-digit returns over the next few years.  Fairfax certainly still looks like that here.  I don't know about 1.5x book, but $1,000 USD over a few years, that seems pretty high-probability.

 

Fairfax's 2022 and '23 YTD outperformance has been nice.

[StubbleJumper]

6 hours ago, This2ShallPass said:

Yes, don't know why they couldn't even increase duration from 1.6 to 1.8. What's the downside, you miss the opportunity to make $1.7B and have to settle for $1.5B?? Locking rates (not 10 yr but more than 1.6 when you already hit the home run) provides the stability. More importantly, the certainty on income stream is what will help increase the multiple.

 

There does exist a downside that we can't just wish away.  Effectively, duration is the sensitivity of the value of your bond port to a change in interest rates. 

 

So, if you have a duration of 1.6 and there was an overnight 100 bps upward shift in the yield curve, the value of your bond port would decrease by about 160 bps.  In the case of FFH's $28 billion bond port, that type of situation would give you an overnight haircut on your bond port of about $450m.  Okay, that's not the end of the world.  Now, Prem has signalled that FFH intends to shift to a duration of 2-ish during 2023.  So, once again, taking a hypothetical 100 bps increase across the term structure of interest, FFH's $28B bond port would be haircut by about 200 bps, or $560m.  TwoCities has expressed a preference for a duration of about 3, so the hypothetical 100 bps increase in rates would haircut the $28B bond port by about $840m.  It's worth noting that if you hold your fixed income instruments to maturity as FFH usually does, there is no economic significance to those valuation changes as they will reverse themselves as the instruments progressively approach maturity.

 

Where it does matter is for the insurance subs' underwriting capacity.  Even if you plan to hold that fixed income port to maturity, you still need to mark those bonds to market which flows through the subs' balance sheets.  Their underwriting capacity is a direct function of their capital level.  For some of them, this is of no consequence while for others, like C&F, capital has been tight for a few years and hair-cutting the bond port could result in an actual underwriting constraint.

 

To compound matters, if you get an interest rate increase, what else is happening at the same time?  So, the type of scenario that Jen Allen should be concerned about is the situation where the Fed engages in an evangelical fight against inflation and elects to continue the aggressive tightening during 2023.  Should that occur, what happens to equity prices?  We've seen a recent stock market rally that might be attributable to investors believing that the Fed's tightening process is largely complete, that we will soon see a pause, and then maybe even a modest cut late in 2023.  But, what happens if that's not what the fed does?  Equity prices likely drop in that scenario which once again results in marking those $5B of securities to market and reducing the subs' capital levels.  If you are thinking about Prem's 1-in-50 year scenario, it's not too hard to imagine the Fed going all out into Volker mode, interest rates rising another 200 bps during 2023 and the stock market plummeting 10-20% as a result.  That type of scenario would be a pretty significant hit to the subs' statutory capital levels and underwriting capacity.

 

When it comes to risks to the subs' capitalisation, the principal risk management tools that Prem and Jen Allen have are essentially portfolio allocation (ie, $5b of equities vs $28b of fixed income) and duration.  While many of us think that duration should have been pushed out a bit more during Q4, we shouldn't pretend that there's no risk or no downside.

 

 

SJ

[StubbleJumper]

19 hours ago, MMM20 said:

I think this just gets at the fact that returns will certainly continue to be lumpy… not the structural drivers of returns and what a fair multiple of normalized earnings should be.
 

If combined ratio is 95-98% and equity returns 8% over the next decade - which I think would be below 10-year estimates from Research Affiliates on a global equity index portfolio - then this is a US$1000 stock right now even if cash+fixed income is only 1-2% for the next decade (in large part b/c of the power of the float) b/c from that point shareholders would still make a low teens  long term CAGR. 

 

So I think the key question is really what normalized earnings are right now at their current size and capabilities. I agree with @Vikingthat US$100/share might be low. 

 

 

If you want to think about what normalized earnings are, I would strongly encourage you to take another read through Prem's annual letters over the history of FFH.  Every year he includes a table with an excerpt of FFH's historical cost (or benefit) of float, the prevailing long bond rate and a calculated financing differential.  For 2023, some of us think that the benefit of float will be about 5% (ie, a CR of 95, maybe even lower!) and it's likely that a garden variety treasury bond will yield ~4%, for a net financing differential of +9%!  FFH's 10-year average financing differential reported in last year's AR is 4.2%.  Looking at that annual table that Prem publishes, you can go back a couple of decades and you will see that you won't find a better year than what we expect in 2023!

 

So, where does that leave us?  Well, FFH's reported float from Thursday's release was $29.6 billion.  We expect to see gold falling from the skies in 2023 because that financing differential might be ~9%.  If you want normalized income, you need to haircut that from 9% and instead use a 10-yr average or 20-yr average which captures the financing differential over multiple insurance cycles because, clearly, we are near the peak of the current cycle.  If you simply take the reported float and apply the 10-yr financing differential instead of the ~9% that we expect for 2023, it will give you an idea of where normalized earnings might be situated.  In short, during 2023, FFH might earn about $60/sh above normalized earnings (ie, $29.6B x (9% - 4.2%)/ 23m shares).  Enjoy it while it lasts, but don't pencil it in over the long-term.

 

 

SJ

[glider3834]

I just wanted to post an update on the contingent value rights (CVR) that Fairfax potentially will have(subject to Ambridge/Resolute deals closing)  - these may be worth something or nothing, but they are not potentially inconsequential either.  I am not sure what the state of the CVR is for the Riverstone Barbados transaction, because I can't see any update on that.

 

Here is my list

 

Fairfax - Contingent value rights

 

Riverstone  – up to $235.7 mil (Riverstone Barbados sale - based on performance targets)

‘On closing the company expects to receive proceeds of approximately $730 for its 60.0% joint venture interest in RiverStone Barbados and a contingent value instrument for potential future proceeds of up to $235.7’ (AR 2020)

 

Davos Brands - up to $36 mil (based on brand performance of Aviation Gin over next 10 yrs)

In 2016 we invested $50 million into Davos Brands (a spirit company) for a 36% interest alongside David Sokol. In September 2020 the company was sold to Diageo: our cash proceeds were $59 million and we are eligible to receive additional consideration of up to $36 million, contingent on the brand performance over the next ten years. (AR 2020)

 

Ambridge - up to $100 mil (Ambridge Group sale - based on performance targets)

On January 7, 2023 Brit entered into an agreement to sell Ambridge Group, its Managing General Underwriter operations, to Amynta Group. The company will receive approximately $400 million on closing, comprised principally of cash of $275 million and a promissory note of approximately $125 million. An additional $100 million may be receivable based on 2023 performance targets of Ambridge. 

 

Resolute Forest Products – up to $200M (potential refund of total lumber duty deposits – calc US$500M x 40% Fairfax stake = $200M  

The transaction will be carried out by way of a merger between Resolute and a newly created subsidiary of Domtar, providing for conversion of each share of Resolute common stock into the right to receive US$20.50 per share, together with one CVR, entitling the holder to a share of future softwood lumber duty deposit refunds. Under the CVR, stockholders will receive any refunds on approximately US$500 million of deposits on estimated softwood lumber duties paid by Resolute through June 30, 2022, including any interest thereon, net of certain expenses and of applicable tax and withholding.

Edited February 18, 2023 by glider3834

[glider3834]

Just on this fixed income debate regarding whether Fairfax should push out duration to lock in extra yield.

 

My view is they are focused on total return which includes capital gains plus yield.

 

 

If economy deteriorates or for some other reason, and Fed forced to cut rates - rates (US1y,2y etc)would drop and treasury prices would increase -depending on size of these rate cuts, potentially Fairfax could go from an unrealised loss to unrealised capital gain position? Also I am not a bond expert so please someone correct me if I am wrong! But wouldn't the shorter end treasuries see the larger price (& capital gain) increases over longer end treasuries? So they could potentially sell their treasuries & realise capital gains, like they did in 2008

 

From 2008 AR

 

Also, as the yield on long (30-year) U.S. Treasuries began to drop below 3%, we sold almost all our U.S. Treasuries (at year-end we had only $985 million left, compared to $6.4 billion on December 31, 2007), having realized net gains of $583 million in 2008 on sales of U.S. Treasuries....Our U.S. Treasury bond position was to a large extent replaced by $4.1 billion in U.S. state, municipal and other tax-exempt bonds (of which $3.6 billion carry a Berkshire Hathaway guarantee) with an average yield (at purchase) of approximately 5.79% per annum.

 

The interest income may not necessarily then be lost if they re-deploy those treasury proceeds into higher yielding parts of the credit market plus they realise capital gains - again like they did in 2008. 

 

So I am just speculating here, no-one knows for sure what will transpire.

 

Prem indicated on Q4 call they are currently pushing duration now closer to 2 years. My view is they are looking to capture some extra duration, but they want to stay nimble - corporate bonds are a big question mark for me at the moment - credit spreads look low yet a lot of refinancing still to come, already signs of problems in commercial real estate bonds

 

https://finance.yahoo.com/news/commercial-property-market-freezes-bond-180729652.html

https://www.afr.com/property/commercial/investors-seek-to-pull-20b-from-core-real-estate-funds-20230201-p5ch5f

 

One other important point is IFRS 17, this impacts how they manage the fixed income side - I am hoping in the AR they will lay out some more details of the impact - but I also need to re-listen to Q4 call where they went into some details.

 

 

 

 

 

Edited February 18, 2023 by glider3834

[This2ShallPass]

9 hours ago, StubbleJumper said:

While many of us think that duration should have been pushed out a bit more during Q4, we shouldn't pretend that there's no risk or no downside.

Good callout on how it'll impact underwriting. Maybe I'm taking a more simplistic view, it's part of doing business for Fairfax. They have to do the right thing from the investment standpoint and the insurance operations will have to work within that.

 

When I started investing in Fairfax, I was inexperienced and drank the value investing Kool aid - buy and hold forever, more money is made sitting etc. Gave Fairfax all the leeway which in hindsight was clearly a mistake and I chalk that up to learning. I get really worried when I see some of their worst tendencies popup (dogmatically holding onto bad ideas like deflation bets, shorting etc. for a very long time) vs. doing what seems to me like the more straightforward thing. Only comfort is this time it's Brian Bradstreet, if it had happened in the equity side I would seriously consider reducing my position (fool me twice and all that).

 

Still, no one is answering TwoCities point about the big miss in 2018 and why this time will be different. That's a $3B+(?) mistake, actually more if we consider the opportunity cost of what they could have done with that..

 

 

[TwoCitiesCapital]

7 hours ago, glider3834 said:

 

If economy deteriorates or for some other reason, and Fed forced to cut rates - rates (US1y,2y etc)would drop and treasury prices would increase -depending on size of these rate cuts, potentially Fairfax could go from an unrealised loss to unrealised capital gain position?

 

Also I am not a bond expert so please someone correct me if I am wrong! But wouldn't the shorter end treasuries see the larger price (& capital gain) increases over longer end treasuries? So they could potentially sell their treasuries & realise capital gains, like they did in 2008

 

The answer to your first question is yes, their bonds would gain in value. Potentially moving to unrealized gains even if they are far enough from maturity to trade at premiums. All the unrealized losses will be made back by Fairfax either by holding then bonds to their maturity OR rates dropping. 

 

Your second question the answer is 'it depends'. It's possible for 1-2 years treasuries to do better than 10-years in a rate cutting scenario, but highly unlikely.  

 

The duration of a 1 year bond is slightly less then 1. You'd expect that bond to gains slightly less than 1% for each 1% the Fed cuts. At this point in time your max gain on those 1-years bonds is 4-5% of we go to 0% on front-end rates. 

 

A 2-year bond sports a duration slight less than 2. So the same 1% decrease in rates results in ~2% return. 

 

A 10-year bond will have a duration closer to 8. If 10-year yields fall by 1%, you'd gain ~8.1% on the bond.

 

So for the 1-year bond to outperform the 10-year, you'd have to believe that a 1.00% cut on the front-end only results in a ~0.125% reduction in rates on the long end. It's possible, but not likely. More likely is 10-years go down by 0.5-0.75%. You make 1% in the one year bond, 2% in the two year bond, and 4-6% on the 10-year. 

Edited February 19, 2023 by TwoCitiesCapital

[MMM20]

On 2/18/2023 at 10:53 AM, StubbleJumper said:

 

If you want to think about what normalized earnings are, I would strongly encourage you to take another read through Prem's annual letters over the history of FFH.  Every year he includes a table with an excerpt of FFH's historical cost (or benefit) of float, the prevailing long bond rate and a calculated financing differential.  For 2023, some of us think that the benefit of float will be about 5% (ie, a CR of 95, maybe even lower!) and it's likely that a garden variety treasury bond will yield ~4%, for a net financing differential of +9%!  FFH's 10-year average financing differential reported in last year's AR is 4.2%.  Looking at that annual table that Prem publishes, you can go back a couple of decades and you will see that you won't find a better year than what we expect in 2023!

 

So, where does that leave us?  Well, FFH's reported float from Thursday's release was $29.6 billion.  We expect to see gold falling from the skies in 2023 because that financing differential might be ~9%.  If you want normalized income, you need to haircut that from 9% and instead use a 10-yr average or 20-yr average which captures the financing differential over multiple insurance cycles because, clearly, we are near the peak of the current cycle.  If you simply take the reported float and apply the 10-yr financing differential instead of the ~9% that we expect for 2023, it will give you an idea of where normalized earnings might be situated.  In short, during 2023, FFH might earn about $60/sh above normalized earnings (ie, $29.6B x (9% - 4.2%)/ 23m shares).  Enjoy it while it lasts, but don't pencil it in over the long-term.

 

 

SJ

Respectfully, this is sort of the point I was trying to make. 
 

The history is instructive, of course I agree. But I believe investors then need to look even harder at where that all puts us *looking forward* in a reasonable base case:

1) the insurance operations acquired/improved and structurally profitably in a sustainable way;

2) exiting a decade of interest rate suppression without a giant hole in their B/S;

3) basic blocking and tackling vs major turnarounds on the equities side (and maybe even continuing to ride the wave of statistically cheap stocks catching up from a decade of all time historically terrible returns vs statistically expensive ones); and 

4) swearing off shorting and eliminating big macro overlay type bets (we think).
 

IMHO that all makes the business much simpler to underwrite and set up to look much different over the next decade than the last, and I believe investors should analyze it in that context.
 

So if you believe the next 10 years:

1) ~95-98% combined ratio b/c of structural improvements in insurance operations;

2) cash+fixed income ~3-5% with more historically normal rates (such that, yes, as a base case the spread should be better than on average historically including the last decade of interest rate suppression); and

3) overall equity portfolio is easier to handicap and as a base case ~6-8% CAGR, still below 10-year estimates on a global equity beta portfolio (Research Affiliates); and

4) excess cash goes to buying back stock at ~10-15% earnings yield along the way, which they’ve telegraphed

 

well, that all adds up to a ~15-20% compound return for shareholders over the next decade from this current valuation. 
 

That’s the gist of why I believe FFH should trade at twice its current valuation right now.
 

So I get your point that the cash/fixed income spread to cost of float looks high, but that seems to be due to structural changes in both their insurance operations over the past 5-7 years and the fixed income markets.

 

Maybe that’s too much of a “this time is different” argument and I get the skepticism!
 

But if the insurance side really is structurally a better business now, and the power of float is much greater looking forward now that borrowing costs are off the lower bound, then that spread *is* structurally higher, with big implications for FFH shareholders that imho the market still doesn’t properly appreciate…

 

maybe specifically b/c we’re exiting a decade-plus of cheap borrowing for everyone, the average analyst at the big funds is about 28 years old, and a Canadian insurance company that your PM probably gave up on in 2017 isn’t exactly the sexiest stock to pitch!

 

 

Edited February 19, 2023 by MMM20

[Cigarbutt]

23 hours ago, StubbleJumper said:

...

Where it does matter is for the insurance subs' underwriting capacity.  Even if you plan to hold that fixed income port to maturity, you still need to mark those bonds to market which flows through the subs' balance sheets.  Their underwriting capacity is a direct function of their capital level.  For some of them, this is of no consequence while for others, like C&F, capital has been tight for a few years and hair-cutting the bond port could result in an actual underwriting constraint.

...

SJ

Sometimes i agree a lot with what you suggest and sometimes less so and sometimes... 

For the bonds held at the typical insurer (especially FFH for this aspect) ie high tier bonds as defined by regulators, bonds are recorded (in their statutory accounting reports) at cost (minor technical detail: the value recorded will change to par value with straight line accounting depending on the premium/discount paid on purchase) and will not be exposed to interest rate risk from the statutory underwriting constraint point of view. The idea is that the typical insurer will be able to hold to maturity and should not be impacted by the embedded interest rate risk that comes with asset-liability matching.

 

i follow now an insurer that recently had to record losses on longer term risk free bonds because of a run-off scenario but an interest rate risk statutory capital charge was recognized only because of the going concern aspect, which is not the case with FFH now.

-----

Of course, the above is a technical irrelevance and the real questions are:

After reaching market levels closer to intrinsic value, how is the downside protected if impairments (other than temporary type) had to be recognized in the foreseeable future?

What is their thought process (individual? committee? which relevant inputs they are using?) concerning their macro outlook on the fixed income side?

[StubbleJumper]

3 hours ago, Cigarbutt said:

Sometimes i agree a lot with what you suggest and sometimes less so and sometimes... 

For the bonds held at the typical insurer (especially FFH for this aspect) ie high tier bonds as defined by regulators, bonds are recorded (in their statutory accounting reports) at cost (minor technical detail: the value recorded will change to par value with straight line accounting depending on the premium/discount paid on purchase) and will not be exposed to interest rate risk from the statutory underwriting constraint point of view. The idea is that the typical insurer will be able to hold to maturity and should not be impacted by the embedded interest rate risk that comes with asset-liability matching.

 

i follow now an insurer that recently had to record losses on longer term risk free bonds because of a run-off scenario but an interest rate risk statutory capital charge was recognized only because of the going concern aspect, which is not the case with FFH now.

-----

Of course, the above is a technical irrelevance and the real questions are:

After reaching market levels closer to intrinsic value, how is the downside protected if impairments (other than temporary type) had to be recognized in the foreseeable future?

What is their thought process (individual? committee? which relevant inputs they are using?) concerning their macro outlook on the fixed income side?

 

Cigarbutt, as always, thanks for the insight.  I will endeavour to write fewer posts with which you disagree.

 

 

SJ