Fairfax 2023

Viking · August 7, 2023

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

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

Conclusion:

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

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

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

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

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

What are the key assumptions?

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

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

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

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

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

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

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

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

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

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

7.) Interest expense: A slight increase.

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

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

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

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

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

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

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

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

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

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

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

11.) Income taxes: estimated at 19%

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

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

Notes:

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

Edited August 7, 2023 by Viking

Xerxes · August 7, 2023

Last week Ackman talked about his short position on the long end (via options) arguing for a repricing of its yield to the upside … if that steepening does happen FFH could lock in the interest stream for longer duration (at a cost of liquidity)

I don’t think Prem & Co had envisioned that, as the sequence that they have in mind is :

1) short term goes up (yield inversion)

2) credit spread widens (recession)

3) long term goes up (yield steepens)

We are now in phase (1), but what if (2) does not happen and we go straight to (3) ??

if “soft landing/no recession” scenario plays out, the higher interest stream is as good as its low duration.

Parsad · August 8, 2023

On 8/6/2023 at 9:02 AM, Tommm50 said:

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

I don't have anything personal against analysts (although I never use them or read them) and I have no idea if there is anything nefarious behind it...but I agree with you that it is so far off that only a complete moron could come to those conclusions. I could see this report being written three years ago when it was at $450 per share and interest rates were low. But really, only someone who has no understanding about insurance companies could come to the estimate he has based on the information available.

Viking has laid out the case about as carefully crafted as you could. But you don't need Viking's reports or posts to tell you that Fairfax is extremely well positioned, with guaranteed positive cash flow coming in well over $100 a year for the next three years, while insurance subs are writing huge business at very profitable rates. Just interest income alone would justify a price around $900 USD. Forget insurance profits and non-fixed income/associate profits. How do you come to a price of $750 CDN?

Cheers!

Parsad · August 8, 2023

On 8/6/2023 at 4:15 PM, StubbleJumper said:

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

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

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

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

SJ

+1! Look I'm the biggest Fairfax groupie and I love Prem like he was family, but never fall in love with a stock or investment. Be it BRK, FFH, or whatever...never become so attached that you ignore reality and any possibility of regression to the mean. Markets flow both ways...too optimistic and too pessimistic.

By all means hold a large position if you believe in the company, management, fundamentals, etc. But never bet the farm! You only have to be wrong once and the farm is gone. I can't imagine starting all over again at my age (54), and I certainly don't want to start again at 75!

I've got all my Fairfax stock in taxable accounts and I'll hold that regardless going forward...just way too much in gains! I would feel sick paying tax on it!

But the biggest advantage I have in my non-taxable accounts is, that I can sell when something is over intrinsic value without worrying about taxes, and then patiently wait for the next fat pitch. Cheers!

Parsad · August 8, 2023

18 hours ago, MMM20 said:

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

It is already and has been for a long-time. But world class companies make mistakes too! Look at META, DIS, BUD, TSLA, GE, KO, AMEX, AAPL (1st incarnation), DELL, IBM, etc...you name it, they've effed up to some degree at some point. Sears was the most dominant retailer in the world for a good 80 years! And then in less than 15 years it essentially disappeared.

Other than Solomon, BRK is the exception and has never really been at risk or done something stupid of significance! Maybe that's why people expect other companies to be like Berkshire, but it's not possible. There is only one Buffett. As a risk manager, he is one of one...or maybe two (Jain)!

There's a thread on the BRK board asking about who is smarter...Buffett or Munger? If I was hiring one of them, I would hands down hire Buffett or Ajit Jain...ahead of Munger. Why? Because as risk managers they are exceptional...maybe the best to have ever roamed the business world. And Munger is no slouch...but look at BABA. If it went further the wrong way, it could have been catastrophic! Buffett has never had any such loss in the hundreds/thousands of investments he's made.

So world class doesn't mean things can't go wrong. Cheers!

MMM20 · August 8, 2023

7 hours ago, Parsad said:

It is already and has been for a long-time. But world class companies make mistakes too! Look at META, DIS, BUD, TSLA, GE, KO, AMEX, AAPL (1st incarnation), DELL, IBM, etc...you name it, they've effed up to some degree at some point. Sears was the most dominant retailer in the world for a good 80 years! And then in less than 15 years it essentially disappeared.

Other than Solomon, BRK is the exception and has never really been at risk or done something stupid of significance! Maybe that's why people expect other companies to be like Berkshire, but it's not possible. There is only one Buffett. As a risk manager, he is one of one...or maybe two (Jain)!

There's a thread on the BRK board asking about who is smarter...Buffett or Munger? If I was hiring one of them, I would hands down hire Buffett or Ajit Jain...ahead of Munger. Why? Because as risk managers they are exceptional...maybe the best to have ever roamed the business world. And Munger is no slouch...but look at BABA. If it went further the wrong way, it could have been catastrophic! Buffett has never had any such loss in the hundreds/thousands of investments he's made.

So world class doesn't mean things can't go wrong. Cheers!

Base rates are skewed heavily against us in the very long run, and something could blow us up over the next few years too. But we are looking for wildly mispriced bets and this is *still* a fat pitch, IMHO - arguably more so than at ~$350 ~3 years ago.

I get the argument for selling some if it has become a huge position, though. A famous investor once told me that if you're lucky enough to find yourself in this situation and struggling with the sizing decision, no one ever went mad (or broke) just cutting it in half.

I'm constantly reminding myself that given a high enough rate of compounding, even ~7%, you double your money roughly every decade. Then you just focus on your lifespan/healthspan. The exponent is really what matters. Longevity of compound > everything. That might be the #1 lesson from Buffett, IMHO. Well, that and the value of float

~5% cash is looking pretty damn good right now… but our "problem" is that Fairfax might be the single best way to invest in that thesis!

Appreciate your thoughts!

Edited August 8, 2023 by MMM20

dartmonkey · August 8, 2023

21 minutes ago, MMM20 said:

~5% cash is looking pretty damn good right now… but our "problem" is that Fairfax might be the single best way to invest in that thesis!

Exactly. I like to think my portfolio is half cash, half conservative stocks. Except that the cash half is actually levered 2:1, plus a dollop of underwriting income and savvy investing in gems like Eurobank, Poseidon and (lest we forget the downside) Blackberry...

UK · August 8, 2023

On 8/7/2023 at 6:12 PM, Viking said:

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

Viking, thanks for update!

I am not sure I understand this IFRS 17 effect correctly (or at all:)), but wouldnt constant rates imply, that this line more likely would be a zero in the future, as only further rising rates would translate into some positive number (and vice versa)?

'On the mechanics of IFRS 17':

Edited August 8, 2023 by UK

SafetyinNumbers · August 8, 2023

25 minutes ago, UK said:

Viking, thanks for update!

I am not sure I understand this IFRS 17 effect correctly (or at all:)), but wouldnt constant rates imply, that this line more likely would be a zero in the future, as only further rising rates would translate into some positive number (and vice versa)?

'On the mechanics of IFRS 17':

All else being equal (rates stay flat, premiums are growing) discounting the reserves under IFRS results in higher underwriting profit than under the old paradigm. While FFH is still reporting the old combined ratio metrics, when I calculate the combined ratio from the disclosure I get a lower IFRS-adjusted combined ratio. That makes intuitive sense.

Besides the discounting of new reserves, by moving one period forward, the balance of reserves accrete each quarter. That offsets some of the benefit but is also included in the adjusted combined ratio. If rates are coming down, that should increase the accretion as the whole reserve balance is discounted at a lower rate and we are moving forward a quarter. There should be an offsetting gain in bonds but I can see in that scenario how the IFRS adjusted combined ratio may not be lower than the reported combined ratio but I don’t know if it’s possible to do a sensitivity given the reserves are opaque.

Intact Financial discloses two combined ratios to illustrate the difference when they report with almost a 400bps difference between the two last quarter. You can see the spread is smaller last year when the interest rate curve was lower.

I’m not sure if I’m right in how I’m interpreting it despite formerly practicing as a CA/CPA and having a MAcc so if anyone knows better please share.

UK · August 9, 2023

10 hours ago, SafetyinNumbers said:

All else being equal (rates stay flat, premiums are growing) discounting the reserves under IFRS results in higher underwriting profit than under the old paradigm. While FFH is still reporting the old combined ratio metrics, when I calculate the combined ratio from the disclosure I get a lower IFRS-adjusted combined ratio. That makes intuitive sense.

Besides the discounting of new reserves, by moving one period forward, the balance of reserves accrete each quarter. That offsets some of the benefit but is also included in the adjusted combined ratio. If rates are coming down, that should increase the accretion as the whole reserve balance is discounted at a lower rate and we are moving forward a quarter. There should be an offsetting gain in bonds but I can see in that scenario how the IFRS adjusted combined ratio may not be lower than the reported combined ratio but I don’t know if it’s possible to do a sensitivity given the reserves are opaque.

Intact Financial discloses two combined ratios to illustrate the difference when they report with almost a 400bps difference between the two last quarter. You can see the spread is smaller last year when the interest rate curve was lower.

I’m not sure if I’m right in how I’m interpreting it despite formerly practicing as a CA/CPA and having a MAcc so if anyone knows better please share.

Thanks very much!

I guess, on the other hand, all this again is also a very good remainder (at least for me) that with an insurance business you really have to trust managment a lot.

I remember I first tried to look at some insurance companies (other than BRK) in 2010 or 2011, after BRK invested in Munich RE and also when AIG was starting its second life:). This is when I also discovered this board and FFH for the first time:). Maybe WB letters and warnings on insurance had a big influence, but at that time I came to a very simple (stupid?) conclusion: no other insurance company other than BRK is investable for me at that time (good sleep), at least for big/high conviction position. I bought some FFH in 2012, but generally just went with BRK for large allocation, which was also quite cheap in 2011-2012 period. Even today, together with other leveraged financials (also after some very different expierence of investing in banks: worked generally really good with US, not so with EU:)) I do not like these companies: no traditional pricing power, high leverage and all the dangers of "creating profits" with pen, dancing till the music stops etc. More so when they are not owner operated etc. On the other hand BRK (and some other companies) has proved, that a well run insurance operation, especially combined with well run investment side of the business, could do wonders for investors. So the crux with FFH, at least for me, is do I trust them with that? I think (or hope), that the answer after the last decade is finally yes with FFH? So I would be very worried if something bad came out of their insurance operations or if they would made another very big insurance acquisition. But it seems so far so good on this side?

Edited August 9, 2023 by UK

Viking · August 12, 2023

What kind of an investor is Fairfax?

Most people would answer: ‘value investor.’ That is the right answer but it doesn’t really tell us much. What kind of a value investor?

To answer this question we are going to look at what Fairfax has been doing. What have they actually been buying? What can we learn? We are going to go back three years (June 30 2020, to Aug 11 2023).

—————

But first, let’s set the table.

1.) "The single most important thing (when investing in the stock market)… is to know what you own." Peter Lynch

The problem with Peter Lynch is he says so many smart (and funny) things that his ‘most important thing’ gets lost in the shuffle. This is the ‘north star’ of everything else he writes. From this naturally flows another of Peter Lynch’s nuggets of gold.

2.) "The best stock to buy is the one you already own." Peter Lynch

This makes intuitive sense. You have already done the research on the stocks you own. You know ‘the story’ and you like it (that’s why you own it). Assuming the fundamentals are still solid, then buying more should be a no brainer. Buffett takes this idea a little further with the following quote:

3.) "Diversification may preserve wealth, but concentration builds wealth." Warren Buffett

The idea is to invest with conviction around you best ideas. Especially if the stock is on sale. This leads us to our next point.

4.)"‘The three most important words in investing are margin of safety." Warren Buffett

Ben Graham introduced ‘margin of safety’ as the central concept of investing in Chapter 20 of his book, The Intelligent Investor. The idea is to only purchase stocks when they are trading at a big discount to their intrinsic value (buy something for $0.50 that is worth $1.00). This approach limits your downside if you are wrong and it provides significant upside if you are right.

What do we get when we combine these four points?

Often, your best investment is to simply buy more of something you already own - especially when it is on sale.

One added twist:

5.) "If you search world-wide, you will find more bargains and better bargains than by studying only one nation." John Templeton

Invest wherever in the world the best opportunities are.

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What does all of this have to do with Fairfax?

Well, guess what Fairfax has been doing for the past 3 years? It has invested close to $6.2 billion in stuff it already owns. Yes, during this time Fairfax has been investing in new ventures but the amount spent is much smaller. In short, Fairfax has been feasting at the buffet of companies it already owns.

Let’s review the actual investments that Fairfax has been making the past 3 years (Aug 2020 to Aug 2023) that fit this theme to see what we can learn.

1.) Buy Fairfax stock = $2.26 billion

Late 2020/early 2021: purchased total return swaps giving them exposure to 1.96 million Fairfax shares
- Total investment = $732 million (notional) = $372/share

Late 2021 - dutch auction: purchased 2 million Fairfax shares
- Total investment = $1 billion = $500/share
June 30, 2020-June 30, 2023 - SIB purchase of an additional 1.133 million shares
- Total investment = $535 million = $490/share

Over the past 3 years Fairfax has ‘purchased’ 5.09 million shares of Fairfax, 19.3% of total effective shares outstanding, at an average cost of $445/share. With shares trading today at $843, the value creation for Fairfax shareholders has been $2 billion.

Fairfax saw incredible value in their shares. They invested with conviction (backed up the proverbial truck). Shareholders are now making out like bandits (the value created by Fairfax is flowing though to a much higher share price). Value investing at its best.

Who does this string of purchases remind you of?

Not Lynch, Buffet or Graham. Who then? Henry Singleton. Who is this guy?

From Prem’s letter in Fairfax’s 2018AR: ““I mentioned to you last year that we are focused on buying back our shares over the next ten years as and when we get the opportunity to do so at attractive prices. Henry Singleton from Teledyne was our hero as he reduced shares outstanding from approximately 88 million to 12 million over about 15 years.”

At the time, many laughed at Prem for making this comment. I don’t think these same people are laughing at Prem today.

2.) Increase Ownership of Insurance Businesses - Buy Out Partners = $1.9 billion

Insurance is the most important economic engine Fairfax has. Top line growth in the insurance businesses is critical to sustainable profit growth at Fairfax over time. And profitability is what determines the share price over the medium to long term.

Fairfax is slowly and methodically taking out the minority partners in its insurance companies. They spent $1.9 billion over the past 3 years doing this. As a result they own a larger share of (growing) future earnings of these high quality companies.

3.) Increase Ownership of Equity investments:

Consolidated Equities = $0.67 billion

These are the equity investments that Fairfax exerts a great deal of control over. They invested $666 million the past three years. The big purchase was taking Recipe private and being able to buy the stock at a big pandemic discount.

Remaining Equity Holdings = $1.4 billion

These are the equity investments Fairfax doe not exert a great deal of control over. They invested $1.4 billion the past three years. The biggest deal was expanded the partnership with Kennedy Wilson in real estate, with the 2 transactions below being part of much the bigger deal (debt platform and PacWest loans). There are lots of solid single type of investments on this list.

In total, over the past three years, Fairfax has invested a total of $6.2 billion to increase ownership in companies it already owns. Many of the investments were opportunistic and made at bear market low prices. Investments were made all over the world - value drove the decision, not geography. As a result Fairfax (and its shareholders) now own a greater proportion of the future earnings streams of these many businesses. The returns on the investments made in recent years are starting to come in and they are very good (in aggregate). With lots of upside in the future.

Conclusion: What did we learn?

How Fairfax is investing right now is incredibly simple. Invest in what you know. Buy at a discount. Act with conviction. Cast a wide net (global). Boring. Safe. Generating a very good return for shareholders. Something i think the masters would approve of. In short, Fairfax has been putting on a master-class in value investing over the past three years.

So, after all that, let’s get back to our initial question.

What kind of an investor is Fairfax?

Fairfax is a value investor. Their approach is a hybrid of 5 masters: Lynch, Buffett, Graham, Templeton and Singleton.

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Some of the companies Fairfax owns are doing the same thing:

The best example is Stelco who has reduced shares count by 38% over the past 2.5 years, which has increased Fairfax’s stake in the company from 14.7% to 23.6%.

Actions like these provide additional benefits to Fairfax and its shareholders. When combined with what Fairfax is doing, they have a ‘multiplicative’ effect for Fairfax shareholders (in terms of owning larger proportion of future earnings).

Edited August 13, 2023 by Viking

valuesource · August 12, 2023

On 8/6/2023 at 12:02 PM, Tommm50 said:

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

I’m struggling to understand Morningstar’s motivation. This isn’t Sell Side research, where they would look to capture investment banking business. We could use that to explain the bullish bias by NBF, Cormark, CIBC and BMO. I’d have to guess Morningstar is being compensated directly by some entities rather than by a soft dollar arrangement.

StubbleJumper · August 12, 2023

31 minutes ago, Viking said:

At the time, many laughed at Prem for making this comment. I don’t think these same people are laughing at Prem today.

I believe that I likely expressed more disdain than anyone for Prem's comment in the 2018 annual letter. My argument at the time was that for most of 20 years, FFH had been chronically short of capital and, nonetheless, had chronically acquired both insurance and non-insurance subsidiaries. It did this by issuing large amounts of debt and by repetitively increasing its share count. My argument at the time was that, as a serial acquirer, Prem would be unable to make a meaningful reduction in the share count because the capital/cash at the holding company level required to do so would never be there because there would always be another business to buy.

Well, I was wrong....mostly. FFH has meaningfully reduced its share count since 2018, and it was mainly done in a very rational and opportunistic manner. The largest buybacks were conducted at objectively significant discounts to any reasonable notion of FFH's fair intrinsic value. But, how was it done? Well, it was done principally by increasing FFH's corporate debt-level, selling subsidiaries (Riverstone and Pet Health), and by issuing what I consider to be "quasi-debt," which are the recurring transactions with partners like OMERS where FFH "sells" part of an asset and then "repurchases" it a few years later at a price that always seems to give the partner a predetermined 8-10% return. Effectively, the share repurchases and the operations of the holdco have been largely financed by issuing debt (including quasi-debt) and selling assets. I don't have a particular problem with that, provided that the terms that FFH receives for the sale of its subsidiaries and for the issuance of debt are broadly acceptable, and if FFH is being rational and opportunistic about its buyback prices.

The strategy of continuing to lever up after the 2018 letter has mostly worked out very well, mainly because the asset side of the balance sheet has exploded over the past two years. Having said that, the risk of that strategy became palpable during the first wave of covid (Q2 2020) as M2M losses on equities and corporate bonds and covid cat losses pushed the company uncomfortably close to its debt ceiling as defined by the revolving credit facility's debt covenants, and debt markets dried up which impeded FFH's ability to float bonds as an alternative to using the revolver. In the end, it worked out, but in Q2 2020 it was not at all obvious how FFH would fund its operations if equity markets were to continue to decline and/or covid cat losses grew appreciably. This sort of situation is the potential downside of levering up and leaving yourself reliant on bank credit (ie, a revolver).

I can happily say that FFH's share repurchases to date have been an unmitigated success. The prices paid were such a significant discount to book that it's hard to envision a scenario where the decision could be declared a failure, ex post. That being said @Viking, there is a line missing from the table analysing the buyback profitability, and that line is cost of financing the repurchases. That line item would include the cost of "dividends" that Odyssey is paying to OMERS and the ultimate cost of "repurchasing" the Odyssey position (it will be "bought back" by FFH in 5 or 6 years, at a price that will guarantee OMERS it's 8-10% return, right?) and the cost of maintaining the TRS. If the Odyssey quasi-debt is repaid in a relatively short period, the fall 2022 repurchase will be an overwhelming success as the discount was so large it will easily exceed any cost of financing, but if the quasi-debt languishes for a prolonged period the analysis might be a bit more ambiguous (8-10% per year for a decade or more would be a little painful). Similarly, if the TRS continue to increase in value at a pace that drastically outstrips the cost of the swap, it will be an unambiguous win for FFH, but if the share price growth should flatten (or, gasp, go negative!) and FFH continues to pay the juice for a number of years the outcome could become less obvious. In any event, the odds are overwhelmingly in favour of this working out very well for shareholders over the long-term, but always keep in mind that financing was not free and it was not without risk.

All of this brings us to today. The FFH holdco is once again a little light on cash and management seems to understand that large dividends from the insurance subs during a hard market might be undesirable because it could impede growing the subs' books during the virtuous part of the insurance cycle when both underwriting and investments are providing strong returns. Buybacks slowed to $80m during the first 6 months of 2023, likely because the holdco had limited cash available. The company has pushed out the "repurchase" of the minority position in Allied for a few years to give itself time to make a pile of money before it ultimately shrinks its books of business (it bought back 0.5% for $30.6m so repurchasing the remaining 16.6% will require about $1B of cash). As much as I don't like seeing FFH increase its debt load, I would say it's probably time that they float some bonds to fund the holdco's operations for a little while. If they can fund the holdco's requirements for the next couple of years until the hard market is over, FFH will make a pile of money and can spend the 2026-28 period releasing a few billion dollars of excess capital from the subs to "repurchase" some of the outstanding minority positions and possibly complete the share buyback that was initiated through the TRS position. They have made some pretty large moves over the past couple of years that are not yet fully digested.

SJ

SafetyinNumbers · August 12, 2023

1 hour ago, valuesource said:

I’m struggling to understand Morningstar’s motivation. This isn’t Sell Side research, where they would look to capture investment banking business. We could use that to explain the bullish bias by NBF, Cormark, CIBC and BMO. I’d have to guess Morningstar is being compensated directly by some entities rather than by a soft dollar arrangement.

I can tell you exactly how something like Morningstar happens.

They are paid directly by discount brokers who by settlement post the dot com bubble have to provide research. Morningstar having a good brand name adds a new business line selling equity research.

Because they are quants, they use their models to come up with target prices and earnings estimates. The analyst then just has to write a narrative to support the “AI” valuation. With ChatGPT, maybe AI is writing that too. Every analyst covers a lot of companies and probably gets paid very little. He covers a lot of companies. He can’t be an expert.

At the crux of it, quants can’t value a lumpy 15% very well. They don’t understand the business model and the structurally high ROE. All they do is look at history and weigh the recent history extra because that’s what works for the rest of the stocks in their universe whose businesses are more predictable.

It doesn’t matter by the way that it’s bad at valuing Fairfax in particular. I think regulators should look at banning this type of research because individuals read it and think that it’s Fairfax specific research when in fact it’s a snippet of a big data project that is being shared with an individual in a more personalized way via the analyst narrative. A fund managed based on that quant strategy might still beat the market!

It’s a big reason why an obviously cheap liquid company like Fairfax can stay so obviously undervalued when everybody has the same information. The number of active managers has diminished significantly in the past 20 years and the ones left for the most part are good at hugging the index and/or using quant screens to pick stocks. They might as well be following Morningstar research because their quant screen knocked Fairfax out of consideration.

None of this should be surprising. If passive and quant based funds are taking all of your assets it makes business sense to mimic your peers. It’s a very hard job. I know I would find it very difficult to make money with those constraints. That’s a big reason why I don’t do it but if I found myself needing a job I might give it a shot! I would try to find an unconstrained seat first of course!

Frankly, I don’t think there has been a better time for unconstrained investors in decades. It’s one of the reasons I’m so bullish on Fairfax. They are an unconstrained investor with the potential to make 10%+ returns on the equity portfolio while the fixed income portfolio is making 5%. That all translates to 20%+ ROE potential.

Viking’s brilliant well written post above spells out how easily that can happen. Buying insurance subsidiaries at < 10x earnings is also a 10%+ return on investment. I think selling 10% of Odyssey at a premium valuation to fund the SIB was a Singleton move. When I talk to investors about Fairfax, the focus is still on the downside and I fear that’s why there is selling at these prices on a daily basis. People are worried about a near term drawdown which could absolutely happen and likely will but that has nothing to do with intrinsic value.

I know a lot of people are hoping for more buybacks but I hope Fairfax keeps making buying what they know (Stelco could be next) and making the company more durable. That will make it easier for shareholders to hang on and worry less about drawdowns. That will gives Fairfax a much better chance of a premium valuation as the index huggers and momentum quants keep buying which I’m sure Prem will use to issue equity (Singleton!) and increase book value that much more

When I was in UBS Equity Sales as a desk analyst, one of my bosses clients gave me the nickname “The Dream”. My boss actually said he gave me the nickname but as a 27 year old kid at the time I remember thinking it was awesome that a hedge fund manager running billions of dollars knew who I was. He didn’t know my name though which is why he called me The Dream.

My ego took it like I was at a Hakeem Olajuwon level but in reality he was just referring to my propensity to figuring out the narrative where everything goes right. At the time we were trading a lot of risk arbitrage and event driven trades so some creativity was helpful and paid off big time as there was a lot of money to be made in 2004.

To that end, I’m clearly focusing on what could right for Fairfax. I think that’s an important part of the expected returns and focusing on the downside might make me let shares go too early which I will almost certainly will regret doing.

Edited August 12, 2023 by SafetyinNumbers
Typo

Redskin212 · August 12, 2023

Stelco - what are the chances Kestenbaum takes the company private with some assistance from Prem in the next 12 months? He clearly is a great operator and capital allocator, so likely a perfect fit for Fairfax.

SafetyinNumbers · August 12, 2023

1 hour ago, Redskin212 said:

Stelco - what are the chances Kestenbaum takes the company private with some assistance from Prem in the next 12 months? He clearly is a great operator and capital allocator, so likely a perfect fit for Fairfax.

The best part about is that they could do it without putting any new cash in using Stelco’s cash on hand and some term debt.

Edited August 12, 2023 by SafetyinNumbers

Viking · August 12, 2023

4 hours ago, StubbleJumper said:

I believe that I likely expressed more disdain than anyone for Prem's comment in the 2018 annual letter. My argument at the time was that for most of 20 years, FFH had been chronically short of capital and, nonetheless, had chronically acquired both insurance and non-insurance subsidiaries. It did this by issuing large amounts of debt and by repetitively increasing its share count. My argument at the time was that, as a serial acquirer, Prem would be unable to make a meaningful reduction in the share count because the capital/cash at the holding company level required to do so would never be there because there would always be another business to buy.

Well, I was wrong....mostly. FFH has meaningfully reduced its share count since 2018, and it was mainly done in a very rational and opportunistic manner. The largest buybacks were conducted at objectively significant discounts to any reasonable notion of FFH's fair intrinsic value. But, how was it done? Well, it was done principally by increasing FFH's corporate debt-level, selling subsidiaries (Riverstone and Pet Health), and by issuing what I consider to be "quasi-debt," which are the recurring transactions with partners like OMERS where FFH "sells" part of an asset and then "repurchases" it a few years later at a price that always seems to give the partner a predetermined 8-10% return. Effectively, the share repurchases and the operations of the holdco have been largely financed by issuing debt (including quasi-debt) and selling assets. I don't have a particular problem with that, provided that the terms that FFH receives for the sale of its subsidiaries and for the issuance of debt are broadly acceptable, and if FFH is being rational and opportunistic about its buyback prices.

The strategy of continuing to lever up after the 2018 letter has mostly worked out very well, mainly because the asset side of the balance sheet has exploded over the past two years. Having said that, the risk of that strategy became palpable during the first wave of covid (Q2 2020) as M2M losses on equities and corporate bonds and covid cat losses pushed the company uncomfortably close to its debt ceiling as defined by the revolving credit facility's debt covenants, and debt markets dried up which impeded FFH's ability to float bonds as an alternative to using the revolver. In the end, it worked out, but in Q2 2020 it was not at all obvious how FFH would fund its operations if equity markets were to continue to decline and/or covid cat losses grew appreciably. This sort of situation is the potential downside of levering up and leaving yourself reliant on bank credit (ie, a revolver).

I can happily say that FFH's share repurchases to date have been an unmitigated success. The prices paid were such a significant discount to book that it's hard to envision a scenario where the decision could be declared a failure, ex post. That being said @Viking, there is a line missing from the table analysing the buyback profitability, and that line is cost of financing the repurchases. That line item would include the cost of "dividends" that Odyssey is paying to OMERS and the ultimate cost of "repurchasing" the Odyssey position (it will be "bought back" by FFH in 5 or 6 years, at a price that will guarantee OMERS it's 8-10% return, right?) and the cost of maintaining the TRS. If the Odyssey quasi-debt is repaid in a relatively short period, the fall 2022 repurchase will be an overwhelming success as the discount was so large it will easily exceed any cost of financing, but if the quasi-debt languishes for a prolonged period the analysis might be a bit more ambiguous (8-10% per year for a decade or more would be a little painful). Similarly, if the TRS continue to increase in value at a pace that drastically outstrips the cost of the swap, it will be an unambiguous win for FFH, but if the share price growth should flatten (or, gasp, go negative!) and FFH continues to pay the juice for a number of years the outcome could become less obvious. In any event, the odds are overwhelmingly in favour of this working out very well for shareholders over the long-term, but always keep in mind that financing was not free and it was not without risk.

All of this brings us to today. The FFH holdco is once again a little light on cash and management seems to understand that large dividends from the insurance subs during a hard market might be undesirable because it could impede growing the subs' books during the virtuous part of the insurance cycle when both underwriting and investments are providing strong returns. Buybacks slowed to $80m during the first 6 months of 2023, likely because the holdco had limited cash available. The company has pushed out the "repurchase" of the minority position in Allied for a few years to give itself time to make a pile of money before it ultimately shrinks its books of business (it bought back 0.5% for $30.6m so repurchasing the remaining 16.6% will require about $1B of cash). As much as I don't like seeing FFH increase its debt load, I would say it's probably time that they float some bonds to fund the holdco's operations for a little while. If they can fund the holdco's requirements for the next couple of years until the hard market is over, FFH will make a pile of money and can spend the 2026-28 period releasing a few billion dollars of excess capital from the subs to "repurchase" some of the outstanding minority positions and possibly complete the share buyback that was initiated through the TRS position. They have made some pretty large moves over the past couple of years that are not yet fully digested.

SJ

@StubbleJumper Yes, i did not discuss where the money came from to fund the $6.2 billion buying spree. I thought the post was already long enough

Here are some quick thoughts:

2020-2021 - FFH TRS purchase has been a home run. Yes, at the time, Fairfax did not have the cash. Hence, the genius of this investment. And with Fairfax shares today trading at 5.3 x 2023E earnings i think this investment has much further to run. Yes, there is a cost to hold this position. But I trust that Fairfax is laser focussed on this and they will exit the TRS at an appropriate time. With the significant earnings coming in each of the next three years Fairfax has the ability to help the share price get closer to what they believe is intrinsic value (by cranking up buybacks). My guess is Fairfax holds this position for a couple more years.
Late 2021 - Dutch auction taking out 2 million shares at $500 million was also a home run. At the time Fairfax did not have the cash. Another very good investment with book value today at $834/share and likely on its way to $900 by year end. To fund it, yes, they had to sell 10% of Odyssey in a funky deal with partners (OMERS) who i think get a fixed return of around 8%. However, in return i think Fairfax is able to buy back the stake at a fixed price (set when the deal was struck). And (i believe) Fairfax keeps 100% of the growth in value of the underlying business, including the 10% owned by the minority partners. So the 8% ‘cost’ is likely much less (as long as the business grows in value). Not really sure - just my guess.
2022 - The sale of the pet insurance deal will do down as one of the biggest heists in the insurance industry in recent years. So yes, Fairfax ‘sold an asset.’ But that was a criminally good deal for Fairfax investors.
The sale of Riverstone UK is a little more nuanced. I think it was a very well run operation. However, a run off business is never going to be valued anywhere close to an appropriate level by Mr Market. Bottom line, i also like this sale given what Fairfax was able to do with the proceeds.

I think i look at things a little differently than you. When looking at the individual transactions it is always through the lens of Fairfax as a whole.

Is their total level of debt today ok? Yes. Especially considering the likely trajectory of operating earnings (2023-2025).
Are they reducing ‘minority interest’ in insurance subs? Yes. As you point out, with some puts and takes. I expect this trend to continue in the coming years - Fairfax will continue (on balance) to take out more of its minority partners.
Insurance asset sales (pet insurance, Riverstone UK, Ambridge) are delivering significant value to shareholders. This is not a negative, this is a big positive. Non-insurance asset sales are the same (Resolute Forest Products). I expect this to continue.

The net/net of all the moves over the past 3 years is Fairfax is a much, much stronger company today than it was June 30, 2020. Were all the decisions perfect? No, of course not. But taken as a whole, they have hit the ball out of the park. They are delivering a clinic in value investing.

Now where the Fairfax story gets really interesting is right about now. In the past, Fairfax was capital constrained. Not anymore. My current forecast is for Fairfax to deliver net earnings of around $11.3 billion in 2023, 2024 and 2025 (total over these three years - after minority interests). For reference, my past estimates have been on the low side and i think that could well be the case here too.

Today, being short of capital is not a concern for me for Fairfax.

Edited August 13, 2023 by Viking

MMM20 · August 12, 2023

5 hours ago, valuesource said:

I’m struggling to understand Morningstar’s motivation. This isn’t Sell Side research, where they would look to capture investment banking business. We could use that to explain the bullish bias by NBF, Cormark, CIBC and BMO. I’d have to guess Morningstar is being compensated directly by some entities rather than by a soft dollar arrangement.

Never attribute to malice that which can be adequately explained by stupidity.

Hanlon’s razor.

Parsad · August 12, 2023

5 minutes ago, MMM20 said:

Never attribute to malice that which can be adequately explained by stupidity.

Hanlon’s razor.

LOL! +1! Cheers!

UK · August 14, 2023

On 8/7/2023 at 3:15 AM, StubbleJumper said:

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

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

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

SJ

FFHfloat.xls 10.5 kB · 25 downloads

Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK!

ffh brk float.pdf ffh brk float.xlsx

Edited August 14, 2023 by UK

StubbleJumper · August 14, 2023

@UK That is quite interesting. I knew that BRK was concerned that Geico had not been keeping up with Progressive, but I would not have guessed that BRK's benefit of float including GenRe had been trending downward for a decade.

Edited August 14, 2023 by StubbleJumper

SafetyinNumbers · August 14, 2023

58 minutes ago, UK said:

Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK!

ffh brk float.pdf 124.81 kB · 7 downloads ffh brk float.xlsx 37.75 kB · 3 downloads

Float to market cap and float to BV would also be an interesting comparison over time and currently vs peers.

UK · August 14, 2023

https://www.wsj.com/articles/wildfires-and-thunderstorms-are-throwing-insurance-market-into-turbulence-2c62ab7b?mod=hp_minor_pos19

Not only have reinsurers in some cases raised the cost of coverage, but they have also moved up the starting point for when they will begin to absorb losses. Thus, the amount of losses that primary insurers have to take before reinsurance kicks in is in many cases getting larger. Reinsurers are now typically seeking to start at the level of catastrophe losses that occur around once every 10 years, rather than the more typical starting point of one-in-three-year or -five-year events, Gallagher Re said in its January report. Clearly, the insurance industry as a whole needs to keep adjusting to worse events, more often. That won’t happen without cost.

treasurehunt · August 15, 2023

16 hours ago, UK said:

Not sure if I did it without mistakes, but it is quite interesting if you compare this data of FFH with BRK!

ffh brk float.pdf 124.81 kB · 9 downloads ffh brk float.xlsx 37.75 kB · 3 downloads

Nice work! I checked the BRK data for the past ten years and your chart looks correct. Even accounting for differences in the lines of business, I am surprised that Fairfax's underwriting has been noticeably better than Berkshire's in recent years. I mean, Buffett is very proud of the quality of Berkshire's insurance business, but Fairfax has had better underwriting results for the last six years or so. Very impressive.

ValueMaven · August 15, 2023

@treasurehunt big issue there has been GEICO - so not really comparing apples to apples imho

Fairfax 2023

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