Fairfax 2023

[John Hjorth]

@SafetyinNumbers,

 

From the Markel Topic in the Investment Ideas forum a few years ago :

 

 

and

 

Just to elaborate on the basis return calculations in the considerations above, where cost of float in period n isen't 1-CR_n.

[StubbleJumper]

19 minutes ago, SafetyinNumbers said:

What if the equity portfolio returns 5-10% per year on average for an indefinite period of time? Wouldn’t an ROE of 15-20% be achievable then even if combined ratios inevitably go higher? 

 

 

Sure, but the traditional thesis for investing in FFH is that you'd hope that their equity returns would be a little higher than 5-10%.  The constraint on what this can actually do for a shareholder is that, by necessity, an insurance company keeps two-thirds or three-quarters of its portfolio in fixed income.  So, in the case of FFH, they currently have about US$12.5 billion in common stocks and associates.  A 10% return on that would be $1.25b, or about $50 or $60/sh.  It definitely helps, but the 15% ROE is a big hurdle over the long term (just look at the table that Prem publishes in his letter every year).

 

 

SJ

[MMM20]

1 hour ago, StubbleJumper said:

 

 

Sure, but the traditional thesis for investing in FFH is that you'd hope that their equity returns would be a little higher than 5-10%.  The constraint on what this can actually do for a shareholder is that, by necessity, an insurance company keeps two-thirds or three-quarters of its portfolio in fixed income.  So, in the case of FFH, they currently have about US$12.5 billion in common stocks and associates.  A 10% return on that would be $1.25b, or about $50 or $60/sh.  It definitely helps, but the 15% ROE is a big hurdle over the long term (just look at the table that Prem publishes in his letter every year).

 

 

SJ

The traditional math is less applicable now that they have upwards of $30b in float, isn’t it? ~5-10% equity returns, ~3-6% fixed income returns, ~0% cost of float, and the dividend and ongoing buybacks add up to a ~15-20% return for shareholders now, right?

[StubbleJumper]

41 minutes ago, MMM20 said:

The traditional math is less applicable now that they have upwards of $30b in float, isn’t it? ~5-10% equity returns, ~3-6% fixed income returns, ~0% cost of float, and the dividend and ongoing buybacks add up to a ~15-20% return for shareholders now, right?

 

No, the math is what it is.  The long-term financing differential (ie long bond rate minus the cost of float) is a shade over 4 percent.  So if you hypothesize a 0 percent cost of float you should be thinking about a 4 percent treasury bond rate.

 

If you have 25 percent equities that return 10 pct and 75 pct fixed income, your float yields 0.75x4 + 0.25x10 = 5.5 pct.  Lever it up by 2 assuming that your premiums to surplus ratio is that high (usually ffh runs it lower) and your insurance subs might get an roe as high as 11 pct if they jettison excess capital.  Ffh's subs usually carry more capital, so drop your expectation accordingly.

 

The investment thesis is really that they will generate some alpha on the investment side.  

 

 

SJ

[gfp]

If you are taking underwriting profit out of the equation in your example above, the simple math in your example is 5.5% on $56.6B of invested assets against an $18.6B common shareholders' equity.  The leverage is closer to 3 than 2.  Which is what gets you to 15% on equity.

[StubbleJumper]

22 minutes ago, gfp said:

If you are taking underwriting profit out of the equation in your example above, the simple math in your example is 5.5% on $56.6B of invested assets against an $18.6B common shareholders' equity.  The leverage is closer to 3 than 2.  Which is what gets you to 15% on equity.

 

You are right.  The basic math above was about the roe you might expect from one of the insurance subs. 

 

For the corp as a whole, you need to add in the return from other non insurance assets held by the hold co, and then strip off interest, taxes and Holdco admin costs.

 

It is worthwhile looking at the table depicting growth in BV that Prem publishes every year the annual letter.  Hitting 15%+ is a notable event.  We will probably get three or four of those types of years in rapid succession, so we should be pleased about what we see.  But people should project that forward over many years at their own risk and péril!

 

 

SJ

Edited August 20, 2023 by StubbleJumper

[SafetyinNumbers]

12 minutes ago, StubbleJumper said:

 

You are right.  The basic math above was about the roe you might expect from one of the insurance subs. 

 

For the corp as a whole, you need to add in the return from other non insurance assets held by the hold co, and then strip off interest, taxes and Holdco admin costs.

 

It is worthwhile looking at the table depicting growth in BV that Prem publishes every year the annual letter.  Hitting 15%+ is a notable event.  We will probably get three or four of those types of years in rapid succession, so we should be pleased about what we see.  But people should project that forward over many years at their own risk and péril!

 

 

SJ

How many years in that table depicting growth in BV was the float 2x the BV?

[TwoCitiesCapital]

3 hours ago, StubbleJumper said:

 

To do this, you need to argue that FFH has some sort of special sauce that enables it to write a 94 CR while buying US treasuries yielding 5%, but nobody else can/will do so.  So, in essence, the argument needs to be that $1 of capital in Crum or Odyssey can be used to write $2 of premium, the underwriting earnings will be 12 cents (94 CR) and riskless investment income will be 10 cents (a US Treasury yielding 5%), providing a slick return of 22% on that equity, BUT no other company can replicate that.  No other company will see this, obtain new capital, expand their book of business, and competition will not push the CR rate up and squeeze FFH's books of business.  If you can hammer out this argument in your own mind why FFH can do this and nobody else can/will, then your earnings are sustainable and you can simply slap some sort of market average PE onto current earnings to arrive at a valuation estimate.

 

 

I think it's possible the earnings may be more sticky than otherwise assumed. 

 

Other companies MAY see it, but may NOT be able to capitalize on it due to capital constraints after they're fixed income portfolios went down ~10+% last year. 

 

If interest rates do NOT go down, other companies would have to either issue new equity to raise capital OR organically wait for current earnings and amortization of bond discounts to refill capital holes over the course of the next 2-3 years just to get back to where they were at YE 2021. 

 

And that assumes no major catastrophes during that 2-3 year period so CRs can remain positive and not contribute to loss of capital. A large catastrophe year could further extend the timeline. 

 

I don't think insurance CRs and earnings can continue at this level of growth and profitability into perpetuity, but Fairfax did itself a large favor on the fixed income side by protecting capital. When Prem mentioned in the past the ability to 2-3x premiums written in a hard market, who here thought it'd happen in an environment where nobody else could? I definitely underestimated that potential and the lucrative profitability that results from it. 

[Viking]

13 hours ago, StubbleJumper said:

 

 

I'm not Pete, but I'll take a run at this.

 

If you want to value a security using PE as a metric, you need to do so on the assumption that earnings are neither unusually high nor unusually low and that they are sustainable for a prolonged period.  A PE is essentially a mental short-cut for assessing the value of a perpetuity.  To make the argument that a 5.2 PE is cheap and that the company should have a PE of, say, 12, you need to assume that the current excellent operating conditions for an insurance company will persist for many years on end.

 

To do this, you need to argue that FFH has some sort of special sauce that enables it to write a 94 CR while buying US treasuries yielding 5%, but nobody else can/will do so.  So, in essence, the argument needs to be that $1 of capital in Crum or Odyssey can be used to write $2 of premium, the underwriting earnings will be 12 cents (94 CR) and riskless investment income will be 10 cents (a US Treasury yielding 5%), providing a slick return of 22% on that equity, BUT no other company can replicate that.  No other company will see this, obtain new capital, expand their book of business, and competition will not push the CR rate up and squeeze FFH's books of business.  If you can hammer out this argument in your own mind why FFH can do this and nobody else can/will, then your earnings are sustainable and you can simply slap some sort of market average PE onto current earnings to arrive at a valuation estimate.

 

Setting aside the argument about the sustainability of earnings, the comment saying, "And I think the stock looks fairly cheap on that basis" is in my view a reasonable and valid comment.  You have quite rightly pointed out that FFH has locked in some fairly attractive investment returns for the next few years.  You've done the arithmetic through to develop pro forma earnings estimates going forward 2.5 years and shown that there will be big earnings coming down the pipe, even if a guy gives a moderate haircut to underwriting profitability for 2024 and a  massive haircut to underwriting profitability for 2025 (but, hey if they actually continue to write a 94 CR, so much the better!).  If you do this, it is difficult to envisage a scenario where adjusted BV (after accounting for the excess of market over book for certain associates) doesn't hit $1,100 by Dec 31, 2025.  If operating conditions in the insurance market continue to be as wonderful as they currently are, with a CR of 94 and a treasury of 5% being SIMULTANEOUSLY available, that Dec 2025 BV could be higher, but it seems to be a no-brainer that they'll make the $1,100 BV given that the returns on the fixed income portfolio are largely locked in.  So, someone who doesn't buy the argument that FFH ought to currently trade at PE12x$180EPS=US$2,000+ can quite reasonably believe that it could trade at somewhere between 1x and 1.2x BV on Dec 31, 2025.  With the shares currently trading at ~US$830, a price on Dec 31, 2025 of $1,100 to $1,300 is quite plausible and is fully consistent with the observation, "And I think the stock looks fairly cheap on that basis."

 

It really amounts to a bit of a differing view of just how far into the future you are comfortable to predict outstanding insurance results.  I am assuming that we are at the peak of the insurance cycle and that conditions will deteriorate as capital enters the industry and companies competing to expand their books of business push the CRs higher (probably to slightly above 100 before it's all said and done).  If it actually does work out that FFH can routinely obtain a 22% return on an incremental dollar of capital, so much the better.  But, personally, I am unwilling to assume that today's wonderful insurance conditions will persist for a prolonged period.  I would be happy in 10 years if I am wrong today!

 

SJ

 

@StubbleJumper My point with the PE in my post was to highlight that it is absurdly low for Fairfax right now. Fairfax's stock price today of $828 makes sense if Fairfax was earning about $80 per year (and assuming earnings grow modestly in the future). It is a well run P&C insurer so trading at a PE of 10 is hardly an aggressive multiple to attach.

 

My current estimate is Fairfax will earn $160 this year. And with slightly conservative assumptions, earnings will grow in 2024 and 2025. That is not in the same universe as $80 in earnings.

 

So a buyer of Fairfax's stock today at $828 is getting $80 in estimated 2023 earnings for free ($160-$80). That is one hell of a discount for something that might or might not happen in 2026 or later. It doesn't make any rational sense. It is too large.

 

Yes, my earnings estimate for 2023 might be a little high. And it also might be a little low. We are almost 8 months through the year.

 

My thesis is investors are way underestimating what a 'normalized' amount of earnings is for Fairfax today. Yes, the future is uncertain. There are risks. But there are also opportunities. Some income streams will face headwinds. At the same time other income streams will experience tailwinds.  

Edited August 21, 2023 by Viking

[UK]

6 hours ago, Viking said:

 

@StubbleJumper My point with the PE in my post was to highlight that it is absurdly low for Fairfax right now. Fairfax's stock price today of $828 makes sense if Fairfax was earning about $80 per year (and assuming earnings grow modestly in the future). It is a well run P&C insurer so trading at a PE of 10 is hardly an aggressive multiple to attach.

 

My current estimate is Fairfax will earn $160 this year. And with slightly conservative assumptions, earnings will grow in 2024 and 2025. That is not in the same universe as $80 in earnings.

 

So a buyer of Fairfax's stock today at $828 is getting $80 in estimated 2023 earnings for free ($160-$80). That is one hell of a discount for something that might or might not happen in 2026 or later. It doesn't make any rational sense. It is too large.

 

Yes, my earnings estimate for 2023 might be a little high. And it also might be a little low. We are almost 8 months through the year.

 

My thesis is investors are way underestimating what a 'normalized' amount of earnings is for Fairfax today. Yes, the future is uncertain. There are risks. But there are also opportunities. Some income streams will face headwinds. At the same time other income streams will experience tailwinds.  

 

Viking, again, thank you very much for sharing your work and thoughts!

 

It is really almost impossible anything to add to it, but one thing, I am not sure if really you assumptions could be called "slightly conservative". I do not think at all that you have to be conservative or that these numbers are impossible, or that there could not be further positive upsides or surprises etc, but incorporating CR of 96 or less for longer term, I think is quite optimistic (possible but not sure if probable). Regardless I agree very much with your general thinking and however you look at FFH today (or even at CR 98 or 100), either on absolute or on relative, it is still to cheap and you still do not need scales to see if patient is way too fat here:). I also like very much that FFH (as also BRK but with lesser degree) is very well positioned if rates will stay higher/normal for longer or ever. But most importantly, it finally seems that at this stage, in order for them to do really well, say to earn their 15 per cent target for longer term, all they have to do is just not to do anything really stupid, to paraphrase Munger:). And if they will do something clever, as they did many times in different areas in recent 5 years, then even better! Given that, I do not understand how it is not selling at least 1.2-1.3 BV already and would not be shocked to see them trade at some 1.5 BV in mid term and my plan is just to hold it. Unless something really stupid is done, but I do not expect this at all:)

 

Edited August 21, 2023 by UK

[Dudley]

Whether @Viking's earnings estimates are exactly right or approximately right is not important. He is directionally right. There is no doubt that earnings have skyrocketed due to a Munger-esque lollapalooza confluence of factors that Viking has outlined. The stock has not kept up and after a few more impressive earnings results and maybe some buybacks, the stock price will eventually reflect the true earnings power of Fairfax.

 

The beauty of this setup is that even if Wall Street continues to be slow to appreciate the story here, Fairfax has the ability and desire to buy back stock, which would make the stock even more attractive. It's a win-win scenario that could only possibly be improved by more cash at the Holdco.

[jfan]

On 8/20/2023 at 7:52 AM, StubbleJumper said:

I am assuming that we are at the peak of the insurance cycle and that conditions will deteriorate as capital enters the industry and companies competing to expand their books of business push the CRs higher (probably to slightly above 100 before it's all said and done). 

The Insurance Market Cycle: Hard Versus Soft Markets - Cottingham & Butler (cottinghambutler.com)

 

I understand your thought process here about the cyclical nature of the insurance business as well as interest rates affecting it. It would be lovely to have a hard market that last as long as the recent soft market. I certainly can come up with a narrative that interest rates will likely remain higher for longer vs returning back to their lows over the past decade. With many insurance companies mal-positioned over the past decade (in terms of their investment portfolio), how many of them will have the capacity to write more policies, or raise capital at attractive valuations to do so? Furthermore, with higher interest rates, will alternative sources of capital (eg private equity) have increasing difficulties raising funds effectively to buy these poorly performing insurance companies?

 

Am I way off base if I assume that the average hard market typically last 4 years? And if this one started in 2018, the cycle should have moderated at this stage and more premium growth unlikely to persist? If the above narrative plays out, how much longer could a semi-hard market last? one? two? more years?

 

 

 

 

Edited August 21, 2023 by jfan

[UK]

1 hour ago, jfan said:

The Insurance Market Cycle: Hard Versus Soft Markets - Cottingham & Butler (cottinghambutler.com)

 

I understand your thought process here about the cyclical nature of the insurance business as well as interest rates affecting it. It would be lovely to have a hard market that last as long as the recent soft market. I certainly can come up with a narrative that interest rates will likely remain higher for longer vs returning back to their lows over the past decade. With many insurance companies mal-positioned over the past decade (in terms of their investment portfolio), how many of them will have the capacity to write more policies, or raise capital at attractive valuations to do so? Furthermore, with higher interest rates, will alternative sources of capital (eg private equity) have increasing difficulties raising funds effectively to buy these poorly performing insurance companies?

 

Am I way off base if I assume that the average hard market typically last 4 years? And if this one started in 2018, the cycle should have moderated at this stage and more premium growth unlikely to persist? If the above narrative plays out, how much longer could a semi-hard market last? one? two? more years?

 

 

 

 

 

This is very interesting info, thanks! As I think about all this, I am coming to maybe such conclusions: a. insurance cycle impossible to predict over longer term, but it is unlikely to remain always beneficial, however b. even with underwriting results at zero, FFH is still cheap, and c. as with other important things (investments etc), when insurance cycle turns negative, the extent of negative consequences will also depend on what decisions FFH will take and how they will execute, and I think there is some basis for optimism here, looking at how they managed everything in the last 5 years? 

 

Edited August 21, 2023 by UK

[SafetyinNumbers]

I chat with quite a few Fairfax holders and my impression is that many of them are looking for reasons to sell. I think it’s mostly to avoid drawdowns which might lead them to feel or worse look stupid. Especially to their bosses/clients if they are portfolio managers. Meanwhile, the index huggers just buy stock on VWAP so are price insensitive. 

 

Personally, I think it makes little sense to consider selling until Fairfax trades at least 1.5x book value because that seems likely over the next 5 years given how underowned Fairfax is by Canadian PMs benchmarked to the S&P/TSX and how active shareholders like ourselves see very strong book value growth over the same period.

 

In the past three years, Fairfax has gone from 47bps in the index to 89bps. The shares outperformed the index by 170% but that was offset by growth in capitalization of the index and Fairfax’s share buybacks.

 

It’s already very hard for active PMs not to own Fairfax given how it’s crushed the index recently but given the built in growth that I think we all agree is highly probable, if the stock just stays at 1x BV, it’s weighting will go well above 100bps and the urgency to own it will increase. 

 

It’s easy to think up narratives PM’s will use to justify paying up to 1.5x BV. They can point to comps like BRK, MKL that trade there. They can point to long term and recent ROE north of 15%. They can point to exposure to Greece and India in the equity portfolio and how cheap it is although that might be to justify paying 2x BV!

 

I really want to avoid selling too early because I think we could be in the first year of Fairfax’s 95-98 experience where ROE hit 20% four years in a row and the multiple went from 1.5x BV to > 3x BV. Fairfax also increased shares outstanding (Singleton like) by 33% which contributed to the growth in book value from $39 to $112.

 

These analogs are all pretty useless except they do show us what’s possible if not probable. It’s easy to hold or buy at 1x book value, it will be much harder north of 1.5x but I don’t have to worry about steeling myself until we get there. In 1995, the starting point was 1.5x BV. I don’t know if I would have been interested back then even if I had my knowledge now. That set of shareholders didn’t make it easy for the index huggers as the market cap grew from ~$800m to north of $7b. Maybe this set of shareholders is jaded enough given the last decade to hand over their shares easily but I’m trying to hold on to mine.

 

Of course, everyone should do whatever makes them comfortable. This is not investment advice. It’s just my thought process for which I welcome criticism.

[petec]

On 8/20/2023 at 9:55 AM, Viking said:

 you are a night owl! 

 

Early morning my side of the Atlantic!

 

Sorry it took me a while to come back to this.

 

On 8/20/2023 at 9:55 AM, Viking said:

My view is the true anomaly was the period 2010-2020 and zero interest rates.

 

That's entirely fair, and yes Prem & team positioned themselves for a reversion to normal beautifully. But (being pedantic) you said the increased earnings power is simply down to their decisions, and it absolutely isn't, IMHO.

On 8/20/2023 at 9:55 AM, Viking said:

The part of your comment i do not understand is: “And I think the stock looks fairly cheap on that basis.”

 

My estimate is the stock is trading at 5.2 x 2023 earnings. That is not ‘fairly cheap’… that is crazy cheap. Do you not think $4.3 billion is a reasonable estimate for operating earning for 2023? 
 

Or is it more a weighting issue… where Fairfax is getting too big and you want to lighten up to rebalance your overall portfolio? Regardless of fundamentals or what the stock might actually be actually worth?

 

It's definitely partly weighting. I went into covid owning a lot of this and had the great good fortune to add significantly at about $250 IIRC, so FFH has definitely grown as a % of my portfolio.

 

But it's also value. If we agree FFH's operating earnings are in large part rate-dependant, then we're straying into territory where I don't trust my opinions, and I don't assume that this level of earnings is sustainable. Instead I tend to value it at 1x or 1.2x 2-3y forward BV, including the excess of carrying over fair and a bump when the digit deal finally closes (and I don't penalise them for IFRS17, which arguably we should).

 

That still gets you a VERY nice return from here. But I can find other things with a similar outlook so why not diversify the risks?

 

To be clear though, I've probably taken 5% of my peak position off the table - i.e. not much. It is still my biggest holding by some distance. I expect to own it permanently because I have great respect for management, but the size will vary with valuation.

[petec]

On 8/20/2023 at 12:40 PM, SafetyinNumbers said:

 

I think this take on Brit and Allied ignores that Fairfax issued stock at 1.3x book plus and issued preferred at tight spreads to partially fund these acquisitions. Singleton is a legend not only for the buybacks below book but for issuing stock early on well above book to grow the earnings power of the business. Call it towering ego if you like, I call it accretive capital allocation.

 

 

Agree, but nonetheless I think these will turn out to be good deals.

[petec]

On 8/20/2023 at 12:52 PM, StubbleJumper said:

 

 

I'm not Pete, but I'll take a run at this.

 

If you want to value a security using PE as a metric, you need to do so on the assumption that earnings are neither unusually high nor unusually low and that they are sustainable for a prolonged period.  A PE is essentially a mental short-cut for assessing the value of a perpetuity.  To make the argument that a 5.2 PE is cheap and that the company should have a PE of, say, 12, you need to assume that the current excellent operating conditions for an insurance company will persist for many years on end.

 

To do this, you need to argue that FFH has some sort of special sauce that enables it to write a 94 CR while buying US treasuries yielding 5%, but nobody else can/will do so.  So, in essence, the argument needs to be that $1 of capital in Crum or Odyssey can be used to write $2 of premium, the underwriting earnings will be 12 cents (94 CR) and riskless investment income will be 10 cents (a US Treasury yielding 5%), providing a slick return of 22% on that equity, BUT no other company can replicate that.  No other company will see this, obtain new capital, expand their book of business, and competition will not push the CR rate up and squeeze FFH's books of business.  If you can hammer out this argument in your own mind why FFH can do this and nobody else can/will, then your earnings are sustainable and you can simply slap some sort of market average PE onto current earnings to arrive at a valuation estimate.

 

Setting aside the argument about the sustainability of earnings, the comment saying, "And I think the stock looks fairly cheap on that basis" is in my view a reasonable and valid comment.  You have quite rightly pointed out that FFH has locked in some fairly attractive investment returns for the next few years.  You've done the arithmetic through to develop pro forma earnings estimates going forward 2.5 years and shown that there will be big earnings coming down the pipe, even if a guy gives a moderate haircut to underwriting profitability for 2024 and a  massive haircut to underwriting profitability for 2025 (but, hey if they actually continue to write a 94 CR, so much the better!).  If you do this, it is difficult to envisage a scenario where adjusted BV (after accounting for the excess of market over book for certain associates) doesn't hit $1,100 by Dec 31, 2025.  If operating conditions in the insurance market continue to be as wonderful as they currently are, with a CR of 94 and a treasury of 5% being SIMULTANEOUSLY available, that Dec 2025 BV could be higher, but it seems to be a no-brainer that they'll make the $1,100 BV given that the returns on the fixed income portfolio are largely locked in.  So, someone who doesn't buy the argument that FFH ought to currently trade at PE12x$180EPS=US$2,000+ can quite reasonably believe that it could trade at somewhere between 1x and 1.2x BV on Dec 31, 2025.  With the shares currently trading at ~US$830, a price on Dec 31, 2025 of $1,100 to $1,300 is quite plausible and is fully consistent with the observation, "And I think the stock looks fairly cheap on that basis."

 

It really amounts to a bit of a differing view of just how far into the future you are comfortable to predict outstanding insurance results.  I am assuming that we are at the peak of the insurance cycle and that conditions will deteriorate as capital enters the industry and companies competing to expand their books of business push the CRs higher (probably to slightly above 100 before it's all said and done).  If it actually does work out that FFH can routinely obtain a 22% return on an incremental dollar of capital, so much the better.  But, personally, I am unwilling to assume that today's wonderful insurance conditions will persist for a prolonged period.  I would be happy in 10 years if I am wrong today!

 

 

SJ

 

I should have read this before replying - nailed it I think!

 

The one query I have is how much CR and rates are related. It may be that 0% rates forces capital into the industry and CR's down, and 5% rates have the opposite effect. In other words I suspect the sources of operating earnings are highly correlated, and if you assume rates are now higher for longer, all insurance companies will earn more. But equally, the cost of capital is by definition higher in that scenario, and the net impact on stock price makes my head hurt.

[petec]

On 8/20/2023 at 1:27 PM, MMM20 said:

But I do think there is now a totally plausible upside case in which you could pay $4000 today and make ~10% returns long term from there.

 

I would put the probability of this at about 1%, but only because nothing really has a 0% probability.

 

But if you want my stock for $4000 you're welcome

[Viking]

8 hours ago, SafetyinNumbers said:

I chat with quite a few Fairfax holders and my impression is that many of them are looking for reasons to sell. I think it’s mostly to avoid drawdowns which might lead them to feel or worse look stupid. Especially to their bosses/clients if they are portfolio managers. Meanwhile, the index huggers just buy stock on VWAP so are price insensitive. 

 

Personally, I think it makes little sense to consider selling until Fairfax trades at least 1.5x book value because that seems likely over the next 5 years given how underowned Fairfax is by Canadian PMs benchmarked to the S&P/TSX and how active shareholders like ourselves see very strong book value growth over the same period.

 

In the past three years, Fairfax has gone from 47bps in the index to 89bps. The shares outperformed the index by 170% but that was offset by growth in capitalization of the index and Fairfax’s share buybacks.

 

It’s already very hard for active PMs not to own Fairfax given how it’s crushed the index recently but given the built in growth that I think we all agree is highly probable, if the stock just stays at 1x BV, it’s weighting will go well above 100bps and the urgency to own it will increase. 

 

It’s easy to think up narratives PM’s will use to justify paying up to 1.5x BV. They can point to comps like BRK, MKL that trade there. They can point to long term and recent ROE north of 15%. They can point to exposure to Greece and India in the equity portfolio and how cheap it is although that might be to justify paying 2x BV!

 

I really want to avoid selling too early because I think we could be in the first year of Fairfax’s 95-98 experience where ROE hit 20% four years in a row and the multiple went from 1.5x BV to > 3x BV. Fairfax also increased shares outstanding (Singleton like) by 33% which contributed to the growth in book value from $39 to $112.

 

These analogs are all pretty useless except they do show us what’s possible if not probable. It’s easy to hold or buy at 1x book value, it will be much harder north of 1.5x but I don’t have to worry about steeling myself until we get there. In 1995, the starting point was 1.5x BV. I don’t know if I would have been interested back then even if I had my knowledge now. That set of shareholders didn’t make it easy for the index huggers as the market cap grew from ~$800m to north of $7b. Maybe this set of shareholders is jaded enough given the last decade to hand over their shares easily but I’m trying to hold on to mine.

 

Of course, everyone should do whatever makes them comfortable. This is not investment advice. It’s just my thought process for which I welcome criticism.

@SafetyinNumbers Given the run that Fairfax has had the past 3 years, it does not surprise me that some investors are looking to lighten up, especially if Fairfax is now too big of a weighting in their portfolio. I call that a ‘first class’ kind of problem to have. 
 

Personally, i think Fairfax is still ‘dirt cheap.’ I love the push back from others on this board who feel that Fairfax is no longer ‘dirt cheap.’ Sorry, you haven’t convinced me (yet) with your pushback. My read is earnings are going to be much more resilient looking out 3 or 4 years than you think. We will see in another 12-24 months who is right. And that is what i love about investing (and this board). We share ideas and discuss/debate. We all do our own analysis. We place our bets. And we live with the results. Hopefully we earn enough along the way to be able to keep playing the game. Best of luck to everyone. 

[Viking]

33 minutes ago, petec said:

hIf we agree FFH's operating earnings are in large part rate-dependant, then we're straying into territory where I don't trust my opinions, and I don't assume that this level of earnings is sustainable.

@petec Why do you think FFH’s operating earnings are in large part rate-dependent? What do you see that is going to cause a big fall off in 2026 and later? Recession? 
 

1.) underwriting income

2.) interest and dividend income

3.) share of profit of associates

 

Interest rates especially further out on the curve have been moving higher over the past 2 months. That is very bullish for Fairfax. That means interest and dividend income is likely going even higher as a significant amount of bonds likely mature each quarter and are reinvested likely at much higher rates. Fairfax’s fixed income portfolio has an average duration of 2.4 years (very low compared to peers). What if they extend this in 2H 2023 to 2.75 or even 3 years? They likely couldn’t extend duration in Q2 partly because they had to come up with $1.8 billion to buy the PacWest loans. But Q3? We will see.

 

My point is it looks to me like you are assuming rates come down rapidly over the next year and Fairfax gets caught flat footed (operating income falls dramatically in 2025 and later). My view is for every risk there will be opportunity. If we get a recession, yes, treasury rates will likely fall. But credit spreads will also likely widen out. And that will allow Fairfax to flip into corporates and higher yields. My point is i think you are thinking about downside risk. And not giving any credit for the value of active management being able to take advantage of the mouth watering opportunities that will present themselves. 

 

[petec]

1 hour ago, Viking said:

@petec Why do you think FFH’s operating earnings are in large part rate-dependent? What do you see that is going to cause a big fall off in 2026 and later? Recession? 
 

1.) underwriting income

2.) interest and dividend income

3.) share of profit of associates

 

Interest rates especially further out on the curve have been moving higher over the past 2 months. That is very bullish for Fairfax. That means interest and dividend income is likely going even higher as a significant amount of bonds likely mature each quarter and are reinvested likely at much higher rates. Fairfax’s fixed income portfolio has an average duration of 2.4 years (very low compared to peers). What if they extend this in 2H 2023 to 2.75 or even 3 years? They likely couldn’t extend duration in Q2 partly because they had to come up with $1.8 billion to buy the PacWest loans. But Q3? We will see.

 

My point is it looks to me like you are assuming rates come down rapidly over the next year and Fairfax gets caught flat footed (operating income falls dramatically in 2025 and later). My view is for every risk there will be opportunity. If we get a recession, yes, treasury rates will likely fall. But credit spreads will also likely widen out. And that will allow Fairfax to flip into corporates and higher yields. My point is i think you are thinking about downside risk. And not giving any credit for the value of active management being able to take advantage of the mouth watering opportunities that will present themselves. 

 

 

I am not *assuming* anything - that's not how I invest. I just try to think through all the reasonably plausible scenarios to get a sense of the risks (in both directions).

 

I *very largely* agree with your analysis, which is why Fairfax is my largest position. I also agree that rising long bond yields are a potential boon.

 

But I can also envision a scenario in which inflation continues falling, rates settle back a bit lower, more capital enters the industry, Fairfax cedes and operating earnings fall. Or a recession, in which case all of those things might be combined with reduced demand and rising claims.

 

Much more importantly for me, if you're valuing it on PE, you're basically making an assumption about *terminal* earnings power, not just earnings power over the next 3 years. This is a critical point. I don't really disagree with your 3-year assessment as being the most probable pathway from here. But I am not so convinced that this level of earnings can be sustained from 2026 until eternity, which is what a PE valuation effectively calls for. That's why I value this on 2-3y forward BV.

 

 

 

 

 

 

 

 

[Xerxes]

4 hours ago, petec said:

 

I should have read this before replying - nailed it I think!

 

The one query I have is how much CR and rates are related. It may be that 0% rates forces capital into the industry and CR's down, and 5% rates have the opposite effect. In other words I suspect the sources of operating earnings are highly correlated, and if you assume rates are now higher for longer, all insurance companies will earn more. But equally, the cost of capital is by definition higher in that scenario, and the net impact on stock price makes my head hurt.

Hi Pete ,

did you mean the reverse ?

0% rates forces capital into the industry and CR's UP, and 5% rates have the opposite effect.
 

- - -

 

as far as the on-going conversation here is concerned, my concern would be if BV goes down on a sustainable basis !!
 

So (absent some catastrophe) whether after-three years, and post hard market, their operating earning drop from today’ peak earning, is not really of concern for me because I didn’t pay 1.2 book for it. 
 

even buying today as BV, you are still catching the growing NAV, which will grow at a slow rate past peak earning. 
 

put it differently, end of the hard market does not mean BV dropping. Just that it will grow much slower, as one of FFH’ growth engine start to falters. At that point in time, value per share (rather than just value) will start to matter more as surplus capital get funnelled to share repurchase as organic business growth stalls.  

[MMM20]

5 hours ago, petec said:

 

I would put the probability of this at about 1%, but only because nothing really has a 0% probability.

 

But if you want my stock for $4000 you're welcome

I’ll model it out for you and maybe we’ll both get the chance to sell to compounder bros. 

[MMM20]

6 hours ago, petec said:

 

The one query I have is how much CR and rates are related. It may be that 0% rates forces capital into the industry and CR's down, and 5% rates have the opposite effect. In other words I suspect the sources of operating earnings are highly correlated, and if you assume rates are now higher for longer, all insurance companies will earn more. But equally, the cost of capital is by definition higher in that scenario, and the net impact on stock price makes my head hurt.

Maybe in theory better operating conditions immediately attract new entrants who drive profitability down, but we have just come from an unprecedented environment in which both 1) rates moved the quickest ever off the lower bound and 2) weather (climate?) losses are all time high and going higher. And so with the collective industry balance sheet so hobbled and required returns higher, this was already happening much more slowly and that dynamic might even be accelerating (decelerating?) now. It’s sort of a perfect storm for FFH and few others to continue taking share at much higher pricing. Maybe recent cycles are not really representative.

 

 

Time to stay patient and not unnecessarily interrupt the 8th wonder of the world… the hardest part of this.
 

Just my hypothesis at least. 

 

Edited August 22, 2023 by MMM20

[SafetyinNumbers]

Lots of discussion of what might happen to the downside without a lot of odds or timing included. A lot of positive things could also happen with the equity portfolio which seemingly almost no one is counting on for a contribution to ROE. I’m also curious what kind of valuation multiple the momentum and index hugging buying can take us. I’m guessing we find out post hurricane season as both buyers and sellers will be less afraid of a near term drawdown.