Fairfax 2023

[Viking]

9 hours ago, Munger_Disciple said:

Somewhat Conservative Valuation of Fairfax

 

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

Assumptions:

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

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

 

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

 

According to Buffett, investors need to determine 3 things: 

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

The prevailing interest rate is also important:

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

-----------

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

 

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

 

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

 

 

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

 

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

 

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

 

So what explains the difference? 

 

Let's compare our estimates.

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

Summary:

 

Two buckets explain most of the difference in our forecasts:

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

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

 

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

 

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

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

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

 

What is the major flaw with my estimates? 

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Edited September 18, 2023 by Viking

[StubbleJumper]

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

 

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

 

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

 

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

 

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

 

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

 

 

SJ

Edited September 18, 2023 by StubbleJumper

[MMM20]

I think these frameworks need to be combined.

 

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

 

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

 

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

 

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

 

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

 

Edited September 18, 2023 by MMM20

[nwoodman]

25 minutes ago, MMM20 said:

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

 

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

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

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

[Viking]

50 minutes ago, StubbleJumper said:

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

 

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

 

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

 

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

 

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

 

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

 

SJ

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

 

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

 

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

Edited September 18, 2023 by Viking

[glider3834]

3 hours ago, Viking said:

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

just on corporate overhead

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

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

 

 

Edited September 18, 2023 by glider3834

[glider3834]

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

 

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

 

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

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

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

 

 

 

 

 

[Munger_Disciple]

8 hours ago, StubbleJumper said:

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

 

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

 

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

 

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

 

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

 

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

 

 

SJ

 

+1

Yes, I have tried to estimate "normalized earnings" of Fairfax, not what they are in the next year or two. 

[Munger_Disciple]

@Viking I don't expect you or anyone else to agree with my estimate of normalized earnings for Fairfax. I did it for my own benefit.  I try to be conservative in my estimates, and that is my margin of safety. Since I received so much value from others' posts including yours, I decided to share my view. It doesn't bother me that you have way higher & different estimates. To each his own.....

 

I would just add a few more things:

1. It is much more important to look at normalized earnings power than temporarily high earnings in the next few quarters for any company. None of the cyclicals like mining companies or commodity companies trade based on cyclical peak earnings for a  reason. Believe it or not , insurance is a cyclical business. As you very well know, intrinsic value of any company doesn't take into account just the next few quarters.  
2. The main difference (from what I can tell) between your view & mine is that you are willing to assume way better CR for the insurance businesses than I am. I would caution you to heed Buffett's advice that almost all surprises in insurance tend to be negative. Furthermore, assuming 100CR is not the worst case scenario for insurance over the cycles, so I am trying to give benefit to FFH for their possibly improved operations. I would be happy to be wrong on the upside but it would really suck to be wrong on the downside given the high insurance operating leverage at Fairfax.  
3. Regarding valuation, I tend to focus more on the downside of any investment than the upside. You can call it a lesson learned at the school of hard knocks. If I am wrong about the upside potential, I would be delighted; it is always the left tail that bites us in the a$$. 
4. Finally I would echo @StubbleJumper's sentiment that neither you nor me are saying that FFH is overvalued. We just have different views on its cheapness. 

Edited September 18, 2023 by Munger_Disciple

[MMM20]

1 hour ago, Munger_Disciple said:

It is much more important to look at normalized earnings power than temporarily high earnings in the next few quarters for any company. None of the cyclicals like mining companies or commodity companies trade based on cyclical peak earnings for a  reason.

 

Respectfully, I think this is a fallacy and applying this mental model to Fairfax now is one reason it remains so cheap to intrinsic value. 1) We're not talking about the market paying a market or above-market multiple of peak earnings (if they're even peak earnings). We're talking ~5x, arguably a ~8-10x multiple of mid cycle. "Fair" in that simple sense is probably 50-100% higher anyway. 2) We are not talking about the man with a hammer syndrome that affects many cyclical commodity management teams. Fairfax management are value investors and can literally just park the cash flow (again, we're talking about them potentially adding an absurd ~50%+ to shareholder equity over ~3 years) in short term bonds at 5% and go on offense when it makes sense. And I mean, this isn't speculation - we literally just saw them do exactly that going into this hiking cycle. I think many investors overlook this point, maybe because they don't agree that Fairfax management are great capital allocators. If you have management like OXY's that sends back capital at $90 oil... well, then you see Buffett averaging up!

 

Edited September 18, 2023 by MMM20

[Munger_Disciple]

10 minutes ago, MMM20 said:

 

I think this is a fallacy and that applying this mental model to Fairfax is one of the reasons it remains so absurdly cheap. 1) We are not talking about paying a market or above-market multiple of peak earnings right now (if they're even peak earnings). We're talking ~5x, arguably a ~8-10x multiple of mid cycle. "Fair" in that simple sense is probably 50-100% higher anyway. 2) We are not talking about the "man with a hammer" syndrome that affects many cyclical commodity management teams. Fairfax management are value investors and can literally just park the cash flow in short term bonds at 5% and go on offense when it makes sense. I think many investors overlook this point, maybe because they don't agree that Fairfax management are great capital allocators. If you have a management team like OXY that sends back cash to shareholders at $90 oil, well, you see Buffett averaging up for a reason!

 

 

 

 

I can only conclude from your post that you disagree that one should look at normalized earnings for FFH. If so, we can agree to disagree.

 

As I said before, it doesn't bother me that others have higher estimates for FFH & it shouldn't bother you that someone else may have lower estimates. That's what makes it a market anyhow.  

Edited September 18, 2023 by Munger_Disciple

[MMM20]

5 minutes ago, Munger_Disciple said:

 

I can only conclude from your post that you disagree that one should look at normalized earnings for FFH. If so, we can agree to disagree.

 

As I said before, it doesn't bother me that others have higher estimates for FFH & it shouldn't bother you that others may have lower estimates. That's what makes it a market anyhow.  

 

I agree that we should look at normalized earnings. But I don't agree that we should look through what could be a few years of ~$160+ earnings, which is what your methodology implies, because I don't expect them to light those earnings on fire like most cyclical commodity management teams. And that quantum of earnings, even if peak earnings, will be ~95% retained and so should mean a step function in "normalized" earnings a few years out with reasonable capital allocation. I think it's fair to look at it both ways and capitalize Year 4 "normalized" earnings and discount all of it back. That gets me to $2500+ IVPS.

 

Edited September 18, 2023 by MMM20

[Munger_Disciple]

1 minute ago, MMM20 said:

 

I agree that we should look at normalized earnings. I don't agree that we should look through what could be a few years of ~$160+ earnings because I don't expect them to light those on fire. And that quantum of earnings, even if peak earnings, should mean a step function in "normalized" earnings a few years out. I think it's fair to look at it both ways and capitalize Year 4 "normalized" earnings and discount it all back, and that gets me to $2500+ IVPS right now.

 

To each his own

Edited September 18, 2023 by Munger_Disciple

[MMM20]

2 minutes ago, Munger_Disciple said:

 

To each his own

 

Yes, I'll continue to assume Fairfax will not light capital on fire

[SafetyinNumbers]

Ultimately, it doesn’t really matter if we think it’s under or overvalued. Current supply is probably from those that think it’s fairly valued. Most of those likely sold earlier in hurricane season (why not if it’s fairly priced in their opinion) and perhaps that explains why volumes have diminished recently. Active buyers might wait until we are through hurricane season before becoming more aggressive and I think they will be accompanied by index huggers who buy on VWAP (that buying never stopped). 
 

There seems to be relatively high certainty despite the consensus estimates that book value is going to be at least 50% higher in 3-5 years and as long as the stock tracks book that means the weighting in the index will be going up all else being equal. It’s at 87bps now and based on the near term earnings, it seems likely the stock will be through 100bps soon. At that point, it will be much harder for the PMs that “hate Prem” to not take another look. It’s a much easier decision to buy than chasing CSU as a value manager in 2018 when it crossed 100bps but now that everyone is a quality growth manager they will have to find a way to forget the past and buy FFH based on its quality growth.

 

Analysts will get bolder with their estimates and will start to model in growth in earnings. Instead of declining ROEs, they might model a steady 15% which they know will be wrong but shows growth year over year based on compounding. That will bring quant investors in droves which will invite every other active investor left to take a look. My concern is selling too early in this process. Momentum is more pronounced than it’s ever been given the popularity of passive and quants. Things could get out of hand and I’m here for it. 

[Munger_Disciple]

@Viking

I think @StubbleJumper explained very well the difference between our views. At a high level you are focusing on 2 or 3-year estimates whereas I am looking at what sustainable normalized earnings may look like. 

 

Your arguments about me not taking compounding into account & thus looking at FFH as a non-growing static entity are not valid. With my assumptions, I implicitly assumed FFH can compound at 10% per year by reinvesting earnings back into its business with any added P/B expansion juicing the results a tiny bit (thus adding an additional 1-2% return per annum for awhile, but not forever). And I would be happy with 10% compounded results over the next decade. 

More importantly, you seem to be thinking that $160 per share earnings for the next couple of years are already in the bag. This ignores a fundamental fact. Insurance underwriting is a probabilistic game. One could be right about the odds and still lose money on any single bet (or in any single accident year). You only know whether you are winning or losing in a probabilistic game with a large number of repeated trials, or in the case of an insurance company over many years covering long cycles. As an example let us say someone offers you 3 to 1 odds on a fair coin toss coming up heads. You would take that bet all day. But on any given coin toss you could lose; that doesn't mean you made a mistake in underwriting that bet. And the Kelly Criterion tells us what % of bankroll we should bet on a game where the expected value of the outcome is positive but we could naturally lose money on any single throw. Similarly, Fairfax could lose a ton of money in insurance next year due to hurricanes, fires, mud slides, terrorism, whatever; that doesn't necessarily mean that their insurance underwriting is bad. It just means that they are playing a probabilistic game. So no, your $160 estimate is not in the bag because you incorrectly assume that underwriting profit is a given in the next year or two. 

 

Edited September 19, 2023 by Munger_Disciple

[jbwent63]

Terrific discourse here folks. My $0.02 is that in valuing businesses you try to come up with maintainable earnings (EBITDA, EBIT etc.) which are based not only on history but your assessment of the future. Like some, I believe FFH has turned a corner and that the past is not a good indicator of the future. Of course with P&C insurance the CR could be 90 or 110, but based on recent history and the track record of underwriting FFH's subsidiaries have created, I would be more inclined to discount the chance of 110 much more than the liklihood of 90. In any event we all see things differently and I appreciate the views expressed by the above writers.

[Viking]

25 minutes ago, Munger_Disciple said:

More importantly, you seem to be thinking that $160 per share earnings for the next couple of years are already in the bag. 

@Munger_Disciple to be clear, i may have a lot of conviction in my estimate for 2023. I have never said any estimate is ‘in the bag’. That, of course would be idiotic. As we move to 2024, the estimate gets less clear. 2025 even less. And i don’t even attempt to forecast 2026 as there are too many moving parts. 
 

You have built an estimate… i have built an estimate. We both have provided our logic. Discussing the build is how we learn. I appreciate the opportunity to debate.
—————

Below is what i said in my response to you two days ago
 

What is the major flaw with my estimates? 

 

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

 

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

 

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

 

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

[Crip1]

Respectful disagreement discussions allow far better opportunity to learn than any other, so thanks to all for the viewpoints and the means by which said viewpoints are presented.

 

A perfect crystal ball does not exist, so nobody is going to be right. What looks to be clear now is that Fairfax is in the middle of an extraordinary (albeit finite) growth period where the hard market is juicing the returns for the company. I think that Viking makes a compelling case that 2023 – 2025 will show extraordinary returns, so I like the idea of using his 3 year projection (with a haircut if one is so inclined). As the ’23-’25 projections are not guaranteed, any projections beyond that time are most certainly unknown. Munger_Disciple’s projections (Combined Ratio, returns on Fixed Income and Equity Portfolios, etc) present a reasonable look at what we can expect 2026 and beyond.

 

The goal would be two fold. First, look at Viking’s projection to calculate the annual cash flows between now and 2025. Second, using the size of the company at the end of 2025, apply the MD’s methodology to project the next 3-5 years cash flows. From there, the company will clearly still have a value which we can approximate as BV at the end of the 3-5 year period. Finally, discount all of these back to present value and that will give us an implied value now. The more that value is above current price, the better a buy the company is today (and, of course, if that value is less than current price, the company is not worth the investment.

 

Obviously, there are so many variables that this cannot be counted upon with precision. Rather, it gives an idea of what the company should be worth right now. Any attempts to be more precise are likely going to be fruitless, rather, we’re going to have to be happy with being approximately right as opposed to being precisely wrong.

 

-Crip

[MMM20]

More broadly, I've come to the conclusion that most investors won't give Fairfax a fair look. For most, it's either outside their circle of competence or they're indexers/quants who will never care or will need to see the transformation if in the reported numbers for at least this year. Others have too much baggage and can't look at the company anew. Still others for the sake of conservatism will simply use arbitrarily low estimates that imply a dim view of the company's transformation. Therefore, the stock will have to continue climbing a wall of skepticism. That's fine. Without any heroic assumptions, it might give the company the chance to take out 20%+ of the shares at a steep discount to IV over the next few years, depending of course on alternative uses of capital. I'm just here for the ride unless it triples overnight or something fundamental changes out of left field.

 

Edited September 20, 2023 by MMM20

[StubbleJumper]

Funny story about my most recent FFH two-bagger.

 

As everybody knows, in late 2021 FFH initiated a substantial issuer bid which ultimately was priced at US$500/sh.  Wanting to do a little low risk arbitrage, I reorganized a pile of assets in my tax-advantaged accounts and loaded up on FFH at ~US$450/sh and then tendered the whole works.   To my great surprise, the tender offer was over-subscribed and I was prorated, with only 90% of my tender being accepted.  As it worked out, tendering 90% of those shares at US$500 gave me a full return of the capital that I had used to buy 100% of the shares at US$450.  My intention was to unload the 10% extra shares some time in early 2022 as I already owned a boat-load of FFH prior to the tender announcement.

 

Well, what does Buffett say about investing?  It requires long periods of inactivity bordering on sloth.  And sometimes it also involves a wee bit of neglect, sloppiness and other forms of inattention.  I never did get around to selling those 10% of shares that were not accepted in the tender.  Nearly two years later, those surplus shares are perilously close to becoming a two-bagger.

 

Good thing for me that the SIB ended up being oversubscribed and that I got busy in early 2022 and failed to sell the excess shares.  Sometimes it's better to be lucky instead of good.

 

 

SJ

[Crip1]

14 minutes ago, StubbleJumper said:

Funny story about my most recent FFH two-bagger.

 

As everybody knows, in late 2021 FFH initiated a substantial issuer bid which ultimately was priced at US$500/sh.  Wanting to do a little low risk arbitrage, I reorganized a pile of assets in my tax-advantaged accounts and loaded up on FFH at ~US$450/sh and then tendered the whole works.   To my great surprise, the tender offer was over-subscribed and I was prorated, with only 90% of my tender being accepted.  As it worked out, tendering 90% of those shares at US$500 gave me a full return of the capital that I had used to buy 100% of the shares at US$450.  My intention was to unload the 10% extra shares some time in early 2022 as I already owned a boat-load of FFH prior to the tender announcement.

 

Well, what does Buffett say about investing?  It requires long periods of inactivity bordering on sloth.  And sometimes it also involves a wee bit of neglect, sloppiness and other forms of inattention.  I never did get around to selling those 10% of shares that were not accepted in the tender.  Nearly two years later, those surplus shares are perilously close to becoming a two-bagger.

 

Good thing for me that the SIB ended up being oversubscribed and that I got busy in early 2022 and failed to sell the excess shares.  Sometimes it's better to be lucky instead of good.

 

 

SJ

Mae West: Too much of a good thing can be wonderful.

[Viking]

52 minutes ago, Crip1 said:

Respectful disagreement discussions allow far better opportunity to learn than any other, so thanks to all for the viewpoints and the means by which said viewpoints are presented.

 

A perfect crystal ball does not exist, so nobody is going to be right. What looks to be clear now is that Fairfax is in the middle of an extraordinary (albeit finite) growth period where the hard market is juicing the returns for the company. I think that Viking makes a compelling case that 2023 – 2025 will show extraordinary returns, so I like the idea of using his 3 year projection (with a haircut if one is so inclined). As the ’23-’25 projections are not guaranteed, any projections beyond that time are most certainly unknown. Munger_Disciple’s projections (Combined Ratio, returns on Fixed Income and Equity Portfolios, etc) present a reasonable look at what we can expect 2026 and beyond.

 

The goal would be two fold. First, look at Viking’s projection to calculate the annual cash flows between now and 2025. Second, using the size of the company at the end of 2025, apply the MD’s methodology to project the next 3-5 years cash flows. From there, the company will clearly still have a value which we can approximate as BV at the end of the 3-5 year period. Finally, discount all of these back to present value and that will give us an implied value now. The more that value is above current price, the better a buy the company is today (and, of course, if that value is less than current price, the company is not worth the investment.

 

Obviously, there are so many variables that this cannot be counted upon with precision. Rather, it gives an idea of what the company should be worth right now. Any attempts to be more precise are likely going to be fruitless, rather, we’re going to have to be happy with being approximately right as opposed to being precisely wrong.

 

-Crip

@Crip1 well said. What are your thoughts about the interplay between underwriting profit and investment returns? Are they linked? Can we put numbers to each?
 

At the end of the day, publicly traded P/C insurance companies need to make a 8-10% ROE over time. The CEO’s want to hit their bonus payouts and also keep their jobs.
 

As a result, i think CR and investment results are linked. Let’s assume fixed income yields stay at the elevated levels we are seeing today. Can a 100 CR get a company to a 10% ROE? Maybe Fairfax today because of the leverage they have with float. But i think most P&C insurers would struggle to deliver an ROE of close to 10%. Given most have taken a capital hit on their fixed income portfolios due to rising interest rates i just don’t see a big or rapid turn to a soft insurance market. Bond yields are still too low. And insurance companies lots of near term risks they need to build into their models when pricing (elevated catastrophe losses, reinsurance costs, inflation etc).   

Edited September 19, 2023 by Viking

[TwoCitiesCapital]

20 minutes ago, Viking said:

@Crip1 well said. What are your thoughts about the interplay between underwriting profit and investment returns? Are they linked? Can we put numbers to each?
 

At the end of the day, publicly traded P/C insurance companies need to make a 8-10% ROE over time. The CEO’s want to hit their bonus payouts and also keep their jobs.
 

As a result, i think CR and investment results are linked. Let’s assume fixed income yields stay at the elevated levels we are seeing today. Can a 100 CR get a company to a 10% ROE? Maybe Fairfax today because of the leverage they have with float. But i think most P&C insurers would struggle to deliver an ROE of close to 10%. Given most have taken a capital hit on their fixed income portfolios due to rising interest rates i just don’t see a big or rapid turn to a soft insurance market. Bond yields are still too low. And insurance companies lots of near term risks they need to build into their models when pricing (elevated catastrophe losses, reinsurance costs, inflation etc).   

 

Supposedly they are linked, but weren't CRs high while interest rates were low in the late 2010s? 

 

And now CRs have been low for a bit while interest rates have been rising quite a bit?

 

And the higher interest rates go destroys more capital keeping CRs low due to higher underwriting prices? 

 

The rationale of why they are linked makes a lot of sense to me, but I'm not seeing it in the results. At what point does the "rationale" assert itself? And why has it not been asserting itself in the last 5-7 years? 

[Santayana]

I completely understand @Munger_Disciple's points about the risks, but I feel like the biggest risks to Fairfax at this are actually industry risks, and that Fairfax is better positioned than most right now.