Fairfax 2023

[SafetyinNumbers]

Has anyone done analysis on the administrative expense of underwriting i.e. the part of the combined ratio that does not include claims paid? It seems like Fairfax insurance businesses have grown so much recently that should result in scale advantages which all else being equal makes the combined ratio structurally lower. A point or two really matters.

[Viking]

1 hour ago, TwoCitiesCapital said:

 

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? 

I think the last true hard market in PC insurance was around 2004. That suggests the insurance cycle can run in a 20 year cycle from hard to soft and back to a hard market. At the same time, you also have an interest rate cycle. Interest rates peaked in 1980 and the trough was 2020. That 1/2 cycle in rates was 40 years. 
 

What does this tell us about how to value Fairfax today? I am pretty sure the two are linked. But i have no idea how to overlay that linkage to how i value Fairfax. 
 

Perhaps management is the key. Good management teams will usually thrive over time. Bad management teams will usually struggle/fail. And cycles will happen like they always do. 

[Munger_Disciple]

4 hours 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.

 

 

 

[Crip1]

16 hours 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).   

Viking, you asking me a question like this is not unlike Bill Belichick asking me about football!

 

Interest rates most definitely have an impact on combined ratio as higher interest rates will, all things being equal, allow for higher combined ratio. Laws of supply and demand factor in as well as excess capital will apply upward pressure to CRs. 

 

-Crip

[SafetyinNumbers]

16 hours ago, SafetyinNumbers said:

Has anyone done analysis on the administrative expense of underwriting i.e. the part of the combined ratio that does not include claims paid? It seems like Fairfax insurance businesses have grown so much recently that should result in scale advantages which all else being equal makes the combined ratio structurally lower. A point or two really matters.

In 2018 ~$2b in other underwriting expenses vs ~$12b in net premiums. In 2022 ~$2.7b in other underwriting expenses vs ~$21b in net premiums. Not sure how that compares to others but it’s a material improvement in the expense ratio.

[UK]

8 minutes ago, SafetyinNumbers said:

In 2018 ~$2b in other underwriting expenses vs ~$12b in net premiums. In 2022 ~$2.7b in other underwriting expenses vs ~$21b in net premiums. Not sure how that compares to others but it’s a material improvement in the expense ratio.

 

This is a very good point! So from almost 17 to 13 per cent. Almost all improvement in CR and all structural? Also, if I recall correctly, Prem talked about scale needed, while was acused for empire building...

[SafetyinNumbers]

25 minutes ago, UK said:

 

This is a very good point! So from almost 17 to 13 per cent. Almost all improvement in CR and all structural? Also, if I recall correctly, Prem talked about scale needed, while was acused for empire building...

I think that’s the right way to interpret the data but I’m not an insurance expert.

 

Using stock at 1.3x book value to get scale in insurance is part of the Singleton playbook that investors generally don’t focus on but it’s part of why the stock got so depressed (a lot more shares for investors to absorb) and why the opportunity is so good now. 

[Hamburg Investor]

18 hours ago, Santayana said:

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.

Spot on. And it's not only better positioned; it's valued way cheaper.

[Hamburg Investor]

On 9/18/2023 at 10:20 AM, Viking said:

 

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.

 

 

Very exciting discussion between @Viking and @Munger_Disciple. Thank you!

Maybe some thoughts on this: In the end, Munger's approach reminds me a bit of the early Buffett of Cigar Butt Investments. Of course not really, because Munger is also interested in the PE ratios and not the liquidation value; but Munger just insists on a very cautious assessment of the earnings, also sees no moat, and thus consequently focuses very strongly on the "margin of safety"; and especially this point reminds me of Cigar Butt.

Viking, on the other hand, I often understand to mean that with the many in-depth analyses of the individual parts and the many changes in perspective, he ends up - in my perception - shedding much more light on management and its capabilities, and thus, in my view, the overall picture evolves of a value-oriented company that has become increasingly well-managed over the years and that uses "float" as leverage. Whereas decades ago, CRs were regularly extremely poor relative to the market, Fairfax has averaged a few percentage points better than the market over the past decade. Thus, Prem is following much more closely in the footsteps of a Buffett or Gayner at this point. Fairfax has had by far the strongest premium growth of the top 25 insurers over the past three years. Many investments in India, Greece and the U.S. have paid off or are performing well right now. And so on. And then Viking also builds in a Margin of Safety (one that I personally think is sufficient and reasonable!), but just less conservative than Munger. So the picture that emerges is one of many positive individual decisions that form an overall picture of how Fairfax has changed after 2016. Viking's number analyses are important, but a second layer (management, moat) is forming, and I personally read a strong case for management and the presence of a moat above all else from the mosaic of many individual analyses. And at the end Viking also builds in a Margin of Safety, but to show a possible, conservatively realistic compounding perspective it is lower than Munger's. Both seem perfectly legitimate and consistent to me. They are just completely different methods.

Gayner explained in a podcast some time ago ("the evolution of a value investor") that he now pays much more attention to the development of a company than to its current state. In a sense, he said he is much more interested in the corporate movie that is being created over time than a still image (or something like that). If you have a company with a moat, the best way to recognize it is in a movie, that is, in an analysis over a longer period of time in the past, than by looking at just one point in time. I was very attracted to the idea.

It is probably rare that a company can already be considered cheaply valued without a moat and it (possibly; tbd) also has a moat on top. Otherwise, there would probably not have been this exchange here. Either way, there is a lot to be said for either a good investment or even one along the lines of "Once in a Lifetime" . We will see.
 

[SoonParted]

On 9/19/2023 at 12:17 PM, 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).   

I'm speculating here, but is there an effect where poor underwriting forces a larger proportion (beyond legal requirements) of low-yielding "safe" investments as a reserve against claims?  And good underwriting could allow for higher-return investments with a bit more risk.

[glider3834]

https://www.theinsurer.com/reinsurancemonth/brit-shows-blueprint-on-how-apollo-may-exit-3-5bn-aspen/

 

 

[giulio]

Fairfax now owns more than 25% of Ovostar Union pcl, an egg producer in Ukraine.

https://www.money.pl/gielda/komunikaty/6943676719220865.html

 

Looks like they are increasing exposure to the agri/food sector.

https://ovostar.ua/en/pro-kompaniyu/pro-nas/

 

[sleepydragon]

Just listened to this last night. Very informative and interesting:

 

https://spotify.link/uCxoomTAjDb
 

[newtovalue]

So we're past peak hurricane season and so far no major storms. 

 

Fingers crossed but looks like this season may be milder than in the past. This will be a huge windfall for all the insurance companies that wrote CAT insurance in Florida. I remember BRK had done it - but not sure if FFH - any insight from the board?

[gfp]

36 minutes ago, newtovalue said:

So we're past peak hurricane season and so far no major storms. 

 

Fingers crossed but looks like this season may be milder than in the past. This will be a huge windfall for all the insurance companies that wrote CAT insurance in Florida. I remember BRK had done it - but not sure if FFH - any insight from the board?

 

Fairfax certainly has exposure to hurricane risk and profit but is much more diversified in their cat exposure.  Berkshire this year is extremely unbalanced in their cat exposure with unusual concentration in Florida hurricane risk.  Fingers crossed, there is still plenty of Hurricane season left.

 

Quote from Peter Clarke on the most recent (august) conference call -

Quote

Peter Clarke

Yes. Thanks, Nik. You're exactly right. The markets continue to harden, but especially on the property side and the property cat side. To date, we've grown marginally on property cat. We're taking advantages. We're seeing rate in excess of 30%. And our net exposure has been going up as we reduced the amount of reinsurance we bought. But generally speaking, we're evaluating that as we speak. It continues to be a very good market, the property cat market. And we'll look at it again on the 1/1 renewals.

 

Edited September 24, 2023 by gfp

[SafetyinNumbers]

4 hours ago, gfp said:

 

Fairfax certainly has exposure to hurricane risk and profit but is much more diversified in their cat exposure.  Berkshire this year is extremely unbalanced in their cat exposure with unusual concentration in Florida hurricane risk.  Fingers crossed, there is still plenty of Hurricane season left.

 

Quote from Peter Clarke on the most recent (august) conference call -

 

Still not out of the woods on hurricane season but Q3 consensus EPS is only ~US$25 and that seems very beatable without large cat losses in the quarter. I think it’s why the stock made new highs this week. Presumably FFH is trading below book value again based on real time book value.

[Viking]

4 hours ago, newtovalue said:

So we're past peak hurricane season and so far no major storms. 

 

Fingers crossed but looks like this season may be milder than in the past. This will be a huge windfall for all the insurance companies that wrote CAT insurance in Florida. I remember BRK had done it - but not sure if FFH - any insight from the board?

Strictly from a financial perspective, we all should be praying for a couple of bad hurricanes. Small hit to short term results. But it would likely extend the hard market another year of two - resulting in higher for longer profits (price increases and better terms and conditions).
 

I think much of what people are discounting into their models when valuing Fairfax is too pessimistic and one sided. Because each risk has a corresponding opportunity. Discounting the risk and not adding back some of the opportunity is not being conservative. That makes no sense to me.

[SafetyinNumbers]

3 hours ago, Viking said:

Strictly from a financial perspective, we all should be praying for a couple of bad hurricanes. Small hit to short term results. But it would likely extend the hard market another year of two - resulting in higher for longer profits (price increases and better terms and conditions).
 

I think much of what people are discounting into their models when valuing Fairfax is too pessimistic and one sided. Because each risk has a corresponding opportunity. Discounting the risk and not adding back some of the opportunity is not being conservative. That makes no sense to me.

 

I think the long term analysis is complicated. The extra capital from avoided losses this season can be invested at high returns. If pricing gets worse and premium growth declines that would free up even more capital for potential equity investments. 
 

I think in the short term, the stock likely benefits if we avoid any meaningful cat losses in Q3. Hurricane season makes holders antsy and buyers reluctant. Between this hurricane season and next, I think we likely get some multiple expansion. 

[Viking]

2023 Interest and Dividend Income - Earnings Update

 

The key to forecasting is getting the ‘big rocks’ right. From an earnings perspective, there is no more important item to Fairfax today than interest and dividend income. From 2016-2022, this one ‘bucket’ represented a total of about 30% of Fairfax’s various income streams. With ‘higher for longer’ increasingly becoming the new reality for interest rates, interest and dividend income will likely increase in the near term to represent close to 40% of Fairfax’s various income streams.

 

If we can get can get our estimates for this part of earnings modelled properly we should be well on our way to coming up with a quality earnings estimate for the company as a whole.  

 

Interest and dividend income is quite simple. It is relatively easy to calculate. It is usually not very volatile quarter to quarter. And it is pretty predictable, looking out a couple of years. This is why interest and dividend income is considered the highest quality source of earnings for an insurance company. 

 

Bottom line, interest and dividend income is important to Fairfax (and investors) because of its size, growth and its quality.

 

Interest and dividend income - components

 

Fairfax reports ‘interest and dividend income’ as a line item on its Consolidated Statement of Income. It is made up of three parts:

• Interest income: received from the fixed income portfolio (cash, short term investments, bonds, derivatives and other invested assets)
• Dividends: received from equity portfolio (common and preferred stocks)
• Investment expenses: paid to Hamblin Watsa

When looking at ‘interest and dividends’ for Fairfax, dividends now represent less than 10% of the total. Interest income represents more than 90% of the total, so this is what we are going to focus on. 

 

Before we do the deep dive on interest income at Fairfax, let’s step back a look at the big picture. 

—————

 

What did we learn in financial markets this week? 

 

Like a splash of cold water to the face, financial markets are waking up to the likelihood that interest rates are not coming down any time soon. At the longer end of the curve, despite the big move that has happened over the past month, bond yields look like they could be headed even higher.  

 

What is ‘higher for longer?’ 

 

Higher for longer is the realization from financial markets that the Fed will likely need to keep interest rates elevated well into 2024. The Fed met this week and they delivered this message loud and clear. US economic growth continues to surprise to the upside. Employment is strong. Oil is back over $90. Although it has come down, inflation remains stubbornly high.

 

Further out on the curve, bond yields have reached new cycle (16 year) highs. Financial markets are likely saying they don’t think higher interest rates are going to cause a recession - the economy can handle higher interest rates. The current supply / demand situation also suggests rates further out on the curve might go even higher: issuance (supply) of longer dated treasuries has increased while demand remains muted and this has pushed prices lower (and yields higher). This supply/demand dynamic is expected to persist in 2H 2023. 

 

What were financial markets thinking at the end of 2022?

 

At the end of 2022, financial markets were expecting a recession in 2023. And it was expected the Fed would be cutting the Fed funds rate by 100 basis points in 2H 2023. 

 

Financial markets were completely wrong in December 2022. Today, they are now expecting Fed fund rate to peak near 5.5% in January 2024. And from there to slowly drift a little lower but to still be over 5% in July of 2024. 

 

Yes, financial markets could be wrong again. Bottom line, ‘higher for longer’ appears to be what has been getting priced into financial markets in recent weeks.    

 

Source: https://x.com/asif_h_abdullah?s=21

 

What does all this mean for Fairfax?

 

‘Higher for longer’ is a big deal for Fairfax. They have a $40 billion fixed income portfolio. As we discussed, interest and dividend income is already the largest driver of earnings for Fairfax. So an already big number is going to get even bigger.

 

The fixed income portfolio of Fairfax has a very short average duration of 2.4 years at June 30, 2023. This means a significant amount of their portfolio continues to mature each quarter. Compared to all other P&C insurers (not named WR Berkley - who is also at 2.4 years), Fairfax is able to reinvest a significant portion of their fixed income portfolio at still increasing interest rates. This means the quarterly run rate for interest income will likely continue to move meaningfully higher in the coming quarters. 

 

As a result of ‘higher for longer,’ estimates for interest and dividend income for Fairfax will need to be updated - yes, it is going higher. And given the importance of interest and dividends, this means earnings estimates will also need to go higher. Analysts are going to feel like they are living their own version of the movie Groundhog Day. However, we will not wait until Fairfax reports Q3 results to ‘discover’ what we already largely know - we are going to update our forecast for interest and dividend income in remainder of this post.

—————-

 

Interest Income - a deep dive

 

Two items drive interest income: 

• The size of the fixed income portfolio
• The average yield earned on the investments held in the portfolio

How big is the fixed income portfolio at Fairfax?

 

The fixed income portfolio at Fairfax increased in size from $20.3 billion in 2016 to $38.9 billion in 2022. The total increase was 92% and the annual compound growth rate was 11.5%.

 

My forecast is for the size of the fixed income portfolio to: 

• increase 8% in 2023 to $42 billion. This will be driven by growth in premiums from the continuing hard market. It will also be driven by earnings, some of which will likely be reinvested in fixed income securities. The continuing bear market in longer dated bonds is a small headwind (as the value of these securities fall).
• increase 12% in 2024 to $47 billion. Similar to 2023, this will be driven by the hard market and growth in earnings. The closing of the GIG acquisition will add $2.4 billion to fixed income portfolio. This may happen in Q4 of 2023. 
• increase 6.4% in 2025 to $50 billion. This is a very rough number. Strong earnings are expected to be a tailwind. We will fine tune this estimate when we get into 2024 as we get more information.   

Bottom line, we are seeing strong growth in the size of the fixed income portfolio at Fairfax and this should continue moving forward. 

 

How much did Fairfax earn on its fixed income portfolio? A look back.

 

Total interest income at Fairfax increased from $514 million in 2016 to $874 million in 2022. The total increase was 70% and the annual compound growth rate was 9.3%.

 

The average yield on the fixed income portfolio from 2016-2022 was 2.4%. Yes, that is a low number. From 2016, Fairfax has been positioned very conservatively with their fixed income portfolio (high quality and low duration). 

 

Green shoots: in 2022, interest income was $874 million, an increase of 54% over 2021. This was a new record for Fairfax. 

 

Active management matters again - duration and credit quality

 

One of their best investment decisions ever: in Q4, 2021 Fairfax shortened the average duration of their fixed income portfolio to 1.2 years. They also shifted to holding mostly government bonds. Of note, in Q4 of 2021, Fairfax sold $5.2 billion in corporate bonds at a yield of 1% and realized a $253 million gain (these bonds were purchased in March/April of 2020 when credit spreads blew out due to covid). 

 

And in 2022, the fed moved to aggressively moved to increase interest rates which unleashed hell on bond (and stock) markets. Of course, with their fixed income portfolio sitting at 1.2 years average duration, Fairfax avoided billions in losses on their fixed income portfolio. This positioning also allowed Fairfax to quickly benefit from much higher interest rates. Interest income bottomed out in Q4 2021 and has been relentlessly moving higher every quarter since then (more on this below). 

 

In 2022 Fairfax began extending duration to 1.6 years. And in 1H 2023 average duration has been increased further to 2.4 years. This is locking in higher rates for years into the future. 

 

‘Higher for longer,’ with yields on longer dated treasuries hitting 16 year highs this month, Fairfax has a wonderful opportunity to extend duration even more. This will be something to watch for when Fairfax reports Q3 results.

 

Quality management: lead by Brian Bradstreet, the fixed income team at Fairfax/Hamblin Watsa has been executing exceptionally well in recent years. This is not surprising - their track record over the long term has been outstanding. Another misunderstood and under appreciated part of Fairfax.

 

The move in US treasuries over the past 7 quarters has been epic - and that is not hyperbole.

 

Fun thought exercise

 

Can we estimate how much of Fairfax’s $40 billion fixed income portfolio is ‘maturing’ each quarter and what the pickup in yield is when the proceeds are reinvested at todays much higher rates? Let’s assume $2.5 billion is maturing each quarter and the yield pickup is 2%. If close to accurate, this suggest interest income should continue to grow at $50 million each quarter over the prior quarters number. And this should continue for the next couple of quarters.  

 

What to board members think? Too high?

 

Forecast for fixed income for 2023, 2024 and 2025

 

Given the importance of interest income to the Fairfax story we are going to get into the weeds a little bit more. 

 

Because so much has changed so fast over the past 24 months, historical numbers are pretty much useless to use on their own to estimate interest income. This is why most analysts have been so wrong with their earnings estimates for Fairfax over the past year. They are primarily using historical numbers to estimate interest income. In another couple of quarters, once interest income ‘normalizes’ then the analysts earnings estimates will better reflect reality. 

 

To build an accurate forecast for interest income we do need to start with historical numbers, as they provide a valuable baseline. But we need to use quarterly numbers. And then we need to overlay the new news (I call these ’swings’): 

• interest rate pickup - for bonds maturing each quarter which are then reinvested at much higher rates. Let’s assume $20 million per quarter. Likely way low. Is $50 million more accurate as per my numbers above? To be conservative let’s assume there is no interest rate pickup in 2024; my guess is there will be some in Q1.
• organic growth - this is growing the size of fixed income portfolio. Let’s assume an increase in the size of the fixed income portfolio of $2.5 billion x 4% = $100 million per year = $25 million per quarter. 
• new business - interest rate pickup: PacWest loans are expected to deliver a 10% total return. Some of this gain will be price. It seems reasonable to assume the yield pickup will be about 4% or 5% = $90 million per year = $22 million per quarter, starting in Q3, 2023.
• new business - increase in fixed income portfolio: when it closes the GIG acquisition will add another $2.4 billion to the fixed income portfolio. Let’s assume an interest rate of 4% = $100 million per year = $25 million per quarter. Let’s start this in Q1 2024. If the deal closes in Q4, as expected, we can move this forward a quarter when we do out next update.
• Fed rate cuts - let’s build in 2 rate cuts from the Fed in 2H 2024. Let’s assume this cut impacts $10 billion by 0.5% = $50 million annual decline = $12.5 million per quarter. To be conservative lets go with a decline of $25 million per quarter.

The key here is to try and understand what the largest drivers of change are and to do a very rough estimate of the impact. 

 

Bottom line, doing our estimate by quarter should add a lot of accuracy to our quarterly and annual estimates.

 

Step 1: Understand interest income swings by quarter

 

Below I have tried to capture the big ‘swings’ that will impact interest income moving forward. By breaking down the impact by quarter we now have a rough number we can add to our baseline numbers.

 

Please note, it is important to get these estimates approximately right. Some will be high. Other will be low. Collectively, they will should be close.

 

Step 2: Build our annual forecast by quarter

 

Together with our baseline (historical) numbers, we used the ’swings’ above to help us come up with our new forecasts for the remainder of 2023 and for 2024 and 2025. Note, i did take my ‘swings’ numbers above down a little for each quarter - to add some conservatism. 

 

My new forecast for interest income for Fairfax is:

• $1.865 billion in 2023, a YOY increase of 114%
• $2.4 billion in 2024, a YOY increase of 29%
• $2.24 billion in 2025, or a YOY decline of 7% 

This results is a portfolio yield of:

• 4.4% in 2023
• 5.1% in 2024
• 4.5% in 2025

The total number of $2.4 billion for 2024 looks high (just because it IS a huge number). But the portfolio yield of 5.1% looks reasonable (remember the Kennedy Wilson portfolio is about $4 billion and it is yielding around 8%). But these numbers are where my logic and math takes me so that is what I will go with for now. As new information comes in (or I discover errors in data to logic) I will update my forecasts. 

 

Important: this is my first stab as this kind of detail. So there will be errors. Please let me know where my logic is wrong so I can make the estimate better over time. Discussing/debating the assumptions/logic with others on the board is when the learning really happens. Thank you in advance

 

 

Interest and Dividend Income

 

Coming full circle, let’s now overlay our new estimate for interest income into our estimate for interest and dividend income.

 

My new forecast for interest and dividend income for Fairfax is:

• $1.945 billion in 2023, a YOY increase of 102% 
• $2.525 billion in 2024, a YOY increase of 30%
• $2.381 billion in 2025, or a YOY decline of 6% 

 

 

Conclusion

 

Interest and dividend income is the most important income stream for Fairfax. It is poised to increase more than 100% in 2023 and another 30% in 2024.

 

The driver of this increase is the fixed income portfolio. 

• double in size: the total fixed income portfolio more than doubled in size the past 8 years from $20.3 billion in 2016 to an estimated $42 billion in 2023.
• double in yield: The yield on the fixed income portfolio averaged 2.4% from 2016-2022. It is estimated to come in at 4.4% in 2023 and 5.1% in 2024.   

A double in size combined with a double in yield is nuts. Investors are getting served up a double-double with Fairfax’s fixed income portfolio (that line will only make sense to Tim’s coffee drinkers). 

 

The story gets better. 

 

Fairfax is positioned perfectly to benefit from ‘higher for longer.’ Fairfax has an opportunity today to lengthen duration. This would then lock high interest income into 2025 and 2026.  

 

What about corporates? Fairfax has the majority of its fixed income portfolio invested in safe but lower yielding government bonds today. What if they start to move out on the curve AND at the same time shift more into corporates. That would likely result in a yield pickup of around 1.5% or 2% over governments bonds. So for all of you out there who are thinking that interest and dividend income will peak out at $2.5 billion in 2024… maybe not.  

—————

 

Dividends

 

Dividends have increased from $80 million in 2014 to $140 million in 2022, a compound increase of 7.2% per year over 8 years.

 

Dividends should continue to increase in the future. Eurobank would like to start paying a dividend in 2024. They have discussed 25% as a reasonable payout ratio. If this happens, Fairfax could see dividends increase by up to $75 million just from Eurobank. That would be a 50% increase to dividends. Regardless, we should see this continue to increase in the future as Fairfax grows its equity holdings and as existing holdings increase their payouts. 

—————

 

Where do i go to learn about where interest rates might be going?

 

I follow a guy named Joseph Wang - The Fed Guy. I have been following Joseph for more than a year and he has been remarkably accurate with his projections for interest rates. Just as importantly, Joseph is a great educator. He lays out his thinking on interest rates (and the Fed meeting last week) in his most recent podcast on September 23.

 

Edited September 24, 2023 by Viking

[StubbleJumper]

1 hour ago, Viking said:

Important: this is my first stab as this kind of detail. So there will be errors. Please let me know where my logic is wrong so I can make the estimate better over time. Discussing/debating the assumptions/logic with others on the board is when the learning really happens. Thank you in advance

 

 

Thank you for sharing your thought process.  Don't worry about being wrong, as it's impossible to be precisely right.  The quarterly report gives a breakdown of the fixed income portfolio broken down by ranges of maturity, but even with those breakdowns it's still not possible to take an aging of accounts approach because there is undoubtedly a great deal of churn within the fixed income port during a year (eg, sell a whackload of 5-yr and use the proceeds to buy 2-yr, then turn around and sell a whackload of 2-yr and use the proceeds to buy 10-yr).  The approach you've taken gets you to the right neighbourhood for interest income, and that's probably good enough, particularly for 2025 when the level of uncertainty grows.

 

1 hour ago, Viking said:

Fairfax is positioned perfectly to benefit from ‘higher for longer.’ Fairfax has an opportunity today to lengthen duration. This would then lock high interest income into 2025 and 2026.  

 

 

Higher for longer would definitely be a major boon for FFH if they keep the duration relatively short.  I do wonder, however, whether they aren't looking at the 5-yr these days and contemplating a slight increase in duration.  Then again, I was the guy who suggested in Feb 2022 that the 2-yr looked like a bit of a sweet spot, and if FFH had held that same view, it would have cost a pile of interest income.  In fact, in 2023, FFH would have been better off to shorten duration rather than lengthen it!  All of our collective hand-wringing in Feb 2023 about whether duration should be 2, 2.5 or 3 years has been entirely directionally wrong!

 

1 hour ago, Viking said:

What about corporates? Fairfax has the majority of its fixed income portfolio invested in safe but lower yielding government bonds today. What if they start to move out on the curve AND at the same time shift more into corporates. That would likely result in a yield pickup of around 1.5% or 2% over governments bonds. So for all of you out there who are thinking that interest and dividend income will peak out at $2.5 billion in 2024… maybe not.  

 

 

 

I don't think that we will see a wholesale move into corporates unless all hell breaks loose in credit markets.  FFH tends to be pretty rational about when to reach for yield and when to stick to sovereign debt.  In short, they don't tend to buy risky bonds unless they are getting adequately paid to do so.  I don't think a spread of 1% or 2% is anywhere close to enough to trigger a shift into risky bonds.  On the other hand, if all hell does break loose in credit markets and the market does begin paying for risk, that will be the time when FFH becomes opportunistic and we will see more corporates, and, in particular, more bond/warrant deals.

 

Keep your fingers crossed for another couple years of favourable underwriting conditions AND favourable movement in fixed income markets.  It's a remarkable set of conditions!

 

 

SJ

[dealraker]

8 hours ago, Viking said:

Strictly from a financial perspective, we all should be praying for a couple of bad hurricanes. Small hit to short term results. But it would likely extend the hard market another year of two - resulting in higher for longer profits (price increases and better terms and conditions).
 

I think much of what people are discounting into their models when valuing Fairfax is too pessimistic and one sided. Because each risk has a corresponding opportunity. Discounting the risk and not adding back some of the opportunity is not being conservative. That makes no sense to me.

Yes.

[MMM20]

https://www.wsj.com/real-estate/commercial/commercial-real-estates-next-big-headache-spiraling-insurance-costs-604efe4d?st=jtyozjrpfikx3at&reflink=desktopwebshare_permalink

 

So, all else equal, what happens to insurance pricing if property values actually do reset down ~20-30%, with mortgage rates being what they are and the markets actually starting to price in higher rates for longer? Obviously don't want to read too much into SF office prices down 50%+ or whatever it is exactly from peak. Just trying to poke holes in the FFH thesis...

 

Edited September 26, 2023 by MMM20

[gfp]

Not sure I understand your question.  Commercial property values have already reset down 20-30%.  The replacement cost of the buildings hasn't gone down.  I don't think the price of commercial insurance is closely linked to the market value of the properties except to the extent that the size of the loan on a building will set a floor on the amount of coverage a lender will let you get away with.

[StubbleJumper]

8 minutes ago, MMM20 said:

https://www.wsj.com/real-estate/commercial/commercial-real-estates-next-big-headache-spiraling-insurance-costs-604efe4d?st=jtyozjrpfikx3at&reflink=desktopwebshare_permalink

 

So, all else equal, what happens to insurance pricing if property values actually do reset down ~20-30%, with mortgage rates being what they are and the markets actually starting to price in higher rates for longer? Obviously don't want to read too much into SF office prices down 50%+ or whatever it is exactly from peak. Just trying to poke holes in the FFH thesis...

 

 

Well, when you buy insurance, what are you buying?  You aren't insuring for the cost of buying a replacement building on the commercial real estate market.  You are insuring for the cost of repairing the existing building, or in the worst case, rebuilding it.  The cost to rebuild can be much higher or much lower than the prevailing market price for a similar existing building.

 

The interesting thing that actually has happened is that repair and rebuild prices have both gone up substantially due to inflation, so premium must follow....

 

 

SJ

[MMM20]

Yeah, I guess I'm conflating replacement cost with market prices, but you'd think one would follow the other. Property values down -> weakening demand for building materials and labor and so prices down -> replacement costs down -> insurance rates down. Maybe not the best logic. 

 

Edited September 26, 2023 by MMM20