Fairfax 2023

[UK]

41 minutes ago, giulio said:

The accounting changed but the economic substance did not. I think it is not worth it to focus on the impact of discounting/interest rates. it will move up and down, like mark-to-market investment gains (which should be excluded from earnings and not projected forward). 

I try to measure look-through earnings instead.

I try to understand if they are writing profitable business and what CR will be over a cycle.

I think Mr. Watsa said on CC that IFRS 17 will not have any impact on the way FFH conducts business, so let the equity research analysts deal with this mess in their models!

focus on the business, don't let the accounting obfuscate economic reality.

 

 

Well, I agree, but if you still want to model any future EPS/BV, as Viking does, you have to decide what to do with this item:). Perhaps to stay conservative one can omit it altogether. Look through earnings is an alternative/different way to look at investment portfolio,  I agree it may be better in some respects, but maybe not for EPS estimate.

 

Edited October 11, 2023 by UK

[StubbleJumper]

7 minutes ago, sleepydragon said:

reading Fairfax's annual letters last night. I am new to this stock.. but they are writing insurance everywhere in the world -- like Indonesia etc.. Do they really know what risks they are taking on? It makes me a bit hard to sleep at night. 

 

 

When they write policies in Indonesia or Brazil, they are not doing so from headquarters in Toronto!  It is almost always a local subsidiary that does the underwriting in those countries.  In general, those local subsidiaries have been in operation for many years (decades!) and know the situation on the ground very well.  FFH has bought several of those insurance companies around the world.

 

There is an argument that owning several foreign subs might make you actually sleep better.  Something bad might happen in Indonesia, but if that occurs, it's unlikely to be accompanied simultaneously by bad news in South Africa, Brazil or Singapore.  The international subs are pretty geographically diverse.

 

 

SJ

[returnonmycapital]

On 10/9/2023 at 6:49 AM, giulio said:

FFH floating rate preferred shares are trading at >10% yield, possible redemption in dec 24/dec 25.

Canadian 3 month t-bill rate + spread (2.5-3%), resetting quarterly.

Bradstreet bought these in dec 2022.

The probability that they get called is low IMO, still looks like a good deal.

What am I missing? 

I'm curious about these variable rate prefs., especially the Series D & F which are redeemable in 447 days (1.2 yrs) and 537 days (1.5 yrs), respectively. Using current yield, they offer 10.8% and 11.2%, respectively. At par, they currently cost Fairfax 8.3% and 7.3%, respectively. Their dividends are paid with after-tax earnings, making them closer to 10% cost to FFH on a bond-equivalent basis. Those levels compare poorly to interest cost on FFH borrowings and I challenge those who would suggest that FFH assets will return higher over the next year or so. This is expensive capital. Is there something that I am missing? Why wouldn't a rational FFH redeem them?

 

I suppose the answer is that we don't know that things will remain equal in one year's time. But in the meantime we clip attractive cash "coupons" at preferential tax rates (for Canadian tax residents) and if things do look somewhat like today in one year's time, we could very well see a redemption and that would equate to a "yield to maturity" of 36% and 48% per annum, respectively. I know of no investment currently offering that level of yield/YTM combination, let alone one that is money-good.

 

I am making assumptions: That things don't change much and that FFH acts rationally. I see those as perhaps a better risk/reward than on the common.   

[StubbleJumper]

5 minutes ago, returnonmycapital said:

I'm curious about these variable rate prefs., especially the Series D & F which are redeemable in 447 days (1.2 yrs) and 537 days (1.5 yrs), respectively. Using current yield, they offer 10.8% and 11.2%, respectively. At par, they currently cost Fairfax 8.3% and 7.3%, respectively. Their dividends are paid with after-tax earnings, making them closer to 10% cost to FFH on a bond-equivalent basis. Those levels compare poorly to interest cost on FFH borrowings and I challenge those who would suggest that FFH assets will return higher over the next year or so. This is expensive capital. Is there something that I am missing? Why wouldn't a rational FFH redeem them?

 

I suppose the answer is that we don't know that things will remain equal in one year's time. But in the meantime we clip attractive cash "coupons" at preferential tax rates (for Canadian tax residents) and if things do look somewhat like today in one year's time, we could very well see a redemption and that would equate to a "yield to maturity" of 36% and 48% per annum, respectively. I know of no investment currently offering that level of yield/YTM combination, let alone one that is money-good.

 

I am making assumptions: That things don't change much and that FFH acts rationally. I see those as perhaps a better risk/reward than on the common.   

 

Yes, those prefs are redeemable and not retractable.  So, like all such prefs, that means that FFH can redeem them in situations that are attractive to the company.  But, how do they redeem them?  It requires cash at the holding company level to do so.

 

What is the hierarchy of uses for cash (capital) available at the holdco?  Well, FFH needs to use some cash:

 

-to fund the holdco's operations,

-pay the annual US$10/sh dividend

-pay interest on the large holdco debt

-perhaps it might wish to buy a new subsidiary (or a portion of a subsidiary),

-it might want to repay some debt

-it might want to add cash/capital to an insurance sub so that it can underwrite more business

-or, as you said, it might want to redeem some or all of its outstanding preferreds.

 

At the end of Q2 the holdco had about US$600m of cash and liquid securities available.  It has an untapped US$2B revolving credit faciltiy.  It could float more bonds/notes.  It could consider sending larger dividends from its insurance subs to the holdco.  But, however you look at it, the FFH holdco is not currently swimming in cash, nor is it likely to be swimming in cash during 2024.

 

When considering its capital allocation for 2024, FFH will definitely look at all potential sources and uses of capital and rank them in a hierarchy.  As you noted, they could get a ~10% pre-tax "return" by redeeming the series D and F.  But, they could probably get an even higher return by repurchasing OMERS' minority position in Odyssey Re.  They could probably get a better return by repurchasing the common shares at the current valuation of ~1x BV.  In short, there are many places where they can obtain a similar return to redeeming the prefs.

 

Given the many possible uses of cash/capital, I don't expect to see a penny dedicated to redeeming prefs during 2024 or 2025.  In fact, as a common shareholder, I would be furious if they redeem those prefs for $25/sh during 2024 or 2025 when they can simply make open market purchases under the NCIB right now at a significant discount to the redemption price.

 

 

SJ

[returnonmycapital]

1 hour ago, StubbleJumper said:

 

Yes, those prefs are redeemable and not retractable.  So, like all such prefs, that means that FFH can redeem them in situations that are attractive to the company.  But, how do they redeem them?  It requires cash at the holding company level to do so.

 

What is the hierarchy of uses for cash (capital) available at the holdco?  Well, FFH needs to use some cash:

 

-to fund the holdco's operations,

-pay the annual US$10/sh dividend

-pay interest on the large holdco debt

-perhaps it might wish to buy a new subsidiary (or a portion of a subsidiary),

-it might want to repay some debt

-it might want to add cash/capital to an insurance sub so that it can underwrite more business

-or, as you said, it might want to redeem some or all of its outstanding preferreds.

 

At the end of Q2 the holdco had about US$600m of cash and liquid securities available.  It has an untapped US$2B revolving credit faciltiy.  It could float more bonds/notes.  It could consider sending larger dividends from its insurance subs to the holdco.  But, however you look at it, the FFH holdco is not currently swimming in cash, nor is it likely to be swimming in cash during 2024.

 

When considering its capital allocation for 2024, FFH will definitely look at all potential sources and uses of capital and rank them in a hierarchy.  As you noted, they could get a ~10% pre-tax "return" by redeeming the series D and F.  But, they could probably get an even higher return by repurchasing OMERS' minority position in Odyssey Re.  They could probably get a better return by repurchasing the common shares at the current valuation of ~1x BV.  In short, there are many places where they can obtain a similar return to redeeming the prefs.

 

Given the many possible uses of cash/capital, I don't expect to see a penny dedicated to redeeming prefs during 2024 or 2025.  In fact, as a common shareholder, I would be furious if they redeem those prefs for $25/sh during 2024 or 2025 when they can simply make open market purchases under the NCIB right now at a significant discount to the redemption price.

 

 

SJ

Perhaps I'm thinking incorrectly, but I think of assets and the capital backing those assets in terms of spread. Assets need to have a positive spread over the capital backing them. Given the situation currently, FFH is showing a materially negative spread on their variable rate preferred capital. Should the situation continue, it would seem rational to exit that situation. I agree that it is best to do so in the open market, given the current discount to par prices but if they come right up to the date of redemption and there is still some variable-rate preferred outstanding on a negative spread, I'm not sure that I'd be furious with management if they redeemed.

[Thrifty3000]

8 hours ago, UK said:

Tom MacKinnon

And then on the change in the discount rate, is that just generally, if we have a flat interest rate environment, then we wouldn't get that noise as well, I assume.

Jennifer Allen

Correct.

Great info @UK. Thanks for sharing. So, incorporating Fairfax's CFO's interpretation of discounting into @Viking's model would result in EPS projections that look more like this:

 

2023: $155

2024: $148

2025: $153

[Thrifty3000]

Normalized $150 EPS per share is more in line with where I personally model FFH's earnings. However, I've been considering making one more adjustment that I recall one insurance analyst doing that made sense to me.

 

I can't remember which analyst did it, but they would go ahead and bake in an assumption of 1 mega cat - like Hurricane Katrina - happening every 5 years, and spread the expected losses over the 5 year period.

 

So, if we assume a Katrina-sized mega cat will happen at some point in the next 5 years and will shave, say, $50 per share off FFH's earnings in that year, then we can normalize it by reducing expected EPS by $10 annually. So, I'm considering reducing my normalized EPS estimate from $150 to $140. 

[Malmqky]

10 minutes ago, Thrifty3000 said:

Normalized $150 EPS per share is more in line with where I personally model FFH's earnings. However, I've been considering making one more adjustment that I recall one insurance analyst doing that made sense to me.

 

I can't remember which analyst did it, but they would go ahead and bake in an assumption of 1 mega cat - like Hurricane Katrina - happening every 5 years, and spread the expected losses over the 5 year period.

 

So, if we assume a Katrina-sized mega cat will happen at some point in the next 5 years and will shave, say, $50 per share off FFH's earnings in that year, then we can normalize it by reducing expected EPS by $10 annually. So, I'm considering reducing my normalized EPS estimate from $150 to $140. 

I really like this approach as well. Thanks for reminding me of this, I remember reading something along these lines a while back but don’t remember the analyst either or where I read it.

[StubbleJumper]

23 minutes ago, returnonmycapital said:

Perhaps I'm thinking incorrectly, but I think of assets and the capital backing those assets in terms of spread. Assets need to have a positive spread over the capital backing them. Given the situation currently, FFH is showing a materially negative spread on their variable rate preferred capital. Should the situation continue, it would seem rational to exit that situation. I agree that it is best to do so in the open market, given the current discount to par prices but if they come right up to the date of redemption and there is still some variable-rate preferred outstanding on a negative spread, I'm not sure that I'd be furious with management if they redeemed.

 

 

Well, that's true.  If you were going to buy an asset today, over the life of the asset, you would want the expected return on that asset to exceed the expected cost of capital backing it. 

 

At first glance, FFH's balance sheet is replete with assets that return less than the cost of maintaining the preferred shares.  But, there's one major problem with that: almost all of FFH's assets are held by its insurance subsidiaries.  In fact FFH has tens-of-billions of dollars of sovereign debt that yields less than the cost of those prefs.  However, that relatively low-yielding sovereign debt is required for the insurance subsidiaries' reserve requirements.  The regulators will not allow FFH to just sell the treasuries and use the proceeds to retire more costly debt and preferred shares because the treasuries are effectively the guarantee that the company will pay indemnities to the policy holders.  To the extent that the insurance subsidiaries currently have excess capital, FFH could liquidate some treasuries, use the proceeds to issue a dividend to the holding company, and then use that cash to redeem prefs or repay debt.  However, as a general rule, when an insurance company is in the midst of a very profitable hard market and is trying to grow its book of business, you don't shed excess capital because it constrains your ability to grow.  So, for 2024 and maybe 2025, I would not expect to see abnormally large dividends from FFH's insurance subs to the holdco.  There may be some other marketable assets held by the holdco that do not yield ~10% pre-tax, but I can't think of many low-yielding assets that could be sold to redeem the prefs.

 

If you want to buy the prefs, you do it because, beginning in 2025, they'll likely provide a nice tax-advantaged dividend of ~10% on today's market price.  If you are lucky, the hard market will turn in 2025, FFH will shrink its books of business and at that point you might see some larger dividends to the holdco.  But, even at that point, I doubt that redeeming the prefs will rank very highly on FFH's hierarchy of capital uses.

 

 

SJ

[StubbleJumper]

18 minutes ago, Thrifty3000 said:

So, if we assume a Katrina-sized mega cat will happen at some point in the next 5 years and will shave, say, $50 per share off FFH's earnings in that year, then we can normalize it by reducing expected EPS by $10 annually. So, I'm considering reducing my normalized EPS estimate from $150 to $140. 

 

Really, to do that properly would require going back into the ARs and grabbing 10 or 20 years worth of CRs and stripping out the cat losses so that you calculate an average number of CR points lost to cats.  Happily, FFH usually reports both the composite CR and a CR excluding cats.  It's not an enormous task, but then you can use that average CR points of cat loss to help build a normalized earnings estimate.

 

 

SJ

[Tommm50]

4 hours ago, sleepydragon said:

reading Fairfax's annual letters last night. I am new to this stock.. but they are writing insurance everywhere in the world -- like Indonesia etc.. Do they really know what risks they are taking on? It makes me a bit hard to sleep at night. 

 

I agree with StubbleJumper. Having written business internationally myself I can say writing liability business (largely what Fairfax does) outside the U.S. is way more consistently profitable than in the U.S.. Americans are one of the most litiguous

populations on the planet.

 

Also, U.S. is a mature market with fierce competition and modest incremental growth. The economies of other countries around the world have an ability to grow at a much faster pace (although obviously smaller scale). India is the poster child. The opportunity to grow profitably in emerging markets is much more attractive as instead of achieving growth by taking an account from another insurer you have more insureds that are just starting and need insurance.

 

This means Fairfax's geographic spread and presence in significant emerging markets is one of its greatest strengths and a huge strategic advantage. You should sleep well mon ami.

[SafetyinNumbers]

2 hours ago, Thrifty3000 said:

Great info @UK. Thanks for sharing. So, incorporating Fairfax's CFO's interpretation of discounting into @Viking's model would result in EPS projections that look more like this:

 

2023: $155

2024: $148

2025: $153

It’s funny, I read the same post and it made me think I was right. I think to take out the IFRS17 plug, you have to assume no premium growth which isn’t consistent with the rest of the forecast.

[UK]

22 minutes ago, SafetyinNumbers said:

It’s funny, I read the same post and it made me think I was right. I think to take out the IFRS17 plug, you have to assume no premium growth which isn’t consistent with the rest of the forecast.

 

I think you are right, but the question is size of the plug, since YTD it was probably partly/mostly interest rate driven and the impact of reserve growth alone could be much lower in the future?

[glider3834]

Moody's has upgraded Fairfax's senior debt

 

[glider3834]

7 hours ago, StubbleJumper said:

At the end of Q2 the holdco had about US$600m of cash and liquid securities available.

Not sure how you got this number

 

'The company believes that holding company cash and investments, net of holding company derivative obligations, at June 30, 2023 of $1,064.2 provides adequate liquidity to meet the holding company’s remaining known commitments in 2023'

[StubbleJumper]

1 hour ago, glider3834 said:

Not sure how you got this number

 

'The company believes that holding company cash and investments, net of holding company derivative obligations, at June 30, 2023 of $1,064.2 provides adequate liquidity to meet the holding company’s remaining known commitments in 2023'

 

You need to read Note 5 in the Q2.  Of that "billion," $358m are derivatives.  As far as I am concerned, derivatives are not liquidity. 

 

I bemoaned this state of affairs back in August and suggested that FFH would benefit from floating another $500m or $750m of notes because the holdco could use the actual liquidity.  They've pushed back the repurchase of Brit a bit, presumably because they don't want to burn more cash, and they've reduced the pace of common repurchases.  So, either we will see an abnormally large divvy from the insurance subs in the midst of a very profitable hard market, or they'll float some debt, or?

 

 

SJ

[Viking]

8 hours ago, Thrifty3000 said:

Great info @UK. Thanks for sharing. So, incorporating Fairfax's CFO's interpretation of discounting into @Viking's model would result in EPS projections that look more like this:

 

2023: $155

2024: $148

2025: $153

 

@Thrifty3000 and @UK and @SafetyinNumbers (and others), thanks for wading in on this topic. It is great to be able to get others perspectives and debate ideas. Slowly I am learning (yes, I hate that when it happens!).

 

I have made a few changes to my 2023-2025 forecasts for Fairfax, based on the feedback I have been getting from my last update (just a couple of days ago). I think I have said before, I am constantly updating my model to reflect 'new news' (usually weekly). Please keep the questions and comments coming... I will keep making updates to my model and I will keep the updates coming. Continuous improvement is out goal...

 

1.) For 2024 and 2025, I adjusted 'Effect of discounting and risk-adjustment' down. The 2023 number has been increasing as interest rates rise. My assumption for 2024 and 2025 is interest rates stay roughly where they are today - of course, this will likely not be the case. So, I think it makes sense to go with a lower number for 2024 and 2025. Is this number still too high? Too low? Not sure. Like all the other numbers in the spreadsheet, I'll keep an open mind and adjust as needed moving forward. 

2.) For 2023, I adjusted 'Effect of discounting and risk-adjustment' up and 'Net gains (losses) on investments' down to reflect the continued increase in bond yields in Q3. Currency will also be a headwind for Fairfax in Q3, given the US$ strength.

 

Putting it all together, my new forecast is earnings of about $150/share in 2023 and around $160/share in 2024 and 2025.

 

The bear market in bonds had an impact on Fairfax in Q2, 2023. It will be the same in Q3, 2023. So today I am thinking earnings in Q3 might come in closer to $20/share (unrealized losses on bonds/currency will be the headwind). That would put Q4 earnings closer to $40-$45, which seems reasonable (and assumes the GIG acquisition closes in Q4).

 

Please keep the questions coming... the more questions/discussion/debate the better. 

 

 

 

Edited October 12, 2023 by Viking

[UK]

1 hour ago, Viking said:

 

@Thrifty3000 and @UK and @SafetyinNumbers (and others), thanks for wading in on this topic. It is great to be able to get others perspectives and debate ideas. Slowly I am learning (yes, I hate that when it happens!).

 

I have made a few changes to my 2023-2025 forecasts for Fairfax, based on the feedback I have been getting from my last update (just a couple of days ago). I think I have said before, I am constantly updating my model to reflect 'new news' (usually weekly). Please keep the questions and comments coming... I will keep making updates to my model and I will keep the updates coming. Continuous improvement is out goal...

 

1.) For 2024 and 2025, I adjusted 'Effect of discounting and risk-adjustment' down. The 2023 number has been increasing as interest rates rise. My assumption for 2024 and 2025 is interest rates stay roughly where they are today - of course, this will likely not be the case. So, I think it makes sense to go with a lower number for 2024 and 2025. Is this number still too high? Too low? Not sure. Like all the other numbers in the spreadsheet, I'll keep an open mind and adjust as needed moving forward. 

2.) For 2023, I adjusted 'Effect of discounting and risk-adjustment' up and 'Net gains (losses) on investments' down to reflect the continued increase in bond yields in Q3. Currency will also be a headwind for Fairfax in Q3, given the US$ strength.

 

Putting it all together, my new forecast is earnings of about $150/share in 2023 and around $160/share in 2024 and 2025.

 

The bear market in bonds had an impact on Fairfax in Q2, 2023. It will be the same in Q3, 2023. So today I am thinking earnings in Q3 might come in closer to $20/share (unrealized losses on bonds/currency will be the headwind). That would put Q4 earnings closer to $40-$45, which seems reasonable (and assumes the GIG acquisition closes in Q4).

 

Please keep the questions coming... the more questions/discussion/debate the better. 

 

 

 

 

Thanks, Viking! With so much moving parts and different earning streams, FFH is one of the companies, which earnings is extremely hard to model (and maybe it is a plus and an opportunity vs analysts/market), but I think you did an incredible job doing this.

 

[Thrifty3000]

12 minutes ago, UK said:

 

Thanks, Viking! With so much moving parts and different earning streams, FFH is one of the companies, which earnings is extremely hard to model (and maybe it is a plus and an opportunity vs analysts/market), but I think you did an incredible job doing this.

 

Hear, hear  

[Thrifty3000]

 

Wow. Progressive just posted 3rd quarter results and their YOY numbers are SOLID. Net premiums up 22%. CR of 92.4 vs 99.2 last year. Policies in force up 10%. Also looks like they've been issuing shares, which makes sense given how richly priced they are. Their shares are up over 7% today. Hopefully these results are indicative of what we can expect from FFH this quarter.

 

 

 

[SafetyinNumbers]

I don’t think I fully appreciated how much Fairfax would have earned last year if IFRS 17 had been implemented a year earlier. I know they got the full benefit in the book value at the beginning of year and it’s helped by half a billion or so this year (so far) but to actually report the earnings would have had a bigger impact on valuation I think. It also really highlights the spectacular macro call of keeping short duration on the bond portfolio. 
 

IFRS 17 only increased book at Jan 2022 by ~$150m. The majority of benefit actually came in 2022 as rates increased substantially. The restated H12022 results go from a big loss to a profit.

[glider3834]

On 10/12/2023 at 10:48 AM, StubbleJumper said:

 

You need to read Note 5 in the Q2.  Of that "billion," $358m are derivatives.  As far as I am concerned, derivatives are not liquidity. 

 

I bemoaned this state of affairs back in August and suggested that FFH would benefit from floating another $500m or $750m of notes because the holdco could use the actual liquidity.  They've pushed back the repurchase of Brit a bit, presumably because they don't want to burn more cash, and they've reduced the pace of common repurchases.  So, either we will see an abnormally large divvy from the insurance subs in the midst of a very profitable hard market, or they'll float some debt, or?

 

 

SJ

they paid 380M dividends from insur/reinsu subs to Holdco in 2022 (excl C&F pet sale div) but only $79M in 1H23 so far (excl Brit div from Ambridge sale). So just to match 2022, they would need to pay another $300M divs to Holdco in 2H23.

 

Looking at 1H23 operating income of insur/reinsur subs of $1.75B (vs $1.2B in 1H22) or increase of 46% YoY, & if things continue int he same trend over the 2H23, I think insurance subs might build decent amount of div capacity on top of $2.7B (rounded) level at 31 Dec2022.

 

In 2022, the subs built up around $700M in div capacity (ie from $2B to $2.7B),  after paying $380M in divs to the Holdco (with group interest and dividend income $960M in 2022) 

 

So if operating earnings of these insurance subs in 2023 are now trending over 40% above 2022 (with group interest & dividends expected at over $1.5B in 2023) , then couldn't we see an even bigger build in div capacity in insur/reinsur subs in 2023 assuming same divs paid to Holdco as in 2022?

 

We are still not through end of hurricane season (he says with fingers crossed  ) ,& there are always other risks that could create volatility in insur sub operating results, so nothing is guaranteed of course with the above, but really I am just trying to extrapolate what trends I can see in operating result of the insurance subs YTD 

 

SJ I do agree with you it would be better to see more cash in the Holdco over time

 

Edited October 16, 2023 by glider3834

[MMM20]

"Overall, it's still a tough environment for our insurance risk-bearing partners. They are grappling with stubbornly high loss cost inflation and more catastrophe losses at higher reinsurance attachment points. So when I roll it all together, we are not seeing and don't expect a meaningful slowdown in primary P/C rate increases. And thus, we remain steadfast and focused on helping our clients navigate and mitigate premium increases." - Arthur J Gallagher (AJG ) CEO Patrick Gallagher

[Luke]

Tbh, i cant find anything that has as good a setup for the next 2-3 years as FFH. Its not only a hedge but even a compounder id gladly buy, if a recession hits, nice, if it doesnt we are also fine. Really thinking of increasing my ridiculous close to 50% position even more because if i look at everything else i can easily see how things go at least sideways or worse and FFH wont suffer under most circumstances except extreme climate events which can blow it down temporarily. 

[Luke]

Even their stock portfolio consists of value and things that are cheap and ownable now...id even sleep well with 100% in FFH but scratching my head if I should go even more overweight.