Fairfax 2023

[Hamburg Investor]

3 hours ago, gfp said:

 

The year 2000 wasn't a black swan event for Fairfax or Markel, but they both had just completed acquisitions (Crum & Forster & TIG at Fairfax and what became Markel International - Terra Nova, at Markel).  These acquisitions took longer to turn around and Markel had some newly acquired lines of business that they decided to discontinue.  So in both companies, I think the poor consolidated combined ratios you observed for 2000 were largely acquisition related.

Thanks. I just realize, that being an investor into Markel, Berkshire and Fairfax starting in 2007 and 2009 makes me a greenhorn here…  

[Hamburg Investor]

8 hours ago, UK said:

 

Thanks. Sure. But how did this reputation was any better in 2016 vs 2023? This makes no sense to me? So OK, maybe it is still far from perfect in the eyes of the market, maybe only halfway to being perfect, everybody is entitled to have an opinion, but it seems to me, anyway you look, reputation should be way better now, than in 2016? But valuation is not.

Even after 2016 on the surface Fairfax wasn‘t a big winner over some years. Looking back 15 years from 2016 growth might have been more spectacular against the market than looking back 15 years today.  
(I haven’t looked, just anticipating the brilliant hedge against the housing market around 2007/2009 and the longtime underperformance of Fairfax in the no-interest-growth-wins-time we look back today).

We can project earnings over the next couple of years and Vikings numbers are as good as they could be, but looking back Fairfax growth over 10 years hasn‘t shot the lights out.
 

And always remember: Mr. Market is doing the price. And he‘s not exactly famous for being rational.

[glider3834]

25 minutes ago, Hamburg Investor said:

Thanks. I just realize, that being an investor into Markel, Berkshire and Fairfax starting in 2007 and 2009 makes me a greenhorn here…  

some history on Markel's acquisitions here & interestingly they also were in advanced talks to acquire Allied World before it was acquired by Fairfax https://www.slipcase.com/view/inside-in-full-markel-trying-to-be-berkshire-without-buffett/12

[TwoCitiesCapital]

18 hours ago, SafetyinNumbers said:

I guess I misunderstood I thought it was the discussion of the moat that got us there. Using your mental model, I wouldn’t pay NAV+ for a levered bond fund. Would you?
 

Sure insurance is a commodity business but Fairfax gets to choose how much business it writes when prices are low. Effectively that’s part of the culture/cap allocation moat, isn’t it?

 

I’m curious for the people looking at the track record in CR, how can you tell how well the comps have been reserving vs Fairfax over time? If Fairfax, over reserves after every acquisition would that skew combined ratios higher? Do you track operating expense ratios vs comps to see if there is a delta in structural cost advantages?

 

You may not, but plenty of people do. Numerous instances over the years of fixed income CEFs trading at premiums to NAV despite having a significantly higher fee structure and cost of leverage than Fairfax has. 

 

I wouldn't pay a ton for access to leveraged bond management, but if the leverage is lower-cost than I can receive and higher quality (less callable) than I can receive then it's certainly worth something - especially in the hands of capable management who use it to generate reasonably good net returns. 

[Munger_Disciple]

8 hours ago, dartmonkey said:

Is it fair to say that unlike Buffett, you both don’t think float generating businesses are worth more than book value?

 

For my part, no, not at all, on the contrary. The float is the source of the leverage.

 

[SafetyinNumbers]

1 hour ago, TwoCitiesCapital said:

 

 

I wouldn't pay a ton for access to leveraged bond management, but if the leverage is lower-cost than I can receive and higher quality (less callable) than I can receive then it's certainly worth something - especially in the hands of capable management who use it to generate reasonably good net returns. 

I think you make great points which contributes to the moat. Another feature of Fairfax is that you know your optionality on the stock doesn’t get impaired by an opportunistic take-private bid from management. Arguably, the market gives Fairfax a discount for this feature as its participants are more interested in short term gratification.

[StubbleJumper]

24 minutes ago, SafetyinNumbers said:

I think you make great points which contributes to the moat. Another feature of Fairfax is that you know your optionality on the stock doesn’t get impaired by an opportunistic take-private bid from management. Arguably, the market gives Fairfax a discount for this feature as its participants are more interested in short term gratification.

 

 

I would encourage you to not hold this viewpoint very firmly.  The history of FFH would suggest that investors are best advised to ensure that their interests are aligned with Prem's interests to the greatest extent possible.  There have been numerous occasions when minority shareholders of subsidiaries have been unhappy with being bought out on terms that they viewed as unfavourable (in fact, just last week FFH announced it would buy back Farmers Edge.  Are the minority holders happy?  I haven't seen any feed back, but I don't doubt there would be some unhappiness).  Prem's interests are broadly clear as the result of his having the overwhelming majority of his personal assets in FFH shares (and not directly in the subs where shareholders believed they were screwed).

 

The advantage of being a minority shareholder of FFH is that it would require an absolute boatload of capital to buy us out.  But, if Prem could find somebody who would provide US$20-25 billion on favourable terms, I don't doubt for a minute that he would buy out minority holders if it were advantageous to the Watsa family.  What is more, Prem has advanced significant hints about large scale share repurchases and has even trotted out the Teledyne example.  If he actually follows through, in 10 years a family buyout might become more realistic.  In any case, it's not something to lose sleep over at the moment, but I would say that it's a mistake to assume that there will never be a take-private offer and that minority holders will never be screwed.

 

If you see a smiling shark, accept him for what he is.

 

 

SJ

[TwoCitiesCapital]

1 hour ago, StubbleJumper said:

 

 

I would encourage you to not hold this viewpoint very firmly.  The history of FFH would suggest that investors are best advised to ensure that their interests are aligned with Prem's interests to the greatest extent possible.  There have been numerous occasions when minority shareholders of subsidiaries have been unhappy with being bought out on terms that they viewed as unfavourable (in fact, just last week FFH announced it would buy back Farmers Edge.  Are the minority holders happy?  I haven't seen any feed back, but I don't doubt there would be some unhappiness).  Prem's interests are broadly clear as the result of his having the overwhelming majority of his personal assets in FFH shares (and not directly in the subs where shareholders believed they were screwed).

 

The advantage of being a minority shareholder of FFH is that it would require an absolute boatload of capital to buy us out.  But, if Prem could find somebody who would provide US$20-25 billion on favourable terms, I don't doubt for a minute that he would buy out minority holders if it were advantageous to the Watsa family.  What is more, Prem has advanced significant hints about large scale share repurchases and has even trotted out the Teledyne example.  If he actually follows through, in 10 years a family buyout might become more realistic.  In any case, it's not something to lose sleep over at the moment, but I would say that it's a mistake to assume that there will never be a take-private offer and that minority holders will never be screwed.

 

If you see a smiling shark, accept him for what he is.

 

 

SJ

 

If he's successful w/ the Teledyne example, in 10-years time it would take a boatload of money to buy out the remaining holders so I'm probably still ok with that. 

 

But agreed - invest in Fairfax subs/investments at your own risk. Their only allegiance is to their own shareholders and not those of their publicly traded associated entities. 

[SafetyinNumbers]

2 hours ago, StubbleJumper said:

 

 

I would encourage you to not hold this viewpoint very firmly.  The history of FFH would suggest that investors are best advised to ensure that their interests are aligned with Prem's interests to the greatest extent possible.  There have been numerous occasions when minority shareholders of subsidiaries have been unhappy with being bought out on terms that they viewed as unfavourable (in fact, just last week FFH announced it would buy back Farmers Edge.  Are the minority holders happy?  I haven't seen any feed back, but I don't doubt there would be some unhappiness).  Prem's interests are broadly clear as the result of his having the overwhelming majority of his personal assets in FFH shares (and not directly in the subs where shareholders believed they were screwed).

 

The advantage of being a minority shareholder of FFH is that it would require an absolute boatload of capital to buy us out.  But, if Prem could find somebody who would provide US$20-25 billion on favourable terms, I don't doubt for a minute that he would buy out minority holders if it were advantageous to the Watsa family.  What is more, Prem has advanced significant hints about large scale share repurchases and has even trotted out the Teledyne example.  If he actually follows through, in 10 years a family buyout might become more realistic.  In any case, it's not something to lose sleep over at the moment, but I would say that it's a mistake to assume that there will never be a take-private offer and that minority holders will never be screwed.

 

If you see a smiling shark, accept him for what he is.

 

 

SJ

I thought it was clear I was discussing FFH. Sorry for the misunderstanding. And no I don’t think he would ever take Fairfax private even if he had the resources to do so. I’m surprised you think that he would. Do you think Buffett would do the same to Berkshire?

[StubbleJumper]

14 minutes ago, SafetyinNumbers said:

I thought it was clear I was discussing FFH. Sorry for the misunderstanding. And no I don’t think he would ever take Fairfax private even if he had the resources to do so. I’m surprised you think that he would. Do you think Buffett would do the same to Berkshire?

 

 

I know you were talking about FFH and so was I!  There is little likelihood that FFH will go private, but never say never.  It would require a particular set of circumstances, and a lengthy period of buybacks would be a necessary precursor because the Watsa family's economic ownership is not currently all that high.  With a lengthy period of buybacks and a pile of outside capital, it could be possible.  Let's just say that if the Watsa family were in the situation of the Jackman family, my guess is that they'd have gone private five years ago...  My only caution is not to assume that we'll never see an opportunistic take-private bid from the Watsa family because my take is their constraint is currently financial capacity more than desire.

 

Buffett is clearly currently disposing of his BRK ownership, so there's no question of going private. 

 

 

SJ

[SafetyinNumbers]

45 minutes ago, StubbleJumper said:

 

 

I know you were talking about FFH and so was I!  There is little likelihood that FFH will go private, but never say never.  It would require a particular set of circumstances, and a lengthy period of buybacks would be a necessary precursor because the Watsa family's economic ownership is not currently all that high.  With a lengthy period of buybacks and a pile of outside capital, it could be possible.  Let's just say that if the Watsa family were in the situation of the Jackman family, my guess is that they'd have gone private five years ago...  My only caution is not to assume that we'll never see an opportunistic take-private bid from the Watsa family because my take is their constraint is currently financial capacity more than desire.

 

Buffett is clearly currently disposing of his BRK ownership, so there's no question of going private. 

 

 

SJ

Prem seems to be saying never 

https://financialpost.com/executive/capitalist-manifesto-how-capitalism-and-canada-made-prem-watsa

[StubbleJumper]

14 minutes ago, SafetyinNumbers said:

Prem seems to be saying never 

https://financialpost.com/executive/capitalist-manifesto-how-capitalism-and-canada-made-prem-watsa

 

 

Actually, what he's saying in that particular quote is that the Watsa family will never sell its interest to an outside party.  He's not saying that the Watsa family won't expand its interest, and possibly take it private some day.  In fact, a couple of days after that interview was conducted, FFH's substantial issuer closed and the Watsa family interest in FFH effectively increased by about 4% because they didn't tender any of their shares...

 

It's not anything that will happen any time soon.  But, it's always a remote possibility, and given how minority shareholders have been treated in other FFH transactions, that possibility should not be dismissed lightly.

 

 

SJ

[SafetyinNumbers]

7 minutes ago, StubbleJumper said:

 

 

Actually, what he's saying in that particular quote is that the Watsa family will never sell its interest to an outside party.  He's not saying that the Watsa family won't expand its interest, and possibly take it private some day.  In fact, a couple of days after that interview was conducted, FFH's substantial issuer closed and the Watsa family interest in FFH effectively increased by about 4% because they didn't tender any of their shares...

 

It's not anything that will happen any time soon.  But, it's always a remote possibility, and given how minority shareholders have been treated in other FFH transactions, that possibility should not be dismissed lightly.

 

 

SJ

It doesn’t fit with what I understand Prem to be all about. Do most people agree with Stubble?

[nwoodman]

4 hours ago, SafetyinNumbers said:

It doesn’t fit with what I understand Prem to be all about. Do most people agree with Stubble?

 

If you look at past actions, I think SJ is suggesting that you need to be a little wary.  In no way is he suggesting running for the hills, it is just something to keep in mind.  Probabilistically if you are a passive minority shareholder in a sub that Fairfax controls, the chances of getting screwed are reasonable; as a direct investor in Fairfax, it is low but not zero etc.   

 

That's why, for me, Farmers Edge isn't about the money. It is the effect on their reputation.  However Fairfax has been flipping assets on and off the markets for as long as I have been following them, they seem to get away with it despite what I think.     This ain't Berkshire and that's fine with me because I have plenty invested already in that name.

[glider3834]

5 hours ago, SafetyinNumbers said:

It doesn’t fit with what I understand Prem to be all about. Do most people agree with Stubble?

I think FFH probably gains more from being public than private (eg liquidity for staff restricted share awards or funding optionality eg Allied acquisition or investment optionality eg TRS on FFH shares) & I think if Prem wanted to take it private then it would have likely happened already - Fairfax is now in its 38th year or so. With stock buybacks, there is shareholder alignment IMHO.

Edited November 25, 2023 by glider3834

[This2ShallPass]

9 hours ago, StubbleJumper said:

The history of FFH would suggest that investors are best advised to ensure that their interests are aligned with Prem's interests to the greatest extent possible.

True. Look at Fairfax India, they came up with an agreement to charge performance fees on BV and not on the current price. As if that was not egregious enough, Fairfax gets paid in discounted shares, so they will get 60% more than they would deserve. Actually, they deserve nothing as no one would be able to cash out at this "performance" they claim to have achieved. Part of the reason for the big discount is the association w Fairfax.

 

More than happy to pay them the fees when their terms are aligned with everyone. The least they could have done to narrow the gap and reduce the shares they get is announce a SIB to close the gap somewhat..

[TwoCitiesCapital]

11 hours ago, This2ShallPass said:

True. Look at Fairfax India, they came up with an agreement to charge performance fees on BV and not on the current price.

 

 

At a prior time, it traded at a premium to NAV and would've been disingenuous to charge on share price

 

NAV is a far better metric than share price to charge the fees on because  it is firmly in the control of the management where the share price isn't.

 

We just happen to be in a period where the discount to NAV results in a favorable arrangement for Fairfax - but they didn't create that arrangement intentionally nor do anything to "deserve" the discount  IMO

 

 

11 hours ago, This2ShallPass said:

Part of the reason for the big discount is the association w Fairfax.

 

 

That's just simply not true. It traded at a sizable premium to NAV for much of its public company life which is why I didn't own it until post-Covid. It's always been associated with Fairfax - even when it had the premium. 

 

The discount is simply a measure of sentiment - it can change tomorrow or next year without Fairfax having to do much of anything other than continuing to deliver performance. 

Edited November 25, 2023 by TwoCitiesCapital

[SafetyinNumbers]

4 hours ago, TwoCitiesCapital said:

 

At a prior time, it traded at a premium to NAV and would've been disingenuous to charge on share price

 

NAV is a far better metric than share price to charge the fees on because  it is firmly in the control of the management where the share price isn't.

 

We just happen to be in a period where the discount to NAV results in a favorable arrangement for Fairfax - but they didn't create that arrangement intentionally nor do anything to "deserve" the discount  IMO

 

 

 

That's just simply not true. It traded at a sizable premium to NAV for much of its public company life which is why I didn't own it until post-Covid. It's always been associated with Fairfax - even when it had the premium. 

 

The discount is simply a measure of sentiment - it can change tomorrow or next year without Fairfax having to do much of anything other than continuing to deliver performance. 

Very good points TwoCities. I think the sentiment is the impact of passive and quants on ownership of a company that’s not in anyone’s benchmark and has no earnings estimates. Add to that a much more inefficient market and active investors think and probably do have better risk/rewards with much quicker payoffs. It’s hard to find the marginal buyer besides the company and FFH. Maybe that changes with the Anchorage IPO as it will dramatically increase the marked-to-market  portion of the portfolio and potentially give FIH a vehicle to grow with that has a low cost of capital in India.

 

Also as I believe @glider3834 pointed out, once Fairfax is at 49%, they can no longer accept payment of performance fees in shares so this performance period is the last one for which that gripe matters. Despite all of the consternation it hasn’t mattered for the first two performance periods for two reasons. First, the stock was close to NAV for the first performance fee period and the performance fee was only ~500k shares for the second period. Second, they have bought back way more stock cheaper before and since those fees were paid. If they choose to take stock this time then almost certainly if they want more they will have to buy them in the market and I’m guessing they will. Hopefully not too opportunistically but that has to be the expectation. Buying near the floor of the discount seems like a good risk/reward. I guess we’ll find out.

 

Edited November 26, 2023 by SafetyinNumbers

[Viking]

This is a long post. Fixed income is an under followed and under appreciated part of Fairfax. This post is broken into 3 parts: 

• Part 1: an introduction to the fixed income portfolio of Fairfax
• Part 2: fixed income - some basics 
• Part 3: what does all this mean for P/C insurers?

Part 1: An Introduction to the Fixed Income Portfolio of Fairfax

 

The team: how does Fairfax manage fixed income?

 

All investments at Fairfax are managed through Hamblin Watsa.

 

“Hamblin Watsa Investment Counsel, a wholly-owned subsidiary of Fairfax Financial Holdings Limited, provides global investment management services solely to the insurance and reinsurance subsidiaries of Fairfax.” Source: Hamblin Watsa website

 

Within Hamblin Watsa, the team that manages the fixed income portfolio is lead by Brian Bradstreet. Brian has been with Fairfax for 36 years - from the very beginning.

 

 

Is the team any good?

 

Under Brian’s leadership, the fixed income team at Fairfax has done an exceptional job over the decades of managing Fairfax’s fixed income portfolio. They have a very good long term track record. I think we can say the fixed income team is a competitive advantage for Fairfax compared to peers. This is important because fixed income is by far the largest piece of Fairfax’s total investment portfolio.

 

(As an aside, it was Brian Bradstreet who brought the CDS opportunity to Fairfax’s attention just as the housing bubble was getting going in the US. By 2009, that investment had made Fairfax $2 billion in profit. Not too shabby.)

 

How big is Fairfax’s fixed income portfolio?

 

Fairfax has an investment portfolio of about $57.5 billion. Of this total, about $16.5 billion or 29%, is invested in equities. The vast majority, about $41 billion or 71%, is invested in fixed income securities.

 

 

When investors talk about Fairfax and investments, they usually focus exclusively on the equity holdings. The fixed income part of Fairfax is rarely discussed - even though it is the much larger part of the total investment portfolio.

 

Well, this is changing. Why? Follow the money…

 

Has the fixed income portfolio been growing in size?

 

The fixed income portfolio at Fairfax has increased from $20.3 billion at Dec 31, 2016 to an estimated $42 billion at Dec 31, 2023. The increase is $21.7 billion, or 107%. The CAGR from 2016 to estimated 2023 is 11%. With the expected closing of the GIG acquisition in Q4 and the continuation of the hard market we should see similar growth in 2024.   

 

 

How much does Fairfax earn on its fixed income portfolio?

 

The returns that Fairfax earns in its fixed income portfolio come primarily in two ways:

• Interest income
• Investment gains (losses) - realized and unrealized

Fairfax actively manages its fixed income portfolio and has generated meaningful realized investment gains over time. However, to keep our analysis simple (and this post to a reasonable length), we are going to focus here on the largest bucket, interest income.

 

The historical returns for interest income

 

Interest income averaged $647 million per year from 2016-2021. From this average, it increased to an estimated $1.8 billion in 2023 or +182%. It is forecasted to increase further in 2024 to about $2.1 billion (my latest estimate).

 

The average yield on the fixed income portfolio from 2016-2021 at Fairfax was about 2.4%. The yield has almost doubled to an estimated 4.3% in 2023 and 4.6% in 2024.

 

 

Summary

 

Fixed income investments are managed by a very capable team at Fairfax, lead by Brian Bradstreet. The fixed income portfolio has more than doubled in size from 2016 to 2023. At the same time the yield Fairfax is earning on its fixed income portfolio has almost doubled (from the average from 2016-2021). As a result of these two doubles (size and rate of return), interest income has spiked higher to about $2 billion per year (the current run rate).

 

Interest income is now the largest income stream at Fairfax. This is important because this source of income is considered to be very high quality by investors and analysts. It is considered to be high quality because it is relatively predicable and durable.

 

What happened to spike interest income so much? In short, over the past 2 years the fixed income team at Fairfax delivered a clinic in value investing and active management. But before we explore this further, let’s first cover off some bond basics.

 

Part 2: Fixed Income - Some Basics

 

Fixed income investing is very different from equity investing. Let’s spend a few minutes and review a few things that are relevant to our analysis.

 

The greatest bull market in history.

 

From 1981-2020, bonds experienced the greatest bull market in history. It began in September 1981, when the interest rate on the 10-year US treasury peaked at around 16%. It ended 40 years later, in June 2020, when the interest rate on the 10-year US treasury bottomed at 0.65%. Ever falling interest rates was an incredible 40-year tailwind for fixed income investors (actually, all investors - equity, real estate etc).

 

 

The bull market lasted so long some of the risks of owning bonds, like interest rate risk, receded into the shadows…. largely forgotten by fixed income investors.

 

But everything changed in early 2022. The scourge of double digit inflation escaped from its cage and was wreaking havoc on the global economy. The Federal reserve and other central banks began a historic tightening cycle and in the process unleashed hell on bond markets.

 

The greatest bond bear market in history

 

From 2021-2023, bonds experienced the greatest bear market in their history. The interest rate on the 10-year US treasury - that had bottomed at 0.65% in 2020 - hit a 15 year high of 4.98% in October 2023. The relentless move higher in interest rates over the past 2 years has caused the value of fixed income portfolios to crater.

 

Where are the losses hiding? The massive losses are sitting on the balance sheets of central banks, pension funds and financial institutions all over the world. And yes, P/C insurance companies.

—————

The Worst Bond Bear Market in History

October 13, 2023 by Ben Carlson

• https://awealthofcommonsense.com/2023/10/the-worst-bond-bear-market-in-history/

“One of the strange parts about living through the worst bond bear market in history is there doesn’t seem to be a sense of panic. If the stock market was down 50% you better believe investors would be losing their minds. Yes, some people are concerned about higher interest rates but it feels pretty orderly all things considered.

 

“So why aren’t people freaking out about bond losses more?

 

“It could be there are more institutional investors in long bonds than individuals. There are lots of pension funds and insurance companies that own these bonds.

 

“It’s going to take a very long time for investors to get made whole but you can hold these bonds to maturity to get paid back at par.”

—————

Active management matters again

 

As the bear market in bonds clawed its way though fixed income portfolios, a few P/C insurance companies were much better prepared than others. To understand who the relative winners and losers were/are it is helpful to first review the risks of investing in bonds.

 

A review of some of the risks of investing in bonds

• Interest rate risk - rising interest rates cause bond prices to fall. Duration matters a lot with this risk. Spiking interest rates impact long duration bond portfolios much more than short duration portfolios.
• Credit risk - the risk the issuer may default on one or more payments. Market dislocations / recessions matter a lot with this risk - events that cause credit spreads to blow out. Commercial real estate (in particular office) has taken a beating over the past year.
• Inflation risk (purchasing power risk) - the risk that inflation is higher than the total return received on the bond. Unexpected inflation is what matters with this risk. Especially if the inflation is high and persists for years.
• Reinvestment risk - the risk that at maturity, the proceeds will be reinvested at a lower rate than the bond was earning previously.

Part 3: What does all this mean for P/C insurers?

 

To state the obvious, how fixed income portfolios were structured in 2020 / 2021 - when interest rates bottomed - has determined how the bear market in bonds has impacted individual P/C insurers. The two key metrics were:

• duration
• credit quality

So far, the clear winners have been the P/C insurers that had fixed income portfolios in 2021/2022 that were low duration. (If we get an economic slowdown / recession then credit quality will likely also become an important factor.)

 

Interest rate risk

 

“Only when the tide goes out do you discover who's been swimming naked.” Warren Buffett

 

Most P/C insurers match the duration of their insurance liabilities with the duration of their fixed income portfolio. So, in 2020/2021, many P/C insurers had an average duration in their fixed income portfolios of about 4 to 4.5 years.

 

As a result of spiking interest rates in 2022, most P/C insurers saw the value of their fixed income portfolio plummet. This in turn caused book value to crater. This happened despite earning a strong underwriting profit in 2022.

 

 

Let’s look at one P/C insurer to better understand what happened

 

Chubb is viewed by many investors/analysts as being one of the better run P/C insurers. At the end of 2020, Chubb’s fixed income portfolio of $107.6 billion was sitting on an unrealized gain of $6.5 billion. Interest rates started to rise in 2021 and at year-end the fixed income portfolio was sitting on a smaller gain of $3.2 billion. In 2022, interest rates spiked higher. At the end of 2022, Chubb was suddenly sitting on a loss of $8.4 billion. Holy shit batman! The two year change in the fair value of Chubb's fixed income portfolio was a staggering swing in value of $14.9 billion (from a gain of $6.5 to a loss of $8.4 billion). As a result, despite earning a strong underwriting profit, book value at Chubb got crushed in 2022.

 

To put this in context, from 2020 to 2022, Chubb earned an average of $3.5 billion per year in interest income from its fixed income portfolio. So a $14.9 billion swing in value over 2 years is a big deal.

 

 

How did Fairfax manage to increase book value in 2022?

 

In terms of book value growth in 2022, Fairfax was a clear outlier. Why? In late 2021 Fairfax reduced the average duration of their fixed income portfolio to 1.2 years (more on this in my next post). As a result it was not impacted by spiking interest rates nearly as much as other P/C insurers.

 

Did any other P/C insurers have extremely low duration?

 

Yes. Berkshire Hathaway had very low average duration (my guess is their loss in book value in 2022 was due in part to mark-to-market losses on their equity portfolio). WR Berkley also deserves a shout-out as their average duration at December 31, 2021, was 2.4 years, which was much lower than the average. As a result, in addition to Fairfax, WR Berkley was one of the few P/C insurers who were able to deliver an increase in book value in 2022.

 

How should we think about these losses?

 

Yes, big unrealized losses sounds scary. But P/C insurers have said they will simply hold the bonds until they mature. Unless there is an unexpected liquidity need (perhaps like a 1-in-100 year catastrophe) it is unlikely we are going to see forced sales. So if the losses will not be realized are they really a problem?

 

Given the sizeable impact to book value there may be regulatory implications - insurance regulators and credit rating agencies are likely paying close attention.

 

Perhaps the more important question is how long are some P/C insurers going to have to sit on those (shit) low yielding bonds they are holding? The key is duration. P/C insurers with fixed income portfolios with an average duration of 4 or 5 years are likely going to need another couple of years to get the (shit) low yielding bonds off their books. Low yielding bonds - means low interest income - means lower earnings.

 

P/C insurers with a low duration portfolio have a big earnings advantage for the next couple of years over P/C insurers with longer duration fixed income portfolios. We will discuss this more below.

 

Inflation risk

 

Expected inflation is generally not a problem. Unexpected inflation, if it is high and persistent, can be a big problem for P/C insurance companies. And guess what we have had for the past 2 years? Unexpected high (double digit) inflation.

 

Why is unexpected inflation an issue? Because most P/C insurance companies are sitting on tens of billions in insurance liabilities.

 

P/C insurers get paid a fixed amount up front when they write an insurance policy. When they price the policy, they have to guess at its cost. After doing all this, they hope to make a profit.

 

Unexpected inflation is a big problem for P/C insurers. It means costs are likely going up more than expected. This is especially problematic for long tail lines of business. Because those higher than expected losses keep happening for years into the future.

 

And if you also have a long duration fixed income portfolio - and, at the same time, you are stuck with (shit) low yielding bonds - well, your problems are even worse.

 

High unexpected inflation and a long duration / low yield fixed income portfolio is not a good combination for the profitability of a P/C insurer - it has the potential to squeeze earnings for years.

 

Perhaps this partly explains why the hard market that started in late 2019 kept going strong in 2023 and looks set to continue strong into 2024 - despite repeated predictions of its imminent demise.

 

Reinvestment opportunity (not risk)

 

The increase in interest rates the past 18 months has been historic in amount and speed. P/C insurers are seeing interest rates today - across the curve - at 15 year highs.

 

 

P/C insurers with shorter duration fixed income portfolios have been able to capture the spike higher in interest rates much more quickly than P/C insurers with longer duration portfolios. We can see this by looking at the trend in interest income for the last 2 years.

 

Fairfax is estimated to see interest income increase 133% in 2023 and 222% over the past 2 years. Chubb, on the other hand, is estimated to see interest income increase 33% in 2023 and 47% over the past two years.

 

The speed of the earn-through for Fairfax is more than 4 x that of Chubb.

 

 

It is also interesting to note that the yield on both Fairfax’s and Chubb’s fixed income portfolio now looks remarkably close. What is very different, however, is what they hold in their respective fixed income portfolios.

 

Credit Risk

 

The one risk I have not discussed is credit risk - the risk the issuer may default on one or more payments. Fairfax’s fixed income portfolio is stuffed mostly with government bonds. High quality. Chubb? Very different.

 

The yield on Fairfax’s and Chubb’s fixed income portfolio might be similar. However, the credit risk (made up of the holdings in each of the two portfolios) looks very different to me. Which portfolio is more risky? Which portfolio should perform better it we see an economic slow down? This post is long enough already… I’ll let you answer those two questions on your own.

 

Conclusion

 

The historic bear market in bonds has crushed the value of fixed income portfolios of many P/C insurance companies - in turn this has cratered book value. But a few odd ducks were prepared - Fairfax, Berkshire Hathaway and WR Berkely. On a relative basis, over the past 24 months, P/C insurers with low duration fixed income portfolios have been the clear winners over P/C insurers with long duration fixed income portfolios. Fairfax was exceptionally well prepared. 

 

Short duration portfolios protected book value. And the earn-through from higher interest rates (in the form of spiking interest income) has been much quicker - which is boosting profitability - compared to long duration peers. 

 

Having a short duration portfolio has also provided valuable optionality - it allows P/C insurance companies to be opportunistic should we see any dislocations in financial markets (like April of 2023, and the crisis that hit regional banks in the US).

 

In my next post (coming next week), I will take a closer look at what the team at Fairfax has done with their fixed income portfolio over the past 2 years. What can we learn about Fairfax and their fixed income team? Does value investing also apply to bonds? Does active management matter?

—————

Background Information:

 

How P/C insurance companies account for their bond holdings is important for investors to understand.

 

Most bonds at most P/C insurance companies are held in the ‘available-for-sale’ bucket. This means that unrealized losses do not show up in earnings (or ROE calculations). However, these unrealized losses are real - instead they show up in ‘other comprehensive income’ and book value.

 

How an Available-for-Sale Security Works

• https://www.investopedia.com/terms/a/available-for-sale-security.asp#:~:text=Available%2Dfor%2Dsale%20(AFS,a%20ready%20market%20price%20available.

“Available-for-sale (AFS) is an accounting term used to describe and classify financial assets. It is a debt or equity security not classified as a held-for-trading or held-to-maturity security—the two other kinds of financial assets. AFS securities are nonstrategic and can usually have a ready market price available.

 

“The gains and losses derived from an AFS security are not reflected in net income (unlike those from trading investments) but show up in the other comprehensive income (OCI) classification until they are sold. Net income is reported on the income statement. Therefore, unrealized gains and losses on AFS securities are not reflected on the income statement.

 

“Net income is accumulated over multiple accounting periods into retained earnings on the balance sheet. In contrast, OCI, which includes unrealized gains and losses from AFS securities, is rolled into "accumulated other comprehensive income" on the balance sheet at the end of the accounting period. Accumulated other comprehensive income is reported just below retained earnings in the equity section of the balance sheet.”

Edited November 26, 2023 by Viking

[This2ShallPass]

11 hours ago, TwoCitiesCapital said:

NAV is a far better metric than share price to charge the fees on because  it is firmly in the control of the management where the share price isn't.

I disagree we should choose a metric to pay fees that management can control, in fact that introduces a significant conflict of interest. At a very basic level, if I charge you for performance fees, you should be able to cash out at the said price levels where the performance fees were charged.

 

To bring it back to the original discussion around Fairfax not treating minority investors fairly, this is another example. You can give them a pass if it was a one off.

 

11 hours ago, TwoCitiesCapital said:

That's just simply not true. It traded at a sizable premium to NAV for much of its public company life

 

Fairfax India will always be tied to Fairfax's reputation, in fact that's why they named the fund with their name on it. If the fund trades at a premium because of their brand or association with them, then I don't have a problem with paying more fees...again as long as I get the benefit of cashing out at said price levels.

 

Most closed end funds trade at a discount to NAV not at a premium, which Fairfax knew.

[Maverick47]

Sheer pleasure to be educated by your post, Viking.  I enjoy the question and answer format.  I have to admit I’ve tended to focus on the equity investments myself, and my understanding of bond portfolio management is rudimentary at best.  I appreciate the comparison with other companies.

[Viking]

42 minutes ago, Maverick47 said:

Sheer pleasure to be educated by your post, Viking.  I enjoy the question and answer format.  I have to admit I’ve tended to focus on the equity investments myself, and my understanding of bond portfolio management is rudimentary at best.  I appreciate the comparison with other companies.

@Maverick47 thanks for the feedback. What really jumps out at me is how much Fairfax was under-earning in recent years on their fixed income portfolio (looking only at interest income). I haven’t factored in investment gains, so only looking at interest income does understate what they were actually earning on their fixed income portfolio. 
 

Regardless, i am looking forward to learning in the coming years how much Fairfax is able to earn on its fixed income portfolio. In the current high inflation / higher for longer interest rate world, think active management matters more than most investors realize. Not just in terms of fixed income, but also from a total investment portfolio perspective. 

[UK]

7 hours ago, Viking said:

Credit Risk

 

The one risk I have not discussed is credit risk - the risk the issuer may default on one or more payments. Fairfax’s fixed income portfolio is stuffed mostly with government bonds. High quality. Chubb? Very different.

 

The yield on Fairfax’s and Chubb’s fixed income portfolio might be similar. However, the credit risk (made up of the holdings in each of the two portfolios) looks very different to me. Which portfolio is more risky? Which portfolio should perform better it we see an economic slow down? This post is long enough already… I’ll let you answer those two questions on your own.

 

Thanks Viking!

 

And yet CB trades at almost 1.8 BV vs FFH at 1+ BV. I know, I know: everybody else has a better story, reputation, moat and never makes any mistakes etc...except you will not see this in their recent results or track record:)

[dealraker]

1 hour ago, UK said:

 

Thanks Viking!

 

And yet CB trades at almost 1.8 BV vs FFH at 1+ BV. I know, I know: everybody else has a better story, reputation, moat and never makes any mistakes etc...except you will not see this in their recent results or track record:)

In the early 2000's First Union and many other big banks were going around paying 4 times book for community banks earning 10% on equity.  They'd flush both the silly price excess and future expenses in a huge one time charge.  Thus for years the book value of First Union under Fast Eddie Klutzfield's "Hell, with the accounting we use I can pay 5 x book and make it work" model stayed the same and naive investors favorite metric, sold by all the analysts with obsession...that ROE thingy for these liars went to and stayed 25-28%.  Celebrate...celebrate...dance to the music!

 

But the above?  Hell, it had already gone on for 10 damn long years and more.  The ending of it?  Nobody knew for sure, but it was going to come.

 

And today not one Brookfielder will own up to the absolutely brain dead bizarre way the subs, and thus the part owners of the subs, tally up thier stuff.  How long can that go?  There's not one single person, even those who know it is all made up - not one can tell you within a decade of when it will stop.  Same was true when the four of us thoroughly enjoyed the public thrashing and condemnation we got from our "The 12 Ways GE Misleads Investors" stuff.  Even today, some 25 years after we began that my cousin CPA says with a smirk (this guy is a brilliant investor but he did lose a whopping $5 mil of family money with Enron), "You didn't prove a thing."  He is 100% correct; we proved nothing...absolutely no proof of anything ever with our GE report.

 

And nothing will ever be proven with Brookfield either.  Life....ain't it plum unfair and awful?
 

But angst as with Fairfax hovering around book?  Can you invest there today and get a return that's almost surely above inflation and above what you'll get with safe fixed?  I'd say...."Hmm...seems the probability is about 95%."  

 

Do you have to worry about Prem's accounting?  Is he out shouting shit like plan value is double of the current stock price?  Is he like Welch upon retirement coming on CNBC daily to rant, "17-18 percent with GE as far as I can see" a few days before the largest one-time write down in the insurance business history...followed by 20 plus years of fake accounting coming unglued.

 

And the problem with Fairfax is....???  There is no problem with Fairfax except that you can buy all you want.  

 

My morning rant!  Have a great day everybody.  

[UK]

39 minutes ago, dealraker said:

In the early 2000's First Union and many other big banks were going around paying 4 times book for community banks earning 10% on equity.  They'd flush both the silly price excess and future expenses in a huge one time charge.  Thus for years the book value of First Union under Fast Eddie Klutzfield's "Hell, with the accounting we use I can pay 5 x book and make it work" model stayed the same and naive investors favorite metric, sold by all the analysts with obsession...that ROE thingy for these liars went to and stayed 25-28%.  Celebrate...celebrate...dance to the music!

 

But the above?  Hell, it had already gone on for 10 damn long years and more.  The ending of it?  Nobody knew for sure, but it was going to come.

 

And today not one Brookfielder will own up to the absolutely brain dead bizarre way the subs, and thus the part owners of the subs, tally up thier stuff.  How long can that go?  There's not one single person, even those who know it is all made up - not one can tell you within a decade of when it will stop.  Same was true when the four of us thoroughly enjoyed the public thrashing and condemnation we got from our "The 12 Ways GE Misleads Investors" stuff.  Even today, some 25 years after we began that my cousin CPA says with a smirk (this guy is a brilliant investor but he did lose a whopping $5 mil of family money with Enron), "You didn't prove a thing."  He is 100% correct; we proved nothing...absolutely no proof of anything ever with our GE report.

 

And nothing will ever be proven with Brookfield either.  Life....ain't it plum unfair and awful?
 

But angst as with Fairfax hovering around book?  Can you invest there today and get a return that's almost surely above inflation and above what you'll get with safe fixed?  I'd say...."Hmm...seems the probability is about 95%."  

 

Do you have to worry about Prem's accounting?  Is he out shouting shit like plan value is double of the current stock price?  Is he like Welch upon retirement coming on CNBC daily to rant, "17-18 percent with GE as far as I can see" a few days before the largest one-time write down in the insurance business history...followed by 20 plus years of fake accounting coming unglued.

 

And the problem with Fairfax is....???  There is no problem with Fairfax except that you can buy all you want.  

 

My morning rant!  Have a great day everybody.  

 

Thanks. You are right, angst is not necessary and I need to be more patient, because, on the other hand, how could one even complain, with FFH up like 50+ per cent YTD, after a few up years before:)