Fairfax 2024

[value_hunter]

1 hour ago, Cigarbutt said:

The rating agency is rather oblivious to the potential higher return of holding equity (tied to slow-growing retained earnings and the related % "coupon") but is concerned about the higher risk, with the concern resulting in a higher risk-based capital haircut (charge), equity versus investment-grade corporate bonds. At this point, FFH insurance subs are in an excess capital position and moving capital around and related investment decisions are part of the opportunistic capital allocation process.

The following table will give you an idea of the potential charge although these tables are only a guide and an unusually large investment with 100% control may give rise to an additional "concentration" charge. i seem to remember a video where both Mr. Buffett and Mr. Munger voiced some kind of amusement when a rating agency alluded to the possibility of a 100% haircut on the BNSF investment (which used to be 100% held within NICO).

-----

For the zzz investment, one has to understand the economics of the retail mattress industry or one has to outsource the analysis and the thinking to Hamblin-Watsa..

If Fairfax truly believe this type of transaction has a better risk/reward than corporate bond and not consider the credit rating impact, can it replace its bond portfolio with more of these type transactions in their sub-insurance business? Is there any regulation restriction?  BRK seems are doing the same and has a disproportional high percentage of sub-business vs bond portfolio than traditional P/C insures.

[nwoodman]

12 hours ago, value_hunter said:

If Fairfax truly believe this type of transaction has a better risk/reward than corporate bond and not consider the credit rating impact, can it replace its bond portfolio with more of these type transactions in their sub-insurance business? Is there any regulation restriction?  BRK seems are doing the same and has a disproportional high percentage of sub-business vs bond portfolio than traditional P/C insures.

Really depends on how the acquisition affects the MCT calculation (Canada) or RBC (USA). If these ratios are still in acceptable ranges then absolutely.  I think this is the ultimate end game.  I always saw Shaw Carpets as a bit of a P/C clawback.  Perhaps I will come to see bedding the same

 

Edit:  or conversely you wanted some real time data on household formation. Real time macro data can be quite helpful.

Edited August 10 by nwoodman

[petec]

14 hours ago, value_hunter said:

Can someone explain to me why it's better to buy a business (PE:19, PB: 2.5) than buy its own share (PE 7, PB 1.1)? 

 

I have not read the replies yet so sorry if I am duplicating, but

1) the insurance subsidiaries need capital to write premiums. There's a limit on how much they can dividend to the holdco for buybacks.

2) Price/value now isn't what matters. Price/value in the future is what matters. I don't have a view on ZZZ's future value but presumably FFH do.

3) Liquidity. FFH are already buying back shares, and probably can't do it a lot faster without finding blocks. They found one from Prem but may not be able to find others. 

[Thrifty3000]

23 hours ago, value_hunter said:

Can someone explain to me why it's better to buy a business (PE:19, PB: 2.5) than buy its own share (PE 7, PB 1.1)? 

If you want to get rich, concentrate. If you want to stay rich, diversify.

 

If your goal is to own an asset that will pay dividends to your great great grandchildren, while also paying dividends to future generations of Watsas then your interests are probably well aligned with FFH.

 

If you want maximum near term financial engineering to boost share prices so you can flip your shares to the next impatient “investor” then there’s probably more disappointment to come.

 

IMHO, FFH is best viewed as the Watsa and friends family office. A family office wants the best long term - multi-generational - risk adjusted returns. 

[value_hunter]

16 hours ago, nwoodman said:

Really depends on how the acquisition affects the MCT calculation (Canada) or RBC (USA). If these ratios are still in acceptable ranges then absolutely.  I think this is the ultimate end game.  I always saw Shaw Carpets as a bit of a P/C clawback.  Perhaps I will come to see bedding the same

 

Edit:  or conversely you wanted some real time data on household formation. Real time macro data can be quite helpful.

Just want further expand this discussion. Nowadays more and more PE firm like APO, Blackstone, BN are buying or partnering with insurance companies. Replacing their bond portfolios with higher return private equity while still maintain their high credit rating. This seems a trend. And is also BRK's model.  Ultra wealth families are allocating more and more in private equity (https://www.cnbc.com/2024/08/09/wealthy-investors-find-opportunities-in-stock-market-sell-offs-.html).  All of sudden everyone seems want to buck this trend. But the beauty is Fairfax has much lower multiples than PE firm like BX, APO.

Edited August 10 by value_hunter

[Thrifty3000]

When Charlie Munger and I buy stocks — which we think of as small portions of businesses — our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. 

 

What will the next 10 years of FFH earnings look like?

 

Will it be the dreaded earnings cliff, where interest rates round trip to the zero bound, FFH hedges equities, combined ratios edge back towards 100, and maybe the Canadian Government raises corporate taxes or a string of mega-cats catch FFH completely by surprise. That nightmare scenario may look something like this...

 

 

Or, if you're the perpetual optimist, then maybe you assume that after a decade of carefully and deliberately structuring its management team, insurance business and investment team for a future sans Prem, that the "new Fairfax" is finally geared to achieve its dual mandate of a 7% portfolio return and a 95 combined ratio. Maybe your crystal ball foretells this happy future...

 

 

Or, if we can assume with 80% confidence that real life will land somewhere between our best and worse cases, that some results will turn out better than feared, and others will turn out worse than hoped, then maybe we can assume a result that falls somewhere reasonably between the two - and invest with conviction when Fairfax - as it is today - is fairly priced for even our worst case scenario. The base case...

 

 

^ I think a job well done for a value investor is to follow that approach diligently and consistently. Much easier said than done!

 

PS. My forecasts above are necessarily rough and change constantly as new insights arise.

Edited August 10 by Thrifty3000

[hasilp89]

1 hour ago, value_hunter said:

Just want further expand this discussion. Nowadays more and more PE firm like APO, Blackstone, BN are buying or partnering with insurance companies. Replacing their bond portfolios with higher return private equity while still maintain their high credit rating.

It's an interesting topic and trend. From what I understand what the ALT's are doing is different from BRK/FFH though. My understanding is that they're are sticking to more annuity type insurance business - I don't believe they do significant P/C or reinsurance.

Also I don't believe they are matching Athene annuity liabilities with much if any private equity assets (pg 8 of link below shows asset mix) lots of alt fixed income (CLO's, mortgages, private credit etc).  Their private equity funds are still made up of traditional insitutional LP's. It seems simple but to do what BRK/FFH are doing takes something special. 

 

https://d1io3yog0oux5.cloudfront.net/_daa2d19294221014c85571d1c996fa66/athene/db/2271/21954/pdf/Athene-2024-Asset-Risk-and-Stress-Considerations.pdf

[value_hunter]

12 minutes ago, hasilp89 said:

It's an interesting topic and trend. From what I understand what the ALT's are doing is different from BRK/FFH though. My understanding is that they're are sticking to more annuity type insurance business - I don't believe they do significant P/C or reinsurance.

Also I don't believe they are matching Athene annuity liabilities with much if any private equity assets (pg 8 of link below shows asset mix) lots of alt fixed income (CLO's, mortgages, private credit etc).  Their private equity funds are still made up of traditional insitutional LP's. It seems simple but to do what BRK/FFH are doing takes something special. 

 

https://d1io3yog0oux5.cloudfront.net/_daa2d19294221014c85571d1c996fa66/athene/db/2271/21954/pdf/Athene-2024-Asset-Risk-and-Stress-Considerations.pdf

Thanks for your info. Fairfax march in mortgages area with KW seems eating ALT's lunch.

[TwoCitiesCapital]

53 minutes ago, hasilp89 said:

It's an interesting topic and trend. From what I understand what the ALT's are doing is different from BRK/FFH though. My understanding is that they're are sticking to more annuity type insurance business - I don't believe they do significant P/C or reinsurance.

Also I don't believe they are matching Athene annuity liabilities with much if any private equity assets (pg 8 of link below shows asset mix) lots of alt fixed income (CLO's, mortgages, private credit etc).  Their private equity funds are still made up of traditional insitutional LP's. It seems simple but to do what BRK/FFH are doing takes something special. 

 

https://d1io3yog0oux5.cloudfront.net/_daa2d19294221014c85571d1c996fa66/athene/db/2271/21954/pdf/Athene-2024-Asset-Risk-and-Stress-Considerations.pdf

 

Quite honestly, it's probably because they can't. 

 

The idea of using insurance liabilities to invest in long duration equity assets SHOULD be terrifying. High leverage with a very uncertain repayment schedule gives you a duration mismatch worse than banks. 

 

Which is why it's so important to get the underwriting piece right, and then having ample liquidity, so you don't ever have to force-sale equities at inopportune times. 

 

Most people shouldn't be trusted to do it and regulations have since been passed to prevent many from trying to do things like this. What expertise do these finance guys have in underwriting insurance liabilities? 

 

Moving to more exotic forms of fixed income DOES make a lot more sense with less danger.  It's surprising to me that it's taken this long for people to do it. 

 

When Exor bought PartnerRE, the first thing they did was flip the fixed income into corporates. Surprising that they didn't already own those and that it was so easy to pick up another 1-2% on float. 

 

 

Edited August 10 by TwoCitiesCapital

[Viking]

4 hours ago, Thrifty3000 said:

When Charlie Munger and I buy stocks — which we think of as small portions of businesses — our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. 

 

What will the next 10 years of FFH earnings look like?

 

Will it be the dreaded earnings cliff, where interest rates round trip to the zero bound, FFH hedges equities, combined ratios edge back towards 100, and maybe the Canadian Government raises corporate taxes or a string of mega-cats catch FFH completely by surprise. That nightmare scenario may look something like this...

 

 

Or, if you're the perpetual optimist, then maybe you assume that after a decade of carefully and deliberately structuring its management team, insurance business and investment team for a future sans Prem, that the "new Fairfax" is finally geared to achieve its dual mandate of a 7% portfolio return and a 95 combined ratio. Maybe your crystal ball foretells this happy future...

 

 

Or, if we can assume with 80% confidence that real life will land somewhere between our best and worse cases, that some results will turn out better than feared, and others will turn out worse than hoped, then maybe we can assume a result that falls somewhere reasonably between the two - and invest with conviction when Fairfax - as it is today - is fairly priced for even our worst case scenario. The base case...

 

 

^ I think a job well done for a value investor is to follow that approach diligently and consistently. Much easier said than done!

 

PS. My forecasts above are necessarily rough and change constantly as new insights arise.

@Thrifty3000 I think we can all agree that ‘baseline’ earnings for Fairfax will be very robust for at least the next three years. That is simply based on the facts - what we know today. I don’t think that is a controversial thing to say. Yes, there are downside risks. But there is also a good chance we get some upside surprises (one example: asset sales/revaluations resulting in large investment gains). For the next couple of years, i think the ‘risks’ are skewed to upside surprises for Fairfax. 

 

Parts of your analysis ignores what we know today. Is that a rational way to try and value Fairfax?

 

Or put another way… if you had done this exact same analysis three years ago would it have helped you or hurt you in trying to value Fairfax? Especially when it came to position size (the ‘how undervalued’ a company is part of investing).

 

PS: by ‘baseline’ earnings I mean earnings excluding unknown/extraordinary events.

Edited August 10 by Viking

[Thrifty3000]

1 hour ago, Viking said:

@Thrifty3000 I think we can all agree that ‘baseline’ earnings for Fairfax will be very robust for at least the next three years. That is simply based on the facts - what we know today. I don’t think that is a controversial thing to say. Yes, there are downside risks. But there is also a good chance we get some upside surprises (one example: asset sales/revaluations resulting in large investment gains). For the next couple of years, i think the ‘risks’ are skewed to upside surprises for Fairfax. 

 

Parts of your analysis ignores what we know today. Is that a rational way to try and value Fairfax?

 

Or put another way… if you had done this exact same analysis three years ago would it have helped you or hurt you in trying to value Fairfax? Especially when it came to position size (the ‘how undervalued’ a company is part of investing).

 

PS: by ‘baseline’ earnings I mean earnings excluding unknown/extraordinary events.

 

I think the main difference between your near term estimates and mine is that I use the fully diluted share count (since it hasn't been declining as quickly as the common share count). If I used the common share count I think our EPS estimates would be within a couple dollars of each other's for at least this year and next year.

[Thrifty3000]

I go back and forth on whether to use an average of the common and diluted count since not all dilution will actually occur. But, we know that more than 0% dilution will definitely happen, so I don't let myself use the common.

[Viking]

Volatility and Fairfax - Part 2

 

Earlier this week we began our exploration of volatility in financial markets and the different ways it impacts Fairfax. Given the size of the topic, we broke our analysis into two parts/posts.

 

In our first post, we introduced the concept of volatility and then explored the following:

• Part 1: Fairfax’s ability to profit from volatility

Clink the link to read Part 1: https://thecobf.com/forum/topic/20517-fairfax-2024/page/72/#comment-574244

 

Below is part 2 of our discussion of volatility.

 

Part 2: The impact of volatility on Fairfax’s short term reported results

 

‘New Fairfax’

 

Fairfax as a company has undergone a number of important changes ‘under the hood’ over the past 5 years. These changes have make the company a very different animal from the company that existed previously. To help differentiate between the two versions, I call Fairfax as it exists today ‘New Fairfax’ and the Fairfax from +5 years ago ‘Old Fairfax.’

 

Volatility of Fairfax’s reported results

 

The historic reported results (earnings and book value) of ‘Old Fairfax’s’ were always VERY volatile. Not just the quarterly results, but also the annual results. This was due to a number of reasons - largely related to its business model but also how Fairfax was executing the business model.

 

Moving forward, my guess is the reported results of ’new Fairfax’ will be much less volatile than what investors are used to.

 

Why?

1. There has been a significant change in the size of the income streams that Fairfax generates - with a massive shift to lower volatility, higher quality operating earnings.
2. The management team at Fairfax has been making many important changes ‘under the hood’ that suggests reported results in many of Fairfax’s individual income streams should be less volatile moving forward.

Let’s dig into each of these a little more.

 

Fairfax’s results are now being driven by high quality operating earnings

 

Let’s first look at the time period from 2016 to 2021. Over this 6 year period, Fairfax’s biggest income stream was investment gains and it represented an average of 54% of all of Fairfax’s income streams. Operating earnings (interest and dividend income, underwriting income and share of profit of associates) averaged 46%.

 

From 2016-2021, investment gains were - by far - the most important income stream for Fairfax. This income stream was also exceptionally volatile. In turn, this caused Fairfax’s reported results to swing quite dramatically from year to year.

 

‘New Fairfax’

 

This split - investment gains vs operating earnings - has changed dramatically over the past four years.

 

As Prem said very loudly at the AGM this year: ‘Fairfax has been transformed.’

 

Operating income (interest and dividend income, underwriting income and share of profit of associates) has exploded in size at Fairfax over the past 3 years. It averaged $1.1 billion per year from 2016 to 2021. In 2024 it is estimated to come in at around $4.5 billion, an increase of $3.4 billion. This is a massive increase.

 

Operating income is considered by Wall Street to be the ‘high quality’ source of earnings for P/C insurance companies - because they are considered to be predictable and durable sources of income. On the other hand, given their unpredictability in the short term, investment gains are considered to be a ‘low quality’ source of earnings.

 

Today, operating income is Fairfax’s largest income stream - it now represents 81% of Fairfax’s total income streams. Investment gains now represent 19% of Fairfax’s income streams.

 

There are two really important points:

• The total size of Fairfax’s income streams has exploded in size.
• All of the growth has happened in the operating income bucket.

This has profound implications on how changes in financial markets will affect Fairfax’s reported results (earnings and book value) in the future (when compared to the past). Fairfax’s reported results will likely be much less volatility than in the past.

 

 

But there is more to the volatility story.

 

Let’s take a closer look at what has been going on under the hood at Fairfax

 

Fairfax has three economic engines:

• P/C insurance
• Investments - Fixed income
• Investment - Equities

Let’s review some of the changes that have happened in each of these buckets in recent years.

 

P/C insurance

• Runoff is now a much smaller part of Fairfax’s total P/C insurance business. In 2016, the runoff business represented 20.5% of shareholders’ equity at Fairfax. In 2023, runoff represented 1.9% of shareholders’ equity.
• Fairfax has been shrinking its total catastrophe exposure (as a company) in recent years, especially at Brit.
• The hard market in P/C insurance has now been going on for 4.5 years - Fairfax should be well reserved.

All things being equal, this suggests that Fairfax’s reported underwriting results will likely be less volatile in future years than they were in the past.

 

Investments: Fixed income

 

As required by regulators, Fairfax began using IFRS 17 accounting on January 1, 2023. Moving forward, when interest rates change, IFRS 17 (and how it accounts for insurance liabilities) will largely work as an offset to changes in the mark to market value of Fairfax’s fixed income portfolio. It will not be an exact offset (one goes up the same as the other goes down and vice versa). But it should smooth out the swings quite a bit.

 

This suggests that large changes in interest rates should result in less volatility in Fairfax’s reported results (earnings and book value) in future years than in the past.

 

Investments: Equities

 

Since 2020, the composition of Fairfax’s equity portfolio has changed dramatically.

• Non-insurance consolidated (private) equity holdings has substantially increased in size in recent years.
  • Recipe and Grivalia Hospitality were added to this bucket in 2022 and the Sleep Country acquisition was just announced.
  • This group of holdings has increased in recent years to now represent about 20% of the total equity portfolio (including Sleep Country).
• Associate equity holdings has also substantially increased in size in recent years - to about 35% of the total equity holdings (not including Stelco now that it has been sold).
  • Fairfax’s two largest equity holdings are in this bucket: Eurobank as of January 1, 2020 and Poseidon (formerly Atlas/Seaspan) as of Q1 2020.

The non mark to market group of holdings has increased significantly in size over the past 5 years. The majority of Fairfax’s equity holdings (about 55%) are no longer mark to market type holdings.

 

The quality of the equity portfolio has also improved materially

 

Back in 2018, Fairfax’s equity portfolio was stuffed with many ‘problem’ equity holdings. Over the past 5 years Fairfax has done a great job of dealing with all of its poorly performing equity holdings. As a result, the overall quality of the equity portfolio has improved dramatically.

 

There are two really important points:

1. The quality of Fairfax’s equity portfolio has improved dramatically over the past 5 years.
2. Over the past 5 years, the composition of Fairfax’s equity portfolio has shifted from mostly mark to market holdings to mostly non mark to market holdings (at about 55% in 2024).

This suggests a big sell-off in equity markets should result in much less volatility in Fairfax's investment gains (losses) and reported results (earnings and book value) in future years than in the past.

 

Remember, investment gains  is now also a much smaller income stream for Fairfax as a percent of total income streams. So a much smaller income stream will also be much less volatile - this is a double impact.

 

Summary

 

Many important changes have happened at Fairfax over the past number of years:

• Operating income, at about 80%, is now - by far -  Fairfax’s largest income stream.
• The P/C insurance business continues to improve in quality and shrink its catastrophe exposure.
• The implementation of IFRS 17 will smooth results in the fixed income portfolio.
• The equity portfolio has improved dramatically in quality and significantly shifted away from mark to market type holdings.

All of these changes should make Fairfax’s future reported results (earnings and book value) much less volatile than in the past.

 

Important: this does not mean that Fairfax's reported results will not have some volatility to them in the future. The point is the volatility should be much less than what we have seen in the past. 

 

Volatility and market multiple

 

This is important because for Wall Street, earnings volatility and market multiple are linked at the hip. All things being equal, the stocks of lower volatility businesses (from an earnings perspective) usually receive a higher multiple. And the stocks of higher volatility businesses usually receive a lower multiple.

 

My guess is Wall Street does not yet fully grasp the changes that have happened at Fairfax that will lower the volatility of future reported results (when compared to the past). As a result, ‘lower volatility’ is likely not yet priced into Fairfax’s stock. This provides another important tailwind for long term investors.

 

Fairfax's Valuation

 

Fairfax is trading today at a trailing P/BV multiple = 1.1

• Fairfax has delivered the best growth in book value per share among P/C insurance peers over the past 5 years.
• We also know that Fairfax's book value is materially understated (gain from Stelco sale + excess of market value over carrying value of equity holdings).
• Fairfax is poised to deliver mid teens ROE in 2024 and the coming years.
• And now we know Fairfax's future reported results will likely be much less volatile than in the past (meaning they are of much higher 'quality').   

All of this warrants a trailing P/BV multiple of 1.1? Really?

 

Is it any surprise that Fairfax has been VERY aggressive taking out shares YTD in 2024 at a slight premium to book value? 

 

Edited August 11 by Viking

[wondering]

@Viking  Thanks again for all the great posts.  A further discussion point on Volatility part II post.

 

Is it your argument that Fairfax is changing the way they hold equities on purpose (ie to reduce volatility on earnings).  For example, buying less minority interests on publicly traded stocks, and owning more companies privately.

 

My thinking was always Fairfax are value hunters and they will go where they see value. Period.  The way they hold the investment in secondary.

 

They took Atlas private, but it was my thinking that they would bring it back to public markets when they felt the time was right.  I figured owning publicly traded stocks makes things easier for Fairfax since they have to comply with regulators etc...

 

Any thoughts?

[SafetyinNumbers]

AQN is the 60th biggest component of the S&P/TSX 60 and after their bigger than expected dividend cut and more importantly lower than expected proceeds from an asset sale is now sitting right at 20bps in the index. Perhaps a bit below as of today. The index committee might have a decision on its hands if it drops below 20bps at the time of the quarterly rebalancing/measurement date which is August 31. The 20bps threshold is a rule of thumb based on previous deletions and the committee could choose not to make any changes.
 

To be clear, even though FFH is the largest component of the S&P/TSX Composite that’s not in the 60, the committee also weighs the industry representation in the Composite vs the 60 in its decision and Financials are already overweight. For that reason, I don’t think most funds are positioned for it being added. 
 

Given, my expectation that FFH will execute well on BVPS growth for the next 5 years, I continue to think it’s only a matter of time before it goes in the index as at some point it’s too big to ignore. 
 

My bet is that a new ~4% shareholder that is buying stock every month (passive flows) will help with multiple expansion.
 

 

 

[Viking]

4 hours ago, wondering said:

@Viking  Thanks again for all the great posts.  A further discussion point on Volatility part II post.

 

Is it your argument that Fairfax is changing the way they hold equities on purpose (ie to reduce volatility on earnings).  For example, buying less minority interests on publicly traded stocks, and owning more companies privately.

 

My thinking was always Fairfax are value hunters and they will go where they see value. Period.  The way they hold the investment in secondary.

 

They took Atlas private, but it was my thinking that they would bring it back to public markets when they felt the time was right.  I figured owning publicly traded stocks makes things easier for Fairfax since they have to comply with regulators etc...

 

Any thoughts?

@wondering  A lot of the discussion points in my posts are fluid… things that looks interesting that could go in different directions in the future. I am not sure what Fairfax’s thinking is on weightings within the equity bucket (mark to market, associate or consolidated). 
 

I agree with your summary: “My thinking was always Fairfax are value hunters and they will go where they see value. Period.  The way they hold the investment in secondary.”

 

i would add a little to your comment: Fairfax also seems to like the true value of their holdings to be reflected in book value (at least looking at it from an historical perspective).

 

Having said that, i wonder if they do not want to have some non-insurance consolidated holdings. ‘Bond type’ holdings that spit out cash. As a important offset to the P/C insurance business. But even here, if there is an opportunity to realize a big investment gain (like take take Recipe public in the future) my guess is they will do it.

 

I think there has been a trend in the general market towards more private and fewer public holdings. Fairfax has many deep pocketed partners. Perhaps part of what is happening at Fairfax i s just a microcosm of what is going on in the larger marketplace (towards more private holdings).

 

It might also be a reflection of Fairfax’s size - as Fairfax gets bigger it makes sense when they make investments they will own bigger stakes in companies (+20% or more) which will push more investments into the associates bucket or (50% or more) the consolidated bucket.

 

And some holdings are just better suited to be held as private holdings - versus public. AGT Food Ingredients is a great example if this - their business is too volatile and none of their peer group are publicly traded. I think taking Recipe private was smart for the business - my guess is they needed to restructure their operations after 10 years of acquisitions and this is difficult to do as a publicly traded company (they got started on this in the 2 years before Fairfax took them out). 

 

Of interest, when i calculate Fairfax’s splits (mark to market, associate and consolidated) i include the FFH-TRS in the mark to market bucket. If you exclude that holding (it is a derivative), the mark to market bucket is even smaller. 
 

And within the remaining holdings in the mark to market bucket, you have the significant limited partnership holdings that total $2 billion - BDT, ShawKwei, JAB etc. 

 

The true mark to market ‘common stock portfolio’ is $4.5 billion out of $20 billion in ‘equities’ and +$65 billion in total investments.

Edited August 12 by Viking

[73 Reds]

23 hours ago, Viking said:

Volatility and Fairfax - Part 2

 

Earlier this week we began our exploration of volatility in financial markets and the different ways it impacts Fairfax. Given the size of the topic, we broke our analysis into two parts/posts.

 

In our first post, we introduced the concept of volatility and then explored the following:

• Part 1: Fairfax’s ability to profit from volatility

Clink the link to read Part 1: https://thecobf.com/forum/topic/20517-fairfax-2024/page/72/#comment-574244

 

Below is part 2 of our discussion of volatility.

 

Part 2: The impact of volatility on Fairfax’s short term reported results

 

‘New Fairfax’

 

Fairfax as a company has undergone a number of important changes ‘under the hood’ over the past 5 years. These changes have make the company a very different animal from the company that existed previously. To help differentiate between the two versions, I call Fairfax as it exists today ‘New Fairfax’ and the Fairfax from +5 years ago ‘Old Fairfax.’

 

Volatility of Fairfax’s reported results

 

The historic reported results (earnings and book value) of ‘Old Fairfax’s’ were always VERY volatile. Not just the quarterly results, but also the annual results. This was due to a number of reasons - largely related to its business model but also how Fairfax was executing the business model.

 

Moving forward, my guess is the reported results of ’new Fairfax’ will be much less volatile than what investors are used to.

 

Why?

1. There has been a significant change in the size of the income streams that Fairfax generates - with a massive shift to lower volatility, higher quality operating earnings.
2. The management team at Fairfax has been making many important changes ‘under the hood’ that suggests reported results in many of Fairfax’s individual income streams should be less volatile moving forward.

Let’s dig into each of these a little more.

 

Fairfax’s results are now being driven by high quality operating earnings

 

Let’s first look at the time period from 2016 to 2021. Over this 6 year period, Fairfax’s biggest income stream was investment gains and it represented an average of 54% of all of Fairfax’s income streams. Operating earnings (interest and dividend income, underwriting income and share of profit of associates) averaged 46%.

 

From 2016-2021, investment gains were - by far - the most important income stream for Fairfax. This income stream was also exceptionally volatile. In turn, this caused Fairfax’s reported results to swing quite dramatically from year to year.

 

‘New Fairfax’

 

This split - investment gains vs operating earnings - has changed dramatically over the past four years.

 

As Prem said very loudly at the AGM this year: ‘Fairfax has been transformed.’

 

Operating income (interest and dividend income, underwriting income and share of profit of associates) has exploded in size at Fairfax over the past 3 years. It averaged $1.1 billion per year from 2016 to 2021. In 2024 it is estimated to come in at around $4.5 billion, an increase of $3.4 billion. This is a massive increase.

 

Operating income is considered by Wall Street to be the ‘high quality’ source of earnings for P/C insurance companies - because they are considered to be predictable and durable sources of income. On the other hand, given their unpredictability in the short term, investment gains are considered to be a ‘low quality’ source of earnings.

 

Today, operating income is Fairfax’s largest income stream - it now represents 81% of Fairfax’s total income streams. Investment gains now represent 19% of Fairfax’s income streams.

 

There are two really important points:

• The total size of Fairfax’s income streams has exploded in size.
• All of the growth has happened in the operating income bucket.

This has profound implications on how changes in financial markets will affect Fairfax’s reported results (earnings and book value) in the future (when compared to the past). Fairfax’s reported results will likely be much less volatility than in the past.

 

 

But there is more to the volatility story.

 

Let’s take a closer look at what has been going on under the hood at Fairfax

 

Fairfax has three economic engines:

• P/C insurance
• Investments - Fixed income
• Investment - Equities

Let’s review some of the changes that have happened in each of these buckets in recent years.

 

P/C insurance

• Runoff is now a much smaller part of Fairfax’s total P/C insurance business. In 2016, the runoff business represented 20.5% of shareholders’ equity at Fairfax. In 2023, runoff represented 1.9% of shareholders’ equity.
• Fairfax has been shrinking its total catastrophe exposure (as a company) in recent years, especially at Brit.
• The hard market in P/C insurance has now been going on for 4.5 years - Fairfax should be well reserved.

All things being equal, this suggests that Fairfax’s reported underwriting results will likely be less volatile in future years than they were in the past.

 

Investments: Fixed income

 

As required by regulators, Fairfax began using IFRS 17 accounting on January 1, 2023. Moving forward, when interest rates change, IFRS 17 (and how it accounts for insurance liabilities) will largely work as an offset to changes in the mark to market value of Fairfax’s fixed income portfolio. It will not be an exact offset (one goes up the same as the other goes down and vice versa). But it should smooth out the swings quite a bit.

 

This suggests that large changes in interest rates should result in less volatility in Fairfax’s reported results (earnings and book value) in future years than in the past.

 

Investments: Equities

 

Since 2020, the composition of Fairfax’s equity portfolio has changed dramatically.

• Non-insurance consolidated (private) equity holdings has substantially increased in size in recent years.
  • Recipe and Grivalia Hospitality were added to this bucket in 2022 and the Sleep Country acquisition was just announced.
  • This group of holdings has increased in recent years to now represent about 20% of the total equity portfolio (including Sleep Country).
• Associate equity holdings has also substantially increased in size in recent years - to about 35% of the total equity holdings (not including Stelco now that it has been sold).
  • Fairfax’s two largest equity holdings are in this bucket: Eurobank as of January 1, 2020 and Poseidon (formerly Atlas/Seaspan) as of Q1 2020.

The non mark to market group of holdings has increased significantly in size over the past 5 years. The majority of Fairfax’s equity holdings (about 55%) are no longer mark to market type holdings.

 

The quality of the equity portfolio has also improved materially

 

Back in 2018, Fairfax’s equity portfolio was stuffed with many ‘problem’ equity holdings. Over the past 5 years Fairfax has done a great job of dealing with all of its poorly performing equity holdings. As a result, the overall quality of the equity portfolio has improved dramatically.

 

There are two really important points:

1. The quality of Fairfax’s equity portfolio has improved dramatically over the past 5 years.
2. Over the past 5 years, the composition of Fairfax’s equity portfolio has shifted from mostly mark to market holdings to mostly non mark to market holdings (at about 55% in 2024).

This suggests a big sell-off in equity markets should result in much less volatility in Fairfax's investment gains (losses) and reported results (earnings and book value) in future years than in the past.

 

Remember, investment gains  is now also a much smaller income stream for Fairfax as a percent of total income streams. So a much smaller income stream will also be much less volatile - this is a double impact.

 

Summary

 

Many important changes have happened at Fairfax over the past number of years:

• Operating income, at about 80%, is now - by far -  Fairfax’s largest income stream.
• The P/C insurance business continues to improve in quality and shrink its catastrophe exposure.
• The implementation of IFRS 17 will smooth results in the fixed income portfolio.
• The equity portfolio has improved dramatically in quality and significantly shifted away from mark to market type holdings.

All of these changes should make Fairfax’s future reported results (earnings and book value) much less volatile than in the past.

 

Important: this does not mean that Fairfax's reported results will not have some volatility to them in the future. The point is the volatility should be much less than what we have seen in the past. 

 

Volatility and market multiple

 

This is important because for Wall Street, earnings volatility and market multiple are linked at the hip. All things being equal, the stocks of lower volatility businesses (from an earnings perspective) usually receive a higher multiple. And the stocks of higher volatility businesses usually receive a lower multiple.

 

My guess is Wall Street does not yet fully grasp the changes that have happened at Fairfax that will lower the volatility of future reported results (when compared to the past). As a result, ‘lower volatility’ is likely not yet priced into Fairfax’s stock. This provides another important tailwind for long term investors.

 

Fairfax's Valuation

 

Fairfax is trading today at a trailing P/BV multiple = 1.1

• Fairfax has delivered the best growth in book value per share among P/C insurance peers over the past 5 years.
• We also know that Fairfax's book value is materially understated (gain from Stelco sale + excess of market value over carrying value of equity holdings).
• Fairfax is poised to deliver mid teens ROE in 2024 and the coming years.
• And now we know Fairfax's future reported results will likely be much less volatile than in the past (meaning they are of much higher 'quality').   

All of this warrants a trailing P/BV multiple of 1.1? Really?

 

Is it any surprise that Fairfax has been VERY aggressive taking out shares YTD in 2024 at a slight premium to book value? 

 

Viking, thanks again for your incredible depth of research.  Has the company really changed so much or have they simply learned from their mistakes?  A company doesn't grow BV at a CAGR of 18%+ for over 35 years by accident.  I loosely followed the company all throughout the 2010s and have the same questions now as I did then about some of the more public investment mistakes but now we recognize that management took ownership of their mistakes and moved on.  It was their "taking ownership" part that convinced me to invest; still looks like the same company to me, albeit that much larger.

[Viking]

1 hour ago, 73 Reds said:

Viking, thanks again for your incredible depth of research.  Has the company really changed so much or have they simply learned from their mistakes?  A company doesn't grow BV at a CAGR of 18%+ for over 35 years by accident.  I loosely followed the company all throughout the 2010s and have the same questions now as I did then about some of the more public investment mistakes but now we recognize that management took ownership of their mistakes and moved on.  It was their "taking ownership" part that convinced me to invest; still looks like the same company to me, albeit that much larger.

 

@73 Reds The fact that Fairfax has been able to attract (and keep) shareholders of your quality gives me confidence that they are moving in the right direction. I agree with you - I think Fairfax has learned a great deal over the past 10 years. They have also had some important personnel changes (adding Wade Burton/Lawrence Chin, subtracting Paul Rivet, promoting Peter Clarke to name just a few).

 

Lots of investors don't want to invest in Fairfax today (or hold their shares long term) because of the very visible mistakes Fairfax made in the past. Given what we have seen from the management team at Fairfax over the past 6.5 years, I think the past mistakes actually make Fairfax a much stronger company today. As an investor, given what we know today, it makes me more confident in their future - it makes me want to invest in the more. It is really counter intuitive.

 

The cost of Fairfax's past mistakes was bourne by shareholders from 2010 to 2020 - and it was not pretty. Someone buying Fairfax shares in 2020 or later have been big beneficiaries of Fairfax's past mistakes - Mr. Market was irrationally pessimistic.

 

What were the big mistakes?

• The disastrous equity hedge/short 'decision' cost the company dearly (financially and reputation ally). But it also exposed a massive flaw in their investing framework.
• Blackberry was an unmitigated disaster. As was Abiliti-Bowater investment. Both of these investments exposed more flaws in their investing framework.
• Sandridge Energy, Fairfax Africa, APR Energy, Farmers Edge were all terrible investments. These investments exposed more flaws in their investing framework.

These all became great teachable moments for Fairfax.

 

Bottom line, Fairfax looked in the mirror and didn't like what they saw - they recognized they were the problem.

• Ending the equity hedge in late 2016 was the start and also the most important move (it was the biggest drag on results).
• By 2018, it was clear Fairfax started putting a much premium on management (Seaspan/Sokol and Stelco/Kestenbaum investments).
• In late 2020, Fairfax closed out its last short and very publicly promised not to repeat the equity hedge/short disaster.
• Around 2020/2021, Fairfax also stopped being a piggy bank to underperforming equities in their portfolio - generating cash flow became the new mantra. If they got cash from Fairfax it usually required restructuring by the company, a pound of flesh (increase in Fairfax's ownership on very favourable terms) etc.

Fast forward to today and you have a MUCH stronger company. Investors have never actually seen this version of Fairfax before.      

 

Fairfax today looks like a star athlete that has just entering their prime. With Fairfax, there is a good change we haven't even seen their best performance yet. And that is why I push back so much on people on this board who think Fairfax is at 'peak earnings' today. Peak? I think we are just getting a glimpse of what they can do. 

 

The crazy thing is Fairfax's stock is priced today like the company will be going into a steep earnings decline looking out 3 or 4 years. A big decline? WTF?

 

So even if I am completely wrong in my outlook for Fairfax, the stock will likely still perform reasonably well moving forward. And if I am right... well that would result in significant upside - that I am getting for free today. What a wonderful set-up. And that is why I love investing so much. 

Edited August 12 by Viking

[SafetyinNumbers]

17 minutes ago, Viking said:

 

The crazy thing is Fairfax's stock is priced today like the company will be going into a steep earnings decline looking out 3 or 4 years. A big decline? WTF?

 

To be fair to the quants that set prices, that’s exactly what the humans are expecting to happen. 
 

[73 Reds]

43 minutes ago, Viking said:

 

@73 Reds The fact that Fairfax has been able to attract (and keep) shareholders of your quality gives me confidence that they are moving in the right direction. I agree with you - I think Fairfax has learned a great deal over the past 10 years. They have also had some important personnel changes (adding Wade Burton/Lawrence Chin, subtracting Paul Rivet, promoting Peter Clarke to name just a few).

 

Lots of investors don't want to invest in Fairfax today (or hold their shares long term) because of the very visible mistakes Fairfax made in the past. Given what we have seen from the management team at Fairfax over the past 6.5 years, I think the past mistakes actually make Fairfax a much stronger company today. As an investor, given what we know today, it makes me more confident in their future - it makes me want to invest in the more. It is really counter intuitive.

 

The cost of Fairfax's past mistakes was bourne by shareholders from 2010 to 2020 - and it was not pretty. Someone buying Fairfax shares in 2020 or later have been big beneficiaries of Fairfax's past mistakes - Mr. Market was irrationally pessimistic.

 

What were the big mistakes?

• The disastrous equity hedge/short 'decision' cost the company dearly (financially and reputation ally). But it also exposed a massive flaw in their investing framework.
• Blackberry was an unmitigated disaster. As was Abiliti-Bowater investment. Both of these investments exposed more flaws in their investing framework.
• Sandridge Energy, Fairfax Africa, APR Energy, Farmers Edge were all terrible investments. These investments exposed more flaws in their investing framework.

These all became great teachable moments for Fairfax.

 

Bottom line, Fairfax looked in the mirror and didn't like what they saw - they recognized they were the problem.

• Ending the equity hedge in late 2016 was the start and also the most important move (it was the biggest drag on results).
• By 2018, it was clear Fairfax started putting a much premium on management (Seaspan/Sokol and Stelco/Kestenbaum investments).
• In late 2020, Fairfax closed out its last short and very publicly promised not to repeat the equity hedge/short disaster.
• Around 2020/2021, Fairfax also stopped being a piggy bank to underperforming equities in their portfolio - generating cash flow became the new mantra. If they got cash from Fairfax it usually required restructuring by the company, a pound of flesh (increase in Fairfax's ownership on very favourable terms) etc.

Fast forward to today and you have a MUCH stronger company. Investors have never actually seen this version of Fairfax before.      

 

Fairfax today looks like a star athlete that has just entering their prime. With Fairfax, there is a good change we haven't even seen their best performance yet. And that is why I push back so much on people on this board who think Fairfax is at 'peak earnings' today. Peak? I think we are just getting a glimpse of what they can do. 

 

The crazy thing is Fairfax's stock is priced today like the company will be going into a steep earnings decline looking out 3 or 4 years. A big decline? WTF?

 

So even if I am completely wrong in my outlook for Fairfax, the stock will likely still perform reasonably well moving forward. And if I am right... well that would result in significant upside - that I am getting for free today. What a wonderful set-up. And that is why I love investing so much. 

Yes, I largely agree with everything you write.  In fairness, I only started buying just after Covid but have been steadily buying shares over the last few years.  In fact when the MW report came out I literally used all the idle cash in various accounts to buy only Fairfax shares because the thesis sounded ridiculous, even to a round-numbers, "big picture" investor like me (my baseline for buying stocks - like you - is that I don't have to be precisely right about anything to still do well).  The difference between now and 2020 seems to be that earnings to a great extent are more predictable and predictably good.

[gfp]

Posting the Odyssey Re Q2 NAIC filing for those interested.  Investment activity is toward the end of the file.  

23680.2024.P.Q2.P.O.2.4808959.pdf

[glider3834]

2 hours ago, gfp said:

Posting the Odyssey Re Q2 NAIC filing for those interested.  Investment activity is toward the end of the file.  

23680.2024.P.Q2.P.O.2.4808959.pdf 1.73 MB · 5 downloads

thanks - this was interesting

 

 

 

Edited August 13 by glider3834

[glider3834]

 

I don't know much about this one but I think @petec mentioned this one previously - it looks like it has come to life a bit this year but a small holding

 

 

 

[SafetyinNumbers]

3 hours ago, glider3834 said:

thanks - this was interesting

 

 

 

Waterous Energy Fund’s only holding is Strathcona Resources SCR.TO. I think FFH owns ~14.5m shares indirectly. They are supposed to report results tonight and announce an initial dividend. I own some stock as I think it’s too cheap to NAV and they are motivated to get the shares to NAV.

[petec]

18 hours ago, Viking said:

@wondering  A lot of the discussion points in my posts are fluid… things that looks interesting that could go in different directions in the future. I am not sure what Fairfax’s thinking is on weightings within the equity bucket (mark to market, associate or consolidated). 
 

I agree with your summary: “My thinking was always Fairfax are value hunters and they will go where they see value. Period.  The way they hold the investment in secondary.”

 

i would add a little to your comment: Fairfax also seems to like the true value of their holdings to be reflected in book value (at least looking at it from an historical perspective).

 

Having said that, i wonder if they do not want to have some non-insurance consolidated holdings. ‘Bond type’ holdings that spit out cash. As a important offset to the P/C insurance business. But even here, if there is an opportunity to realize a big investment gain (like take take Recipe public in the future) my guess is they will do it.

 

I think there has been a trend in the general market towards more private and fewer public holdings. Fairfax has many deep pocketed partners. Perhaps part of what is happening at Fairfax i s just a microcosm of what is going on in the larger marketplace (towards more private holdings).

 

It might also be a reflection of Fairfax’s size - as Fairfax gets bigger it makes sense when they make investments they will own bigger stakes in companies (+20% or more) which will push more investments into the associates bucket or (50% or more) the consolidated bucket.

 

And some holdings are just better suited to be held as private holdings - versus public. AGT Food Ingredients is a great example if this - their business is too volatile and none of their peer group are publicly traded. I think taking Recipe private was smart for the business - my guess is they needed to restructure their operations after 10 years of acquisitions and this is difficult to do as a publicly traded company (they got started on this in the 2 years before Fairfax took them out). 

 

Of interest, when i calculate Fairfax’s splits (mark to market, associate and consolidated) i include the FFH-TRS in the mark to market bucket. If you exclude that holding (it is a derivative), the mark to market bucket is even smaller. 
 

And within the remaining holdings in the mark to market bucket, you have the significant limited partnership holdings that total $2 billion - BDT, ShawKwei, JAB etc. 

 

The true mark to market ‘common stock portfolio’ is $4.5 billion out of $20 billion in ‘equities’ and +$65 billion in total investments.

 

 

+1 - I think they are optimising for value to be reflected in book value, and for cash flows, not volatility of earnings.