FFH or ORH: which do you like more right now?

[link01]

 

As I have said before (and I still don't think anyone has agreed with me on this) I think FFH is a mutual fund (equities) plus an insurance company  (float and associated FI assets). If the insurance company adds 10% to the mutual fund's performance each year, and the mutual fund is well managed and will probably beat the S&P 500 on its own . . . then the question is, what should you pay to buy this mutual fund.

 

 

of course, you could apply this same perspective to all insurance co's...except that few truly excel on the either the float investment side or the underwriting side, & very very few excel at both.

 

but a very nice post, t-bone.

[ubuy2wron]

I couldn't agree more. Even if float has a cost . ..  maybe a few percent per year over time . ..  it is a huge advantage for a long term investor like Hamblin Watsa. That being said, I think some of us are focused too much on the last few years and not enough on the next few.  In the spirit of Ericopoly's post, I posit the following points. If I am wrong on any of these, you would be doing me a great service to point that out. Thanks:

 

1) To roughly paraphrase Prem, reserves are in the best shape they have been in for years. I think the company is certainly overreserved at this point, which is both tax efficient and provides a hidden asset. This will improve the CR as excess reserves roll off

 

2) I think FFH has a higher combined ratio than some competitors right now because of their expense ratio not their loss ratio. I believe that they are writing good business, they just have an organization that is sized to write more business. I think this is an asset and that when the market hardens, we will benefit both from lower loss ratios and lower expense ratios (because the expenses will be spread over more business) at the same time.

 

3) After a couple of years of FFH holding safe low-yielding investments, we are now seeing what happens when they can finally reach (safely) for some yield. $10 per share, per quarter, in passive interest and dividend income is a beautiful thing.

 

4) While we are starting to enjoy "success mode" on the investment side (I don't mean capital gains, but the type of repeatable passive income that insurance company analysts look for in valuing a company), we still haven't seen "success mode" on the insurance side. We all patiently waited for FFH to deploy their treasuries into better investments, I don't understand why everyone is so impatient with the insurance operations. I think this is a huge asset that they will deploy (write more business) at the right time. When the market turns we will be in a position to write more business than ever, and likely at some of the best CR's in the industry.

 

5) The possible affect of writing more business at a 95% (or better) CR at the same time as earning an after tax 5% return (or better) on the FI portfolio is likely event at some point in the next few years. Over a float/asset base of $16B this would lead to 33% book value growth from operating income alone.

 

This isn't a hedge fund and this isn't "success mode" . . . FFH has made a lot of progress and I believe they have built the right vehicle, but they aren't at the finish line yet. I think FFH's insurance operations (and the income associated with the float) can add 10-20% to BV per year over the next few years.

 

As I have said before (and I still don't think anyone has agreed with me on this) I think FFH is a mutual fund (equities) plus an insurance company  (float and associated FI assets). If the insurance company adds 10% to the mutual fund's performance each year, and the mutual fund is well managed and will probably beat the S&P 500 on its own . . . then the question is, what should you pay to buy this mutual fund.

 

I think 10% from the insurance side will be an easy bogey to hit over the next few years. If the expected return of the stock market is less than 10% over the next few years (which is likely in my opinion) then I think you could say the insurance portion is worth as much as the mutual fund (tangible book) portion. This suggests to me that the company is worth 2X book value.

 

I am not suggesting anyone pay 2X book, but I am suggesting:

 

1) for this company to not trade at some meaninful premium to tangible book (adjusting both the goodwill and ICICI position - which basically cancel out) is very very silly

 

2) FFH is a slumbering giant in insurance right now. The current combined ratios should be critisized no more than the 3% yields they were getting on ten year treasuries. Safety and prepartion for a big opportunity is worth far more than a few percent per year.

 

I welcome (and even request) any and all criticism of the above

 

 

I agree on every point except it is not an isurance company and a mutual find it is an insurance company and a hedge fund without the 2/20 vig. I look at anything less than BV with this co. as a gift

[Cardboard]

"For Berkshire and Fairfax, by writing long-tail insurance, they also create another near permanent form of capital, where they can do what they want with it for 10-15 years plus.  Whether that float is zero-cost or low-cost is irrelevant, as long as the cost is less than issuing debt.  Naturally, zero-cost would be preferrable though."

 

That is the problem at Fairfax. They can't do what they want with it. The portfolio only contains 30% of the stuff that they truly love: WFC, GE, JNJ, DELL, ICO and others.

 

I have no problem with float, I think that the concept is great. I am also not suggesting for Fairfax to become a hedge fund. I am simply suggesting to find a way to get float without getting into too much restrictions from regulators and other things. For example, if we were to cut our float by 30%, would we be able to move our portfolio to 60% in stocks and others? By cutting our float, would we be able to be more selective with our policies and obtain a better CR? We could have better ratings. It is all linked. 

 

IMO, this is what Warren did instead with insurance (cherry picking) and it has been very successful. Book value has compounded at 15.2% a year between 1995 and 2005. And he did it from a base of $17.2 billion in shareholders equity. I think that Fairfax could do much better than that from a base of $5.5 billion today.

 

It just seems to me that they are a bit agressive to acquire capital to manage via insurance while the benefits are not totally there due to: restrictions on capital allocation, big profit hits during bad catastrophe years and a combined ratio that is too high overtime to generate much if any profits. We manage a ton of capital, but why? It is a case where less could mean more.

 

Cardboard

[SharperDingaan]

 

T-Bone: Great post

 

May we suggest that you look at FFH/ORH more as a business, & less as an investment - as they are not neccessarily the same.

 

Agreed reserves are very likely on the high side, & the expense ratio is artifically high. We would also point out that if they went to the 'industry' asset mix, & yield, they could also triple their UW income very easily.

 

But ask yourself;

From a business perspective, over the next 12-18 months, how likely is it that HW will ever again see such reasonably safe opportunties to double (or even triple) their UW business - in their lifetime ?

- They have the reserves to cover them against significant estimation error

- Their financial flexibility cant get much better (debt maturities, ratios, hidden asset value, cash, etc)

- They have surplus expertise, & the experience to merge entities

- They have time to confirm which way the NA economy is going (double-dip, inflation/deflation, etc). 

- While they wait they can expect to get stronger.

 

Good businessmen also diversify their product lines, so don't assume another NA P&C, or similar lines. There's a nice growing class of US muni debt out there looking for some kind of insurance  :P 

 

Prem doesn't just have an arc, he also has a war chest.

At some point he'll use it.

 

SD

 

 

[Viking]

T-bone, nice post. I have a question regarding the following comment:

 

"2) I think FFH has a higher combined ratio than some competitors right now because of their expense ratio not their loss ratio. I believe that they are writing good business, they just have an organization that is sized to write more business. I think this is an asset and that when the market hardens, we will benefit both from lower loss ratios and lower expense ratios (because the expenses will be spread over more business) at the same time."

 

Regarding underwriting I simply would like to understand why it appears their numbers at NB & C&F are higher than one would expect given Prem's continuing statements regarding underwriting discipline. I get that written premiums are falling (this is similar to other companies). I still do not know why their combined ratio at these two subs is higher than their peer group. Possible reasons:

1.) peer companies are downsizing their cost structure aggressively keeping their expense ratio lower

2.) peer companies are releasing reserves from prior years to keep reported loss ratio lower

3.) NB & C&F are average underwriters

As with much in life we will only find out the answer with the passage of time. It would be nice if Prem would provide a little more clarity on this question in a future conference call.

[Rabbitisrich]

It's fascinating to see that we are all getting rich on this company despite our differing opinions. I'm with Cardboard on the topic of FFH as a mutual/hedge fund. You can't separate the investment and underwriting sides because the activities of one affects the other. I certainly hope that Watsa and Co. are not internally dismissing 100+ CR because of their "likely" investment returns. When you leverage assets with varying volatilities, you want to minimize the cost AND the volatility of the liabilty.

 

 

[T-bone1]

May we suggest that you look at FFH/ORH more as a business, & less as an investment - as they are not neccessarily the same.

 

Agreed reserves are very likely on the high side, & the expense ratio is artifically high. We would also point out that if they went to the 'industry' asset mix, & yield, they could also triple their UW income very easily.

 

But ask yourself;

From a business perspective, over the next 12-18 months, how likely is it that HW will ever again see such reasonably safe opportunties to double (or even triple) their UW business - in their lifetime ?

- They have the reserves to cover them against significant estimation error

- Their financial flexibility cant get much better (debt maturities, ratios, hidden asset value, cash, etc)

- They have surplus expertise, & the experience to merge entities

- They have time to confirm which way the NA economy is going (double-dip, inflation/deflation, etc).   

- While they wait they can expect to get stronger.

 

 

SharperDingaan,

 

Thanks for your comment. I could not agree with you more, and I can assure you that I look at FFH as a business, not as some combination of investment vehicles. I use this model (fund + float income) as a guide to value the business, or at least as a way of showing (I think) that FFH is worth a lot more than tangible book value.

 

I look forward to seeing what this business does next, and am curious about the team of Middle East investment bankers FFH just hired (BB story yesterday).

 

Thanks,

 

T-Bone1

[T-bone1]

Regarding underwriting I simply would like to understand why it appears their numbers at NB & C&F are higher than one would expect given Prem's continuing statements regarding underwriting discipline. I get that written premiums are falling (this is similar to other companies). I still do not know why their combined ratio at these two subs is higher than their peer group. Possible reasons:

1.) peer companies are downsizing their cost structure aggressively keeping their expense ratio lower

2.) peer companies are releasing reserves from prior years to keep reported loss ratio lower

3.) NB & C&F are average underwriters

As with much in life we will only find out the answer with the passage of time. It would be nice if Prem would provide a little more clarity on this question in a future conference call.

 

Viking,

 

I think this has to be a combination of 1 and 2. However, this is a subjective opinion, and as you say time will tell.

 

We do have a few facts to look at: Prem's reputation and willingness to take the blame for any and everything (including many things that aren't his fault) suggest to me that if C&F and NB really were average underwriters, Prem would be the first to say so . ..  and then he would do something about it - So I think number 3 is unlikely.

 

Number 1, the cost structure: I think is definately true and Prem backed this up on the call. It is just a question of how much of an effect this has.  Can FFH write twice as much insurance in a hard market and see their expense ratio fall from 25% to 15% (I'm just making these numbers up), I don't know.

 

Number 2, reserve releases: Again I think it is pretty clear that FFH is better reserved and more cautious/conservative right now than many other companies who are having a much harder time. Like number 1 above, I think it is just a question of how much of an effect this will have.

 

Time will tell, but considering the corporate culture at FFH and their current ability to be conservative, I would guess we will be pleasantly surprised yet again at some point in the future.

 

Thanks,

 

T-Bone1

[rogermunibond]

T-bone

 

 

Re: the ME investment bank

 

Fairfax I.S. Plc is not the same as Fairfax Financial Holdings.

 

Fairfax I.S. PLC is a Member of the London Stock Exchange (LSE), an AIM Nominated Advisor and Broker, an Approved Sponsor of the UK Listing Authority (UKLA).

 

They headquartered in London, Dubai, and NY.

[T-bone1]

T-bone

 

 

Re: the ME investment bank

 

Fairfax I.S. Plc is not the same as Fairfax Financial Holdings.

 

Fairfax I.S. PLC is a Member of the London Stock Exchange (LSE), an AIM Nominated Advisor and Broker, an Approved Sponsor of the UK Listing Authority (UKLA).

 

They headquartered in London, Dubai, and NY.

 

Thanks, they have updated the story. The first version said it was Fairfax Financial Holdings. It did sound a little strange.

[ERICOPOLY]

MKL reported a combined ratio of 99% for Q2, and 97% for the full six months.  They reported book value of $239.68.

 

So MKL is trading at 1.38x  Q2 book value right now.

 

Put this in perspective.  ORH trades at about 0.86x Q2 book despite doing far better in the underwriting profit department, and far better in the investment management department.

 

Hmm.

 

FFH's consolidated combined ratio was better than MKL's in Q2 -- 98.4% vs 99%.  For the full six months, the comparisons are 98.5% vs 96% for MKL.

 

Seriously, a 40% premium for this?

 

 

[Guest misterstockwell]

I had a bunch of MKL bought near book and sold it all at 345 this morning. Although they have many value investor fans, I still don't get it. There are better underwriters out there(HCC being my favorite) and much better investors(FFH). They have lots of excess capital, but I see no reason for them to trade at such a premium to book.

[FFHWatcher]

Somewhat off topic but involving ORH.  Does anyone recall where FFH holds their ORH shares?  I don't believe they are in the holding company, certainly not entirely? 

Can someone refresh my memory and perhaps comment on the flexibility or lack of flexibility that FFH has with where they hold their ORH shares?  I believe this asset is held within the reserves or perhaps at the subs holding company (non-regulated entities).  Is it set up the same as NB or C&F?

Thanks,

[ERICOPOLY]

Somewhat off topic but involving ORH.  Does anyone recall where FFH holds their ORH shares?  I don't believe they are in the holding company, certainly not entirely? 

Can someone refresh my memory and perhaps comment on the flexibility or lack of flexibility that FFH has with where they hold their ORH shares?  I believe this asset is held within the reserves or perhaps at the subs holding company (non-regulated entities).  Is it set up the same as NB or C&F?

Thanks,

 

The 2008 AR claims that runoff owns 17.8% of ORH -- at TIG I think.

 

[Crip1]

MKL reported a combined ratio of 99% for Q2, and 97% for the full six months.  They reported book value of $239.68.

 

So MKL is trading at 1.38x  Q2 book value right now.

 

Put this in perspective.  ORH trades at about 0.86x Q2 book despite doing far better in the underwriting profit department, and far better in the investment management department.

 

Hmm.

 

FFH's consolidated combined ratio was better than MKL's in Q2 -- 98.4% vs 99%.  For the full six months, the comparisons are 98.5% vs 96% for MKL.

 

Seriously, a 40% premium for this?

 

 

 

Eric,

 

I would caution you to infer too much from the most recent quarter. Review of the most recent three years tells a different, and I would argue, more comprehensive story:

 

Combined Ratios

                    FFH      ORH      MKL 

’08                110%    104%      99%

’07                  94%      96%      89%

’06                  96%      97%      87%

 

This does not necessarily mean that Markel is a better investment as I have more FFH than MKL. But the market rewards consistency and punishes “lumpy returns”. We can all agree that the quarterly returns for FFH and to a lesser extent ORH quarterly returns are quite lumpy which is the reason for their relatively lower valuation (as a % of BV) compared to MKL.

 

It’s interesting to note that it is widely acknowledged that FFH/ORH has shown to be as adept at investing as any of the other insurers out there, but it appears that this is discounted by the market in favor of the better combined by the MKLs of the world. Considering that the investment leverage (investments divided by BV) for FFH is 4 while MKL is 3 suggests that investment prowess is MORE important for FFH than for MKL. So, why then is the market not rewarding FFH considering that for every dollar one is investing in FFH, one receives 4x investable funds in the hands of widely acknowledged savvy investors? Not sure, but I would attribute that to the “lumpy” returns and the comparatively less impressive underwriting performance.

 

On another thread, I had said that if FFH can show consistently solid underwriting, that it would be come not a great holding, but an absolutely outstanding holding. Not sure whether there is any indication of industry-wide underwriting performance for 2009 available, but the closer that FFH comes to being average or better, the higher the valuation FFH will receive in the market.

 

From the perspective of MKL, I believe that the Q2 underwriting performance is an aberration and that subsequent quarters will show a return to higher underwriting profitability. If not, then my MKL thesis will have changed and I’ll need to re-deploy my MKL. I have a bit of an emotional attachment to MKL as my father-in-law worked for them, but one needs to separate that when the analysis suggests alternative action. Time will tell.

 

-Crip

 

 

 

[ERICOPOLY]

I would caution you to infer too much from the most recent quarter. Review of the most recent three years tells a different, and I would argue, more comprehensive story:

 

I agree, ignoring 2009 and 2008 results makes all of the above companies look like very good, and MKL the best by far.

 

Cardboard layed into FFH pretty thick for not being a Chubb with a CR in the mid 80s today.  Doesn't it seem equally fair to sling that at MKL?

 

A couple of days ago when I posted that, MKL traded at a 60% premium to ORH's Q2 book.  60%!!!!!   So a person with $1,000 in ORH gets the same amount of equity as somebody with $1,600 in MKL.  This means that you had better be earning at least $60 from the $600 premium you are paying for MKL if you slap a P/E of 10 on their underwriting advantage.  So let's say the expected advantage is 9 full points of combined ratio, which after tax is something like the $60 that you are paying the P/E of 10 for.  That's assuming premium volume is equal in size to 86% of book value.

 

But roughly that's how I think it works out.  Anyways, they are completely different companies.  As I've been saying for over a year now, I think of ORH and FFH as a hedge fund or mutual fund, and by contrast I think of MKL as more a company where you pay a big multiple for an earnings stream.  Now, is insurance that good a business such that a P/E of 10 makes sense during a time when a JNJ trades at 12x?