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Fairfax investment returns


ap1234
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I have been looking at Fairfax’s historical investment results recently. Given the importance of the investment returns to the company’s BV/share growth (historically accounted for 100%+ of the growth ), I’m interested in getting a sense for what is a reasonably expectation (rough ball park figure) for the company’s investment returns over the next 5-10 years? It appears this figure is extremely important because it is what will drive whether BV/share growth ends up being 3%/annum, 5%/annum, 10%/annum or 15%/annum (the company's LT objective).

 

The historic returns are phenomenal. Since 1985, the total (unlevered) return on the investment portfolio has been 9.4%/annum. Over the past decade, the total return on the portfolio has been 9%/annum. Even if you exclude the CDS gains, the total return on the portfolio was approx. 8%/annum over the past decade. Since inception, the company has only had two negative years (-4% in 1990, -2% in 1999).

 

On an asset class basis, the company’s equity portfolio (with hedging)  has returned 13.5%/annum over the past 15 years (beating the market by 9%/annum) and the taxable bond portfolio has delivered 10.8%/annum (beating the market by 4.4%).

 

The problem I have is the investment environment for bond investors over the past 30 years is unlikely to look anything like future. This could be a material headwind for all insurers if int. rates stay low for a long time. I'd love to hear thoughts from members of the board on the following questions:

 

1. What do you think the pre-tax total return on the investment portfolio will be over the next 5-10 years? How do you arrive at that figure (i.e. what asset mix and returns are you assuming)?

 

2. Historically, it looks like approx. 75% of the portfolio was invested in cash/bonds. The past 25+ years have been an amazing time to be a bond investor. Going forward, the tailwind from int. rates is gone. What is a reasonable return on Fairfax’s bond portfolio over the next 5-10 years assuming int. rates stay low?

 

3. Does anyone know any specific details about Fairfax’s fixed income portfolio. The returns of Brian Bradstreet and his team are out of this world. What % would be high yield or distressed? What kind of bond investments do they own? What is classified as 'taxable bonds'? For example, if Fairfax lends money to the Brick or Megabrands, are these investments counted in the bond returns?

 

If anyone has thoughts on any of these questions, I’d love to hear a discussion about what is a reasonable expectation for Fairfax’s investment returns over the next 5 or 10 years. 

 

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I have heard this kind of objection to OAK future returns too. Yet the evidence is that OAK returned much more on the capital it raised during distressful times than during good times. Imo, both if a low interests world lasts a long time, and if interests start creeping up, capital will leave other insurance companies and flow into Fairfax. Because both those environments are extremely distressful for standard insurance companies, while Fairfax has shown to be a much more skillful and opportunistic allocator of capital.

If Fairfax achieves a 7.5% annual return on its portfolio going forward, it will compound BVPS at 15% annual. A 7.5% annual return is 20% lower than its historic average. How is it going to achieve that? Well, if I knew exactly, I would be running my own Fairfax, right?!  ;D Any way, I can try a guess: of course, not lots of treasuries… instead, distressed debt special situations, a much larger percentage of the portfolio allocated to equities (as soon as this market finally comes down!), and acquisitions of entire businesses a la Berkshire, or a la Markel Ventures. Acquisitions of entire businesses would be almost a completely new source of growth for Fairfax!

Last, but not least, if you heed Mr. Barnard’s words, and you factor in the fact Fairfax is striving to achieve “underwriting excellence”, the annual return from investments needed to compound BVPS at 15% annual in the future could be even less than 7.5%. :)

 

giofranchi

 

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First, the questions you are asking are predictions...and like any prediction, they are often incorrect and usually irrelevant to how a business operates in the future, as most CEO's have to be flexible, adaptable, focused and pro-active.  Predictions are usually based on circumstances as they are, rather than what they may actually be.  It's like Wayne Gretzky's quote about going to where the puck will be, rather than where the puck is...Fairfax's team has to continue to go to where the puck will be.

 

1.  What do you think the pre-tax total return on the investment portfolio will be over the next 5-10 years? How do you arrive at that figure (i.e. what asset mix and returns are you assuming)?

 

I have no clue, other than to say that they will continue to have plenty of fixed income instruments as long as Brian Bradstreet is around...he's one of the best in the world.  They are very opportunistic, so if markets correct, they will go top-heavy into equities and distressed debt. 

 

2.  Historically, it looks like approx. 75% of the portfolio was invested in cash/bonds. The past 25+ years have been an amazing time to be a bond investor. Going forward, the tailwind from int. rates is gone. What is a reasonable return on Fairfax’s bond portfolio over the next 5-10 years assuming int. rates stay low?

 

Again, you cannot view their portfolio as static.  They made a massive move from bonds to cash recently, and in the last few years, they had made a massive move to insured municipal bonds.  The team is very flexible with their portfolio...like Gretzky, they will go to where the yield on investment is highest...be it through preferreds, corporate financings, bonds, equities or acquistions.  I don't expect the yield on the overall portfolio to be much different than the past as long as the existing team is together...so don't segregate what the returns on the bond portfolio may be. 

 

3.  Does anyone know any specific details about Fairfax’s fixed income portfolio. The returns of Brian Bradstreet and his team are out of this world. What % would be high yield or distressed? What kind of bond investments do they own? What is classified as 'taxable bonds'? For example, if Fairfax lends money to the Brick or Megabrands, are these investments counted in the bond returns?

 

The original Brick deal was through the purchase of debentures.  The Megabrands deal was done through a private placement purchase of stock and warrants.  Usually, these types of investments are reported under "Investments in Associates"...Note 6 in the 2012 Annual Report Financials.  I recommend you read all of their annual reports from day one, and that will give you a better idea of how the company allocates capital and reports it on their financial statements.  Alot of work, yes...but there are no real shortcuts for really understanding a business.  Cheers!

 

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First, the questions you are asking are predictions...and like any prediction, they are often incorrect and usually irrelevant to how a business operates in the future, as most CEO's have to be flexible, adaptable, focused and pro-active.  Predictions are usually based on circumstances as they are, rather than what they may actually be.  It's like Wayne Gretzky's quote about going to where the puck will be, rather than where the puck is...Fairfax's team has to continue to go to where the puck will be.

 

1.  What do you think the pre-tax total return on the investment portfolio will be over the next 5-10 years? How do you arrive at that figure (i.e. what asset mix and returns are you assuming)?

 

I have no clue, other than to say that they will continue to have plenty of fixed income instruments as long as Brian Bradstreet is around...he's one of the best in the world.  They are very opportunistic, so if markets correct, they will go top-heavy into equities and distressed debt. 

 

2.  Historically, it looks like approx. 75% of the portfolio was invested in cash/bonds. The past 25+ years have been an amazing time to be a bond investor. Going forward, the tailwind from int. rates is gone. What is a reasonable return on Fairfax’s bond portfolio over the next 5-10 years assuming int. rates stay low?

 

Again, you cannot view their portfolio as static.  They made a massive move from bonds to cash recently, and in the last few years, they had made a massive move to insured municipal bonds.  The team is very flexible with their portfolio...like Gretzky, they will go to where the yield on investment is highest...be it through preferreds, corporate financings, bonds, equities or acquistions.  I don't expect the yield on the overall portfolio to be much different than the past as long as the existing team is together...so don't segregate what the returns on the bond portfolio may be. 

 

3.  Does anyone know any specific details about Fairfax’s fixed income portfolio. The returns of Brian Bradstreet and his team are out of this world. What % would be high yield or distressed? What kind of bond investments do they own? What is classified as 'taxable bonds'? For example, if Fairfax lends money to the Brick or Megabrands, are these investments counted in the bond returns?

 

The original Brick deal was through the purchase of debentures.  The Megabrands deal was done through a private placement purchase of stock and warrants.  Usually, these types of investments are reported under "Investments in Associates"...Note 6 in the 2012 Annual Report Financials.  I recommend you read all of their annual reports from day one, and that will give you a better idea of how the company allocates capital and reports it on their financial statements.  Alot of work, yes...but there are no real shortcuts for really understanding a business.  Cheers!

 

Thank you very much, Parsad!

Very insightful and helpful answers, as always! :)

 

giofranchi

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Thank you Parsad and Giofranchi for your replies!! That was very helpful. I really appreciate you sharing your insights on how to think about Fairfax. This is what I love about the board.

 

I agree with both of you. That is why I own Fairfax. The market looks at things statically (i.e. assumes cash will be 30% forever, hedges will be on forever, etc.) and sees no BV/share growth. Fairfax tomorrow could look very differnet from Fairfax today.

 

HOWEVER, at the end of the day, to buy Fairfax at 1x BV today I need to believe that BV/share growth can be 10%/annum. I wouldn't pay more than 1x BV for a very lumpy 10% return. And the investment returns (while extremely difficult to forecast) are the single biggest input into Fairfax's BV/share growth. Without a view on investment returns (even a range), I am not sure how you can invest in Fairfax. If the return on the portfolio changes from 5%/year to 7%/year, that has a huge impact on the long-term returns of the stock. I don't want a precise #. But I do want to get a sense for what is reasonable going forward. To be clear, I am NOT looking for 1 year or 2 year invesmtent returns. I am looking for what people think is a conservative range of investment returns over the next 5 or 10 years.

 

I understand the opportunistic approach of Fairfax. I have met several members of the HWIC investment team. They are very talented people. However, I can't understand how the past 25 years of declining int. rates did not provide a significant tailwind for fixed income returns. This was not a cyclical run in the bond markets. This was a multi-decade secular trend. Given the starting point of int. rates today, you can't repeat the tailwind again. So if Fairfax can do 10%/year in fixed income, it will be almost pure alpha.

 

Parsad and Gio, my (long-winded) follow-up question is:

 

1. The reason I segregate returns on bonds and equities is that Fairfax is an insurance company as opposed to a hedge fund that can invest in any asset class they want in any quantity. That are using float and debt to leverage their returns. Today they have $378 in BV/share and $1,289/share in investments. Are there any restrictions on how much of the portfolio Fairfax could invest in equities? Can they go 50%+ in equities. Today, if they were 50% in equities, they would have $645/share in equities or 1.7x BV. If the market dropped 20% and they were unhedged, they would wipe out $130/BV (pre-tax).

 

If Fairfax can't invest in any asset mix they want, I need to make an assumption of a max weight for equities. That means the majority of the portfolio will always be in bonds/cash whether or not Fairfax thinks that's the best place to invest. As such, I wanted to get a sense for reasonable level of returns on the cash/bond portfolio over the next 5-10 years?

 

Gio, just to put some #'s around your suggestion I did a back of the envelop BV/share growth assuming 7.5% pre-tax investment returns (this was your return assumption). I looked out 1 year and didn't include any float growth.

 

Am I missing anything obvious? If not, Fairfax needs an investment return of 7.5% to get 15% BV/share growth today. 7.5% returns seems pretty high if Fairfax can't invest their entire portfolio in equities (unless equities drop significantly allowing a lower starting point to invest). 

 

Net premiums earned: $6 billion

Combined ratio: 100% (better than their historical record)

Underwriting profit: 0

Investment (total return): 7.5%

Investment portfolio: $26.1 billion

Investment income/cap gains: $1.96 billion

Corporate overhead/runoff: $200 million

Interest expense on debt: $200 million

Pre-tax income: $1.56 billion

Taxes: $383 (assuming 25% tax rate – might be different because some of gains might be unrealized, etc.).

Net income: $1.18 billion

Dividends on prefs: $55 million

Net income to shareholders: $1.13 billion (EPS - $55/share)

Book value/share (initial): $378

Book value (ending): $433

BV/share growth: 14.5%

 

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Guest Dazel

 

 

Bonds.

 

I have not seen anyone globally do as well as Brian Bradstreet and his team has done at Fairfax. They are the best bond group on the planet....I would say that without the carefully selected CDS portfolio that made Fairfax billions in 2008...

 

Our money is on Bradstreet to continue to outperform... as for equities their allocation is much smaller so they do not move the needless as much as the bond portfolio....and they have been Hedged in on way or another for all of about 6 months since 2003. They are protected on the down side which should prove to be smart in the coming years...but for the last 3 it has been a tremendous drag.

so no idea what equities will do at Fairfax going forward...we will likely stay here at $400 until the market breaks...

 

Dazel.

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If Fairfax can't invest in any asset mix they want, I need to make an assumption of a max weight for equities. That means the majority of the portfolio will always be in bonds/cash whether or not Fairfax thinks that's the best place to invest. As such, I wanted to get a sense for reasonable level of returns on the cash/bond portfolio over the next 5-10 years?

 

ap1234,

I understand your point very well. Unfortunately, I cannot answer to your question precisely. Because I really don’t know how much float Fairfax must keep in bonds and cash at any time, no matter what. I know it might be an apples to oranges comparison, but, if you look at Berkshire’s Consolidate Balance Sheet at 2012 yearend, you can see $42 billion in cash, $31 billion in fixed maturity securities, $86 billion in equity securities, and $191 billion in total shareholders’ equity. It shows other $5 billion in cash in Railroad, Utilities and Energy and in Finance and Financial Products, and has total assets of $427 billion.

So, Berkshire at the end of 2012 had:

- 25% of equity in cash

- 11% of total assets in cash

- 16% of equity in bonds

- 7% of total assets in bonds

- 41% of equity in bonds + cash

- 18% of total assets in bonds + cash

- 45% of equity in stocks

- 20% of total assets in stocks

- 184% of equity in stocks + investments other than cash and bonds

- 82% of total assets in stocks + investments other than cash and bonds

This is something I have checked out very quickly, so there might be some errors, but I guess it is clear that Berkshire returns in the future won’t depend very much on the bonds environment. I don’t know if Fairfax could replicate the way Mr. Buffett invested Berkshire growing capital through the years, buying an ever increasing number of whole businesses, instead of solely relying on the stock or bond markets, but I guess Mr. Watsa will carefully take it into consideration, if other opportunities for satisfactory investment returns won’t be available.

 

giofranchi

 

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"HOWEVER, at the end of the day, to buy Fairfax at 1x BV today I need to believe that BV/share growth can be 10%/annum.

..."

 

in fact, I am wondering if the current book is still 380+ b/c of the huge market surge in the first quarter - this must have done some damage their short - to me the loss on the short seems bigger than their long gain. Anyone has a guess what's the current book ?

 

Thank you Parsad and Giofranchi for your replies!! That was very helpful. I really appreciate you sharing your insights on how to think about Fairfax. This is what I love about the board.

 

I agree with both of you. That is why I own Fairfax. The market looks at things statically (i.e. assumes cash will be 30% forever, hedges will be on forever, etc.) and sees no BV/share growth. Fairfax tomorrow could look very differnet from Fairfax today.

 

HOWEVER, at the end of the day, to buy Fairfax at 1x BV today I need to believe that BV/share growth can be 10%/annum. I wouldn't pay more than 1x BV for a very lumpy 10% return. And the investment returns (while extremely difficult to forecast) are the single biggest input into Fairfax's BV/share growth. Without a view on investment returns (even a range), I am not sure how you can invest in Fairfax. If the return on the portfolio changes from 5%/year to 7%/year, that has a huge impact on the long-term returns of the stock. I don't want a precise #. But I do want to get a sense for what is reasonable going forward. To be clear, I am NOT looking for 1 year or 2 year invesmtent returns. I am looking for what people think is a conservative range of investment returns over the next 5 or 10 years.

 

I understand the opportunistic approach of Fairfax. I have met several members of the HWIC investment team. They are very talented people. However, I can't understand how the past 25 years of declining int. rates did not provide a significant tailwind for fixed income returns. This was not a cyclical run in the bond markets. This was a multi-decade secular trend. Given the starting point of int. rates today, you can't repeat the tailwind again. So if Fairfax can do 10%/year in fixed income, it will be almost pure alpha.

 

Parsad and Gio, my (long-winded) follow-up question is:

 

1. The reason I segregate returns on bonds and equities is that Fairfax is an insurance company as opposed to a hedge fund that can invest in any asset class they want in any quantity. That are using float and debt to leverage their returns. Today they have $378 in BV/share and $1,289/share in investments. Are there any restrictions on how much of the portfolio Fairfax could invest in equities? Can they go 50%+ in equities. Today, if they were 50% in equities, they would have $645/share in equities or 1.7x BV. If the market dropped 20% and they were unhedged, they would wipe out $130/BV (pre-tax).

 

If Fairfax can't invest in any asset mix they want, I need to make an assumption of a max weight for equities. That means the majority of the portfolio will always be in bonds/cash whether or not Fairfax thinks that's the best place to invest. As such, I wanted to get a sense for reasonable level of returns on the cash/bond portfolio over the next 5-10 years?

 

Gio, just to put some #'s around your suggestion I did a back of the envelop BV/share growth assuming 7.5% pre-tax investment returns (this was your return assumption). I looked out 1 year and didn't include any float growth.

 

Am I missing anything obvious? If not, Fairfax needs an investment return of 7.5% to get 15% BV/share growth today. 7.5% returns seems pretty high if Fairfax can't invest their entire portfolio in equities (unless equities drop significantly allowing a lower starting point to invest). 

 

Net premiums earned: $6 billion

Combined ratio: 100% (better than their historical record)

Underwriting profit: 0

Investment (total return): 7.5%

Investment portfolio: $26.1 billion

Investment income/cap gains: $1.96 billion

Corporate overhead/runoff: $200 million

Interest expense on debt: $200 million

Pre-tax income: $1.56 billion

Taxes: $383 (assuming 25% tax rate – might be different because some of gains might be unrealized, etc.).

Net income: $1.18 billion

Dividends on prefs: $55 million

Net income to shareholders: $1.13 billion (EPS - $55/share)

Book value/share (initial): $378

Book value (ending): $433

BV/share growth: 14.5%

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