Hey, Mr. Market! Do I really have to make FFH 50% of my portfolio?

[giofranchi]

Please, look at the image in attachment: maybe, FFH's CPI linked securities are starting to recover?

 

giofranchi

[racemize]

I overheard Monnish talking about fairfax and the hedges at the airport after the Berkshire meeting. He indicated the hedging / stance was largely due to the float / equity. I think he said ffh was at  near 2:1 vs 1.3:1 for mkl or brk. 

 

Then I guess there is the deflation derivatives, but they aren't that expensive.

 

Hi Joel,

I wouldn’t be so sure… last time that I checked, MKL had substantially larger investments in stocks, as a percentage of equity, than FFH!

 

giofranchi

 

Hi Gio, I think he was not talking about the portion of equity in the portfolio, but instead the float / book value ratio for the company (i.e., that FFH had more float to shareholders equity of FFH than the corresponding ratio at BRK).

[racemize]

Please, look at the image in attachment: maybe, FFH's CPI linked securities are starting to recover?

 

giofranchi

 

isn't this showing the rates though?  So we'd have to have corresponding deflation to offset the > 1% amounts for the last few years for them to work out?  (I still do not thoroughly understand how these are set up).

[giofranchi]

I overheard Monnish talking about fairfax and the hedges at the airport after the Berkshire meeting. He indicated the hedging / stance was largely due to the float / equity. I think he said ffh was at  near 2:1 vs 1.3:1 for mkl or brk. 

 

Then I guess there is the deflation derivatives, but they aren't that expensive.

 

Hi Joel,

I wouldn’t be so sure… last time that I checked, MKL had substantially larger investments in stocks, as a percentage of equity, than FFH!

 

giofranchi

 

Hi Gio, I think he was not talking about the portion of equity in the portfolio, but instead the float / book value ratio for the company (i.e., that FFH had more float to shareholders equity of FFH than the corresponding ratio at BRK).

 

Yes, I understood what he meant, but I am not so sure I would agree… In a stock market decline, the losses that will hit your capital are only the losses you would incur on the stocks portfolio… the rest of the float is invested in bonds, or something else… am I wrong? So, which equity will shrink more in a stock market decline? FFH’s or MKL’s? I think MKL, because its portfolio of stocks is worth a higher percentage of equity than FFH’s. This of course was before the merger with Alterra.

Let’s do some very simple math:

 

FFH:

Total portfolio of investments = 30

Equity = 10

Portfolio of stocks = 6

Portfolio of bonds + cash + privately held companies + etc. = 24

 

MKL:

Total portfolio of investments = 20

Equity = 10

Portfolio of stocks = 8

Portfolio of bonds + cash + privately held companies + etc. = 12

 

Let’s assume a 40% decline in the stock market, and let’s assume their holdings go down with the market. Let’s assume also that bonds + cash + privately held companies + etc. don’t change. The two resulting scenarios would be as follows:

 

FFH:

Total portfolio of investments = 27.6

Equity = 7.6

Portfolio of stocks = 3.6

Portfolio of bonds + cash + privately held companies + etc. = 24

 

MKL:

Total portfolio of investments = 16.8

Equity = 6.8

Portfolio of stocks = 4.8

Portfolio of bonds + cash + privately held companies + etc. = 12

 

Although FFH’s total portfolio of investments is 3 times its equity, while MKL’s total portfolio of investments is only 2 times its equity, the same price decline in stocks would be more detrimental to MKL’s capital than FFH’s: in the MKL case it would decline from 10 to 6.8, in the FFH case, instead, it would decline from 10 to 7.6. This is because MKL’s stock portfolio at the beginning was a higher percentage of its equity than FFH’s: 8 / 10 = 80% in the MKL case, and only 6 / 10 = 60% in the FFH case.

 

If I am wrong, please correct me!

 

giofranchi

 

[racemize]

Gio, I think you are right--I think I was wrong in comparing FFH to MKL.  In retrospect, I'm pretty sure Monnish was referring to BRK rather than MKL.  And BRK has a ton of cash/short-term stuff on hand, so that would make more sense.

[SharperDingaan]

Gio, it is easiest if we use a numerical example.

 

Let’s say that for 20 years;  UW performance has averaged an annual CR of 96 on a moderately growing book of business. The extremes were 2 years of CR at 108 (ie: Katrina) & 3 years of CR at 87 (ie: Hard Markets). At its simplest - over the 20 year period (ignoring DCF & the timing of UW gains & losses ), the company has made a total UW gain of 15 years of average CR gain (100-96)+3 years of extraordinary CR gain (96-87)+2 years of extraordinary CR loss (96-108); or a total UW gain of roughly 63% of the average annual premium. Business is great.

 

But we know that weather event payouts are getting higher, more frequent, & that UW market under-pricing is occurring for longer periods ...  Lets say average CR is now 97.5 (lower pricing), there are 3 years of bad CR at 110, & 2 yrs of good CR at 90. The UW gain is now  15 years of average CR gain (100-97.5)+2 years of extraordinary CR gain (97.5-90)+3 years of extraordinary CR loss (97.5-110); or a total 20 year UW gain of roughly 15% of the average annual premium. Business sucks.

 

Same skill but suddenly you are short 48% of average annual premium, or about 2.4% of annual premium – every year. Those worsening weather events really mean that you need either more investment income, or significant realized gains - every year; just to track to historic performance. 

 

We all know that if you can continually roll short-term debt - it will act like long term debt. But the effect also applies to any other liability – & turns P&C short tail UW risk into long tail risk. And we all see the long tail Life Co’s getting crippled because of the low rate environment.  It is the same thing here, but with weather as the trigger.

 

Given that 1 bad year at 110,could wipe out 4 yrs of average performance at 97.5; you are really betting that bad weather events are going to happen no more than twice every decade –& that it will only be after that, before we truly start making money. A great 8 yr track record could get wiped out by 2 years of back-to-back UW losses, that were nothing more than poor timing (ie: noise).   

 

SD

 

[giofranchi]

Thank you SD for your numerical example!

Yet, my question remains unanswered: why do you suppose Mr. Barnard ignores what you have written?! Instead, I am almost sure he is very well aware of it! Anyway, he stated that one of FFH’s goals is to become as highly regarded on the insurance side of the business as it already is on the investment side… So, is he promising something that cannot be attained?! Knowing how FFH has always been conservative in its promises to shareholders, that would struck me as highly unusual… almost unprecedented!

Also, Mr. Watsa has very often repeated that with interest rates so low “there is no place to hide” for the industry, unless an underwriting profit is achieved.

To reach for yield, when it is reckless to do so, clearly is not the solution. So, two things might happen:

1) An hard market develops and CRs fall,

2) Insurance as a business will cease to be a viable option for the private sector. As it always happens for a necessary service that cannot be fulfilled by the private sector, because returns on capital are not adequate, the whole insurance industry will be gradually nationalized…

 

giofranchi

 

[Uccmal]

I am seriously considering selling all my FFh and buying back at a later date. 

 

We are under absolutely saturated conditions inToronto.  Now I know flooding is not directly covered but all sorts of ancillary coverages are provided that relate to Canada's largest city being flooded.  Also, you tend to honour large commercial customers when they make claims, if there is some ambiguity. 

 

If I were a betting man I would suggest that FFH is probably looking at a billion or more in losses this quarter from the assorted events.  Add in another half billion from the hedges.  Another major hit from Rimm.  I am putting book value under 300, after today. 

[Gamecock-YT]

when there's blood in the streets....

[giofranchi]

I am seriously considering selling all my FFh and buying back at a later date. 

 

Ok, let me ask you a question: if it were just between you and me, no Mr. Market involved, would you sell your shares of FFH at $380 to me? I would buy them without hesitation. But, forget about having them back at a later date. Because I won’t sell them back to you or to anyone else for anything below $700!

 

If your answer is no, you are playing the market with the shares of a company that already is undervalued. If it weren’t undervalued, your answer would be yes (but, of course, you wouldn’t be receiving this offer from me!! ;))

Well then, good luck!

 

I am putting book value under 300, after today. 

 

What happened yesterday?

 

giofranchi

[ASTA]

Toronto rainstorm leaves 300,000 without power

http://www.bbc.co.uk/news/world-us-canada-23236921

 

Bad flooding in Toronto I can assume.

[giofranchi]

Morningstar has a fair value of FRFHF @ $325 I think. Their analyst report is pretty balanced overall....

 

Clearly those guys at Morningstar are following too many companies, and they have not done their homework on FFH.

 

FFH’s fair value:

After 3 years of no growth, with 30% of the investments portfolio in cash, and all equities hedged, $370 is a conservative way to value FFH BVPS. Of course, these things will fluctuate, because FFH is strong enough to report “mark-to-market”… You all remember that in March 2009 “mark-to-market” was removed, right? Otherwise, US banks would have been insolvent. Even today many European banks would be insolvent, if they had to report “mark-to-market”… Yet, even if Q2 2013 BVPS might be substantially lower, $370 is a conservative value.

Now, I tend to think about BRK as a safer business, with fewer opportunities for growth. More safety, less growth: all in all, I would apply the same multiple to both businesses.

Here a remark is due: you all tend to think about BRK as a safer business… but, actually, I am not so sure… Imo, even more than growth, safety is strictly dependant on the quality of the people at the helm… And I would put Mr. Watsa and his team second to none!

Given the fact that I think Mr. Buffett would not repurchase BRK share, if they weren’t at least 35% undervalued, I would put a multiple of 1.2 / 0.65 = 1.85 to BVPS, to calculate FV. Why not? The S&P500 is selling for 2.46 x Book Value and it has done and will probably continue to do more poorly than both BRK and FFH (on a ROE basis).

Therefore, we are left with a FV for FFH of $370 x 1.85 = $685.

Morningstar itself uses a multiple of 1.65 x BVPS, to calculate BRK’s FV. If we use 1.65 for FFH as well, instead of 1.85, we get: $370 x 1.65 = $610… still much higher than $325…

 

giofranchi

 

[ERICOPOLY]

I am seriously considering selling all my FFh and buying back at a later date. 

 

Ok, let me ask you a question: if it were just between you and me, no Mr. Market involved, would you sell your shares of FFH at $380 to me? I would buy them without hesitation. But, forget about having them back at a later date. Because I won’t sell them back to you or to anyone else for anything below $700!

 

If your answer is no, you are playing the market with the shares of a company that already is undervalued. If it weren’t undervalued, your answer would be yes (but, of course, you wouldn’t be receiving this offer from me!! ;))

Well then, good luck!

 

I am putting book value under 300, after today. 

 

What happened today?

 

giofranchi

 

Hypothetically, if they offered to invest your money in an unleveraged equity mutual fund with no management fee, would you sell your FFH stock and put the cash in that unleveraged fund?  You've talked in the past about a 15% rate of book value growth, but that sounds to me a bit similar to their historical returns on equities, unleveraged.

 

The equity fund shares of course would be purchased for tangible book value.  Your unwillingness to sell FFH below $700 suggests that you would be willing to buy into FFH up to a bit more than 1.8x tangible book value.  So I'm not sure that 55.5 cents growing at 15% is going to be as good a deal as $1 growing at perhaps the same pace, or maybe slightly less (a percent or two).

 

I don't know.  What are your thoughts on how much faster FFH can compound versus what they could do just running a 100% unleveraged stock mutual fund?

 

[Phaceliacapital]

MS Write up for your comfort.

FFH_CA_201305031.pdf

[giofranchi]

Hypothetically, if they offered to invest your money in an unleveraged equity mutual fund with no management fee, would you sell your FFH stock and put the cash in that unleveraged fund?  You've talked in the past about a 15% rate of book value growth, but that sounds to me a bit similar to their historical returns on equities, unleveraged.

 

The equity fund shares of course would be purchased for tangible book value.  Your unwillingness to sell FFH below $700 suggests that you would be willing to buy into FFH up to a bit more than 1.8x tangible book value.  So I'm not sure that 55.5 cents growing at 15% is going to be as good a deal as $1 growing at perhaps the same pace, or maybe slightly less (a percent or two).

 

I don't know.  What are your thoughts on how much faster FFH can compound versus what they could do just running a 100% unleveraged stock mutual fund?

 

Eric,

in any business I look both at safety (first) and growth (second). The leverage provided by float cannot be enjoyed by any unleveraged stock mutual fund. The fact FFH has to achieve a 7.5% annual return on its portfolio of investments, to compound BVPS at 15% annual, means a lot to me. Should mean a lot to any business owner! (It is the reason why Mr. Watsa first got involved with insurance...) Because FFH’s management will not be under the pressure of achieving 15% on their investments, like an unleveraged stock mutual fund would be. And that is great safety imo. Rationality is among the most important things to be successful in business, and rationality is high, when we are calm and have options; vice versa, it is low, when we are under pressure.

You also clearly don’t believe that FFH could achieve an underwriting profit… Nobody would believe that, based on FFH’s history, but I think that the future will be different and more profitable than the past. We will see! :)

 

giofranchi

 

[LongTerm]

The logic of the Morningstar report is baffling; they maintain that it is likely insurance operations will produce the same mediocre returns in the future as in the past but that the investment returns of the past are unlikely to be replicated in the future. It looks to me like they are simply afraid of the volatility that the business structure produces and are not interested in the overall long-term results.

[giofranchi]

MS Write up for your comfort.

 

Stewardship Rating… Standard?!?! … Well, ok … If FFH’s management is “standard” I’d better give up, and find a good and honest job, because I am clearly not made for business…  :(

 

giofranchi

 

[Uccmal]

Gio, I respect your position with betting on Fairfax.  Obviously, I have held it continuously in various forms since 1998.  I will note that I would have made almost no money on FFH had I not been very opportunistic, vastly reducing my position at times, and loading up with options, and common when things were not being recognized.

 

There has been a disquieting trend at Fairfax to do outsize macro bets.  These are killing performance.  People draw comparisons to the CDS bet in comparing the equity hedges, and deflation bets of today.  The two are quite different.  The CDS bet was small and asymmetric, with limited downside, and huge upside.  The equity hedges have limited upside, and essentially unlimited downside.  They are so far out of the money that only an absolute market catastrophe will make them worthwhile. 

 

What do we know about FFh today:

 

Positives:

1) Certain equity investments and real estate that should work out over time. 

2) An apparent trend toward buying whole businesses, although I am not convinced they have a good handle on this.

3) Good stock pickers.

 

Negatives:'

1) Insurance operations, particularly North American.  We are into a hard or at least a stable market and the low combined ratios are just not there.  I dont believe they ever will be.  Especially not after this quarter. 

 

2) Equity hedges.  The S&P has to drop 40 % before these even break even.  In the meantime we get further and further from break even, and lose more and more on the way. 

 

The problem right now, in my mind is that the negatives are going to keep the stock moribund for years.  Meanwhile I am getting 20 % returns or greater per year despite a 25% position in Fairfax.  What would you do, if you always outperform FFH?

 

 

 

 

 

[Kraven]

Gio, I respect your position with betting on Fairfax.  Obviously, I have held it continuously in various forms since 1998.  I will note that I would have made almost no money on FFH had I not been very opportunistic, vastly reducing my position at times, and loading up with options, and common when things were not being recognized.

 

There has been a disquieting trend at Fairfax to do outsize macro bets.  These are killing performance.  People draw comparisons to the CDS bet in comparing the equity hedges, and deflation bets of today.  The two are quite different.  The CDS bet was small and asymmetric, with limited downside, and huge upside.  The equity hedges have limited upside, and essentially unlimited downside.  They are so far out of the money that only an absolute market catastrophe will make them worthwhile. 

 

What do we know about FFh today:

 

Positives:

1) Certain equity investments and real estate that should work out over time. 

2) An apparent trend toward buying whole businesses, although I am not convinced they have a good handle on this.

3) Good stock pickers.

 

Negatives:'

1) Insurance operations, particularly North American.  We are into a hard or at least a stable market and the low combined ratios are just not there.  I dont believe they ever will be.  Especially not after this quarter. 

 

2) Equity hedges.  The S&P has to drop 40 % before these even break even.  In the meantime we get further and further from break even, and lose more and more on the way. 

 

The problem right now, in my mind is that the negatives are going to keep the stock moribund for years.  Meanwhile I am getting 20 % returns or greater per year despite a 25% position in Fairfax.  What would you do, if you always outperform FFH?

 

Good post.

[Packer16]

I agree.  I have not added to my FFH position and probably will not until they lift the hedges.  With the hedges they have hedged away their competitive advantage.  I hope they realize this soon.  Howard Marks' Mar letter has a great view on the market and if this view is true then FFH will continue to sputter.  If they would just raise the hedges, they would be able to overcome so much of the negative underwriting they have today.  We will see.

 

Packer

[giofranchi]

Gio, I respect your position with betting on Fairfax.  Obviously, I have held it continuously in various forms since 1998.  I will note that I would have made almost no money on FFH had I not been very opportunistic, vastly reducing my position at times, and loading up with options, and common when things were not being recognized.

 

There has been a disquieting trend at Fairfax to do outsize macro bets.  These are killing performance.  People draw comparisons to the CDS bet in comparing the equity hedges, and deflation bets of today.  The two are quite different.  The CDS bet was small and asymmetric, with limited downside, and huge upside.  The equity hedges have limited upside, and essentially unlimited downside.  They are so far out of the money that only an absolute market catastrophe will make them worthwhile. 

 

What do we know about FFh today:

 

Positives:

1) Certain equity investments and real estate that should work out over time. 

2) An apparent trend toward buying whole businesses, although I am not convinced they have a good handle on this.

3) Good stock pickers.

 

Negatives:'

1) Insurance operations, particularly North American.  We are into a hard or at least a stable market and the low combined ratios are just not there.  I dont believe they ever will be.  Especially not after this quarter. 

 

2) Equity hedges.  The S&P has to drop 40 % before these even break even.  In the meantime we get further and further from break even, and lose more and more on the way. 

 

The problem right now, in my mind is that the negatives are going to keep the stock moribund for years.  Meanwhile I am getting 20 % returns or greater per year despite a 25% position in Fairfax.  What would you do, if you always outperform FFH?

 

Al, why do you think insurance operations will always be run poorly? Isn’t it different to try and turn around deeply troubled insurance companies, which had made silly promises in the past, than to be now free from the past and to make new, well thought-out, and carefully studied promises? Isn’t it different to try and build scale in the insurance industry, and to increase rapidly the float generated and managed, accepting to buy deeply troubled insurance companies at a discount, than to run an organization now more focused on profitability than growth?

Why do you expect the two situations to yield the same results? Maybe, I am seeing things through rose-colored glasses, but I seriously don’t understand…

What about last quarter? Was it difficult for everyone, or do you think FFH will be alone to suffer, because of its own bad decision making?

 

I have already written exhaustingly and boringly enough about my view on the equity hedges, so you are spared! I won’t repeat me here! :)

 

With regard to your 20% annual return, I can only say one thing: sell you FFH shares immediately!!

As I have always plainly admitted, I have nothing to say to people who can compound capital at 20% annual. My only game is to find businesses that I can understand, that I think will be safe no matter what for many years into the future, and buy them when the price is right. Then I stick with them. This clearly is not the recipe to compound capital at 20% annual… At least, not with my own poor abilities…

 

giofranchi

 

[petec]

I find it hard to believe that underwriting results won't be better all else equal than they have been in the past, since we (probably) have no under-reserved acquisitions to worry about.

 

I also think it is slightly missing the point to say that the S&P has to drop 40% before the hedges breakeven.  Clearly the hedges were a bad call (and I concur entirely on their nature vs the CDS bet) but they are marked to market and will protect BV *from here* if the market falls *from here*.  (Correct me if I am wrong.)

 

I think I am right in saying y/e BV in 1998 was $185 per share.  They've only compounded BV at ~5% since then, but they are way ahead of the S&P, and are unlikely to repeat the TIG/C&F experience.

 

Personally this is my biggest single positon at 17% and I think it offers me a good chance of market beating returns in the long run starting from 1xBV plus a very good hedge (equity hedges + deflation options + cash + reinvesting all this at the bottom) against another major crash.  20% a year?  No, but I haven't the time (or skill!) to get that anyway so it is not a relevant benchmark.

[watsa_is_a_randian_hero]

The leverage provided by float cannot be enjoyed by any unleveraged stock mutual fund. The fact FFH has to achieve a 7.5% annual return on its portfolio of investments, to compound BVPS at 15% annual, means a lot to me.

 

Did you count taxes in this equation?  An unlevered stock mutual fund pays no taxes.  You will own taxes once, on the original cap gains/dividends as they pass through to you. 

 

All else the same, FFH has to earn a higher return on investments to generate the same net return to investors because of the double taxation in the corporate structure.  This mitigates the benefits of cheap leverage to some degree. 

[giofranchi]

The leverage provided by float cannot be enjoyed by any unleveraged stock mutual fund. The fact FFH has to achieve a 7.5% annual return on its portfolio of investments, to compound BVPS at 15% annual, means a lot to me.

 

Did you count taxes in this equation?  An unlevered stock mutual fund pays no taxes.  You will own taxes once, on the original cap gains/dividends as they pass through to you. 

 

All else the same, FFH has to earn a higher return on investments to generate the same net return to investors because of the double taxation in the corporate structure.  This mitigates the benefits of cheap leverage to some degree.

 

When I did the math, Eric corrected me as follows:

I took giofranchi's math at face value, but now that I've done a bit of number crunching I don't get it.

 

They have:

$25b cash and investments

$3b LT debt  (I believe they paid about 6.9% interest on that debt in 2012)

 

So total return coming in the door at 6.6% on $3b of investments is effectively a wash against the 6.9% interest due on $3b of LT debt (money out the door).

 

So they have $22b of net cash and investments

 

There are 20.2m common shares.  That brings us to $1,089 net investments per share.

 

So 6.6% on that brings in $72 before taxes, 19% pre-tax return on $378 BV per share.

 

So 13.3% growth in BV per share at 30% tax rate.  More like 13.1% after including the non-controlling interests.

 

Then there is corporate overhead, but hopefully underwriting profits can overwhelm this and then some.

 

I believe they need about 7.5% total return on investments in order to achieve 15% growth in BV per share.  (assuming underwriting profit merely nets out against corp overhead)

 

So, yes, taxes are included.

 

giofranchi

[ERICOPOLY]

Eric,

in any business I look both at safety (first) and growth (second). The leverage provided by float cannot be enjoyed by any unleveraged stock mutual fund.

 

This is the irony I am seeing.  These guys are wonderful equity investors and just a few years ago I was reading that their lifetime return on equities was 17% annualized. 

 

One who looks at safety first and return second, isn't satisfied with this performance and would choose to add the risk of insurance operation to get better results?  Myself, I'm guilty as charged and would do the same, but I wouldn't claim that it reduces my risk.  I would call this looking at growth at the expense of some additional calculated risk.

 

I'm of the opinion that an unlevered fund is safer than a levered one, even if that leverage be from insurance.  There was a little bit of a scrape they got into ten years ago that suggests I'm right about this.  Then of course Berkshire was run at the risk of permanent 100% capital loss for years before Buffett woke up to the risk of terrorists -- history could be written differently and Berkshire could be a zero today.  He might have had a long string of wonderful results followed by a zero.  Fortunately, he realized his blind side and nothing terrible ever came to pass.  More recently he claims that his operation was last in a line of dominoes (financial crisis) that would have fallen if the government hadn't acted in 2008. 

 

The fact FFH has to achieve a 7.5% annual return on its portfolio of investments, to compound BVPS at 15% annual, means a lot to me. Should mean a lot to any business owner! (It is the reason why Mr. Watsa first got involved with insurance...) Because FFH’s management will not be under the pressure of achieving 15% on their investments, like an unleveraged stock mutual fund would be.

 

They are going to earn 7.5% on their investments without a good chunk of it coming from their equities that are not under pressure to perform?  That's a lot of yield in the bond portfolio don't you think? 

 

You laid out a target of 7.5% and portray it as having no pressure on equity stock picking.  Then does it have pressure on bond picking?  Remember these are the same guys that run the hypothetical unleveraged stock equity fund.  Why are they under pressure in one scenario but not the other, when it's obvious that you either need to cream it in bonds to make 7.5% in this low yield environment or cream it in stocks?  Or some of both at the same time if you like.

 

 

You also clearly don’t believe that FFH could achieve an underwriting profit… Nobody would believe that, based on FFH’s history, but I think that the future will be different and more profitable than the past. We will see! :)

 

I do?