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

[racemize]

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.)

 

This was my understanding (although it is limited!)--Al, or anyone else, please correct this understanding if it is wrong.

[plato1976]

"A billion loss from the flood ?"

 

I am not sure how accurate this guess is :)

 

let's see

 

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.

[wknecht]

"A billion loss from the flood ?"

 

I am not sure how accurate this guess is :)

 

let's see

 

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.

I think Uccmal may have been referring to several events in the aggregate. A billion for the floods alone is extremely speculative. Based on Odyssey's annual report, 3% of GPW are concentrated in Canada ($82 mm). Northbridge will take a hit, but they write about a billion total. Recall that Sandy is estimated to cost Fairfax $261 mm (and Odyssey wrote at 88.5% despite this) and the industry $25-30 b.

 

Uccmal, I'm curious how you come up with your estimate?

[SharperDingaan]

Keep in mind that it is not just the Toronto flooding, there will also be losses from Calgary & High River as well. And if you want to do business with these folks again - you are not going to be breaking heads.

 

We have been saying for a very long time that you do not get paid enough to hold FFH through the high risk summer weather events, the magnitude of the risks are getting bigger, & that you need to hedge the risk. Not popular, but unfortunately it is proving to be bang on.

 

Good luck to all.

 

SD 

[A_Hamilton]

"A billion loss from the flood ?"

 

I am not sure how accurate this guess is :)

 

let's see

 

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.

I think Uccmal may have been referring to several events in the aggregate. A billion for the floods alone is extremely speculative. Based on Odyssey's annual report, 3% of GPW are concentrated in Canada ($82 mm). Northbridge will take a hit, but they write about a billion total. Recall that Sandy is estimated to cost Fairfax $261 mm (and Odyssey wrote at 88.5% despite this) and the industry $25-30 b.

 

Uccmal, I'm curious how you come up with your estimate?

 

A 1% increase in Northrbidge's combined ratio was $9.9 million pre-tax at 12/31. So even to get to a half a billion dollar hit to BV you'd need to write at ~170% combined ratio at NB for the year...

[watsa_is_a_randian_hero]

I think he was saying we'd have a billion loss between all of these events...the floods, the tornados, the storms, the interest rate spikes

[LakesideB]

I agree with much of what giofranchi has said.

 

I have only recently looked at the company so please take all this with a grain of salt.

 

With respect to underwriting, I think looking at historic underwriting results is probably not that fruitful. Investors have to ask themselves two questions:

 

1) Why are the accident year and calendar year numbers so far off with each other:101.8% vs. 95.8% over the last 10 years

 

2) Is there a reasonable possibility that the two could converge in the near future?

 

Calendar year numbers muddle things up for evaluating performance of an insurer. Much of the deterioration in the calendar yr numbers is due to bad/terrible business written prior to Mr. Watsa's leadership. Look at the accident year numbers - it shows that business written in the last decade, which captures the full insurance cycle, under Fairfax's stewardship was profitable.

 

The answer to the second question is trickier and one that is contingent on you believing that when Prem says he is done buying distressed insurance operations he truly means it. The higher the business written under Fairfax's stewardship becomes as a % of the overall book of business the faster the convergence.

 

This situation is somewhat similar to one of a rail investor in 2003. If one were to look at railroad’s decade long performance in 2003, you would have rightly summed up the business as terrible and one that hardly met its cost of capital. Hindsight is 20-20 but the genius was obviously in realizing the inadequacy of historical performance for railroads to predict the future. One truly had to focus on the transformation of the book of business in the railroad industry.

 

A combined ratio of 100% meant an ROE of 16% in 1980s ... while right now its means an ROE of around 8% to 10%. The industry participants need to price properly or risk being eliminated. The increased cat occurrence means that they need to adjust their pricing to the new cat reality. In the current environment, in absence of yield to boost ROE, insurers are one cat event away from earning a negative ROE. So on the risk adjusted basis, the capital is earning low to negative returns. This is likely not going to last long.

 

With respect to hedging……. the hedges are not to be confused with a short position on the index. The former is a market neutral strategy and the latter is one which has an unlimited downside. I am not sure I agree with the statement that hedging has neutralized their competitive advantage. Here is why. ...

 

Take a look at these numbers:

 

As at Dec 31, 2012                           5 Yr  10 Yr  15 Yr

Common Stocks (with equity hedging)                    5.5%  14.5%  13.5%

S&P500                                    1.7%    7.1%  4.5%

Diff                               3.8%   7.4% 9%

 

If you truly believe in your competitive advantage of being able to pick stocks AND you are worried about the economy, then wouldn't you want to neutralize the lift you got from market returns in exchange for protecting your equity base against a massive crash?

 

If you know you can achieve 7% to 9% returns with a market neutral strategy, while eliminating all the downside to your equity base, in the long run, wouldn't you take that bet?

 

The above numbers actually understate the true outperformance as it includes the results on equity hedging. Their true unhedged stock performance is likely a lot more.

 

That 7% to 9% market neutral unlevered return means wonders to FFH's shareholders in FFH's structure.

 

This obviously means one has to take a long term view on FFH.

 

Regarding comparison to an unlevered fund … having float finance a large portion of your capital is hugely advantageous if you can do a negative cost. It has value even if you have a positive cost but it has to be lower than the long term bond yield. If underwriting convergence happens, its possible that investors start to assume float as being a zero coupon perpetual bond similar to BRK.

 

The bottom line I think is that FFH doesn’t need to do something massive to get to a 15% ROE. By my calcs it needs to deliver 6.5% on its $26b investment portfolio and with little help from convergence happening on the underwriting side, I think this should trade closer to 1.7 to 1.8 times book.

 

I can see however, why its difficult to see how they are going to generate a 6.5% return in the short term given the massive cash and bond position.

[plato1976]

If this turns out to be true , the current price didn't reflect it yet. And we may get nicer price down the road.

Well, that's probably the point of max_pain:

 

big hit from natural disasters;

interest rate hike to hurt the remaining long duration bond;

spx near all time high to hurt the hedge;

some equity holding is performing terribly, like blackberry; I believe bank of ireland also pulled back a lot

 

I wish the max_pain would show up after ER so I can buy back some at low

 

I think he was saying we'd have a billion loss between all of these events...the floods, the tornados, the storms, the interest rate spikes

[ap1234]

Great analysis LakesideB! In my opinion, I think you captured the salient points of the Fairfax investment thesis.

 

The only things I would suggest if you do more analysis are:

 

1) Fairfax's 10 year average accident year CR is 96%. But the past 10 years is not necessarily a good proxy for a full insurance cycle. You have the benefit from a VERY hard market following 9/11 (which may or may not be repeated over the next cycle) and then a prolonged soft market from 2006-11. It seems that a combination of a few hard market years and a long soft market would equate to a full insurance cycle but I'm not certain that is the case with the past 10 years.

 

If I were analyzing their underwriting, I would break out their individual accident year CR's as opposed to looking at a 10 year average. In other words, I don't think they really earned 96% CR over a 'full cycle'. Then you can decide whether 96% is a better proxy for the next cycle assuming no more troubled acquisitions, Andy Barnard's leadership, a renewed focus on underwriting discipline, etc.

 

I would pick an insurance company that you think has a better underwriting culture (ex. Markel). Compare Markel's 10 year average CR to Fairfax's 10 year average CR. You can decide whether you think Fairfax has any competitive advantages in their insurance business relative to an insuarance company with a more sustainable moat. If they don't, what is a reasonable CR they can generate over the next full cycle.

 

2) You suggested that Fairfax can generate 7-9% returns with a market neutral strategy. I think this is the wrong conclusion.  If you're going to use Fairfax's long-term returns, you might want to look at what their asset mix has been over time and what the asset class returns were (i.e. what was the return on bonds, stocks, cash, etc.). Then go through each component and test the reasonableness of achieving those returns in the future. I don't mean predicting 1 or 2 year returns. I mean what do you think each component of Fairfax's investment portfolio (stocks and bonds) can earn over the next 5-10 years.

 

For example, Over the past 30 years corporate bond returns have been 8% (this coincides with Fairfax's history as a public company). If you think corporate bond returns will be 8% over the next 10 years, then Fairfax's investment capabilities should generate similar returns (i.e. start with 8% then add Fairfax's alpha). If you don't, then you need to have a view on how the portfolio would look different so they can still generate 7-9% returns when the massive tailwinds of declining int. rates are gone.

 

Even a 6.5% investment portfolio return with 25% in equities and 75% in cash/bonds may or may not be optimistic over the next 5-10 years. Everyone will have a different interpretation on what future investment returns will be but I think it's important to dissect why they achieved the returns they did in the past and what is the likelihood that similar returns will be generated in the future.

 

 

 

 

[LakesideB]

Thanks ap1234. Excellent points.

 

1) Underwriting. I agree 96% accident yr number over the last 10 yr is probably not a good proxy for the future 10 years due to the massive hard markets of 2001. Although, I find that last hard market of 1984 - 1987 due to liability crisis resulted in even a bigger rate increases (closer to 50%) than the hard mkt following 9/11. Generally looking at the historical P/C cycles I find that hard markets in the last two decades have become shorter in duration and much further away from each other. This is obviously not a good trend for a P/C operator. The yield has allowed the weaker players to persist for much longer allowing for much longer soft cycles. Although in absence of yield, I don't know if weaker players have any place to hide.

 

Something has to give and capital has to flow out of this industry if yields persist at these levels for much longer. As I said earlier, if you believe cat events are only increasing in frequency, this only means on a risk adjusted basis much of the capital is not earning any return so will flow out or risk becoming impaired.

 

It bodes well for well capitalized P/C operators and especially ones which have a market neutral stance.

 

But for my analysis I have assumed that the 96% calendar moves up to a 100% combined. So the 6.5% return is based on 100% combined. Anything below that should be a good positive.

 

 

2) I didn't say 7% to 9% on the full capital. The table I included was for their equity only performance including hedging. I was trying to point that given that chart ... wouldn't you take a 7% to 9% return over the long term on your equity portfolio while protecting your capital base? I recognize the equity portion is relatively small vs bonds and that they benefited from the massive tail wind their bond portfolio.

 

But I offer two points:

1) Look at their bond performance relative to the benchmark

                                                                  5Yr          10Yr          15Yr

Taxable Bonds                             14.0% 12.4% 10.8%

Merrill Lynch US Corp                     6.9% 5.7%         6.4%

Diff                                                        7%          6.7%        4.4%

 

Presumably the benchmark has also benefited from the lower IR tail wind. In future this tail wind is no longer there ... so their outperformance can be viewed as an indication of what they will earn in absolute returns. Obviously they can play with duration and credit sprds to limit the destruction of rising rates... so their alpha is only a rough approximation of the absolute return they can achieve.

 

2) A rising rate environment should help them plenty on the yield side. 

 

Now regarding 30%+ cash: it can have two meanings. To a short term investor this is probably one of the biggest concerns. While a long term investor sees massive future optionality that exists in this positioning and a big reason to believe why they can do atleast a 6.5% return on their invested capital in the long run.

 

Your suggestion to look at markel is great. I will pull up their numbers and that should help me get a handle on future combined ratio. For now I think assuming 100 is not too aggressive and a number which justifies why FFH's structure is massively better than an unlevered fund.

[SharperDingaan]

Keep in mind that the P&C industry is not an oligopoly. There are enough new entrants underpricing to get the business & obtain the float to wreck the model. Yes the existing new entrants go out of business on the first big loss event, but the next round spring up as soon as the markets hardens.

 

The P&C industry is very much like the airline industry; for most, a sub-standard return on equity. You are looking at only the better companies, & after survivor bias.

 

Quasi-nationalization is also common - nuclear power stations, natural disasters (flood relief, state of emergency, etc). If we had to pay the 'true' cost for the nuke & flood plain risk, the power stations would not be built & there would be no new housing built. Hence the government offers insurance at a loss to achieve a higher standard of living, & insurers accept a lower return.

 

SD   

[ERICOPOLY]

Ultimately I view most insurers as leveraged bond funds that attempt to get a bit extra from underwriting profits.  They (in a sense) compete against leveraged bond funds for capital investment.

 

Is that completely off the wall?

 

So it follows that if investors in leveraged bond funds (making low ROE in a low rate environment) see insurers making a lot of profit (from a hard market) they would then push money into the insurance market to drive ROE back down.

 

So I'm curious enough to ask if there is a long term relationship between ROE from leveraged bond funds and ROE from insurers.  Do leveraged bond funds tend to typically earn a given spread below what insurers earn (and the spread is there to account for the added risk)?  So in other words, will there really be a hard market due to low rates that will drive insurance ROE's back up, or will bond investors drive it back to a soft market again in a reversion to the mean ROE spread of leveraged bond funds vs leveraged insurers?

 

 

[Liberty]

The past few posts have been excellent, thanks everybody.

[LakesideB]

SD, I think P&C Insurance Not being an oligopoly is a very good thing. Alteast this allows guys like BRK, FFH, Greenlight, etc to come and set up a model where they can juice their returns even more provided they have adequate skills/temprament to do so. Imagine if the industry was one that was similar to industrial gas industry where there are only 5 players : 4 of which have been in existance for the last 100 years and the fifth one only entered the industry in 1980s.

 

If you know the limitations of what you are doing, have the right mentality and the right structure, you should be able to get an underwriting profit regardless whether industry is able to collectively do this or not. For instance, in the last 35 years, the industry overall has only been profitable 3 times : 2004, 2006 and 2007. ROEs have rarely crossed over 10% ... but that doens't mean there aren't companies like Ace, Markel, etc who are able to consistently do much better than the industry.

 

I agree both P&C and Airline aren't industries one would want to be in. But there is something very unique about the P&C industry. It has forbidden fruit of the 'free leverage' ... or the ability to have a big part of you asset base financed by a zero coupon perpetual bond . Many participants either become banckrupt in their pursuit of this in this comoditized industry... or if they manage to achieve it don't have the skills to utilize it to the max on the asset side of the eqation.

 

BRK is that rare company that has been able to show skill on both sides of the balance sheet. FFH to me is well on its way to show its skill on the liability side. Ultimately, I feel its a business model that is not very well appreciated by investors and it completely baffles me as once you game this model, the power of this structure is tremendous.

 

Mr. Watsa realizes that the value of this model is only harnessed by a relentless focus on the downside. The upside will take care of itself. Hence, the positioning.

 

As he said in his annual report this year. 'The long term is where its at!'

 

[HJ]

Ultimately I view most insurers as leveraged bond funds that attempt to get a bit extra from underwriting profits.  They (in a sense) compete against leveraged bond funds for capital investment.

 

Is that completely off the wall?

 

So it follows that if investors in leveraged bond funds (making low ROE in a low rate environment) see insurers making a lot of profit (from a hard market) they would then push money into the insurance market to drive ROE back down.

 

So I'm curious enough to ask if there is a long term relationship between ROE from leveraged bond funds and ROE from insurers.  Do leveraged bond funds tend to typically earn a given spread below what insurers earn (and the spread is there to account for the added risk)?  So in other words, will there really be a hard market due to low rates that will drive insurance ROE's back up, or will bond investors drive it back to a soft market again in a reversion to the mean ROE spread of leveraged bond funds vs leveraged insurers?

 

Return on their fixed income portfolio is one of the many factors that affect insurer ROEs.  For P&C guys, the underwriting cycle drives much more of their ROE's.  For Life guys, they have a meaningful portion of the book dedicated to annuities, where they have to deal with pricing of minimum guarantees, etc.  With the development of the Cat bond market, and the popularity of side car deals and ease of forming a new Bermuda reinsurer, argument can be made that the P&C insurance cycle may very well be dampened meaningfully going forward.  But still, the underwriting cycle will having a much more dramatic impact on ROE (over the long term) than simply bond market returns.  For one thing, the bond portfolio of P&C guys tend to be very high rated, AA- type, which is not what most levered bond portfolio look like.  Although in extreme bond market return scenarios (like the ones we went through in '08-'09', ROE was clearly affected by bond returns, that tend not to be the norm.

[giofranchi]

Ultimately I view most insurers as leveraged bond funds that attempt to get a bit extra from underwriting profits.  They (in a sense) compete against leveraged bond funds for capital investment.

 

Is that completely off the wall?

 

So it follows that if investors in leveraged bond funds (making low ROE in a low rate environment) see insurers making a lot of profit (from a hard market) they would then push money into the insurance market to drive ROE back down.

 

So I'm curious enough to ask if there is a long term relationship between ROE from leveraged bond funds and ROE from insurers.  Do leveraged bond funds tend to typically earn a given spread below what insurers earn (and the spread is there to account for the added risk)?  So in other words, will there really be a hard market due to low rates that will drive insurance ROE's back up, or will bond investors drive it back to a soft market again in a reversion to the mean ROE spread of leveraged bond funds vs leveraged insurers?

 

Eric,

I understand the comparison, but don’t agree 100%. If they were truly the same, both Mr. Buffett and Mr. Watsa wouldn’t have taken the trouble to run insurance operations, right? Instead, the difference is clear enough to me: once again I repeat that “safety” comes first. And, if you write insurance profitably, nobody can take the leverage provided by float away from you, no matter what. To paraphrase Mr. Buffett:

We are paid to hold other people’s capital. And that puts a big smile on our faces.

Even the best funds, see for instance Mr. Berkowitz in 2011, don’t enjoy such a luxury and constantly risk to disappoint their clients… In insurance you are working for yourself, not for clients: apparently, it seems a small difference, in practice I think it gives a huge advantage to insurance over leveraged funds.

 

giofranchi

 

[giofranchi]

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. 

 

Sorry Eric,

But I don’t quite agree with this also…

Equity investing and insurance underwriting have a lot in common. Those who are successful in investing usually possess the right mental attitudes and skills to be successful in insurance too. They know how to be opportunistic, how to look for neglected markets, how to recognize and take advantage of other people’s errors, and they know how to wait for the odds to be disproportionately stacked in their favor, then invest aggressively or write a lot of premiums. They also understand cycles, or the importance of the “pendulum”, paraphrasing Mr. Marks. So, I see insurance underwriting basically as “diversification”, or the opportunity to employ their skills in a slightly different and mostly uncorrelated business. I agree that diversification in not always good, but FFH’s insurance management, led by Mr. Barnard, has by now become one of the most experienced in the world. And I really don’t see them making too many serious mistakes going forward. Instead, they will take pressure off the shoulders of the HWIC: clearly, it has been 3 years they don’t want to be aggressive in equity investing, right? Well, thanks to insurance they can afford that luxury, without compromising long term performance.

And that’s safety imo: they can afford to swim against the current, or hold their stance against the market, for much longer than any mutual or hedge fund. They are free to change their mind only when the facts change, not when the pressure becomes unbearable.

 

giofranchi

 

[giofranchi]

Keep in mind that it is not just the Toronto flooding, there will also be losses from Calgary & High River as well. And if you want to do business with these folks again - you are not going to be breaking heads.

 

We have been saying for a very long time that you do not get paid enough to hold FFH through the high risk summer weather events, the magnitude of the risks are getting bigger, & that you need to hedge the risk. Not popular, but unfortunately it is proving to be bang on.

 

Good luck to all.

 

SD

 

SharperDingaan,

You already know that I don’t agree... right? ;D ;D

Anyway, I thank you and all the members of this board for your deep thinking and well thought-out analysis!

But… please, don’t miss the forest for the tree… Maybe, it is just me, who doesn’t think and analyze deeply enough… yet, I always try to keep in mind Mr. Buffett’s definition of the best among businesses:

A royalty on the growth of others. Which grows and costs nothing to do so.

Profitable underwriting + float managed on a value basis = Mr. Buffett’s definition of the best among businesses.

And with FFH today you can buy Mr. Buffett’s definition of the best among businesses at BV.

Now, imo that is the forest!

Then, I am sure there are a lot of “terrifying trees” and there will be some trouble down the road… But I am not smart enough to predict it, or when it will occur.

I am content enough with a clear picture of the forest: a wonderful business, a wonderful management, a wonderful price.

We will see!

 

giofranchi

 

[petec]

So it follows that if investors in leveraged bond funds (making low ROE in a low rate environment) see insurers making a lot of profit (from a hard market) they would then push money into the insurance market to drive ROE back down.

 

I had not thought of it in this way exactly but I do think that easy money generally is responsible for the softness of the insurance market.  Easy money has boosted asset prices and book values which has made surviving cat losses easier, and has also funded a lot of new entrants which has depressed pricing.  So yes, insurance and leveraged bonds have similarities in that they both likely provide low ROEs at the same time...but equally they are both likely to have a better performance in terms of cash flows and ROEs (but not mark to market book values) as monetary conditions tighten.  I would not be surprised to see the mother of all hard markets at that point, whenever it is!

 

Excellent discussion everyone, thanks.

[Uccmal]

I wrote a really nice post last night but goofed on sending it.  Our power has been out for two days.  I charged my IPad on a generator. 

 

RE: Insurance loss estimates: I was thinking in aggregate.  Calgary, Toronto, Tornados.  Commercial insurance is not the same as personal insurance.  If Shell, Suncor, or Bell Canada make a claim, FFH is forced to reach a settlement or lose the client forever.  Too say that flooding is not covered is to put yourself into a legal battle and lose a client at the same time. 

 

Re: Hedge losses.  The hedges were written around 1060 S&P 500, Russell, and other indexes at equivalent levels.  1662 to 1060 is a 40% drop Just to break even.  Does anyone think that FFh will sell these hedges somewhere on the way down and take their losses.  I dont.  FFH has drank the Jaoan Koolaid, against all demographic and economic evidence to the contrary.  Also, if the S&p drops 40% what happens to RIM, Bkir etc.  Rim is OOB.  BKIR has to run another stock dilution.  ABX (resolute) is OOB.  The way I see it the losses from the hedges are permanent.

 

FFH could easily have capped the effect of these hedges on the topside.  They didn't.  Why?  It would have been dirt cheap back when the S&P was at 1100.  They have a very serious blind spot. 

 

I figure FFh is dead money pushing forward at least 5 years.  I have been a long term shareholder, but am steadily losing the faith.  I can buy the stock back in the mid 200s.  I am down to 15 % of my portfolio.

 

 

[giofranchi]

I wrote a really nice post last night but goofed on sending it.  Our power has been out for two days.  I charged my IPad on a generator. 

 

RE: Insurance loss estimates: I was thinking in aggregate.  Calgary, Toronto, Tornados.  Commercial insurance is not the same as personal insurance.  If Shell, Suncor, or Bell Canada make a claim, FFH is forced to reach a settlement or lose the client forever.  Too say that flooding is not covered is to put yourself into a legal battle and lose a client at the same time. 

 

Re: Hedge losses.  The hedges were written around 1060 S&P 500, Russell, and other indexes at equivalent levels.  1662 to 1060 is a 40% drop Just to break even.  Does anyone think that FFh will sell these hedges somewhere on the way down and take their losses.  I dont.  FFH has drank the Jaoan Koolaid, against all demographic and economic evidence to the contrary.  Also, if the S&p drops 40% what happens to RIM, Bkir etc.  Rim is OOB.  BKIR has to run another stock dilution.  ABX (resolute) is OOB.  The way I see it the losses from the hedges are permanent.

 

FFH could easily have capped the effect of these hedges on the topside.  They didn't.  Why?  It would have been dirt cheap back when the S&P was at 1100.  They have a very serious blind spot. 

 

I figure FFh is dead money pushing forward at least 5 years.  I have been a long term shareholder, but am steadily losing the faith.  I can buy the stock back in the mid 200s.  I am down to 15 % of my portfolio.

 

Al, I don’t know what is going to happen… Maybe you are right, and I will average down to the mid 200s…

If that happens, it will be a major blunder on the part of the man at the helm and his team. Remember: with all their hedges they are really trying to do just 1 thing: to protect capital. If BVPS declines to the mid 200s, they will have failed miserably...

 

Yet, it won’t change my view that profitable insurance underwriting coupled with the investment of float on a value basis is a wonderful vehicle to do business.

 

And, if management is making such serious mistakes now, let’s hope they admit them sooner or later, and change course of action! Why shouldn’t they?

 

giofranchi

 

[Packer16]

I 100% agree on the hedges.  When you look at the other successful float insurance companies, Berkshire, Markel, etc., have they ever hedged their equity exposure? No, as a matter of fact BRK has been on the other side of a declining equity bet (sold puts).  With equities these firms have had the tailwinds of equity appreciation and stock selection out performance. 

 

If we look at the ERP today (assuming an earnings yield of 6.25%), we have about 500bp versus bonds (assuming a ST bond interest rates will rise to 100bp at some point).  This is about as large as it has even been.  If FFH can outperform the market buy 500bp (which would be great given the amount of money they are managing), they are hedging away 50% of their stock returns.  Given low returns on bonds going forward, then how does FFH get close to their book value growth target by hedging away 50% of their equity returns?  I think they had good insight in the last swoon and confirmation from other smart investors like Howard Marks.  If you read Marks today he has suggested that there will be modest equity price increases to correct the large ERP.  If this occurs, then FFH will continue to underperform unless they can pull a rabbit out of the underwriting hat.

 

Packer

[giofranchi]

I 100% agree on the hedges.  When you look at the other successful float insurance companies, Berkshire, Markel, etc., have they ever hedged their equity exposure? No, as a matter of fact BRK has been on the other side of a declining equity bet (sold puts).  With equities these firms have had the tailwinds of equity appreciation and stock selection out performance. 

 

If we look at the ERP today (assuming an earnings yield of 6.25%), we have about 500bp versus bonds (assuming a ST bond interest rates will rise to 100bp at some point).  This is about as large as it has even been.  If FFH can outperform the market buy 500bp (which would be great given the amount of money they are managing), they are hedging away 50% of their stock returns.  Given low returns on bonds going forward, then how does FFH get close to their book value growth target by hedging away 50% of their equity returns?  I think they had good insight in the last swoon and confirmation from other smart investors like Howard Marks.  If you read Marks today he has suggested that there will be modest equity price increases to correct the large ERP.  If this occurs, then FFH will continue to underperform unless they can pull a rabbit out of the underwriting hat.

 

Packer

 

Packer,

You assume they don’t know what you have written? Of course not!

Then, why? I would really like to know what you, Al, Eric, and others on the bear camp think about Mr. Watsa and his team. What do you think their reasoning actually is? And why do you think they persist in their mistakes?

 

giofranchi

 

[Packer16]

I think they are human just like the rest of us and it may take time for them to change.  They made great calls/timing moves in 2008/2009.  The CDS bet and pulling off the hedges at the bottom.  To think these did not make them feel more confident I think is naive.  I have had my greatest fall (2008) after my greatest outperformance to date (2006/2007).  I purchased a subprime mortgage lender because I thought was it was safe and Monish was a holder.  I was wrong.  Fortunately, it was a small portion of the portfolio.  In FFH's case of hedges it is not.  Time will tell but I think over time I think alot of the analogies to the 1930s and Japan in the 1990s will not be the case.  Just my 2 cents.

 

Packer 

[giofranchi]

I think they are human just like the rest of us and it may take time for them to change.  They made great calls/timing moves in 2008/2009.  The CDS bet and pulling off the hedges at the bottom.  To think these did not make them feel more confident I think is naive.  I have had my greatest fall (2008) after my greatest outperformance to date (2006/2007).  I purchased a subprime mortgage lender because I thought was it was safe and Monish was a holder.  I was wrong.  Fortunately, it was a small portion of the portfolio.  In FFH's case of hedges it is not.  Time will tell but I think over time I think alot of the analogies to the 1930s and Japan in the 1990s will not be the case.  Just my 2 cents.

 

Packer

 

Ok. What happened after 2008? After your greatest fall, what has pulled you out of the hole? If you were able to regain lost ground, why do you assume Mr. Watsa and his team won’t be able to change course?

 

giofranchi