Your 2008/2009 Experience

[wisdom]

Float gives you permanent capital unlike a hedge fund plus leverage if done right.

 

The switch from cigar butts to buying good businesses isn't as easy as it mind sound either - otherwise BRK would have never become what it is (everyone would have done the same).

[ERICOPOLY]

Float gives you permanent capital unlike a hedge fund plus leverage if done right.

 

The switch from cigar butts to buying good businesses isn't as easy as it mind sound either - otherwise BRK would have never become what it is (everyone would have done the same).

 

This is permanent capital too:

 

Existing company's shareholder equity without insurance float.

 

HWIC manages this equity in addition to pimping out their services managing OPM.

[Uccmal]

Float gives you permanent capital unlike a hedge fund plus leverage if done right.

 

The switch from cigar butts to buying good businesses isn't as easy as it mind sound either - otherwise BRK would have never become what it is (everyone would have done the same).

 

This is permanent capital too:

 

Existing company's shareholder equity without insurance float.

 

HWIC manages this equity in addition to pimping out their services managing OPM.

 

here's 4 that Fairfax has had joint ventures with, or previously owned, or own now:

 

Russel Metals -tsx

Mullen Group - MTL - tsx

H&R REIT

Kennedy Wilson- KW has the lumpiness problem

 

We have watched them spend enough money on other things: RIM, Restaurants, Sporting Life, Reitmans to easily have taken one of the above private. 

[LC]

I am certainly not an expert on FFH like many of the board members here are, but the way I view it is that the insurance operation offers two distinct benefits:

 

1. Increase the scale of Fairfax. This enables them to get better terms, participate in bigger deals, etc. etc. etc. Akin to increasing the AUM were they a hedge fund only.

 

2. Optionality. Eric mentions the 15% average. IMHO that is a 15% in relatively bearish times, or when constrained by the hedges. What happens if/when the tide changes? So if they can "break even" at 15% during the worst of times, then the insurance leverage should add some value during better times.

[original mungerville]

Except they are not as good as Buffett and Ajit Jain.  The equivalent time frame would be around 1993.  Buffett owned the best underwriters by then.  They had a stable of wholly owneds that were pouring out massive amounts of cash, a huge investment in Coke.  BRK was getting annual returns closer to 30%.  FFh is targeting 15% and barely reaching it over the last 15 years.

 

Unless FFh buys some wholly owneds that really put fuel on the fire they are doomed to mediocre results going forward.

 

Al,

of course I already knew what your answer would be. And you might be right. But please consider:

 

1) You don’t want to compare returns in the midst of a spectacular secular bull, with returns in the midst of a secular bear.

 

2) Sincerely, I think OdysseyRe is among the best underwriters today.

 

3) Mr. Watsa + Mr. Barnard don’t have really to be as good as Mr. Buffett + Mr. Jain, otherwise we would be expecting 20%-25% returns, instead of 15%.

 

4) With all due respect for BRK and all Mr. Buffett has accomplished, in 1993 they certainly weren’t what they are today: net operating earnings were $477.7 million, of which $321.3 were Net Investment Income and $20.1 million came from underwriting. Operating businesses earned: Dexter $28.8 million, Commercial & Consumer Finance $14.1 million, Fechheimer $6.9 million, Kirby $25 million, Nebraska Forniture Mart $10.4 million, Scott Fetzer $23.8 million, See’s $24.4 million, World Book $13.5 million. BVPS increased 14.3% and BRK’s net worth increased by $1.5 billion, which means that stock investments (increase in value + sales) contributed more or less $1 billion… It is clear to me that in 1993 BRK still counted on insurance and investing for most of its increase in net worth.

 

5) Please, also note that as good as those other operating businesses truly were, they almost count for nothing in today’s BRK.

 

Listen, what I see in FFH is at least two bright and trustworthy people at the helm of a vehicle that could eventually follow in the footsteps of BRK. They have the brains and they have the right mean to achieve such a goal… This being said, I am certainly not saying they will succeed! Nobody of course can be sure about it.

 

Gio

 

 

Gio, you basically made my case for me.  At a similar size BRK was pulling in well over 100 million per year from wholly owneds.  The insurers under Buffett have always done better than FFHs insurers over time.  FFh has done very well with low probability, high payout situations.  Original Mungerville mentioned the nearly 1 b in bond gains they booked in the short days.  All of that money went to paying for bad insurance underwriting. 

 

The underwriting has improved to the point where it is not much of a drag now. 

 

So the big questions going forward I am asking:

 

1) Is it worth keeping the insurance operations.  Should they expand or focus these operations as per Markel, BErk.

 

2) The lack of stable cash flow is handicapping them now.  They cant get the ratings up to AIG, or BRK levels until this is remedied.  Lumpy doesn't work well.  Because they aren't a double AA insurer they cant Get the best clients and the best combined ratios. 

 

3) Buffett could point his the rating agencies to his incoming cash flow from dividends, and operating companies.  FFh cant do this because the wholly owneds are weak as compared to Sees, Furniture Mart, or now Mid-american.  I see no sign of a desire to move up the quality curve so far. 

 

4) So we are left with middling insurers, weak operating companies, and some low probability high payout bets. 

 

5) If there is a massive insurance event who will come out of it better: FFh or BRK.  if there is another recession who will come out better off: FFH or BRK.  BRK on both counts. 

 

I am kind of all over the place on this, but it explains why I don't believe FFH will do better than 15%, or even as good as 15% going forward.  I have spent 15 years listening to these arguments and have yet to see them consistently write insurance to a significant profit, across most units.

 

I would think that we could all agree that they have substantial investment assets relative to equity - probably too substantial. What this means is that at a minimum, instead of buying new insurance companies and keeping the existing debt/equity structure, any profits should be used to pay down all existing external debt to zero. This would get the equity up relative to the investable assets and reduce that ratio of leverage. To me, that is the first no-brainer step to take. You just don't need more leverage from debt when you already have enough leverage from float. I have thought this for some time now. Ericopoly is taking it one step further, but at a minimum, I would like to see them take care of this no-brainer first.

 

I think they need to produced underwriting results to refute Ericopoly's line of questioning. But keep in mind that their historical track record in underwriting is better than it looks. I am not saying its Berkshire-like, its just better than it looks because when you buy at 70% of book and do 110% combined ratios for 3 years while you turn around the acquisition (assuming you are writing 100% in revenues relative to equity and disregarding taxes for simplicity), then all you have done is really pay the equivalent of book value for the acquisition and done 100% combined. So the underwriting track record looks much worse than it actually is when you factor this in. The big question is what is it going to look like going forward.

 

 

[giofranchi]

I don’t know if this adds some worthwhile perspective on Eric’s question about the effectiveness of FFH’s business model compared to the mutual / hedge fund’s business model... I will give it a try:

 

At the end of 1985 FFH’s equity was worth $7.6 million. If you compound $7.6 million for 28 years at 20% annual, you get to a capital of $1,253 million. I have chosen 20% annual for 28 years, because I don’t know of any mutual / hedge fund with such a stellar track record.

 

Even if you don’t consider 1986, which was a formidable year for FFH, at the end of 1986 FFH’s equity was worth $29.7 million. If you compound $29.7 million for 27 years at 20% annual, you get to a capital of $4,080 million.

 

Instead, FFH’s equity today is worth $7.9 billion.

 

This comparison already takes into consideration the “not so good” underwriting track-record FFH has shown until now (though I understand and agree with original mungerville’s point of view that FFH’s underwriting track record is not as bad as it seems). Think how much better the comparison will look, if and when FFH starts underwriting profitably year after year! :)

 

Gio

 

[ERICOPOLY]

I don’t know if this adds some worthwhile perspective on Eric’s question about the effectiveness of FFH’s business model compared to the mutual / hedge fund’s business model... I will give it a try:

 

At the end of 1985 FFH’s equity was worth $7.6 million. If you compound $7.6 million for 28 years at 20% annual, you get to a capital of $1,253 million. I have chosen 20% annual for 28 years, because I don’t know of any mutual / hedge fund with such a stellar track record.

 

Even if you don’t consider 1986, which was a formidable year for FFH, at the end of 1986 FFH’s equity was worth $29.7 million. If you compound $29.7 million for 27 years at 20% annual, you get to a capital of $4,080 million.

 

Instead, FFH’s equity today is worth $7.9 billion.

 

This comparison already takes into consideration the “not so good” underwriting track-record FFH has shown until now (though I understand and agree with original mungerville’s point of view that FFH’s underwriting track record is not as bad as it seems). Think how much better the comparison will look, if and when FFH starts underwriting profitably year after year! :)

 

Gio

 

Share issuance I believe is something you want to factor into their growth of equity rate.  You don't need to be an insurer to issue shares.

 

How about you think beyond simply hedge funds and mutual funds.  Leucadia is not a mutual fund/hedge fund.  We can agree that they aren't deep in insurance either.  They have done well for themselves anyhow.

 

I am merely asking how much insurance operations help Fairfax.  Seems like the first question one should ask of them:  Why did you enter the insurance business?  You already kick ass investing, how much faster did you compound your money after adding insurance risk?  It does add risk doesn't it -- are you achieving meaningful risk-adjusted returns?

 

You have years when equities are at their cheapest, and I think the insurance model is a drag then as it hinders their ability to load up.  That's something that isn't discussed -- people only look at their float and only talk about underwriting loss as a cost of that float.  I'm suggesting the float costs more than that because it hinders their flexibility at times when you least want to be encumbered.

[giofranchi]

Share issuance I believe is something you want to factor into their growth of equity rate.  You don't need to be an insurer to issue shares.

 

How about you think beyond simply hedge funds and mutual funds.  Leucadia is not a mutual fund/hedge fund.  We can agree that they aren't deep in insurance either.  They have done well for themselves anyhow.

 

I am merely asking how much insurance operations help Fairfax.  Seems like the first question one should ask of them:  Why did you enter the insurance business?  You already kick ass investing, how much faster did you compound your money after adding insurance risk?  It does add risk doesn't it -- are you achieving meaningful risk-adjusted returns?

 

If you don’t consider the outlier year of 1985, FFH’s BVPS at the end of 1986 was $4.25. Therefore, BVPS has compounded at 17.5% annual for 27 years.

Sincerely, I don’t know many mutual / hedge funds, but among those that I know not one managed to sustain 17.5% annual for 27 years.

 

Leucadia imo has yet another business model: I think it has been much more of an activist value investor than many people realize. Just read the last letter by former management and it simply jumps out of the pages! Activist value investing, like Mr. Ichan has proven many times, exploits a weak link in modern capitalism, and therefore enjoys a clear mean to outperform. Just like insurance, also activist value investing is not without risks… That’s why, just like insurance, it works only in the hands of skilled and shrewd entrepreneurs.

 

Gio

 

[ERICOPOLY]

 

If you don’t consider the outlier year of 1985, FFH’s BVPS at the end of 1986 was $4.25. Therefore, BVPS has compounded at 17.5% annual for 27 years.

 

17.5%.  And how much of that is due to issuing shares at 2x or 3x book value?  Then, take that adjustment, and compare the final result to their historical return on equities.  Then you get to whether or not it has been worth it, and to what degree.

 

Sincerely, I don’t know many mutual / hedge funds, but among those that I know not one managed to sustain 17.5% annual for 27 years.

 

Irrelevant.  It doesn't matter how many you know of outside of Fairfax, because there is only one HWIC.  And it can be decoupled from Fairfax.

 

It's like saying Buffett can't do well outside of the Berkshire structure because you can't think of mutual funds that sustain high returns.  I would say "so what, they're not him!". 

[giofranchi]

You have years when equities are at their cheapest, and I think the insurance model is a drag then as it hinders their ability to load up.  That's something that isn't discussed -- people only look at their float and only talk about underwriting loss as a cost of that float.  I'm suggesting the float costs more than that because it hinders their flexibility at times when you least want to be encumbered.

 

With this I agree of course! But overall, over the course of 28 years, it seems to me that on average float has done more good than harm.

On page 24 of the book "Fair and Friendly: The First 25 Years of Fairfax", you can read:

One day, Francis asked Prem almost casually, "Do you know how Warren Buffett made his money?"

He was referring to "The Float", of course.

 

Gio

[giofranchi]

And how much of that is due to issuing shares at 2x or 3x book value? 

 

Well, I would argue that the ability to issue shares at 2x or 3x has been just another advantage over a mutual / hedge fund? Has it not?

 

Gio

 

[ERICOPOLY]

Share issuance I believe is something you want to factor into their growth of equity rate.  You don't need to be an insurer to issue shares.

 

How about you think beyond simply hedge funds and mutual funds.  Leucadia is not a mutual fund/hedge fund.  We can agree that they aren't deep in insurance either.  They have done well for themselves anyhow.

 

I am merely asking how much insurance operations help Fairfax.  Seems like the first question one should ask of them:  Why did you enter the insurance business?  You already kick ass investing, how much faster did you compound your money after adding insurance risk?  It does add risk doesn't it -- are you achieving meaningful risk-adjusted returns?

 

If you don’t consider the outlier year of 1985, FFH’s BVPS at the end of 1986 was $4.25. Therefore, BVPS has compounded at 17.5% annual for 27 years.

Sincerely, I don’t know many mutual / hedge funds, but among those that I know not one managed to sustain 17.5% annual for 27 years.

 

Leucadia imo has yet another business model: I think it has been much more of an activist value investor than many people realize. Just read the last letter by former management and it simply jumps out of the pages! Activist value investing, like Mr. Ichan has proven many times, exploits a weak link in modern capitalism, and therefore enjoys a clear mean to outperform. Just like insurance, also activist value investing is not without risks… That’s why, just like insurance, it works only in the hands of skilled and shrewd entrepreneurs.

 

Gio

 

Fairfax has been very activist.  Their model was to take broken insurance companies and try to fix them -- this was not passive investing.  They take board seats at OSTK and BBRY (and others).

 

[ERICOPOLY]

And how much of that is due to issuing shares at 2x or 3x book value? 

 

Well, I would argue that the ability to issue shares at 2x or 3x has been just another advantage over a mutual / hedge fund? Has it not?

 

Gio

 

 

This is a positive advantage to a holding company structure. 

 

Fairfax can have such a structure without writing insurance.

 

I have not argued that holding companies are bad structures -- I have merely asked about the insurance operations.  Specifically, I am asking if they can achieve these same returns without the risk and hassle of insurance.

[giofranchi]

Irrelevant.  It doesn't matter how many you know of outside of Fairfax, because there is only one HWIC.  And it can be decoupled from Fairfax.

 

It's like saying Buffett can't do well outside of the Berkshire structure because you can't think of mutual funds that sustain high returns.  I would say "so what, they're not him!".

 

Well, but it is relevant to me! Because I have to choose between investing in FFH and BRK’s business model, or investing in mutual / hedge fund’s business model!

 

Sincerely, it is irrelevant to me to think how Mr. Watsa and Mr. Buffett would have performed without writing insurance and gathering float! We will never know!

 

Gio

 

[giofranchi]

I have not argued that holding companies are bad structures -- I have merely asked about the insurance operations.  Specifically, I am asking if they can achieve these same returns without the risk and hassle of insurance.

 

Well, I guess that’s a matter of what you do best and what your circle of competence is. Although, I am sure Mr. Malone has been very successful with his Liberty Media, I wouldn’t want to see Mr. Watsa investing heavily in telecom and engineering mergers and spin-offs a la Mr. Malone… Exactly like I wouldn’t want to see Mr. Malone writing insurance… I think they are both great entrepreneurs… as long as they keep inside their own circle of competence: to Mr. Malone mergers and spin-offs of media companies, to Mr. Watsa the gathering and investing of float through insurance.

 

The point is they both have found a way to get an advantage over simply investing capital. That’s what also Mr. Ichan has done being an activist value investor. I like holding companies only if they show to have some kind of advantage over simply investing capital.

 

Gio

 

[rayfinkle]

Fwiw...

 

http://www.econ.yale.edu/~af227/pdf/Buffett's%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf

[ERICOPOLY]

I have not argued that holding companies are bad structures -- I have merely asked about the insurance operations.  Specifically, I am asking if they can achieve these same returns without the risk and hassle of insurance.

 

Well, I guess that’s a matter of what you do best and what your circle of competence is.

 

They have extraordinary investing results.  This is where their circle of competence is.

 

They do NOT have extraordinary underwriting results. 

 

So will you tell me where their should stay if you advocate for circle of competence? 

 

Staying within circle of competency is exactly what I am arguing for if I suggest that a pure investing structure might get them the same (if not better) results with less risk.

 

[gary17]

I'd guess the float was helpful in early years bit probably not so much now.

 

But why not ask the man at the dinner that Sanjeev has setup this year.

[wisdom]

From the annual report cost of float v bond rates:

 

Weighted average since inception (2.5)% 4.5%

Fairfax weighted average financing differential since inception: 2.0%

[ERICOPOLY]

I'd guess the float was helpful in early years bit probably not so much now.

 

But why not ask the man at the dinner that Sanjeev has setup this year.

 

 

I don't go to those dinners.

[ERICOPOLY]

From the annual report cost of float v bond rates:

 

Weighted average since inception (2.5)% 4.5%

Fairfax weighted average financing differential since inception: 2.0%

 

 

I'm looking for the line that illustrates the opportunity cost of the conservative investment portfolio as a cost associated to the insurance operations.

 

Just ask Sanjeev... he'll tell you.  Many times he has posted about how the portfolio is managed with the mindset that it's a large financial company (insurance) and thus the shareholder's equity cannot be managed the way it otherwise could be with respect to equities investing.  I believe he specifically said this with regards to the large amounts of equity hedging.

 

I don't think Sanjeev has it wrong.

[ERICOPOLY]

I also look at float as a means of gaining leverage from bonds.

 

But let's say for every dollar of shareholder equity that needs to get conservatively idled (my explanation for their smallish allocation to equities despite hedging the equities and having permanent capital), you leverage it 3x with bonds. 

 

So let's say they have 4% bond yield -- times 3x is 12%.  After tax that's in the 8%-9% range.  Then add in a couple of points for underwriting profits (after tax) if they start to generate some. 

 

Then you get a number on what they actually generate from the insurance side of things.  I'm merely saying that if you compare this number to what they earn historically on equities, it might actually be lower.

 

[wisdom]

On bonds they have averaged over 10% over the last 15 years. with leverage 3x it is more like 30% on equity. That is 2x their returns on stocks over the last 15 yrs.

 

From AR going back a couple of yrs

 

Investments

The table below shows the time-weighted compound annual returns (including equity hedging) achieved by Hamblin Watsa Investment Counsel (HWIC), ...

 

 

                                                      5 Years 10 Years 15 Years

Common stocks (with equity hedging)    8.7 %  15.8%    14.2%

Taxable bonds                                  13.3 %  12.5%    10.4%

 

[ERICOPOLY]

On bonds they have averaged over 10% over the last 15 years. with leverage 3x it is more like 30% on equity. That is 2x their returns on stocks over the last 15 yrs.

 

From AR going back a couple of yrs

 

Investments

The table below shows the time-weighted compound annual returns (including equity hedging) achieved by Hamblin Watsa Investment Counsel (HWIC), ...

 

 

                                                      5 Years 10 Years 15 Years

Common stocks (with equity hedging)    8.7 %  15.8%    14.2%

Taxable bonds                                  13.3 %  12.5%    10.4%

 

14.2% is not far from 15%.  So if they could simply earn 14.2% in a mutual fund I could purchase it in my RothIRA and get virtually the same as their 15% goal without using any leverage at all.

 

I don't put too much weight on their historical bond returns because of the great bull run from high interest rates to today's low interest rates.  This is why I went with 4%.

 

Anyways, what is their actual leverage level?  If it's 50% equities and the rest must be sequestered for the insurance operations, then the bond leverage is expressed as a multiple on that sequestrated percentage.  But if only 25% must be sequestered, then the bond leverage is expressed as a multiple of that smaller amount (double the leverage yet again).

 

I'm obviously not dead-set opposed to their insurance operations (why would I be), I just want to quantify what their actual returns are from insurance -- it's all muddied together and if I knew how much they sequester for insurance (versus equity investing), then I could easily determine whether it offers a better return versus just using that sequestered money for equity investing instead.

 

I think Berkshire doesn't have to sequester any money for insurance because they have relatively smaller insurance operations relative to their total pie.  I believe the cash they have on hand for catastrophe events is actually just uninvested insurance float.

[giofranchi]

I have not argued that holding companies are bad structures -- I have merely asked about the insurance operations.  Specifically, I am asking if they can achieve these same returns without the risk and hassle of insurance.

 

Well, I guess that’s a matter of what you do best and what your circle of competence is.

 

They have extraordinary investing results.  This is where their circle of competence is.

 

They do NOT have extraordinary underwriting results. 

 

So will you tell me where their should stay if you advocate for circle of competence? 

 

Staying within circle of competency is exactly what I am arguing for if I suggest that a pure investing structure might get them the same (if not better) results with less risk.

 

Eric,

the simple fact is we will never know if they would have succeeded in compounding capital at 17.5% annual for 27 years only investing capital… What I am sure about is that I don’t know anybody who has been able to achieve such an outstanding result… Therefore, I wouldn’t bet on Mr. Watsa to be the only one able to do so… It is not a reasonable bet…

Furthermore, to say that insurance is not Mr. Watsa’s circle of competence… well, then, probably we just see things too differently regarding FFH! ;)

 

Gio