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Fairfax - Continued Insurance for the Equity Investor
Posted by: The Science of Hitting (IP Logged)
Date: October 30, 2012 09:06AM

Fairfax Financial (FRFHF) reported third quarter earnings last week, and the results were solid: The consolidated combined ratio for the insurance operations was 95.4%, a significant improvement from 2011 when large catastrophe losses of $172 million (compared to $61 million in the third quarter of this year) resulted in an additional 8.5 combined ratio points (12.3 compared to 3.8 this quarter). In addition, net written premiums from the company’s insurance and reinsurance operations increased by 5.6% to $1.51 billion, from $1.43 billion in third quarter 2011. On the call, Prem Watsa discussed the industry dynamics that are driving the increase:

“As I have said in recent calls, we continue to grow our premiums. The large catastrophe losses in 2011, very low interest rates, and the reduced reserve redundancies mean that there's no place to hide for the industry. Combined ratios have to drop well below 100% for the industry to make a single-digit return on equity with these low interest rates.”

From my view, Fairfax continues to be an attractively priced insurance policy on the global macroeconomic picture. The company continues to keep their equity book 100% hedged, and holds long term (eight years remaining) CPI-linked derivative contracts that pay-off in the a big way if the U.S. encounters bouts of deflation similar to that experienced during the Depression in the 1930s (as described by Watsa in the most recent shareholder letter, “For a small amount of money we have significantly protected our company from the ravages of potential deflation”).

Mr. Watsa discussed the company’s current positioning in a bit more detail during the question and answer session on the conference call:

“…common stock positions are fully hedged. We have very little corporate bonds. Our muni bonds are predominantly guaranteed by Berkshire Hathaway, so it's a very conservative portfolio. And the reason for our conservative portfolio is very simply, the -- it seems to us that the disconnect between the fundamentals, in terms of companies and economies, and markets. So stock price -- stock and bond markets are high and the fundamentals, we think, are quite different, meaning on the low side. And so you'll either have the fundamentals go up over time to catch up with stock prices, catch up with very low spreads, or you'll have the markets come down.

And we've said for some time, this time period, we think of it as a 1 in 50, 1 in 100-year event. It's not a normal time period. And so we just think you have to be very, very careful. The fact that we've got cash in our portfolios, making no money today is a big advantage as and when opportunities come. Because of course, the only people who can take advantage of it is the people who have cash. In 2008, Tom -- 2008, 2009, you had a very significant -- 2 things happened, right? You had the stock market dropped almost 30% and the spreads widened significantly. And in that time period, we had 75% of our portfolios in cash and government bonds so we could take advantage of the opportunities that presented themselves to us. And 2010, 2011, we've started hedging and in by 2011, we've hedged significant parts of our portfolio.”

Fairfax isn’t interesting simply because of the company’s contrarian portfolio positioning; the critical components come down to history, valuation and the optionality of the protection. The company’s track record is solid – over the past 20 years, the current management team has increased book value at a compounded annual rate north of 16% per annum (and more than 20% over the past 25 years); despite this enviable history, shares essentially trade at parity with book value. It’s also critical to note that while clearly confident in his views, Mr. Watsa hasn’t bet the ranch – through the most recent quarter, the CPI-linked derivatives have a cost of less than $450 million, equal to about 5% of the fair value of the company’s bond portfolio for sake of comparison (on the other hand, the potential outcome is material, with the payoff expected to approach $6.5 billion – by my estimates – if cumulative deflation through 2020 was comparable to that of the 1930s).

Many people are increasingly nervous about their investments, particularly after the recent run-up in the U.S. equity markets; in comparison to Treasuries or cash, I think there’s a strong case for looking at Fairfax Financial common stock as insurance against global economic weakness in the years to come.


Stocks Discussed: FRFHF,
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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: vgm (IP Logged)
Date: October 30, 2012 11:01AM

"I think there’s a strong case for looking at Fairfax Financial common stock as insurance against global economic weakness in the years to come."

I think there's every reason to look at FFH common as an attractive stock in its own right, for the long run. Watsa has said previously that he is confident of delivering 15% over the long term. There aren't too many stocks where we can confidently project that. In addition, the stock must be trading a bit below book at present.

Something I've never understood is why Watsa obsesses about deflation while Buffett has categorically said on several occasions that we will not see deflation.


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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: ecotycoon (IP Logged)
Date: October 30, 2012 02:27PM

Thanks for sharing, i also find the conference call was really good, some questions where smart, according to my knowledge Fairfax is certainly one of the best business in the world if not the best, with the best management too, presently trading at cheap price with equity fully hedge, it's pretty hard to beat that:

http://www.fairfax.ca/news/press-releases/press-release-details/2012/Fairfax-Announces-Conference-Call1131432/default.aspx



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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: marcolanaro (IP Logged)
Date: October 30, 2012 04:27PM

@vgm
with all the QE we have been seeing lately, my take is that we are experiencing slowing economies everywhere instead of overheating economies, so Prem Watsa has a point.
I do think like you that FFH is an attractive stock on its own even without the hedging and at book value it is cheap.

@SOH
thank you for the interesting article. There is something very interesting that was said in the conference call referring to the insurance combined ratio, Watsa said that the insurance operation has been restructured in the last years and all that work shows in the latest ratios. Before I thought of Fairfax of a mediocre insurance business with an outstanding investing team, now I think that it is ready for serious book value growth and compounding.


Stocks Discussed: FRFHF,
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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: vgm (IP Logged)
Date: October 30, 2012 05:37PM

Marco,

thanks for your thought. It's unreasonable to think Buffett is missing such an obvious argument, however.


Stocks Discussed: FRFHF,
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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: marcolanaro (IP Logged)
Date: October 30, 2012 06:35PM

Vgm,
you are right, should be unreasonable to think that Buffett could be missing that. However, the fact is that QE seems not to be working as planned and is just able to keep the economy from falling into deflation, what's your take?


Stocks Discussed: FRFHF,
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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: The Science of Hitting (IP Logged)
Date: October 30, 2012 06:36PM

Thanks for the comments! To clarify, I think it's a great investment regardless of the macro picture - I was simply suggesting that for people who are scared of equities in general, Fairfax stands out as a particularly interesting investment for that crowd. In terms of the insurance operations, that's a great point Marcolanaro - if the underwriting results year to date are a sign of the years to come, the insurance operations should prove to be much better than they have been in the past...


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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: zenlighten (IP Logged)
Date: October 30, 2012 07:36PM

Thank you for the thoughtful article. I've owned FFH (now FRFH) for about 8 years and share Watsa's macro view. I have been planning on adding to my position as a hedge against all the insanity, but have held off on pulling the trigger. Fairfax helped me weather the economic storm of 2007-08, however does anyone have a view of how the share price / company will weather the havoc Sandy has created?


Stocks Discussed: FRFHF,
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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: AlbertaSunwapta (IP Logged)
Date: October 30, 2012 07:42PM

Watsa's one of the few managers that seems to have seen potential parallels between the Japanese and other markets. Think about it, world's second largest economy, a country of savers, yet a market that tumbled for years and years and then stayed down for a couple decades.


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Re Fairfax - Continued Insurance for the Equity Investor
Posted by: marcolanaro (IP Logged)
Date: October 31, 2012 12:40AM

@Zenlighten
I have found this table that could be of your interest, it seems that Fairfax exposure to be really small, not so for Berkshire. Anyway Fairfax has been trading on the Toronto stock exchange and was both monday and tuesday on the positive side so my guess is that it is true that it has little exposure. Here is the link:
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/10-2/20121030_sandy2.png


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