Yesterday, I asked whether Paul Desmarais of Power Corporation of Canada (POW) was the Warren Buffett of Canada. Today, we’ll be talking about Prem Watsa of Fairfax Financial (FFH).
Warren Buffett runs Berkshire Hathaway (NYSE:BRK.B). Prem Watsa runs Fairfax Financial.
Here are their records:
|S&P 500 Total Return||Berkshire Book Value Change||Fairfax Book Value Change|
From the data alone, we can see Prem Watsa and Warren Buffett are both good investors. Both men’s minimum, maximum, median, and mean returns are all better than the S&P 500. Prem Watsa and Warren Buffett also both have lower coefficients of variation (CV) than the S&P 500. While a lot of folks look at standard deviation when studying an investment record – the variation coefficient is a much more interesting number.
When investors are deciding whether to buy shares of Berkshire Hathaway or Fairfax Financial they really aren’t worrying about the size of the moves in book value. They’re looking at the past record and asking: how likely is it that this record will be repeated in the future?
How reliable is the past record?
In general, the reliability of an investor’s record has more to do with the variation coefficient of his returns that the standard deviation. This is especially true when his variation coefficient is very different from the S&P 500’s.
Some of the best value investors from the past had market beating returns with market matching variation. That means both their average returns and their standard deviation were higher than the S&P 500. But a few – like Warren Buffett and Benjamin Graham – tended to have much better variation coefficients.
When you look at the relation between the average and the standard deviation, you find guys like Warren Buffett and Ben Graham are really good and really different from the S&P 500.
We can see that here.
Berkshire Hathaway – which owns plenty of businesses in full, not just stocks – has a stellar variation coefficient: 0.80.
Berkshire’s book value growth is way more reliable than the growth in the S&P 500. If you have a choice between investing a dollar in the S&P 500 and buying Berkshire at a price-to-book ratio of 1 – buy Berkshire every time.
Investors know this. That’s why Berkshire often trades above book value. It has to. Otherwise, there’d be no doubt Berkshire would crush the S&P 500 going forward.
Historically, Berkshire has had better – less jerky – returns. In fact, when you scale the jerkiness (standard deviation) to the trajectory (mean), you find that Berkshire’s course is twice as straight as the S&P 500’s.
What about Fairfax?
Fairfax has a much higher standard deviation than the S&P 500. But it also has a much higher average return. The result is – like Berkshire – a lower variation coefficient. This means that although Fairfax’s returns jerk around quite a bit, the size of the jerks are bigger just because the speed Fairfax is rocketing at is faster.
Fairfax has a variation coefficient of 1.25. The S&P 500 is worse at 1.59.
I wouldn’t worry too much about the idea that Fairfax has better returns just because it takes bigger risks.
Qualitatively and quantitatively – it’s clear Fairfax is a riskier company and a riskier stock than Berkshire. But there isn’t a strong case that Fairfax is riskier than the S&P 500.
We can look at this in a few ways. Almost all of them support the idea that Fairfax is not just a riskier version of the S&P 500:
· From 1986-2009, the S&P 500 had 5 losing years; Fairfax only had 4.
· The S&P’s worst year (-37%) was worse than Fairfax’s (-21%).
· Fairfax has a higher standard deviation but lower CV than the S&P.
These points suggest that Fairfax definitely rocketed much faster from 1986 to 2009 than either the S&P 500 or Berkshire. But they don’t say that Fairfax’s aim was worse than the S&P 500. They only say that Fairfax’s aim was worse than Berkshire’s. That’s undeniable.
Fairfax has had higher highs and lower lows than Berkshire. If you’ve followed the company’s history and its battle with short-sellers you already knew that.
I’m not knocking Fairfax’s record.
It’s better than Berkshire’s. But I think it’s less reliable than Berkshire’s. A lot less reliable. We’ll get into the reasons for that in a minute.
But before we leave the Fairfax / S&P 500 comparison, I’d like to stress that Fairfax is not just some leveraged version of the S&P 500. It’s very different. You can see that by comparing the year by year returns for the S&P and Fairfax.
They aren’t just amplified. They’re different.
How Fairfax is different from Berkshire?
The Morningstar analyst who covers Fairfax said it best: “Fairfax combines stellar investment management with mediocre insurance operations.”
Since 1985, Prem Watsa’s investment record has been better than Warren Buffett’s. But Fairfax’s insurance record has been worse than Berkshire’s. By Watsa’s own admission, Fairfax’s float has actually cost the company money since 1985.
Fairfax’s insurance companies lose about 2.3 cents per year per dollar of float. That means Fairfax’s underwriting is not turning a profit, it’s actually borrowing at 2.3% a year. Since anyone can make more than 2.3% a year on their money over the long-term, Fairfax’s insurance operations would be profitable in any investor’s hands.
They are very profitable in Prem Watsa’s hands.
Over the last 15 years, Fairfax’s common stock portfolio – including hedges – returned 18.3% a year. That means Prem Watsa can take underwriters that lose 2.3% a year and turn them into insurance companies that make 16% a year.
That’s the secret to Fairfax’s success. And it sounds a lot like the secret to Berkshire’s success.
But it’s not.
Berkshire’s investment management hasn’t been as good as Fairfax’s. But it’s insurance operations have been much better. Berkshire owns a world class collection of insurance companies. They rank among the top players in the world in terms of premiums written. But that’s not what matters. What matters is the combined ratio. And Berkshire’s combined ratio is consistently better than its peers. A lot better.
The big insurance companies that underwrite as well as Berkshire don’t invest as well as Berkshire. And they don’t have some fully owned businesses on the side. And they don’t have Berkshire’s credit rating. And they don’t have Warren Buffett as their chairman.
The combination means Berkshire is a much better money growing machine than other big insurers.
But is it better than Fairfax?
Fairfax clearly has the better record. It’s a shorter record. But it’s a better record. And given Fairfax’s size, it’s very likely Fairfax will continue to grow its book value faster than Berkshire.
So whenever Fairfax and Berkshire trade at the same price-to-book ratio – you should buy Fairfax, right?
I don’t know about that.
I admire Fairfax’s record. And I imagine it can be continued.
But I share one Fairfax shareholder’s concerns about owning the stock:
“This idea is 90% about management. Unless you touch the consumer directly – like GEICO, for example – the insurance business is an average-return business. What makes Fairfax exceptional is Prem Watsa, who as CEO and Chief Investment Officer has an unsurpassed record of making investment decisions over the past 25 years. He’s outperformed in both fixed income and equities, increasing book value by more than 20% annually over that time. That’s a significant and sustainable competitive advantage. We’d think differently if Watsa were not there, even more so than if Warren Buffett were not at Berkshire Hathaway.”
I agree with that last point. Berkshire has become much more than Warren Buffett. Is Fairfax much more than Prem Watsa?
It’s hard to say without digging into the inner working of the company. Prem Watsa definitely involves more people in the investment management part of the business. Warren Buffett never involved anyone other than Lou Simpson and Charlie Munger. Prem Watsa is definitely trying to create a company that lives on after he’s gone. He may even be doing a better job than Warren Buffett.
But the assets he’s cobbled together make that questionable. Insurance has fueled Fairfax’s rocketing growth. No doubt about that. But the insurance engine itself is very ordinary.
Recently, Fairfax looks like it’s been trying to change that. They bought Zenith which has a 30 year plus record of writing at a combined ratio of 95. That’s an amazing record. Fairfax also bought a much smaller company called First Mercury Financial (NYSE:FMR). First Mercury is a niche insurer with a good long-term underwriting record.
I’m harping on Fairfax’s very ordinary combined ratio for a good reason. Although it may sound like the combined ratio is just a matter of execution – it’s really not.
A combined ratio is an insurer’s profit margin. An insurer’s long-term average combined ratio tells you the same thing any company’s long-term average free cash flow margin tells you. It tells you how insulated the company is.
Do they control their own destiny? Is there a moat? Or do they have to fend off cattle raids each and every day?
Fairfax’s underwriting record says it’s a no moat insurer. It hasn’t carved out niches where it’s at the top of the food chain. It competes with a lot of other predators. And when the mix of predators and prey – capital and customers – gets out of whack, Fairfax has to take the same weak prices other insurers take.
How bad is this for Fairfax?
With Prem Watsa at the helm, it’s totally fine. It’s not a big deal. Fairfax can write as badly as the next insurer and rack up market thumping returns. Shareholders will prosper. You’ll get rich.
That’s how good Fairfax has been at investing it’s float for 25 years.
And that’s how Prem Watsa has beaten Warren Buffett.
But it’s also how Prem Watsa has differed from Warren Buffett. It’s not just a question of size and timing as some people suggest. It’s not like Fairfax is just a younger, smaller version of Berkshire.
Fairfax and Berkshire are different. Just like Prem Watsa and Warren Buffett are different.
When Buffett left the hedge fund game in the late 1960s – yes, Warren Buffett ran what was basically a hedge fund (even he says so) – he decided to start buying businesses. This didn’t start with Nebraska Furniture Mart. Buffett really got into the idea of buying and holding businesses in addition to stocks.
The 1970s happened.
Stocks went from way too expensive (1965) to way too cheap (1982) faster than Buffett expected. From the early 1970s to the early 1980s, it didn’t make a lot of sense to buy businesses. It made sense to buy stocks. Buffett knew that buying and hoarding stocks at those prices would eventually pay off.
And that gave people the impression that Buffett was just trying to create an insurer that bought common stocks. He was just running his old hedge fund.
If that was true – Warren Buffett would be just like Prem Watsa.
But it’s not.
Buffett made a few decisions along the way:
1. Buffett wanted to – maybe even preferred to – buy entire businesses instead of stocks.
2. Buffett wanted to buy and hold these businesses forever.
3. And Buffett wanted to buy and hold his favorite stocks forever.
There was a fourth decision.
Warren Buffett had always been interested in insurance. He learned about insurance through GEICO. And – when he took over Berkshire – he immediately went out and bought a great little insurance company. He also had some bad experiences with insurance along the way. And – with the exception of Ajit Jain’s work – he found Berkshire couldn’t grow its own insurance business from scratch.
Buffett learned that good insurance companies were rare. Mediocre insurance companies were common. And he didn’t want to own mediocre insurance companies.
The combination of these 4 decisions is what separates Prem Watsa and Fairfax Financial from Warren Buffett and Berkshire Hathaway.
Prem Watsa is willing to grow float by buying mediocre insurers. He may not say that. That may not have been his intention. But that’s what has happened. Watsa is also willing to sell stocks faster than Buffett. And he’s willing to focus on investing in stocks and bonds instead of buying entire businesses.
All of these things separate him from Warren Buffett.
Do they make Prem Watsa a worse investor? Or Fairfax a worse stock?
There’s a very strong case for arguing the opposite. Prem Watsa’s willingness to run Fairfax as a leveraged investment fund is what makes Fairfax so successful.
If the question is whether Prem Watsa has an investment record worthy of comparison to Warren Buffett – the answer is yes.
Prem Watsa’s investment record is every bit as good as Warren Buffett’s.
But if saying Prem Watsa is Canada’s Warren Buffett means you bring along all the other Buffett baggage: how Buffett thinks about insurance, how Buffett allocates capital, how Buffett buys and holds stocks – then, no, Prem Watsa is not Canada’s Warren Buffett.
He’s just Canada’s best investor.