Much like Berkshire, management at Fairfax has a corporate objective of building long term shareholder value by achieving a high rate of compounded growth in book value per share; as indicated by this metric, they are doing a fantastic job. As will become evident, volatile short term earnings are not very indicative of the business results; as noted by CEO Prem Watsa (and which will become apparent when we look at the investment portfolio), “With the introduction
of IFRS accounting standards in 2011, mark-to-market accounting will make our earnings very volatile – more the reason for you our shareholders to focus on our book value growth over the long term.” The chart below shows the results in incremental periods, and for the full 25 year period that the current management team has been in control:
(NOTE: all numbers/figures are based on year end 2010 data for FFH)
|As of 12/31/10||5 Years||10 Years||15 Years||20 Years||25 Years|
During the past quarter century, a lot of progress (and growth) has occurred at Fairfax. What started as one insurance company in Canada with $10 million in premiums is now a worldwide corporation operating in over 100 countries and with more than $5 billion in premiums. The stock price has moved in tandem with BV, increasing by 21.3% per annum over the 25 year period (slight difference due to the fact that book value is in US dollars, while stock price is in Canadian dollars; change in exchange rate over time has created the slight variation). In 2010, book value increased 5% to $379.46 per share, meaning that at the current price ($360.01), the stock currently trades at a 5.4% discount to book value.
Since 1985, V. Prem Wasta has been the Chairman and CEO of Fairfax Financial. Over time, the successful mix of consistently strong investment returns on float and expanding insurance operations (which are similar to Berkshire Hathaway) has led to Mr. Wasta being nicknamed “Canada’s Warren Buffett”. Much like Warren, Prem has the significant majority of his wealth (99%) invested in his company’s own stock. As he noted in the 2010 shareholder letter, “even on my death I expect my controlling interest will not be sold (my children are in tears!), so that Fairfax can continue uninterrupted in building long term value for you, our shareholders.”
In mid-2007, a couple weeks after the Dow Jones Industrial Average (DJIA) crossed over 13,000 for the first time ever, Prem Watsa had this to say: “There’s a possibility of a one-in-50 or one-a-100 year storm coming; when the music stops, it ends very quickly.” By the time of the first big drop in the Dow (over 400 points on July 26, 2007), Mr. Watsa was ready: he had moved the large majority of the portfolio out of equities and into treasury bonds and cash. He also used credit default swaps ($341 million invested) as a wager on U.S. credit markets; before all was said and done, that investment was worth more than $2 billion in profit.
After the collapse, Prem moved quickly to position the portfolio in response to the market’s overreaction, investing $2.3 billion on shares in equities at bargain bin prices (while still remaining 25-30% hedged). As a result, Fairfax’s book value per share increased by 53%, 21%, and 33% in 2007, 2008, and 2009 (respectively), compared to returns during the same time period of 5.61%, -37%, and 26.5% for the S&P 500.
One of the big moves at the top of Fairfax in the past year was the promotion of Andy Barnard to the position of President and COO of our Fairfax Insurance Group, who will “oversee all of Fairfax’s insurance and reinsurance operations and to work with our presidents on strategy and coordination”. Mr. Watsa had this to say in the annual letter: “Andy has built over 15 years one of the most successful reinsurance companies in the world. When Andy joined OdysseyRe (the old Skandia Re) in 1996, it wrote $200 million in premiums, operated only in the U.S. and had shareholders’ capital of $315 million. With a few acquisitions, Andy has built OdysseyRe into a nimble, worldwide reinsurance operation focused on serving its customers while achieving an underwriting profit with good reserving. OdysseyRe wrote premiums of $1.9 billion in 2010 with shareholders’ capital of $3.7 billion – after returning net capital to its shareholders of $247 million. OdysseyRe compounded its book value per share since it went public in 2001 at 20.4% per year – the best track record in the reinsurance business that I know of.” Much like with the future of Berkshire Hathaway without Warren Buffett and Charlie Munger, the future of Fairfax Financial without Prem Watsa is frightening; in both situations, I think the men in charge have instilled a corporate culture and placed a team of people around them who are capable of picking up where they leave off, and understand the importance of driving long term shareholder value.
(An important side note: the company has pending litigation against a group of hedge funds, and is seeking $6 billion in damages; a favorable outcome would materially affect Fairfax considering the current market cap. See link at in sources at end of document for a comprehensive article of the situation.)
BUSINESS QUALITY & OPERATING RESULTS
An important metric used by insurance companies is the combined ratio, which is a measure of profitability that indicates the effectiveness of operations. The general benchmark is a combined ratio below 100%, which indicates the company is making an underwriting profit and is holding the float at no cost. On the other hand, a ratio above 100% indicates the company is paying out more in claims than they are bringing in through premiums. In situations where the combined ratio exceeds 100%, the float being invested is similar to a loan with interest payments that need to be made; subpar investment results that don’t cover the “interest” expense will result in overall losses for the company.
The results of Fairfax’s major subsidiaries (shown below) reflect the impact of soft insurance markets (low premiums, intense competition, and dwindling profits). The consolidated combined ratio for Fairfax in 2010 was 105.2%, which resulted in an underwriting loss of $236.6 million (of which Zenith accounted for $101.7M) and a cost of 2.3% on the float ($10.43 billion). The overall ratio was affected by short term issues at Zenith National, where premium cuts (due to “wildly competitive market behavior”) and additions to loss reserves (which added 9.1 combined ratio points) negatively impacted full year results. As noted by Mr. Watsa, “We expect it is only a question of time before Zenith’s 30 year average combined ratio of 95% comes back.” The overall increase of in the combined ratio by 5.4 points year over year was due to 2.5 points due to expenses, and 3.5 points from catastrophe losses. The elevated expenses are a result of shrinking premiums during a soft market (rather than writing too much business at the wrong time); as noted in the 2009 Annual Report, “We are not focused on the top line (market share) but on underwriting profitability and the bottom line.”
|Subsidiary||Combined Ratio||Net Earnings||ROE (average)|
|Crum & Forster||109.1%||64.2||5.8%|
Besides Zenith National (which was discussed above), the other insurance subsidiaries performed well in 2010 (combined pushing 110% aside). When we look at longer term results (2002-2010), the numbers suggest conservative long term underwriting, much like BRK.A:
|Subsidiary||Cumulative Net Premiums Written (in CDN billions)||Average Combined Ratio|
|Crum & Forster||7.9||99.8%|
These four companies represent the core operations of Fairfax (with Zenith entering the equation in May 2010), and have been the driver of growth for the company over the past nine years as indicated by compounded growth rates averaging 19.55% since 2001.
As noted in the shareholder letter, “Our long term goal is to increase the float at no cost. This, combined with our ability to invest the float well over the long term, is why we feel we can achieve our long term objective of compounding book value per share by 15% per annum over the long term.” For investors, the focus is on two areas: 1) growing no cost float, and 2) strong returns on investment.
Full year results for 2009 and 2010 clearly lay out the accounts that drive free cash flow generation at Fairfax. In 2009, a small underwriting profit ($7.9M), interest and dividends of $557M, and net gains on investments of $668M were the key drivers in net earnings of $990 million. In 2010, underwriting losses of $236.6M and a decline in net gains on investments to $215.4M resulted in net earnings decreasing by more than 50% to $471.2 million. As evident in these figures, mark-to-market accounting will create lumpy earnings at Fairfax over the coming years (based on the current investment portfolio).
FLOAT & INVESTMENTS: THE KEY TO GROWTH
As noted previously, successful investment of float (average of $10.43 billion, up 10.6% in 2010) is fundamental in the insurance business. From 2007-2009, the investment portfolio at Fairfax gained nearly 50%, compared to a 23% loss for the S&P 500 over the same period. However, relative results weakened in 2010, with a 3.9% return at Fairfax compared to 11.6% for the index. This underperformance is rooted in two key factors, which warrant further discussion.
The first factor was a decrease in the municipal bond portfolio by $220.6 million (4%), due to higher municipal bond interest rates. As noted by Mr. Watsa, “We do not think that general concern is a valid concern for our portfolio of muni bonds, as almost 65% of our muni bond portfolio is insured by Berkshire Hathaway, and essentially all of the rest of our muni bonds are from essential services like large airports or transportation systems, or from large states like California.”
The second factor is that the equity portfolio is hedged nearly 100%. While the company had a combined realized and unrealized gain on equities of $956.5 million in 2010, they had nearly identical hedging losses of $936.6 million ($45.61/share); in aggregate, hedging cost Fairfax 4.2% in total returns for the year. The four “very long term” equity positions in the portfolio are Wells Fargo (cost basis - $19.36, market value - $620M), Johnson & Johnson ($61, $469M), US Bancorp ($16.27, $428M), and Kraft Foods ($26.56, $344M). In aggregate, portfolio investments (between bonds, preferred, common, derivatives, etc) are worth nearly $22 billion.
While the one year results disappointed, it is important to look at the overall picture, not just a split image. Historical results indicate that the investment portfolio has consistently beaten the market. Over the past 15 years, the common stock investment (including equity hedging) has returned 17.2% per annum, compared to 6.8% for the S&P 500 over the same time period. Taxable bonds have had relatively strong returns as well, with a 15 year average of 10% per annum, compared to 6.2% for the Merrill Lynch U.S. corporate (1-10 year) bond index.
An annual outperformance of more than 10% per annum in over the past 15 years in equity investments shows the true genius behind the team at Fairfax. As noted previously, mark-to-market accounting with the current investment portfolio creates volatile quarterly EPS results (“lumpy”) that are not reflective of the operating results (2010 EPS by quarter: $14.02, $15.49, $10.24, $(18.43)). For this reason, it is imperative (as long term investors) that we focus on other metrics (like book value) as a proxy for intrinsic value.
The balance sheet as of December 31, 2010, shows $1.47 billion in cash & equivalents, compared to $2.73 billion in total debt, which is equal to a net debt position of $1.26 billion. While the overall cash position in negative (net debt), the company is financially healthy, with debt/equity of 14.4%, debt/total capital of 23.8%, and interest coverage of 2.8x.
As far as the insurance businesses are concerned, management has patiently waited for hard markets to return, which is evident in the numbers. Based on year end 2010 figures, the company was averaging about 0.5x net premiums written to statutory surplus. This compares to an average closer to 1.5x during the hard markets from 2002-2005. For the time being, waiting for greener pastures has led to sound and conservative financial strength in the insurance businesses.
At today’s price, you are buying Fairfax for less than book value. If historical results are any indication (24.7% per annum over the past 25 years), investors will continue to outperform market returns through FFH if it continues to advance at the rate as the past quarter century. In my mind, the opportunity to buy an insurance company at book that has expanded BV at such a high rate of return over a long period of a time is very attractive.
Think about that in this sense: In the shareholder letter, Prem Watsa wrote, “At the end of 2010, we had approximately $641 per share in insurance and reinsurance float. Together with our book value of $379 per share and $119 per share in net debt, you have approximately $1,139 in investments per share working for your long term benefit – about 7% higher than at the end of 2009.” For a cost of $360, you have $1,139 in investments working for you, in the hands of someone who has beat the market by more than 10% per annum (on average) over the past 15 years, and who has 99% of their personal wealth invested with you (no 2 and 20 like at hedge funds); in my mind, this sounds like a formula for success with little/no risk.
In the past five years, average annual earnings were equal to roughly $820 million, for an earnings yield (on the current market cap of $7.82B) of more than 10%. However, this figure includes 2008 investment gains of more than $2 billion from credit default swaps, which are certainly a one time (or at least not reoccurring) gain. With that removed from the calculation (and other “one time” items), the normalized earnings yield would be closer to 6-7%, or a P/E around 14x-16x. In my opinion, these results indicate that under normal market conditions, FFH is a safe investment, but not a screaming buy; however, the real benefit of owning Fairfax is as protection against the “worst case scenario”.
CATALYSTS: A HEDGE AGAINST DEFLATION
In 2007, Prem Watsa was spot on with his diagnosis; as a result, FFH has advanced 75-80% from 2007-2011, while the major indices in the United States are still in the red. Part of the logic behind an investment in Fairfax Financial at this time is a hedge against deflation. Mr. Watsa, who likely wouldn’t argue with being called a contrarian, believes that we may still experience a time period like the US in the 1930’s or Japan since 1990, when nominal GDP was flat for 10-20 years, and bouts of deflation occurred (for his full discussion, see page 15 of the shareholder letter). As he notes, in the 1930’s in the US and during the past ten years in Japan, cumulative deflation was approximately 14%.
Based on his deflationary concerns, Mr. Watsa has invested in CPI-Linked Derivative Contracts, which are ten year contracts that are linked to the consumer price index of specific countries/regions. The payoff on these are linked to the purchase price on the correlated index, with the payout equal to the percentage below the index price at the time of purchases times the nominal value. Here are the company’s holdings, which will help with an example:
|Underlying CPI Index||Notional ($ billions)||Avg Strike Price (CPI)||12/31/10, CPI|
Let’s assume that in 9.4 years (remaining average term on the contracts), Mr. Watsa ends up being correct; across the board, we see 14% deflation (equal to US in 1930’s and Japan in 2000’s). Based on that price, the payoff would be 14% of $34.2B, or $4.79 billion. Assuming that we live in a world where the only potential results are 14% deflation or no payoff (conservative estimates because it eliminates the probability of payoffs from 0-14%), the pricing on this contract ($302.3 million) assumes that this event has a (simplified) probability of 6.3%. Is it likely that this outcome would occur once if we played out the global environment 15 times? Prem Watsa thinks so, and has positioned himself accordingly. As an investor with only long equity positions (which comprises most individual investors), I think that investments in Fairfax have merit as a hedging tool. At the same time, Fairfax has limited risk from the contracts, and will be financially sound even if they expire worthless. I view this as a hedge that pays off handsomely in the event of a downturn, and that possibly lags (while the rest of your portfolio advances) in the event of a global recovery. In essence, Fairfax acts as insurance, and is well worth a couple percentage points of excess return (if historical results are indicative, it won’t even cost you that) on the upside for protection from deflation.
As long term results suggest, Fairfax has consistently outperformed the market. For the time being, the company has reverted to conservative insurance (due to soft markets) and investment (100% equity hedging) practices in anticipation of future events. As Prem Watsa noted on the Q4 2010 Conference Call, “we’re focused on protecting our capital from worst case events.” For most individual investors, I believe Fairfax is an intelligent addition to their portfolio due to the strong long term growth characteristics, a current P/B of less than one, and as a hedge against deflation in key global markets.
Sources & Key Documents for Consideration:
2010 Annual Report: http://www.fairfax.ca/Assets/Downloads/AR2010.pdf
2010 Shareholder Letter: http://www.fairfax.ca/Assets/Downloads/110304ceo.pdf
2009 Annual Report: http://www.fairfax.ca/Assets/Downloads/AR2009.pdf