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.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.