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Fairfax - Continued Insurance for the Equity Investor

October 30, 2012 | About:
The Science of Hitting

The Science of Hitting

258 followers
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:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.2/5 (19 votes)

Comments

vgm
Vgm - 2 years ago
"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.
ecotycoon
Ecotycoon premium member - 2 years ago
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

marcolanaro
Marcolanaro - 2 years ago
@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.
vgm
Vgm - 2 years ago
Marco,

thanks for your thought. It's unreasonable to think Buffett is missing such an obvious argument, however.
marcolanaro
Marcolanaro - 2 years ago
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?
The Science of Hitting
The Science of Hitting premium member - 2 years ago
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...
zenlighten
Zenlighten - 2 years ago
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?
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
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.
marcolanaro
Marcolanaro - 2 years ago
@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
vgm
Vgm - 2 years ago
Marco,

My take is that the global growth glass remains half full. China has slowed to "only" about 7%, the US is coming back, albeit very slowly, and parts of Europe (which cannot be considered a single entity) are doing OK. It will not be a straight line and currently there's a downward trend given the looming fiscal cliff in the US and (in particular in Europe) Spain's inability to make a bailout decision.

So, while I side with Buffett on inflation versus deflation, I'm intrigued by Watsa's hedge on equities and that he is still looking for a 1 in 50 or 100 year black swan-type event. As a long-only investor, I'm listening very carefully to Watsa while not forgetting my basic Buffettology!

But back on topic, I see Fairfax as an excellent long-term holding, as mentioned above.
vgm
Vgm - 2 years ago
Zenlighten,

It's ironic that you have been holding Fairfax "for about 8 years and share Watsa's macro view" and yet seem concerned about Sandy's effect on Fairfax's stock price. Insurance operations will always have down years, or need to take one-off hits, but it cannot matter for the long run to a Fairfax or a Berkshire.
marcolanaro
Marcolanaro - 2 years ago
Vgm, I own for myself both Berkshire and Fairfax as largest positions in my portfolio along with Pargesa Holdings, so I guess that we are both on the same thinking framework. Any way I see macroeconomic forecasting as too tough and I just try to put my money in solid securities with excellent governance and I get that in Fairfax as well in berkshire even if they have different views.
vgm
Vgm - 2 years ago
Marco,

Good move. Great companies. I also don't put any weight on my own macro views in terms of investing, but I do seek out those who have much broader and deeper insights, if only to have a feel for how they're thinking. In addition to Buffett and Watsa, I like to know what Wilbur Ross and the folks at Leucadia are thinking.
zenlighten
Zenlighten - 2 years ago
@Marco - thanks for the excellent chart. You are right, looks like their exposure is relatively small.

@Vgm - thanks for the snarky response. I don't find anything ironic about being concerned with the timing of a large (for me anyway) purchase/addition to my position in a property and casualty insurance company following an natural disaster that affects 54 million people w/estimates of 50B in losses. Am I missing something?
vgm
Vgm - 2 years ago
"Am I missing something?"

Yes. (1) Long term perspective and (2) confidence in those who manage Fairfax, not to mention (3) some basic appreciation of insurance companies.

Apologies. It was not intended as a "snarky response". Just genuine surprise, bordering on disbelief.
zenlighten
Zenlighten - 2 years ago
Vgm - so nice to get your "genuine and sincere" apology, but I'd rather have my original question answered.

Instead of criticizing me for my short-term perspective, impugning my lack of confidence in Prem/team, and telling me that you are in a state of utter shock and disbelief as to how anyone could ask such a ridiculous question, why don't you instead enlighten me as to the basics of insurance and share your wisdom on the topic of why a P&C company will see no/limited impact from a once in a generation storm? If I knew the answer to this question myself I would have never logged in here and asked.

If you don't know, you don't know. Maybe someone else can jump in here and explain?
vgm
Vgm - 2 years ago
Zen - now you're misquoting me. Poor style.

As a Fairfax investor of eight years' standing, arguably you ought to know about the basics of insurance. Read Buffett's letters is my advice. It's all laid out there, nice and clear.

The problem was not asking about exposure - MarcoI provided the (known, published) answer to that, and there were already estimates that Sandy would cost much less than other hurricanes - but that you wanted guidance on the short term price action of Fairfax stock on account of Sandy. No-one can know that. And a Fairfax investor should know it doesn't matter.
forexnutca
Forexnutca - 2 years ago
Why hold bonds in your portfolio at anemic yields when you can hold Fairfax at 2.5% dividend, and alpha potential on a fully hedged float portfolio with deflation insurance to boot.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Forex,

Good question! And one I've yet to find an adequate answer to...
zenlighten
Zenlighten - 2 years ago
Vgm - even poorer style is to misquote me misquoting you, but nevermind. If you actually read my original question you'd find I was inquiring about the short term impact on the share price AND the the long term impact on the company, which still seems to me to be a reasonable question. But that's alright, turns out the market answered my first question and Marco answered my second ... and you my friend answered neither, instead you chose to be pedantic and bust my balls. And then you have the nerve to give me a homework assignment ...Berkshire letters ;).

huang.touchstone
Huang.touchstone premium member - 2 years ago
combine ratio of faifax insurance business is excellent and all we wait is the investment return he makes. if no undervalued target found then you just wait and see.

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