Fairfax Financial (TSX:FFH) is a world-class insurance holding company that is a long-term compounding machine and worth significantly more than its current trading price. The security also provides significant protection against any downturn in the market, given the company’s positioning of its investment portfolio. The company’s quarter-end book value was $387 USD per share at June 30, 2014. There are approximately $45 per share in mark-to-market adjustments that can be added to this, resulting in an adjusted book value of $432 US per share. At its current quote ($445), one can purchase the company for 1.05x book value. The company is easily worth 1.3-1.4x book value, and that value will continue to increase. A more reasonable valuation is $600 per share.
Through its various subsidiaries, Fairfax is engaged in property/casualty insurance, reinsurance, and investment management, among other things. The group has operations in Canada, USA, Brazil, Europe and at Lloyd’s, as well as in Asia.
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The company’s major insurance divisions include:
Reinsurance: The gem of Fairfax, led by OdysseyRe, accounts for almost half of the company’s business and has produced an average combined ratio of 92.6% over the last 10 years. Odyssey is headquartered in New York and Stamford, and operates in 100 countries with 24 offices worldwide. Its agile organizational structure is a major strength, with multiple profit centers that allow it to very quickly “dial up” or “dial down” any of its profit lines depending on market conditions.
Northbridge Financial: Toronto-based property and casualty company that is one of the largest commercial property casualty insurers in Canada based on gross premiums written.
Crum & Forster: Leading commercial property and casualty insurance company in the United States. The company offers a broad range of coverages, primarily related to specialty commercial insurance markets, focusing on niche and underserved segments.
Asia: Various Fairfax subsidiaries that write both personal and commercial lines of non-life insurance across various classes such as fire, marine, professional indemnity, worker’s compensation, and personal accident. These include First Capital (Singapore), Falcon (Hong Kong), and Pacific Insurance (Malaysia).
The Chairman and CEO of Fairfax is an Indian-born entrepreneur named Prem Watsa (Trades, Portfolio). Watsa has been at the Fairfax helm for 30 years, ever since he and his partners took over Markel Financial, a troubled Canadian trucking insurance company and renamed it Fairfax Financial Holdings. Over this time, Watsa has compounded book value by 21% per annum, and built the business from a fledgling trucking insurance company, to a collection of world-class property and casualty companies that write more than $7 billion in annual premiums. While occasionally mentioned as the Canadian Warren Buffett (Trades, Portfolio), Watsa is not a one-man show. Fairfax has a very deep team of exceptionally talented analysts that are anchored in the discipline of value investing. The team is housed in a company called Hamblin Watsa, which has an investment track record that is almost unparalleled. Despite recently misunderstood hedging activities that have been a drag on performance, the company’s 15-year annual return on its stock portfolio has been 13.5% vs. 4.7% for the S&P 500. Its bond investment performance has been equally outstanding, as shown below:
These returns include certain periods during which the investment portfolio was almost completely hedged. This strategy has allowed the company to continuously protect its liabilities and maintain a conservative financial position. This conservative posture extends to the holding company balance sheet as well. At quarter end, the company had $3 billion in long-term debt for a debt-to-equity ratio of .31x, with more than $1.1 billion in holding company cash and investments. Its portfolio investments contained another $6.8 billion in cash and short-term investments (28% of the portfolio), which they could upstream at any time or put to use opportunistically, should any bargains appear.
On the insurance side, the company is led by Andy Barnard, the president and COO of Fairfax Insurance Group. His previous position was at OdysseyRe, where he created an exceptional company from scratch. He now oversees the entirety of Fairfax’s growing worldwide insurance group.
At the last annual meeting, Barnard said his goal was to have Fairfax become as well known for its insurance underwriting as it is for its investment results. Its group of insurance companies continue to improve their operating results, and last year the company achieved a record underwriting profit with a combined ratio of 92.7%. The company has also proven itself to be conservative in its reserving, with reserve redundancies in each of its core insurance operations that averaged close to 8% for the trailing ten-year period (i.e. if reserves had been set at $100 they would have come down, on average, to $92).
The full-cycle combined ratios of the major subsidiaries below, demonstrate the quality of the Fairfax insurance operations. Over the 10-year period through the end of 2013, the core insurance operations earned an average combined ratio of 96%. These results are exceptional and provide significant cost-free float, which we will discuss in more detail below.
As one can note in the graph below, the company is currently writing about .8x net premiums to its statutory surplus. This leaves significant capacity to increase premium volume significantly during a hard insurance market. In the last hard market (2002-2005), the company wrote 1.5x net premiums to equity. This strategy of being a disciplined underwriter, as opposed to chasing volume has served Fairfax well, and will pay off again in the future when the market begins to harden.
While the company’s current book value is $388 per share, it has several investments that are not currently being carried at market value on its balance sheet. Its investment in associates is currently sitting on an unrealized gain of $440 million (slide says $382 million (year-end)) that is reflected in book value (the company equity accounts for positions in which it owns more than 20%, so any mark-to-market gains are not reflected). Adjust to reflect actual economics and you get something closer to $420 per share in actual book value (in USD), or less than 1.1x the current trading price.
The insurance business allows Watsa and company to control something highly valuable for an investment team of their caliber: float.
Float represents funds provided by policyholders in the insurance business. While float is similar to a loan, it certain circumstances, it can be a much more powerful value-creating mechanism. While a loan will most certainly have a maturity date, as long as a company continues writing a similar amount or increasing premiums, float funds are held in perpetuity. Tom Gayner (Trades, Portfolio), chief investment officer of Markel, recently commented that Markel had sent him money every month since he began running Markel’s portfolio, and never asked once for a withdrawal. Not a bad gig, if you ask me. So while banks may be unwilling to lend to an insurance company after poor results, policyholders are unlikely to stop needing insurance. A while no one would ever lend money at a negative interest rate, it is entirely possible that the cost of float can be negative. When an insurance company’s combined ratio (premiums minus expenses and insurance losses) is less than 100%, the “interest rate” on the float is negative.
With this float from policyholders, Fairfax can create an enormous lever for value creation that the stated book value doesn’t consider. As was shown earlier, Fairfax subsidiaries have shown a history of underwriting profitable business over a full insurance cycle. These premiums have created an enormously valuable “loan” for Fairfax, and at almost no cost. This $15+ billion in float allows Fairfax to invest significantly more capital than its shareholder’s equity without incurring traditional debt and, thus, magnifies investment returns. This source of funds has proven to be extremely valuable for Fairfax, given its outstanding investment performance.
While recent investment performance appears terrible, the performance of Fairfax investments over the long term has been outstanding. The performance has been brought down by a costly decision to hedge against the company’s equity-related holdings. On June 30, the company held equity hedges with a notional amount of $6.6 billion. The largest of these hedges continues to be short exposure to the Russell 2000. At quarter-end, this exposure was $4.5 billion and the index ended the period at 1,193. At the current index value of 1,113, the company’s quarter-over-quarter market gain is $300 million, which would add another $15 per share in book value. Joel Greenblatt recently commented on CNBC about the Russell 2000 being in the 3rd percentile in terms of its historical valuation. Many have continued to avoid Fairfax stock due to the idea that the company will be unable to earn decent returns until its hedges are removed. They have proved this notion wrong several times, including via its hedges and credit default bets during the last financial crisis. Given the long-term returns of Hamblin Watsa are almost unmatched, I will continue to give them the benefit of the doubt on their hedging strategy (especially at these prices). History has shown their judgment is usually questioned at the wrong times. These guys are far from stupid.
Below is an illustrative example of the compounding machine in action. While Fairfax had roughly $7 billion in shareholder’s equity at year end, it had roughly $15.5 billion in additional float working on behalf of its shareholders. This left the company with nearly $1,200 per share in investments working on behalf of its investors. Assuming a 99% combined ratio and a 6% return on investments, the company will earn a recurring pre-tax return on equity of close to 20%. As you can note from the slide above, over the last 15 years, both the stock and bonds portfolios have achieved returns well in excess of this, so the assumption seems fair. Any returns above this are gravy. As are better underwriting results (current combined ratio is much lower than my assumption). Also, any increase in net written premiums will provide further upside via additional float. Since inception, the company has compounded book at 21% per annum after-tax—well in excess of my calculation. Bottom line: At less than 1.05x book value, the company is an absolute steal.
Low interest rates: Given that much of the industry returns are derived from the investment portfolio, low interest rates/low bond returns have made it necessary for combined ratios to drop well below 100% for the industry to make a single-digit return on equity. Over time, rates will increase or insurance pricing will adjust to compensate for these lower returns. Could be a headwind for the next few years, but the bond bubble will inevitably come to an end.
Insurance linked securities: Instead of paying premiums and giving away float, you sell insurance linked securities to yield starved investors that are looking for risk uncorrelated with the general market. You have then effectively created fully collateralized reinsurance that you can immediately access upon a loss event. Works very well for definable loss events that are short tail in nature—essentially selling bonds to investors with a very low cost of capital that are almost certainly less sophisticated than reinsurers.
Above are a few interested pieces on its growing use. You can clearly see that the alternative capital entering reinsurance is exploding in size (currently represents 15% of reinsurance capital ($50 billion)). Some of the industry experts are saying this could move to 40% in the next 10 years. This may be an incremental negative for OdysseyRe over time, but given that you are essentially receiving the insurance operations for free, the risk is already baked into the equation and more than manageable.