This is pretty much an exact copy of Buffetts early days Berkshire: Getting access to cheap funds through an insurance operation which focuses upon underwriting at zero cost and then allocating these cheap funds – called float - wisely.
Present management runs the business since 1985. At the helm is Prem Watsa, an Indian investor following the business principles as have been developed by Graham & Buffett. The stock ended the year 1985 at 6 C$ and 2007 at 300 C$. Without taking the modest dividend of around 1% into account, that is an annualized return of 19.5%. Prem Watsa and other employees own a significant part of the company and are not hesitating to state that they will not sell their stake – regardless of price.
The number one objective of every insurance operation is to underwrite at no cost. As we can see in the table this objective has not been fulfilled. The reason for that regression however is the purchase of the badly run insurance companies Crum&Forster and TIG. When we just take into account insurance operations which have been run at least 5 years under the helm of Fairfax we will get a different picture: indeed the operations show even a moderate underwriting profit of 2%. The reason is a disciplined underwriting approach: Management is halted to underwrite profitably by paying foremost attention to return on equity and not premium volume. It is therefore to be expected that in the next soft market we can expect underwriting results that far exceed those of the last soft market in the 2000s.
GROWTH
Check Warren Buffett’s outlook for insurance business in his latest annual (‘07):
“The party is over. It’s a certainty that insurance-industry profit margins will fall significantly in 2008. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by 4 percentage points. Be prepared for lower insurance earnings during the next fewyears.”
Fairfax has three ways to grow their business:
1. Buying other insurers on the cheap
2. Writing larger sums of insurance
3. Buying stocks of wonderful companies at reasonable prices
Whereas A) can be the most rewarding (just look at Prem raising book value some 20% annually in Fairfax first decade of existence…) it is also the most difficult approach to turn a badly run insurance operation around – as has been painfully experienced with Crum and TIG. B) and C) however are basically questions of operating excellence. A well run insurance company will over time be able to underwrite larger sums profitably. And a value orientated investment approach will over time grow delicious fruits. It is impossible to anticipate the growth through A) – as opportunities are rare and often arise without indication. B) and C) again are a lot more foreseeable as B) grows in waves and C) is a source of actually quite stable growth if we put the focus on intrinsic business value and not stock market prices.
Prem Watsa has stated the objective to increase book value by 15% annually through the combined use of A),B) and C). As he accomplished a 20%+ return on book value in the past there’s no reason to believe he has overstated the companies underlying economics.
MOAT – Where is it?
The moat is attitude. The job that’s done by Prem Watsa and his fellows cannot be done by others. If the concept of value is not deeply ingrained in the people who run the business the results will never even come close to those people who have grown up in Graham & Doddsville. Just look at the results of the large insurance companies of AIG,AXA and the likes. They clearly have structural disadvantages to Fairfax . Their only upside was their financial strength that allowed them to write larger sums. With Fairfax improving rapidly on that issue even the last “size edge” is wiped out. Watsa states:”We protect our portfolio from a 1 in 100 year financial storm.” Whereas other value guys were getting punished for being superficial - Watsa and his investment team earned a fortune by correctly realizing that credit spreads have come down to unsustainably low levels when in the same time credit quality has eroded. A few figures to underlie the aforementioned:
Evaluation
Looking at the current share price of 280$ we actually do not need any algebra;
With book value of 260$ per share and the knowledge that this business is run by honest owners, who promise to compound book value 15% annually it is easy to see that the security is cheap enough to provide safety of principal. However let’s do some algebra to provide support of that thesis.
Fairfax has more than 1000$ investable assets per share. This amount is split into around 80% cash and bonds and 20% common stock investments. If we assume Fairfax achieves a modest long term return of 5% on their bond portfolio and 15% on their common stock portfolio we get a per share earnings power figure of 7% of 1000$ which equals 70$ earnings power per share. After interest and taxes there’s around 42$ left. Putting a modest 12X multiple on this earnings power we would arrive at 500$ per share. Of course float can shrink and we assumed the company underwrites at zero cost. However even in a soft market intrinsic value will hardly be impaired: Let’s assume float shrinks to 800$ per share and the combined ratio is an unpleasant 105%. Even then net earnings power will equal 26$ per share. Again with a 12X multiple we arrive at 300$ - above the current share price.
Conclusion:
Even if the earth trembles and we get a soft market combined with significant catastrophes - for years - there is no risk of permanent capital loss. The only big risk here comes from understated reserves. There is no chance for the outside investor to judge the adequacy of loss reserve levels. I can just point at the outstanding track record of Fairfax , combined with the honest and capable owners & managers and argue that these people have run the business conservatively for decades and I expect them to do so in the future. With that being said I “have nothing to add” besides that I am deeply excited and grateful to support Prem Watsa and his team having no intention to ever sell a single share of this great company.
If you are interested in Fairfax I highly recommend reading the Fairfax annual letters form the chairman – available at: http://www.fairfax.ca/
You can also find an excellent presentation from September on the website.
Present management runs the business since 1985. At the helm is Prem Watsa, an Indian investor following the business principles as have been developed by Graham & Buffett. The stock ended the year 1985 at 6 C$ and 2007 at 300 C$. Without taking the modest dividend of around 1% into account, that is an annualized return of 19.5%. Prem Watsa and other employees own a significant part of the company and are not hesitating to state that they will not sell their stake – regardless of price.
| in billion $ | 2007 | 2006 | 2005 | 2004 | 2003 | 2002 | 2001 | 2000 |
|---|---|---|---|---|---|---|---|---|
| Float | 10.5 | 10.5 | 8.7 | 7.4 | 6.6 | 6.0 | 5.6 | 5.6 |
| EPS (in $) | 58.38 | 11.92 | (27.75) | 3.11 | 19.51 | 17.49 | (31.93) | 5.04 |
| Combined ratio (in %) | 96.7 | 97.4 | 106 | 97.5 | 98 | 11 | 112.4 | 109.3 |
| Equity per share (in $) | 230 | 150 | 137 | 162 | 163 | 125 | 117 | 148 |
| RoE (in %) | 32.2 | 8.5 | (18.1) | 1.8 | 13.9 | 14.5 | (23.5) | 3.3 |
| Total investments | 19.0 | 16.8 | 14.9 | 13.5 | 12.5 | 10.6 | 10.2 | 10.4 |
The number one objective of every insurance operation is to underwrite at no cost. As we can see in the table this objective has not been fulfilled. The reason for that regression however is the purchase of the badly run insurance companies Crum&Forster and TIG. When we just take into account insurance operations which have been run at least 5 years under the helm of Fairfax we will get a different picture: indeed the operations show even a moderate underwriting profit of 2%. The reason is a disciplined underwriting approach: Management is halted to underwrite profitably by paying foremost attention to return on equity and not premium volume. It is therefore to be expected that in the next soft market we can expect underwriting results that far exceed those of the last soft market in the 2000s.
GROWTH
Check Warren Buffett’s outlook for insurance business in his latest annual (‘07):
“The party is over. It’s a certainty that insurance-industry profit margins will fall significantly in 2008. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by 4 percentage points. Be prepared for lower insurance earnings during the next fewyears.”
Fairfax has three ways to grow their business:
1. Buying other insurers on the cheap
2. Writing larger sums of insurance
3. Buying stocks of wonderful companies at reasonable prices
Whereas A) can be the most rewarding (just look at Prem raising book value some 20% annually in Fairfax first decade of existence…) it is also the most difficult approach to turn a badly run insurance operation around – as has been painfully experienced with Crum and TIG. B) and C) however are basically questions of operating excellence. A well run insurance company will over time be able to underwrite larger sums profitably. And a value orientated investment approach will over time grow delicious fruits. It is impossible to anticipate the growth through A) – as opportunities are rare and often arise without indication. B) and C) again are a lot more foreseeable as B) grows in waves and C) is a source of actually quite stable growth if we put the focus on intrinsic business value and not stock market prices.
Prem Watsa has stated the objective to increase book value by 15% annually through the combined use of A),B) and C). As he accomplished a 20%+ return on book value in the past there’s no reason to believe he has overstated the companies underlying economics.
MOAT – Where is it?
The moat is attitude. The job that’s done by Prem Watsa and his fellows cannot be done by others. If the concept of value is not deeply ingrained in the people who run the business the results will never even come close to those people who have grown up in Graham & Doddsville. Just look at the results of the large insurance companies of AIG,AXA and the likes. They clearly have structural disadvantages to Fairfax . Their only upside was their financial strength that allowed them to write larger sums. With Fairfax improving rapidly on that issue even the last “size edge” is wiped out. Watsa states:”We protect our portfolio from a 1 in 100 year financial storm.” Whereas other value guys were getting punished for being superficial - Watsa and his investment team earned a fortune by correctly realizing that credit spreads have come down to unsustainably low levels when in the same time credit quality has eroded. A few figures to underlie the aforementioned:
| 5yrs | 10yrs | 15yrs | |
| FFH Return on Common Stocks: | 25.90% | 18.50% | 19.50% |
| S&P 500: | 12.80% | 5.90% | 10.40% |
| FFH Return on Bonds: | 10.90% | 9.10% | 10.10% |
| US Corporate Bond Index: | 4.60% | 6.10% | 6.50% |
| billion USD | Q2/08 | 2007 | 2006 | 2005 |
| Total Debt: | 1.8 | 2.2 | 2.4 | 2.5 |
| Net Debt: | 0.7 | 1.2 | 1.6 | 2 |
| Common Equity: | 4.6 | 4.1 | 2.8 | 2.7 |
| Net Debt/Equity | 15% | 29% | 57% | 74% |
| Interest Coverage: | N/A | 11.3X | 5.3X | N/A |
Evaluation
Looking at the current share price of 280$ we actually do not need any algebra;
With book value of 260$ per share and the knowledge that this business is run by honest owners, who promise to compound book value 15% annually it is easy to see that the security is cheap enough to provide safety of principal. However let’s do some algebra to provide support of that thesis.
Fairfax has more than 1000$ investable assets per share. This amount is split into around 80% cash and bonds and 20% common stock investments. If we assume Fairfax achieves a modest long term return of 5% on their bond portfolio and 15% on their common stock portfolio we get a per share earnings power figure of 7% of 1000$ which equals 70$ earnings power per share. After interest and taxes there’s around 42$ left. Putting a modest 12X multiple on this earnings power we would arrive at 500$ per share. Of course float can shrink and we assumed the company underwrites at zero cost. However even in a soft market intrinsic value will hardly be impaired: Let’s assume float shrinks to 800$ per share and the combined ratio is an unpleasant 105%. Even then net earnings power will equal 26$ per share. Again with a 12X multiple we arrive at 300$ - above the current share price.
Conclusion:
Even if the earth trembles and we get a soft market combined with significant catastrophes - for years - there is no risk of permanent capital loss. The only big risk here comes from understated reserves. There is no chance for the outside investor to judge the adequacy of loss reserve levels. I can just point at the outstanding track record of Fairfax , combined with the honest and capable owners & managers and argue that these people have run the business conservatively for decades and I expect them to do so in the future. With that being said I “have nothing to add” besides that I am deeply excited and grateful to support Prem Watsa and his team having no intention to ever sell a single share of this great company.
If you are interested in Fairfax I highly recommend reading the Fairfax annual letters form the chairman – available at: http://www.fairfax.ca/
You can also find an excellent presentation from September on the website.
