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The Science of Hitting
The Science of Hitting
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Fairfax - Cheap Portfolio Insurance

March 14, 2012 | About:

In September of last year, GuruFocus interviewed Prem Watsa (link here), chairman and chief executive of Fairfax Financial Holdings (FRFHF); here are some of the interesting things Mr. Watsa had to say about Fairfax and its valuation (bold added for emphasis):

Watsa: So we have a 15% compounded growth rate, and we think that growth rate continues to be achievable for us. Our capital base is about $8 billion, our investment portfolio is at $24 billion, business premiums are written at about $5 billion, we have international businesses, if you take our equity holdings in companies like ICICI Lombard and the Chinese company, Alltrust, and the others we list in our annual report, at about another $1.5 billion, so we have about $6.5 billion in aggregate premium. So it’s significantly larger than where we began 25 years ago, but in terms of the world markets, we think that there's a lot of opportunity to grow over time and make a 15% real return, which is making an underwriting profit plus interest and dividend income plus capital gains all after-tax. So you put all of that together, we figure mark-to-market book value, including the dividends that we pay out, will over time compound book value at 15% a year. But you know we're not quarterly focused, we've never issued guidance, we've never given any quarterly numbers, so we're focused on performing over a long period of time.

GuruFocus: So you feel comfortable over the long term, 15% is still achievable.

Watsa:Yes, that rate of return continues to be our goal.

In regards to Fairfax’s intrinsic value, Prem had this to say:

Watsa: Our book value at the end of June of this year was approximately $360 per share, as reported in our quarterly statement. But about intrinsic value, if you look at the fact that our rate of return has been very significant over 5 years, 10 years, 15 years, 25 years, then the intrinsic values of our companies are significantly higher than our book value. Change in book value is not a bad way of looking at change in intrinsic value, but if you think we can make 15% a year as our target, we've achieved better than that in the past, nothing to say we'll achieve that in the next five years, but if we do, then of course the intrinsic value of our company is significantly higher than our book value.

GuruFocus: But you cannot put a number on it?

Watsa: No, that's what I leave for you and all the analysts and everyone who follows us.

While Prem still hasn’t put a number on it, his wording on page 10 of his 2011 letter to shareholders (which came out last Friday) suggests that the shares are increasingly attractive (from his perspective):

“Our stock price is currently reflecting the short term volatility of earnings rather than the buildup of long term intrinsic value. We think you will see the long term intrinsic value being reflected in time (we hope!!).”

At roughly $400 per share, Fairfax trades around 1.1x book (as reported at the end of FY2011); not only that, but the company has two other components (besides the valuation and a strong track record) that might peak equity investor’s interests:

1. CPI Linked Derivative Contracts – these contracts are marked to market, and have been written down to $208 million as of the end of the year – essentially, if they expire worthless, the impact is relatively small; on the other hand of the spectrum, these positions are worth billions in the case of deflation through 2020, and would lead to huge gains.

2. Hedged Equity Portfolio – At the end of the year, the portfolio was 104.6% hedged; the company’s long term equity holdings are in three names – Wells Fargo (WFC), Johnson & Johnson (JNJ), and US Bancorp (USB).

From my perspective, this is the definition of insurance: limited downside, but an attractive way to hedge against equity declines or long term deflation. For investors considering buying treasuries or TIPS, it may be worth their time to take a second look at Fairfax Financial.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.3/5 (17 votes)


Ramands123 - 5 years ago    Report SPAM

does anyone know how can one buy these CPI's deivatives? or is it just for institunal investors
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM
I don't think you can, but not positive....
Ryan_sequeira - 5 years ago    Report SPAM

I'm also looking to buy these CPI-linked derivatives, so if anyone knows, please help out! Thanks

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