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Tarn P Crowe
Tarn P Crowe

Why Fairfax Financial (FFH) remains one of my largest positions

January 17, 2008 | About:

Property and casualty insurers will face tough headwinds over the course of 2008. On the underwriting side, over-capacity is driving rates down and lowering premiums and we are likely to see worsening combined ratios. On the investing side, some insurers face losses on CDOs and riskier corporate bonds while insurers with large equities positions will see lower returns from capital gains as economic growth slows.

It all sounds a bit grim. There are opportunities out there for investors in insurance stocks, but now is the time to be extremely selective.

Canadian based insurer Fairfax Financial is one company I own and remains one of my top holdings. Here are my reasons

Fairfax will benefit from a large housing downturn and I think we still have ways to go. Fairfax owns a large credit default swap position ( with a notional value of over$18 billion at 30th September 2007) on 30 names exposed to a collapse in the housing market such as mortgage insurers, financial guarantors and mortgage lenders. Fairfax has enjoyed substantial unrealized gains on this CDS portfolio to date, in excess of $1 billion as of the 3Q 2007 conference call, and this CDS portfolio will likely have continued to appreciate in recent months.

Substantially all of Fairfax’s fixed income portfolio is in government bonds, they have no CDOs or other toxic securities . As treasury yields(and interest rates) fall, Fairfax will enjoy unrealized gains on the bonds they own, a 1% fall in interest rates will lead to a 10% increase in the value of their bond portfolio(2006 Annual report). This will boost shareholder equity and book value per share.

Fairfax has hedged 80% of its equity portfolio against a decline in the S&P. This is insurance for Fairfax, protecting its capital position against any unforeseen shock we might see to equities as the economic fundamentals and business conditions deteriorate.

Fairfax’s Asian operations will continue to grow rapidly with the economic expansion throughout the Far East. US is facing a recession but the prospects in Asia continue to look favourable. Fairfax’s net premiums written on its Asian subsidiaries are up 20% year over year.

Fairfax’s investment portfolio is worth more than its carrying cost. Their 26% interest in ICICI Lombard, India’s largest general insurer, is carried on the books at $60 million well below its fair value estimated at $147 million in Fairfax’s balance sheet disclosures. Commentators such as Whitney Tilson have placed even high fair value estimates. Also Fairfax owns private equity investment in Chou Associates Fund that would be in the books at cost.

Softer insurance pricing for reinsurance and general insurance will affect Fairfax’s US and Canadian operations. However, even as the top line shrinks, Fairfax enjoys an improved reserving position from that which existed a few years ago which means Fairfax can continue to improve its bottom line through a stronger combined ratio. In the first nine months to 30th September 2007, even though net premiums were down slightly, Fairfax’s had a big improvement in underwriting profit of $198million versus $62 million for the year earlier.

Prem Watsa, Fairfax's Chairman and CEO, is a fantastic value investor with a great track record. Investors in Fairfax should rejoice over declining equity values, as Prem Watsa will have the opportunity, the smarts and financial wherewithal to take full advantage.

Finally, with an estimated book value of around $220 as at December 2007. At around $280 per share Fairfax trades for a reasonable 1.3x book value. That’s cheap considering Fairfax has compounded book value at a 24%+ clip over 20 years . Looked at another way, Fairfax has around $1000 per share in cash and invested assets, if they can do conservative 5% after tax return that’s $50 a share on a $280 share price.

In part due to poor equity market conditions, Fairfax’s shares are also likely discounted as a result of Fairfax’s troubles over the last few years. However, on the latter point, I remain confident, based on their improving reported financials, that Fairfax have now put these reserving issues behind them.

Disclosure: I own Fairfax Financial (FFH) shares

Disclaimer: The opinions expressed in this article represent those of the author and are not intended as investment advice and should not be relied upon as investment advice.

About the author:

Tarn P Crowe
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.3/5 (28 votes)


Msmclachlan - 9 years ago    Report SPAM
No question Mr watsa is a very smart Investor. He just hasn't been very good at buying Insurance Companies. Unfortunately if someone is selling an insurer for less than book there's usually a good reason for it. Now that he's stopped buying insurers his fortunes will probably improve.
Rsodhi - 9 years ago    Report SPAM
As per my knowledge Prem is Graduate from Indian inst. of Technology, Indian Inst. of Mgmt and Univ. of Western Ontario all prestigious institutes. Prem has agreat reputation as honest and very smart man. All obove motivated me to buy my first 15 shares for $400 each in 1997. I was adding in last 10 years, including when business went through perfect storm. I am proud owner of 2100 shares now and FFH is my number one holding. For my I am part owner of FFh and would love to own this business for ever. Ravi Sodhi

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