Canadian insurer Fairfax Financial shares trade for book value, around $253 a share. I think this is cheap for a insurance business that I think can achieve a high rate of book value growth over time. The intrinsic value of Fairfax in my opinion sits somewhere between 1.5x to 2x book value.
This valuation would more fairly reflect Fairfax’s track record of 26% growth in book value over the last 22 years and their unique value investment record. Prem Watsa, CEO of Fairfax, had this to say on how investors can distinguish between Fairfax’s intrinsic value and book value
“When a company like Fairfax earns more than 20% on shareholders' equity then, given that long term interest rates are below this figure, the intrinsic value of the company will exceed its book value and its stock price will reflect its intrinsic value over time. So while stock prices fluctuate in the short term reflecting the twin emotions of fear and greed in the long term they always reflect underlying intrinsic value. This is how we view the link between book values, intrinsic values and stock prices. We have given you a framework to value Fairfax but you will have to come up with your own number for intrinsic value.” (Prem Watsa – Fairfax Financial Annual Report 1997)
Put simply, if you believe Fairfax will earn 5% on shareholder’s equity (assuming 5% long term bond interest rate), then pricing the shares at book value is warranted. Arguably as the 5% bond rate (on a treasury) is essentially risk free, an expectation of more than 5% would be needed. However, if you believe that Fairfax can achieve at least 15% return on shareholder’s equity over time or even higher then the intrinsic value of Fairfax must be higher than book value.
Fairfax Financial has over $1000 in cash and investments per share and a stock price of around $253. Assuming they can break even on their underwriting operations and they achieve an after tax return of 5% on their cash and investments, Fairfax can do around $50 per share or an after tax return on shareholder’s equity of close to 20%. Even if they fall short, 15% does not seem an unrealistic hurdle rate. Further, Hamblin Watsa Investment Council, Fairfax’s investment team, have achieved a 19% return on equities and a 10% return on bonds over the last 15 years from 1993-2007. So they have a proven record of achieving good returns on their cash and investments over time.
Fairfax – update
Fairfax’s book value is likely to be relatively flat or down slightly since last quarter despite the fall in the CDS portfolio post April 1 which I believe led to investors selling Fairfax’s stock and resulting in an almost 8%+ fall in Fairfax’s share price when earnings were announced. The shares have now fallen 15% since May 1.
Fairfax reported at the end of the March quarter that their CDS portfolio had declined in value from 1st April to 25th April from $990 million to $685 million. The CDX index was around 100 on 25th April. Corporate risk has risen since then and the index was over 114 as of yesterday. So I estimate the decline in value would have narrowed since 25th April from ( $300) million to ($220) million.
Fairfax’s stock portfolio has seen gains of around 10% or $300 million since the beginning of April 2008, driven by investments in Level 3 (LVLT), Overstock(OSTK) and International Coal (ICO).
Fairfax’s bond portfolio of treasuries would have declined with yields approaching 31st December 2007 levels, I would expect a fall of ($160) – ($180) million in these bond values as the unrealized gains Fairfax took in the March quarter are reversed. While, Fairfax’s convertible bond investment in Abitibi Bowater (ABH) has appreciated by around $80 million.
In sum, the post earnings sell off of Fairfax Financial has created a good opportunity to buy the shares for book value. As I have argued the intrinsic value of Fairfax sits well above book value due to the earnings power of the business and the track record of management. I have added shares to my position recently also.
Disclosure: I own shares of Fairfax Financial Holdings (FFH, Financial)
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Source: Insurance Stock Investor
This valuation would more fairly reflect Fairfax’s track record of 26% growth in book value over the last 22 years and their unique value investment record. Prem Watsa, CEO of Fairfax, had this to say on how investors can distinguish between Fairfax’s intrinsic value and book value
“When a company like Fairfax earns more than 20% on shareholders' equity then, given that long term interest rates are below this figure, the intrinsic value of the company will exceed its book value and its stock price will reflect its intrinsic value over time. So while stock prices fluctuate in the short term reflecting the twin emotions of fear and greed in the long term they always reflect underlying intrinsic value. This is how we view the link between book values, intrinsic values and stock prices. We have given you a framework to value Fairfax but you will have to come up with your own number for intrinsic value.” (Prem Watsa – Fairfax Financial Annual Report 1997)
Put simply, if you believe Fairfax will earn 5% on shareholder’s equity (assuming 5% long term bond interest rate), then pricing the shares at book value is warranted. Arguably as the 5% bond rate (on a treasury) is essentially risk free, an expectation of more than 5% would be needed. However, if you believe that Fairfax can achieve at least 15% return on shareholder’s equity over time or even higher then the intrinsic value of Fairfax must be higher than book value.
Fairfax Financial has over $1000 in cash and investments per share and a stock price of around $253. Assuming they can break even on their underwriting operations and they achieve an after tax return of 5% on their cash and investments, Fairfax can do around $50 per share or an after tax return on shareholder’s equity of close to 20%. Even if they fall short, 15% does not seem an unrealistic hurdle rate. Further, Hamblin Watsa Investment Council, Fairfax’s investment team, have achieved a 19% return on equities and a 10% return on bonds over the last 15 years from 1993-2007. So they have a proven record of achieving good returns on their cash and investments over time.
Fairfax – update
Fairfax’s book value is likely to be relatively flat or down slightly since last quarter despite the fall in the CDS portfolio post April 1 which I believe led to investors selling Fairfax’s stock and resulting in an almost 8%+ fall in Fairfax’s share price when earnings were announced. The shares have now fallen 15% since May 1.
Fairfax reported at the end of the March quarter that their CDS portfolio had declined in value from 1st April to 25th April from $990 million to $685 million. The CDX index was around 100 on 25th April. Corporate risk has risen since then and the index was over 114 as of yesterday. So I estimate the decline in value would have narrowed since 25th April from ( $300) million to ($220) million.
Fairfax’s stock portfolio has seen gains of around 10% or $300 million since the beginning of April 2008, driven by investments in Level 3 (LVLT), Overstock(OSTK) and International Coal (ICO).
Fairfax’s bond portfolio of treasuries would have declined with yields approaching 31st December 2007 levels, I would expect a fall of ($160) – ($180) million in these bond values as the unrealized gains Fairfax took in the March quarter are reversed. While, Fairfax’s convertible bond investment in Abitibi Bowater (ABH) has appreciated by around $80 million.
In sum, the post earnings sell off of Fairfax Financial has created a good opportunity to buy the shares for book value. As I have argued the intrinsic value of Fairfax sits well above book value due to the earnings power of the business and the track record of management. I have added shares to my position recently also.
Disclosure: I own shares of Fairfax Financial Holdings (FFH, Financial)
_______________
Source: Insurance Stock Investor
