As the Dow Jones Industrial Average fell 610 points (3.39%) after the Brexit announcement, Fairfax Financial (FFH, Financial) was up 1.64% in the U.S. market and 3.55% in the Canadian market. If the market continues its turbulence, I would expect more of the same from the company led by value investing guru Prem Watsa.
Although Watsa comes from the Benjamin Graham school of thought on value investing, he also prides himself on having his company excel through times of crisis such as the financial crisis of 2007-2009. Fairfax Financial is an $11.9 billion market cap insurance company headquartered in Toronto with operations throughout the world. Following the methods of Warren Buffett, chairman and CEO of Berkshire Hathaway (BRK.A, BRK.B), Watsa invests the company’s float in equities using value investing principles. For insurance companies, the float is the amount of money on hand at any given moment that an insurer has collected in insurance premiums but has not paid out in claims. What makes Fairfax Financial different is that Watsa will hedge against catastrophic events that he foresees.
Leading up to the financial crisis of 2007-2009, Fairfax Financial’s investment portfolio was protected through the use of equity hedges and credit default swaps. Leading up to the crisis (2003-2006), the hedges and CDSes lost $498 million. Once the crisis hit, the hedges and CDSes gained $1.29 billion in 2007 and $3.37 billion in 2008. The gains helped increase the book value of the company by 53% in 2007 and 21% in 2008 while the global stock markets were crashing.
Since 2010, Watsa has been gearing up his hedges to protect against another stock market crash and global deflation. His weapon of choice this time around is CPI-linked derivative contracts. He foresaw the commodity bubble as far back as 2010 in his annual letter to shareholders stating that the real estate bubble in China was causing a commodity bubble. The commodity bubble has now burst as shown in the chart below:
Watsa’s call on deflation has been going against the grain since most people would think that loose monetary policies by the world’s central banks would lead to inflation. In his 2015 letter to shareholders, Watsa pointed out, “The most important risk we saw was that the 2008-2009 recession was not like any we had experienced in the last 50 years. The closest comparables were the U.S. in the 1930s and Japan since 1990. Most investors consider the 2008-2009 recession and crash to be a once-in-a-generation event – and it’s over! We differ because we think we escaped the serious adverse consequences of the recession as a result of huge fiscal stimulus from the U.S., even greater fiscal stimulus from China and the reduction in interest rates to 0% with massive monetary stimulus in the U.S, Europe and Japan through QE programs. There is nothing to fall back on now if the U.S. and Europe slip back into recession.”
Although Watsa did not specifically hedge for the Brexit, his hedges in place were built for such an event. Just like in the years leading up to the financial crisis, Watsa’s hedges have been generating losses, but they have now begun to produce gains.
Even without the hedges, Fairfax Financial is a solid company with its core insurance business being more profitable than ever generating a low combined ratio of 89.9%. A combined ratio 100% is break even for insurance companies with levels below 100% equating to underwriting profits. The losses in the hedges have not held back the company too much with Fairfax Financial increasing its book value by an average of 3.7% over the past five years and its investment portfolio returns increasing an average of 3% per year. If the hedges come to fruition, large book value increases will occur just as they did during the financial crisis. Throughout the company’s history dating back to its beginnings in 1985, Fairfax Financial has provided Berkshire Hathaway type returns with an average annual book value increase of 20.4% per year.
Similar companies are typically valued on a price-to-book (P/B) ratio. Fairfax Financial’s P/B ratio is at 1.26. The two companies that are thought of as being the most similar are Berkshire Hathaway and Markel (MKL). The P/B ratios of Berkshire Hathaway and Markel are 1.33 and 1.56. With a P/B ratio near that of Berkshire Hathaway, Fairfax Financial's closing prices of $513.25 (FRFHF) and C$665.21 (FFH.TO) are fairly valued. If the hedges work out for Watsa, the value of Fairfax Financial will be much higher.
Disclosure: I own shares of Fairfax Financial, Berkshire Hathaway and Markel.
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