Shares in Warren Buffett (Trades, Portfolio)’s insurance and manufacturing conglomerate Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) have been on a staggering run over the past six months.
Since the beginning of July 2016, the shares have added nearly 11%, outperforming the Standard & Poor's 500 by around 5.5%. Unfortunately, as the shares now trade at $161 and change, they look relatively expensive compared to the conglomerates' estimated book value of around $130, which may put some investors off.
If you’re looking for a Berkshire Hathaway alternative, Fairfax Financial (TSX:FFH, Financial), which is led by its charismatic CEO Prem Watsa (Trades, Portfolio), often called the Warren Buffett of Canada, may be an appealing alternative.
Berkshire on the cheap?
While shares in Berkshire Hathaway have rallied since Donald Trump was elected president, shares in Fairfax have declined by nearly 10% over the past six months and are nearly 20% below their 52-week high.
There is one main reason for this poor performance, and that’s Fairfax’s investments. While the company has compounded book value by 20.4% CAGR and the stock price has followed it, achieving a CAGR of 19.4% over the same period, the company’s recent performance has been dented by a loss of $378 million on equity investments and a loss of $436 million on CPI linked to derivatives. These derivatives are a bearish bet on the world economy and have a notional value of around $109 billion.
Watsa made a similar bet in the runup to the financial crisis, which paid off handsomely for the conglomerate, but this time around the substantial derivative bet on deflation seems to be holding the group back. Of course, if it does pay off, then Watsa and shareholders will be handsomely rewarded so as a hedge it's a relatively attractive opportunity.
There’s more to the conglomerate than just this one loss-making bet. For example, the company’s insurance operations have generated $954 million of underwriting profit over the past five years. The gains in the equity portfolio were unrealized at the end of 2015; the market value of investments was about $650 million below the cost of investments.
At the end of last year, Watsa started to change his view on equity markets. Fairfax has now reduced its equity hedges, and at the beginning of November, hedges represented approximately 50% of the company's equity and equity-related holdings (a reduction from 112.7% on Sept. 30, 2016).
The rest of the business continues to grow
Ultimately, Fairfax’s equity hedges are just that, hedges. While the equity hedges and CPI derivatives may be costing the conglomerate in the short term, they are designed to pay off if the business environment deteriorates, which removes some cyclicality from the rest of the conglomerate.
And away from the equity portfolio, Fairfax continues to grow rapidly through the acquisition of insurance businesses around the world. During 2015 the company acquired U.K. insurer Brit for 1.2 billion pounds ($1.45 billion) which itself followed an agreement to buy insurance businesses in Central and Eastern Europe from QBE. Almost a year later the Toronto-based insurer announced a deal to buy New York-listed Allied World (AWH, Financial) for $4.9 billion. Wall Street sees it as a play on Trump’s plan for lowering taxes, cutting red tape and spending on infrastructure, which should boost growth and create underwriting opportunities.
Allied’s 12% annual growth in revenue from premiums over the past three years is already roughly double that of Fairfax.
A month after the Allied acquisition, Fairfax announced it was investing $150 million in Mosaic Capital Corp. (TSXV:M, Financial), a Calgary-based value investor that acquires established businesses at attractive prices operating primarily in Western Canada and then helps those businesses grow by providing strategic, business, financial, accounting and legal expertise. This funding deal gives Fairfax access to smaller companies and will allow the conglomerate to benefit from Mosaic’s skilled management and private equity expertise. All of the investment is made via interest-bearing securities as well as stock warrants.
Room to grow
These deals give me confidence in Fairfax’s ability to continue to grow despite the company’s investment setbacks. With this being the case, the recent decline in the firm’s shares is an excellent opportunity to buy and piggyback on Watsa's success. There’s also the equity hedges to consider which limit the potential downside for investors.
Disclosure: The author owns no stocks mentioned.
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