Fairfax –Actions and Results Speak Louder than Words

Fairfax is a global P&C insurance company led by its charismatic CEO, Prem Watsa, often dubbed as the Warren Buffett of Canada. Fairfax has compounded book value by 20.4% CAGR since inception and the stock price has closely followed it at a 19.4% CAGR. However, the recent performance has been anemic and  events have left a lot of questions unanswered about Fairfax.

frfhf-performance

Picture Source: 2015 Fairfax Annual Report

Fairfax Macro Position:

Fairfax has had a long history of making bold macro calls and producing returns for its investors. The most recent successful macro bet was during the great financial recession between 2007-2009. Fairfax was early in the macro call before the recession but profited handsomely when shocks permeated through the financial world.

gfr-position

Source: 2013 Annual Report

Coming out of the recession in 2010, Fairfax saw similarities between the 2008 recession and the 1929 depression and took a position based on the assumption that the recession story had not been completely played out. Fairfax took a bearish stance in two different ways, through derivatives linked to CPI’s and equity hedges on its portfolio. The CPI linked derivatives have been covered extensively in several places and is a key component to the bullish thesis on Fairfax. However, these are not the securities that have caused the under performance. It is the equity picks of Fairfax.

As we will see later, the under performance on the equity picks meant that the equity hedges kept Fairfax in a net short position in a bull market over the last several years.

Book Value per Share:

The book value per share compounded 2.6% CAGR between 2011 and 2015 for Fairfax. This can be separated into two different components. The shareholder’s equity has been compounding at 4.8% CAGR and the shares outstanding has been diluting at 2.1% CAGR over the last five years resulting in a net compounding of 2.6% over the five year horizon.

book-value-per-share

As with most insurance companies, Fairfax’s economic engine is driven by

  1. A profitable insurance underwriting company that generates benefit of float and a great capital structure,
  2. An investment portfolio consisting of bonds and stocks to generate leveraged returns for shareholders

Insurance operations at Fairfax:

Fairfax has a decent record of underwriting over the last five years. The company’s insurance operations have generated $954M of underwriting profit over the last five years. The insurance operations provides a capital structure that enables Fairfax to borrow cheaper than the government of Canada and get paid to hold the premiums in advance. As the tailwinds in the insurance markets continue, Fairfax will continue to benefit out of this. The capital structure is a great source of competitive advantage for insurance companies. I would like to cast the readers attention to our article on capital structure some time ago here.

Fairfax Insurance Returns.png

Investment Returns at Fairfax:

When one looks at the net result of realized and unrealized gains at Fairfax from 2011 to 2015, one would notice that the equity investments have lost Fairfax $378M over the last five years. This mediocre performance has been driven by the under performance of the equity that Fairfax has invested in as compared to the strength of the bull market in general over the last five years. In addition to this, the CPI linked derivatives have cost another $436M to shareholders. However, given the extreme pay off ratio if some of these bets do realize probably makes them a speculative risk worth considering given Fairfax’s long term macro record.

fairfax-equity-returns

At the end of 2015, the value of market investments for Fairfax was about $650M below the cost of the investments. This is before any equity hedges or derivatives causing further deterioration. The common stock exposure (below table excludes funds that are common stock investment funds that primarily has fixed income bonds) shows that close about 40% of the common stocks are held in the US and Canada. There is a significant exposure to stock markets in Greece, Egypt, Ireland, India, China and Kuwait. This is not something for the fainthearted. There are two ways to look at this, the brighter side is that these markets could be a source of alpha, and on the less brighter side, these could result in a host of political, volatility and currency risks.

frfhf-equity-investments

We looked through the most recent 13-f filings for Fairfax’s performance of its long positions in the US.

Fairfax US Positions.png

The four positions in the US make up around 83% of the reported US equity portfolio. Their performance has not been inspiring. We looked up the buying period when Fairfax added these positions and their relative performance against the S&P 500.

bbryfrfhfibmfrfhfkwfrfhfrfpfrfhf

In addition, we reproduce the below extract from the annual report for one of the biggest Greece investments for Fairfax.

frfh-greece-investments

The under performance of the equity picks from Fairfax as against the Russell and the S&P index has caused erosion in the value of the investments for Fairfax. Instead of hedging against equities, the poor long picks of Fairfax has landed them in a net short position that caused them to lose money ($377M) against the general market.

These risks continue to exist in Fairfax stocks today. After the recent election results, the equity hedging has been reduced to 50% from the 112% at the end of Sep, 2016. Unless the underlying picks start performing better, the returns from the equity side will continue to be anemic. The foreign markets risk is something a prudent investor must think carefully over before investing in Fairfax.

The bond portfolio:

With the great disconnect in mind, Fairfax piled on bonds in the anticipation of lower interest rates. With the recent interest rise hikes and the anticipation in the future, one needs to closely look at the duration of the bonds at Fairfax.

frfhf-bond-maturity

Close to half the bonds held at Fairfax have a maturity greater than 10 years which is result in interest rate sensitivity being high on the bond portfolio.

frfhf-interest-rate-sensitivity

Contrast this with Berkshire Hathaway where less than 10% of the bonds was have duration greater than 10 years.

brk-fixed-income-portfolio

Source: Berkshire Hathaway 10-K 2015

Correction: Subsequent to Q3, Fairfax sold 90% of long dated US treasuries which is about $5.6-$5.7B of Bonds. It will be interesting to see the use of cash subsequently as another source of profits in the last few years has dried up.

treasury-bonds

Allied World Acquisition:

Fairfax announced the acquisition of Allied World for $4.9B or $54 per Allied Share. $10 of dividend from the cash between Fairfax and Allied World and the rest in the form of Fairfax shares. Essentially, $0.9B of cash between Fairfax and Allied and then $4.0B of Fairfax stock with an option to replace $2.7B of stock with cash within 75 days of the announcement. It was very interesting to see the conference call where it was announced that Allied would be decentralized and there are no cost synergies. So essentially Fairfax is paying between $435 and $485, a share implying a book value of 1.07 to 1.19 (9/30 2016 BVPS) to buy a company at 1.35 times book value.

allied-world-acquisition

Source: Allied Acquisition Slides

Okay. Here is an excerpt of the intrinsic value of Fairfax from the 2015 annual letter.

frfhf-intrinsic-value

So, essentially, Fairfax took undervalued shares to buy Allied World at 1.35x book without any cost synergies. I do hope that Fairfax understand what they are getting in return. Given the long duration bond portfolio and the lackluster performance of the equity book, the additional float for investment cannot be solution to the problem. The current shareholders are going to be diluted anywhere between 12% and 41% through this acquisition.

Dilution.png

All the recent events and their performance raises more questions than answers. As a long term holder of Fairfax, I have to re-think a lot of the assumptions about Fairfax and this post is part of the evaluation. Any new buyers, caveat emptor.

Advertisements

Buffett on Reinsurance

Just a post to keep some notes on reinsurance to self.

The Berkshire Shareholders meeting had little in terms on new content though it was good to see that both Charlie and Warren razor sharp as ever.

Probably one of the most interesting insights came in the initial parts of the Q&A. Reinsurance. Berkshire Hathaway had sold down its position in Munich Re and Swiss Re in 2015. When asked a pointed question about it, Buffett was very articulate and gave two key reasons for it: a. Low to negative yields in Europe b. Surplus capacity in reinsurance industry.

In a way, Buffett was alluding to the fact that with hedge funds like Greenlight Re and Thirdpoint Re entering the reinsurance business and being hungry for float, it is likely that too much competition will make (or has made) pricing softer in the market. Supply up, demand is the same. This should raise two questions: a. Buffett is reducing exposure to the reinsurance business by reducing his stake, Greenlight Re and Thirdpoint Re are going long at the same time. One must thoroughly consider the consequences of betting against the man who built the most profitable reinsurance business in the world and has constantly reminded us that the insurance industry is survived the longest by those who walk away when pricing is not adequate to the risks taken. b. If there is going to be softer pricing in the market, investors in companies like Greenlight Re and Third Point re, not only have to tide over the cost of float but also the rich fees that the hedge funds rake in.  The two net cost adders might make the economics very difficult for investors to make meaningful returns unless the reinsurance companies have many home runs on the investment side.

With the low to negative yields, float becomes less valuable as the capital structure of many of the reinsurance business like Swiss Re and Munich Re allows them to invest float in only certain types of securities. Buffett is essentially betting that it will be tough for reinsurance companies to invest float in positive returns instruments for quite sometime to come. Unless of course, you are Prem Watsa and assume that deflation is going to take over in which case the bonds become very useful. Time will tell. Time to increase watch on the insurance holdings.

TRIP owned by Allan Mecham

Very interesting to see that Allan Mecham of Arlington value capital has been buying TRIP. See articles related to Allan Mecham here.

See our post on Trip Advisor here.

Period Shares % of Portfolio Activity % Change to Portfolio Reported Price
2015   Q4 324,040 3.48 Add 109.89% 1.82 $85.25
2015   Q3 154,389 1.31 Buy 1.31 $63.02

Source: dataroma.com

Sotheby

I got drawn towards Sotheby’s stock after watching a video where Jim Chanos claimed that he was short Sotheby (NYSE:BID) Jim interestingly alluded that it was a great way to bet on the economy as it catered to the 10% of the top 1% and that the stock hit $10 in every financial crisis. I decided to go through BID’s annual report to see what I could find.

Sotheby’s business can be divided into three segments: Agency, Principal and Financing.

The Agency business is where Sotheby matches buyers and sellers and cuts a premium from both at the end of the transaction. Sotheby’s sales in this segment was $825M out of the total $938M it reported for the company in 2014. It is a very high GP margin business with 88%  and uses about $2.3B of assets out of which $900M+ are receivables from customers from the busy Q4 season. The main cost drivers for this segment are  marketing & promotions to ensure that the right dealers and collectors are present during the collection. This has been the cash cow for the company and Sotheby’s has been seeing some serious competition from Christie’s on this. The  buyer’s commission and seller’s premium that Sotheby earns in a transaction is about 14.9% on average hammer price.

Sotheby’s main rival is Christie’s and both compete furiously. It is one of the oldest duopoly in the world and is predominantly a reputation business. Sotheby’s share of the auctions done between them and Christie’s is 47%. Both have taken on different strategies off late with Sotheby catering to the ultra luxury segment and bigger ticket items and Christie’s moving lower to give a more complete collection. While other competitors like Phillips exist, the faster growing rivals are in China and HK where both the companies have expanded their horizons through acquisitions. Both operate a classic business model where reputation matters, and in which a seller is attracted to a network that will connect them to the most prospective buyers and buyers are attracted to a network where the highest potential exists for a particular interesting and authentic piece of art.

Principal: In this segment, Sotheby’s puts up capital to buy art pieces opportunistically. However, the numbers tell a very different story. The company sold about $69M of art works under this segment and made about $1.9M in the process with a gross margins of 2.7%. The period for which this capital was locked is not very clear. It is only 8% of the business and sucks about $0.1B capital and is a low return business. Given the information that Sotheby’s holds in this entire process, it is very surprising to see the low return in this business. One must also wonder why they are doing this.

Finance: Here, Sotheby finances art with a LTV of < 50%. This is an very interesting segment, as cost of capital from a credit revolver is around 2% and they are lending at close to 10% per annum. GE capital has provided this revolver for Sotheby. Sotheby has loaned about $644M with $445M in debt at 2% and rest being equity. Their NPA’s have been negligible and past dues barely any. It is one of the bright spots of the company and about 4% of the revenues are drawn from here.

At a consolidated level, Sotheby carries a debt of $2.3B of debt with $1.0B due to sellers after getting payment from buyers; $230M of mortgage for a NY properly that is adequately secured and $450M of loan from the credit revolver facilities making up the major chunk of the debt. On the asset side, this is compensated by close to $700M of cash, $900M of accounts receivable (they don’t have an obligation except where they have provided guarantees unless the buyer pays) and $698M of receivables from the financing segment.

Sotheby trades at $2.3B of market cap ($32 per share) at the time of writing. Net Income for the 2014 was $117M and $143M when you adjust for the third point activism charges that they incurred in 2014 or $2 adjusted EPS. It looks a decent franchise which will continue to play a leading role in the art world.

There are two big catches to this story:

a. Given the free monetary policies around the world, asset prices are inflated and art pieces are no exception. During the previous recessions, these companies have had really tough times moving stuff through their auction houses. Given the current state of the economy, investing in this would be a straight forward bet on the economy that it would do well.

b. The free cash flow of Sotheby has been anemic. In the last three years, it has generated about $162M of free cash flow with an average of $54M per year as compared to GAAP earnings which is closer to the $120M mark. The main culprit here in the working capital of the business, with receivables and inventory ballooning up faster than sales. It use last three years average FCF; the stock is trading north of 40 times the average FCF generated by the business.

While we do not typically short stocks, we thought it is an interesting idea to hold in the back pocket if it indeed gets any cheaper from a FCF or an owner’s earnings perspective. I must however comment that I am inclined to think favorably towards  Jim Chanos’s view of Sotheby  being a proxy economic indicator of the economy.

What are we reading?

  • Pershing Sqaure Quarterly Call (Valuewalk)
  • Ackman defends Pershing’s loss in Valeant (NYTimes)
  • My indirect experiences with Valeant (GuruFocus)
  • Why Whitney Tilson is loading up on BRK.A/B? (GuruFocus)
  • Jim Chanos on Wall Streek Week (YouTube)

Been reading a book called ‘Extreme Ownership — How Navy Seals Lead and Win’ — Terrific book on leadership. Found a lot of lessons practical and useful as a leader (Amazon)

Tata motors

Was caught thumb sucking  on  Tata Motors stock at around INR 285 earlier this month. It was so cheap that it was a screaming buy and I understood what was going on there and had a strong opinion on it and I had been smacking my lips for it to get to that price and then I sucked thumb instead of buying…

It is already 30% higher now in a couple of weeks and no longer has the same margin of safety…. Alas!

Cost of omission!

Ferrari and the Fiat Stub — RACE

Warning: Automobile sector definitely does not fall into our circle of competence.

  • Ferrari listed in NYSE and finished on 23rd Oct with a market cap of $10.7B
  • Absolute top class luxury brand with an earnings of ~$300M in 2014
  • Works out to an earnings yield of 3% and a PE of almost 35
  • We feel that Mr. Market is valuing the brand of Ferrari very highly. In our opinion, this is counted twice as the earnings already has the pricing power of the brand factored into it
  • Even if the company increased the production from 6K pcs to 9K pcs, the earnings yield will still be hovering around the 5% mark.
  • It is a low return on capital and low asset turnover business
  • Two positives abound the stock; supply is constrained and revenue and earnings stability will last longer than a normal automobile company
  • It looks as though Mr. Market is pricing RACE much ahead of its earnings potential

On the other hand, Fiat is trading with a market cap of $19.9B and if Mr. Market is pricing Ferrari at $10.7B and is right about it and Fiat owns 80% of Ferrari, then the rest of Fiat must be ~$11B. The last ten years average profit margins of Fiat is 1.7% which would result in a normalized earnings of $1.7B (excluding $300M of Ferrari earnings) valuing Fiat at 6.5 times earnings or an earnings yield of 15%. If one wants the Fiat stub ex-Ferrari, one can go long Fiat and short Ferrari to get exposure to only the Fiat piece of the stock.

We will be watching and learning in this case and not investing / speculating as this does not fall into our circle of competence but to our limited knowledge RACE looks overvalued and since we are not familiar with the cycles of the auto industry, we have no real comment on the cheapness of the Fiat stub.

Note: We are not comfortable with the interest coverage of FIAT for the debt it holds at the consolidated level. It makes us feel that the low margins are levered returns and the underlying returns could be far worse.

what are we reading?