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.

The contrarian insurance play — Fairfax Financials 2014 Letter

Fairfax Financials, run by the contrarian CEO, Prem Watsa, continues to be bearish on the prospects for the world economy and Fairfax is backing his conviction with a very big bet on CPI linked contracts. While the world continues to be riveted on the statements of the Fed and is expecting a rate hike in the near future, Fairfax bets seem to question the sustainability of the hikes. Recent comments from Bridgewater chief, Ray Dalio, seems to the only other prominent voice echoing similar sentiments.

Fairfax had a good 2014, as is the case with most insurers, primarily driven by lack of catastrophes. Book value increased 16% to $395.  Combined ratio was 90.8% and the company ended with $11.7B of float. Unrealized gains from bonds held in the investment portfolio contributed $1.1B of gains and drove the net earnings number higher in 2014. A closer look at the performance of the investment portfolio shows a mixed picture. The equity hedges has cost the company a pretty penny and almost all of the gains have come from the bonds portfolio.

Performance

Fairfax’s bet on bonds has spectacularly paid off while its equities have severely underperformed the market primarily driven by hedging. Prem Watsa and his team seem to be very confident about the market unravelling due to the grand disconnect between fundamentals and stock prices. It is worth noting that ten years ago, Prem Watsa had placed a similar bet on the housing market and suffered through initial years of losses before spectacularly reversing the losses during 2007 and 2008 as seen below. Only time can tell whether Fairfax will gain spectacularly on these CPI linked hedges.

20032006

If one digs a little deeper into this, the cost of these contracts seem to be only 7% of equity. On the surface, it looks like a bet where the payoff is huge with minimal downside risk. Currently, they have a string of loses to show for the bet between the CPI linked contracts and the equity hedges. Cumulatively, it has cost Fairfax Shareholders close to $4B to keep this bet on.

Hedges

Furthermore, Fairfax is increasing the size of the CPI linked bet on deflation. The notional amount is now $111B. CPI seems close to the strike price and for the first time, the bets looks like having any chance of making money for shareholders.

CPI1

So far so good. However, if inflation does occur like the rest of the investment community believes in, Fairfax stands to suffer from a triple whammy. Firstly, the loss from the CPI indexed contract. Secondly, the gain on equity will be minimal due to the hedges involved if the market does not unravel. Thirdly and most importantly, the bond portfolio might come under attack. Fairfax would still retain the option on holding the bonds to maturity and redeeming them but will have to announce mark to market losses in the meantime.

In net, Fairfax seems to be riding the wave of good underwriting profit along with most of the good insurers. The future seems to be hinged on the great disconnect in the stock markets. Only time will tell whether there the grand strategy will pay off or will it result in a lost decade for the insurer.

Disclosure: Long Fairfax

Thomas Cook and Fairfax

Prem Watsa, Chairman and CEO of Fairfax Financials, has compounded book value at 21.2% and stock price at 19% since 1985. There was a great deal of excitement when Fairfax took over the Thomas Cook operations in India. All investors, value, momentum and traders piled up on the stock. The best analysis post the acquisition was provided by renowned value investor, Sanjay Bakshi on Thomas Cook as an investment vehicle for Fairfax in India. See here

Fast forward, a couple of years and below is what appeared on the annual report of Fairfax Financials in March.

Fairfax

It raises the following questions

  • Looks like Thomas Cook will also be a acquisition vehicle but all big ticket items would go through this new entity.
  • Given the fees that Fairfax would gain from the transactions through the new entity, it seems it is logical that the best of ideas might flow through the new entity.
  • Why could Fairfax just not recapitalize Thomas Cook to be owned through an entity in Canada and issue more stock at the current price?
  • Will there be any conflict of interest every time Fairfax uses the allocation vehicle instead of Thomas Cook to Thomas cook shareholders? Will Thomas Cook shareholders be shortchanged in the long run?

I have always been a big fan of Prem Watsa but it looks like the current move is more beneficial to Fairfax owners than to Thomas Cook.

Disclosure: Own shares of both Fairfax and Thomas Cook India