One of the more amusing games in financial markets is the labeling of nearly any company that owns businesses in multiple sectors to be compared to Berkshire Hathaway or any value investor with an above average record to Warren Buffett. The Virginia insurer Markel is sometimes called a “baby Berkshire.” When Eddie Lampert first took control of Sears and Kmart, talking heads declared that it was to become the next Berkshire Hathaway. Sometime in the past, Fairfax Financial Holdings’ CEO Prem Watsa was regularly compared to Warren Buffett and called “the Oracle of Ontario.”
There are many dimensions to Berkshire Hathaway that have accounted for its success including an unbelievable culture, discipline, and conservative financial positioning that are never fully captured just because another company nominally copies that playbook. Fairfax Financial Holdings, for instance, does not have as much in common with Berkshire Hathaway as many assume at first glance. Whereas Berkshire invests primarily in the United States, Fairfax has substantial international investments in India, Africa, Eastern Europe, Latin America, and Asia. Watsa has also been very much willing to position Fairfax’s investment portfolio on macro calls, something Warren Buffett would never do.
Despite the distinctions, Fairfax compounded growth at an impressive clip for years after Watsa took the company over. It has now fallen deeply out of favor and trades for a seemingly very cheap 9% premium to its book value. At its peak valuation in 1996, Fairfax traded for 3.3x its book value. With the low headline valuation in mind, Watsa stated on two separate occasions in his recently released letter to shareholders that Fairfax would be focused on using its cash flow this year to repurchase its own stock. Does that make the stock a great contrarian pick currently? Clearly, this article argues that Fairfax is compelling at its current valuation, but to answer why, it is important to retrace some history and understand what has happened to the company to cause investors to lower the valuation it places on it from 3.3x book value to 1.1x book value over the last twenty years.
From Cheap Acquisitions to Nightmares
Fairfax Financial came into form in 1985 when Watsa led a capital injection into a specialty insurance company called Markel Financial. The company had severe reserving issues, but Watsa believed – correctly – that if the insurer was adequately capitalized it could once again be profitable.
In the years that followed, Watsa purchased numerous insurance companies and invested the growing insurance float wisely. But, being a Graham and Dodd investor, Watsa purchased insurers that were statistically cheap, often less than book value. If you are able to do that continuously, it can be quite easy to show large increases in book value just from consummating the transaction.
Purchasing another insurer is not an easy thing to do, however. Insurance accounting to a large extent is based upon estimates. When a customer purchases an insurance policy, the insurer needs to estimate how much it will ultimately lose in claims on that policy. If it has inaccurate models that predict the likelihood and severity of loss or if it chooses to reserve for claims aggressively, then the “book value” of an insurance company will have little to do with its economic value. Economic reality caught up to Fairfax in 1998 when it bought two insurers at a discount to book value: Crum & Forster and TIG. When reserving issues and catastrophe losses such as 9/11 and Hurricane Katrina were factored in, 1998-2005 was an incredibly difficult stretch for Fairfax. Ultimately, the company had to raise some capital to ensure its solvency. The period also led to a bitter fight with short sellers who spread rumors about the financial health of the company and were later sued by Watsa.
The difficulties for Fairfax soon gave way to probably Watsa’s greatest moment when he bet heavily on future economic distress by shifting the investment portfolio to cash and treasuries, shorting the stock market, and purchasing credit default swaps. Book value grew by 49% in 2007 and 21% in 2008. Lately, though, Fairfax’s results have lagged again. That is in large part due to macro calls by Watsa that have not come to fruition, including a bet on deflation and the hedging of the entire common stock portfolio. While nothing has happened to threaten the soundness of Fairfax, Watsa’s bearishness has meant that Fairfax has not participated in increases in equity prices.
The chart above summarizes how Fairfax’s growth in book value has trended along with the price to book value that investors have placed on its shares. Between 1985 and 1998, book value per share grew more than 40% per year and investors placed an average valuation of 1.8x book on Fairfax, but in the years since book value per share has only compounded at 9.3% (adjusting for dividends paid).
The Future Ain’t What It Used To Be
Watsa has stated that his goal is to compound book value per share by 15% each year and in his most recent letter stated that if it underwrote policies at a 95% combined ratio, it would need to generate an investment return of 7% to reach that goal. His math is likely similar to the chart below to reach that 15%.
Whether or not Fairfax can get there, of course, depends on the actual performance of its underwriting and investment operations.
Underwriting performance has improved measurably over time as Fairfax’s insurance acquisitions have tended more towards quality and better management has been in place.
In the past five years, on average, Fairfax has received a benefit from float of 2.2% per year. Allied World’s results have been even better, which should give a slight boost to overall performance. At its current level and distribution of float, Fairfax should not have any problem reaching an average 95% combined ratio.
The current positioning of investments, however, is another matter. They are currently heavily concentrated in cash and short-term securities.
In combination, Fairfax has a 24% combined weighting in common stocks, associates, and Fairfax India and Africa, with 44% in short-term investments and 23% in fixed maturities. The remaining 9% of the portfolio is held at the holding company, in derivatives, and in preferred shares. That distribution makes a path to a 7% investment return in the near-term nearly impossible to achieve. The portfolio is currently geared to return close to 4%.
At that return on the portfolio, Fairfax is set to deliver roughly 8% returns on book value to common shareholders. There are various ways to view that potential return.
Playing the Long Game
For one, that return need not be Fairfax’s long-term potential. The enormous weighting that Watsa currently has in cash and short-term investments is clearly a result of high equity prices and low-interest rates. An investor in Fairfax’s shares, then, is somewhat inoculated against rising interest rates and stock market declines. If those events are in the cards in the near future, Fairfax would be prepared to take advantage and immediately increase the potential return of the overall portfolio.
Secondly, an 8% return on book value implies an increase in common equity of almost exactly $1 billion in the coming year, or $36 per share. At a price of $490, Fairfax is trading at an adjusted price to earnings multiple of 13.6x. That is hardly at nosebleed levels and reflects earnings power that is less than Fairfax’s long-term potential because of current market prices.
No one will get obscenely wealthy in a short period of time by purchasing shares of Fairfax, but a reasonable investor can expect that investment to work out nicely in the coming decade. A return to normalcy in interest rates and equity markets would mean that Fairfax could comfortably increase book value at 10% or more per year by reallocating its investment portfolio and if the stock itself was re-rated to a more appropriate level – say 1.3x book value – returns should compound at about 12% per year. The extent to which Fairfax is able to repurchase stock may magnify that return somewhat.
Few other securities offer such a potential currently, particularly with Fairfax’s path to getting there being so realistically achievable. That makes Fairfax pretty compelling at the moment when any intelligent alternative is considered.