I was re-reading the very first article I had ever seen on Fairfax Financial. It was by Jeff Bronchick of Reed, Conner & Birdwell and was published at the Street.com. In it, Bronchick had stated that he had recently just become aware of Fairfax and Prem. At the time, Fairfax had about $1250 of float per share, and Prem had compounded book at 41% per annum for 13 years! The shares were trading at $410/share at that point. It was May 5th, 1999!
Now ten years later, we have over $1000 of float per share, and the stock is trading at $260/share. In 1999, we had just finished our acquisitions, and no one knew what lay ahead...at least not to the degree that we suffered. But Bronchick had some very astute, if unfortunately timed, commentary on Fairfax's business model. He had estimated that at a 6% return on the $18B portfolio of investments that Fairfax held, shareholders would earn $34 per share, even if the company's combined ratio was at 106%! At 10%, that worked out to about $89/share in earnings at a 106% combined ratio!
I look at Fairfax in this environment, at this point in time, and I can't help but wonder if after ten years, finally Prem will be able to live up to the legend that Bronchick had first illuminated to me. With all the subs firing on all cylinders, expanding business abroad, debt and recoverables down to very reasonable levels, profitable float, and a portfolio that is rock-solid in an environment where other insurers are suffering, is this where Fairfax now grows into something spectacular? Only time will tell!
Interestingly, Bronchik spoke at the Value Investing Congress on Friday. I think it's absolutely fascinating how he was incorrect in going long on Fairfax at $410 back in 1999, while he is now long on the equivalent of what I think Fairfax will be on the verge of becoming in ten years...AIG! Cheers!
The Buffett North of the Border
By
Jeff Bronchick Special to TheStreet.com
5/5/99 6:07 PM ET
URL:
http://www.thestreet.com/comment/buysider/743556.html This is clearly
Berkshire Hathaway (BRK.A:NYSE) week; witness TheStreet.com's
own Chris Edmonds' excellent on-the-spot coverage. Since I have problems getting a decent table at
Gorat's in Omaha, I have had to look elsewhere to invest my dollars, and in the process, may have stumbled upon a
Buffett-like legend in the making.
It was while doing a little
apres-skiing at the Post Hotel in Lake Louise, Canada, that I came across an article regarding the overflowing crowd at the
annual meeting of
Fairfax Financial Holdings (FFH:Toronto), based in Toronto.
Yes, Canadians love a free donut, just like we do south of the border, but food
alone couldn't explain the unusual turnout for a mere annual meeting. The
story also used the phrase "the
Warren Buffett of Canada." That's a sure hook line, and I put a call into Fairfax asking for a financial packet the very
next day. Within a week, I had received and consumed 13 years worth of
annual reports.
What I found was unbelievable -- Mr.
V. Prem Watsa, the founder and resident genius behind Fairfax, has put together a 13-year record that is so
good, I am embarrassed as an investment professional not to have been aware
of it. (Not to mention crying over not owning the stock!)
It turns out that, for the 13 years ended in December 1998, Mr. Watsa
compounded his company's book value per share at a 41% annual rate. Putting
that in perspective, Buffett and Munger have grown Berkshire's book value at
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27.3% a year (true, they never sell, so book value reflects the portfolio's
historical cost). And Fairfax stock has compounded at 48% annually, while
the company's been earning an average return on equity of 20.4%. In fact,
there are just one Canadian and two U.S. companies whose stock prices have
compounded faster over these 13 years. Do I have your attention now?
So who's Prem Watsa? Try reading the annual report at the Web site and
you'll get the picture. There is no investor relations staff, only 15 people at
HQ, and they don't take calls from whiny analysts and shareholders. The
annual report is in Berkshire style -- full of forthright disclosure and detailed
information -- although Prem does lack the gifted pen that Warren wields with
such flourish.
To make a long story short, Fairfax is the story of a
Ben Graham disciple who studied and admired both Buffett and Laurence Tisch (of
Loews (
LTR:NYSE) fame) and, in 1995, got a chance to buy the failing insurance company
Markel Canada on a shoestring. As luck would have it, Markel's major competitor went bankrupt within a year, and Fairfax was able to
quadruple in size overnight. Markel's mission statement has always echoed
Berkshire's, namely, to generate positive "float" from insurance operations,
invest it intelligently at high returns on capital, be ultra-shareholder-oriented
and treat everyone like your brother. And, like Berkshire, the company pays
no dividends, and makes no stock splits.
For 13 years, it's worked like a charm. Fairfax has put up huge numbers on the
investment side, generating the cash to steadily acquire additional insurance
companies on the cheap, which then generates a larger investment pool from
which to work. This has culminated recently with some very large deals that
have quietly made Fairfax one of the 10 largest reinsurance companies, and
one of the top 20 property casualty insurers, on the planet. It also puts C$18
billion of investible assets at Watsa's command. And here's where the
numbers get really interesting.
There are two key issues here. The first is that, while insurance generates
upfront money, or "float," to play around with, you have to be able to
successfully run an insurance business, or you will very soon be playing threecard
monte. That means keeping your combined ratio, which is an all-in
number of losses and expenses, somewhere near 100 (think of it as a
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percentage figure).
If you write insurance with a ratio under 100, you are getting free money
because you are making money selling the insurance -- which means you get
to keep all the investment returns.
But if you are over 100, you are incurring losses and effectively paying for the
use of the float and the investment income. It has been very difficult to
maintain a combined ratio of under 100 during the past decade in most lines of
property-casualty insurance, and it's not getting any easier.
The second issue here is the enormous leverage available from Fairfax's
investment portfolio. For each share of Fairfax worth, as of today, about
C$410, the accumulated float equals some C$1,250 per share. In other words,
for each Canadian dollar invested in Fairfax, you own the return of almost
C$3 per share of investment portfolio. Just for comparison's sake, that dwarfs
Berkshire's ratio of about 65 cents of investment portfolio for every dollar's
worth of share price (a number that assumes decent multiples for the value of
Berkshire's operating businesses).
Below are some basic financials for Fairfax to provide an idea of how the
company's investment assets can generate some very compelling value. In the
first scenario, I assume that Fairfax keeps its C$18 billion invested in
corporate bonds, earning 6% interest. In that case, the company generates a
15% return on equity (which, incidentally, would put it in the top decile of
insurance companies), and a little north of C$34 in earnings per share. This
makes the stock very reasonably priced at its current price of C$410 per share,
and gives zero value to one of the better equity investing records in the
industry.
In the second scenario, I ran the same numbers, this time assuming a 10%
return on the investment portfolio, which is clearly not a stretch, given
Watsa's track record averaging 20%-plus a year for over a decade.
Investment Decisions: How Fairfax Might Fare
Fairfax Financial Holdings' projected 1999 earnings
Scenario 1: Bonds Scenario 2: Stocks
Premiums earned C$5,500 C$5,500
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In both examples, I assumed pretty poor operations from the insurance side: a
pro-forma combined ratio of 106 in 1999 (after acquisitions), improving
slightly over time. It may be right, but like any insurance company modeling,
it could be awfully wrong.
So aside from Yankee ignorance, why is the stock down from C$600 in
February to the low C$400s today?
Like Buffett, Watsa had a rotten year investing. As a deep value investor, he
found the pickings slim, and has kept 90% of his portfolio in bonds for two
years, which clearly hurt performance. Watsa buys cheap and sells dear and is
not afraid to stray from North America. Thus, while North American stocks
represent 5% of the portfolio, he has picked around Korea and South America
for the other 5%, and this represents a major departure from Buffett. So there
are worries that it will be tough (as he states five times in the annual report)
for Watsa to continue to put up the big numbers in the current environment.
On the other hand, hiring a guy with 90% cash in this environment might be a
nice hedge.
Note that there is always risk when you buy an insurance company in distress
-- even when you pay huge discounts from book value, with fairly fat reserve
coverage -- and Fairfax has bought three large, ugly ones in the last 18
months. To dig out of these messes, the goal is to stop writing bad business
and whittle the combined ratio down to 100, but that takes time. And nobody -
- and I mean nobody -- truly knows what you are buying when you buy an old
book of insurance.
Combined ratio 106 106
Assumed return on portfolio 6% 10%
Total investment portfolio C$18,000 C$18,000
Investment income C$1,080 C$1,800
Underwriting losses C$435 C$435
Net income C$484 C$1,024
Earnings per share C$34.29 C$89.46
Return on equity 14% 26%
Dollar amounts except earnings per share are in millions. Source: Company reports; Reed
Conner & Birdwell estimates.
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Watsa makes a fairly convincing, Ben Graham-style argument for just how
cheaply he bought these companies with a big margin for safety. But they are
clearly not the prize stallions like
Geico and General Re, which Buffett acquired. And that's a risk you have to live with at Fairfax. On the plus side,
Fairfax has historically been very conservatively reserved and has run its
insurance operations "decently," generally hovering around a combined ratio
of 100.
Lastly, there is a C$1 billion share overhang that will hit the market in late
May that is financing recent acquisitions, which has held the stock up.
Read the annual report. Better yet, read a bunch of them. This is stock that you
must be willing to put away for five years ... or, hopefully, a lot more. And
best of all, Watsa is in his early 50s, and often makes statements to the effect
that he will die -- Buffett-like -- at his desk.
Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angelesbased
money management firm with about $1 billion of assets under management for
institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value
Fund. At time of publication, RCB was long Fairfax Financial Holdings, although
holdings can change at any time. Under no circumstances does the information in this
column represent a recommendation to buy or sell stocks. Bronchick appreciates your
feedback at
jbronchick@rcbinvest.com. © 1999 TheStreet.com, All Rights Reserved.
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