Fairfax 2017

[petec]

I'm looking at fairfax at the moment but let me play devil advocate for a minute.

 

During the last 6 years the average ROE is about 4% (12.7% if you ignore the hedging losses, But I'm not sure you really wanna do that since every company in the world earns at least 15% ROE if you just pick the good use of that equity).

 

FFH is selling at about 1.2 book value if I understand the adjustments correctly regarding the Allied World acquisition and the India investments.

 

What returns do we realistically can expect FFH to make at such low interest rate, high prices and large influx of money going into insurance and reinsurance environment ?

 

Why Allied World that had 12% ROE is worth 1.4 book value ? can they really boost ROE by investments that much that paying 1.4 book will lead to 15% ROI ? (by my math ROE should go up to 19% starting today to make that 15% ROI)

 

When you guys say it is extremely cheap, what returns range do you expect ?

 

I wouldn't say it's extremely cheap.  I'd say it is priced at a level where you can compound nicely (7-10% over the long term with little risk) and you have real optionality on a higher rate of compounding if the investments do well.

 

With bond interest plus underwriting at 95% less holdco costs and tax, Fairfax can probably do a 7% roe, meaning that if it holds its multiple it matches the market's long run return.  With a tailwind from equities, or outperformance in bonds, you can get past 10% fairly easily and towards 15%, which is their target. 

 

Re: AW, a 12% roe at 1.4% book is an 8.6% return on your purchase price, effectively in perpetuity.  That's not amazing, but it's not bad in a context of 7% long run returns from stocks and sweet FA on bonds today.  If you can juice the ROE with some nice investments, it gets exciting.

 

BTW while you're right that you can pick and choose what you include in ROE for any company, the difference here is that the hedges were a (bad) choice that has been changed.  Most companies can't do that so easily.  Ford can't suddenly decide that carmaking is a low ROE business and switch into pharma.  Fairfax, effectively, can (on the investment side).  So I'd argue that looking at their longer term investment and ROE record is legitimate, rather than just 5y.

 

Again, it is not extremely cheap.  But it is a very fair value for what has become a really powerful underwriting/investing/operating platform with a superb culture.  It ought to compound nicely.

[WneverLOSE]

I'm looking at fairfax at the moment but let me play devil advocate for a minute.

 

During the last 6 years the average ROE is about 4% (12.7% if you ignore the hedging losses, But I'm not sure you really wanna do that since every company in the world earns at least 15% ROE if you just pick the good use of that equity).

 

FFH is selling at about 1.2 book value if I understand the adjustments correctly regarding the Allied World acquisition and the India investments.

 

What returns do we realistically can expect FFH to make at such low interest rate, high prices and large influx of money going into insurance and reinsurance environment ?

 

Why Allied World that had 12% ROE is worth 1.4 book value ? can they really boost ROE by investments that much that paying 1.4 book will lead to 15% ROI ? (by my math ROE should go up to 19% starting today to make that 15% ROI)

 

When you guys say it is extremely cheap, what returns range do you expect ?

 

I wouldn't say it's extremely cheap.  I'd say it is priced at a level where you can compound nicely (7-10% over the long term with little risk) and you have real optionality on a higher rate of compounding if the investments do well.

 

With bond interest plus underwriting at 95% less holdco costs and tax, Fairfax can probably do a 7% roe, meaning that if it holds its multiple it matches the market's long run return.  With a tailwind from equities, or outperformance in bonds, you can get past 10% fairly easily and towards 15%, which is their target. 

 

Re: AW, a 12% roe at 1.4% book is an 8.6% return on your purchase price, effectively in perpetuity.  That's not amazing, but it's not bad in a context of 7% long run returns from stocks and sweet FA on bonds today.  If you can juice the ROE with some nice investments, it gets exciting.

 

BTW while you're right that you can pick and choose what you include in ROE for any company, the difference here is that the hedges were a (bad) choice that has been changed.  Most companies can't do that so easily.  Ford can't suddenly decide that carmaking is a low ROE business and switch into pharma.  Fairfax, effectively, can (on the investment side).  So I'd argue that looking at their longer term investment and ROE record is legitimate, rather than just 5y.

 

Again, it is not extremely cheap.  But it is a very fair value for what has become a really powerful underwriting/investing/operating platform with a superb culture.  It ought to compound nicely.

 

Thanks for the reply, I seem to agree with everything, the hedges will only affect if they try to constantly predict macroeconomics situations, I guess they learned their lesson ?

[petec]

 

Thanks for the reply, I seem to agree with everything, the hedges will only affect if they try to constantly predict macroeconomics situations, I guess they learned their lesson ?

 

 

Maybe. maybe not.  They have a 50% hit rate with macro prediction derivatives (counting the hedges and deflation swaps as one bet and the CDS as the other).  Who knows which lesson they have learned?!

[TwoCitiesCapital]

I'm looking at fairfax at the moment but let me play devil advocate for a minute.

 

During the last 6 years the average ROE is about 4% (12.7% if you ignore the hedging losses, But I'm not sure you really wanna do that since every company in the world earns at least 15% ROE if you just pick the good use of that equity).

 

FFH is selling at about 1.2 book value if I understand the adjustments correctly regarding the Allied World acquisition and the India investments.

 

What returns do we realistically can expect FFH to make at such low interest rate, high prices and large influx of money going into insurance and reinsurance environment ?

 

Why Allied World that had 12% ROE is worth 1.4 book value ? can they really boost ROE by investments that much that paying 1.4 book will lead to 15% ROI ? (by my math ROE should go up to 19% starting today to make that 15% ROI)

 

When you guys say it is extremely cheap, what returns range do you expect ?

 

I absolutely think it's cheap relative to POTENTIAL earnings power. Now, when that earnings materializes is anyone's guess. It could take a year or two or three, but let's just think about this.

 

As of 12/31/2016, Fairfax had $1231/share working for you ($722 in no-cost float, $367 in book value, and $142 in net debt). I haven't run the figures to know how the acquisition of allied world impacts this, but it was my initial understanding that it was accretive to these metrics so it is likely higher now.

 

You're buying the earnings power of $1231 for $476 today (and as low as $420 at its recent lows). Obviously, the return on much of that $1,231 is constrained by regulations, but you only need a 4.4% net return on those assets to drive a 15% ROE and a 5.8% net return to get 15% from the current price.

 

With an investment team that has traditionally beaten those returns metrics just in bonds, let alone their long-term returns from equities, I'd expect that these are low hurdles for a 15% return form here on out.

 

Of course it won't happen over night - much of that $1,231 is sitting in cash and is uninvested. You can wait until it is invested for you to get the confidence that they'll return 10-15% a year from those investments, but my guess is the share price will be much higher once that uncertainty is removed.

 

[petec]

 

You're buying the earnings power of $1231 for $476 today (and as low as $420 at its recent lows). Obviously, the return on much of that $1,231 is constrained by regulations, but you only need a 4.4% net return on those assets to drive a 15% ROE and a 5.8% net return to get 15% from the current price.

 

 

a) I don't think that's true if you include holdco and interest costs

 

b) 4.4% net isn't that easy in a business where you are constrained re: what you can invest in, when treasuries yield 2.5% gross.  I've been digging through their investment portfolio and there's some great potential in there, but i) some of the Indian prices have gone from silly cheap to pricing in quite a lot, so that move may be done for now, and ii) they have 25% of the post-AW portfolio in cash earning nothing.  I love this thing long term and agree there is great earnings POTENTIAL, but it's going to take some very good investments to realise that potential.

 

Fairfax's historic investment performance had a massive tailwind from falling bond yields (as did everyone's).  That won't repeat, so historic absolute returns aren't a good guide to the future.

[Jurgis]

IMO Petec has a pretty good handle into possible Fairfax performance.

[TwoCitiesCapital]

 

You're buying the earnings power of $1231 for $476 today (and as low as $420 at its recent lows). Obviously, the return on much of that $1,231 is constrained by regulations, but you only need a 4.4% net return on those assets to drive a 15% ROE and a 5.8% net return to get 15% from the current price.

 

 

a) I don't think that's true if you include holdco and interest costs

 

b) 4.4% net isn't that easy in a business where you are constrained re: what you can invest in, when treasuries yield 2.5% gross.  I've been digging through their investment portfolio and there's some great potential in there, but i) some of the Indian prices have gone from silly cheap to pricing in quite a lot, so that move may be done for now, and ii) they have 25% of the post-AW portfolio in cash earning nothing.  I love this thing long term and agree there is great earnings POTENTIAL, but it's going to take some very good investments to realise that potential.

 

Fairfax's historic investment performance had a massive tailwind from falling bond yields (as did everyone's).  That won't repeat, so historic absolute returns aren't a good guide to the future.

 

I don't disagree with much here. I'll simply re-iterate that by the time you have the clarity on how they'll be achieving those returns of 4.4% net, the stock won't likely trade at $420-$475.

 

It doesn't take much - a recession that blows out equity premiums and corporate spreads? An acceleration in inflation that lifts long-term rates to ~4%? A continuous correction in the dollar that results in their foreign businesses appreciation signficantly in value in USD terms? The demise of a large competitor that allows them to pick up compelling assets on the cheap? A massive natural disaster that resets the insurance and re-insurance rates to singificant premiums?

 

Who knows what will happen to get them to that 4.4%. The point is, when it does happen, it probably won't trade where it's at for you to take advantage of it. And if it does? You can always buy more.

 

[Dazel]

 

 

Fair value of investment in associates is now $1.82 billion above carrying value....expect Prem to talk about this tomorrow on the call as book value understates the company's value.... The intrinsic value of Fairfax and their earnings power going forward is much higher than the present book value because Of the massive hedge losses and poor common stock investing over the last 5 years.

 

Prem and his team know this so we think they will start a substantial buy back program  at these levels.

[WneverLOSE]

 

 

Fair value of investment in associates is now $1.82 billion above carrying value....expect Prem to talk about this tomorrow on the call as book value understates the company's value.... The intrinsic value of Fairfax and their earnings power going forward is much higher than the present book value because Of the massive hedge losses and poor common stock investing over the last 5 years.

 

Prem and his team know this so we think they will start a substantial buy back program  at these levels.

 

Why investing returns should be better going forward ? what changed ?

Will they stop making macro calls or if they see something 2 years from now they will take a 5B position in it ?

 

Book value is a proxy to business value since usually a decent return is achieved on that equity but unless they can do it why do they deserve a premium ?

Until recently most insurers traded well bellow book value since the returns on equity are bad. With the hedging losses it is really bad and without it its above the average but nothing like the long term results or the states goal of 15%, if they do 12% best case and 4% in the real world why is it worth book ?

 

Why do you expect investment returns to improve going forward and not deteriorate ? If Rates will go higher it will hurt current fixed income investments (I know they are on the short maturity side at FFH but still) and equity prices will go down to reflect a higher future returns. If rates don't go up FFH stays again holding cash while everyone is riding the train towards richtown.

 

I feel that it's hard to determine if FFH is cheap or expensive, if you believe rates will go up fast in the near term and that prem hasn't lost his touch it's cheep, if you don't know about rates it's kind of a bet that can go either way and if you think rates will stay low / go up slowly it's probably expensive to you.

 

Would you pay 1.25 book value for another insurance company that had 4% ROE for the last 6 years ? that's not a short amount of time so there is a big difference between current results to long term results and it's very much about the return to the mean thesis, this takes some belief that I don't have. Maybe the financial gods will punish me for my disbelief.

[petec]

 

I don't disagree with much here. I'll simply re-iterate that by the time you have the clarity on how they'll be achieving those returns of 4.4% net, the stock won't likely trade at $420-$475.

 

 

Agreed and for full disclosure this is my largest personal position.

[petec]

 

Why investing returns should be better going forward ? what changed ?

Will they stop making macro calls or if they see something 2 years from now they will take a 5B position in it ?

 

Book value is a proxy to business value since usually a decent return is achieved on that equity but unless they can do it why do they deserve a premium ?

Until recently most insurers traded well bellow book value since the returns on equity are bad. With the hedging losses it is really bad and without it its above the average but nothing like the long term results or the states goal of 15%, if they do 12% best case and 4% in the real world why is it worth book ?

 

Why do you expect investment returns to improve going forward and not deteriorate ? If Rates will go higher it will hurt current fixed income investments (I know they are on the short maturity side at FFH but still) and equity prices will go down to reflect a higher future returns. If rates don't go FFH stays again holding cash why everyone is riding the train towards richtown.

 

I feel that it's hard to determine if FFH is cheap or expensive, if you believe rates will go up fast in the near term and that prem hasn't lost his touch it's cheep, if you don't know about rates it's kind of a bet that can go either way and if you think rates will stay low / go up slowly it's probably expensive to you.

 

In order:

- I think investing returns will be good going forward because I think these guys are good long term investors.  Looking at their recent investors reinforces this.  You might disagree.

- They might stop making macro calls, they might not.  They've made two historically, one of which was a great success and one of which was a great failure.  Importantly, I know they might and I can live with it.  Don't invest if you can't.

- It's worth at least book, IMHO, because there is clear franchise value here.  Valuing it at book suggests you'd make as much money by closing the business as you would by running it.  I doubt that.  I think they've built a platform with multiple competitive advantages and I expect it, therefore, to produce a good ROE over time.  To put it another way I think the ROE will be higher than my required return, which means it's worth more than book.  Depends on yyour required return.

- They are so short on the curve that if rates rise it will be a huge help.

- I don't think Prem has lost his touch.  I do think he made and reversed a mistake.  I also think he has built an incredible platform and in recent years has added a lot of value through management action on both the insurance and investment sides.  I'm happy to wait and see whether I'm right.

 

Cheers

 

P

[Dazel]

 

It's not trading at 1.25 times book value.

There is $67 above book value in the investment associates and the insurance company book values are low.

 

It's cheap no matter how you look at it.

[Dazel]

 

 

And it's cheap because it is hated....for all the reasons given. The market has lost faith in Prem and his teams investing skills. We have not and large part of our thesis involves Brian Bradstreet the best bond manager in the world.

[Dazel]

 

 

Bradstreet has not lost his touch he continues to greatly outperform on short and long term metrics...his record is legendary.

[Cardboard]

"They might stop making macro calls, they might not.  They've made two historically, one of which was a great success and one of which was a great failure."

 

False. They made at least 4. You have to include the bet against Japan in the late 80's and against the Nasdaq in 1998-2000.

 

On all of them, they were early. The CDS bet was great and well publicized.

 

A major problem with Fairfax, which I have mentioned multiple times over a long period of time now, is their love for expensive leverage and a low percentage of money invested into stocks and non-insurance businesses. There is over $6 billion of debt and preferreds vs around $10 billion invested.

 

Contrarily to Berkshire where Buffett has had zero cost float for a very long time, very low coupon debt and is able to invest a substantial percentage of shareholders equity into stocks and non-insurance businesses earning high returns this is not the case at Fairfax.

 

Why keeping well over $12 billion in cash and over $7 billion in low return bonds instead of repaying debt? There is already a very large amount of leverage built in due to float. Regulation is a reason why they cannot allocate more towards stocks and non-insurance businesses a la Berkshire but, I would argue that holding $6 billion in debt for essentially nothing is not contributing to better ratings which would help solve this issue.

 

Cardboard

[Dazel]

 

 

Cardboard,

 

It's been a long time...I have agreed with your sentiment a lot over the years..

 

I will add to your thoughts...

 

Remember Fairfax has had to wait out the Allied transaction and look at the possibility of it not happening, look at Allied's substantial bond portfolio as a risk (if rates were to rise), and also prepare for it to go through which had them holding a large cash reserve. There were about $100m in interest rates derivative charges in the quarter which were likely put there to hedge Allied's bond portfolio.

 

As for structure you are correct and we anticipate Prem restructuring a lot of the now very large Fairfax. We think that includes trimming the share count at these levels...but also debt buy backs where appropriate. Allied is a high quality company so integration is almost 0. But the $14b in premiums and solid operations give Fairfax flexibility that takes them more towards the Berkshire model. You are absolutely correct in your views and we see them transitioning towards the goals...the

Gravilia and APR Energy purchases in July as well as the purchases of companies through Fairfax India, Fairfax Africa are an example of putting more capital to work...now that the Allied deal is done we see them getting very busy both internally (debt and buy backs) and buying bigger position in companies they control like Berkshire did.

 

[petec]

"They might stop making macro calls, they might not.  They've made two historically, one of which was a great success and one of which was a great failure."

 

False. They made at least 4. You have to include the bet against Japan in the late 80's and against the Nasdaq in 1998-2000.

 

 

Thanks, I'll read up on those.  Were they just early, or wrong?

 

I agree with your point on using leverage to fund low return bonds.  The warrants and converts give more equity exposure than is obvious, as do the investments in associates, but still.

 

Berkshire is less levered by debt and pref, but also less levered by cheap float.  Overall it's significantly less levered full stop (roughly 2x assets/equity vs 4x, and even more so on tangible equity).

 

[petec]

APR Energy?  I missed that. 

[RichardGibbons]

To me, the negative opinions on Fairfax are far too extreme because, based on the outcome of a single event, people seem to have concluded that Fairfax can't do macro.  But suppose that, at the time the last macro bet were made, there was a 50% chance that the bet was right.

 

If that were the case, Fairfax was betting on a coin flip, where, if it came up tails, they'd lose $X, and if it came up heads, they'd make, say, $6X.  Well, it turns out the coin came up tails, so they lost $X.

 

But now to claim because of that single bet that Fairfax's are likely to be low in the future--particularly when that single bet may have been a good bet to take--simply because the bet had a bad outcome seems illogical.  It kind of smells like outcome-oriented thinking unless you believed strongly seven years ago that the bet was a bad one.  And to my (faulty) memory, I don't remember many people making strong claims back then that the macro bets were a bad idea.

 

(In fact, if it were the case that the odds were like the coin-flip described above, I'd be delighted if Prem et al make those macro bets again and again.  The more the better.)

[WneverLOSE]

Ok let's forget about the last 6 years.

 

Since 1999 (The max range google finance gives on BRK.A and FFH) Berkshire Created 273% of value to it's shareholders while Fairfax produced 38% to it's shareholders, far from spectacular. (the s&p did 83%).

 

Where is the value creation ?

[racemize]

Ok let's forget about the last 6 years.

 

Since 1999 (The max range google finance gives on BRK.A and FFH) Berkshire Created 273% of value to it's shareholders while Fairfax produced 38% to it's shareholders, far from spectacular. (the s&p did 83%).

 

Where is the value creation ?

 

Well, you are picking the absolute worse beginning point for FFH, and when it was selling for nearly 3x book.  So...

[WneverLOSE]

Ok let's forget about the last 6 years.

 

Since 1999 (The max range google finance gives on BRK.A and FFH) Berkshire Created 273% of value to it's shareholders while Fairfax produced 38% to it's shareholders, far from spectacular. (the s&p did 83%).

 

Where is the value creation ?

 

Well, you are picking the absolute worse beginning point for FFH, and when it was selling for nearly 3x book.  So...

 

If they are great capital allocators wouldn't it make sense they would understand the situation and issue stock at such high valuation and create shareholder value this way ?

 

Using your stock as currency is a major strength that a smart management team should know how to do.

 

[racemize]

Ok let's forget about the last 6 years.

 

Since 1999 (The max range google finance gives on BRK.A and FFH) Berkshire Created 273% of value to it's shareholders while Fairfax produced 38% to it's shareholders, far from spectacular. (the s&p did 83%).

 

Where is the value creation ?

 

Well, you are picking the absolute worse beginning point for FFH, and when it was selling for nearly 3x book.  So...

 

If they are great capital allocators wouldn't it make sense they would understand the situation and issue stock at such high valuation and create shareholder value this way ?

 

Using your stock as currency is a major strength that a smart management team should know how to do.

 

It seems clear you want to view this stock with a very particular rear-view mirror.  I'm not sure why you are picking that date, and it is the one that will make them look the worst.  You could, for example, try their inception date.  Or you could look at BVPS growth rather than stock price growth (though I don't think that would make them outperform BRK at that date).

 

In any event, they did issue stock and made the worst acquisition in their history.  They then barely survived the resulting turmoil and tough insurance environment.  Then they made an insane amount of money during the GFC.  Then they bet the wrong way for too long.  So, sure, they did a really really shitty job at that moment.  Then they did amazing.  Then they did shitty.  The longs in this thread are indicating that it looks like prospective returns look good.  You don't have to believe them/us, but pointing at 1999 returns as if the people talking don't know about it doesn't make that much sense, given this board's history/focus.

 

 

[Cardboard]

"If they are great capital allocators wouldn't it make sense they would understand the situation and issue stock at such high valuation and create shareholder value this way ?

 

Using your stock as currency is a major strength that a smart management team should know how to do. "

 

They sure did! Fairfax was a serial acquirer or roll-up in the late 80's and 90's. They issued shares and debt to gobble up a lot of troubled insurers. As long as the magic worked of acquiring them with cheap capital and turning them around, the price to book value remained very elevated.

 

Then in the late 90's, they bought TIG and Crum & Forster and it was the end of that fast growth era. It took them nearly 10 years to turn the company around and they only truly regained their fame after the CDS bet. Lots of shares issued during that time just to survive at very poor multiples.

 

So looking at the historical record of Fairfax book value growth is meaningless in my opinion. You have to look at the current structure and try to figure out if they will earn a good return on equity going forward and if BVPS will grow in tandem.

 

My biggest disappointment with Prem is not the negative bet of the last 7 years, although the structure of it and passing on to so many great purchases in 2008-2009 is hard for me to comprehend. It is more about not learning from the past and from others such as Buffett.

 

The need for a clean balance sheet and carrying low fixed costs should be obvious. Not there yet.

 

There is also this apparent gambler desire to repeat successful macro bets from the past. There is no need to do that and Berkshire and Markel don't engage into such speculation. Doing the boring thing everyday would get them to great results and fame but, they seem stuck into cigar butts and going for some assymetric bet.

 

Cardboard

[WneverLOSE]

As I said I got that date "randomly" by pressing the "Max" length in google finance, I don't want to talk about performance since inception because I'm trying to argue that the performance was good at the beginning and stunk from their.

 

Since 1989 (4 years after inception) book value compounded at 14% till 2016. and this is me trying to pick the best combination of long time frame and good performances. (during the first 4 years book value compounded at 52.6% so yeah...)

 

You have to look at the current structure and try to figure out if they will earn a good return on equity going forward

 

I 100% agree that this is the best theoretical way but how can it be done when the insurance operations generate 6.4B in earnings and 4.4B is thrown out of the window ? How much will be spend on betting aginst global worming ? :P