2017 Annual Letter

[petec]

Only $9 billion is currently in bonds; of this amount only $1 billion is 5-10 year duration and $2 billion is more than 10 year duration.

 

...and even that part is fully rate-hedged, according to this letter.

[StubbleJumper]

I am offline more than online these days, but I gave the letter a quick read on my phone.  The tone was better, but the governance issues persist.  I will say it because nobody else has.  Prem's underhanded move to reweight his multiple voting shares continues to manifest itself in poorer governance.

 

1) Does anybody actually believe his explanation of shifting $50m of shareholders' money to be invested by his son?  Suddenly in 2017 it became critically important to put a tiny portion of the port into small and med caps?  So since 1986 it wasn't important, but now it is?  And the existing brains in hamblin Watsa couldn't do it in house?  My bullshit detector is ringing rather loudly.

 

2) Minority shareholders need independent board members to keep Prem from doing wacky and reckless things from his little echo chamber.  Actually, I should say MAJORITY shareholders need this because the Watsa family has only a small minority economic interest in FFH.  So, Prem is going to use his multiple voting shares to appoint his daughter to the board.  Yet another appointee who lacks business and life experience.  We need these board members to challenge Prem's tendency to do wacky things.  Young family members who are beholden to Prem for any future ownership of FFH shares cannot do this effectively.  And damned few people under age 50 do a good job of this sort of challenge function because they just don't have the range of experience required to do it.

 

3) After 5 shitty years due mainly to Prem's ill considered hedging strategy, the company is finally well positioned to make some money in the next few years.  We just need him to not make the next position sizing error like blackberry or the hedging (hedging was a position sizing problem, principally).

 

4) After the pathetic governance abuses over the past 3 or 4 years, all we can do is hope to Christ that Prem doesn't do the ultimately stupid move and give one of his kids a real job at FFH where their lack of experience can really fuck things up.  At least with Ben, the worst fuck-up is likely the shortfall of 300 or 400 bps of return on a risk adjusted basis.  If they are ever given the role of president in one of the subs, we may be in deep trouble.

 

 

Some things never seem to improve.

 

 

SJ 

[FairFacts]

Petec

"Won't they equity account it and therefore still not record it in BV?"

 

I'm not certain of this but I believe that if FFH receive the spin-out shares in Quess they will book them at their current market value which will be reflected in BV.

[petec]

Petec

"Won't they equity account it and therefore still not record it in BV?"

 

I'm not certain of this but I believe that if FFH receive the spin-out shares in Quess they will book them at their current market value which will be reflected in BV.

 

I'm fairly sure that as it is a >20% holding Fairfax would equity account it, reporting their share of Quess's net income and book value and ignoring the market price. That's why equity accounted associates contribute to the $1.2bn of unrealised gains that aren't in the book value currently. Quess would just add to that, I think.

 

SJ - largely agree with you - not too bothered about Ben's $50m mandate but the appointment of a second child to the board worries me and the suggestion that it is done to defend the culture without any detail as to why she is the right person to defend the culture is insulting both to our collective intelligence as shareholders and, frankly, to the significant number of very bright people at FFH who are more deserving of that seat and whose experience of the culture is far greater. Very annoying. And if they are going into Singleton-style buyback mode as they say, at some point in the next decade those multivoters will have outright control.

[Spekulatius]

I agree on above criticism by Stubblejumper and I really think that the culture is of questionable value here (as discussed in another thread) and I would rather see a culture change than preserving it.

 

i am not sure about this, but if it were not for realized gains, FFH would have shown an operating losss, due to underwriting losses (mostly from FFH) which interest income did not compensate for. Again, this can happen, but it’s not a great result operationally. Did anyone notice thwt AWH (which they bought last year) had an understand ration above 100 before catastrophe losses? Not great either, hopefully it’s a one off.

 

Also Premium blabbers a bit too much about all these small deals that  are with 1-2% positions (if not less) and while they work out well, they don’t do all that much for the bottom line. They need to get big things right (AWH acqusition etc.)

[petec]

I agree on above criticism by Stubblejumper and I really think that the culture is of questionable value here (as discussed in another thread) and I would rather see a culture change than preserving it.

 

i am not sure about this, but if it were not for realized gains, FFH would have shown an operating losss, due to underwriting losses (mostly from FFH) which interest income did not compensate for. Again, this can happen, but it’s not a great result operationally. Did anyone notice thwt AWH (which they bought last year) had an understand ration above 100 before catastrophe losses? Not great either, hopefully it’s a one off.

 

Also Premium blabbers a bit too much about all these small deals that  are with 1-2% positions (if not less) and while they work out well, they don’t do all that much for the bottom line. They need to get big things right (AWH acqusition etc.)

 

I think the culture is phenomenally valuable. It's very clear to me Fairfax attracts and retains superb people and is increasingly a company that people want to sell to. Changing that would be madness. But that's not the same as saying power should be heritable. Power should go to the person best able to protect the culture.

 

I don't think I'd expect an operating profit (excl gains) in a big cat year, especially when interest rates are so low. I actually thought the underwriting results were phenomenal - if you look at the subsids FFH where FFH controlled the underwriting, i.e. excl AWH, FFH would have made an operating profit in a massive CAT year for the industry. That's extraordinary and not what I would have expected at all. AWH was awful but Prem was clear that they don't expect AWH's results to differ so substantially from FFH's going forward, which is a way of saying they'll influence the underwriting. The idea that one bad hurricane season somehow makes AWH - a company with a good history - a bad deal seems nuts to me. I suspect it'll be a home run. Could be wrong.

 

As for the investing, far better that they focus on putting together a series of asymmetric outcome 1s and 2s than try to do something big. I love the details on those.

 

 

[Shane]

I thought it was curious that he didn't buyback more shares, but then realized he mentioned using FCF to buyback shares.  Has he indicated he will use the proceeds from First Capital/ICIC to fund repurchases directly that I may have missed?

 

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

[Dazel]

 

 

 

Fairfax closed the first capital, deal on Dec 28 2017....we have not seen any buy back numbers since that deal closed. They are limited in what they can buy back per day. I would like to see consistent buybacks at these levels....to the maximum they are allowed.

 

Once again there are different opinions on where Fairfax is....and that’s great it makes a market. The longer we stay cheap the better for a Singleton type buy back plan. Long term shareholders win...hard to imagine that anyone would be upset if Fairfax bought back enough stock so that the Watsa family once again owned the majority of the shares! If Fairfax operates like the plan is set out...shareholders will once again be very happy if not well....everyone will be grumpy including me! I have been around for the grumpy and I have been around for the euphoria.

I made ton of money during Grumpy times and would like to do it again!

 

“You can’t buy what’s  popular and do well in investing”

 

Warren Buffett

[petec]

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

 

He's referenced Singleton and Teledyne before and in the letter. Teledyne issued to acquire for years and then turned the ship and bought back for years. The buyback is a long term thing. They can't put too much to work too fast - the stock isn't liquid enough, unless they do an SIB, but then they'd have to pay a premium - and they've never said they wanted to. Expect the share count to be much lower in 10 years but not necessarily in 10 months.

[ourkid8]

The proceeds at the Holdco ( First Capital/ICICI) looks to be earmarked to buy out their joint venture partner OMERS to control Eurolife, Brit etc...

 

-"We expect to buy out OMERS within the next two years, so Eurolife will become a Fairfax insurance subsidiary. "

-"Fairfax currently owns 70.1% of Brit and has the ability to repurchase the shares owned by OMERS over time."

 

I thought it was curious that he didn't buyback more shares, but then realized he mentioned using FCF to buyback shares.  Has he indicated he will use the proceeds from First Capital/ICIC to fund repurchases directly that I may have missed?

 

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

[gokou3]

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

 

He's referenced Singleton and Teledyne before and in the letter. Teledyne issued to acquire for years and then turned the ship and bought back for years. The buyback is a long term thing. They can't put too much to work too fast - the stock isn't liquid enough, unless they do an SIB, but then they'd have to pay a premium - and they've never said they wanted to. Expect the share count to be much lower in 10 years but not necessarily in 10 months.

 

I vaguely remember there is a restriction by the TSX by how many % of O/S a company can buy back in a year under NCIB, as well as a restriction based on trading volume (i.e. not exceeding X% of daily volume).  Is anyone familiar with such rules on TSX?

[ourkid8]

25% of the daily trading volume.

 

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

 

He's referenced Singleton and Teledyne before and in the letter. Teledyne issued to acquire for years and then turned the ship and bought back for years. The buyback is a long term thing. They can't put too much to work too fast - the stock isn't liquid enough, unless they do an SIB, but then they'd have to pay a premium - and they've never said they wanted to. Expect the share count to be much lower in 10 years but not necessarily in 10 months.

 

I vaguely remember there is a restriction by the TSX by how many % of O/S a company can buy back in a year under NCIB, as well as a restriction based on trading volume (i.e. not exceeding X% of daily volume).  Is anyone familiar with such rules on TSX?

[petec]

The proceeds at the Holdco (proceeds from First Capital/ICICI) looks to be earmarked to buy out their joint venture partner OMERS to control Eurolife, brit etc...

 

-"We expect to buy out OMERS within the next two years, so Eurolife will become a Fairfax insurance subsidiary. "

-"Fairfax currently owns 70.1% of Brit and has the ability to repurchase the shares owned by OMERS over time."

 

I think you're right and the same applies AWH eventually, I would think.

[Viking]

The proceeds at the Holdco (proceeds from First Capital/ICICI) looks to be earmarked to buy out their joint venture partner OMERS to control Eurolife, brit etc...

 

-"We expect to buy out OMERS within the next two years, so Eurolife will become a Fairfax insurance subsidiary. "

-"Fairfax currently owns 70.1% of Brit and has the ability to repurchase the shares owned by OMERS over time."

 

I thought it was curious that he didn't buyback more shares, but then realized he mentioned using FCF to buyback shares.  Has he indicated he will use the proceeds from First Capital/ICIC to fund repurchases directly that I may have missed?

 

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

 

I also wonder if this is why we are not seeing more aggressive share buybacks today. Buying the remainder of Allied World is also part of the bigger plan. The challenge is what is Allied World worth today? Given the size of the losses reported and the poor underwriting, it must be worth less than what it was purchased for. OMERS is going to want a premium.

[Shane]

The proceeds at the Holdco (proceeds from First Capital/ICICI) looks to be earmarked to buy out their joint venture partner OMERS to control Eurolife, brit etc...

 

-"We expect to buy out OMERS within the next two years, so Eurolife will become a Fairfax insurance subsidiary. "

-"Fairfax currently owns 70.1% of Brit and has the ability to repurchase the shares owned by OMERS over time."

 

I thought it was curious that he didn't buyback more shares, but then realized he mentioned using FCF to buyback shares.  Has he indicated he will use the proceeds from First Capital/ICIC to fund repurchases directly that I may have missed?

 

If he intends to use FCF as the primary source of funding for repurchases, many people on this board will be very disappointed.

 

I also wonder if this is why we are not seeing more aggressive share buybacks today. Buying the remainder of Allied World is also part of the bigger plan.

 

It would make sense.  I'm struggling a bit with his mentioning Teledyne.  Singleton bought back shares because they were cheap and he lacked a better use of capital.  How can Fairfax know whether their shares will be cheap at any point other than the near term?  Buybacks should be done opportunistically.  I'm willing to give him the benefit of the doubt that he'll only make repurchases at attractive prices, but laying out a long-term plan to reduce share count doesn't make a lot of sense to me.

[petec]

I think the structure of the Brit deal with OMERS is:

- They don't have to pay a dividend but if they do it all goes to OMERS up to a hurdle, and above that it goes to FFH holdco.

- They can buy OMERS out over several years at cost plus an incentive which I seem to remember being about 7% a year.

 

So if the BV compounds at >7% the p/bv falls and if not, it rises.

 

AW has clearly had a rotten start to that but I suspect we are a few years from them buying the stub and it's got a great record of BV growth so time is on their side.

[petec]

It would make sense.  I'm struggling a bit with his mentioning Teledyne.  Singleton bought back shares because they were cheap and he lacked a better use of capital.  How can Fairfax know whether their shares will be cheap at any point other than the near term?  Buybacks should be done opportunistically.  I'm willing to give him the benefit of the doubt that he'll only make repurchases are attractive prices, but laying out a long-term plan to reduce share count doesn't make a lot of sense to me.

 

Agreed, but he hasn't made a commitment and they are value monkeys at heart. My guess is they will be very disciplined. I think of it more as a floor, like the Buffet 1.2x BV floor.

 

That said he clearly thinks IV is well above book so it will be interesting to see where they stop!

[Spekulatius]

Yes, doing a Teledyne only makes sense if shares are quite undervalued and there is no wayside knowing how Mr. Market will value FFH going forward.

Talking about a huge buyback in context of above makes sense.

[StevieV]

Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

Vinod,

 

Thanks for correcting my calculations.  Seems to me it's a tall order to get to 7% return in this kind of market (high stock AND bond valuations).

 

My earlier post on this should be ignored.  I was reading and posting too fast.  7% for the equity portion of the portfolio and 7% for a blended portolio is much different.  A 14-16% return for the equity portion isn't plausible.

 

I need to look more closely at this later today.  The numbers below are a little hasty.

 

It looks to me as though the book value is about $12.5B US.  A little under $10B CAD.  (most I see are per share; so perhaps I have this total book value incorrect).

 

If there are $40B in investments, at a 95% combined ratio, why would they need a 7% return to grow book at 15% (about 1.8B USD)?

 

Anyway, I've gotten myself confused here and need to take a fresh look.

 

I guess I need help here.  Here is the quote from the letter.

 

"With $40 billion in investments, a current run rate of $11.5 billion in net premiums written and $12.5 billion in

common shareholders’ equity, we need an investment return of approximately 7% in order to achieve an annual

15% increase in book value per share, assuming a consolidated combined ratio of 95% at our insurance operations."

 

7% return on $40B is $2.8B.  $2.8B would much greater than a 15% increase in the book value.  It seems to me as though they are subtracting from the $40B in investments to get the 7% number, but I don't understand the steps.  Some of the 40B is certainly necessary for claims, but they should keep the investment returns.  That being said, they don't have a free hand on the entire 40B given the necessity to be able to pay out claims.  Is that what they are taking out, or is there something else?

 

Thanks in advance for any assistance.

[gokou3]

Need to break down the 7% returns.

 

Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them).

 

Assuming a 25% 50% 25% cash bond stock allocation.

 

If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%.

 

Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually.

 

Vinod

 

Vinod,

 

Thanks for correcting my calculations.  Seems to me it's a tall order to get to 7% return in this kind of market (high stock AND bond valuations).

 

My earlier post on this should be ignored.  I was reading and posting too fast.  7% for the equity portion of the portfolio and 7% for a blended portolio is much different.  A 14-16% return for the equity portion isn't plausible.

 

I need to look more closely at this later today.  The numbers below are a little hasty.

 

It looks to me as though the book value is about $12.5B US.  A little under $10B CAD.  (most I see are per share; so perhaps I have this total book value incorrect).

 

If there are $40B in investments, at a 95% combined ratio, why would they need a 7% return to grow book at 15% (about 1.8B USD)?

 

Anyway, I've gotten myself confused here and need to take a fresh look.

 

I guess I need help here.  Here is the quote from the letter.

 

"With $40 billion in investments, a current run rate of $11.5 billion in net premiums written and $12.5 billion in

common shareholders’ equity, we need an investment return of approximately 7% in order to achieve an annual

15% increase in book value per share, assuming a consolidated combined ratio of 95% at our insurance operations."

 

7% return on $40B is $2.8B.  $2.8B would much greater than a 15% increase in the book value.  It seems to me as though they are subtracting from the $40B in investments to get the 7% number, but I don't understand the steps.  Some of the 40B is certainly necessary for claims, but they should keep the investment returns.  That being said, they don't have a free hand on the entire 40B given the necessity to be able to pay out claims.  Is that what they are taking out, or is there something else?

 

Thanks in advance for any assistance.

 

See http://www.cornerofberkshireandfairfax.ca/forum/fairfax-financial/2017-annual-letter/msg326836/#msg326836

 

[StevieV]

I see.  My bad.  Taxes, expenses, etc.

[Dazel]

 

 

Fairfax used the 2007 and 2008 CDS winnings to buy back ORH, NB, Zenith and others....they were some of the best investments Fairfax has ever made (I have recently seen other posters still calling Prem a thief because of how good the deals turned out for Fairfax). They are the reason that FFH is undervalued. I believe they will do the samething  going forward but buybacks will be the priority. If they make a extra couple of  billion on Blackberry or Greek investments etc...Then you will see them buy back more of Brit and Allied.

Are we not all glad they did not own all those two companies last year! For some reason memories are short right now with Fairfax....nature of the beast.

 

Can someone please comment on Brian Bradstreet’s bond record it’s astonishing And there is no one close globally over 5,10,20, 30 years!!!!! No one. He is a legend and no one will comment on it...

Someone do the work and try to find someone close please! Crazy.

 

[vinod1]

Can someone please comment on Brian Bradstreet’s bond record it’s astonishing And there is no one close globally over 5,10,20, 30 years!!!!! No one. He is a legend and no one will comment on it...

Someone do the work and try to find someone close please! Crazy.

 

You are measuring against the wrong benchmarks.

 

A couple of years back I am trying to answer the question of why they are outperforming so much in the bond markets. Equity I can understand and we can see the major investments and how they played out.

 

In bond markets the alpha has to come from (a) security selection or (b) making correct macro calls on interest rates.

 

No doubt there is some of both. But it still does not explain such a large out performance. What I realized is that they are including non-stock investments such as convertibles and possibly warrant deals into the fixed income segment. Nothing wrong in that. But they have a different risk profile and you cannot then measure up against pure bond benchmarks.

 

Vinod

 

 

[StubbleJumper]

It would make sense.  I'm struggling a bit with his mentioning Teledyne.  Singleton bought back shares because they were cheap and he lacked a better use of capital.  How can Fairfax know whether their shares will be cheap at any point other than the near term?  Buybacks should be done opportunistically.  I'm willing to give him the benefit of the doubt that he'll only make repurchases are attractive prices, but laying out a long-term plan to reduce share count doesn't make a lot of sense to me.

 

Agreed, but he hasn't made a commitment and they are value monkeys at heart. My guess is they will be very disciplined. I think of it more as a floor, like the Buffet 1.2x BV floor.

 

That said he clearly thinks IV is well above book so it will be interesting to see where they stop!

 

 

Prem talking about buybacks is a bit like a teenager talking about sex.  They both engage the subject with a great deal of enthusiasm, but when the rubber hits the road (or something!), they don't actually do it anywhere near as often or as successfully as their optimistic plans would suggest.  Working from memory, Prem has made enthusiastic references to buybacks in about half of the annual letters -- on some occasions promising to go on offence while on other occasions trying to contextualize a share issuance.

 

My observation is that Prem is a serial acquirer, picking up a new meaningful sub every second year or so.  As long as that's his approach, FFH will be capital constrained.  There will be no meaningful buyback unless he runs out of insurance subs to buy and actually allows cash to accumulate for a couple of years.

 

While I'm not shy to criticize Prem's management when I think it is merited, in this case it amounts to a question of the relative value proposition of buying your own shares vs buying somebody else's.  He mostly finds reasonably priced subs to acquire, so it's not obvious that buybacks would necessarily have been better.

 

Going forward, my sense is that FFH could throw a Bil at buybacks during 2018 if it so desired.  A tender offer for 2m shares at US$550 would likely get the desired response.  But, I would be shocked to see it happen.  I'm guessing that the over/under for sharecount in 2023 would be 30m.

 

 

SJ

[Dazel]

 

 

 

 

Gundlach is the bond king....tell me that his portfolio has not had the opportunity to  similarly weight to Bradstreet’s....so take the bench mark out compare their numbers.

https://doublelinefunds.com/wp-content/uploads/core-fixed-income-fund-fact-sheet.pdf?c=1520932995

 

Fairfax who have supposedly lost their touch because most want to forget their long term record...have missed the fact Bradstreet has remained at the top of his game in any time period you want to look at over the last 32 years (In 1999 and 2000 he would have underperformed) the dismal last 9 years for HW he has destroyed Gundlach’s Double line record  since inception it’s inception. Bradstreet is the bond king!

 

P.s I love Gundlach and listen to all he has to say...