2017 Annual Letter

[ValueMaven]

FFH trading right around BV...anyone warming up to the name given the recent/modest selloff?

 

Sincerely,

VM

[petec]

Kyle Bass of VC Hayman Capital (macro, event driven focus) reckons that Greece will break out in 2018 with a likely change in leadership. He predicts that Tsipras will be ousted before year end and replaced by the far more business friendly Mitsotakis. He says there is tons of money on the sidelines waiting to flood back into Greece.

 

Do you have a source for this?

[FairFacts]

Petec,

https://www.bloomberg.com/news/articles/2017-10-06/bass-bets-greek-elections-called-within-a-year-spurring-rally

 

or

 

https://www.cnbc.com/2017/11/14/kyle-bass-predicts-investors-ready-to-put-billions-into-greek-economy.html

[petec]

Thanks!

 

 

[FairFacts]

FFH trading right around BV...anyone warming up to the name given the recent/modest selloff?

 

Sincerely,

VM

 

I am very warm on FFH these days. I'm not sure what the catalyst will be to get the price moving but a couple of thoughts come to mind.

1. Are the AWH shareholders who received FFH shares selling steadliy and thus depressing the price?

2. The market may need to see several quarters of the new approach 'playing offence' and 'disciplined underwriting'.

3. When and in what form will buybacks take?

 

As WB said "The Stock Market is a device for transferring money from the impatient to the patient".

 

[Dazel]

 

 

I would agree with your number 1. There is a constant seller in the market that is knocking down the price and it is likely former AWH holders that waited for 2018 to sell for lower tax rate on their capital gains. To be honest this is like looking a gift horse in the mouth I would like Prem to pick off all of those shares being sold.

 

 

[LightWhale]

Thanks Petec, Fairfacts and TwoCities,

I'll start digging in on the weekend.

[jfan]

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

 

I was wondering if someone could help me understand something I noticed with FFH's goal to hit a 7% investment return.

 

The average investment portfolio allocation (2000-2017) with respect to cash & short term investments/bonds/stock is the following:

28%/52%/18% (2% in real estate and preferred shares).

 

The 2017 allocation is 49%/26%/23% (2% in real estate and preferred shares).

 

Their 10 year stock return was 4.2% as per their annual report. Assuming a 1.5% return on cash and 2.8% return on bonds. The total investment return is in the order of 2.4% currently.

 

This is significantly far from FFH's goal of 7%.

 

So I did a little digging into their 2017 annual report and came across pg 174 which describes their investment portfolio returns since 1986.

Taking their total return on average investment, I calculated their investment return based on the business cycles. What I got was this:

 

Time interval Geometric Return

Since inception 8.02%

Last 5 years 1.79%

Last 10 years 5.12%

Last 15 years 6.50%

Business Cycle

1986-1991 10.8%

1991-2001 8.9%

2001-2009 10.4%

2009-2017? 3.9%

 

So historically, their returns were above their target 7%. With the last cycle performing poorly (due to the hedging activity).

 

There was a change in accounting practice whereby at least on the table, 2007 to present is IFRS and before that CGAAP.

But included in the table are columns that include "Change in unrealized gains/losses on investments in associates". This is the difference between the Fair value less carrying value of T+1 and FV less carrying value of T0.

 

I notice that over time, there has been a progressive increase in unrealized value over time which is contributing to the total return.

 

I am a bit conflicted with respect to whether this is too aggressive (ie counting your eggs before that are actualized) or whether this would be appropriate given FFH's tendency to seemingly build value in its associates over time (eg Thomas Cook, First Capital).

 

An investment in FFH is really a bet on their ability to improve their investment returns over time. If the inclusion of their unrealized fair value gains is kosher, than perhaps the probability of FFH achieving their average return of 7% would be slightly less far-fetched.

 

Interested in hearing your thoughts on this manner.

 

Jerome

 

 

 

 

 

 

 

 

[StevieV]

As you point out, 7% is aggressive.  Difficult to get there without a change to the mix, and some higher rates.

 

What is interesting is that Fairfax's investment style may make 7% more plausible, while at the same time making a big miss also more of a possibility.  I am not sure if that is a good thing.  Somewhat higher rates, somewhat more aggressive mix, better underwriting and more conservative stock investments may make 7% investment returns less likely, but it may make double-digit BVPS growth more likely. 

[StubbleJumper]

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

 

I was wondering if someone could help me understand something I noticed with FFH's goal to hit a 7% investment return.

 

The average investment portfolio allocation (2000-2017) with respect to cash & short term investments/bonds/stock is the following:

28%/52%/18% (2% in real estate and preferred shares).

 

The 2017 allocation is 49%/26%/23% (2% in real estate and preferred shares).

 

Their 10 year stock return was 4.2% as per their annual report. Assuming a 1.5% return on cash and 2.8% return on bonds. The total investment return is in the order of 2.4% currently.

 

This is significantly far from FFH's goal of 7%.

 

So I did a little digging into their 2017 annual report and came across pg 174 which describes their investment portfolio returns since 1986.

Taking their total return on average investment, I calculated their investment return based on the business cycles. What I got was this:

 

Time interval Geometric Return

Since inception 8.02%

Last 5 years 1.79%

Last 10 years 5.12%

Last 15 years 6.50%

Business Cycle

1986-1991 10.8%

1991-2001 8.9%

2001-2009 10.4%

2009-2017? 3.9%

 

So historically, their returns were above their target 7%. With the last cycle performing poorly (due to the hedging activity).

 

There was a change in accounting practice whereby at least on the table, 2007 to present is IFRS and before that CGAAP.

But included in the table are columns that include "Change in unrealized gains/losses on investments in associates". This is the difference between the Fair value less carrying value of T+1 and FV less carrying value of T0.

 

I notice that over time, there has been a progressive increase in unrealized value over time which is contributing to the total return.

 

I am a bit conflicted with respect to whether this is too aggressive (ie counting your eggs before that are actualized) or whether this would be appropriate given FFH's tendency to seemingly build value in its associates over time (eg Thomas Cook, First Capital).

 

An investment in FFH is really a bet on their ability to improve their investment returns over time. If the inclusion of their unrealized fair value gains is kosher, than perhaps the probability of FFH achieving their average return of 7% would be slightly less far-fetched.

 

Interested in hearing your thoughts on this manner.

 

Jerome

 

 

 

I tend to think of the investment return as something which excludes the private investments which are not readily marketable, but others may wish to include them.

 

Turning to the publicly traded investment return, I'd say that 7% is not a ridiculous hurdle over the longer term.  The 10-year treasury rate has been exceptionally low for about the past 10 years, but it seems to be slowly trending up.  For an outfit like FFH that must hold a large portion of its reserves in the form of sovereign debt, such low rates kneecap their longer term ability to achieve a weighted average of 7% (but in the short term, when prevailing rates decline and Bradstreet shifts from 10-year to 2-year rates, there's a benefit).  Thinking forward a year or two, if we return to a world where financial repression no longer exists and the 10-year treasury returns to say 4% or 4.5% and if you believe that equities have a long-term return of 9 or 10%, it doesn't take a lot of imagination to get to a weighted return of 7% (you wouldn't need much alpha to get there).

 

 

SJ

[Spekulatius]

Anyone turned off the lights here yet?  FFH has gotten absolutely wrecked. I am not quite sure why, their holdings aren’t of the best quality, but their insurance business is really not affected by an economic slowdown.

[StubbleJumper]

Anyone turned off the lights here yet?  FFH has gotten absolutely wrecked. I am not quite sure why, their holdings aren’t of the best quality, but their insurance business is really not affected by an economic slowdown.

 

 

Lots of good companies have gotten wrecked.  The Canadian banks are trading at relatively low multiples and their divvies are approaching 5%.  Even BRK has been administered a haircut.

 

At this point, should we begin to consider FFH to be a dividend stock?  ;D  The good news is that I have no doubt that FFH will be buying back shares, hand over fist, if they can scrape together a bit of cash.

 

 

SJ

[TwoCitiesCapital]

Anyone turned off the lights here yet?  FFH has gotten absolutely wrecked. I am not quite sure why, their holdings aren’t of the best quality, but their insurance business is really not affected by an economic slowdown.

 

They got wrecked because long-term yield have come down ~0.50%. The story of a secular rise in Fairfax's interest income from higher rates is now being questioned.

 

If the Fed is coming to the end of it's tightening cycle, it means Fairfax missed their opportunity to roll into longer-duration debt to lock in higher earnings for the long-haul and it's quarterly profits are dependent on the Fed not cutting rates.

 

.

[Jurgis]

Anyone turned off the lights here yet?  FFH has gotten absolutely wrecked. I am not quite sure why, their holdings aren’t of the best quality, but their insurance business is really not affected by an economic slowdown.

 

I am holding what I have had for X years now, but I'm not buying. BRK seems more attractive and so do some other stocks (including the ones that BRK may be buying).

[obtuse_investor]

Same situation here. I have been owning FFH for years. At this time (timestamp: S&P ~20% drawdown) I am not adding to FFH because relatively speaking, higher quality assets like BRK (and even MKL) are a better buy.

 

I just hope HWC is busy these days, carefully buying high quality assets.

[Spekulatius]

Same situation here. I have been owning FFH for years. At this time (timestamp: S&P ~20% drawdown) I am not adding to FFH because relatively speaking, higher quality assets like BRK (and even MKL) are a better buy.

 

I just hope HWC is busy these days, carefully buying high quality assets.

 

I haven’t added either, in fact I sold a few shares when there was a spike to $480 a few weeks ago. My concern is that HWC busy buying low quality assets. there are some dislocations in the credit markets, that they pot. could take advantage of, or perhaps just buy back their own preferreds (if that is possible).

[shalab]

I too have cleared my FRFHF in favor of Berkshire. Berkshire is a high quality business which will find ways to deploy its tens of billions of dollars in money making ventures. Furthermore with the addition of buy backs, I can easily see Berkshire returning 10-15% per year in the next decade.

 

FRFHF has a huge exposure to BB which is cratering. It also has a portfolio of low quality businesses.

 

The attractive thing about FRFHF is exposure to India - which is a high growth market. GDP is expected to grow from 2.6 trillion to 5 trillion in the next decade. One simply has to open a brokerage account in India and buy Thomas Cook which is FRFHF's India arm. There is no need to own FRFHF. In addition, there are other investment vehicles available in India other than FRFHF.

 

Same situation here. I have been owning FFH for years. At this time (timestamp: S&P ~20% drawdown) I am not adding to FFH because relatively speaking, higher quality assets like BRK (and even MKL) are a better buy.

 

I just hope HWC is busy these days, carefully buying high quality assets.

 

I haven’t added either, in fact I sold a few shares when there was a spike to $480 a few weeks ago. My concern is that HWC busy buying low quality assets. there are some dislocations in the credit markets, that they pot. could take advantage of, or perhaps just buy back their own preferreds (if they is possible).

[chrispy]

Shalab, Fairfax India Holdings would check the boxes to what you are describing, right?

[shalab]

Yes, Fairfax India will also work but I don't like their fee structure. One can do better by opening a brokerage account in India - it is a bit of a hassle but well worth the trouble IMO. My belief is that India will do a lot better than China in the next decade.

 

Shalab, Fairfax India Holdings would check the boxes to what you are describing, right?

[ERICOPOLY]

Some of these holdings are attractively priced now... if they don't repurchase them, what will I be led to believe?

 

 

This is written in the 2017 letter:

 

While we realized $1.0 billion on the sale of these long term common stock holdings, these compound growth

machines resulted in us leaving $1.4 billion on the table. A costly mistake we will try not to repeat!

 

 

[Dazel]

 

 

Yep I see it too....

I don’t see any company more equipped to kill it on this mini crash....full of cash and short term bonds.

[ourkid8]

I really do not see FFH deploying much of their cash as I have highlighted previously, their focus is buying back their Subs and using FCF to buyback stock.

 

Yep I see it too....

I don’t see any company more equipped to kill it on this mini crash....full of cash and short term bonds.

[StubbleJumper]

I really do not see FFH deploying much of their cash as I have highlighted previously, their focus is buying back their Subs and using FCF to buyback stock.

 

Yep I see it too....

I don’t see any company more equipped to kill it on this mini crash....full of cash and short term bonds.

 

 

The deploying of cash would really simply amount to shifting insurance reserves from short-term treasuries into something else, possibly longer term fixed income or equities.  I have my doubts that a ~20% drop in the broad market would suddenly make FFH jump all over equities.  After all, it wasn't so long ago that they had their entire equity portfolio hedged, which would lead me to believe that they were worried about it being perhaps 50%+ over-valued and seriously at risk of a 1-in-50 or 1-in-100 year equity event.  Maybe they nibble around the edges and buy a few select equities.

 

Turning to capital management, I would agree that we should expect them to deploy more capital to buying the minority positions.  I am a bit skeptical about FFH's dedication to buybacks, but time will tell.  They've certainly already bought back more than I expected they would.

 

 

SJ

[petec]

Some of these holdings are attractively priced now... if they don't repurchase them, what will I be led to believe?

 

Do you think they have a lot of capacity to add equity exposure? I fear they’re close to their practical limit. The selloff they need is in corporate and long dated bonds.

[ERICOPOLY]

Some of these holdings are attractively priced now... if they don't repurchase them, what will I be led to believe?

 

Do you think they have a lot of capacity to add equity exposure? I fear they’re close to their practical limit. The selloff they need is in corporate and long dated bonds.

 

That wasn’t the point I was making.

 

They said that they will try not to repeat the costly mistake.  How else can they avoid further opportunity cost than to buy them back?

 

They bought these equities initially and then stated something about how they had learned to hold high quality shares for the long term.  Then they sold soon afterwards and now they say they have learned a lot about how much the sale has cost the shareholders.

 

So if they don’t buy them back, what am I then to think?