Fairfax results?????????

[Daphne]

Hello everyone:

Thought it might be time to get the speculation ball rolling.  How does $425 book value sound?

 

Daphne

[ERICOPOLY]

Hello everyone:

Thought it might be time to get the speculation ball rolling.  How does $425 book value sound?

 

Daphne

 

I'm thinking much lower than that.  Equities did not do well in the quarter, especially some of their bigger holdings like DELL, GE, WFC, USB, LVLT -- ugly.

 

How much do you figure they made in bonds?

[benhacker]

Yeah. I agree Eric, even with CDS spreads widening, I can't imagine book value made much, if any progress this quarter.

 

Ben

[StubbleJumper]

Hello everyone:

Thought it might be time to get the speculation ball rolling.  How does $425 book value sound?

 

Daphne

 

I'm thinking much lower than that.  Equities did not do well in the quarter, especially some of their bigger holdings like DELL, GE, WFC, USB, LVLT -- ugly.

 

How much do you figure they made in bonds?

 

 

The equities are partially hedged.  I took a quick look at the bonds a few weeks back, and figured that the unrealized gain might be as high as $1B (using the sensitivity table that FFH publishes, I applied about a 100bps decline).  But that was pretty quick and dirty.

 

Ultimately I don't much care about the quarter-to-quarter results.  The bigger question is whether management is positioning the company correctly for solid long-term returns...and I would say that is a resounding yes.

 

SJ

[Viking]

At the end of the day I expect book value to fall at FFH (around $378) when they report Q2 results. My guess is they also have been buying back some stock (although this may have happened in July and we may not know for another 3 months). I will be watching to see if they have sold another chunk of equity holdings in Q2...

 

Here is my very rough calculation of what FFH should earn in Q2:

1.) Underwriting income (CR = 102) = - $25 mill

2.) Int / Div Income (Q4 $172.4) = $175

Operating Income = $150

3.) Net Gains on Invest = -$200 (incl unrealized gains)

4.) Interest Exp = -$50

5.) Corporate Overhead = -$25

Pre Tax Income = -$125

6.) Inc Taxes (28%) = $35

Increase in BV = -$90 = -$5/share

 

Q1 BV = $383

BV Growth = -1.5%

 

Net gains on investments is the black box. The equities (I think) were down June 30 about $450 million. Yes, 30% of this is hedged. US Treasury yields came way down; most of FFH holdings are munis and corporates which did not see the same movement as Treasuries. FFH also does a large amount of other interesting things every quarter so they may have anticipated the decline in equities and sold some or hedged further. Bottom line, my guess is realized gains + unrealized gains are negative for the quarter (with risk to the downside).

 

[ERICOPOLY]

The equities (I think) were down June 30 about $450 million. Yes, 30% of this is hedged.

 

I believe they were only 6.5% hedged after you take into account the fact that the hedge did nothing for them above 10,600 on the S&P500 and the market started the quarter at 11,700.

 

Last I heard, the strike on the hedges was 10,600 on the S&P500.  Below that level, 30% of the portfolio is hedged.  But above that level nothing is hedged -- unless they added more hedges, be we don't know about that yet.  I weighted it, and as it turns out (benefit of hindsight) being 30% hedged below 10,600 was just as effective as being hedged 6.5% at 11,700.

 

 

[DCG]

How does $425 book value sound?

 

Unrealistic.

 

I'm not really expecting a BV gain from last quarter, and think there's a good chance of a BV loss.

[T-bone1]

My understanding is that the hedge is an inverse total return swap . . . the equivelent of being short the S&P 500 to the tune of 30% of the March 31 equity portfolio. They put this hedge on at a level of 1060, so it hurt them as the market rose above this level, but will help them on the way back down. 

 

I think Viking is about right on BV, or at least as accurate as we are going to get.  I would be encouraged by buybacks, but wouldn't count on it.

[Guest Bronco]

If this company bought back shares above book value, I would be disappointed.  Surely there are better allocations of capital out there.

 

I've always had a problem with the great "allocators" of capital buying back shares and reducing the capital they can allocate.  Makes no sense, other than if the stock they own is the best possible investment at a given time.

 

That is why I have been critical of Eddie Lampert, even though I think that SHLD is cheap right now. 

 

I like the safeness, flexibility, and growth in a company's capital that is provided by investing excess cash (as opposed ot the buyback).  The great Warren Buffett doesn't pull these stunts.  Which gives me a good idea for a new thread...

[ERICOPOLY]

If this company bought back shares above book value, I would be disappointed.  Surely there are better allocations of capital out there.

 

I've always had a problem with the great "allocators" of capital buying back shares and reducing the capital they can allocate.  Makes no sense, other than if the stock they own is the best possible investment at a given time.

 

That is why I have been critical of Eddie Lampert, even though I think that SHLD is cheap right now. 

 

I like the safeness, flexibility, and growth in a company's capital that is provided by investing excess cash (as opposed ot the buyback).  The great Warren Buffett doesn't pull these stunts.  Which gives me a good idea for a new thread...

 

 

I was just about to say the same thing.

 

Their team must be talented enough to find cheaper stocks than FFH.  They've raised capital by selling shares enough times by now to realize that being short on capital is not a good idea.  Therefore, buying shares in other cheap companies rather than their own shares gives them the OPTION of just selling those shares into the market to raise cash should they ever need cash in the future. 

 

I see buying their own shares as a service to shareholders who wish to sell -- gives them a buyer.  But not a service to the long term shareholders unless it's the best investment they can find.

[gaf63]

From pg. 76 of the AR:

At December 31, 2009, the fair value of the company’s investment portfolio included approximately $11.5 billion of

fixed income securities which are subject to interest rate risk. Fluctuations in interest rates have a direct impact on the

 

market values of these securities. As interest rates rise, market values of fixed income portfolios decline, and vice

versa. The table below displays the potential impact on net earnings and other comprehensive income of market

value fluctuations caused by changes in interest rates on the company’s fixed income portfolio based on parallel

200 basis point shifts in interest rates up and down, in 100 basis point increments. This analysis was performed on

each security individually. Given the current economic and interest rate environment, the company believes a

200 basis point shift to be reasonably possible.

 

 

December 31, 2009 Hypothetical $ change

effect on:

200 basis point increase 9,689.3 (448.6) (752.3) (15.5)

100 basis point increase 10,535.9 (241.5) (389.4) (8.1)

No change 11,468.4 – – –

100 basis point decrease 12,434.0 268.9 384.1 8.4

200 basis point decrease 13,521.5 585.7 806.0 17.9

 

7 yr. treasury declined .86 , 10 yr.- .87 in the qtr.  ,  

on total bond portfolio the value increase would be  793 mil

If you totally exclude the muni portfolio, the increase would be 457 mil

Dont know how much the equity portfolio declined after hedges ,  but I would

think that net gains were flat to positive

 

Viking , how much did you allow for bond gains in your net gain calculation??

 

 

 

 

 

[T-bone1]

Lets say FFH is 35% off (should trade at 1.5 times book) and will grow at 15% per year (Prem's own public target).

 

Do you think JNJ is cheaper than this? What about Dell or GE?

 

If FFH can grow after-tax book value at 15% per year, how is this different from trading at a FCF yield of 15%?

 

FFH might not be as big and safe as JNJ (or just as big as GE or Dell, which I don't think are as safe), but this is also a positive as they can grow at a higher rate for much longer.

 

How many investments has Warren Buffett ever made that would have performed better than buying his own stock? Has KO or AXP outperformed BRK since 1970?

 

I agree that managers/owners shouldn't take their eye off the ball (as some say Lampert did) and make buying back their own stock a primary business activity, but I think FFH is cheaper than any of FFH's large investments, and will have a better return, so I think allocating $400MM to buybacks along with $400MM to WFC makes sense.

 

I realize that they recently had to issue shares, but what's done is done and it shouldn't change the math on what the best decision is right now.  This company is trading at roughly tangible book value (after ICICI adjustments). This means you are paying nothing for an insurance company that I think will be the next AIG (in a good way - pre 2000).  Most people on this board don't seem to want to own this insurance company, but I do, and I know Prem Watsa does. Every share they buy back at book value give them more of this insurance company for free. Maybe none of you believe the insurance company can have an average CR under 100 over time and grow all over the world, but I do, and Prem says they wouldn't run the business if they couldn't get good underwriting results.  

 

I think FFH is cheaper now at book value - due to its quality - than it was at $100 a share when I started buying, at roughly 85% of book if I remember correctly. I don't understand why a group that was so bullish on this company at higher valuations doesn't think it is cheap now.  Prem says that when the market turns they will write twice as many premiums at better loss ratios and dramatically lower their expense ratio. Does everyone think he is senile or wildly optimistic?  I think he won't buy back shares because he is saving the capital for the insurance business, but I would rather own FFH than any of FFH's large equity investments. What would BRK be worth today if Warren bought back 10% of the shares in 1970?

[Parsad]

Hi T-bone,

 

I don't think anyone disagrees with your assessment, and most people think Fairfax is still cheap.  But whether we like it or not, its results will be ultimately tied to insurance premium rates and investment opportunities.  We are not in a hard market...no where near a hard market!  It could be a couple of years before insurance premiums get better. 

 

In that respect, there may be other businesses in the short-term that may have better results simply because they are not tied to the insurance industry.  But yes, when the insurance market turns, Fairfax will be better positioned than almost anyone else, and its price today will look very cheap.  Cheers!

[Guest Bronco]

T-bone - I think you are missing my point.  Goldman and GE were buying back tons of shares (MANY billions) right before the crash.  Then they needed to raise it - when their shares were much cheaper.

 

When you buy back shares, you by definition reduce your capital.  What would BRK be worth if WEB bought back shares?  I have no idea.  But you would have taken 10% of his investment potential away where he invested the capital and grew the capital base.  That higher capital base allows him to write more policies, increase float, make more investments, etc. etc.  If Buffett took that crappy textile mill and did nothing but buy back shares, well the company wouldn't be worth s--t and you and I would have never heard of him.

 

IMO - buybacks are a simple way to say FU to the shareholders.  I qualify that by saying a buyback is ok if it is the best possible investment option (risk vs. reward) available.  Even then I am skeptical.

 

I am more interested in capital growth than capital destruction.  Thats just me.  By the way, there is nothing wrong with a dividend.  Excluding the impact of taxes,  I can accomplish the same thing as a buyback by reinvesting my dividends to buy shares.  And I can mitigate the taxes in a 401k, roth, or whatever.  But at least I have the option of investing the shareholder earnings in the best possible equity.  A better choice for me instead of a board of directors who shows up 4x a year and makes that decision for me.

 

Think of it this way.  Imagine Coke makes $500 million a year in profits allocated to Buffett.  In scenario 1, Coke takes the $500 million and buys back shares.  In scenario 2, it pays out the cash as a dividend.

 

Now fast forward to the real world and look at what Buffett does with dividends.  Does he invest back in Coke?  No - he allocates to the best source.  But in scenario 1, you kill off Buffett's investing prowess.  If Buffett was cool with scenario 1, he would reinvest all dividends back into Coke.  He isn't doing that.  Because he is always looking for the best investment.  Always.  

 

Fairfax is an insurance company.  Insurance companies need capital to exist.  The more capital, the more they can grow.  The more policies they can write.  I don't know why I would invest in a insurance company that wants to lower its capital.  How will it grow?  If there is excess cash, give it back to me, the owner.  

 

Alright, enough of me rambling...you get my point and my opinion...

[ERICOPOLY]

If the dividend tax rate were zero we wouldn't have all this excitement over buybacks.  One could then either buy the shares if they wish, diversify it to other investments, or just spend it  :)

 

This is solely a nice tax issue.  Buybacks and dividends are both a means of returning capital to shareholders.  

 

There is a hard market coming at some point.  Rather than return too much capital to me now, I'd rather they find investments today to try to grow their capital.  Then when the market hardens, they can leverage that capital by writing more insurance at highly favorable prices.

 

I think that will generate higher returns than buying back shares.  The reasoning is clear -- when you buy back shares, you increase your ownership of their current book of float where the underwriting profits are not good.  But when you retain the capital in the business for future underwriting in a hard market, you will then have a higher mix of highly-profitable underwriting.  Thus, more intrinsic value per share should be realized by NOT buying back shares when the underwriting book is sorry -- give it time... wait for the hard market and grab as much juicy business as possible.

 

 

 

[Guest Bronco]

Ericopoly - you make a good point.  With a dividend rate of zero (which I think makes perfect sense with a 35% corporate rate), a buyback would be a 100% slap in the face.

 

However, I never viewed buybacks of returning capital to shareholders.  I view it as returning capital to ex-shareholders, as the SH's who sell get the cash.  Long term shareholders are left with a worsening balance sheet.  Maybe a greater % of future earnings, but also a more leveraged balance sheet.

[ERICOPOLY]

Ericopoly - you make a good point.  With a dividend rate of zero (which I think makes perfect sense with a 35% corporate rate), a buyback would be a 100% slap in the face.

 

Yes well I theorize that buybacks are probably statistically more likely at companies where the big boys in charge have a very large amount of money invested. 

 

A small shareholder who owns the shares in a tax-advantaged retirement account is like "just give me the fu**** money you ****hole", but the big CEO is trying to selfishly manage his own tax load.

 

Just a theory!

[ERICOPOLY]

A psychologist could probably entertain himself for a good long while by studying the effects of market crashes on wealthy investors of stocks that pay out a high percentage of earnings as dividends vs shares that pay little to no dividends.

 

I would suspect that those who get the dividends worry less about the crashes.  Hey, as long as the checks keep showing up where's the reason to sell? 

 

This then truly feels like a real business rather than a piece of paper -- you can actually get your hands on the cash and understand that you own something that does more than just wiggle around on a chart.  It become to feel like the brick and mortar store down on Main Street that your neighbor owns 100% of.

 

[turar]

This then truly feels like a real business rather than a piece of paper -- you can actually get your hands on the cash and understand that you own something that does more than just wiggle around on a chart.  It become to feel like the brick and mortar store down on Main Street that your neighbor owns 100% of.

 

 

I can really relate to that feeling. Psychologically, it's much harder for me to invest in stocks that do not pay dividends, even if other fundamentals are better.

[Myth465]

Hey Eric do you feel better about SSW and FUR vs. something that wiggles around.

 

I think once you start living off dividends and you wont have to work again, you view things differently. I like getting my checks.

 

I like buybacks as well but they are usually done wrong, my company bought back shares in the $40 range and then stopped to "concern capital" during the financial crisis at $18 a share. The right time to buyback shares is similar to the right time to buy stocks in general (when you dont want to / are scared to). I would hate to see FFH buying back shares at 98% book value. Also I believe they were looking for a ratings upgrade.

[ERICOPOLY]

Hey Eric do you feel better about SSW and FUR vs. something that wiggles around.

 

Mr. Market is necessary for realizing the intrinsic value of shares that don't pay dividends -- you depend on him and NEED him. 

 

Yesterday's 25% increase in SSW's payout made me happy.  I can live off of my dividends -- so literally I can ignore Mr. Market. 

 

It impacts my psychology.

 

Were they to have instead cut the dividend to zero, it would have given me a diminishing sense of control.  I would be in psychological handcuffs, begging Mr. Market to be merciful.  Oh please, please give me a fair price... I want to pay the mortgage and if you keep offering me 50% of fair value my money will run out twice as fast.

 

 

[Viking]

gaf63, here is my rough math: "Net gains on investments is the black box. The equities (I think) were down June 30 about $450 million. Yes, 30% of this is hedged. US Treasury yields came way down; most of FFH holdings are munis and corporates which did not see the same movement as Treasuries. FFH also does a large amount of other interesting things every quarter so they may have anticipated the decline in equities and sold some or hedged further. Bottom line, my guess is realized gains + unrealized gains are negative for the quarter (with risk to the downside)."

 

I do not have a very precise view on the bond changes. It looks to me that muni bond yields were flat for the quarter. My guess is corporates were slightly postivie. Yes, gov't bonds moved a fair bit. Total bond portfolio increased in value but not by a great deal (unless FFH has some leveraged positions to long Treasuries which very well may be the case).

 

Equities = -$450

Bonds/Hedges = +$250

Net = $-200

[RichardGibbons]

Buying back shares at a good price is a good thing because the goal isn't to grow the value of the company, it's to grow the value per share of the company.  If we just wanted to grow the value of the company, we could just issue shares again and again, and the market cap would go up higher and higher, while our share price went lower and lower.

 

The problem is that growth has a cost.  Buffett has said with a million dollar portfolio, he'd be able to do 50% annual returns.  As you grow, the universe of potential opportunities diminishes, which means that your returns would typically diminish as well.  Similarly, if Fairfax had 50% less capital for underwriting, they could get rid of 50% of their least profitable business.  And every dollar they make after that point could be put into more profitable underwriting opportunities than it would be put into otherwise.  (Except for the rare opportunity for which you need an absolutely huge capital base to underwrite, like that "win a billion dollars" lottery that Pepsi put on.)

 

So, buy buying back shares, you're not just increasing your earnings per share, but second-order effects make it much easier to grow your EPS at a higher rate, forever.  IMO, Buffett has done a disservice to his shareholders by not buying back shares when they're cheap.  (That said, when you've so admirably acted as a steward for shareholders in almost every other respect, this issue is a minor quibble.)

 

All that said, I trust that Prem will recognize these sorts of second-order effects and take them into account when determining whether or not it makes sense to buy back shares.

[gaf63]

Viking, thanks for the reply. 

 

I'm curious as to FFH's % holdings of treasuries compared to total bonds.  Anyone have an idea or where one could find out??

[ERICOPOLY]

 

Buying back shares at a good price is a good thing because the goal isn't to grow the value of the company, it's to grow the value per share of the company.  

 

 

It does nothing that you can't accomplish via instead paying a dividend and letting the individual shareholder buy more shares with the dividend.  Mathematically what I'm saying is an easily proven fact.  The only gotcha is the potential tax liability the shareholder may incur.  Anyhow, I'm sure you already know this given that I'm the amateur hobbyist and you're the experienced writer.

 

 

If we just wanted to grow the value of the company, we could just issue shares again and again, and the market cap would go up higher and higher, while our share price went lower and lower.

 

 

You probably misunderstood somebody on this thread -- I don't think anyone is advocating any such thing.  The fact that you had to say this suggests that you think we don't understand it though.

 

 

The problem is that growth has a cost.  Buffett has said with a million dollar portfolio, he'd be able to do 50% annual returns.  As you grow, the universe of potential opportunities diminishes, which means that your returns would typically diminish as well.  Similarly, if Fairfax had 50% less capital for underwriting, they could get rid of 50% of their least profitable business.  

 

 

As you suggest they could shrink by 50% by choosing not to renew certain business due to price.  However if you then reward the underwriters by firing them after they've held the line on price, that will go over like a lead balloon.  Because if you don't fire them, you'll have a rising expense ratio -- you couldn't for example keep continually halving your business as you hold the line on price and expect to make an underwriting profit.  At some point people will need to be fired.  It's quite a nasty culture we're starting here -- asking people to dig their graves.  My point is that I don't think you can do this quite as easily as you suggest without causing blowback -- if you behave disloyally I don't know what will happen.  But you won't get the combined ratio you want unless you fire them.  Heck, right now they could fire people but they're not doing it -- they have a climbing expense ratio at this very moment for this reason (holding the line on price).  They're probably not doing it because it is unwise -- Buffett himself has addressed this topic.  Plus, those people will come in handy again when favorable business prices return.

 

 

 

 

And every dollar they make after that point could be put into more profitable underwriting opportunities than it would be put into otherwise.  (Except for the rare opportunity for which you need an absolutely huge capital base to underwrite, like that "win a billion dollars" lottery that Pepsi put on.)

 

So, buy buying back shares, you're not just increasing your earnings per share, but second-order effects make it much easier to grow your EPS at a higher rate, forever.  IMO, Buffett has done a disservice to his shareholders by not buying back shares when they're cheap.  (That said, when you've so admirably acted as a steward for shareholders in almost every other respect, this issue is a minor quibble.)

 

All that said, I trust that Prem will recognize these sorts of second-order effects and take them into account when determining whether or not it makes sense to buy back shares.

 

Yeah, I don't think that fits into the Berkshire culture.  Buffett doesn't trade his wholly owned businesses, and he likes to hold onto shares for tax reasons.  If he keeps dry powder waiting around on the balance sheet, he can pounce when a good deal comes along.

 

Suppose he instead bought a meaningful amount of shares back (is there any other amount worth buying?) with that money.  Okay, it's time to play Gin Rummy, a game he doesn't like.  Does he now sell a wholly owned subsidiary in order to raise cash for the purchase, wrecking his culture.  Or does he sell some common stock, paying capital gains taxes?  

 

Then he likes to also be forever diversifying his income stream.  I believe he has at least once referred to Berkshire's income as comparable to the Amazon with it's many tributaries.  Buying more of the same income stream (buying back shares) doesn't accomplish this.

 

Anytime Berkshire's stock has been cheap there has probably been a very good deal that came along near the same time that he pounced on.  Then that deal grew a lot of capital, which then allowed him to buy another insurance company and lever it and on and on.

 

Yes, that does make the balance sheet grow and over time the compounding rate goes down.  Such is the problem with getting rich.  The trouble with Berkshire and Fairfax shareholders is that as we get rich we might not be looking to leave the boat... so if you think you can shrink the boat by 1/2 then where are the abandoned sailors going to go?  Where would Warren put 1/2 of his money if Berkshire gets too small and illiquid for him?  Somebody would have to be selling and giving up those shares -- at Berkshire if 1/2 of the people sold that would leave nearly all the remaining ownership to Warren.  That's unrealistic that they would sell at low prices -- and that must mean that Warren himself would have to sell out.  But then he's going to be competing with Berkshire as he picks stocks -- and he has in fact cited that very reason for not returning capital to shareholders.  He thought it through and decided it's just a policy he doesn't care to pursue.  It made more sense to him to just let Berkshire get bigger and bigger.

 

Going forward though he has created a contradiction.  He had a no-dividend policy because he didn't want to be competing with the other Berkshire shareholders.  But now he wants to give his wealth away.  So he can give it away instead of reinvesting it.  Maybe this means he can pay a dividend now if Berkshire runs out of things he wants to buy.