Fairfax Financial Holdings is a Canadian insurance company. Through its subsidiaries, the company is engaged in property/casualty insurance and reinsurance. Using the premium float from the insurance business for their investment portfolio, management has been able to compound book value per share by 22.9% since its inception in 1986. Reason for that is the ability of Fairfax’s founder and CEO, Prem Watsa, to seek out above-average returns over a long period of time.
In Prem Watsa’s 2012 letter to shareholders, he is describing the concept, which has made Fairfax so successful:
“Our long term goal is to increase the float at no cost, by achieving combined ratios consistently at or below 100%. This, combined with our ability to invest the float well over the long term, is why we feel we can achieve our long term objective of compounding book value per share by 15% per annum over the long term.”
From the table below you can see the consolidated performance of Fairfax’s insurance business over the last decade:
|Year||Combined ratio||Underwriting profit/loss in USD million||Average float in USD million||Benefit/cost of float||Average long term Canadian bond Government yield|
From my perspective the last ten years give a good indication of a full insurance cycle also including significant losses due to unprecedented catastrophes in 2005 and 2011. So, what we have here is a continuously increasing float which on average cost the company 0.7% per annum. Hence, Prem Watsa’s long term objective to increase the float at no cost was not achieved over the last decade. However, the average cost of float is approx. 190 bps below the current yield for long term Canadian government bonds. As a consequence, Prem Watsa and his team of investment professionals are continuously receiving capital for additional investments from the insurance units at a very low cost.
The table below provides an overview of growth in book value compared to the S&P 500 for different time periods.
|Period||Compounded annual growth in book value||Compounded annual growth S&P 500 incl. Dividends|
Fairfax has done very well since the beginning of the financial crisis with a compounded growth in book value of 16.8% from 2007-2012, as Prem Watsa was one of the very few investors anticipating the financial meltdown in the US housing market.
In his 2005 letter to investors Prem Watsa outlined his current macro view:
“Having lived through the telecom bubble recently and the oil bubble in the late 1970s and early 1980s (and perhaps again today), we see all the signs of a bubble in the housing market currently. It appears to us that buying a house is today viewed as a sure shot investment – perhaps just as housing prices are on their way down, maybe significantly. The U.S. consumer is overextended, savings rates are below zero, credit spreads are at record lows and even emerging market countries are borrowing long term at very low spreads above treasuries.”
Therefore, from 2005 on they started to grow their holdings in credit default swaps and purchased protection on underlying credit exposure, when credit spreads were still low. It took some time until late 2007, but this investment strategy plus hedging the portfolio’s equities exposure worked out perfectly. During the financial crisis from 2007 to 2009 Fairfax grew its book value at an annual compounded rate of 35.0%.
Current Investment Portfolio
In his 2012 letter Mr. Watsa points out that:
” At the end of 2012, we had approximately $784 per share in float. Together with our book value of $378 per share and $127 per share in net debt, you have approximately $1,289 in investments per share working for your long term benefit.”
As a consequence, if Fairfax only earns 4% annually on its per share investment portfolio, it will still earn about 14% on its book value. Given Fairfax’s track record (with average annual returns of 9.4% since 1985) a 4% annual return on the portfolio is a conservative estimate going forward.
Fairfax’s current investment portfolio as of June 30, 2013 had USD 10.4 bn in bonds, USD 4.2 bn in common stocks, USD 0.5 bn in preferred stocks, USD 0.8 bn in private equity investments, USD 0.4 bn in derivatives, USD 0.1 bn in short sale obligations, and USD 7.5 bn in cash and short term securities for a total of USD 23.7 bn.
From my perspective there are currently three things to highlight with regard to their current investment portfolio:
First, in 2010 Fairfax again started to hedge their equity exposure. At the end of 2012 their equity exposure was fully hedged. Prem Watsa outlined the reasoning for this strategy in his 2010 letter to investors:
“If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today. However, we worry, as we have mentioned to you many times in the past, that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GNP remains flat for 10 to 20 years with many bouts of deflation. We see many problems in Europe as country after country reduces government spending and increases taxes to help reduce fiscal deficits. We see the U.S. government embarking on a similar exercise (as it has no other option) and all this while businesses and individuals are deleveraging from their huge debts incurred prior to 2008. Meanwhile we have concerns over potential bubbles in emerging markets.”
Second, in addition to hedging its equity exposure Fairfax has invested in CPI-linked derivative contracts. In his 2010 letter to shareholders, Prem Watsa is explaining the functioning of these derivatives:
“These are ten-year contracts (with major banks as counterparties) that are linked to the consumer price index of a country or region. Say the consumer price index in the U.S. was 100 when we purchased this contract. In ten years’ time, if the CPI index is above 100 because of cumulative inflation, then our contract is worthless. On the other hand, if the index is below 100 because of cumulative deflation, then the contract will have value based on how much deflation we have had. If, for instance, the index is at 95 because of a cumulative 5% deflation over 10 years, the contract at expiry would be worth 5% of the notional value of the contract. That’s how it works! Of course, these CPI-linked derivative contracts, like the CDS contracts previously, are traded daily among investment dealers. Prices in these markets will likely be higher or lower than the underlying intrinsic value of these contracts based on demand at the time. So there is no way to say what these contracts will be worth at any time. However, for a small amount of money we feel we have significantly protected our company from the unintended and insidious consequences of deflation. As an aside, cumulative deflation in Japan in the past ten years and in the United States in the 1930s was approximately 14%.”
Comparable to the CDS investments made, this is again a method to protect Fairfax from a devastating scenario with a small amount of capital to be invested.
However, so far this strategy did not play out and unrealized cumulated losses from equity hedges and CPI linked derivatives are approx. USD 1.8 bn.
Third, one of Fairfax’s major equity investments is their 10% stake in the Canadian mobile company Blackberry. The current value of this stake is approx. USD 550 m (original investment approx. USD 900 m). After a prolonged decline in share price, Fairfax entered into a letter of intent wit Blacberry and is offering USD 9 per Blackberry share in a buyout deal which is subject to further due diligence valuing the company at USD 4.7 bn. Fairfax is saying that they will not invest additional money, but expect its co-investors to commit the capital needed to go ahead with the acquisition. However, Fairfax’s management has not commented yet on who these co-investors are. So from my perspective it is relatively unlikely that the deal will go through. It seems like that Mr. Watsa’s goal is to put a floor on the share price and to attract other potential bidders. Fairfax will receive a break-up fee of USD 160 m, if Blackberry choses another buyer.
With a current price to book value of 1.1x the share price offers the opportunity to participate in the investment skills of Fairfax’s CEO Prem Watsa and his team at an attractive price. Although the company has not met its target to increase book value by 15% per annum during the last three years, chances are quite good that they will be able to achieve that goal over a longer period of time as they have done in the past.
Apart from that, an investment in Fairfax will provide a certain level of protection for WertArt’s portfolio, if markets come down substantially and/or the ongoing deleveraging leads to deflation.
I will establish a 5% position for the portfolio (Limit CAD 445) with Fairfax becoming one of the core positions in the portfolio. Please click here for more information on WertArt Capital and the virtual portfolio.
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