Fairfax Financial ($FRFHF) — Initiation (9/23/21)

Followers of Berkshire Hathaway will be pretty familiar with this one-pager view of operating results… Fairfax ($FFH.TO in CAD and $FRFHF in USD) and its CEO Prem Watsa have been called the “Canadian Berkshire” or the “Warren Buffett of Canada.”

Fairfax results 1985-2020

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[Quick note: First comment right off the bat and something to keep in mind throughout this post. Though this is a Canadian company, figures are mostly reported in USD. The ticker FFH.TO is quoted in CAD while over-the-counter ticker $FRFHF is quoted in USD. If you’re looking at fundamentals here, be sure you’re comparing USD-to-USD or CAD-to-CAD!]

Some of the main US insurers are heads down focused on the same playbook of: a) maintaining underwriting profits to protect float; b) invest capital in operating businesses; c) deploy insurance balance sheet in public equities.

Fairfax is employing an entirely different model. It’s heavy on insurance with minimal non-insurance operating subsidiaries. It’s heavy on investments at various levels of ownership — from a few % up to 70-80-90% stakes. Prem is betting heavily on operators without needing to wholly own those businesses. As such, there’s a little more activity in buying/selling stakes (i.e. portfolio turnover).

I’m not going to make this any more complicated than it needs to be. The stock is cheap relative to book and nearing historic lows in that regard (for reference, Fairfax trades at a cheaper multiple of book today than it did during the financial crisis in 2009).

Price and Book Value 2015-2Q21

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There are fundamental reasons to like the stock too:

Fairfax consists of the following high level business units:

  • Insurance operations
  • Non-insurance operations
  • Investments in Associates
  • HoldCo balance sheet

I’m only going to highlight / walkthrough each of these areas… Not try to value each of them individually. There are so many moving pieces to this juggernaut you could analyze it to death. Simplistically, book value is a good representation of value while potentially being conservative given lower carrying value of certain investments.

The insurance operations…

The primary business line at Fairfax is insurance and reinsurance. There are a number of operating subsidiaries in here and most are wholly-owned but there are plenty with 70-90% ownership stakes and a few others that are not consolidated with less than 50% ownership.

Fairfax is a global insurer but the majority of business is done in the US/North America (76% of 2020 premiums). They primarily write property & casualty business (91% of 2020 net premiums) with a small specialty division (9% of 2020 premiums).

Here’s a look at the insurance group as of 12/31/20:

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I referenced the hard market in insurance and Fairfax is no stranger. Underwriting profit was $318m in 2018, $395m in 2019, $309m in 2020 and close to $600m over the past 12 months!

The concept of “float” gets tossed around with insurers; this idea that if you generate consistent underwriting, then you’re “borrowing” money at low/no cost to deploy toward other endeavors like stocks or operating businesses. Fairfax has a pretty decent long-term track record of underwriting profitability though it has been lower and inconsistent the past 5 years.

Cumulative float performance

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Another Twitter account pointed me to this comment from Alleghany President Joe Brandon which sums up the industry fairly well (bolds are mine):

We have not made a nickel in property underwriting profits on a cumulative basis in the last 5 years. So despite everybody talking about fixable property rates, we don't have the underwriting profits to show it. And that's true at the reinsurance level and that's true at the E&S level. So anybody who thinks these rate increases the industry is getting aren't justified, I think, doesn't have an appreciation for what the industry has gone through in terms of losses in the last 5 years. And I don't think we're the exception. I don't think there's any "smart money" in the property business these days. I think anybody who has been writing this business for 5 years has probably lost money and at best, they've made a little bit, but the returns on capital are unattractive for this risk. And it doesn't matter whether you're alternative capital, traditional capital, E&S, London, U.S., it's just been a very rough patch. And we're now coming up on the fifth year of frequency of $10 billion to $20 billion events around the world. And maybe it's climate change, maybe it's just a tough patch, but the industry has got to charge more for these risks.

We’re already seeing evidence of this in half year results for 2021…

Non-insurance operations…

These are the operating businesses (sort of). They are more like consolidated businesses that are otherwise publicly traded.

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Overall, these are not big profit contributors… Excluding investment gains and equity method earnings (from “Associates”), these collectively chipped in pre-tax earnings of $96m in 2019, a loss of $126m in 2020, and a loss of $32m over the last 12 months.

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Most of these are consolidated for accounting purposes but are not really operating subsidiaries of Fairfax in the true sense of the word. Many of them are publicly traded (i.e. Fairfax India, Dexterra, Recipe Unlimited, Thomas Cook, etc.). That’s a positive in the sense that you can quickly get a quoted value for Fairfax’s ownership stake; it’s a negative in the sense that Fairfax has no real operating subsidiary generating cash flow back to the parent for reinvestment by Prem (a la Berkshire).

  • From a valuation standpoint, the net assets of these businesses are lumped into Fairfax with non-controlling interest under the equity section. One approach could be to strip these out of the income statement and balance sheet and just take the number of shares owned times the current share price. Plenty of these are equity method investments deemed “Associates” (covered below), and therefore reflected in overall book value.

Equity-Method “Associates”

This is probably the 2nd largest piece of “value” in the Fairfax complex. There’s a huge web of investments (much like other insurers)… GAAP accounting typically treats it based on ownership percentages (skip ahead if you don’t care for the technical accounting background);

  • Mark-to-market; Less than 20% — Held as a mark-to-market investment on your balance sheet… typically just recorded at fair value as of balance sheet date… i.e. if you own 100 shares and the price is $10, you have an investment asset of $1000… Plain vanilla fair market value asset.
  • Equity method; Between 20-50% — Recorded as an “equity method” investment; this is a weird treatment that gets untethered from reality fairly quickly and Fairfax has lots of these… Your investment gets recorded on the balance sheet at cost and that cost fluctuates primarily on 2 factors alone: the dividends you receive from that investment and you share of that company’s net profits/losses. Well there are certainly companies out that there are a) not paying dividends; and b) growing intrinsic value without generating much net income. Fair value and carrying value do not always align.
  • Consolidated; Greater than 50% — Fully consolidated in your financials… this is important here as Fairfax has several of these… even if it’s a separate publicly traded company, all revenue, expenses, assets, liabilities, etc., full financials get recorded in the parent company’s accounts with a corresponding “non controlling interest” for the portion of the business not owned recorded in equity. It’s as if Fairfax wholly owns these businesses but then a small balance sheet account (NCI) gets booked to treat the minority interest portion. Where this can get tricky is when the parent (consolidator) has a very different market price than the consolidated subsidiary. For instance, the parent could be trading at a massive discount to book while a subsidiary trades at a premium; implying a heavily discounted “stub” value.

Back to the Associates section of the balance sheet. These are generally in the 20-50% ownership range. Footnote 6 helps to breakdown the components of these investments…

2Q21 Investments in Associates footnote

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Though the yearend disclosure is a bit more detailed…

2020 Investments in Associates footnote

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As of 12/31/20, associates were carried on the balance sheet at $6.4bn but had a fair value of $7.2bn… At 2Q21, they were carried at $6.7b and had a fair value of $9bn. Prem leaves us tidbits as to the value within these balances throughout his annual reports… For example, the recent sale of an equity interest for $165m with a 135% gain (below), or the 10-bagger investment in Digit

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  • Here’s the challenge with this value bucket — Until these investments are sold or monetized, they remain unreflected in the financial statements thanks to equity method accounting.

Many value investors would view that as a dream scenario. Especially if you can buy the whole at a discount to book value while knowing that book value is potentially massively understated. At some point, we need recognition of that value to close the gap.

Investments…

Some backstory here dating to 2010… Prem generated excellent returns from 2007-2010 during the GFC thanks to a hedging program. Post-GFC, those hedges remained in place (all the way to 2016)… Coupled with some bad stock picking, this had a disastrous effect on book value — amounting to $1.7bn in stock losses and $0.5bn in hedge losses during the 2010-2016 period.

2016 annual report - investment performance

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Investment mistakes are starting to turn the corner which is fairly easy to see in book value growth… 2017 and 2019 were good years with solid earnings and BV increases while 2018 and 2020 barely covered the common dividends. Owning Fairfax is an implicit bet on Prem and his investment decisions.

There is some great information in the shareholder letters / annual reports each year (though it also feels like information overload and several tables feel like they don’t tie back to one another).

2020 annual report - investment performance

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You can see in this table that the Investments in Associates are more valuable on the balance sheet than they are through the P&L… we have 2Q21 balance sheet fair value at close to $9bn yet these investments have produced a cumulative $941m in earnings from 2010-2020…

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Interest rates are low and therefore insurers will need to work harder to generate investment returns (or charge higher rates on insurance products — something we’re seeing now). Fairfax has already had very low yields on its portfolio for many years.

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Lastly, here’s a glimpse at some of the mark-to-market common stock holdings at Fairfax — though these are dated as of the 2020 annual report:

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Balance sheet / Holding company…

The insurance assets and bonds more than offset insurance liabilities (float). That leaves holdco debt and a huge chunk of investments in stocks, private businesses, and some derivatives — totaling some ~$13bn at 2Q21 (up from $11.9bn at end of 2019).

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Unlike Berkshire, Fairfax runs with a decently large net debt position (i.e. more borrowings than cash).

HoldCo financial position 2016-2020

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Again, the Fairfax model just isn’t prone to building cash when compared to a Berkshire or a Markel. They have wholly owned operating subsidiaries generating free cash flow to send back to the parent. Fairfax has a small(ish) stream of earnings from insurance operations (plus its float) and then must sell/monetize an investment to reinvest into something else.

There’s also larger use of preferred shares and non-controlling interests. So you’ll need to do some extra work to unpack the balance sheet. Assets to equity ratios are a good proxy for leverage at a financial and Fairfax runs quite a bit higher than peers (though not as high as some).

Valuation / target price…

After that look into the business I’m going to use what feels like an overly simplistic look at a valuation. Most of the detail is just supporting argument.

Historically, Fairfax has traded at about a 10% premium to book value:

10yr avg P/B ratio

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I think book value is understated based on portfolio holdings and future profitability in the insurance division. Fairfax may not have the best insurance business compared to peers but it doesn’t deserve as deep a discount relative to the group.

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Book value should be north of $570/share once the Digit investment is marked to market later this year. At 1.1x, shares would be worth $627 — more than 50% higher than today’s price — and this doesn’t account for a potentially robust 2021-2022 insurance market. (Remember, even if Fairfax generated $0 underwriting profit for the remainder of the year, it would still be a doubling of underwriting profits from 2020 to 2021.)

As to how I’m owning this security… This is still a General position for me with a larger-than-typical weighting — the discount is far too wide. I like the play to close the book value discount gap but beyond that, I’m not sure this is a Core position. There are a lot of moving parts and thus an implicit bet on Prem to make wise investments. These aren’t things you’ll see on the surface level financial statements or in cash flow figures. They’ll reveal themselves after he’s won or lost that particular bet — I don’t love that setup, even with his long term track record. Next is the levered balance sheet; almost the complete opposite of the story at Berkshire with a war-chest of cash to deploy… Fairfax has net debt and has lately been raising capital to deploy elsewhere.