For years, Warren Buffett, CEO of Berkshire Hathaway
Prem Watsa is the man with the snazzy nickname, and Fairfax Financial Holdings
Investing Fire Power
As I discussed in an April article on RenaissanceRe
Over the past 10 years, the Chou Associates fund investing in U.S. equities has had an eye-opening 16.8% annual compound rate of return versus the S&P 500's 11.8%. That's a big gap: $10,000 invested at 16.8 % for 30 years would grow to more than a million, while at the S&P 500 rate, it would be still less than $300,000. With such significant outperformance, if Chou's fund were based in the U.S., rather than Canada, it would be considered a candidate for Champion Funds.
This solid performance, based on successful value investing principles, is also obtained by Fairfax's investment portfolio. In 2000, at the peak of the market, Fairfax had significant positions in bonds and S&P 500 put options, betting that both interest rates and the stock market would fall. Such investments led to realized investment gains of $840 million in 2003, not bad for a company with a market cap below $2 billion. And, like several other value investors including Buffett, Fairfax built up a huge cash position in the summer of 2003 to reduce the potential impact of increasing interest rates.
Like Berkshire, Fairfax has also attempted to apply the value investing strategy to acquisitions and the trading of its own stock. But while Berkshire Hathaway's key investments such as Coke
Looking for trouble
The problem with buying troubled insurers is that they tend to be troubled. For the first decade, Fairfax did great. Then, in 1998, as Berkshire was making its challenging acquisition of GeneralRe, Fairfax made its own difficult acquisitions of TIG and Crum & Forster. The purchase of TIG went so poorly that Fairfax decided to discontinue the majority of TIG's business in 2002. Crum & Forster did better but is only now approaching underwriting profitability.
Thus, despite Fairfax's spectacular history, it has some major negatives -- and several detractors who perform amusing contortions to cast Fairfax in a bad light. The bear argument is based on the belief that Fairfax's balance sheet indicates that a liquidity crisis is looming.
As Zeke Ashton discussed last year, Fairfax's relatively high levels of debt are worrisome. Watsa claims that de-leveraging is a priority and that he has pushed short-term debt maturities out in time. However, Fairfax's net debt-to-equity ratio has shown no real improvement at a high 55%.
Adding to this concern is the perception that Fairfax's leverage is understated because of the nature of some of the company's assets. First, there's the $885 million in deferred tax assets on the balance sheet. These assets arise when a subsidiary loses money. Suppose my business lost $100 last year but makes $500 this year. It would be unreasonable for the entire $500 to be taxed when I lost $100 the previous year. So, I can deduct that $100 loss from my profits this year and pay tax on only the remaining $400. A portion of that $100 loss is a deferred tax asset.
The bear argument is that the deferred tax assets aren't "real" assets and that Fairfax won't be profitable enough to fully utilize the assets before they expire. The first part of this argument has some truth. Fairfax would certainly have a stronger balance sheet if these assets were cash. Deferred tax assets won't help much in a liquidity crisis. The second part of the argument is less believable as more than 80% of the credits expire between 2020 and 2023.
A second asset-related concern is that third-party reinsurers will default on money owed to Fairfax. Suppose that Fairfax insures a company against a $100 million disaster but can't risk paying out the full amount should the disaster actually occur. Fairfax could purchase reinsurance for a large portion of that contract. Then, if the disaster happened, Fairfax would pay the $100 million, getting much of it back from its reinsurers. However, if the reinsurers didn't pay, Fairfax would have a problem. Since about $8.5 billion of Fairfax's assets are reinsurance recoverables, one can understand why investors might be concerned.
This concern is overstated, however. If you assume that insurers with A+ or higher credit ratings are extremely likely to pay and then take a high 5% default rate on those rated A, a 10% default rate on those rated A-, and 20% on the remainder, then Fairfax's net uncollectible reinsurance after existing provisions would be about $175 million. That's a lot, but less than the fluctuation in the value of Fairfax's bond portfolio in some quarters. It's possible to construct scenarios where Fairfax would have difficulties, but the problem is less acute than it might appear at first.
Probably Fairfax's biggest weakness is under-reserving and its history of underwriting losses. Watsa frequently expresses his desire to push Fairfax's combined ratio below 100. He was successful in 2003, but historically, he's achieved this goal only a third of the time. The under-reserving is a relatively new phenomenon but has occurred for several consecutive years now. Under-reserving is particularly disturbing because problems may surface years later. If you can't estimate the cost of insurance accurately, it must be pretty difficult to sell it profitably.
Valuation
Fairfax is the opposite of RenaissanceRe in that Fairfax makes its profits from investments rather than underwriting, a less predicable and therefore less desirable business model. Plus, despite some similarities, Fairfax is not Berkshire Hathaway. Buffett tries hard to never make a bet that could bring down the company, but Fairfax's acquisitions have caused many observers to question the viability of the company.
On the other hand, Fairfax is trading at a price-to-book value multiple of about 0.6, a huge discount to the Property and Casualty industry average multiple of 1.9. Watsa and Chou's records show that they're outstanding investors, and they have $12 billion to play with. With Fairfax's market cap under $2 billion, there is huge potential if Fairfax can reduce leverage and keep its underwriting costs under control. Several value funds, such as Longleaf International, a fund recently described by the editor of Champion Funds as "putting most of its competition to shame," are betting on Fairfax's success.
Thus, Fairfax has significant risks and isn't a stock to buy your mom. But for investors willing to risk a loss of some capital, there could be a large upside.
Richard Gibbons is aspiring to become the "Homer Simpson of the North." He owns shares of Fairfax Financial but none of the other companies in this report.
