Earnings season gives us a chance to hear from some of the greatest investing minds out there. While most investors and analysts run around screaming about a few missed iPhones, there is useful, profitable information to be digested. For this edition of the anti-earnings season report, let's take a look at the discussion with Fairfax Financial Holdings (FRFHF 0.22%) management, including words from the value investing superstar-in-residence, Prem Watsa.
The report
Except for one small error in mistaking this year for the year 2010, Mr. Prem Watsa of Fairfax was his usual to the point, no-nonsense self in reporting the company's third-quarter earnings.
Book value ticked up almost 2% from year-end, adjusted for the $10 per share dividend paid out earlier in the year. The combined ratio, which tells us how an insurance company's underwriters are performing, was very strong, at 95.4% for the quarter and 97.1% for the year. This is a very attractive improvement over the combined ratio of 107.5% for the third quarter of last year. For comparison, Berkshire Hathaway's (BRK.A -0.34%) (BRK.B -0.01%) combined insurance operations have produced an underwriting profit -- that is, a combined ratio under 100% -- for nine straight years. The combined ratio is one of the most crucial elements to an insurance company's business -- if it's above 100%, the company is losing money on its underwriting. On an industrywide basis, P&C insurers generally operate at a combined ratio over 100%.
Various Fairfax subsidiaries continue to post strong gains in net premiums. For Zenith, net premiums were up over 27% for the quarter from the year before. Crum and Foster's net premiums were up nearly 20%, and Odyssey Re's up 6.1%.
Net investment losses dragged the results down to the tune of $26.3 million. Overall, decreased investment performance, though offset by the great underwriting results, brought net earnings down to $35 million from $974 million in the prior year. While that is a bit startling, keep in mind the company is currently maintaining a near 100% equity hedge, limiting its gains in a bull market. Fairfax maintains over $8 billion in cash and short-term investments, putting Prem Watsa in prime position to make some purchases when bargains pop up on the radar.
What it all means
Fairfax has ticked down a few points so far this year, and it's likely because of the firm's more controversial positions and more recently because of the sharp drop in net earnings. None are more chatter-inducing than the company's large stake in Research In Motion (BB 3.21%). As one of the most disliked companies on the public markets, Research In Motion has led analysts and investors to determine Prem Watsa out of his circle of competence and making a large bet on a business he doesn't fundamentally understand.
I agree that there was considerable risk in the investment, which is itself very atypical for Mr. Watsa, but it's a very bold claim to allege that one of the world's top value investors does not understand a business in which he owns more than 10%. As usual, I will refrain from speculating what Watsa's current take on the company is without any update from the man himself. I will, however, reiterate that he has said all along this a five- to seven-year turnaround story, and that people need to be patient.
Fairfax has frustrated investors in recent times due to the equity hedge. Analysts have continuously asked why, with markets appearing to stabilize, the company maintains its hedge and thus limits its ability to profit. In the latest conference call, Watsa addressed this plainly and simply:
We've got 33%, $8 billion in cash, common stock positions [that] are fully hedged. We have very little corporate bonds. Our muni bonds are predominantly guaranteed by Berkshire Hathaway, so it's a very conservative portfolio. And the reason for our conservative portfolio is very simply, the -- it seems to us that the disconnect between the fundamentals, in terms of companies and economies, and markets. So stock price -- stock and bond markets are high and the fundamentals we think, are quite different, meaning on the low side. And so you'll either have the fundamentals go up over time to catch up with stock prices, catch up with very low spreads, or you'll have the markets come down. And we've said for some time, this time period, we think of it as a 1 in 50, 1 in 100-year event. It's not a normal time period. And so we just think you have to be very, very careful. The fact that we've got cash in our portfolios, making no money today is a big advantage as and when opportunities come.
Watsa finishes the call by reminding us all that since the company's inception, it has been long-term focused. Fairfax would love to guarantee 5% or 50% growth every quarter, but it has no idea how to do that, and doesn't view that as a reasonable objective. The strategy for Fairfax has been and always will be long-term value creation.
With that in mind, feel free to speculate away. In my opinion, Fairfax is one of the last bastions of reason in a highly irrational industry. I do not think all stocks are overvalued, or that the markets are heading downward, but I do believe that this company and its manager know how to realize long-term value -- they've managed to compound book value by an average of 20% per year for nearly 30 years.
