With bank accounting and words such as HTM (held-to-maturity), AFS (available-for-sale), and unrealized losses becoming a part of every investor’s daily vocabulary from the verge of a couple of large failing banks, I’ve found there’s an erroneous tendency to treat all financial institutions the same. On the face of it, you get why investors do it. Financial institutions hold money for other people. They then take that money, called float, and invest it in relatively liquid assets, earning the difference until the money will eventually have to be paid back. The source of the funds varies between types of institutions. For banks, it’s mostly depositors. For insurers, it’s mostly policyholders. But the game is the same: managing money and earning the difference between what comes in and what comes out.
The source of the float and the methods to manage it mostly distinguish a bank from an insurer. Unlike banks, insurers bear solvency risk on both sides of the balance sheet, in the risks they underwrite and the assets they buy. Where banks know the running cost of their liabilities, sloppy underwriting at an insurer can nullify or worsen the returns generated by investing the float, but can also turn an advantage if the underwriting is profitable. And unlike banks, recent news being case in point, insurers aren’t subject to bank runs. When bank depositors want their money quickly, there’s little a bank can do but sell its fixed income portfolio to meet redemptions, and if there’s a large unrealized loss on bonds that the bank initially booked to hold to maturity, a run can punch a hole in the bank’s statutory capital. Insurers can be subject to tragedies of equal proportions from catastrophes, but generally employ less leverage and can reinsure for protection. Besides, insurance liabilities are more predictable. If an insurer has 5-year claims on average, that’s 20% of the portfolio that needs to be liquidated at max (if there’s a 15% unrealized loss on the portfolio, that would only be a 3% hit). Both banking and insurance come down to term matching, but because of the insurer’s added visibility, insurers are generally more flexible with how they can invest their float.
But just like banking isn’t an inherently great business, insurance isn’t either. The insurance industry has low entry barriers and marginal differentiation among a large number of underwriters, any of whom may onboard recklessly priced risk at any given time. Still, some factors can turn individual banks and insurers into good businesses. Since this writeup is about insurance, I’ll put banking aside for now and focus on what makes a good insurance company.
From a risk management perspective, you can build a mental model of insurance through two dimensions:
1) Opportunistic vs non-opportunistic insurers: When investors think about opportunistic insurers, they often assume that some companies are better at cycle management than others, expanding when markets are hard and pulling back when conditions soften and competition increases, as if the industry in aggregate forsakes underwriting discipline and overly focuses on top-line growth even as premium rates decline. This is often boilerplate. All insurance companies boast that they have a culture of “opportunistic” underwriting discipline, but that’s table stakes to be in business. Some insurers are better than others, whether it be from experience or courage. But when I say “opportunistic”, I mean on the investment side.
On the investment side, the vast majority of the industry falls in the non-opportunistic camp. This isn’t necessarily bad. “Opportunistic” is usually not a word you want to be passed around about you in the money management business. Non-opportunistic insurers (think State Farm, Allstate, or Nationwide) focus almost entirely on underwriting, either operating profitably by writing carefully selective policies or ramping up leverage to earn a satisfactory ROE by investing the float in low-risk, low-return investments that match their liabilities—an ancillary activity typically outsourced to 3rd-party managers. On the other hand, opportunistic insurers (think Berkshire, Markel, or Fairfax) not only allocate a significant part of their float to equities but also buy non-insurance businesses outright. Because this approach, when done right, may bring outsized returns compared to non-opportunistic insurers, opportunistic insurers may give more leeway as to how profitably the underwriting side of the business operates, as long as the money lost is less (meaning cheaper) than equal opportunities to raise money. Both models work within different instances and competences, but investors tend to favor those that get more of their income from consistently profitable underwriting than those that get most of their income from the float—the reason being that so few insurers manage to underwrite profitably every year that doing so indicates a hard-to-copy advantage, whereas anyone can look smart for a while by gearing up the float or reaching to yield. In other words, an investment edge is harder to verify than an underwriting edge. The counterargument, of course, is that <90% combined ratios aren’t the holy grail either, since that could mean the insurer isn’t optimizing for float size, forsaking an important income stream.
2) Short-tail vs long-tail risks: The “tail” is the time required to learn of and settle claims. It’s an important consideration when an insurer manages its reserves. Short-tail claims (e.g., most property, auto, general liability, or travel) are settled quickly. Each loss event is small, and the law of large numbers applies, making reserving and pricing more synchronized to maintain profitability. But the same factors make short-tail underwriting a price-driven commodity and a game of reaching the lowest-cost advantage. Long-tail claims (e.g., asbestos, workers’ compensation, or product liability) take years or decades to settle and are subject to more uncertainty in reserving. In extreme cases, like asbestos, long-tail claims may take upwards of 40 years to settle, continuously lurking on the insurer’s balance sheet, occasionally requiring painful revisions to cover sins of the distant past. With something short-tail and granular like auto, claims patterns are risky but not uncertain. Long-tail is more uncertain but isn’t as price-sensitive, making it prone to reckless underwriting since consistent under-pricing can take years to uncover.
This brings us to why insurance (or banking) isn’t an inherently great business. An inherently great business can be run by anyone without inept management inflicting mortal damage. That isn’t insurance. In insurance, the ability and temperament of management are all-encompassing because it’s too easy to bet the company, and there are lots of temptations to do the wrong thing, either excessively reaching for yield, causing term mismatch, or writing loads of bad premiums. Such short-termism is insurance’s kryptonite. Because insurance is, by and large, a commoditized necessity, like fresh air, there’s no substitute other than for the uninsured to mechanically chip away at their paycheck, stuff the money under the mattress, and pray for good weather. Reckless management at an insurer can easily tap into that need and achieve outsized growth by aggressively pricing policies or accepting risks that prudent competitors are wise enough to avoid. So growth in itself is far from a reliable measure in insurance. If anything, abnormal growth in premiums written is more often a cause for concern than something to celebrate.
That is with four unlesses: as an insurer, you can rationally outgrow competitors even in a soft market if you either 1) have a low-cost competitive advantage, perhaps stemming from superior technology or sales channels, 2) cushion your growth with consistently prudent reserving, 3) have an investment edge that can afford a higher combined ratio, and/or 4) have a customer-centric culture, translating into higher retention rates and LTV (on a unit basis, a newly-written policy is typically money-losing in year one but gets increasingly below a 100% combined ratio in later years). All four characteristics feed on each other. With a low expense ratio, you’re more likely to think longer term and avoid imprudent reserving to boost quarterly numbers. You can invest for the long term and provide superior service to your policyholders. Insurance brokers appreciate that and are more likely to direct volumes your way.
Fairfax Financial has all four characteristics. Commonly called the ‘Canadian Berkshire’ due to its value investing principles (but a fluke at 1/40th of the size in terms of market cap), it falls right into the opportunistic camp. 15 years ago, if you’d asked an insurance analyst about Fairfax, they’d tell you that it isn’t an insurance company, but an investment company masquerading as an insurance company. And 15 years ago, they’d have been right. Fairfax was never your general insurer focused on maximizing underwriting profits, limiting volatility, and protecting dividends in any given year. And compared to Berkshire, which mostly writes short-tail risk, Fairfax leans more to the long-tail and was never afraid of a little extra volatility on both sides of the balance sheet, trusting that the Hamblin Watsa investment committee’s acumen would more than make up for it. Fairfax’s first 20 years of operation:
With an average 108% combined ratio, an 8% cost of float headwind, Fairfax managed to compound book value per share (BVPS) from $1.5 to $162.76 over these 20 years, a 26.3% CAGR thanks to levered compounding. Over its full 37-year history, BVPS has compounded at 17.8%, a feat achieved only by ~1% of all stocks on American stock exchanges since 1985. But it was no straight line:
Fairfax has undergone several transformations. Something each of these transformations has in common is that the team at Hamblin Watsa has always sought to invest Fairfax’s float in statistically cheap securities, which would sometimes involve private equity-like turnarounds when market sentiment was negative and sometimes involve holding large amounts of cash when it perceived markets to be overpriced. During the GFC, the constant focus on the downside worked out great when Hamblin Watsa bought credit default swaps to hedge against the impending crash, writing to shareholders in 2005:
[…] for a few years now, we have said that we are protecting our shareholders’ capital from a 1-in-50 year or 1-in-100-year event. By definition, [a housing crash] is a low-probability event (like Hurricane Katrina) but we want to ensure that we survive this event if and when it happens.
Post-GFC, though, Fairfax failed to adapt to the new environment. After striking big in 2009, with BVPS increasing 21% in 2008 and then another 33% in 2009, Prem Watsa and co saw other 1-in-50-year disasters on the horizon, including mass deflation, that never materialized. So as the combined ratio finally dipped consistently below 100 after 25 years of operation, it was almost ironically this time when Fairfax entered its investment slump, losing an average of ~$500mn/ year pre-tax between 2010-20 on bets like, but not limited to, BlackBerry, Greece, inflation hedges, shorts, and greenfield African banks—a significant chunk out of the average of ~$860mn operating income earned during the period. The sudden tailwind from profitable underwriting was hampered by the mix of Fairfax’s hedges and ill-timed opportunistic investments (“ill-timed” because some of these investments now look to bear fruit, a topic which I’ll come back to). By far the biggest cost of the lost decade was what you don’t see in the numbers: opportunity costs. As tech high fliers pulled the tide lifting all boats, the statistically cheap stocks Fairfax favored were left behind while the macro hedges (which, given their annual cost, were more “bets” than hedges) proved fruitless. For Fairfax, the decade post-2010 was akin to driving around a race track with the handbrake pulled. BVPS CAGRed at a measly 3%.
The word around the investment community became that Hamblin Watsa were bad stock pickers. That, even though low investment returns were more tilted to the bond portfolio, which was dragged down by low duration and continuously decreasing interest rates over that decade. Over the last 10 years, less than $1 in $5 of the investment portfolio has been in common stocks. Helped by regulatory handcuffs, >40% of the portfolio has been in low-duration bonds. None of Fairfax’s peers, most with larger bond allocations and longer durations, have been immune to falling interest rates.
That said, the fact that interest rates pulled fixed income down only makes Fairfax losing out on sizable equity gains (falling interest rates mean less gravity in equities) all the more disappointing. So it’s no wonder that the poor investment returns were all the limelight. Yet, honing in on just the investment side of the business fails to miss the bigger part of the Fairfax story. While everyone ran around discussing whether Prem and co had lost their magic touch, Fairfax’s insurance group marched ahead in the background to build a track record of growth that would put it on par with a thriving tech company. What the increasingly profitable combined ratios in the post-2010 decade fail to catch is one important dimension: scale. Over that decade, the insurance business went from $4.4bn net written premiums in 2010 to $14.7bn in 2020, then jumped to $22.3bln in 2022, a 14.5% CAGR. The investment portfolio grew from $21bn in 2010 to $55.5bn. In a little over a decade, Fairfax grew into one of the 20 largest P&C insurers in the world.
A $55.5bn investment portfolio, roughly half of which financed by 5% negative-interest float (Fairfax’s current 95% combined ratio) coils to churn out vastly different earnings numbers in a higher-interest environment than Fairfax has ever witnessed. Due to this humongous increase in cash-making float, Fairfax is in another form than ever, and the company’s past history gives poor clues as to how it may perform in the future.
The recent underwriting growth story can be divided into two phases:
1) M&A (2015-2017)
Fairfax has always taken advantage of acquisitive growth, which is what has turned it into the global, decentralized insurance holding co that it is today, spanning 200 different profit centers across >100 countries. But the short period of 2015-2017 was notably impactful since Fairfax completed two large and some smaller insurance acquisitions during the period, spending a total of $5.2bn:
2) Hard market (2019-today)
Whether those acquisitions were any crystal ball prediction by management, I don’t know, but Fairfax was opportunistic and the timing was great. Just when Allied World entered the fold, it went on to CAGR ~18% while its combined ratio went from 98% to 91% after an 8% cat loss impact in 2022. Brit CAGR’d >20% over the same period. What happened was that the insurance industry entered a hard market, which is a rarer occurrence than many think. The mental model many have about the insurance cycle is that hard and soft markets ebb and flow with equal proportions and regularity. But that isn’t true. You would have to go back to 2001 after 9/11 to find the last hard market, and then to 1986 (the tort crisis) and 1976 (stagflation) to find the prior ones. Intermediate years have been characterized by declining rates. That’s why, when a hard market shows up, it’s about stepping the gas pedal as hard as you can. In the 2002-2005 period, Fairfax wrote net premiums at 1.5x its statutory capital.
An important detail in the acquisitions of Brit, Eurolife, and Allied World is that Fairfax didn’t have $4.7bn lying around to pay for them. So it mostly financed them by partnering with minority interests such as OMERS, a Canadian pension fund, and issuing 7.2mn shares at the price of $462/sh, a 36% increase in the share count over a short 3-year period. While that may seem controversial for an insurer practicing conservative value investing, you gotta understand how integrated a capital allocation strategy this has been throughout Fairfax’s life. In fact, since 1985, Fairfax has issued a total of 29.5 million shares as it expanded net premiums written from $10mn to $10bn in 2017 (a net increase of 22.8mln as Fairfax also retired 6.7mn shares over the same period). Out of the Henry Singleton playbook (Teledyne’s share count quadrupled from 1965-1970 when Singleton went on an acquisition spree, only to buy back 90% of the shares in the decade after 1972), Fairfax isn’t afraid to trade its stock to pay for shinier objects with the prospect of buying it back later on the cheap.
What happened after 2017 was that Fairfax repurchased 3.3mn shares for cancellation at, guess what, an average price of $474/sh, significantly cheaper than at issuance considering net premiums had more than doubled, the investment portfolio had increased 41%, and underwriting profits had gone from losing $642mn to earning $1.1bn over the period. In 2021 alone, Fairfax bought back 9% of its stock at 0.8x book after selling a 9.99% stake in Odyssey, Fairfax’s largest subsidiary by premiums written, at 1.84x book. Furthermore, in late 2020, Hamblin Watsa bought total return swaps (TRS) that gave it exposure to another 1.96mn Fairfax shares (~8.4% of the current share count) at an average cost of $372.96/sh for a total of $733mn. This investment alone may turn into one of Fairfax’s best, having returned 85% over 29 months. Hamblin Watsa may have had a prolonged period of bad stock picking, but they sure can trade their stock and are likely to buy back more than they issue in the future.
The buybacks don’t only account for their stock, though. Over the past couple of years, Fairfax has slowly moved into the current third stage as the hard market looks to be maturing: the cannibalism stage, by slowly buying out minority shareholders. In 2021, Fairfax increased its ownership of Eurolife from 50% to 80%, bought out Singapore Re from its previous 28.1% ownership, and paid $733mn in 2022 to increase its ownership in Allied World from 70.9% to 83.9%. Next up are Kipco (buyout) and GIC (from 43.7% to 90%), paying the latter in installments over the next 4 years. As these minority buyouts pick up steam (Fairfax has the option to purchase the remainder of Allied World until Sep 2024, Odyssey until Jan 2025, and Brit until Oct 2023), Fairfax’s structure simplifies and will be easier to understand.
Here’s how the insurance group looks today:
The common denominator for this group is Andy Bernard, who was installed as President of the insurance group in 2010. Bernard has built one of the best insurance track records ever. Bridging the gap between Bernard’s insurance side and Hamblin Watsa’s investment side of the business is Peter Clarke, the President of Fairfax, who effectively takes the role of Chief Risk Officer. Every insurance deal and large investments are signed off by Clarke. What exemplifies the company’s long-term focus is that while both Bernard and Clarke have been with Fairfax for over 26 years, that isn’t unusual. On average, Fairfax’s insurance officers have been with the company for 19 years (18 years for the investment team).
All the talk about opportunism, premiums written, short-tail vs long-tail, and so forth is fine, but if you want to get to the bottom of the moat, this is where to find it. Long tenures are what allow Fairfax to act long-term with the right incentive system in place. In 2017, Prem said he’d never lost a manager to competition despite many of them being offered better compensation. And one thing you’ll notice when you attend/watch the AGM, read Prem’s letters, or watch an interview with him is that he’s the biggest cheerleader of his teams. Insurance presidents are compensated by underwriting profit, not growth, and by running a decentralized holding structure akin to Berkshire, with every president having full autonomy and being a risk officer. Fairfax values trust over synergies. Unlike other executives at Fairfax, Prem doesn’t earn stock-based compensation; he makes money trading his stock. His share of ownership is 10% (43.9% voting; two of his children sit on the board), and his $600k/ year salary has stayed the same for decades.
To some investors, the latter point of family control may understandably be of concern, but in insurance, the benefits of having a controlling, long-term (or permanent) owner can outweigh the shortcomings:
1) Reserving
At the time an insurer underwrites a policy, it estimates its expected losses and sets aside reserves to cover those losses. As time passes, the reserve may be adjusted up and down based on how the policy develops. If the reserve is too low, the insurer will increase it and take a hit to the current year’s earnings. If it’s too high, excess reserves will be released into earnings.
Reserve policies vary significantly between insurers, especially across jurisdictions, and these differences are usually enough of a factor to deem relative valuations across peers by earnings multiples meaningless. Various considerations factor into reserving, including short-tail vs long-tail claims, the quality/homogeneity of data, medical cost inflation, court interpretations, claims handling procedures, and so forth. This means that a reserve policy can either practice hyperbolic discounting or delayed gratification. Scrupulous management will switch between both, either consistently under-reserving to pump up short-term earnings or over-reserving in a hard market to pad earnings in lousy years under the pretense of conservatism. Actual conservative management, however, sticks to consistent reserving, not too far from actual losses but a little to the safe side. Management is more likely to practice the latter if it has long-term skin in the game.
Now, as IFRS 17 has come into the picture, requiring contract liabilities to be discounted, aggressive reserving policies are even more dangerous since you now have a double whammy with possible meddling of the discount rate, a few points of which can make a huge difference in how to account for long-tail risks. This is an effect stemming from accountants trying to be too perfect. Regardless of whether management practices an aggressive or conservative reserving policy, it’ll always fizzle out in the end, though. The final loss is the final loss. But it does tell you something about the quality of management that the market may miss. What happens when an insurer is consistently growing its book, the true impact of reserve releases tends to be hidden—the insurer sets aside excess reserves faster than it releases them. Since 2010, when Bernard sped up the underwriting business, Fairfax has had reserve redundancies every year for an average of $418mn/year, or almost 5pts of combined ratio:
2) Capital allocation
Family control is also more impactful on terminal value. Coming into 2022, Fairfax’s bond portfolio had an exceptionally low average duration of 1.2 years. Refusing to reach for yield when doing so makes you look stupid in the short term (interest and dividend income continued to drop from $880mn in 2019 to $769mn in 2020 to $641mn in 2021) isn’t easy when you have a bunch of exterior pressures to please other than eating your cooking. Part of Fairfax’s bond portfolio was even hedged via forwards to sell US treasuries right before hell was unleashed by the Fed. So when competitors opted to deal with low interest rates by reaching for yield (SVB style), Fairfax only took a 2.8% mark-to-market hit on the fixed income portfolio in 2022 and still increased the BVPS (after dividends) by 6%. Peers, on the other hand:
The verdict? Family-controlled insurers are better positioned for opportunism on the investment side. The result? As Fairfax slowly ramped up the duration in conjunction with rising interest rates, it took its run rate of $530mn in interests and dividends and tripled it to a current run rate of $1.5bn, which now approaches a 3-year duration. I’ve heard a lot of Fairfaxers are disappointed about Fairfax not extending those durations further, but I don’t see why Hamblin Watsa would settle for 3-4% when they have lots of other options, including writing >7% mortgages with Kennedy Wilson at average three-year terms. Cash and cheap stocks may also be better options as of now. Having the discipline to not reach for yield for the past half a decade was the smart choice, especially in an ongoing hard market where competitors are stuck with long maturities for the foreseeable future. There’s also an option with staying nimble. At the 2022 AGM, Prem stated that if a recession comes, risk spreads will blow out, which would prompt Hamblin Watsa to extend duration significantly.
So if we add things up to run rate operating profits, what do we have? As for interest and dividend income, we can be pretty sure about the aforementioned $1.5bn for the next three years. But there are other sources of income/expenses to account for (you can find and change around my model at the bottom of the writeup):
1) Underwriting profit
The insurance industry is in a hard market with the strongest pricing cycle shown in a generation. Following the landfall of Hurricane Ian and reinsurance now looking to continue to pick up the slack (being up a risk-adjusted 40-50% for Fairfax in 2022), favorable underwriting conditions are expected to continue into 2023, although more modestly. Furthermore, should interest rates remain elevated, the unrealized losses that many insurance peers will struggle to unwind over many years could prolong the hard market as there’ll be little price competition in underwriting. Assuming gross premiums increase by 10% in the next three years, a risk retention rate of 78% (the premiums not receded to reinsurers), a combined ratio of 95%, and annual run-off losses of $200mn, I can pencil out a three-year underwriting profit run rate of ~$1.1bn. Every 1pt of combined ratio change would equal a $200mn change in underwriting profit. Note that in the medium term, it’s virtually impossible to predict underwriting results on an annual basis since in any given year shit may hit the fan. Over the long term, a 100% combined would be a good normalized level to assume for any given insurer, especially when treasury bills yield 5%.
2) Share of profits of associates and consolidated investments
Over the 5 years ending in 2021, Fairfax’s share of profits of associates (equity method investments) averaged ~200mn/year. Last year, the number came in at five times that of $1bn, mostly driven by three of the non-insurance companies: Atlas, Eurobank, and Resolute.
Atlas, Fairfax’s largest common stock holding by market value, has been a good investment. Led by David Sokol, who previously compounded earnings by more than 20% over 20 years at Berkshire’s MidAmerican Energy, and Bing Chen, the company’s largest business is a containership leasing company with a current 1mn TEU capacity, expected to double in the next few years by an aggressive newbuild strategy. Management expects EPS to grow 50% over the next couple of years, which translates to Fairfax’s share of earnings perhaps reaching ~$400mn in 2024.
For the first couple of years, Fairfax’s $444mn investment in Eurobank in 2014 during Greece’s debt crisis looked like it may be written down to zero. At one point, the ECB even came in and mandated a 1:100 reverse stock split. But instead of capitulating, Fairfax found value and decided to double down in 2015. And slowly, after Greece elected a pro-business government in 2018 and Eurobank merged with Grivalia Properties, that investment looks mighty good. Fairfax’s share of Eurobank’s profits was $263mn in 2022, up from $162mn in 2021. Fairfax thinks Eurobank will earn €0.20/sh in 2023, translating to a share of earnings of >$300mn in 2023.
The investment in Resolute spans back to 2008 and includes several adds along the way for a total investment of $715mn. This year, the company was sold for $622mn including some potentially worthless contingent value rights, and thus looks like a break-even investment—a long-term poor return and sought-after closed chapter.
That these three investments have been so different isn’t atypical. If you glance across Fairfax’s common stock holdings and how they’ve changed over the years, you could categorize Hamblin Watsa as an investor with many faces:
a) A venture capital investor that funds startups (ICICI, Quess, Digit, Davos Brands, Farmers Edge, Boat Rocker, Ki).
b) An incubator that fosters early-stage ventures (First Capital, Riverstone, Pethealth).
c) A turnaround/activist investor (Bank of Ireland, Eurobank, Blackberry, Torstar, Golf Town, Performance Sports, Dexterra, Resolute Toys “R” Us Canada, and loads more).
d) A real estate investor (Kennedy Wilson, Grivalia).
e) An asset manager (Fairfax India, Fairfax Africa).
f) A private equity investor (BDT Capital, ShawKwei, JAB’s PE fund).
g) A commodity investor (International Coal, Sandridge Energy, EXCO, Altius, Stelco).
h) A cannibal investor, increasing ownership in what it already owns, including its stock.
Selling Resolute musters a recent rationalization of Fairfax’s equity positions, especially in the turnaround (c) bucket. Other examples include selling the non-real estate business of Toys “R” Us Canada, merging Fairfax Africa with Helios, and writing down and taking EXCO private. Turnaround investments increasingly look like a thing of the past, and what you’ll probably see going forward is for Fairfax to dive more into buckets a, d, and h, the former of which already includes several hidden assets.
Digit, which is consolidated, is a golden hidden asset. Essentially the Indian equivalent of Lemonade, Digit is a mobile-first, digital insurer that grew gross premiums by 50% in 2022 to >$900mn at a 114% combined ratio, after just 5 years of operation. Before Digit raised $200mn in 2021, it was valued a $900mn on Fairfax’s books. The valuation came in at $3.5bn, allowing Fairfax to book a gain of $1.49bn, or $53 of additional BVPS. Now, Digit is in talks for an IPO that could unlock additional value. There are likely other levers Fairfax could pull to crystallize more hidden value on its balance sheet, including Ki, another hypergrowth insurer under Brit, which was seeded in 2020. And more things are going on under the hood. As for bucket d, Fairfax started a real estate investment partnership with Kennedy Wilson in 2010 to diversify the bond portfolio. Fairfax currently has $2.4bn invested with Kennedy Wilson at 7.9% floating rates, so that’s a likely added $190mn.
I could go on about the ifs, buts, and maybes of Fairfax’s equity positions (other important assets include GIC, Fairfax India, and Recipe), a lot of which will be speculation, so without losing sight of the big picture, here’s how I see the operating profits from associates and non-insurance consolidated investments in the short term: profits from associates will drop from the 2022 level to ~$800mn in 2023 (just conservatism since adding up Atlas, Eurobank, and Kennedy Wilson would get you there) which will grow 10% from then. As for the non-insurance business, I assume ~$400mn, strongly contributed by Recipe moving from the equity method to consolidated investment, and I assume that to grow 10%/year from then.
3) Overhead
Corporate overhead expenses were $296mn in 2022, or 1.33% of net premiums written. I’m assuming that ratio stays fixed, growing with net premiums written.
Adding the buckets up…
- Interests and dividends: $1.5bn
- Underwriting profit: $1.1bn
- Share of profits of associates: $0.8bn
- Non-insurance operating profit: $0.4bn
- Corporate overhead: -$0.3bn
…gets us to $3.5bn in expected operating income for 2023. That’s not accounting for potential gains on equity positions. If we add a little net gain on investments of 1%/year, add a $275mn gain on sale to be received from selling Ambridge under Brit in 2023, subtract debt interests (which I assume to grow with float), taxes, minority interest (which I assume to grow with earnings), and preferred dividends, we can back into an average of ~$2.4bn of after-tax earnings run rate, or <7x the current market price. After dividends and not counting buybacks, that translates to ~13% book value CAGR over the next three years.
The question is: what would you pay for that? When I bought the stock in May 2020, it was a time when it traded at 60% of book value. It was also a time with considerable uncertainty around the end-of-year fair value of the investment portfolio. Rarely have underwriting and investment results carpooled in Fairfax’s history but that’s where we are now.
Looking across peers, they typically trade for 1.5x to over 2x book value. Fairfax, with its higher growth profile and bigger spending on non-mark-to-market investments (in other words, its book value is smaller than if it had saved instead), trades at a current 1x. While Fairfax as an investment case may seem convoluted (writing this piece while keeping my tongue in my mouth wasn’t easy), what it all comes down to is whether you think the company will be able to deliver its continued long-term goal of compounding BVPS by 15% or whatever lower number you think. If it does compound at 15%, however, you’ll not only get a 15% return by buying at 1x book value but something north of that, because then it won’t continue to trade at 1x for long. While it’s not indicative of where Fairfax is today, it’s worth mentioning that at one point in the late 1990s, Fairfax traded at 5x. With something like Fairfax, you can only forecast a few years into the future since too many variables change after year 3, so this call rests on your assessment of management’s ability and integrity.
One last note about focusing too much on book value: as Fairfax may enter a long period of significant buybacks, transactions that will likely take place at prices above book value but below Hamblin Watsa’s estimate of intrinsic value, the math of such buybacks has it that each transaction will make the per-share intrinsic value go up, while BVPS goes down. Over the long term, this combination will cause the book-value scorecard to become increasingly out of touch with economic reality.
Disclosure: The author owned shares of Fairfax Financial (FFH.TO) at the time this report was posted. This may have changed at any time since.
