Fairfax stock is a buy after reporting its best year
Fairfax (OTCPK: FRFHF) was one of my top holdings for almost four years, and during that time it was a lousy investment. Prem Watsa, the once-legendary value investor, had to clean up some stupid mistakes, but Fairfax still couldn’t regain investor confidence.
Figure 1 shows the strong underperformance of FRFHF against the S&P 500 index measured during my early purchases of the company.
The guilty? Poor investments and a difficult interest rate environment.
blackberry (NYSE:BB), Greece, inflation hedges, short markets, new African consumer banks. They have all eaten away at the insurance company’s book value, while its portfolio of fixed-income assets continues to languish at rates near zero.
Figure 2 presents the investment performance of FRFHF broken down over several time periods. In the early days of the business, it can be seen that the investments performed well. But in recent years, performance has been mediocre at best.
Over the past decade, FRFHF has struggled to reach 5% on its investment portfolio, while the S&P 500 has steadily hit new highs, fueled by growth and technology stocks. This led to below-average growth in book value well below its self-imposed target of 15% per year.
This year, however, Fairfax posted record performances for its 36-year history on nearly every key metric:
- $26.5 billion in revenue up 34% over the previous year
- 3.4 billion USD in net profit up almost 15 times from the previous year
- 15 billion USD in equity, up 20% compared to the previous year
- Consolidated combined ratio: 95% less than 97.8% the previous year
The real question now is: what is the next step? Does this performance mark the long-awaited turning point for stocks or another false start for this Berkshire (NYSE: BRK.A) desire? Let’s first look at the core business of the company: insurance to better understand the management of tomorrow.
The driving force: insurance
Fairfax has spent years building a global insurance platform and creating a conservative underwriting culture. From 1985 to 2021, global premiums grew at a compound rate of 23% to nearly $23 billion or $1,000 per share.
At the same time, the average combined ratio of its insurance portfolio continued to decline. In Figure 2, from 1986 to 1990, the company had an average consolidated combined ratio of 106.7%. Over the past five years, its average consolidated combined ratio has been 98.7% with a median of 97.3%.
Combined ratios are a key measure of the profitability of insurance companies. They measure expected insurance losses plus underwriting costs relative to earned premiums. The lower the combined ratio, the more profitable the insurance company.
They are also an important indication of whether insurance float or premiums collected but not yet paid have a cost. Profitable underwriting for insurance companies, as in the case of Fairfax, means that the returns on investment all go to shareholders.
We can see in Figure 3 that Fairfax has significantly improved its combined ratio from 106.6% in 2017 to 95% in 2021. The difficult market conditions, when insurance companies have the power to raise prices , certainly helped. Gross written premiums at Fairfax increased 25% to $23.9 billion in 2021 from a year ago.
Expect these conditions to persist in the form of social inflation or a tendency for juries to award higher amounts to plaintiffs; disasters crowd out weak carriers; and rising general inflation to conspire for a hard market.
Despite these positive developments, Fairfax investors should beware of some difficult to quantify risks.
Climate change and its impact on weather conditions can put pressure on (re)insurance companies. The view that there will be more frequent, severe and unexpected weather disasters cannot be ignored. For example, Fairfax’s explosive year included another $1.1 billion in catastrophe losses, reducing its combined ratio by 7.2 points; excluding catastrophes, the combined ratio would have been 87.8%!
But that’s why a cautious and adaptive underwriting culture is needed, and I haven’t seen anything to suggest that Fairfax won’t adapt to these new climate realities. Investors, however, should take note of the progress the company has made here.
In addition, the ongoing conflict between Ukraine and Russia could negatively impact Fairfax’s European insurance business. In 2020, the company wrote gross premiums of USD 144 million in Ukraine and USD 114 million in Poland. Brit, which is a UK-based insurer, paid 13% of gross premiums that year.
Inflation will be good for Fairfax
Inflation has been an afterthought in the developed world for more than a decade, but the global pandemic has raised concerns among central bankers about runaway prices. Self-imposed lockdowns and workers reluctant to re-enter the labor market have put enormous pressure on global supply chains, causing consumer prices to rise rapidly.
The US consumer price index, for example, rose 7.5% year-on-year in January, the biggest 12-month increase since 1982. Wall Street, therefore, is forecasting up to seven rate hikes by the US Federal Reserve, while the Bank of Canada could quickly follow suit.
The insurance industry has long suffered from low rates, as their portfolios typically have a large portion of bonds to cover claims. But in a prescient move, Fairfax kept its portfolio short-term by keeping about 50% of its $43 billion in assets invested in cash and short-term instruments.
This means that as rates rise, his portfolio will be more resilient to changes in market value, as longer-dated fixed income instruments are discounted relative to better-priced ones.
Short duration assets do not face the same volatility in rising rate environments. Fairfax may also use its cash to purchase bonds and fixed income instruments when rates better reflect the credit risk being taken. A significant development since interest and dividends represented 28% of (re)insurance operating income in 2021.
Is Mr. Watsa finally giving the floor on share buybacks?
Mr Watsa has been chipping away at the company’s share count since 2018, reducing outstanding shares by an unimpressive 6% through 2020. But in a surprising year-end move, Fairfax launched a buyout of $1 billion primarily using proceeds from a sale of a minority stake in his wholly owned insurance unit of the Odyssey Group.
It was a decision Watsa had been hinting at for a while.
In his 2018 annual letter he wrote about Teledyne’s late great Henry Singleton (NYSE: TDY) fame, which retired 90% of Teledyne shares and generated a 3,000% return for shareholders during this period. Clearly, Watsa still has a long way to go to equal that record, but a stock cut of around 7% isn’t a bad start!
But the transaction was interesting beyond the mere merits of the takeover. It also gave watchful shareholders a window into the company’s undervaluation.
For $900 million, the Canada Pension Plan Investment Board and OMERS purchased a total of 9.99% or 4.995% each of Odyssey Group, the reinsurance and specialty insurance business of the Stamford, CT-based company.
This valued the unit at over $9 billion, or 1.83 times what Fairfax held for the Odyssey Group in 2020 ($4.9 billion in equity attributed to Odyssey).
How does this compare to the set?
Fairfax total common shareholders’ equity was $15 billion at the end of 2021, and the market capitalization of the entire company traded at $13.4 billion recently. The true value of the Odyssey Group was then a startling 60% of book value and 67% of market value.
When you consider Fairfax’s other attractive insurance properties, private business interests and controlling positions in Fairfax India and Africa, it is clear that the intrinsic value of the company is far greater than where the shares are listed today. today.
It can be silly to predict where the stock price will go next. I certainly didn’t have a crystal ball four years ago when I created my job at Fairfax and prices were languishing. But I continue to hold my stocks and buy on the downside taking comfort in Benjamin Graham’s mantra:
In the short term, the market is a voting machine but in the long term, it is a weighing machine.
Fairfax has been in the best shape for years.
The company’s (re)insurance operations are profitable, improving and thriving in a tough market that looks set to continue. Higher interest rates will allow the team to improve its interest income, a long thorn in investment performance. And it seems clear from the sale of the Odyssey Group’s stake that the Fairfax pieces aren’t getting the credit they deserve.
I suspect Mr. Watsa is closing the intrinsic value gap with accretive buyouts and creative financing that “weight” will be on the rise as the market begins to realize the value of this undervalued company.