Fairfax Sues the Hedge Funds

I'd keep an eye on this, even if I didn't own stock in Fairfax Financial Holdings (FFH). As Bloomberg.com reports:

The suit by Fairfax Financial Holdings Ltd. said the hedge funds spread false and negative research reports about Fairfax's accounting and business practices, crippling its reputation. The campaign, which allegedly included harassing employees, helped the hedge funds profit when Fairfax's stock fell, said the suit. The complaint filed in state court in Morristown, New Jersey, seeks $6 billion in damages.

I'm not a short seller, and I'm not a lawyer. I don't know how this suit will play out. I will say that I remain optimistic that my investment in Fairfax will ultimately prove successful. Remember that I recently increased my share count by 30% at US$92. But the position as a whole is under water.

FFH 1-yr chart:

Comments

[NO DooDahs:]

I last looked at FFH in November and didn't find it appealing. It hasn't hit any of my screeners since then, but here are some of my (old) notes about researching FFH. Keep in mind I didn't find it appealing then and am not interested (neither bull nor bear) at the moment, but maybe a reader might be interested in the notes, since it's difficult to value a company as complex as FFH.

FFH most always has high CR from the U.S. unit, but that unit is lead by Crum & Forster, who specializes in WC and GL, so a high CR is expected in those LOB since they have long development tails and throw off a lot of investment income. [insert – if rates stabilize, the investment income will fall and they'll need to address the high CR!] Crum does some property and really got hammered in Florida because of it, but that's not much of their premium, their bread and butter is WC and GL. They own more equities than typical for a U.S. insurer, but their portfolio is much more conservative IMO simply because they avoid derivatives and mortgage-backed securities, and they actively hedge the stock risk through shorting SPDR. I'd rather see this, then the rat's nest of derivative and mortgage-backed investments at an AIG, etc.

I would think you should check out the potential for reserve deficiencies in the WC book – I don’t have any reason to suspect them, other than WC is an area with a typically high level of this occurring.

Check out ORH and who owns what percentage of them. When you look at a balance-sheet valuation for FFH, you have to find how they've booked ORH and remove it, figure a valuation for ORH independent of FFH, and take that percentage over to the FFH books. If there’s anything to avoid, I would look to see how much “finite reinsurance” is written by ORH and if their investments include a lot of MBS or GSE bonds.

Chanos mentioned FFH’s failure to achieve a 15% ROE. Well, duh. See slide 5 and 6 of server.iii.org/yy_obj_... . The U.S. P&C insurance industry rarely breaks a 10% ROE, why would the Canadian P&C insurance industry be any different?

Both FFH and ORH are relatively opaque about their distribution of risks, geographically and by line. I like to see when an insurer delineates what is written where. I would also be curious to know if ORH sells any reinsurance to FFH, which would be interesting …

I don't like the fact the company resorted to stock issuance for financing several times in the last few years, but it's harder to discern earnings quality for a financial than it is for a manufacturer or service provider. The proxy didn't have anything that I saw looking particularly fishy. Since it's a Canadian company, I can't really monitor the insiders like I can with a U.S. company.

I would think you need to watch the growth in interest payment expense.

I checked the list of reinsurers they use, and I don't see any incestuous relationships there. The reinsurance they purchase is good quality and they use a diversified list. Based on how conservatively they invest, I doubt they are skimping on the purchase of that.

Their premium to surplus ratios are in line with the industry. This is a good measure of survivability. They do display some results of capital adequacy modeling, such as the interest rate sensitivity in their annual report. As of YE 2004, their main companies were rated A- or A by A.M.Best. It would be hard for a company to go from an A to out of business; I've seen it done, but that involved some gross mismanagement at the very top of the organization and it went on for years before the situation became obvious (the mutual company in question was funneling assets to the partially owned stock company to benefit the executives who also owned stock in the stock company- since FFH is a publicly traded parent, this situation isn't applicable).

In addition to ORH, they have majority share in several public companies. This may be a case where FFH is undervalued because you in effect "get" these other companies "free" with your FFH shares - I don't know for sure.

Best of luck!

2006 Jul 27 05:11 PM