Fairfax Financial Holdings Limited (OTCQB:FRFHF) is a rock solid investment opportunity. Given the financial turmoil of the current world economy, I cannot think of a better company in which to be a shareholder right now.
Fairfax possesses the following characteristics that make it stand out as an investment of choice:
- Superb management;
- International diversification;
- Strategic positioning against current economic risks.
This list is not intended to be exclusive. It is sufficient to make a reasonable argument as to why Fairfax should be a core part of any portfolio. Let's look at these characteristics in the order presented.
Undervaluation. The current book value is $373 USD per share, as per the first quarterly statement of 2013. This excludes the market value of certain securities which are understated due to the equity method of accounting. It also excludes any undervaluation of the actual securities held within its portfolio, such as Bank of Ireland (IRE), Blackberry (BBRY), Sandridge Energy (SD), Wells Fargo (WFC), etc.
After factoring in a foreseen acquisition of American Safety Insurance (ASI) in 2013, Fairfax has approximately $800 per share in insurance float. Over the very long term, Fairfax has been able to hold the insurance float at almost zero cost. The float also continues to grow over time with the size of the company.
Combining the book value and float, each share of Fairfax has an investment portfolio of approximately $1,173 in value. This does not include money held as debt, which also gets reinvested and has been borrowed at low interest rates.
The current market price of Fairfax, as of 7-23-2013, is $407 per share for a 9% premium over book value. This valuation is very cheap compared to the $1,173 portfolio value per share working toward its long term benefit.
If Fairfax only earned 5% annually on its $1,173 per share investment portfolio, it would still earn about 16% on its $373 book value. Since a 5% annual return on the portfolio is a conservative estimate going into the future (with average annual returns of 9.4% since 1985), Fairfax stands to earn even more than 16% on book value, and its current price is simply a great opportunity from a value investing perspective. It is not too difficult to conclude a significant undervaluation for the shares.
Superb Management. Fairfax is managed by its CEO and founder, Prem Watsa. Watsa has a deep value investment approach to managing the company's money, very similar in style to Benjamin Graham. Nicknamed the "Warren Buffett of Canada" due to his investment track record, Watsa has compounded Fairfax's per share book value at 22.7% annually from 1985 to 2012.
Unlike Warren Buffett, however, Watsa found a way to more than double the value of Fairfax with investment returns from 2007-2009 when everybody else was losing money during the bear market. The Fairfax investment team predicted the U.S. housing market crash and the U.S. stock market crash well in advance of their occurrence. As such, Watsa positioned the company's portfolio to profit from the turmoil, mostly from holding cash to take advantage of cheap equity opportunities and the purchase of credit default swaps to take advantage of the sub-prime lending crisis. No other insurance company in its class had returns similar to Fairfax during the 2007-2009 timeframe.
This record is simply outstanding and speaks for itself. Prem Watsa is one of the best value investors in the world.
International Diversification. Fairfax possesses insurance companies all over the world, to include India, Singapore, Malaysia, China, Hong Kong, Thailand, Kuwait, Poland, United Kingdom, Canada, United States, Bermuda, and Brazil. These companies also conduct business in countries outside their base. Insurance companies, in turn, reinvest their float, mostly in the same countries they operate.
Fairfax also invests its own capital in equities and/or entire businesses outside the insurance industry. These businesses are also located throughout the world. Recent large, non-insurance purchases include Thomas Cook (India), Bank of Ireland, Blackberry (Canada), and Eurobank Properties (Greece). Whenever Fairfax buys equities and businesses, it is because they are perceived to be significantly undervalued by management.
Strategic Positioning Against Current Economic Risks. Fairfax is one of few companies to both acknowledge the danger lurking behind worldwide economic conditions and develop a coherent strategy in dealing with them.
First, let's look at the threat. The worldwide economy is shrinking due to reduced spending and debt deleveraging. The baby boomers are approaching retirement age and changing from consumers to savers. The subsequent generation is not large enough to replace baby boomer spending, putting deflationary pressure on the economy. To top things off, both government and consumer debt are dangerously high, not only in the U.S. but Europe, Japan, and emerging economies. Emerging economies, such as China, are also slowing down as Western demand for manufactured goods continues to decrease due to slow economic growth, high debt, and unsustainable balance-of-trade deficits.
Worldwide governments continue to suppress interest rates, holding them artificially low to counter this growing malaise. Low interest rates, in turn, produce housing, bond, and equity bubbles.
Central banks continue to pump trillions into the economy through quantitative easing, low taxes, low interest rates, and government spending. Despite these efforts, the world economy is not recovering as it should.
A rise in interest rates would burst all investment bubbles, slow down consumption, set off unprecedented defaults (sovereign, business, and consumer), and potentially crash the world economy. The question is if central banks can suppress interest rates forever? I personally do not think so, as investors will eventually demand higher interest rates on bonds to compensate for these growing risks.
Fairfax continues to acknowledge these threats through annual statements and press conferences by Prem Watsa. It has a three pronged approach to mitigating these threats.
First, Fairfax's equity portfolio is approximately 100% hedged with index shorts. Although this decreases capital gains in the short term (negating all broad market capital gains), it offers insurance against a stock market crash which, for reasons already discussed, is a very real and pervasive risk in this environment. Prem Watsa is wisely choosing to avoid this risk and is content, for the time being, to earn capital gains in excess of index returns. He has a track record of consistently beating the indices.
Second, Fairfax has purchased deflation derivative contracts that rise in value inversely to Consumer Price Indices. If the price indices fall (deflation occurs), the derivative contracts increase in value. These act as insurance to offset devastating reductions in earnings from a shrinking economy and reduced spending. The notional amount of these contracts was nearly $50 billion as of the 2012 annual statement, so a 5% cumulative decline from the CPI strike prices would provide Fairfax a $2.5 billion profit to offset reductions in business earnings. It is very good insurance.
Finally, as of the 2012 annual statement, one third of Fairfax's portfolio (approximately $8 billion) is held in cash. Holding cash negates the risk of holding too many bonds, which are overvalued at the moment with low interest rates and will greatly decline in value if, or when, interest rates rise. Also, if deflation does occur, the value of cash increases. It would leave Fairfax in an excellent position to purchase bargain bin opportunities in the ensuing equity, bond, and real estate market crashes.
One could argue that Fairfax stands to earn more money in a systemic crash than it would during broad economic prosperity. Despite this, it also stands to gain during economic prosperity as well, albeit with some opportunity cost for being hedged. This is a great position to be in, considering the huge risks involved with the markets at present.
Conclusion. Fairfax is a safe and conservative investment with the potential to be very lucrative. Not only has it positioned itself against the biggest financial crisis of our era, it is managed by a proven value investor with one of the best track records in the world. It is internationally diversified and expanding in higher growth, emerging economies. Finally, the company itself is selling on the market as a value investment opportunity, further reducing risk and offering a very good potential for returns in excess of 10% over the long term.
All data used in this article was derived primarily from the Fairfax 2012 annual report, 2013 first quarter report, and the 2013 annual meeting slide presentation. These documents can be found on the company web page at www.fairfax.ca.
Additional disclosure: FRFHF.PK is one of my core holdings.