Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

John Varnell – Vice President-Corporate Development

V. Prem Watsa – Chairman and Chief Executive Officer

David Bonham – Vice President and Chief Financial Officer

Analysts

Paul Holden – CIBC World Markets

Mark Dwelle – RBC Capital Markets, LLC

Tom MacKinnon – BMO Capital Markets

Christopher Lafayette – The Clark Estates

Fairfax Financial Holdings Limited (OTCQB:FRFHF) Q2 2014 Earnings Conference Call August 1, 2014 8:30 AM ET

Operator

Good morning, and welcome to Fairfax’s 2014 Second Quarter Results Conference Call. Your lines have been placed in a listen-only mode. After the presentation, we will conduct a question-and-answer session. (Operator Instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

Your host for today’s call is Prem Watsa, and opening remarks from John Varnell. Mr. Varnell, please begin.

John Varnell

Thank you. Good morning, and welcome to our call to discuss Fairfax’s 2014 second quarter results. This call may include forward-looking statements. Actual results may differ, perhaps materially, from those contained in such forward-looking statements as a result of a variety of uncertainties and risks factors, the most foreseeable of which are set out under Risk Factors in our base shelf prospectus, which has been filed with Canadian securities regulators and is available on SEDAR.

I will now turn the call over to our Chairman and CEO, Prem Watsa.

V. Prem Watsa

Thank you, John. Good morning, ladies and gentlemen. Welcome to Fairfax’s second quarter conference call. I plan to give you some of the highlights and then pass it on to Dave Bonham, our CFO, for additional financial details.

In the first half of 2014, book value per share increased by 17.1% adjusted for the $10 per share common dividend paid in the first quarter of 2014. Our insurance companies had an excellent first half with a combined ratio of 92.8% with excellent reserving and significant underwriting profits of $209 millions.

In this second quarter, OdysseyRe again had an excellent combined ratio of 88.6%, while Zenith had a combined ratio of 89.8%.

As shown on Page 33 of our quarterly report, we realized gains on our investment portfolio of $329 million during the second quarter. Excluding all hedging losses and before mark-to-market fluctuations in our investment portfolio, we earned $443 million in pre-tax income.

If you include all hedging losses and mark-to-market fluctuations in our investment portfolio, we reported pre-tax income of $523 million and after-tax income of $364 million in the second quarter of 2014.

Our second quarter has continued the trends of the first quarter. You will note our investment portfolios went up by $544 million in the second quarter of 2014 in spite of being about 85% hedged, 28% in cash and little exposure to corporate bonds.

How did this happen? Long U.S. government bond rates continue to drop and our commons stocks did much better than the Russell Index. We have yet to financially benefit from our hedges and are approximately $100 billion in deflation swaps. And, of course, our cash position gives us great optionality.

At our Annual Meeting, we made the point that while we’re protecting our capital on the downside, our investment portfolios could also do very well. The first and second quarters of 2014 were a case in point.

Our common stock portfolios continue to be hedged at 85%. We did not add to our hedges, but our common stocks outperformed the index. We continue to be soundly financed with the year-end cash and marketable securities in the holding company of $1.1 billion.

Few more points, our insurance and reinsurance premium volumes increased by 4.4% in the quarter, adjusting for the crop insurance at OdysseyRe. The combined ratio for our insurance and reinsurance operations was 92.7% in the quarter.

At the subsidiary level, the increase in net premiums written after adjusting for the one-time impact, described on Page 32 of our interim report and combined ratios for the second quarter was follows. This is all in for the second quarter: OdysseyRe, up 5.8% with a combined ratio of 88.6%; Crum & Forster, up 16.7% with a combined ratio of 98.8%; Northbridge, up 2.7% in Canadian dollars, with a combined ratio of 95.3%; Zenith, up 5% with a combined ratio of 89.8%; and Fairfax Asia, up 14.8% with a combined ratio of 93.4%.

As we have said before, very low interest rates and reduced with the redundancies means there will be no place to hide for the industry. Combined ratios will have to drop well below 100% for the industry to make a single-digit return on equity, with these low interest rates.

However, with a significant excess capital in our industry today and many new entrants, insurance rates will likely go down first, before they eventually go off. On the investment side, net investment gains of $409 million in the second quarter, consisted of the following. Please refer to Page 2 of our press release:

Net gains on equity and equity related investments after equity hedges of $160 million resulting from net gains of $348 million and $188 million net loss in our equity hedge reflects the out performance of our stock portfolio versus the Russell Index. We have realized gains of $320 million on our equity and equity related holdings in the second quarter of 2014 and $713 million in the first half.

Also, in the second quarter, we had unrealized gains of $381 million, primarily on our municipal and treasury bond portfolio, because of the impact of dropping interest rates.

As we’ve mentioned in our annual meetings, annual reports and quarterly calls with IFRS accounting where stocks and bonds are recorded at market and subject to mark to market gains or losses, quarterly and annual income will fluctuate widely and investment results will only make sense over the long-term.

Core inflation continues to be at or above 1% in the United States and Europe, levels not seen since the 1950s in spite of QE1, QE2 and QE3. Long-term government bond rates in Europe are making record lows, quite often the lowest in 200 years.

Our CPI-linked derivatives with a nominal value of approximately $104 billion are down 80% from our cost and are carried on our balance sheet at $122 million, even though they have 7.6 years run. As I’ve said to you before, our CDF experience comes to mind. Also, please remember that it took five years indeed in Japan before deflation set in for the next 18 years.

When you review our statements also please note that when own more than 20% of a company, we equity account, and when we own about 50%, we consolidate, so that mark to market gains in these companies are not reflected in our results.

As you can see on Page 11 of our quarterly report, the fair values of our investment and associates is $2.3 billion, which is a carrying value of $1.8 billion, an unrealized gain of $440 million not on our balance sheet.

We continue to be very concerned about the prospects for the financial markets and the economies of North America and Western Europe accentuated as we have said many times before by potential weakness in China and emerging markets. As we have said now for some time, we believe there continues to be a disconnect between the financial markets and the underlying economic fundamentals.

As of June 30, 2014 we have $7.5 billion in cash and short-term investments in our portfolio, which is 28% of our total investment portfolio to take advantage of opportunities that come our way. As a result, in the short-term our investment income will be reduced.

Finally, I want to bring to your attention on Page 18 of our second quarter report; we have added a paragraph under contingencies regarding our regulatory investigation in Quebec. We are fully cooperating with the Quebec authorities will required strict confidentiality during the investigation, while we are not permitted to give you any further details at this time, I can say there is no personal trading involved and we are confident that we did nothing wrong.

Now, I would like to turn it over to Dave Bonham, my CFO, he can give you some more information on the underlying financials. Dave?

David Bonham

Thank you, Prem. First I’ll focus on Fairfax’s consolidated results for the second quarter 2014, then move on to the operating company results and finish with the consolidated financial position.

For the second quarter of 2014, Fairfax’s reported net earnings of $364 million or $16.15 per share on a fully diluted basis that compared to the second quarter of 2013, when we reported a net loss of $158 million or $8.55 for fully diluted share.

Year-to-date, Fairfax’s reported net earnings of just over $1.1 billion or $51.84 per share on a fully diluted basis was significantly higher than year-to-date net earnings of $4 million at this time last year. Our insurance and reinsurance operations reported higher underwriting profits of $110 million and $209 million and combined ratios of 92.7% and 92.8% in the second quarter and first six months of 2014.

Last year during those same periods, our underwriting profit was $84 million and $170 million and the combined ratios were 94.2% and 94.1%, so that’s an increase of $39 million in our underwriting profit on a year-to-date basis.

Our combined ratios benefited from net favorable prior year reserve development of $76 million and $131 million, translating into 5 and 5.4 combining between 4.5 combined ratio points in the second quarter in first six month of 2014, and that was somewhat lower than net favorable developments of $106 million and $142 million representing 7.4 and 4.9 combined ratio points in the second quarter in first six months of 2013.

Current period catastrophe losses were lower year-over-year and totaled $56 million or 3.7 combined ratio points in the second quarter of 2014 and $86 million or 3 combined ratio points in the first six months of 2014.

By way of comparison, in the second quarter in first six months of 2013, we incurred cat losses of $112 million and $144 million, representing 7.7 and 5 combined ratio points respectively.

Please note that during the second quarter of 2014, OdysseyRe changed the manner in which it recognized premiums from its U.S. crop business. Enhanced underwriting systems and the accumulation of sufficient internal historical data allowed OdysseyRe to recognize the majority of the premium from its U.S. crop insurance business in the second quarter to more closely correspond with the planting season, whereas in 2013 these premiums were recognized in the third quarter.

The full effect of this change in our financial reporting is described on Page 43 of our interim report for the six months ended June 30, 2014. This change increased our net premiums written by $143 million in the second quarter and first six months. So after adjusting net premiums written in 2014 by this amount, net premiums written by our insurance and reinsurance operations increased by 4.4% and 2.3% in the second quarter and for six months.

Now, turning to our operating company results, we’ll start with OdysseyRe. In the second quarter and first six months of 2014 Odyssey reported underwriting profits of $70 million and $146 million and combined ratios of 88.6% and 87.3%. That’s compared to underwriting profits of $75 million or rather $79 million and $174 million and combined ratios of 85.9% and 84.4% in the second quarter and first six months of 2013.

Catastrophe losses totaled $49 million and $71 million and that translated into 7.8% and 6.2% combined ratio points in the second quarter and first six months of 2014 with the largest single loss totaling $25 million in connection with Windstorm Ela in the second quarter. OdysseyRe’s combined ratios included the benefit of $25 million and $47 million or both four combined ratio points of net favorable prior year reserve development in each of the second quarter and first six months of 2014.

With the net favorable reserve development in the first six months of 2014 more heavily weighted towards favorable emergence on prior year’s non-catastrophe loss reserves across all of our OdysseyRe divisions.

Excluding, in 2014, the net premiums written related to its U.S. crop insurance business as we mentioned earlier, OdysseyRe wrote $531 million and a little over $1.1 billion of net premiums in the second quarter and first six months, reflecting an increase of 5.8% in the second quarter and a nominal decrease in the first six months of 2014, principally due to growth across most lines of businesses in the U.S. insurance division, offset by declines in writings of reinsurance business, primarily proportional and excessive loss property lines of business and that was due to competitive market conditions.

Moving on to Crum & Forster. Crum & Forster’s underwriting results improved in the second quarter and first six months of 2014, with underwriting profits of $4 million and $5 million and combined ratios of 98.8% and 99.3%.

Crum & Forster, reported underwriting losses of $6 million in each of the second quarter and first six months of 2013 and those corresponding combined ratios were 102% and just a little below 101%. There is no prior year reserve development in 2014 and 2013 and current period catastrophe losses were $5 million and $12 million in the second quarter and first six months of 2014, adding 1.1 and 1.9 points of the combined ratios during those respective periods.

Net premiums written by Crum & Forster increased by 16.7% and 16.4% in the second quarter and first six months of 2014, primarily reflecting incremental gross premiums written related to the renewal of the American Safety business and growth in the Fairmont Accident & Health business, combined with higher net risk retention in certain lines of business.

Turning to Zenith, Zenith reported underwriting profits of $18 million and $34 million, and corresponding combined ratios of 89.8% and 90.2% in the second quarter and first six months of 2014, and that is a significant improvement over the combined ratios of 95.6% and 102.6% reported in the second quarter and first six months of 2013.

The improvement reflected the following: first, a year-over-year decrease of 2.3% and 4.7 percentage points in the estimated accident year loss ratios in the second quarter and first six months of 2014, due to favorable loss development trends per accident year 2013; second, increased net favorable development of prior year’s reserves, representing 9.4 and 9.8 points of the combined ratios, compared to net favorable development of 6 and 3.2 combined ratio points during those same periods last year; and finally, the underwriting expense ratios benefitted from a 6% and 8% increase in net premiums earned in the second quarter and first six months of 2014.

Net premiums written by Zenith, $161 million and $441 million in the second quarter and first six months of 2014, increased by 5% and 2.4% on a year-over-year basis reflecting premium rate increases.

Northbridge reported underwriting profits of $11 million and $12 million and combined ratios of 95.3% and 97.5% in the second quarter and first six months of 2014. An improvement relative to the combined ratios of 100.4% reported in each of those same periods in 2013.

Northbridge’s underwriting results included the benefit of net favorable prior year reserve development across most accident years and lines of business of $27 million and $42 million representing 11.6 and 9.2 combined ratio points in the second quarter and first six months of 2014. And that was somewhat lower than the net favorable development of $54 million and $62 million, representing 22 and 12.8 combined ratio points in the second quarter and first six months of 2013.

There were no catastrophe events in the first six months of 2014 whereas the Alberta floods in the second quarter of 2013 were principally responsible for adding 13.9 and 6.9 points to the combined ratios in the second quarter and first six months of 2013.

In Canadian dollar terms, net premiums written by Northbridge increased by 2.7% and 2.1% in the second quarter and first six months of 2014, reflecting higher net risk attention and increased gross premiums written at Federated insurance and in the western region at Northbridge insurance. Partially offset by the strategic non-renewal of an unprofitable portfolio business. That’s after adjusting for the one-time impact of the intercompany underwritten premium portfolio transfer on January 1 of 2013 between Northbridge and Group Re that we described on Page 37 underwritten report.

Fairfax Asia’s combined ratios increased from 90.7%, from 90.9% in the second quarter and first six months of 2013 to 93.4% and 93.6% in 2014, primarily as a result of net adverse prior period reserve development of 3 and 3.8 combined ratio points in the second quarter and first six months of 2014, whereas Fairfax Asia reported net favorable prior period reserve development in those corresponding periods last year.

Unfavorable emergence in 2014 was principally related to losses assumed by Pacific Insurance from the Malaysia Motor Vehicle Insurance School were participation is compulsory.

On a year-over-year basis net premiums written by Fairfax Asia in the second quarter and first six months of 2014 increased by 15% and 26%, principally reflecting increased ratings of marine hull, commercial automobile and property business. The combined ratios of the insurance and reinsurance other division of 97.8% and 97.7% in the second quarter and first six months of 2014 improved, compared to the combined ratios of 100.2% and 99.3% reported in the same period in 2013.

Net premiums written decreased by 16% and 17% in the second quarter and first six months of 2014, reflecting the non-renewal of certain classes of business where terms and conditions were considered inadequate at Advent, Polish Re and Fairfax Brazil and excluding the one-time impact of the intercompany unearned premium portfolio transfer on January 1, 2013 between Northbridge and Group Re that we described earlier and which suppressed net premiums written by Group Re in 2013 by $39 million.

Turning to run off. Run off reported operating losses of $29 million and $50 million in the second quarter and first six months of 2014, compared to operating losses of $5 million and $6 million in the same periods in 2013. The year-over-year decrease and operating profitability primarily reflected net adverse development and U.S run off in 2014 and a gain on a significant commutation that was recorded in 2013. But after factoring in net income investments run off reported pre-tax earnings of $65 million and $233 million in the second quarter and first six months of 2014.

Turning to some of our consolidated results, our consolidated interest and dividend income increased from $112 million in the second quarter of 2013 to $120 million in the second quarter of 2014, reflecting lower total return swap expense and a modestly increasing investment income earned.

In the half year, consolidated interest and dividend income, decreased slightly from $212 million to $211 million, reflecting lower investment income earned, partially offset by a decrease in total return swap expense.

The company recorded income tax provisions of $157 million and $491 million in the second quarter and first six months of 2014, at an effective tax rate of approximately 30%. The effective tax rate was higher than our Canadian statutory income tax rate of 26.5%, primarily as a result of significant income earned in the U.S which is taxed at a higher U.S statutory income tax rate of 35%.

Moving onto our financial position, our total debt to total capital ratio decreased to 24.7% at June 30, 2014, from 26.1% December 31, 2013. And that was primarily as a result of the increase in our common shareholders’ equity, reflecting the net earnings in the first six months of the year.

And now, I’ll pass it back over to you, Prem.

V. Prem Watsa

Well, thank you, Dave. Now we are happy to answer your questions. Please give us your name, your company name and try to limit your questions to only one, so that it’s fair to all on the call. So, Rebecca, we are waiting for the questions.

Question-and-Answer Session

Operator

Thank you. We’ll begin the Q&A session. (Operator Instructions) Our first question comes from Paul Holden from CIBC. Your line is open.

Paul Holden – CIBC World Markets

Thank you. Good Morning.

V. Prem Watsa

Hey, good morning, Paul.

Paul Holden – CIBC World Markets

Really it’s two questions, but they’re interconnected, so sort of one question. I guess it’s regarding OdysseyRe and the premium growth you saw there. So just wondering how much of OdysseyRe is comprised of the U.S. specialty lines versus the reinsurance? And then the second part to that is with respect to U.S. commercial lines, still seeing sort of an oversupply situation in sort of a more plain-vanilla type insurance lines, I’m wondering if any of that excess supply is staring to flow over to the specialty lines and causing any pricing pressure there?

V. Prem Watsa

Good question, Paul. OdysseyRe of course is a mix of specialty lines through Hudson and Hudson Insurance and Reinsurance business through OdysseyRe. OdysseyRe has a worldwide platform, as you know, the reinsurance platform. So there’s many dollars that they can move up and many dollars that they can move down. The one big change that’s happening in the business right now, which you’d know, office property cat prices are coming down and so our exposures are coming down and our premium levels are coming down in that area.

But the other areas and the specialty lines, I think, I don’t know, Dave, if you want to add. Some of the prices – if look you at Crum, and prices are still going up, 3% to 4%. Zenith of course is still having single-digit price increases. And our Canadian companies are having 3% to 4% prices increases. The U.S. insurance for OdysseyRe, I think we figure approximately a third of our business, right?

David Bonham

Yes.

V. Prem Watsa

Dave, you want to add?

David Bonham

Yes. U.S. insurance, about $370 million out of the $776 million in gross premiums written in the quarter and about $550 million out of the $1.4 billion gross premium written year-to-date.

V. Prem Watsa

Terrific. Thank you, Paul. If you have any more – if you need a little more clarification please phone Dave or John by now. Rebecca next question?

Operator

Next question comes from Mark Dwelle with RBC Capital Markets.

Mark Dwelle – RBC Capital Markets, LLC

Hey, good morning.

David Bonham

Good morning, Mark.

Mark Dwelle – RBC Capital Markets, LLC

A couple of questions, on the change on the accounting related to the crop business, can you give me an idea, I mean is that most of their crop worker is that picking up about one additional month or couple of different – maybe just generally the overall size of the crop book?

V. Prem Watsa

Dave, do you want to answer that?

David Bonham

Sure, yes, the figures that we disclosed in the interim would basically be there entire virtually all of the spring planting crop premiums, so think of it as just bringing all of the majority of the crop premiums that would have been there next quarter, bringing it into the second quarter.

V. Prem Watsa

So, instead of – Mark, instead of reporting that in the third quarter we have enough systems now and enough confidence to put it in the second quarter capacity putting in the third quarter, we’re putting it in the second quarter, so we’d explain that in the MD&A but that’s what it is. I mean it’s pretty well all of the business right, Dave.

David Bonham

Yes, that’s right. Yes.

Mark Dwelle – RBC Capital Markets, LLC

It was pretty well disclosed, I just – I wasn’t sure whether that was it is same kind of all of the book, most of the book, or just a fraction of the book, so that was – I was mainly after. The second question I had was related to the reserves, I mean definitely seen an improvement in reserve releases over the last several quarters which is excellent news.

I was curious what accident years most of these are coming from, are they relatively older accident years or more recent ones, and if there is any particular lines of business that are accounting for most of the releases.

V. Prem Watsa

Mark, do you know our policy is to have our current accident years always conservative and so that’s where the redundancies is coming in the future for us. We don’t want to ever be in that position where you go the opposite way. But when we look at it here the lot of the redundancies that coming across property lines and more recent property lines and generally across all our companies is what I chief actually here class sales.

Mark Dwelle – RBC Capital Markets, LLC

Okay, that’s all my questions, thank you.

V. Prem Watsa

Terrific, thank you Mark. Rebecca next question.

Operator

Thank you. (Operator Instructions) Our next question comes from Tom MacKinnon, BMO Capital.

Tom MacKinnon – BMO Capital Markets

Yes, thanks very much. Good morning everyone. Question with respect just to the cash, looks like it’s coming down a little bit over the last couple of quarters, and I don’t know if there is any read through here, are you find a little bit more cash to work. How should we be thinking about that and then I’ve a follow up?.

V. Prem Watsa

So Tom, I think of that cash as a resultant right? So we see something publicly we talked about Eurobank and we put money into this bank in Greece which we like. So we use cash for that, so if there is anything we like we go in and buy it. But so it’s not like we want to keep 30% cash at all times, we are using the cash wherever the opportunities are and Eurobank is a classic example.

But we don’t find enough opportunities with significant downside protection to take advantage of the cash that we have. So our thinking is, like we mention as cash, it’s still very significant and I think 25% to 30%. And – but it does give us the ability to react when we see something like that Eurobank to put it in. And so we are continuing to look at opportunities all over the world, but only if it meets our long-term value oriented criteria.

Tom MacKinnon – BMO Capital Markets

And how low do you think it want to take it, I assume you still want to keep at least $1 billion in cash at the hold co., but with $7.5 billion in there do you think you’ve got the opportunity to redeploy $3 billion to $4 billion to $5 billion of that $7.5 billion in cash?

David Bonham

Yes, no I think that is right. That is right, Tom, we’ll always keep $1 billion of course in the holding company as we said before. But in the insurance company, we have lots of flexibility to add to opportunities. Many people feel that because of our – and I highlighted that in my prepared comments that because of the fact that with that cash, it’s also 85% hedged and we have few corporate bonds, that we can’t make any money. Well that is – this is not right under certain circumstances we can make that ton of money.

We’ve done it in the past; we can’t tell you when we’ll do it, when we can – we can’t predict the quarter, the year that will happen. But the first two quarters they are example of that. Under certain circumstances, we can make a lot of money for our shareholders. And I remarked in my prepared comments that these interest rates in Europe are 200 year lows. That means the German 30-year, we call it bonds long bond government bonds are selling below 2%, you’ve to go back 200 years.

So that just telling you that these markets are something is happening on the marketplace, when you’ve 200 year lows that no inflation to speak of and the last number in Europe was 0.4% and the U.S is running around 1%. So there is – with all of this QE1, QE2, QE3 inflation is very muted, very low. And the economy by the way and you saw the 4% in the second quarter 1.7% of that goes to inventory buildup. So it’s more like 2.3%, but if you look at the half, nominal GMP for the United States, nominal for the first half is 2.5%, real GDP for the first half is 0.9%.

So still very tepid in spite of all of this monetary easing, and we are of the opinion that you’ve to protect yourself from that. We never want to look for money and be in a position where we get blind sighted. And we continue to be that grand client, and I know in the last few years that is not necessary, and perhaps we’ll muddle too and perhaps that won’t be necessary.

But we worry about this, perhaps one other point that I could make is, in China there is a few numbers suggesting that there is a little bit of a pickup. I just thought I have talked about it in our annual report. But Dave raised to me an interesting point is – have written a little article where he said, China use more cement in the last three years than the U.S – United States used in the entire 20th century, that is 100 years.

China used more cement in the last three years than the United States used in the entire 20th century. And then you’ll be interested anyone who looked at Japan in the 1990s will be interested in these two comments that an Executive from one of China’s largest real estate companies met in London. The first time and he said was the total land value in Beijing that is only Beijing is 62% of U.S GDP.

Total land value in Beijing is 62% and the second comment you made of China’s house production a 1,000 head of population reached 35. It reached 35 in 2011. And the figure is below 12% in most developed economies even in the housing market is hot, no country has had a figure of greater than 14%. This is the house production per 1,000 head of population. So this is staring us in the face we think and we just want to be careful and conservative. We’re trying to build our company over 25, 30 years. We have to go through periods like this where you’re not going to be – where you have to be careful. But in spite of that, we do have many things in our portfolio, including recent purchases of common stock that can do well for our shareholders.

Tom MacKinnon – BMO Capital Markets

Okay, and one quick follow-up, if I may. In your prepared remarks, you did talk about some pressure on investment income in the short-term and I assume that’s from the cost of the total return swap, as well as the higher cash component. I did notice, though, quarter-over-quarter the total return swaps cost had declined substantially. Just thinking about how should we should be looking at that going forward, or any reason why it may have fallen quarter-over-quarter. Is it a lumpy cost, or what is that?

V. Prem Watsa

So Tom, on these hedges, the total return swaps, I’m thinking of the stock hedges, right, Tom.

Tom MacKinnon – BMO Capital Markets

Yes.

V. Prem Watsa

So that’s predominately Russell 2000. And we haven’t increased them. We’ve kept them flat, the nominal amounts of flat. Of course they go up or down with the stock prices, but the nominal amounts are flat. And when we outperform those indexes, then the hedge ratio drops. And of course if we under-perform, the hedge ratio will increase. And if we add or sell, then it will affect the ratio too, add or sell common shares. If we buy Eurobank, that ratio will drop and if we sell something then that ratio will increase. Dave,

you want to add to that, Dave?

David Bonham

Yes. That’s right. So the expense is going to be a function of the notional amount of the hedge that we have on. And just as an example, you recall, we closed the S&P 500 hedge last year. By not having that hedge in this quarter on the quarter expense, that saved us about $8 million mix in total return swap expense. So that accounts for a significant portion of the decrease in total return swap expense in the quarter. Just that one.

Tom MacKinnon – BMO Capital Markets

Yes, I was looking quarter-over-quarter though. The notional amount had change, but the cost is running about half of what it was in the first quarter. Maybe you can follow-up later on that, but that’s…

V. Prem Watsa

Well, why don’t we follow-up on that with you, Tom.

Tom MacKinnon – BMO Capital Markets

Okay. Thank you.

V. Prem Watsa

Thank you, Tom. Rebecca, next question?

Operator

Our next question comes from Chris Lafayette with The Clark Estates. Your line is open.

Christopher Lafayette – The Clark Estates

Hi, thank you for taking my question. Just two questions regarding the equity hedge. And I think that you alluded to the first question that I have with your comment on China and the cement demand there. How do you expect a slowdown in China in a likely scenario to sort of flow through and impact North America? And second question is regarding your assumptions. It seems a lot of them are macro-related. Is there a valuation component to the equity hedges as well? And if so, what are you looking at from valuation standpoint?

V. Prem Watsa

I know that’s good question, Chris. On China, China is the second largest economy, right. So you’re talking $8 trillion, $9 trillion. The United States $16 trillion, $17 trillion, Europe about the same and then you’ve got China. So any problem there will impact the world, you must remember. You know this of course that China consumes 40%, 50% of almost every commodity you can think of: copper, steel, iron ore. And so, a slowdown in China will impact the rest of the world quite significantly.

And in terms of valuation, your second question, the Russell 2000, any type of price earnings ratios that we would look at would suggest that they’re very high levels. If you look at market cap to GDP ratios, going back 100 years, you’ll see them at high levels. The Shiller ratios that we showed at our Annual Meeting are – and price earnings ratios, Shiller bases on a 10-year average. You’ll see that that’s on the high side.

So many valuation parameters, but also, Chris, of course, earnings. Earnings have been going up some. And in a tougher economic environment, earnings are likely to come down. The S&P is making a lot of money. There’s lots of stock buybacks. So the earnings per share have been going up. And so, there’s not only the macro, but the valuation parameters.

And then finally, we look for things on a bottoms-up basis, and we’re not finding too many things that we think that gives us downside protection and allows us to make a return over time. So you put all of those reasons together and we like competition.

Christopher Lafayette – The Clark Estates

Appreciate the color. Thank you.

V. Prem Watsa

Thank you, Chris. Rebecca, next question.

Operator

I’m showing no further questions.

V. Prem Watsa

Well, thank you, Rebecca. Well, there are no more questions, and thank you all for joining us on this call. We look forward to presenting you again after the next quarter. Thank you.

Operator

Thank you. Thank you all for attending today’s conference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Fairfax Financial Holdings' (FRFHF) CEO Prem Watsa on Q2 2014 Results - Earnings Call Transcript
This Transcript
All Transcripts