In a recent edition of Value Investor Insight, Whitney Tilson and Glenn Tongue reiterated their thesis from last August that Fairfax Financial (FFH) is one of the best ways to play the subprime train wreck.
Few firms were as well-positioned to benefit from the credit crisis as Canadian insurer Fairfax Financial. Primarily due to its giant credit-default-swap [CDS] portfolio on companies exposed to the subprime debacle, Fairfax has feasted on others’ misfortune: earnings are up sharply and the shares have risen 40% since we touted them last summer (VII, August 31, 2007).
While this performance might indicate the bullish case for Fairfax has played out, we believe that’s not at all the case – in fact, we consider the shares more undervalued today than they were last summer. Our rationale: We’re still in the early innings of the financial mess triggered by out-of-control real estate lending, and Fairfax CEO Prem Watsa has done nothing short of a masterful job in positioning Fairfax to continue to benefit from it. The potential gains from Fairfax’s bearish bets are incredible for a company of its size. With a market cap of $5.2 billion, we estimate Fairfax could generate pre-tax gains of some $2 billion in the first quarter – including $1 billion from the CDS portfolio and another $800 million from the almost 100 basis point decline in medium-term interest rates since December 31.
The investment portfolio remains highly attractive if credit markets remain ugly. Fairfax’s CDS portfolio, with $18 billion in notional value as of February 15, is in holdings negatively tied to the fortunes of exposed financials such as PMI Group, Fannie Mae and Societe Generale. It owns roughly $1.1 billion in hedges against the S&P 500. Watsa has also proven his mettle as a long-term investor, compounding Fairfax’s stock portfolio over the past 15 years at 19.5% annually (vs. 10.4% for the S&P 500) and its bond portfolio at 10.1% (vs. 6.5% for the Merrill Lynch mid-term U.S. corporate index).
Gains in the CDS and bond portfolios should substantially increase the company’s book value, but they are likely to be one-time events. Thus, Fairfax’s long-term value will depend on the quality and growth of its insurance operations, where the trends are highly favorable. Fairfax’s three major subsidiaries, Northbridge, Crum & Forster and OdysseyRe, reported 2007 combined ratios that ranged from 92.2% to 95.5%, returns on equity from 22.8% to 25.9%, and six-year compounded annual growth rates of book value of 18.9% to 21.9% – all fabulous numbers. Times have been unusually good for the insurance industry to be sure, but we think Fairfax can achieve its stated objective to compound mark-to-market book value per share at 15% annually.
What’s Fairfax worth? We estimate common shareholders’ equity at the end of March will increase to $5.4 billion, based on the after-tax impact of the CDS and bond-portfolio gains and $100 million in operating earnings. We continue to think a 1.5x multiple of book is reasonable, yielding an intrinsic value of $8.1 billion. We also value Fairfax’s stake in ICICI Lombard, the largest private general insurance company in India, at $200 million more than its book value, bringing the total fair value to $8.3 billion, or $450 per share. That’s nearly 60% above today’s share price of around $283.