Seeking Alpha

It's Time To Trade Fairfax Financial Again

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About: Fairfax Financial Holdings Limited (FRFHF)
by: Canadian Dividend Growth Investor
Summary

Fairfax moves differently from the markets. So, it adds diversification and is a good candidate for buying low and selling high.

We explain why Fairfax's earnings are unpredictable.

Currently, the stock offers upside potential of almost 27% and a yield of 2.1%.

Fairfax Financial Holdings (OTCPK:FRFHF, TSX:FFH) is a curious stock that moves differently from the U.S. and Canadian stock markets, as shown in the chart below. This potentially makes Fairfax a good candidate to trade while adding diversification to investors' stock portfolios.

Chart Data by YCharts

The Business

Fairfax's business model is similar to Berkshire Hathaway's (BRK.A)(BRK.B). It has an underlying insurance business that generates float as a source of low-cost capital to invest for higher returns.

Fairfax's underlying insurance and reinsurance businesses and other subsidiaries operate on a decentralized basis, leaving the companies’ everyday operations to the respective company presidents and allowing Fairfax to focus on capital allocation.

In the first half of the year, Fairfax's insurance businesses were profitable. It had a consolidated combined ratio of 96.9% for its insurance operations. The combined ratio of <100% implies profitability.

As stated on its website, Fairfax's goal is "to achieve a high rate of return on invested capital and build long term shareholder value".

According to Prem Watsa, the chairman, CEO, and founder of Fairfax, the company can achieve a 15% return on shareholders’ equity with a 95% combined ratio and a 7% return from the investment portfolio.

Fairfax's Diversified Investment Portfolio

Here's Fairfax's equity portfolio of 37 holdings as of the end of June from the last quarterly update ordered by market cap:

Source: Gurufocus, Page 1 and 2

It's interesting that Fairfax holds a position in Berkshire, as it's often called a mini version of Berkshire.

One might argue that some of Fairfax's equity holdings aren't exactly high quality *ahem* for example, General Electric (GE). However, Prem Watsa is a guru investor and the investment portfolio works together as a whole. It's important to emphasize that the above stock portfolio only makes up about 14% of FFH's entire investment portfolio.

Source: Q2 Interim Report, Page 2

At the end of Q2 2019, Fairfax held more than US$10 billion in cash and short-term investments and more than $16 billion of bonds against roughly US$5.5 of common stocks. It also had US$2.75 billion invested in emerging markets of India and Africa via Fairfax India (OTCPK:FFXDF, TSX:FIH.U) and Fairfax Africa (OTCPK:FFXXF, TSX:FAH.U), which can lead to greater long-term returns.

The US$10 billion in cash and short-term investments offers liquidity for the company to take advantage of future downturns in the markets.

Strong Long-Term Returns; Weaker Short-term Returns

From 1985 to 2018, led by Prem Watsa, Fairfax compounded its book value per share compounded by 18.7% annually, which translated to the share price growing by almost 185 fold, equating to 17.1% per year.

The graph below shows that in the long run, FFH's book value per share has increased, driving higher share prices.

Chart Data by YCharts

In recent years, Prem Watsa appears to have lost his touch. From before the last financial crisis that triggered a recession (i.e., from 2007) to 2018, FFH's book value per share and stock price have only increased by 5.9% and 7%, respectively, per year. This may be why the stock is trading close to a 10-year low valuation.

Valuation

With the stock trading at below book value, we feel Fairfax offers good value for some of our investment dollars. Assuming a P/B of 1.25, it implies a price target of CAD$738, which represents nearly 29% upside potential from Friday's market close price of CAD$572.

Chart Data by YCharts

Dividend

Different from Berkshire, Fairfax offers a dividend that's good for a yield of nearly 2.2%. Historically, it had paid a U.S. dividend of $10 per share once a year with ex-dividend dates in January.

Erratic Earnings

Fairfax's business is less straightforward than the typical business. To some extent, its profitability depends on the performance of its insurance businesses. Additionally, it generates unpredictable earnings due to its investment portfolio.

For example, in the first half of the year, it generated diluted earnings per share ("EPS") of US$44.17, which was 73% higher compared to the period a year ago. In 2018, it generated diluted EPS of US$11.65, which was down 82% year over year.

Source: 2018 Annual Report (pdf), Page 83

What Can Drive a Rebound in Fairfax?

Since inception, Fairfax has generated an 8% return on investments despite the poor results for the past five years due to the company's deflationary and short bets.

Table showing Fairfax Source: Letters to Shareholders (pdf), p19

As mentioned, Prem Watsa stated the company can achieve a 15% return on shareholders’ equity with a 95% combined ratio and only a 7% return from the investment portfolio.

The company also "took corrective action on [its] insurance operations", which should lead to more consistent underwriting profits.

Additionally, Fairfax's investment portfolios are now led by Wade Burton, who is currently the president and CIO of Hamblin Watsa and in 2018 added to the team, Ian Kelly in the U.K., Wendy Teramoto in New York, and Davies Town. Although Roger Lace, Brian Bradstreet, and Prem Watsa continue to give guidance, the fresh blood can bring new perspectives to drive the overall portfolio performance.

Other factors that can drive a rebound in the stock include growth from emerging markets such as India, and the U.S. economy continues to grow strong, such as if the U.S. forms a trade deal with China and or Europe.

Conclusion

Fairfax is an unusual stock that appears to be good for buying low and selling high. A fairer valuation would imply upside potential of about 29%. Moreover, it offers a yield of close to 2.2%.

Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We're long TSX:FFH. This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.