This is clearly Berkshire Hathaway (BRK.A) - Get BRK.A Report week; witness TheStreet.com's own Chris Edmonds' excellent on-the-spot coverage. Since I have problems getting a decent table at Gorat's in Omaha, I have had to look elsewhere to invest my dollars, and in the process, may have stumbled upon a Buffett-like legend in the making.
It was while doing a little
-skiing at the Post Hotel in Lake Louise, Canada, that I came across an article regarding the overflowing crowd at the annual meeting of
Fairfax Financial Holdings
(FFH:Toronto), based in Toronto.
Yes, Canadians love a free donut, just like we do south of the border, but food alone couldn't explain the unusual turnout for a mere annual meeting. The story also used the phrase "the
of Canada." That's a sure hook line, and I put a call into Fairfax asking for a financial packet the very next day. Within a week, I had received and consumed 13 years worth of annual reports.
What I found was unbelievable -- Mr.
V. Prem Watsa
, the founder and resident genius behind Fairfax, has put together a 13-year record that is so good, I am embarrassed as an investment professional not to have been aware of it. (Not to mention crying over not owning the stock!)
It turns out that, for the 13 years ended in December 1998, Mr. Watsa compounded his company's book value per share at a 41% annual rate. Putting that in perspective, Buffett and Munger have grown Berkshire's book value at 27.3% a year (true, they never sell, so book value reflects the portfolio's historical cost). And Fairfax stock has compounded at 48% annually, while the company's been earning an average return on equity of 20.4%. In fact, there are just one Canadian and two U.S. companies whose stock prices have compounded faster over these 13 years. Do I have your attention now?
So who's Prem Watsa? Try reading the annual report at the Web site and you'll get the picture. There is no investor relations staff, only 15 people at HQ, and they don't take calls from whiny analysts and shareholders. The annual report is in Berkshire style -- full of forthright disclosure and detailed information -- although Prem does lack the gifted pen that Warren wields with such flourish.
To make a long story short, Fairfax is the story of a
disciple who studied and admired both Buffett and Laurence Tisch (of
fame) and, in 1995, got a chance to buy the failing insurance company
on a shoestring. As luck would have it, Markel's major competitor went bankrupt within a year, and Fairfax was able to quadruple in size overnight. Markel's mission statement has always echoed Berkshire's, namely, to generate positive "float" from insurance operations, invest it intelligently at high returns on capital, be ultra-shareholder-oriented and treat everyone like your brother. And, like Berkshire, the company pays no dividends, and makes no stock splits.
For 13 years, it's worked like a charm. Fairfax has put up huge numbers on the investment side, generating the cash to steadily acquire additional insurance companies on the cheap, which then generates a larger investment pool from which to work. This has culminated recently with some very large deals that have quietly made Fairfax one of the 10 largest reinsurance companies, and one of the top 20 property casualty insurers, on the planet. It also puts C$18 billion of investible assets at Watsa's command. And here's where the numbers get really interesting.
There are two key issues here. The first is that, while insurance generates upfront money, or "float," to play around with, you have to be able to successfully run an insurance business, or you will very soon be playing three-card monte. That means keeping your combined ratio, which is an all-in number of losses and expenses, somewhere near 100 (think of it as a percentage figure).
If you write insurance with a ratio under 100, you are getting free money because you are making money selling the insurance -- which means you get to keep all the investment returns.
But if you are over 100, you are incurring losses and effectively paying for the use of the float and the investment income. It has been very difficult to maintain a combined ratio of under 100 during the past decade in most lines of property-casualty insurance, and it's not getting any easier.
The second issue here is the enormous leverage available from Fairfax's investment portfolio. For each share of Fairfax worth, as of today, about C$410, the accumulated float equals some C$1,250 per share. In other words, for each Canadian dollar invested in Fairfax, you own the return of almost C$3 per share of investment portfolio. Just for comparison's sake, that dwarfs Berkshire's ratio of about 65 cents of investment portfolio for every dollar's worth of share price (a number that assumes decent multiples for the value of Berkshire's operating businesses).
Below are some basic financials for Fairfax to provide an idea of how the company's investment assets can generate some very compelling value. In the first scenario, I assume that Fairfax keeps its C$18 billion invested in corporate bonds, earning 6% interest. In that case, the company generates a 15% return on equity (which, incidentally, would put it in the top decile of insurance companies), and a little north of C$34 in earnings per share. This makes the stock very reasonably priced at its current price of C$410 per share, and gives zero value to one of the better equity investing records in the industry.
In the second scenario, I ran the same numbers, this time assuming a 10% return on the investment portfolio, which is clearly not a stretch, given Watsa's track record averaging 20%-plus a year for over a decade.
In both examples, I assumed pretty poor operations from the insurance side: a pro-forma combined ratio of 106 in 1999 (after acquisitions), improving slightly over time. It may be right, but like any insurance company modeling, it could be awfully wrong.
So aside from Yankee ignorance, why is the stock down from C$600 in February to the low C$400s today?
Like Buffett, Watsa had a rotten year investing. As a deep value investor, he found the pickings slim, and has kept 90% of his portfolio in bonds for two years, which clearly hurt performance. Watsa buys cheap and sells dear and is not afraid to stray from North America. Thus, while North American stocks represent 5% of the portfolio, he has picked around Korea and South America for the other 5%, and this represents a major departure from Buffett. So there are worries that it will be tough (as he states five times in the annual report) for Watsa to continue to put up the big numbers in the current environment. On the other hand, hiring a guy with 90% cash in this environment might be a nice hedge.
Note that there is always risk when you buy an insurance company in distress -- even when you pay huge discounts from book value, with fairly fat reserve coverage -- and Fairfax has bought three large, ugly ones in the last 18 months. To dig out of these messes, the goal is to stop writing bad business and whittle the combined ratio down to 100, but that takes time. And nobody -- and I mean nobody -- truly knows what you are buying when you buy an old book of insurance.
Watsa makes a fairly convincing, Ben Graham-style argument for just how cheaply he bought these companies with a big margin for safety. But they are clearly not the prize stallions like
, which Buffett acquired. And that's a risk you have to live with at Fairfax. On the plus side, Fairfax has historically been very conservatively reserved and has run its insurance operations "decently," generally hovering around a combined ratio of 100.
Lastly, there is a C$1 billion share overhang that will hit the market in late May that is financing recent acquisitions, which has held the stock up.
Read the annual report. Better yet, read a bunch of them. This is stock that you must be willing to put away for five years ... or, hopefully, a lot more. And best of all, Watsa is in his early 50s, and often makes statements to the effect that he will die -- Buffett-like -- at his desk.
Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At time of publication, RCB was long Fairfax Financial Holdings, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at