It’s been a long time since I’ve written about Fairfax Financial. Last time was in October 2011 (see here for previous posts). Fairfax recently held their annual shareholder meeting which had some great information about the company, its results, and why it is a good investment. I’ll discuss some of the highlights of the meeting in this post.
First, my investment thesis for Fairfax is pretty simple. Great long term returns, a super conservative and competent management team, and a leveraged but hedged investment. I’ll explain. In 27 years, Fairfax has generated a compound return of 23.3% a year on book value. Easily up there with Buffett. The investment team, led by Prem Watsa – CEO, always has the company positioned conservatively and ready for the next potential crisis. Lastly its the only investment that I have found where my equity dollars are leveraged, due to insurance float, and hedged due to the conservative investment stance of the company. I’ll talk a bit more about this below but Fairfax comes as close to a disaster hedge with upside that I can think of. And I get a 2.5% yield while I wait. On to the annual meeting. Slides from the annual meeting can be found here ….
First, Fairfax is primarily an insurance company. Good insurance companies make money on just writing insurance. Its called an underwriting profit which is measured by the Combined Ratio . Insurance companies charge premiums for policies and pay out claims when they are made. A well run company makes sure that the premiums they charge cover the claims plus the expenses to run the business. That’s what the combined ratio measures. A ratio less than 100% you’re making money on the insurance alone, over 100% you’re not. No one does it better than Berkshire Hathaway and Fairfax ain’t too shaby either. Below is a slide that shows Fairfax’s combined ratio.
Making money on basics over a period of years. Check. Now, insurance companies get to hang on to those premiums waiting for the claims, if any. That money is called float. During the time they hold that money they get to earn investment returns on it. So, as an equity investor what you get is a leverage effect due to the nature of the insurance business and the capital structure of the company. Lets take a look at how it plays out at Fairfax.
For every share you own in Fairfax, $378/share of book value, you are exposed to the return on $1,289/share of investments in the company’s portfolio. That’s a little over 3X leverage. That’s the power of float if managed properly. The last piece of the puzzle is the company’s investment performance. And here again Fairfax has a great track record as seen below.
Since 1986 their dollar weighted compound total investment return has been 9.4% per year. With the leverage of float that has yielded the 23.3% return on book value. Going forward, Fairfax’s stated goal is to grow book value at 15% per year in the future. Based on historical results, the leverage you get as an equity investor, and the strong insurance business, it looks like an easily achievable goal to me. Lastly, one of the things that I like about Fairfax is their conservative portfolio positioning. The chart below shows their portfolio allocation as of the end of 2012.
30% cash, 43% bonds, 24% stocks (100% hedged), and 3% other. Pretty darn conservative. In addition, they also own a chunk of de-faltion hedges (CPI-linked derivative contracts) just in case the world slips into deflation. On the other side, insurance is pretty much an inflation hedged business. This conservative positioning is why I view Fairfax as kind of a disaster hedge, just one I expect to make 15% per year on!
One thing about Fairfax is that their results and stock returns tend to be lumpy. They have historically under performed for significant periods of time. Also, due to their conservative nature they tend to do well when the rest of the market is doing bad. Which makes it great as portfolio diversification. The table below shows how lumpy their results can be.
In summary, I still think Fairfax is a great long term investment which can also act as a disaster hedge and great portfolio diversification tool. Their results for 2012 support all these themes. Q1 2013 interim results are due at the end of this week and I expect more of the same.