by Ben Claremon | Research Analyst
Under normal circumstances, the prospect of leaving sunny Southern California to travel to a place where the day-time temperature encourages the wearing of fur is not particularly appealing. But I decided this year to make the slog to attend Fairfax Financial’s annual meeting in Toronto. Prem Watsa, the Chairman and CEO of Fairfax, has the reputation of being the Warren Buffett of Canada as he has modeled Fairfax to be similar to Buffett’s Berkshire Hathaway in terms of structure and investment approach. Like Buffett, Watsa measures success by comparing the yearly percentage increase in book value to the return of the S&P 500. Like Berkshire Hathaway, Fairfax has a decentralized structure whereby the insurance company presidents and the leaders of the non-insurance operating businesses have a lot of autonomy. This approach has helped Watsa and Fairfax generate substantial wealth for its long-term shareholders, as book value per share has increased from less than $2 twenty-seven years ago to close to $400 today.
However, what presently stands out about Fairfax is not the similarities to Berkshire, but the different investment strategy it is currently employing when compared to Berkshire. Prem Watsa has made a pretty significant bet that the US, Canadian and global economy are entering a period of deflation. Despite the fact that central banks from all around the world are explicitly trying to create inflation, Prem believes that the forces of de-leveraging are too strong for the money printers to counteract. (Read anything written by Van Hoisington if you want more detail on the deflation trade). As such, Fairfax has entered into large, long-term, CPI-linked derivatives that benefit from deflation. In addition, given that de-leveraging and deflation would likely have a strongly negative effect on the value of financial assets such as stocks, Fairfax has hedged 100% of its equity portfolio.
While the deflation bet has not come to fruition and the equity market hedges have hurt returns as stock indices have continued to rise, Watsa remains steadfast in his belief that over the next few years, what he calls “being careful” will pay off massively. The hope is that at the point of maximum pessimism in the markets—where there is inevitably a lot of forced selling—Fairfax will be able to close its hedges at a profit and have ample capital to purchase distressed assets. Of course this investment strategy limits appreciation in book value in the short run and has the potential to generate very lumpy returns, but the beauty of having permanent capital (that which can’t be taken away by investors on a whim)—and shareholders that understand the rationale for the conservative positioning—is that Watsa can be patient and opportunistic. The idea that being early is indistinguishable from being wrong comes to mind when evaluating the risks of this strategy. However, Watsa reiterated a number of times that his first rule is to not lose money and that Fairfax will not stretch for yield—like just many institutional investors from around the world appear to be doing right now.
As a value investor, Watsa’s conservatism appeals to me as the recognition that many investors are essentially picking up pennies in front of a steamroller by buying fixed income securities at rock bottom yields. But the question that arises from a potential investor’s perspective is, even if you are willing to sacrifice short-term returns for long-term opportunity, is Fairfax the proper vehicle to invest in? As Watsa mentioned, in a deflationary environment the cash flows from the insurance and non-insurance companies are likely to decrease and thus hurt the stock price. My devil’s advocate position on Fairfax has in the past been that if you want to protect against deflation and a huge drop in stock markets, just hold a lot of cash and buy some out-of-the-money put options on major stock indices. On the other hand, if you want exposure to an eventual hard market in property and casualty insurance, wouldn’t it make more sense to buy shares of an insurance company that has a history of generating better combined ratios and underwriting profits?
This brings me to what I thought was most interesting about the meeting. Over and over again Watsa and the insurance company presidents stated that the primary goal is to improve underwriting results. For those not interested in insurance, the constant discussion surrounding combined ratios was likely not too thrilling—nowhere near as exciting as the topic of the deflation bet and the equity hedge. But, if Fairfax were able to begin to consistently underwrite at combined ratios well under 100%, returns on equity would certainly improve. When that is combined with the optionality embedded in the investment portfolio (and Prem has proved himself capable of pulling nearly infinite return rabbits out of the hat), I think you can easily make the case that Fairfax would deserve a higher price to book value multiple and that the current valuation looks pretty compelling.
Without further ado, the following are my notes from the 2013 Fairfax Annual Meeting. As always, these were taken in real time without the use of a recording device so please excuse any instances where I was unable to capture the exact nature of what was said. Enjoy!
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