Street Capitalist: Event Driven Value Investments

I recently had a chance to interview Dave Carlson of Tourmaline Advisors on his investment activities in insurance stocks. I think that insurance is a really interesting business, but some value investors totally stay away from financials because they regard them as too complicated. At the same time though, Warren Buffett has been active in the insurance industry for decades — his hiring of Todd Combs seems to indicate that he believes being able to analyze and invest in financials is important.

So I thought it would be a good idea to interview Dave and get him to shed some light on how he analyzes insurers, I hope you enjoy the interview. Feel free to post follow up questions in the comments section.

1. Can you give us some background on why you got into value investing and what got you interested in insurance stocks?

I have to say that my road to value investing has been a series of unexpected turns. Despite growing up where the men on my dad’s side of the family would talk stocks at family gatherings, and my grandfather giving me a book on stocks for my 16th birthday, I had no interest initially in investing. When I started working after college, I began plowing money into mutual funds offered by the company 401K plan as my primary means of investing. When the division that I worked for was sold to another company, I had to make a decision about rolling over my 401K monies.

After spending a month trying to find the right mutual fund, I decided that if I was willing to expend this much effort on selecting a mutual fund, I might as well buy the stocks directly. A family member recommended reading the Investor’s Business Daily and from there I bought some stocks. One of them happened to be American Capital Strategies (ACAS). This was in 1999 and I had overheard people talking about Yahoo Finance message boards. So I started reading the posts on the ACAS board and found an interesting group of fellow amatuer investors. ACAS is a business development company, which not many people fully understand. We spent a lot of time dissecting how the company worked, and this led to other discussions on investing. A group of us enjoyed it so much that we decided to leave the noise of the message boards behind. Our little study group started talking about value investing and relating it to stock decisions. That mix of theory, discussion and application was powerful. From there it just clicked – I was and am a value investor.

My interest in property and casualty insurance stocks is a much simpler story. It was an occupational hazard from working in the industry and why I tend to be cynical about the industry.

2. Why do you think there is increased M&A activity in the specialty underwriting space? Fairfax has done a few of these acquisitions. Do you think they have some kind of moat that allows them to have better underwriting operations? Or are they actually more similar to the rest of the P&C insurance business which has typically relied on investment income?

There are several dynamics influencing M&A at this point. The low valuation on insurers makes it an opportune time to be a buyer. With premiums flat, catastrophes minimal and bond yields anemic, buying another insurer represents a more attractive return. The interest in specialty insurers stems from 1) they tend to have better pricing and 2) there is less overlap because their underwriting focus is narrower. In terms of moat, the property & casualty insurance is largely a commodity business with few moats.

As for Fairfax having a moat, I would say that they have an inverse moat. Sounds crazy but hear me out. They know how to get rid of business, they know how to say no. That is not a moat but a behavior – to be disciplined. Every insurance exec says that they are disciplined underwriters, they’re all from LakeWobegon, but obviously they are not. Insurance is a product sold for which the costs of goods will not be known until a later date, so people can delude themselves by assuming better loss experience. Sort of like the mortgage securitizers who assumed that home prices could only go up. Insurance companies also have a decent amount of fixed costs because you need underwriters, claims people, etc. to support the business, whether you have 50 policies or 5,000 policies. There is a tendency to write any business just to sustain the infrastructure, something you also see in the for-profit education sector.

As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.

3. Is pricing and market position maintained through client relationships (i.e. its a small expense overall for the yacht owner and they like/trust their broker)? Is it through branding and market position (i.e. “everyone know that MKL is the place to go for yacht insurance”)?, or is there some actuarial knowledge (other participants aren’t sure they know how to price the business properly so they stay away).

Branding and marketing is a diverse subject within insurance. There are significant differences between personal and commercial, distribution method and line of business. A good portion of insurance is a commodity business, particularly personal lines. Does it matter whether I buy my car insurance from a gecko or a perky sales clerk? No, but the constant bombardment of advertising will at least drive people to get a quote from them. That is important because they rely on direct marketing.

The commercial side is where you see more relationship building, not so much with the insurance companies, but with the brokers, claims administrators, etc. When you get into specialty insurance, like yacht insurance, the number of insurance companies offering coverage shrinks dramatically. It is easier for one or two companies to dominate a market and that gives them an advantage in terms of experience and distribution. The actuarial advantage is a matter of numbers. If you insure 10,000 yachts, your loss experience will be a lot more predictable than the insurer covering 100 yachts. Insurance is all about the law of large numbers. Companies that can mine their own data can create an advantage.

4. What are your top metrics to look at when analyzing an insurance company? Most people seem to hone in on combined ratios and book value — what else do you look at?

Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.

I also look at the lines of business written because that influences the combined ratio. For short-tailed lines of business, like property and personal lines, investment income is less of a factor, so the combined ratio should be lower because the driver is underwriting profit. Long-tailed lines, like general liability, can afford higher combined ratios because the investment portfolio is larger and is held longer – the magic of compounding.

5. With most insurers trading below book and it being a soft market — are you finding a lot of opportunities or do you think this is the time to be cautious?

I am more cautious. Insurance companies are essentially levered bond funds, so the extended low bond yields have a bigger impact on earnings. My focus has turned to special situations. I bought a small insurer, Penn Millers (PMIC) after its IPO because it was trading below book value despite having a significant portion of the book value being the IPO proceeds.

Another situation arose with Donegal Goup, which has a unique capital structure. It is a mutual insurer that owns a publicly-traded holding company with two series of shares. The mutual retains control through super-voting “B” shares, which have the same economic interest as the “A” shares. There was some confusion over a deal where they offered to buy a bank, half of which involved “A” shares held by the mutual. The result was the “A” shares trading at over a 35% discount to the “B” shares, which has since narrowed. The other situation is a small specialty insurer, Seabright, which I bought at less than 50% of tangible book value. There was a lot of fear after they took a reserve hit in the 2nd quarter that seemed unwarranted.

6. When you value an P/C casuality company, how do you establish that the reserves are accurate?

When it comes to P&C insurers, reserves are a black box. Outside of being an actuary who can review their claims, there is no way to know whether the reserves are adequate. All you can do is look back over time and see how reserves have developed and whether there have been reserve additions or releases. You have to assess behavior over time. Management can play games over the short-term but eventually the claims get paid and then we find out who is covered and who is swimming naked.

7. How long do you foresee the tail before the insurers adjust their rates for the low bond yields? Do you think we will see a hard market soon?

Let me start with the last question first. Hard or soft markets are determined by capital levels. Prices will harden when capital is destroyed or removed from the space. There is no direct tie to low bond yields impacting pricing but lower investment income means underwriting results will have a greater impact on capital.

8. How do you determine if an insurer is over-concentrated?

Over-concentration is a good question. Some situations are obvious, like Universal Insurance Holdings, a home insurer with most of their business in Florida. That is a binary bet on the hurricane season. Seabright is concentrated in workers comp, with slightly less than half their business in California. The regulatory risk is known by investors, as is their ability to compensate through company-level rate changes and other rating factors. Once you get beyond regional or line of business risk, however, it is difficult to spot concentration.

Even insurers struggle with concentration in their own books. On the property side, technology has allowed insurers to do a lot more catastrophe modeling and to better monitor risk but that depends upon having detailed and accurate location descriptions. The problem on the liability side is that a relatively small segment can have significant losses, as happened with E&O/D&O coverage on financials the past three years.

9. Some insurers are limited to only a few geographic areas — do you discount these because they might face some kind of black swan risk? (e.g.: if you were to only write insurance in TX and a hurricane came, damage could be high but your operations dont have areas outside of TX to draw premiums from to offset the losses)

What I find is that most regionals are very conscious of risk and will buy reinsurance to mitigate the risk. That does not mean that a storm won’t impact earnings but it does not blow a massive hole in their capital. Plus, you do not have to be a regional to suffer major losses – look at what happened after the 2005 hurricane season. In the P&C industry, the potential for a black swan is always present, whether natural disasters, unintended coverage or legislative/judical changes. It is not limited to regionals. I have told my friends that when investing in P&C insurers, cut your normal position in half because you are betting against nature.

You may be surprised that the most that I have ever been invested in insurance was back in 2009 following the March meltdown. I had about 30% of my personal account in insurance, with P&C being about 3/4th of that. Currently, I am about 15% in insurance, all of it P&C. Did I mention that P&C is a lousy business?

10. Have you ever looked at insurance brokers? Do you think they are a better way to invest if you assume the market will start hardening?

I have looked at insurance brokers but have not spent much time looking at them. The top 5 brokers represent something like 85% of the publicly traded market cap and you have at least a dozen analysts covering them. I am not going to add any value to the discussion. Of course, that won’t prevent me from expressing an opinion! My impression is that the brokers are focusing on client needs and have moved away from pure commission fee structures to using a mix that includes flat fees. The brokers will benefit from a hardening market but not to the degree that they once did.

11. Do you ever look at reinsurance companies? How do you get comfortable with the cat risks? Are there any metrics you focus on with a reinsurer that you might look at less when analyzing a short tail P/C insurer?

I do look at reinsurers on a periodic basis. As a group, they tend to track together, depending upon which way the wind blows. As for cat risk, you can see over time how they have diversified into other lines, particularly after 2005. Still, the concern is there and is why they trade at single digit P/E ratios. When it comes to metrics, I use the same ones for reinsurers as for insurers. The only difference is that they tend to trade at cheap than regular insurers.

12. When you value an insurer, what methods or models do you typically use? Is it mostly a matter of looking at multiples and comps? Or is there more to it.

Price to book is really the first metric that I look at, followed by price to earnings. It is simple and objective, as I want to know my margin of safety and then the earnings power. If it is cheap enough that I would be a buyer, then I start digging deeper. Usually, there is a reason that an insurer is trading cheap, so then I try to determine what can change with regard to investment income, underwriting results and expenses. That part is subjective. I do look at comps as a point of reference but not as a buying point.

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.

Today, Gregory Zuckerman has a wonderful article on Fairfax Financial in the Wall Street Journal:

As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.

Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.

So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.

What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).

Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.

Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:

Prem Watsa

Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.

Fairfax Financial Holdings Ltd. Q2 2010

By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:

What environment are you positioned for today?

Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.

The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.

So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.

Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.

Are you at all concerned about inflation and rising interest rates?

Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.

If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.

Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).

I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.

Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

The new Bloomberg Businessweek has so far really impressed me with their new content. Today, they ran a great article from David Winters on finding value in companies that will probably be around for 100 years:

A dramatic global change was accelerated by the economic crisis. A couple of billion people in the Far East, India, and parts of Latin America have joined the economic party. They see everything we have and are willing to work hard to get it, too. They want to look good, eat better, be entertained: basic human desires. So we like consumer names, and oil. You’ve got an incremental couple of billion people who want cars and motorcycles. To play on higher oil prices, we try to find oil resources in countries that have good legal systems and also good management. The management of Canadian Natural Resources (CNQ) owns about 4% of the company. CNQ is worth a lot more than 76, which is what it trades for now…

We look for repeat human behavior. People are going to eat chocolate bars 100 years from now. We owned and bought more of Nestlé during this period. It is earning an increasing amount in the Far East. One thing we’ve thought a lot about during this global crisis is pricing power and currency diversification. One of the beauties of Nestlé is that it can generate streams of increasing free cash flow. This helps to protect you as an investor.

Wintergreen’s direct exposure to the U.S. is at the lowest it has been in my 25-year career, 70% outside the U.S. today. The U.S. and European multinational companies we invest in are ones with major global exposure. Coke is listed in the U.S., but roughly 80% of its earnings are abroad. Our largest investment is Jardine Matheson, a 178-year-old conglomerate with activities in China and Southeast Asia. Jardine dominates Indonesian auto manufacturing and will capitalize on increasing car ownership there. The stock trades at a discount of about 35% to net asset value.

Jardine has a controlling interest in Dairy Farm, a supermarket chain that owns other retailers and has 5,000 stores in Southeast Asia, with modest operations in China and India. Dairy Farm’s margins are equal to Wal-Mart’s, but it is a company that almost no one has heard of. Jardine really is a Western company. You get transparency, and the family and management own about 16% of the company, so their bacon is frying along with the other shareholders’.

Target Basic Human Needs. On the Cheap (Bloomberg Businessweek)

A lot of value investors are looking for value globally, as they are finding US equities to be more or less fairly valued. I think that one of the benefits of a global value approach is the fact that you will be able to find great companies in less efficient markets. I imagine there are plenty of Buffett-like companies abroad with great growth prospects at appropriate prices. Given the tailwinds behind these improving economies, these types of companies should be poised for continued growth.

More importantly, I believe that these companies can often generate returns on equity that will help them survive and possible thrive during inflationary periods. Winters makes note of that when he claims that Nestlé can generate ever increasing amounts of free cash flow. Why is that? Because they have a moat around their products because of their brands. People are usually willing to pay more for Nestlé products than generics. That means that if the value of the dollar declines, they can raise prices to compensate.

For me, these are just the types of companies that I have been looking at as possible inflation hedges. Especially when the companies are backed by currencies from natural resource rich countries (Canada, Brazil). I’m not really a gold guy, so I fall more into the Buffett and Bill Ackman approach which involves looking at high quality companies. You can even find some US companies that generate a tremendous amount of revenues from abroad. If you look at Buffett’s stock portfolio, he has a number of consumer companies like Kraft (NYSE:KFT) and Coca-Cola (NYSE:KO) that seem to have pricing power. Ackman is also an investor in Kraft but has a stake in Yum! Brands (NYSE:YUM) too. I think Yum! is probably part of his bet on consumers abroad and pricing power. A company like Yum! must benefit from certain economies of scale that allow it to price better than smaller restaurants in these emerging market nations.

The trick to me, is figuring out the optimal time to buy these companies. You need one that not only has pricing power, but is also cheap. For example, had you bought Coca-Cola in 1998, you would likely be down on your investment. If you had bought 1 share for $80 at that time, you would be down on your investment. Shares currently trade around $54 and you would have collected about $12 in dividends. If you buy into Ackman’s thesis on Kraft being able to increase their gross margins and realize synergies from their merger with Cadbury, you would be looking at a 24% annualized return for the base case. Not bad for a best in class company with pricing power.

I haven’t had the opportunity to get into global value investing myself because of some of the limitations of my brokerage firm. However, my Fairfax Financial shares are poised to benefit from the improving economies abroad. Fairfax is based in Canada but has operations as far as India and Brazil. These are typically countries characterized by having under-banked citizens. As they improve their status, financial services should be made more available to them, providing new sources of growth for Fairfax.

(Photo: Peter J. Thompson/National Post)

A friend recently attended an talk with Prem Watsa of Fairfax Financial (PINK:FRFHF / TSE:FFH). I know there are a lot of Fairfax followers on here, it is a company I’ve been bullish on for a while. Here are some of their notes. Keep in mind, these are just notes, they could be totally wrong:

The Soft P&C Market:
If you look at the insurance sector, a number of businesses are trading at low multiples because of the current pressures of the soft market. Some, like the management over at W.R. Berkely believe that the market is poised to turn around.

-Fairfax has wide reach. Active in over 100 countries, 25% premiums outside of N. America
-Fairfax faces declining volumes because of soft market but Fairfax has power to write more business if they see things improved.
-Globally, P&C markets remain soft. Signs of improvement in certain regions: Northbridge managed to raise rates in Canada.
-Fairfax could easily double underwriting volumes in the face of hard market, boosting earnings and investment float

The Investment Environment:
As some of you may know, Watsa’s Hamblin-Watsa Investment Counsel takes Fairfax’s float and uses it to make investments in all sorts of securities. They have an excellent track record of beating the market over the years.

-Watsa sees the possibility that growth will be flat as we may encounter deflationary pressures on the economy.
-Fairfax has structured their investment portfolio so that it can withstand a 50% drop in equity markets in addition to major CAT losses.
-Fairfax continues to be conservative about the markets and has 30% of the equity portfolio hedged with index swaps.
-2/3 of their muni bonds are insured by Berkshire Hathaway. Most were purchased near bottom prices. This boosts their yield on the portfolio which has an extra kicker of being tax exempt securities with a 5.75% average yield
-Some opportunities for value investors but they are becoming fewer.
-Target holding at least $1B in cash at holdco level in case of negative events.

Zenith Acquisition:
Fairfax recently acquired Zenith National Insurance Group. The company specialized in workers comp insurance and ran a conservatively managed investment portfolio.

-Fairfax has known Zenith management for over 20 years. Zenith has an excellent underwriting record and the company scaled back volumes because of soft market
-Zenith has a vanilla investment portfolio, Fairfax intends to have Hamblin-Watsa take over and try to boost performance
-Crum & Forster may be able to sell products through Zenith’s network of brokers and agents.

When I saw the 13F for Fairfax Financial Holdings (TSE:FFH) come out, one of the things I wondered was when Prem Watsa would do another acquisition. With Fairfax’s success over the last few years and good financial shape, I thought the company would be poised for an acquisition. Watsa has publicly said that they are not interested in straying too far out of the insurance business when it comes to acquisitions. They don’t want to build another Berkshire Hathaway.

So, I’m pretty happy to see this acquisition of Zenith National Insurance (NYSE:ZNT). Zenith is in the workers’ compensation insurance business, which means that policies are generally long tail, meaning that payouts happen over longer periods of time. To contrast, short-tail insurance usually has payouts over shorter periods of time and more frequently. This is typical when you look at the likelihood that a person will get into an accident in their car versus an injury at the workplace.

So why is acquiring long-tail insurance operations so beneficial to a company like Fairfax? For one, Zenith is well operated. Moreover, the long-tail policies enable Fairfax to increase the size of its float — which is the amount of Zenith receives in premiums that it does not have to be paid out immediately or held in reserves. That capital is often invested in securities, in Zenith’s case mostly bonds, which could potentially be redeployed into more attractive securities by smart capital allocators like the people at Fairfax. Fairfax is not the only smart investor to have acquired workers’ compensation insurance companies, Warren Buffett’s Berkshire Hathaway owns National Indemnity which has workers’ compensation operations in California.

The one stickler for the Zenith deal is the fact that Fairfax will have to issue a little equity to complete the deal but will still have about $1 billion in cash on hand after the acquisition.

Via Bloomberg:

Fairfax Financial Holdings Ltd., the Canadian insurer run by Prem Watsa, agreed to buy Zenith National Insurance Corp. for about $1.3 billion in cash, adding sales in California.

Fairfax will pay $38 a share, the Toronto-based company said today in a statement. That’s 31 percent more than Woodland Hills, California-based Zenith’s $28.91 closing price on the New York Stock Exchange yesterday. The deal is expected to be completed in the second quarter.

Watsa, 59, is betting on a rebound in a workers’ compensation market pressured by rising medical costs and falling payrolls. Like Warren Buffett at Berkshire Hathaway Inc. and Loews Corp.’s Tisch family, Watsa built his company by investing the assets of insurance operations, often in out-of- favor securities.

“Workers’ compensation is probably the softest of all lines right now,” Bob Hartwig, president of the Insurance Information Institute, said at a conference in November, using industry parlance for a market where rates are falling. “Rate accounts for the vast majority of premium reduction we have seen in workers’ compensation.”

…Zenith, run by Chairman and Chief Executive Officer Stanley Zax since 1978, said in its 2009 annual report that it has “a long-term record of outperforming the industry.” Zenith’s workers’ compensation loss ratio, a measure of how much of each dollar of premium is paid in claims, was lower than the industry average every year from 2002 to 2008, according to Zenith’s annual report.

“There will be no changes in Zenith’s strategic or operating philosophy,” Watsa said in the statement.

Watsa’s Fairfax Agrees to Buy Insurer Zenith for $1.3 Billion

I recently wrote up some thoughts on Fairfax Financial (NYSE:FFH), before they had released their Q2 earnings on July 31. My objective was to come up with where I thought Fairfax should be trading at today, and not at the end of Q2 earnings (June 30). On the conference call, an analyst asked Prem Watsa what he thought the company should trade at on a multiple basis and how to come up with where book value is at any given day in time.

You might think that’s a bit weird, to value from a daily basis. But given Fairfax’s newly acquired equity positions, book value tends to fluctuate as the market fluctuates. So in a sense, the numbers contained below are a bit outdated. The equity portfolio snapshot was completed on July 20, since then the market has probably appreciated around 5%. If you look at the stock portfolio you can calculate what the gains were since then and break that down to a per share basis.

Some other caveats: the $330 estimate probably undervalues units like ICIC Lombard, which are recorded as costs rather than true market value. I think that its tougher to determine the value of units like these, but given the stock market’s movements and the value of those insurance units true book could be closer to $350. Then of course in the longer term you’d see a multiple assigned to that.

July 30 Fairfax Financial Update:

Undervaluation

In October, as equity markets went into free fall, one company saw their stock price actually appreciate in value. Fairfax Financial.

Fairfax Financial is well known amongst the value crowd. Helmed by Prem Watsa, sometimes called the “Warren Buffett of the North” Fairfax has annually grown its book value by 20% for the last 10 years. Few companies can boast such a record of growth.

So why did a company, which such great stewardship and past performance decline in the last 6 months?

1. Fairfax’s past performance was mainly driven by its portfolio of credit default swaps. For a number of small investors, the portfolio of credit default swaps were a great way to profit from the disruption of the credit markets. When Fairfax sold and profited from these positions, many investors exited. Their theme had played out.

2. After selling the credit default swap positions, Fairfax used the profits to acquire equities that they thought were undervalued. From October to March, the markets took another dive, with a number of securities held by Fairfax moving lower. Prime examples of this behavior were Wells Fargo and General Electric. Such a negative movement in the company’s equity portfolio no doubt led investors to fear Fairfax and sell.

3. Poor underwriting profits. Fairfax remains driven by their investment business. Some of the insurers owned by Fairfax, such as Crum & Forester have reported losses on underwriting, as exhibited by their combined ratios.

The value proposition

By now, you must be wondering, why invest in Fairfax Financial?

Fairfax reports earnings July 31st and while results in March appeared bleak, they’re sure to be vindicated with July’s earnings.

1. Equity Portfolio
Equity markets have moved up considerably since March 31. In the March 31 filing, Fairfax posted a loss of $60M primarily a result of negative investment income. By analyzing the company’s equity portfolio below, we can get a clear idea of how Fairfax’s investments have performed over the last quarter.
Fairfax’s equity portfolio broken out:

Overall, with such gains, Fairfax is likely to have at least sold some of their equity positions to lock in profit. However, even if the positions have been kept, when marked to market, the equity portfolio should add roughly $960M to Fairfax’s book value.

2. Municipal Bond Portfolio
As bond insurers like Ambac came under fire for being poorly capitalized and funding in the municipal bond market came to an almost standstill, Warren Buffett had Ajit Jain rapidly start up Berkshire Hathaway’s bond insurance division. Buffett acted opportunistically, creating a new line of business to seize business at a time when existing players were unable to write new business.

During the same period, Fairfax deployed capital to purchase municipal bonds which were yielding unprecedented rates in comparison to treasuries. Fairfax purchased a $4.36B portfolio of Berkshire backed munis. These were purchased at attractive yields with sound backing from Berkshire Hathaway which adds an extra element of safety.

Since June 30, the S&P National Municipal Bond Index has appreciated 5.5%. With the Fairfax Muni portfolio at $4.36B we can expect that the portfolio’s value contributed $240M to Fairfax’s book value.

3. Other Fixed Income Investments
Along with municipal bonds, Fairfax purchased a number of corporate bonds and treasuries. Collectively, during Q1 these holdings collectively contributed $170M in income, down from $180 from the previous Q. Given the improvement in the corporate bond market since then its likely that this income improved some.

4. Underwriting Performance
Over the last two quarters, Fairfax’s insurance subsidiaries Crum & Forester and Northbridge posted losses for their underwriting business. The company attributes some of this poor performance to Hurricanes Gustav and Ike. When removing these factors, The company’s underwriting performance improves but not enough to make a meaningful contribution to the company’s bottom line.

So far the insurance market has been calm over the quarter but the market has softened. As a result, underwriters have increased the amount of business written at lower rates.Typically this behavior leads to an inflection point, where prices cannot be cut any further and some kind of cat event occurs. This is important for Fairfax primarily because most other underwriters are not only writing bad business but also posted investment losses for 2008. They are clearly weaker, and when the time comes for the market to turn (usually triggered by a cat event ushering in a hard market) Fairfax will be poised to take advantage of its peers distress.
More information on a possible hard market: Marsh “Invisible hard market report”

This means that in the longer-term, we may see an improvement on Fairfax’s insurance end, but primarily for this Q and the near to medium tern, results and performance are going to be driven by the investment side of the business.

Valuation

1. Short Term – Medium Term Valuation
At current prices, Fairfax remains below estimated book value. Book value per share for Q1 was $4558 million or $260 per share.

Estimated investment gains:

$960M Equity Portfolio
$300M Fixed Income Investments (Muni gains + Fixed income investments + Interest/dividend income)
= $1.26B contribution to Book Value or about $70 per share to book value.

Q2 Estimated Book Value Per Share = $330
Current Price $285, a potential 16% gain during a short period as Q2 earnings release will likely serve as the catalyst for rapid price appreciation (note the share price activity over the last 7 days).

2. Long Term Valuation

Over the longer term, Fairfax seems likely to appreciate to a less depressed multiple. Aon Corporation recently released a report on the insurance market. They believe that a number of companies in the industry are trading at depressed multiples due to investment losses (something Fairfax has evaded) but that they believe in the longer term, P&C Insurance companies should return to a traditional multiple of about 1.23X book value. Plugging in a 1.26X multiple with Q2 estimated book value, Fairfax appears to be potentially worth $415 per share or about 45% greater than the current share price.

Read the full Aon research report: Aon Report