Street Capitalist: Event Driven Value Investments

(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

Prem Watsa recently gave a talk at the University of Waterloo about some of Fairfax Financial’s guiding principles in terms of organizing and managing its subsidiaries. I’m sure a lot of interested investors could not make it to the event, but luck for us Rose Simone of The Record has a great article that covers the event:

Fairfax is short for “fair, friendly acquisitions,” Watsa said, adding the company will never consider a hostile takeover.

Furthermore, Fairfax doesn’t believe in selling its companies for a quick profit. “We say our companies are not for sale,” he said.

That may upset some shareholders, but “the advantage is that you can build a company over the long term,” Watsa said. “You can’t replace people or a culture,” he added.

Fairfax believes in “full disclosure,” to shareholders, taking great pains to stress the potential risks of decisions.

“If they want to buy, they can buy. If they want to sell, they can sell. But they cannot say we didn’t tell them,” Watsa said.

The company follows conservative financial practices. The primary goal is “not losing money,” and long-term returns, Watsa added.

That also applies to the company as a whole, Watsa added. “We will never bet the whole company on any acquisition.”

Fairfax has a decentralized structure, giving its executives a great deal of freedom. “Fairfax itself is a small holding company, not an operating company,” he said.

The result is that Fairfax has “never lost a president who has performed well,” and those presidents operate as if the companies are their own, Watsa added.

Most important is the principle of “honesty and integrity in all relationships,” Watsa said.

The company wants its employees and executives to be hard working, “but not at the expense of families,” he added.

After growing Fairfax into a multibillion-dollar company, Watsa cited one his favourite quotes, from the Bible’s Matthew 16:26: “For what is a man profited, if he shall gain the whole world, and lose his own soul?”

Investor advocates honesty, fairness (The Record)

Elsewhere, I saw it reported that Watsa recommended My Years with General Motors by Alfred Sloan which certainly seems interesting when you consider the current troubles at GM. The book seems to primarily be about Sloan’s time at GM and how the company changed its management structure in favor of decentralizing certain decision making roles. When you consider what Watsa says above, it’s likely that the book had an influence on the way Fairfax is run today.

Nice interview here with Prem Watsa of Fairfax Financial — I haven’t been able to dig up too much regarding the annual meeting, but I’ll try to stay on top of it.

(click the image below)

Tara Perkins has out one of the first articles that discusses Fairfax Financial’s annual meeting. It’s short, but it provides answers to a few questions bugging investors, mainly the company’s newspaper investments:

The largest mistake that Fairfax Financial Holdings Ltd. made in the past year was underestimating the effect of the recession on the newspaper industry, chief executive officer Prem Watsa suggested.

Mr. Watsa was responding to a shareholder, at the company’s annual meeting in Toronto on Wednesday, who asked what the biggest mistake of the past year had been.

Fairfax took a 90-per-cent hit on its stake in AbitibiBowater Inc., and also lost money on its investment in CanWest Global Communications Corp. , Mr. Watsa noted.

And on removing the portfolio’s equity hedges:

Mr. Watsa also suggested that, in retrospect, he might have waited a few extra months before removing the hedges that Fairfax had in place on its stock exposure.

The company’s stock portfolio was fully hedged last year, but it recently chose to remove the hedges given how far markets had tumbled. “The fact that we hedged covered up a lot of our sins,” Mr. Watsa said.

He added that roughly three-quarters of Fairfax’s equity investments are in big companies such as Johnson & Johnson and Kraft Foods, and he believes that this is a “time of opportunity” for investors who will be in the market for the long term. Markets will not turn on a dime, but the next five to 10 years will be good to value-oriented investors, he suggested.

Fairfax regrets Abitibi, CanWest deals (Globe Investor)

Its funny, a few months back I looked at the newspaper sector myself (specifically the Sun Times Media Group) but couldn’t figure out what kind of cash flow to normalize my valuation estimates with. I never invested as a result. I guess I got a bit lucky on that end. Then there was also a post I wrote a while back on the NYTimes, I saw what appeared to be declining YoY cash flow numbers combined with difficult industry headwinds and issues with the Class A and B share listing. Since then, the company has fallen considerably.

On the bright side, Prem mentioned that the investment portfolio had two big positions in JNJ and Kraft. Interestingly enough, Kraft looks like they’re trading near a 52-week low. Given the company’s moats I’m going to start digging into them. The predictability there is much better than in the rest of the financial sector.

While most market participants are attacking Warren Buffett’s reputation, one really interesting bit of news came out. Fairfax Financial Holdings (NYSE:FFH) would be investing alongside Warren Buffett by purchasing $500 million in convertible senior notes, issued by USG Corp (NYSE:USG). Now, many of you might remember that Fairfax is run by Prem Watsa, one of the great yet underrated and under-recognized investors today. About 75% of my portfolio is concentrated in my Fairfax position, so you already know that I think highly of Watsa and his company.

This USG deal is quite interesting though. In most cases, Berkshire Hathaway (NYSE:BRK.A) does deals like this by itself. In the past, I know that they’ve partnered with Leucadia National Corp. (NYSE:LUK) but it’s really quite rare. At the very least we can probably agree that Buffett thinks positively about Fairfax, since he’s allowing them to invest alongside Berkshire.

From the Globe and Mail:

Toronto-based insurer Fairfax Financial Holdings Ltd. has teamed up with Berkshire Hathaway Inc. to invest in a U.S. building products company, creating a partnership between the chief executive officer of Fairfax and his investing hero.

“It is our first co-investment with Berkshire,” Fairfax spokesman Paul Rivett said. “We are extremely pleased to be investing in a leading industrial firm with one of the world’s great investors.”

Fairfax CEO Prem Watsa is a devotee of Berkshire CEO Warren Buffett, and is often referred to as the Canadian version of the legendary investor, someone he has openly sought to imitate…

As for their joint investment, USG Corp. will sell $300-million of convertible senior notes to Berkshire, and a further $100-million to Fairfax.

Watsa teams up with his investing hero (Globe and Mail)

As you can see, things haven’t been so good for USG’s stock price. They’ve been hit hard by the downturn in the housing market, but once things turn, USG will be poised for strong performance. The company has sort of a monopolistic position with their sheetrock products which gives the company a pretty sustainable moat. In addition, after their bankruptcy in 2001, the company was able to shed a lot of terrible liabilities which helps bolster their long term prospects.

This, combined with the fact that Fairfax has recently removed their equity hedges makes me think that Watsa is gradually finding some good opportunities for investing our capital. That’s going to be good news for any other shareholders in Fairfax, especially when they factor in the gains that we’ve made from the financial crisis.