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 So in a sense, the numbers contained below are a bit outdated.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

No question, this panic-state among financial stocks has resulted in current portfolio pain. However, history reminds us that extreme valuation opportunities occur in world-class franchises like Freddie and Fannie only when most investors have given up on them. In our own 12-year history we have taken advantage of this phenomenon many times; several of our portfolio holdings were outstanding businesses that we were able to purchase at a fraction of their fair value due to the conventional wisdom at the time.

Looking at this list we can recall the market sentiment surrounding each at their weakest points, and the characteristics are eerily similar to that surrounding the GSEs today; current bad news, uncertainty about the likely duration and depth of the bad news, management missteps, accounting shenanigans, and stronger / better competitors. It is precisely because investors tend to focus exclusively on the struggle of the moment that real analysis becomes the province of the very few daring to question the crowd. This commitment to analyze when everyone else has given up is the fundamental force that drives the excess long-term returns for value investors, and is why we believe Fannie Mae and Freddie Mac are extraordinary values.

FREDDIE MAC AND FANNIE MAE: A SPECIAL UPDATE (Pzena Investment Management)

Pzena states that extreme valuation opportunities occur when investors give up on them, but that really wasn’t the case here. The equity holders of FannieMae (NYSE:FNM) and FreddieMac (NYSE:FRE) were buying ownership of as Barack Obama likes to call it a “weird blend” of private and public entities. When you do that, you open yourself up to the risk of the government having to step in and bailout the company if things go wrong. When that happens, you (the equity holder) are not bailed out because they are not obligated to do so. Instead, their primary focus is only keeping these companies up and running and that was the real worst-case-scenario for their valuation, not fair book value but $0.

In the context of tough credit markets and a poor housing market, I’m unsure of how an investor could have really perceived a true margin of safety with either of these companies because of their relationship with the government. Still, there are conflicting views on what shareholders will get, according to Bloomberg:

Shareholder Fate

Washington-based Fannie and Freddie dropped in after-hours trading. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. Fannie is down about 66 percent since the end of June as concerns about the companies’ capital grew. Freddie has fallen about 69 percent.

Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie’s has fallen to $3.3 billion, from $22 billion over the same period.

The Washington Post reported that the government would make quarterly injections of funds as the companies’ losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn’t name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said.

The New York Times said most or all of both the common and preferred shares would be worth little or nothing.

One of the things I’m curious about is the effect of this on credit default swaps. My largest holding, Fairfax Financial (NYSE:FFH) owns credit default swaps on both Fannie and Freddie. I’ve been wondering about how this might turn out for those positions. According to the New York Times:

As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.

While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.”

Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie’s subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie’s and Freddie’s debt, not allowing it to fail. Talk about the laws of unintended consequences.

However:

It is possible, of course, that a Mac ’n’ Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.

What Will Mac ’n’ Mae Cost You and Me? (NYTimes)

So it seems like until we get more details about the bailout plan, CDS holders will be left wondering about what happens. Hopefully that will come till monday. If anyone has a different view on how the CDS positions will be affected, feel free to comment.

Below is a cool chart I found in the bailout article:

U.S. Rescue Seen at Hand for 2 Mortgage Giants (NYTimes)

In a couple weeks, that happened. DHL announced that they were going to break the contract and source their flights out to UPS and sent ATSG off a cliff. So far, the company’s stock price has declined nearly 60%. When I witnessed this happening, I suspected that there may have been an overreaction.

The company’s complex arrangement with DHL made it quite complicated to concretely peg its value. My best estimate is that even without DHL, ATSG will be able to survive and generate $30 million in FCF. Right now, the company is trading at $72.71M or 2.4x FCF. My own purchase price was $1.70 but with my valuation I believe I paid was less than 50% the company’s true value, which is a strong enough margin of safety.

News has been sparse from management, but i did find this reassuring gem:

Air Transport Services Group said it has the liquidity to meet its debt terms even if a possible deal between DHL Express and UPS takes a large chunk of its business.

“Our preliminary view based upon what we know at this time, which we have shared with our principal creditors, is that our financial strength, marketable asset base and projected cash flow should allow us to remain in compliance with our financial covenants and required debt amortization under our credit agreement for the remainder of their terms,” said CEO Joe Hete in a news release.

SAN FRANCISCO (MarketWatch) — Fitch Ratings said Tuesday it upgraded the ratings of Fairfax Financial Holdings Ltd. (FFH:280.05, +0.05, +0.0%) . The ratings agency upped Fairfax’s issuer default rating to BBB- from BB+, and its senior debt rating to BB+ from BB. The outlook is stable. Fitch attributed the upgrades to Fairfax’s reduced financial leverage, increased cash position, favorable interest coverage and stable runoff operations.

via MarketWatch