Fairfax Financials: Too Cheap To Ignore

Fairfax Financial Holdings (OTCPK:FRFHF) is a Canadian holding company created from scratch in 1985 by Prem Watsa, when he acquired a distressed Canadian truck insurance company named Markel Financial.

Mr. Watsa is often referred to as the Canadian Warren Buffet, as his company resembles Berkshire Hathaway (NYSE:BRK.A)(BRK.B) under many aspects. In fact, the holding seeks to re-invest the income collected by its insurance subsidiaries, as well as their insurance float, in the equity and bond market, leveraging its net asset position.

However, the company’s shares failed to achieve the same results as both Berkshire and Markel (MKL) (another Berkshire’s copycat) in the long run.

Source: Yahoo Finance

The gap shown in the picture above is partially mitigated by the fact that Fairfax has been paid an annual dividend since 2001, while BRK and MKL have never paid a dividend and it is unlikely they will start doing it anytime soon.

Book Value Comparison

The stock price underperformance doesn’t tell us the whole story.

Actually, if we took the book value appreciation into account, which is the best proxy of the intrinsic value of such companies, Fairfax would appear much closer to its peers.

At the time I am writing this, MKL’s price-to-book value is around 1.4, BRK’s is 1.3, while Fairfax’s P/B is in the neighborhood of 0.7!

Even if we looked at the historical price-to-book value figures, the result would not change: Fairfax looks significantly undervalued.

Source: ycharts.com

It could certainly be directly related to the current pandemic crisis, but, indeed, MKL’s and BRK’s investors’ sentiment doesn’t seem to have been much affected by the shut-downs and business closures. At least, not to the same extent as Fairfax.

In the table below, I summed up the deviation from the median P/B value registered in the last five years by the three firms.

P/B % Diff. to 5Y Avg.

MKL

-11.2%

BRK

-5.5%

FRFHF

-36.4%

Source: Seeking Alpha

And this trend is confirmed by Fairfax’s 10-year deviation (courtesy of Gurufocus):

Source: Gurufocus

If we compare the book value appreciation over the last five years, however, the numbers reveal why investors are preferring Fairfax’s counterparts right now.

And yet, taking the dividend paid into account, the gap with Markel is not as abysmal as the stock price seems to suggest. Markel is about twice as expensive as Fairfax, according to the P/B figures.

BV Per Share At 12/31/2014

BV Per Share At 12/31/2019

5 Y CAGR

Dividends Paid

BRK

£146,186

£261,417

12%

_

MKL

£544

£803

8%

_

FRFHF

£395

£486

4.2%

(2% annually)

Source: Companies’ reports – Author’s elaboration

On the other hand, the first two quarters of the year have been more problematic for Fairfax, whose book value per share shrank by more than 8%(after taking into account the dividend paid in the first quarter), against a 6% decrease for BRK and about 2% for MKL.

The Double “I”: Investments and Insurance

P.

Watsa often states that, in order to achieve their long-term target of a yearly 15% book value appreciation, Fairfax insurance operations should attain a 95% combined ratio and investments (bonds, stocks and equity securities) should accomplish a 7% annual return.

Clearly, in the last few years, the investment part of the equation has not done its part:

Source: Fairfax report

The poor investment performance is mostly due to a misplaced short bet (which caused the firm to lose as much as £1.2B in 2016) and to its value investing style, which has become out of fashion in the last few years.

However, I like the fact that P. Watsa is still a pure value investor, unlike Warren Buffet for example, who is actually forced to pass a lot of value opportunities due to the massive size of Berkshire’s investment portfolio. However, even MKL or Alleghany (Y), which are the same size as Fairfax, do not invest in clear value bets like P.

Watsa does.

When (and not if) value investing turns profitable again, Fairfax will return to thrive too!

On the other hand, the insurance engine has never failed to meet its targets in terms of underwriting profit (see the table below) and float growth.

BRK

MKL

FRFHF

2015

96%

89%

90%

2016

95.8%

92%

92.5%

2017

105.3%

105%

107

2018

96.5%

98%

97

2019

99.3%

94%

97

Average

98.6%

95.6%

96.7%

2020 (first 6 months)

96.2%

103%

98.6%

Combined Ratios Compared – Source: Company reports (Author’s elaboration)

Insurance float doubled in the last 10 years, from an average of £9.4B in 2009 to an average of more than £20B in 2019. During this period, not only was float kept without any additional expense, but it indeed produced a small interest gain.

Bottom Line

The current equity market is very dichotomic. On the one hand, some companies break their cap records every day, regardless of their super hefty prices.

On the other hand, companies like Fairfax Financials are extremely inexpensive and such low cost is only partially justified by the recent underperformance.

I believe that, sooner or later, a big rotation will materialize, similar to the one occurred 20 years ago, after the burst of the tech bubble. At that point, investors will greatly prefer real assets and, in turn, financial and real estate businesses will dominate.

Fairfax now offers a big discount to its fair value, as reflected by the recent, significant purchase of subordinate voting shares by Prem Watsa (CEO and Chairman of the company), who stated he had never seen Fairfax’s shares sell at a bigger discount to their intrinsic value.

He could be right, if we consider that Fairfax’s problems appear to be mostly temporary, rather than due to an actual structural issue.

Disclosure: I am/we are long FRFHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha).

I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange.

Please be aware of the risks associated with these stocks.

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