Monday, February 12, 2007

Check-up on Fairfax Financial (FFH) :

Every now and then, it is good to re-visit your investments to refresh the intrinsic value in your head and to keep yourself from falling victim to your own fear or greed. Fairfax Financial is my second largest holding, and is run by- in my opinion- one of the greatest value investors today, Prem Watsa. His track record speaks for itself though, as he has averaged over 20% annually on common stocks over a period of greater than 20 years. In a field such as insurance that throws off tons of cash to invest while claims are being settled, this gives a small moat in an otherwise highly competitive industry. Fairfax has appreciated considerably since my original purchase- is it still cheap?

Fairfax at Sept. 06

473 million cash at holding co level
-1273 holding co. debt
-292 Crum (100% owned subsidiary) debt
+340 Public offering of 10,165,000 ORH shares
+1806 Odyssey Re(ORH) at market value - 45,300,000 shares
+923 Northbridge( at market value - 30,311,300 shares

= 1.977 Billion

In addition to this, you have:

Crum & Forster- with a 99% combined ratio on 1 billion in premiums, a 2.6 billion portfolio, and 1 billion in equity. (Note: Since we included the Crum debt above, the equity here should really be 1.3 billion) To be conservative, I value this business at book-
= 1 Billion

Runoff- This business has a 4 billion portfolio and over 1.7 billion in shareholders equity. The provision for claims seems to finally have stabilized for this business after years of additional charges. It is important to note a defunct feature of insurance accounting- that reserves are provisioned on a "notional" basis. So, even though this runoff business has mostly asbestos and other long-tail liabilities that will not be paid out for several years, the reserves on the balance sheet are not discounted to reflect this. So basically, the reserves account for everything they expect to pay in the future, but in reality they are earning investment returns on a portfolio of over 4 billion for the time being. If you believe the reserves have finally been settled based on the "quiet" activity recently seen in runoff, then this business should be worth more than its equity. If you think reserves are still inadequate, then you need to discount equity. Conservatively, i assume some additional unforeseen provisions coming up and discount equity.
= 1 Billion

Holdco Discount- Since Fairfax would realize taxes if it monetized its shares in ORH and NB, some like to take this into account in their valuations. Others see this as wrong because they could also fully buy back the company and hold onto something the market believes has an intrinsic value of the current market price. I'll discount it, and assume Fairfax cannot come up with anything creative to lower their tax cost. Fairfax's cost basis is 700 million ( I believe? If anything, this number is wrong and way too low), while the value of ORH+NB+the offering is 3 Billion. (3,000 - 700) x 35% tax ...
= -800 million

Overall, this gives Fairfax a safe value of 3.2 Billion, compared to the market price of 3 Billion. Upside potential exists with our valuations for Crum, Runoff, and the tax discount. I'd also make a case that ORH is still undervalued, and that the dramatic improvements in the company's financial position should lead to increased credit ratings, which boosts their underwriting profitability. And in the meantime, you have a great value investor managing over a 15 billion portfolio, leveraging the investment gains compared to your market price by 5:1. It's still too early to sell.

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