Well, I told you yesterday that I’d be following up on the teaser from 12% Letter for their “Black Market Income” website that presents a variety of ways of increasing your investment income … so let’s do it!
If you missed yesterday, I gave a quick run-through of several of the “loopholes” that Dan Ferris from the 12% Letter says can get you that “Black Market Income” that you so richly deserve — those were not, perhaps, as sexy as the term “black market” would have you believe, and the missing ingredient in many of the large income amounts teased is usually either “lots of capital to start with” or “lots of time to wait for compounding and dividend growth) … but still, there’s some reality beneath the tease. If you missed those first few “loopholes,” you can see them in yesterday’s article here.
But today we have one with an even more mysterious description, and I don’t think I’ve ever written about it before … so let’s dig in.
Ferris calls this next loophole “Toronto’s 13% Income Secret.” So what does that mean? Here’s his description … with the clues, such as they are:
“Most Americans put their savings in an ordinary bank account — and collect a tiny 1% to 2% interest a year.
“But I’d like to tell you about an opportunity offered by a unique type of ‘Investment Society’ in Toronto, Canada, which has averaged around 13% a year for the last 15 years.
“This organization is located 500 miles from New York… And it has nothing to do with big Wall Street banks or corporations.
“If you invest your money, the ‘Society’ will send you a dividend check every year. And get this: the company has increased its payouts by 614% since 2004!
“… if you had invested $10,000 back when the ‘Society’ opened its doors to the public — you’d be sitting on close to $60,000 dollars today….
“This unique organization is taking the investment community by storm. Just look at what New York Times financial reporter Gretchen Morgenson recently said about it: ‘Come hell, high water [or] credit crisis — [Toronto’s ‘Investment Society’] is that rarity — [a] company whose shares have stood tall through it all.'”
This takes me back — it was a few years ago, in the early days of this site before the newsletter publishers quaked in their Gucci’s about the next Gumshoe undressing, that the Stansberry folks put out a teaser about investing in a bunch of “secret investment societies” … those were detailed in this article if you’re curious, the stocks (yes, sorry, they were boring old stock market investments, not “societies”) were mostly interesting ideas from the world of conglomerates and investment partnerships, stocks like Leucadia (LUK), Loews (L), Berkshire Hathaway (BRK.B), Icahn Partners (IEP) and Brookfield Asset Management (BAM) — and no, by “interesting” I don’t necessarily mean “profitable”, those teasers ran in late 2007, and all of those stocks later got clobbered by the financial crisis and recession … not all of them have recovered.
But anyway, I mention that by way of getting to today’s point: The stock being teased as “Toronto’s 13% Income Secret” is, like Loews or Berkshire Hathaway, an insurance-driven conglomerate and a value investor darling: Fairfax Financial (FFH in Toronto, FRFHF on the pink sheets).
Fairfax Financial is a favorite of value investors largely because of the reputation and performance of its CEO, Prem Watsa, who is nearly always referred to in the media as the “Warren Buffett of Canada.” Fairfax is almost entirely focused on insurance, unlike Berkshire or Loews, and has grown through strategic acquisition of insurers and through the investment performance that is attributed to Prem Watsa, but also has historically been very volatile. It’s probably overvalued as an insurance company, trading for about 1.15X book value and losing money on insurance operations, but it may well be substantially undervalued as an investment fund if they can keep up their historical performance. And I’ll bet that this idea comes from Dan Ferris’ work as a deep value investor for Extreme Value, since it’s not necessarily a steady or reliable income stock like we usually see from the 12% Letter.
Fairfax Financial is not, as long as you’re talking about the common shares, a dramatic income producer — they do pay an annual dividend, which in recent years has been $10 per share (from a C$390 share price, that means about a 2.5% yield — and the dividend is dramatically higher than it was before 2009, but there isn’t necessarily a history of steady dividend increases to use to project growth of payouts, they do not have a “dividend growth” policy and the dividend depends on company performance). Oh, and don’t buy it now for that dividend if you’re at all short-term oriented, they pay once a year, in January.
So most of that 13% growth (and Fairfax has usually done better than that) would have to be capital gains — depending on when you bought the shares you could certainly have earned more, but the stock has been very volatile over the long term. Recent performance has been spectacular, with Watsa doing very well investing through the credit crisis and recession, but they had a few huge down dips in the stock price in the years before that. They have compounded book value at almost 25% per year over their history, which is spectacular even if the last ten years have been well below that (after all, the S&P has come out about flat over that decade). The company and its investment portfolio are far larger now so one might expect growth to be somewhat more difficult, but it’s still not a huge firm — market cap is less than $10 billion.
How am I sure that Fairfax is the solution? Well, the numbers generally match up — but the real kicker is that the quote in the tease is from a Gretchen Morgenson column in the NY Times, though it’s a few years old. You can see that column here if you like.
Fairfax has been valued primarily as Prem Watsa’s investment vehicle — he has historically made some very large bets, as he did on the right side (mostly) before and during the housing/asset bubble debt crisis, but it is those decisions by him and his investment team that drive the performance of Fairfax Financial. They are primarily an insurance company, with a large number of firms under their wing and a substantial focus on reinsurance, runoff, and US and Canada property and casualty insurance (with faster growth, but substantially smaller businesses, in Asia and a number of emerging market areas), but unlike Markel (from which Fairfax was born, as they took over a failing Markel company in Canada) or Berkshire Hathaway, Fairfax hasn’t necessarily been a particularly effective company on the insurance side — the insurance companies seem largely to be there to supply leverage to Watsa’s investments.
What do I mean? Well, most insurance companies are evaluated — and evaluate themselves — based on their “combined ratio,” which is a quick shorthand number that tells you whether they’re profitable. The combined ratio basically tells you how the insurance losses (claims that they pay out) and the insurance company’s expenses compare to the value of the premiums they bring in — so if the combined ratio is 100%, that means you break even on the insurance business, if it’s below that your business is profitable on an operating basis, and it’s above it your business is losing money.
Combined ratio doesn’t go straight to the bottom line for insurance companies, because the great “secret” of insurance, and the overwhelming reason for Berkshire Hathaway’s tremendous compounding power over time, is that insurance companies get to hold and invest the premiums they receive, sometimes for years or decades, before they have to pay them out in claims. So insurance companies get a huge pile of cash to work with in generating investment income, and if they can keep their combined ratio below 100 they basically get to use that cash for free or even get paid to invest it — if the number is over 100, you can think of the excess as being kind of like the cost of borrowing for their investment portfolio. Markel, for example, focuses on profitable insurance operations even in soft markets when premiums are low (as we’ve had for several years), and almost always manages to achieve an underwriting profit (ie, combined ratio below 100), and Berkshire Hathaway, likewise focused on quality top-of-the-food chain insurance companies in their niches, also generally reports underwriting losses only occasionally, usually in years with big natural disasters.
Fairfax almost always reports an underwriting loss — reports I’ve seen say that the average combined ratio for Fairfax Financial has been pretty weak, in the range of 102-105, with the long-term average probably about 102.5 or so in the 25 years Prem Watsa has been running the company (last year’s ratio was 105, I have not checked the historical averages myself). That doesn’t mean it’s a bad company — far from it, Fairfax Financial is a leveraged investment fund that has put up often stellar numbers and genuinely stellar average performance for 25 years, it’s just that they’re doing this by running average or below-average insurance operations and investing the premiums in an extremely above-average way. There’s a great article about Fairfax Financial by Geoff Gannon here comparing Watsa and Buffett (Gannon is a value investor whose writing I’ve followed loosely for years, well worth a read). There are a lot of property and casualty insurers who routinely post underwriting losses, and most of them don’t invest nearly as effectively as Prem Watsa.
And Fairfax has also been a controversial company — mostly because of frequent battles with short-sellers, including the long-running one with SAC Capital that even involves Stephen Cohen’s ex-wife (that SAC suit goes back, I think to 2002 or 2003, when SAC and other hedge funds allegedly colluded with analysts and journalists to drive down Fairfax shares). Third Point is (or was) also involved in these lawsuits that Fairfax has spent years fighting, and I don’t know how it will call come out in the wash.
So those short attacks and Fairfax’s own history of pretty volatile investment returns have given the stock some crazy years — but recently things have been far calmer, the stock has been in a range of about $350-420 for just about two years now, bouncing around a bit on news and acquisitions but not having the huge shakeups we saw in the years before that (most of the big moves in the couple years prior to that were from Watsa’s big bets on crisis-related investments, largely, but not always, “good” moves in investors’ eyes). It’s right in the middle of that range at about C$390 right now (that’s Canadian, so about US$400 — they trade mostly in Toronto, but report their earnings and results in US$, so be careful with your currency conversions if you research the stock).
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It even looks like there’s some potential for Fairfax Financial to focus somewhat more on their insurance business and build that into a more profitable engine beyond it’s ability to supply investable float, if you look optimistically at some of their larger recent acquisitions and believe the various prognosticators, but I guess we’ll have to wait and see if that proves out in the combined ratio numbers. For now, the operational numbers are not so hot, particularly because of the Japanese earthquake — they reported a pretty big loss in the first quarter and a drop in book value to just about $350/share, but the shares are still up a few percent from when that report was released in late April.
Morningstar, for one, has put the fair value of the shares at about $380 and reiterated the concerns that many have had over the company — that is, that it’s a great investment fund powered by a weak insurance company, and the “great investing” part is hard to count on given Watsa’s large bets. Makes sense to me if you wish to evaluate the firm conservatively, compared to other insurance operations.
Still, the long-term performance of Prem Watsa and the investment managers at Fairfax Financial do make it seem like complaints about whether their capital costs them 1% or 4% miss the point: they’ve clobbered the market for 25 years and also beaten the far larger Berkshire’s compounding performance over that time (and any other good-sized insurance company you can name), so the question is whether or not you think they’ll continue to do that. Watsa, for what it’s worth, is almost exactly 20 years younger than Warren Buffett — so the succession issue, while probably even more important for Fairfax than Buffett’s succession is for Berkshire, may not be as big a near-term deal. (Why “even more important?” Fairfax doesn’t generally make money from its insurance subsidiaries, just from its investment portfolio, so the company operationally depends far more on Watsa and his investment management team than Berkshire does on Buffett’s capital allocation performance — Berkshire will take a hit when Buffett departs, but would also churn out a huge amount of money almost on autopilot from profitable operations and subsidiaries like GEICO and Burlington Northern).
Fairfax Financial is probably a fairly risky bet, if you follow the classic definition and believe that volatility means risk, but it has certainly rewarded the patient and the strong-stomached over the last 25 years. I wouldn’t classify it as an “income secret” unless they happen to be obliquely referring to Fairfax preferred shares or bonds (their longer-term bonds generally yield about 7%, preferred shares in the 5-7% range according to my quick checks, I’d find it less interesting to be involved with Fairfax without the investment performance kicker), but outside of the value investing world it’s probably not all that well-known among individual investors. I owned Fairfax at one point in the early 2000s but sold before most of the huge up and down moves, and other than occasionally reading about Prem Watsa’s larger bets on the economy and the market I haven’t looked closely at their filings since then — I bet there are some staunch Fairfax followers out there in the great Gumshoe Multitudes, so if you’ve an opinion to share I’m sure we’d all be delighted to hear it … just use the handly little comment box below.