This one came through as a bit of a challenge for the Thinkolator, but I think we’ve got a solid answer for you…
This tempting note yesterday from Motley Fool Stock Advisor Canada majordomo Iain Butler is what drove a bunch of questions our way:
“… sometimes there’s a stock I keep coming back to… a stock that looks poised for off-the-charts growth… is unbelievably cheap… has first-class management… or sometimes, all of the above. That’s exactly the sort of stock that we just sent out a ’10-Bagger’ buy alert on this morning!”
“10-bagger” is just a popular term for an investment that goes up by 10X… I guess it’s got roots in baseball, and it is certainly widely used by the Motley Fool and others these days, but the term was popularized by Peter Lynch in his One Up on Wall Street about 30 years ago. (That book has aged a bit, I don’t think it’s been updated since 2000 or so, but it’s still a great intro to the world of stock market investing.)
And who doesn’t want to get 10X returns, right? So what’s this new alert from the Canadian Foolies all about?
Here’s a little more of a taste of the ad, this is about all we get by way of clues…
“… you should know that this investing strategy directly relates to a little-known Canadian stock that one billionaire insider says is “ridiculously cheap” right now.
“In fact, he’s so convinced that he just picked up an additional $149 MILLION worth of stock for his personal portfolio!
“Now, it’s one thing to make a bold statement… it’s another thing entirely to put your money where your mouth is…
“And this is just one more reason why we’re pounding our fists on the table that this under-the-radar TSX stock is a screaming BUY today!”
That “investing strategy” they talk about is “buying founder-led companies,” which Tom Gardner over at the Fool has certainly talked up as an important factor in his investing decisions (and it’s the core strategy of one of his “upsell” newsletters, the Ownership Portfolio)… here’s how they put it in the ad:
“… while our AVERAGE recommendation in Stock Advisor Canada is beating the market by nearly 3x… it’s our founder-led stocks picks that are leading the pack with more than 10x returns….
“Investing in founder-led companies has been more lucrative than any other investment strategy we have EVER recommended in The Motley Fool’s history.”
And that’s about all we get in the way of clues… so what’s the story?
Well, I can’t say that I’m quite 100% sure of the Thinkolator’s response to this one, but I did pull her out of the garage and give her a nice rubdown before pulling the starter cord, and our answer did come out pretty quick… so I’ll say I’m 99% sure that Butler is teasing… Fairfax Financial (FFH.TO, FRFHF).
Sound familiar? Yes, the stock has been teased many times, and I’ve written about it quite a bit over the past decade as I’ve been in and out of the stock personally, so it’s not new to longtime Gumshoe readers. But it’s been a while, so let’s dig in a bit.
What’s the story? Fairfax Financial has often been talked up as the “Berkshire Hathaway of Canada”, and founder and CEO Prem Watsa as the “Buffett of the North” — though that bloom has come off the rose a bit in the past few years as Fairfax has seen faltering investment performance and some folks, like me, have lost a bit of confidence in Watsa.
The company is a conglomerate of wholly and partially owned insurance companies, loosely controlled by the Fairfax HQ, and the investment of those insurance portfolios and of any extra cash spun out of those businesses is handled by CEO Prem Watsa, following a value investing strategy that he believes emulates Warren Buffett. Watsa essentially built the company on top of a distressed Canadian trucking insurance specialist firm called Markel Financial that he and his partners bought control of in the mid 1980s, and, yes he is the founder and still leads the firm.
If you’re curious about that name, Markel Financial was indeed controlled by Markel (MKL), which is now a pretty well-known “baby Berkshire” specialist insurance conglomerate in the US but at the time was tiny — Markel went public in 1986 with a market cap of about $40 million (it’s around $16 billion today) — and was a little overextended in Canada, that business was almost bankrupt and Watsa, then a young investment analyst who had worked at an insurance company for a couple years and was impressed with Warren Buffett, saw the opportunity to take it off Markel’s hands, recapitalize it, and build something new.
It has been an extraordinary success, and, yes, has turned Prem Watsa into a billionaire and a hugely admired CEO and investor both in Canada and in his native India. The company has been very active in acquiring and disposing of investments over the past 35 years, and has ridden some major ups and downs both because of investment wins and losses and because of major catastrophes that hit its insurance and reinsurance operations. I typically judge insurance companies on their ability to grow book value per share over the long term, and on that front Fairfax has done quite well over the past 30 years… though not very well over the past ten — this is the 30-year chart of Fairfax’s growth in book value (in blue) compared to Markel (MKL, orange), Berkshire Hathaway (BRK-B, red) and W.R. Berkley (WRB, green), for some context:
And here’s the ten-year chart:
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You can see in those charts some of the volatility of Fairfax compared to Markel or W.R. Berkley, which are generally of similar size — and that’s mostly from Prem Watsa’s investing. Unlike most big insurance companies, Prem Watsa has historically made some big directional bets on the market and on distressed assets — sometimes those work extremely well, like his well-timed bets against the overheated mortgage/housing bubble going into the 2008-2009 financial crisis, sometimes they are a huge drag on returns, as with his persistent “short” bet against the markets for many years coming out of that 2009 crash, a weight he only really lifted from the portfolio after President Trump’s election in 2016 as he (correctly) envisioned a return of “animal spirits” in the market.
Watsa has said that he learned his lesson after losing close to two billion dollars on his failed bets on deflation rising from 2011-2016 and from other “short the market” hedge positions, and isn’t doing so much macro “betting” any more, but that tendency continues to both offer some potential return and to elevate the risk, and it continues to worry me. After attending one of Fairfax’s annual meetings a couple years ago, and watching his commentary in 2019, I personally decided my funds were better invested elsewhere.
Which doesn’t mean Fairfax Financial is a bad investment. It has some appeal as a low-downside investment here, at a little discount (about 10%) to book value, so the risk is probably pretty limited over the long term (Chris Mayer posted some good thoughts along those lines back in 2019, if you want a different perspective — I don’t know what his more recent opinion might be), but when I sold most of my stake, at average prices in 2019 that were right around where the stock trades today, about US$460-470, I essentially concluded that there also wasn’t a real reason to expect meaningful upside.
So have things changed in the ensuing couple years?
Well, the shares took a tumble down the stairs last year, along with everything else — so there was no downside protection in the crash just because Fairfax traded at book value going into the COVID panic, it still fell, like everything else, and bottomed out at about 60% of book value. And indeed, that’s the most specific way in which Fairfax matches this Fool tease — it was last Summer, when the stock traded at about 60% of book value, that Prem Watsa came out and said the stock was “ridiculously cheap” and said he would spend $150 million of his own money to buy shares of Fairfax Financial (the actual purchase ended up being actually $149 million in shares, as teased).
The shares did recover pretty strongly, perhaps in part because of that endorsement, to get back to now about 90% of book value. If you ignore the 2020 crash and recovery, that’s more or less the natural continuation of the trend in falling price/book valuation of the past five years.
And to me, personally, a valuation somewhere in the neighborhood of book value makes reasonable sense for Fairfax Financial — maybe it’s a little discount, maybe there’s some downside protection in that, but performance has been generally disappointing for years and I don’t see why that should change dramatically. I don’t expect a big upside. A recovery to “catch up” with the valuations that the more popular and consistent insurance conglomerates have earned from investors (maybe up to 1.3X book value like Markel, for example), would indeed mean strong returns for Fairfax from here… I just don’t see that, personally, as being very likely.
Maybe I’m biased because I’ve been disappointed by Watsa’s investment decisions and commentary in recent years, so I don’t want to feed you too much pessimism on Fairfax Financial… it’s still a collection of insurance companies that are probably underrated, and I like a lot of the investments Prem Watsa has made over the years (including in some companies that I also own, like Kennedy-Wilson (KW) and Altius Minerals (ALS.TO, ATUSF)). It might not take many “wins” to restore Watsa’s lustre among value investors and perhaps earn the stock a premium valuation again, I’d just urge you not to go into Fairfax shares with daydreams of 10X returns. Low downside, possible upside would be my starting point in thinking about Fairfax today.
If you want to dig into Fairfax Financial, the best place to start is with their Annual Report and with Watsa’s annual letter to shareholders — as with somewhat similar companies like Berkshire and Markel, the annual letter (and the annual meeting, if you can attend — Fairfax was remote again this year, like Berkshire) is a good summary of management’s view of the business and the future strategy, and gives you a good insight into the “personality” of the company.
For 2020, Fairfax (like Markel) had some meaningful COVID losses, largely from international policies and event cancellation insurance, and the scope of the loss was also similar — Fairfax had a combined ratio of 98% in 2020 (would have been 93% without COVID), and Markel was at 98% (would have been 92% without COVID). Combined ratio is just a measure of insurance profitability — Claims plus operating costs, divided by incoming premiums earned — so anything over 100 means your costs are higher than the money you’re bringing in, insurance operations are losing money… and anything under 100 means you have an underwriting profit. In the past many insurance companies have been content to write policies at break-even or a small loss because the money they could make by investing their float and other accumulated capital still meant they were profitable, but with falling interest rates the “free income” isn’t there and that has generally helped to push insurance prices higher, making underwriting more profitable.
Booking an underwriting profit even during a tough year is reasonably impressive, though most specialty insurers, at least in the US (where pandemic exclusions are common in business insurance policies), had far better numbers… both because insurance rates have been rising, and because claims were lower than usual thanks to the lack of economic activity (fewer people around means fewer accidents… and the courts are also even more behind than usual, so claims that have to be litigated are taking an extra long time).
And the general commentary about insurance rates is very similar to what we’ve heard from other insurance companies recently:
“Premium increases accelerated during the year, rising from 12% in the first quarter to 16% in the fourth quarter – mainly due to rate increases. After many years of a soft market, the property and casualty insurance industry is experiencing a hard market accentuated by COVID-19 losses, catastrophe exposures, social inflation and low interest rates. Interest rates were at record lows in 2020 – never seen before even in the depression of the 1930s!”
Interest rates have begun to recover a bit as inflation fears have heated up, which is generally a good thing for insurance companies (most of their “float” — premiums they’ve received from selling policies that hasn’t yet had to be paid out in claims — has to be in very safe investments, which mostly means bonds and cash, so higher rates means more income from the float), but they’re still obviously very low.
When it comes down to it, though, the returns for Fairfax Financial just haven’t been there … and I don’t have a lot of faith that they will be there, since so much of Fairfax’s long-term growth has come from the occasional jolts from exceptional macro bets or successful large investments, and that’s not the kind of thing we should count on in the future.
I like Markel’s general focus on long-term growth in book value per share, and that colors how I look at these kinds of companies. Markel’s policy to base a lot of their employee incentive compensation on rolling periods of growth in book value per share — they particularly like the five-year growth in book value as an indicator of the company doing the right things and growing well. Markel has had a down few years, with growth slowing from the heady 15-20% book value growth of prior decades, but as of the last annual report MKL was back to a five-year compound annual growth rate in book value per share of 10%.
Fairfax Financial, by comparison, is right now at about 1% on that same metric, and at only 5% for a full ten years (MKL’s 10-year compound growth in book value is 10.5% per year). I tend to be a value-conscious investor at heart, despite my dalliance with some nosebleed-valuation growth stocks over the years, so a discount to book value does stand out as interesting… but I have trouble buying mediocrity at a small discount. Even though I do like Prem Watsa, believe that he has an excellent investment track record over his lifetime, and think he has built a strong and admirable company.
I do agree with Prem Watsa that, particularly in retrospect, Fairfax was “ridiculously cheap” when it got down to 50-60% of book value during the worst moments of the pandemic last Spring… and if that’s what I had been looking at in May of last year maybe I would have been interested in buying more (I did buy more Markel at the time, when it slipped below book value), but we don’t have a time machine and that’s no longer the price being offered. I’d rather pay 1.2-1.3X book value for the likelihood of at least 5-10% growth than pay 0.9X book value for no growth.
Insurance is a great business, and Fairfax is a good company and is probably trading at a fair valuation, but I still prefer lots of insurance companies over Fairfax Financial.
That’s just my take, though, and when it comes to your money it’s your opinion that matters… what do you think of this founder-led Canadian giant? Expect great long-term returns from a relatively discounted valuation? Let us know with a comment below.
Disclosure: Of the companies mentioned above I own Markel and Berkshire Hathaway. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.