Recently, I’ve been writing a fair bit about insurance companies. Today, GuruFocus published an interview with Mason Hawkins and Sately Cates of Longleaf Partners Fund. Here is an exchange regarding Fairfax Financial.
Absent Prem Watsa’a speculations, Fairfax Financial Holdings’ performance would be greatly diminished. How does a value manager like you analyze an investment that is so dependent on the actions of one person?
[Hawkins:] First, unlike Berkshire Hathaway, where Mr. Buffett is virtually the sole investor, Fairfax has a very deep team of exceptionally talented analysts and investors, and they are anchored like almost no other investment group that we know of in Ben Graham’s margin-of-safety disciplines.
This team is housed in a company called Hamblin Watsa. It has an over-30-year record. It is led by Roger Lace, who is its president and head of equities. Brian Bradstreet oversees their fixed-income investing. Another leader is Chandran Ratnaswami who leads their international efforts. Sam Mitchell, who has had a terrific long-term record at another company, is part of the Hamblin Watsa group. Paul Rivett is their chief legal officer and also adds insight.
In Fairfax’s case, there is clearly a coordinated, cooperating, and collaborating investment team. They have executed like no other. Prem is part of that team, but by no means oversees the day-to-day execution of their investing efforts. Their record is nonpareil. In the last 15 years, they have grown book value per share at 16.4%, versus a 6.8% growth rate for the S&P 500. They have the number-one record in the insurance world of growing book value per share over that 15-year period. Over the last five years, Fairfax has grown book value at 22.5%, also number one among insurance companies. That was a period when the S&P had a 2.3% return. They far and away have exceeded their peers.
Turning to their long-term investment record, over the last 15 years their common stock investments have compounded at 17.2%, versus 6.8% for the S&P 500. Their bond record is equally superb. Their bonds have compounded over the last 15 years at 10.0% versus only 6.2% for the Bank of America Merrill Lynch US Corporate Index. Both bonds and stocks over the last 15 years have outperformed, and they have records in those two asset arenas unlike anyone we have studied, including those in the insurance world, hedge fund, and investment advisory world. They have a history of thinking independently, applying their appraisals, and using their discipline to say “no” unless something is exceptionally attractive from both a risk and a return standpoint.
Their hedging activities are misunderstood, and, to your question, they are not “speculations;” they are enabling them to lock in their investment performance and to protect their liabilities with their assets. Fairfax is a unique company, and they have evolved into one of the leading investment groups in the world, overlying a group of much-improved insurance companies. They have evolved with terrific management in the insurance companies that the holding company oversees.
Look at the team of talents that leads each of their insurance companies: Doug Libby at Crum and Forster, Mark Ram at Northbridge, and Nick Bentley running their runoff business called River Stone. You see well disciplined managers that understand that insuring risk has to be done at reasonable cost and against reasonable potential claim exposure. Dennis Gibbs is still a consultant of theirs, and he may be one of the most sagacious insurance minds there is.
Andy Bernard was just recently made president and COO of Fairfax Insurance Group. He previously ran OdysseyRe and created an exceptional company from virtually scratch. Now he oversees the various components of Fairfax’s worldwide and growing insurance group. As you probably know, they have nascent operations in many of the evolving world economies: India, China, the Middle East, and Eastern Europe. We believe that those early-day undertakings will pay great dividends as we go forward.
Fairfax is a combination of a superior investment team, with a lot of individuals who are very capable of running insurance companies and who have proven their worth and merit over a full cycle of insurance premium pricing. Prem has assembled a really unique group of operating and investing talent.
In last Friday’s Links of Interest, I posted a link to a research document by Ineichen Research and Management. The document contains an article by Joe Taussig entitled “In search of permanent capital”.
Taussig reversed engineered Buffett’s investment record within Berkshire Hathaway and came to some rather intriguing conclusions about the sources of Berkshire’s dramatic outperformance.
“Had the shareholders of Berkshire Hathaway sold all of their holdings in 1969 and reinvested the proceeds in the S&P 500, their $70 million would have compounded at 8.9% for 40 years and be worth $2.1 billion today. But what of Warren Buffett, the “world’s greatest investor”? We have reverse engineered his investment record within Berkshire Hathaway: 12.0% per year. In investment parlance, his investment “alpha” is 3.1% per year. This is pretty good, but does it qualify him for the reputation he has as the “world’s greatest investor”? Had the same investors liquidated their holdings in Berkshire Hathaway and had Buffett the asset manager manage the proceeds in the Buffett Partnership, the $70 million would have grown to $4.4 billion in 40 years. This is a far cry from the $153 billion of market cap that BRK/A enjoys today. This difference between $153 billion and $4.4 billion is what we call “structural alpha”.
In the (re)insurance businesses, the industry standard is that underwriting profits (or losses) equal premiums, minus claims, minus operating expenses. These generate an average underwriting loss of 3% per year (also known as the cost of insurance or “COI”) for each dollar of reserves. The industry generally invests these reserves in long-only fixed income (“because that is how we have always done it”). Assume that the fixed income generates 5% per year. Thus, for every dollar of reserves in a traditional (re)insurer, returns are 2% per year (5% for investments minus 3% COI). In terms of ROEs, the key is the ratio of reserves to equity (leverage), which runs around 5x in the industry. With its equity invested in the fixed income portfolio at 5% plus 5x of reserves earning 2% per increment of reserves, pre-tax ROEs tend to be 15% and after-tax ROEs are roughly 10%.
Under Buffet’s leadership, Berkshire never had a cumulative underwriting profit until 2006 (after which time his cumulative cost of “float” or COI became less than 0.0%). Up until that time, Berkshire’s underwriting losses were still better than the industry norm (his COI was 1% to 2% p.a.). Furthermore, at 2x, his level of leverage was far less than the industry standard of 5x. Investing the equity at 12% and adding 10% for each increment of reserves (investment returns of 12% minus the 2% COI), the total was a pre-tax 32% (12% + 2×10%). Taxes reduced it to an after-tax 20.3%. 20.3% compounding for 40 years turns $70 million into $120 billion. A price to book of 1.29x brings it to $153 billion. Thus the structure generated $149 billion of alpha ($114 billion in better ROEs and $35 billion in a premium to book value).
Stated another way, if Buffett had been run over by a truck 40 years ago but Berkshire had done all of the same things that it did in the meantime, except that it invested in the S&P 500, Berkshire would still be worth $26 billion (versus $2.2 billion in the S&P or $4.4 billion with a manager who could consistently generate returns of 12%). Substitute the HFRI Composite Index (a random selection of hedge funds) for the S&P 500 and the amount is $101 billion. While $153 billion seems like a lot more, Buffett’s share of the difference is far greater than any major hedge fund manager’s performance fees, save Steve Cohen.”
Taussig credits much of Berkshire’s massive outperformance to the way Buffett ingeniously levered the balance sheet 2x. Tausigg appears to be using the debt/equity ratio.
Because Buffett has been explaining it for decades, we’ve understood for a long time that insurance float provides Berkshire with a huge advantage. It functions as quasi free, permanent capital that Buffett can use to invest. What we may not have fully appreciated is the magnitude of the impact.
Taussig does not provide the details of what went into his calculations, which would be fascinating to walk through.
I did take a look at Berkshire’s balance sheet since 1994 using all the data available on line. The average leverage since 1994 is 1.2x. Interestingly, float only accounts for 40% of the leverage during the same period. Although Buffett doesn’t put a spotlight on it, Berkshire definitely benefits from cheap debt financing owing to its fortress balance sheet. (Note that, for simplicity, equity includes minority shareholders’ interests.)
What are some of the takeaways from this?
Trying to get 20% plus returns buying the types of stocks Buffett has typically purchased for Berkshire’s investment portfolio will probably not work. Buffett had the advantage of very low cost, permanent leverage working in his favor. (In fairness, most Buffett watchers feel that he does not invest this way in his personal account.)
The market is focused primarily on Buffett’s skill as an investor and what will happen when his services are no longer available. The market under-appreciates the degree of Berkshire’s structural advantage – access to massive insurance float and low-cost long-term debt, which should be a source of “alpha” for many years to come.
Taussig’s insights give investors a template to use in search of other insurance companies that enjoy the same structural advantages (along with demonstrable investing skill) with the benefit of having a much longer runway.
In Defense of the “Old Always” – James Montier – Montier offers a persuasive critique of trying to predict the economy. It should be noted that this is different from hedging, which is a form of insurance, and attempting to value the market. Klarman is a proponent of hedging, particularly when it can be done inexpensively. Holding a reasonable amount of cash is the simplest hedge, in my view.
Koo’s “Good News” – Interview with Nomura economist Richard Koo. Koo argues that the United States is in a balance sheet recession. His view is that monetary stimulus alone will not create economic expansion in the current environment. The reason is that private sector aggregate demand will continue to suffer as consumers rebuild their balance sheets. You may disagree with his conclusions but his reasoning is solid, and he provides a useful framework for making sense of current economic data.
When Irish Eyes Are Crying | Business | Vanity Fair – “First Iceland. Then Greece. Now Ireland, which headed for bankruptcy with its own mysterious logic. In 2000, suddenly among the richest people in Europe, the Irish decided to buy their country—from one another. After which their banks and government really screwed them. So where’s the rage?” – Michael Lewis
Over the weekend I came across some excellent investing counsel from hedge fund titan Ray Dalio in the book The Global-Investor Book of Investing Rulesby Philip Jenks and Stephen Eckett. Although not known as a “value investor” in the classic sense of the phrase, Dalio’s approach is solidly grounded in value investing principles. Per Wikipedia, “Ray Dalio is an American businessman and hedge fund manager who in 1975 founded Bridgewater Associates which manages approximately $80 billion in assets. As of 2007, his net worth was estimated at $4.0 billion.”
There are some general principles that most winners of this game employ that losers neglect. If you want to win any game, you must know what the principles of the game are, and then work to develop the required skills – e.g. counting the cards and calculating odds for poker. What I describe here is my approach to playing the game, which is a mix of these general principles and my own twists on them. For me, the following are required.
1. A deep understanding of the fundamentals so that pricing inefficiencies can be identified.
Adding value (getting a return greater than that available from passive investing) requires one to see how markets are mispriced, and this requires an understanding of how they should be priced. This is required to be a winner over time. It is the equivalent of being able to count cards and calculate the odds of a winning hand in poker – it is the fundamental assessment that allows you to discern a good bet from a bad one.
Some people say that understanding the fundamentals isn’t required and that one can play and win the game by playing it technically. If by technical they mean an approach that is devoid of understanding fundamental cause-effect relationships – like trend following – then I believe that they are wrong. Sometimes markets trend, and sometimes they chop, and they do so for reams. So, without an understanding of these reasons, one will be blindly betting that markets trend more than they chop. Do markets trend more than they chop? This is one of thus cosmic questions that can’t be definitely answered, and certainly not without an understanding of the fundamentals that determine marks behavior.
There is no escaping the need to have a deep understanding of the fundamentals so that one can sensibly assess what is cheap and what is expensive. In playing poker, I would rather place my bet based on my ability to count the cards and calculate odds than on the likelihood of hot streak continuing (e.g. betting that I will do well because I won the last few hands).
Adding value is a zero-sum game – for me to add value I must be a better player than my opponents. The markets are extremely competitive. That means that my understanding must be very deep, which requires focus. I have rarely seen investors that win over time who trade a lot of different markets. The winners I know discuss their markets with the same depth that specialists in other professions (e.g. physicians, scientists, etc.) discuss the subjects of their focus [emphasis added].
In addition, successful market players have the capacity to think conceptually and independently. Equipped with knowledge and perspective, they can justifiably have the confidence to stand apart from the crowd, which is essential for being able to buy low and sell high.
3. Perspective without data-mining.
Many years ago I did a lot of discretionary trading based on the flow of information I was seeing at the time. I wrote down the criteria I used to make each trade so that I could reflect on the trade later. I learned that if I specified the criteria clearly I could see how these criteria would have worked in the past, and in different countries, which gave me perspective. That perspective was invaluable.
In many cases I learned that the criteria wouldn’t have worked in the past and I could see why. In other cases I learned how well my decision rule worked so that I would not abandon it when it lost (all rules lose sometime) or put too much on it because it has recently been hot and I thought it was better than it really was. As a result, I developed a good sense of what I could expect from my criteria.
I learned that I could program the computer to scan the world for opportunities, according to these criteria. And I learned a lot more. I learned to be especially wary about data mining – to not go looking for what would have worked in the past, which will lead me to have an incorrect perspective.[Greg Speicher’s note: “If past history was all there was to the game, the richest people would be librarians. – Warren Buffett] Having a sound fundamental basis for making a trade, and an excellent perspective concerning what to expect from that trade, are the building blocks that have to be combined into a strategy.
Knowing how to identify good bets is only the first step. Knowing how to balance these bets – how much to place to on each based on their different expected returns, risks and correlations – is at least as important. This requires an understanding of probabilities, statistics, and money management principles. It requires the ability to simulate how this strategy would have worked in the past and to stress test its performance under varying conditions.
5. Substantial resources.
The days that an astute individual trader equipped with little more that his wits, being able to be a substantial winner at this game are over. Now, world class teams consisting of conceptual thinkers supported by specialists and advanced technology set the standard of play. While technology has radically advanced the average level of play, in markets as in warfare, it has served to widen the gap between the resource-rich and the resource-constrained players.
2) I came up with the best independent opinions I could muster to get what I wanted. For example, when I wanted to make money in the markets, I knew that I had to learn about companies to assess the attractiveness of their stocks. At the time, Fortune magazine had a little tear-out coupon that you could mail in to get the annual reports of any companies on the Fortune 500, for free. So I ordered all the annual reports and worked my way through the most interesting ones and formed opinions about which companies were exciting.
3) I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. I never cared much about others’ conclusions–only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people.
4) I remained wary about being overconfident and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing.
Property and casualty insurance companies which combine disciplined underwriting with solid investing can generate wealth. The good ones produce what has been called “structural alpha” because their float gives them low-cost – or no-cost – leverage. The best ones actually generate a profit on their float. Returns are typically lumpy because the insurance industry is inherently subject to episodic events which generate large numbers of claims.
A good point to get greedy is when they trade at or below book value. Another metric to track is the ratio of investments per share to the share price. For example, consider a case where you could buy a good P&C company at $100 per share that holds $300 per share in investments. If the company has a history of generating long-term investing results of 6% it implies an 18% return on your initial carrying cost.
Here are a few names to track taken from Fairfax Financial’s 2010 Annual Slide Presentation. These results include a very difficult time in the stock market. I have also included three additional slides which show Fairfax Financial’s long-term performance. Although much less known than Warren Buffett, Prem Watsa of Fairfax Financial – sometimes called “the Warren Buffett of Canada” – and Tom Gayner of Markel are worth studying. By way of disclosure, I am long Fairfax, Berskhire and Markel.
The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.