I believe that Fairfax Financial Holdings Limited (Fairfax) (TSE:FFH) (PINK:FRFHF) is undervalued and is worth as much as $574.00 per share. (All dollar amounts in this analysis are in U.S. dollars including the share price.)
As of June 30, 2010, Fairfax had a book value of $382.70 per share. As I write this, Fairfax is trading at $402.00 per share which gives it a price-to-book ratio of 1.05. I believe that Fairfax’s intrinsic value is at least 1.5x book value based on a reasonable mathematical expectancy that it can achieve a 12% return on its investment portfolio going forward. This expectation is further supported by Fairfax’s management talent, the significant concentration of ownership by management, and its long successful track record. For long-term investors, intrinsic value should grow – albeit in what may be a “lumpy” ride – at 12-15% annually for the foreseeable future. If Fairfax grows intrinsic value at 12% and is revalued at a more appropriate 1.5x book value, its intrinsic value could grow to over $1,000 per share over the next 5-years which would yield an annual return of 20% based on an entry price of $402.00.
BOOK VALUE MULTIPLE
If we assume a risk-free return of 3-4% from long-term government bonds and a return on high quality long-term corporate bonds of 4-6%, the present value of Fairfax’s outperformance of 12% over the long-term warrants a fair value multiple of at least 1.5x. See my blog post Price-to-Book Ratio and ROE Offer Strong Value Clues. Of course, the question is whether Fairfax can actually earn a 12% return on equity over the long-term.
As I learned from studying Bruce Berkowitz and Chuck Akre, the key to valuing an insurance stock like Fairfax is to look at the investments per share. Here’s what Berkowitz said in an October 2000 article in Businessweek about how he valued Markel.
Look, the key concept for insurance companies is to take a look at the investments per share. And you can find companies where the investments per share are significantly higher than the stock price. Markel has roughly $400 per share of investments. If they can break even on their underwriting and only make a 5% after-tax investment return, that’s $20 per share. Not bad for a company at $140 per share.
So the trick is to have that investment leverage and at the same time break even or make an underwriting profit.
Fairfax has a high quality investment portfolio that was worth $21.14 billion as of June 30, 2010 which, based on 20,546,935 shares outstanding, equates to $1,028.90 of investments per share. That is a ratio of 2.56 dollars in investments to each dollar of cost of its stock. If Fairfax can earn just 5% on its investments going forward it would be $51 per share and generate a 12.8% return on equity.
Fairfax has grown book value by 25% over the past 23 years, although from a much smaller base. Watsa has a stated expectation of compounding “book value per share over the long term by 15% annually”. Fairfax’s weighted cost of float since inception is 2.7%.
The 5% return seems reasonable given that 17% percent of the portfolio comprises high-quality dividend paying common stocks, including 6,884,300 shares of Johnson & Johnson, 9,949,871 shares of Kraft Foods and 14,074,100 shares of Wells Fargo. The portfolio also includes $12.3 billion of bonds, of which $5.5 billion comprised tax-exempt bonds as of December 31, 2009 purchased at favorable terms during the recent crisis ($3.5 billion of these bonds are insured by Berkshire Hathaway Assurance Corp).
Moreover, Fairfax’s investment record is superlative:
5 years – 12.2%
10 years – 19.1%
15 years – 16.1%
5 years – 9.6%
10 years – 9.3%
15 years – 9.4%
Prem Watsa and his management team have proven to be outstanding long-term investors as evidenced by their long-term track record. Moreover, in the Graham and Dodd tradition, they define risk as permanent loss of capital and attempt to run Fairfax with a margin of safety, which includes prudent investment and reserving, along with underwriting discipline. Watsa showed great skill in anticipating the economic meltdown of the past two years and positioning his portfolio to not only preserve capital but make a significant profit. As further evidence of Watsa’s think-about-risk-first approach, as of June 30, 2010, according to Watsa’s comments on the Q2, 2010 conference call, as a result of the run-up in the stock market, they increased their “hedge ratio to approximately 90% of equity.”
Similar to Buffett, Watsa draws a modest annual salary of C$600,000 and perks of only C$21,000. Watsa’s interests are well aligned with shareholders as he owns individually or otherwise controls a large block of stock. His annual shareholder letters are transparent and informative. They have high “signal” value that Watsa “gets it” and is focused on a legacy of building value for shareholders.
Intrinsic value going forward should be increased by a string of acquisitions. On February 31, 2009, Fairfax announced the purchase of Zenith National Insurance Corp. for $38.00 per share. This price is approximately 1.4x book value, and it represents a fair price for a high-quality company that has tripled its equity in the past decade and has an outstanding average combined ratio of 95% over the past 30 years and 89% over the past 10 years. It has also shown outstanding discipline in a soft insurance market by allowing a drop in underwriting volume rather than write business with a negative mathematical expectancy; it has a long-term track record of similar behavior.
Other recent transactions include the privatization of OdysseyRe, Advent and Northridge and the acquisition of Polish Re, a Polish reinsurance company. Fairfax also has exposure to the fast growing Indian and Brazilian insurance markets.
In summary, Fairfax is a high-quality insurance company that is trading at a discount to its intrinsic value. Long-term holders should benefit from a 12-15% growth in intrinsic value over time driven by intelligent share repurchases, select rational acquisitions, growth in float and premium volume and skillful investing. Management is honest and capable and has a long track record of accomplishment. This will likely be a bumpy ride as there is no attempt to “smooth” or “manage” earnings, but the end result should be worthwhile.
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