Author Topic: Is this patient investor flogging a dead horse with FFH? I Sell side discipline  (Read 7127 times)

EricSchleien

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Good points vinod1.

My own reservations regarding Fairfax are as follows:

1. Leverage: FFH has roughy $3 in insurance liabilities for $1 of common equity and another $0.50 mostly in debt. With so much insurance liability leverage, I think they are forced to keep most of the float in fixed income or cash. Obviously when it works, leverage produces great results but the reverse is true also. One major CAT loss, a huge portion of common equity will be wiped out. I really don't like the way annual letter shows underwriting results with and w/o CAT losses as if CAT losses were not supposed to happen and are highly unusual. It is as if management wants shareholders/readers to ignore these insurance losses when they are normal part of being in the insurance business.

2. Invested Assets: Just the fixed income portion of assets is larger than common equity. And it is highly unlikely that FI portfolio will produce great results going forward. And common stock selection has been awful during the last 10+ years. As others pointed out, they like to go for the crappy stuff all the while completely avoiding quality long term investments.

3. Macro Calls: A big negative in my book. One can easily see them making a 2020 US election macro bet for example if past is any indication.

4. Sub-optimal capital allocation: The dividend policy doesn't make any sense especially because they immediately issued more stock many times in the past right after declaring dividends. If they need more capital why not retain earnings? Why force shareholders to pay tax on dividends and immediately dilute them with new stock issuance?

5. Board governance: Too much Watsa family involvement without a clear benefit to the company or shareholders.

Obviously the dividend policy is in place to keep control and pay the Watsa family


jfan

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In this low interest rate environment, their 3:1 insurance leverage, would it make sense for them to consider alternative investments with fixed income qualities (eg infrastructure plays and other real assets)?

It would be amusing to see them use Brookfield's private funds to achieve better returns. But will it be too much for their egos?
« Last Edit: October 02, 2019, 07:55:53 PM by jfan »

Parsad

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Good points vinod1.

My own reservations regarding Fairfax are as follows:

1. Leverage: FFH has roughy $3 in insurance liabilities for $1 of common equity and another $0.50 mostly in debt. With so much insurance liability leverage, I think they are forced to keep most of the float in fixed income or cash. Obviously when it works, leverage produces great results but the reverse is true also. One major CAT loss, a huge portion of common equity will be wiped out. I really don't like the way annual letter shows underwriting results with and w/o CAT losses as if CAT losses were not supposed to happen and are highly unusual. It is as if management wants shareholders/readers to ignore these insurance losses when they are normal part of being in the insurance business.

2. Invested Assets: Just the fixed income portion of assets is larger than common equity. And it is highly unlikely that FI portfolio will produce great results going forward. And common stock selection has been awful during the last 10+ years. As others pointed out, they like to go for the crappy stuff all the while completely avoiding quality long term investments.

3. Macro Calls: A big negative in my book. One can easily see them making a 2020 US election macro bet for example if past is any indication.

4. Sub-optimal capital allocation: The dividend policy doesn't make any sense especially because they immediately issued more stock many times in the past right after declaring dividends. If they need more capital why not retain earnings? Why force shareholders to pay tax on dividends and immediately dilute them with new stock issuance?

5. Board governance: Too much Watsa family involvement without a clear benefit to the company or shareholders.

Out of those five items, only really the macro calls affected performance.  Their equity positions overall have done reasonably well since 2008, excluding the puts and derivatives.  That's what really killed about $2B in gains.  As for the Watsa family involvement, Ben has only been involved for the last 3 years, while Christine has been involved for one year...are you going to tell me that was the reason Fairfax underperformed for the last decade?

Ben Graham must be turning over in his grave. Do not blame value investing or indexing.

What happened over the past decade is that earnings for companies that fall in the value spectrum have not grown as much as they have historically done. Why that is so is a separate topic of discussion. Where as for the growth stocks they are pretty much in line with history. See attached table from philosophical economics blog. Pay attention to the earnings growth rate of value.

This earnings slowdown for value stocks is what is causing the under-performance. Market is paying attention to fundamentals. That is in line with what Ben Graham has been teaching. Stocks. Long Run. Weighting Machine.

Fairfax portfolio and Fairfax itself performed poorly because the earnings of their portfolio companies and itself were below par. Are we really blaming indexing for Fairfax's portfolios poor returns? Should Blackberry be worth $100 because Fairfax first paid what $45 a share several years back?

Vinod



Fairfax is not buying the market...be it value or growth.  So that's not an excuse, nor the reason why it underperformed.  We all know clearly from the letters that the macro calls since after 2009 offset about $2B in gains.  And that extremely conservative position left them holding a ton of cash and a ton of bonds, when equities were priced at 50 year lows.  So if shareholders want to blame anything, I would say they should be blaming the macro calls on what might happen.

- Going back to shareholders holding the stock or considering buying...if you think that Fairfax has learned their lesson on macro calls, Fairfax will probably do well in the future. 
- If you think that Fairfax will continue to try and make these macro bets, then yes, it is possible Fairfax will be out of step. 

I personally am betting on the former, but at the same time, I manage a considerable amount of my own portfolio and only a portion is in Fairfax.  Cheers!
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Munger_Disciple

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Out of those five items, only really the macro calls affected performance.  Their equity positions overall have done reasonably well since 2008, excluding the puts and derivatives.  That's what really killed about $2B in gains.  As for the Watsa family involvement, Ben has only been involved for the last 3 years, while Christine has been involved for one year...are you going to tell me that was the reason Fairfax underperformed for the last decade?


Parsad,

I never told you or anyone for that matter that the items I listed in my previous post were the reasons for Fairfax underperformance during the last decade. I can only assume that you are mixing up my comments with someone else's.

Added: I also don't understand how you can claim their equities have done well by excluding puts and derivatives. That is like saying a long/short hedge fund did well on the long side if you ignore their short positions. Doesn't make much sense to me.

-MD
« Last Edit: October 02, 2019, 09:18:19 PM by Munger_Disciple »

Parsad

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Out of those five items, only really the macro calls affected performance.  Their equity positions overall have done reasonably well since 2008, excluding the puts and derivatives.  That's what really killed about $2B in gains.  As for the Watsa family involvement, Ben has only been involved for the last 3 years, while Christine has been involved for one year...are you going to tell me that was the reason Fairfax underperformed for the last decade?


Parsad,

I never told you or anyone for that matter that the items I listed in my previous post were the reasons for Fairfax underperformance during the last decade. I can only assume that you are mixing up my comments with someone else's.

Added: I also don't understand how you can claim their equities have done well by excluding puts and derivatives. That is like saying a long/short hedge fund did well on the long side if you ignore their short positions. Doesn't make much sense to me.

-MD

I'm not saying their overall portfolio did well.  I'm saying that they made macro bets on the market and economy, including those puts and derivatives, which hurt their equity picks.  Prem has said as much in the annual letters.  And for all intents and purposes, those macro bets were a mistake.  But if you are using 3.5-1 asset to equity leverage, plus debt, plus float, then you may be hamstrung by having to make macro bets to ensure you don't suffer catastrophic losses that reduce statutory surplus when you are writing insurance business.

My point was, that if they have learned from those mistakes, their portfolio should do better over time.  If they haven't learned from those mistakes, their portfolio could continue to suffer from macro bets.  Investors should decide what they are comfortable with before buying Fairfax.  Cheers!
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TwoCitiesCapital

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Good points vinod1.

My own reservations regarding Fairfax are as follows:

1. Leverage: FFH has roughy $3 in insurance liabilities for $1 of common equity and another $0.50 mostly in debt. With so much insurance liability leverage, I think they are forced to keep most of the float in fixed income or cash. Obviously when it works, leverage produces great results but the reverse is true also. One major CAT loss, a huge portion of common equity will be wiped out. I really don't like the way annual letter shows underwriting results with and w/o CAT losses as if CAT losses were not supposed to happen and are highly unusual. It is as if management wants shareholders/readers to ignore these insurance losses when they are normal part of being in the insurance business.

2. Invested Assets: Just the fixed income portion of assets is larger than common equity. And it is highly unlikely that FI portfolio will produce great results going forward. And common stock selection has been awful during the last 10+ years. As others pointed out, they like to go for the crappy stuff all the while completely avoiding quality long term investments.

3. Macro Calls: A big negative in my book. One can easily see them making a 2020 US election macro bet for example if past is any indication.

4. Sub-optimal capital allocation: The dividend policy doesn't make any sense especially because they immediately issued more stock many times in the past right after declaring dividends. If they need more capital why not retain earnings? Why force shareholders to pay tax on dividends and immediately dilute them with new stock issuance?

5. Board governance: Too much Watsa family involvement without a clear benefit to the company or shareholders.

Out of those five items, only really the macro calls affected performance.  Their equity positions overall have done reasonably well since 2008, excluding the puts and derivatives.  That's what really killed about $2B in gains.  As for the Watsa family involvement, Ben has only been involved for the last 3 years, while Christine has been involved for one year...are you going to tell me that was the reason Fairfax underperformed for the last decade?

Ben Graham must be turning over in his grave. Do not blame value investing or indexing.

What happened over the past decade is that earnings for companies that fall in the value spectrum have not grown as much as they have historically done. Why that is so is a separate topic of discussion. Where as for the growth stocks they are pretty much in line with history. See attached table from philosophical economics blog. Pay attention to the earnings growth rate of value.

This earnings slowdown for value stocks is what is causing the under-performance. Market is paying attention to fundamentals. That is in line with what Ben Graham has been teaching. Stocks. Long Run. Weighting Machine.

Fairfax portfolio and Fairfax itself performed poorly because the earnings of their portfolio companies and itself were below par. Are we really blaming indexing for Fairfax's portfolios poor returns? Should Blackberry be worth $100 because Fairfax first paid what $45 a share several years back?

Vinod



Fairfax is not buying the market...be it value or growth.  So that's not an excuse, nor the reason why it underperformed.  We all know clearly from the letters that the macro calls since after 2009 offset about $2B in gains.  And that extremely conservative position left them holding a ton of cash and a ton of bonds, when equities were priced at 50 year lows.  So if shareholders want to blame anything, I would say they should be blaming the macro calls on what might happen.

- Going back to shareholders holding the stock or considering buying...if you think that Fairfax has learned their lesson on macro calls, Fairfax will probably do well in the future. 
- If you think that Fairfax will continue to try and make these macro bets, then yes, it is possible Fairfax will be out of step. 

I personally am betting on the former, but at the same time, I manage a considerable amount of my own portfolio and only a portion is in Fairfax.  Cheers!

I'm not convinced they have learned. It was only 3 years ago that they dumped 100% of their long bond portfolio in response to Trump winning the election.

It was a smart move in the short term, but they failed to start re-adding to that position and have now missed out on additional gains from the duration rally while being stuck in short-bonds while we cut rates.

Macro calls will continue. Sometimes they'll be right. Sometimes they'll be wrong. They need to get better about the risk management when the latter occurs. 

Fat Pitch

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I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.
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EricSchleien

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I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

On the latter point, I spoke for about 2 hours in depth about this at my annual meeting this year in NY. I think you're exactly on point here :)

Packer16

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I think the change to many industries from on-line businesses is real.  The end state will be close to what the disrupters describe but there are many ways to get there and the timing is uncertain.  In some industries, the new disrupter will win however for many of the incumbents will adopt the innovation and either defeat the disrupters or delay the time of disruption to long into the future.  Given the uncertainty here you have IMO many smart marketers that can raise money for businesses that either in the end will not disrupt, become a less advantaged competitor (despite a high multiple today) or the timing for the disruption is so long they will run out of money.  The current low interest rate environment has led to a proliferation of these types of firms IMO.

This IMO leads value investors to dig deep & estimate the growth of their businesses going forward.  The should lead to a discussion of the growth implied in the share price versus what the value investor thinks the growth rate should be.  The growth rate debate is one place where IMO value investors will make their money going forward.  One interesting observation is that as interest rates decline the "premium" for growth increases.  One way to quantify this is via Grahams 8.5 + 2g.  What this formula implies is 0 growth is equal to an 8.5 multiple and the growth multiplier is 2.  LT interest rates has declined by 1/3rd since this formula was derived, so, the current 0 growth multiple is 13 (7.7% yield) & the growth multiplier is 3.

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petec

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I remember selling out of this stock back when Prem added those equity hedges when franchise businesses were selling below book value. I'll give them the benefit of the doubt that they may have been over-levered for a protracted recession, but boy what an error.

For those "value" investors clinging on for hopes of getting validation, here's something to consider: "Software is eating the world". It's not "value" investing isn't working it's just that these companies are getting destroyed by fundamental shifts in the global economy brought on by technology. The opportunity costs are enormous when you consider tech companies can grow at 0% marginal costs while "value" companies are lucky to get 5% ROIC going forward.

On the latter point, I spoke for about 2 hours in depth about this at my annual meeting this year in NY. I think you're exactly on point here :)

How does software "destroy", for example, Stelco? Or is the thesis just that software companies have higher ROICs and can therefore grow faster, provided demand is there? Because if it's the latter, you're right, but that doesn't mean you can't make an amazing return on a Stelco if you buy at the right price. And it may be easier/lower risk to make money that way vs investing in software, because 1) everyone is looking at software and ignoring the likes of Stelco and 2) it's not always easy to predict the winner software winners before the market does.

FD: Microsoft is one of my biggest positions so I have drunk the Kool-Aid - but only to a point.