Fairfax Financial (FFH.TO or FRFHF.PK) reported results for 2010 a week or so ago. Before commenting on the results, I had been waiting for the annual letter from Chairman Prem Watsa and over the weekend it was posted to the site. I’ve posted on Fairfax before (here and here) and I called them a great stealth dividend stock. Well, despite posting ‘weak’ results for 2010 Fairfax continues to be undervalued, a great long term investment, and still a great stealth dividend stock.
First, I highly recommend reading Prem Watsa’s annual letter for yourself. He’s not called the Warren Buffet of Canada for nothing. And, of course, read Buffet’s annual letter as well. There’s a ton of valuable and free investment advice in both letters.
Fairfax had a mediocre year in 2010. Book value increased only 5% in 2010 after the 3 previous years where book value increased by 146%. Results reflected the weak insurance market and mark to market losses on their investment portfolio. The weak insurance market resulted in a combined ratio of over 100% for 2010. The increase in the combined ratio was mainly due to their unwillingness to write new business at a loss to pad earnings – a long term positive. The mark to market losses in their investment portfolio were mainly due to losses on the muni bond portfolio (of which 65% is insured by Berkshire Hathaway) and their decision in the middle of 2010 to hedge 100% of their equity holdings. While these losses cause short term pain, and mark to market losses that show up in the income statement, they say nothing about the long term value of the portfolio. Fairfax builds their portfolio for the long term and not short term earnings.
During this period of weak insurance markets Fairfax is taking the opportunity to pick up more high quality insurance businesses. In 2010 they acquired 5 companies and still had $1.5B in cash on the books at the end of the year. This cash combined with their operating cash flow has them sitting pretty and looking for more acquisitions to build long term value. When the insurance markets turn around these new business plus the capacity to start writing profitable business in their current lines of business will generate substantial profits.
On the valuation front Fairfax trades below book value. As of today US shares trade at about $377 versus year ending book value of $379 per share. Due to the soft insurance cycle many insurance companies are trading near or below book. Talk about the baby being thrown out with the bath water. But lets take a look forward at prospective returns for Fairfax. Historically, Fairfax has grown book value at 25% per year over the last 25 years and has a stated goal of growing book value at 15% per year going forward. How realistic is that range given the current value and their investment portfolio? Here is where the true power of the insurance business shows, i.e. the power of the float. Here is break down of Fairfax’s total investment portfolio in per share numbers:
- Book Value – $379
- Debt – $119
- Insurance Float – $641
- Total – $1,139
When you buy a share for say $379, you get $1,139 in investments per share working in your favor. In order to generate 15% to 25% returns on book value the investment portfolio return needs to be approximately 10% to 15% per year. I used conservative estimates to arrive at these numbers. I assumed the cost of float averages a negative 1% per year, an average tax rate of 30%, and long term average expense ratios and interest costs. The float acts like leverage to investment returns. Over the last 25 years, the investment team at Fairfax has done better than this (see page 14 of the CEO letter). Even over the lat 5 years, returns have been 14% for equity investments and 13% for bond investments. So it looks like at the minimum that 15% growth on book value target is conservative.
Now what about that stealth dividend I mentioned? Looking at the financials, 2010 dividend and interest income from Fairfax’s investment portfolio was $41.31 per share. That’s $41.31 on a book value of $379 or an 11% income yield on book value. That goes quite a long way to meeting that book value growth of 15% per year and one reason I think it is conservative. That’s what I call a great stealth dividend! And management has a great track record of reinvesting those dividends and bond coupons for the long term. The market may take a while to realize this, probably until the insurance market turns, but eventually the stock price closely follows book value.
In short, Fairfax continues to build shareholder value for the long term. The stock is cheap due to insurance market weakness and I think it represents a compelling long term value consistent with my dividend theme.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.