The Guide to Investing in Stocks and Shares

Fairfax financial holdings

Dan Tebbutt - A Shareworld Contributor

Published - 23th September 2010

My largest shareholding is in Warren Buffett's investment conglomerate Berkshire Hathaway, so when I read an article about Fairfax Financial Holdings in which its CEO Prem Watsa was described as "Canada's Warren Buffett", my interest was piqued. Although Berkshire looked cheap when I bought my shares, it's since risen to what I consider fair value; if Fairfax is undervalued, it could make sense to switch from one into the other.

Fairfax is a similar company to Berkshire Hathaway. It is an insurance company that uses its capital and float to invest in shares, bonds and other financial instruments. Unlike Berkshire they do not tend to buy whole companies.

Price

Fairfax's main listing is on the Toronto Stock Exchange (TSE). Its share price is currently C$408, which is US$396 (from this point I'm going to use $ to mean US$). There are 21.3m shares outstanding, so it has a market cap of $8.5bn.

Value

My valuation model for Berkshire Hathaway makes the following assumptions:

• That the long-term growth rate of the float is at least zero.
• That the long-term cost of float is at most zero.
• That the float and equity would be invested at least as well as I could invest it myself.

If those also hold true for Fairfax, then I would value it as:

• 10 times pre-tax earnings of wholly-owned non-insurance companies, PLUS
• Net assets, PLUS
• Float.

Fairfax have no wholly-owned non-insurance companies. In their most recent interims, they reported shareholder equity of $7.8bn ($6.9bn if you strip out intangibles). Their average float throughout 2009 was $9.5bn. So if my assumptions are correct, then Fairfax is drastically undervalued.

Float

First lets deal with the easy bit - the float. Over the last 5 years it has grown at about 6% per year. We can tick that box. However, the average cost of the float over the last 25 years was 2.3% - that's less good, but still not disastrous - we'll just have to factor it into our calculations.

Management

Fairfax have an excellent investment record, boasting a return on common stocks of 15-20% per year over the last 5,10 and 15 years, and bond returns of 10-12%.

Their record is not exactly flawless: they made approximately no money at all between 1999 and 2006. But that has all been eclipsed by essentially one very smart move - taking an enormous position in Credit Default Swaps on financial companies in the years preceding the financial crisis.

Prem Watsa's letter to shareholders in early 2006 summarises his prediction of disaster, and what Fairfax did to protect their shareholders:

• "We see all the signs of a bubble in the housing market currently"
• "For a few years now, we have said that we are protecting our shareholders' capital from a 1 in 50 year or 1 in 100 year event"
• "We have a diversified list of companies, mainly financial institutions, with respect to which we have paid approximately $250 million to purchase protection on underlying credit exposures"

Over the course of 2008 and 2009, when other financial institutions were suffering hugely, Fairfax emerged with more then $2bn of profit from their credit default swaps. I'm happy to accept they are at least as smart as I am!

Conclusion

I'm not going to value Fairfax's float at its full face value (as I would for Berkshire Hathaway) for two reasons:

• It has a non-zero cost.
• Fairfax must invest it fairly conservatively, due to their weaker capital position.

If they can pay 2% for it and earn 6% then it is worth half as much as unencumbered capital earning 8%, so I'm going to discount its face value by 50%. That makes $4.7bn.

Then there is their shareholder equity. This is free, but given their capital position they must still be relatively conservative. I will therefore discount it by 20%, to give $6.2bn.

That makes for a fairly conservative valuation of $10.9bn, vs. their market cap of $8.5bn - an upside of more than 25%. As a sanity check that is 1.4 times book value, which again sounds roughly right to me.

I don't plan to make any hasty decisions, but Fairfax has definitely done enough to make it onto my watch list.