The following segment is taken from this funding letter.
A year has passed since our initial letter on Fairfax Financial and although the stock price has risen, we believe the reduction to intrinsic value has actually expanded considerably. Having recently covered our qualitative thesis on The Globe and Mail stocks, we now want to highlight the growing earnings power that is likely to trickle down to shareholders in the future. There are two main revenue drivers for an insurance company, its underwriting performance and its investment portfolio.
Underwriting: In 2021, Fairfax had a combined ratio of 95%, which means that for every dollar in premiums, the company had to pay 95 cents in losses and expenses (a lower combined ratio is preferable). That’s slightly better than its 10-year average of 96%. Although the first six months of this year posted a combined ratio of 94%, Hurricane Ian will undoubtedly push Fairfax’s combined ratio higher this quarter. However, going forward, if Fairfax can maintain its 10-year average at the current level of $21 billion in net premiums earned, Fairfax would realize over $1 billion in underwriting profits.
Investment portfolio: Although Fairfax has a stock portfolio filled with old-economy value stocks worth $5 billion, it is dwarfed by its $35 billion in bonds and cash. As described in our article, unlike almost all other insurance companies, Fairfax remained disciplined and did not seek yield in the bond bubble to increase investment income. As a result, Fairfax’s bond portfolio has a duration of only 1.2 years compared to 4.2 years for the industry, allowing for rapid redeployment into higher yielding fixed income securities.
For example, in the last quarter of 2021, Fairfax had annualized interest income of $500 million, if rates average 4% next year, Fairfax is on track for $1.4 billion. per year in interest. Recent sell reports have 2023 EPS estimates of $79 per share, but we think it’s only a matter of time before rising rates push them to revise higher.
But wait, there’s so much more… Fairfax’s pet insurance business was recently sold for $1.4 billion. This rarely mentioned division sold for more than 10% of Fairfax’s market capitalization when it only accounted for 1% of total premiums. Additionally, more than half a billion in cash is expected to arrive in the first half of 2023 with the closing of the Resolute Forest sale. Finally, Fairfax has filed paperwork for a possible Digit Insurance IPO. After regulatory approval, Fairfax will own 74% of Digit, which is expected to be valued between $4.5 billion and $5 billion.
Not only is Fairfax trading today at less than 6 times its forward earnings estimate, it is also trading at a 30% discount to its book value. Management has been vocal about its undervalued stock, but the attractive insurance price environment has steered capital toward underwriting; Premiums issued by Fairfax have more than tripled over the past 7 years. Yet even though the capital will expand underwriting, outstanding shares have still shrunk by 15% since 2017.
Prem Watsa is a founder who regularly quotes takeover legend Henry Singleton and Prem has already bought out a quarter of his company in a single year. The incentives are certainly there for further redemptions; Prem is the company’s largest shareholder and Fairfax has swaps on 2 million of its own shares (8% of outstanding shares). We note that when Fairfax had a similar influx of cash less than a year ago, they announced a substantial tender offer for 9% of the company which was completed at a share price above the value today.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.