Fairfax Financial Holdings Ltd. (DDH-T) is on the other side of an inflection point in its earnings and valuation that position it for an extraordinary run over the next decade. It’s following in the footsteps of Warren Buffett’s Berkshire Hathaway, which shot up 27 times after it reached the size Fairfax is now in 1995.
Fairfax and Berkshire both have large property and casualty insurance operations that collect premiums and invest them in a portfolio of stocks and bonds, which is then used to pay claims. The total of these potential claims is called the insurance float. Besides generating float, well-run insurance companies make money from their operations by charging slightly more than their combined expense and claims costs. Insurers call this measure the combined ratio, and aim to keep it under 100 per cent. Fairfax has generated profits from its insurance operations over the past 10 years by running a ratio below 100 per cent. It has averaged 94.2 per cent over the past three years.
Fairfax’s float grew to $33-billion by the end of 2023, while the company’s market capitalization recently reached nearly $26-billion. By comparison, Berkshire had an insurance float of US$3-billion versus a US$26-billion market capitalization in early 1995, before Mr. Buffett used Berkshire’s shares to acquire Geico and Gen Re to materially increase Berkshire’s float. Today, Berkshire has a float of US$169-billion and a market capitalization of US$856-billion.
Over all, Fairfax has a US$65-billion investment portfolio thanks to its retained earnings and float, which provides it low-cost leverage. It also benefits from the current high-interest-rate environment because it has locked in investment income by extending the average maturity of its bond portfolio – which represents over 75 per cent of the total investment portfolio – to four years. As a result, Fairfax’s earnings are the most reliable they have ever been.
At Fairfax’s annual meeting on April 11, chief executive officer and founder Prem Watsa said the company is well positioned to earn at least $4-billion pretax per year for the next four years, and yet the market cap is only $26-billion. The company has also shown a strong ability to navigate insurance catastrophes over the last decade and underwriting only represents 20 per cent of its expected earnings over the forecast period, including reasonable gains for its equity portfolio.
Management’s strategy is to be reactive to opportunities to redeploy capital from fixed income into better return opportunities in high-quality equities. It prompted me to buy more shares on April 12 and Fairfax now represents more than 35 per cent per cent of my personal portfolio.
On the valuation front, Fairfax trades at 7.5 times consensus 2024 earnings-per-share estimates and near one times consensus 2024 year-end book value estimates. In comparison, Berkshire ended 1995 at 2.2 times book value.
Fairfax trades at a low multiple because many investors avoid companies with volatile earnings. They prefer a steady 10-per-cent compound annual growth rate to lumpy 15-per-cent growth and are willing to pay more for the former than the later.
Return expectations for Fairfax can be broken into book value growth and multiple expansion. The growth in book value over the next four years seems easy to handicap given expected earnings from interest income on U.S. and Canadian government bonds, strong insurance markets and an equity portfolio with a high earnings yield.
When it comes to multiples, share prices are a function of supply and demand and Fairfax is currently underrepresented in the portfolios of Canadian equity mutual funds. Its recent success, however, makes it the 26th biggest company in the S&P/TSX Composite and a likely candidate to enter the S&P/TSX 60 soon. If it is added to the index, passive buyers will provide demand for over 4 per cent of its shares outstanding, according to index analysts at National Bank Financial. The buying pressure will likely drive up its multiple and prompt active managers to take another look at the company, which might result in even more demand and an even higher multiple.
The narrative on Fairfax is likely to change with a new focus on the company’s transformation, higher level of expected earnings, growing durability and increasing quality, all of which suggest its shares will trade at higher multiples.
In my view, Fairfax Financial represents a compelling investment opportunity and has a better setup than Berkshire Hathaway did almost 30 years ago. Existing shareholders should update their old intrinsic value estimates for the company to avoid missing out on what could be a generational investment opportunity.
Asheef Lalani, CFA, is chief investment officer at Toronto-based family office Berczy Park Capital. He was previously a portfolio manager for UBS Securities and auditor at PricewaterhouseCoopers.
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