Watsa circles his crown jewel

What makes Prem Watsa a good investor? Ask his friends on Bay Street, and they'll give you the usual answers: He's patient. He's level-headed. He has conviction.

Never will they phrase it in more pejorative terms: Prem Watsa is a shark. That's not meant as a slight - it's just the truth. Lurking inside any very successful investor is a cold-blooded opportunist, someone who can spot fear in the eyes of others and profit from it. It's a quality that Mr. Watsa, the chairman, CEO and controlling shareholder of Fairfax Financial Holdings, has displayed in abundance during the financial crisis, never more so than in his play for Northbridge Financial, Canada's biggest commercial property insurer.

Northbridge is probably the crown jewel of Mr. Watsa's $7-billion insurance and investment empire. Most consumers have never heard of it, but its subsidiaries occupy lucrative corners of the business insurance market. Northbridge insures truckers who haul auto parts up and down Highway 401. It sells policies to small-business owners who worry about theft by employees. Most importantly, it's fabulously profitable - it has lost money only once in the past 10 years, and from 2003 through 2007, it never failed to make at least 15 cents on every dollar of shareholders' equity.

The company is also debt-free, a valuable thing in tough times. And Mr. Watsa knows a thing or two on that subject, because it wasn't so long ago that Fairfax itself was strapped for cash. That's why, in 2003, after a series of bad years, it took Northbridge public and raised a quick $200-million. Another sale of Northbridge shares the following year raised $150-million for the parent company. Today, the public owns 37 per cent, Fairfax the rest.

Mr. Watsa hated to do it. (Who ever wants to sell even a small piece of an excellent business?) But he needed the money to keep Fairfax going while it tried to restructure its own finances. Then, in 2007, the credit crunch hit Wall Street and Fairfax's bearish bets on U.S. and European credit markets became a winning lottery ticket. It made more than $2-billion on credit derivatives.

His balance sheet problems repaired, Mr. Watsa has become a lender of last resort to the weak, the desperate and the nearly broke. Last spring, Fairfax threw a $350-million (U.S.) lifeline at AbitibiBowater. Just before Christmas, it lent $200-million (Canadian) to H&R, the struggling real estate investment trust that's building the tallest office tower in Western Canada in Calgary. Interest rate: 11½ per cent (and Fairfax got warrants, too).

That's what opportunists do. When they have cash that others need (but can't get elsewhere), they use it to try to extract big returns. But both of those deals are dwarfed in size by Fairfax's bid to privatize Northbridge for $686-million or $39 a share. Prem Watsa wants his crown jewel back.

The timing is shrewd. The offer was made on Dec. 1, 11 days after the market hit a new low. It's all cash, attractive for mutual fund managers who have been hit with redemptions and need to give customers some money back.

And - here's the really clever bit - the deal expires before Northbridge reports its fourth-quarter profit. Those results will be driven in part by the performance of the insurer's $3.5-billion investment portfolio. What's in it? Mostly government bonds. And what one asset class had a stupendous rally during last fall's market collapse? Government bonds.

Mr. Watsa says he's playing fair. "If we knew of a significant increase to Northbridge's book value in the fourth quarter, there is no way we wouldn't disclose it." He points out that Northbridge shareholders have made boffo returns since the IPO, which was at $15 a share. "It's never traded at $39 before ... It's not like we're taking it private at $10," Mr. Watsa said.

Even so, some minority owners smell something they don't like. The outlook for property insurance is good: higher premiums are coming soon, as AIG breaks up and weaker competitors die off because of investment losses. What's that potential worth? A lot more than $39, says Tony Arrell, chairman of Burgundy Asset Management, one of Northbridge's largest minority shareholders (it owns about $80-million worth of stock).

The two men have been friends for more 30 years; Mr. Arrell even used to sit on the Fairfax board. But he has told his friend to forget it - his firm is not selling. "We just think the price isn't fair," Mr. Arrell says. Friendships are one thing. But when you're dealing with a shark, business is business.