Sunday, February 27, 2011

Fairfax Financial – 4th Quarter Review

I did manage to read the Fairfax Finacial 4th quarter earnings release and listen to the conference call twice as soon as I got home.  I hope I will be able to make it to the annual meeing, but Iw ill have to pull a few strings to make it happen.  To summarize they lost something like $18/shr in the 4th quarter and increased book value a modest 5% for the full year.  Fairfax currently has hedged 90% of their equity exposure with puts on the Russell 2000.  The Russell index is too high in my opinion, as I believe it is selling for close to 30 times earnings.  Many of the small cap names are selling for far too much and the large high quality companies in the DOW are quite cheap in comparison. 

Fairfax did also take a hit on its municipal bond portfolio on a mark to market basis.  These losses are nothing but temporary.  Meredith Whitney and friends have created fear in the muni bond area and investors ran for the exits in Q4.  Prem Watsa noted in the conference call that these bonds are selling for ridiculous prices.  They are currently yielding around 6.5% and are worth around 8.8%-9% on a pretax equivalent basis.  I do find it paradoxical that he also said it is very hard to purchase any bonds at this time.  Perhaps the selloff is based on low volume. 

Fairfax’s muni bond portfolio is 65% guaranteed by Berkshire Hathaway, Warren Buffett’s company. 

While on the topic of Warren Buffett, I found it interesting that he now isn’t a firm mark to market proponent as he once was.  He made the comments in a taped 2-hour interview with the FCIC on the cause(s) of the financial crisis.  Click here to access.  (If you want the coles notes version of the interview Click Here.) 

While I disagreed with Warren when he was a stanch mark to market proponent, his stance now is much better (as briefly mentioned in the interview).  There are times when mark to market doesn’t work, and we found that out during the financial crisis.  Mark to market does not work when the market is not function properly.  Just because no-one would purchase residential mortgage back securities during the crisis didn’t mean their value was zero. 

As yourself this question… If you put your house for sale and for one year you don’t get any offers on it does it mean your house is worth zero?  That is what mark to market accounting would say it’s worth.  There could be numerous reasons why you didn't recieve an offer in any particular year. 

Illiquid assets, and markets that are not functioning properly cannot be fairly valued by mark to market accounting.  Now the securtized mortgage market was not functioning properly during the financial crisis.  Isn’t it ironic that the stock market turned the corner is March 2009 after mark to market accounting was thrown out?  (Hmmm, something to seriously consider)

Warren should know this as all value investors look for mispricing in the market.  People are motivated all the time to buy or sell for reasons other than price.  This mispricing is what allows value investors to pick up dollar bills for fifty cents. Now to be fair Warren prefers mark to market accounting because it doesn’t allow wiggle room for accounting fraud.  I agree with him on that but to allow no wiggle room on illiquid assets is ridiculous, especially when it was bankrupting our banking system. 

Back to FFH

Looking at the rest of FFH results, I have the utmost faith in Prem Watsa to run our company.  If you listen to the call you will hear that companies like Zenith are only writing half of the business they were doing compared to recent times.  In the future they feel they are capable of writing 3 times the current levels they are currently underwriting.  Zenith is focused mainly in California, specializing in workers' compensation insurance.  They feel that current current insurance climate doesn't meet the standards of the company and as a result they are passing on business that they don't feel make economic sense. 

Now to be clear,the biggest negative of the report was the combined ratio of the US insurance divisions.  It came in at 130.6%.  That clearly isn't sustainable.  Now because of the tough insurance environment in US, I don't have any problem with the conservative stance Fairfax has taken on both it's equity exposure to it's underwriting stance.  Being patient is the best way to ride out this phase in the insurance market.


Anyway, enough for now.  I will be back with some further comment's on Peyto's reserve report that was released a couple weeks ago.  If you are looking to invest in the natural gas sector, I wouldn't waste much time researching much further than Peyto. 

My only problem is finding time to write these blog posts.  I am seriously considering writing a book for my children to help them better understand life, human action, economics, business, investing, & why both Canada (& the USA) are the wealthest countries in the world.  I feel that their are some key concepts, principles, and values which if I had know when I was in high school would have changed my life.  Remarkable many of these concepts are interrelated.  I also have some thoughts on how globalization will change their lives.  Perhaps I will be right, perhaps I will be wrong, but at least they will have the tools to understand how our world works. 

If I could put in a book plug here, it would be for Poor Charlie's Almanack.  This is a book of the wit and wisdom of Charlie Munger.  It is a fabulous book.  It discusses mental models and more importantly synthesizing mental models.  As Charlie points out we have numerous divisions in our universities and very little interdepartmental cooperation.  Intergrating the "soft sciences" with the "hard sciences" rarely happens but they should.  If you think psychology doesn't have anything to do with business and investing you are grossly mistaken.  Now if the book doesn't get you interesting in psychology, nothing will.  I found it facinating... In fact, just writing this short review makes me want to re-read the book for a third time. 

Well it's seriously time to sign off.

Best Regards,

Kevin Graham

P.S. I applogize for my poor spelling and grammer.  Everytime I read one of these posts I find another error.  Remember, it's the thought that counts. 

Full Disclosure: Long FFH & PEY

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