Saturday, April 13, 2013

Fairfax Shareholder Letter Part 1: Buy BlackBerry

After reading the 2012 Annual Letter to shareholders of Fairfax Financial Holding, I thought I should post their interesting and different perspective on the markets.  In short, everyone today seems to be accepting an out sized amount of risk today because of quantitative easing.  Prem Watsa (CEO of Fairfax) is having none of it and is very defensive. 

I want to use this post, and the following one, to highlight my highlights of the Fairfax Annual Letter to shareholders.  As I have said before, too many people focus on the upside when investing while value investors fret over the downside.  Anyone who has invested long enough knows that you don't have to have very large gains in your portfolio, so long as you don't suffer huge losses. 

One bad year, say a loss of 33%, means that you have lost 1/3rd of your capital and have to now earn 50% on the remaining capital just to get back to where you started.  Thus it is imperative and prudent to always obsess over the downside.  Ben Graham, the father of value investing, in his book the intelligent investor said, "Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY." (Chp. 20, emphasis mine)

With that introduction in mind let's look at Prem Watsa's Annual Letter.  I will put each quote in italics and bold and my comments will follow.  This will break up this post into two parts just so it's not so too long. 

"OdysseyRE is the jewel in the crown, accounting for almost half our business and producing an average accident year combined ratio in the last ten years (since 2003) of 92.8%."

This truly is an outstanding business and I wish they owned more.  To be honest and rational, the only other really strong business is Fairfax Asia that has a 10 year average combined ratio of 71.8% and a 26.5% compounded annual rate of growth in book value (2002-2012).  However the only problem is Fairfax Asia is writes 1/7th the amount of premiums.  That said, if Fairfax Asia keeps growing at a decent clip, it may well be the crown jewel someday.  The emerging markets have years of strong growth ahead as Prem went on later to say, "All of these (emerging) markets are growing rapidly because of the low penetration of insurance."

The only other problem is their "crown jewels" often compensate for some of less valuable insurance companies that have been running terrible combined ratios over the part couple years.  As I like to say, less is often more.  That said, unless the business is consuming capital there is little reason to sell it. 

"In 2012, we earned a total investment return of only 4.5%...mainly because of our 100% hedge of our common stock portfolio."

Given the hedges this is not a bad result, especially since the downside protection is so high.

"Markets fluctuate - and often in extreme directions... (Discussing his investment in BlackBerry) At it's low of $6-1/2 per share, it sold at 1/3rd of book value and a little above cash per share (it had no debt).  The stock price declined 95% from it's high!"

Mr Watsa then goes on to discuss his rational for the investment in BlackBerry (BB).

"The brand name, a security system second to none, a distribution network across 650 telecom carriers worldwide, a 79 million subscriber base, enterprise customers accounting for 90% of the Fortune 500, almost exclusive usage by governments in Canada, the U.S. and the U.K., a huge original patent portfolio, an outstanding new operating system developed by QNX and $2.9 billion in cash with no debt, are all formidable strengths as BlackBerry makes its comeback!"

While those are all interesting facts, what came next is even more interesting and is the missing link to the Blackberry investment.

"And please note, 1.8 billion cell phones are sold worldwide annually, and of the 6 billion cell phones in the world, only 1 billion are smart phones.  Lots of opportunity for Canada's greatest technology company!"

Boy, he just had to throw that in there... What does it mean?  Well, here is the logic as I see it. 

1) BlackBerry currently has 76 million subscribers worldwide as per their latest earnings, so BlackBerry has a little more than 7-1/2% market share of all smartphones in the world. 

2) The growth of the smartphone market is still in it's infancy since only 16% of worldwide cell phones are smartphones. 

3) Over time, a large percentage of cell phones will be upgraded to a smartphone.  Let's say over the next decade the smartphone market grows from 1 billion to 4 billion (2/3 of total cell phones).

4) If, and I say if, BlackBerry simply retains it's market share in smartphones... How many subscribers will it have?  The answer is over 300 million or over 4 times it's current subscriber base. 

Of course you can make your own assumptions and of course be conservative (everyone else is), but you easily see they have room for a lot of growth.  Even if their market share shrinks, they can still grow their business. 

Now for the ironic news of the day... Guess who has higher gross margins, Apple or BlackBerry?  That right, Blackberry's gross margin was 40.1% in Q1, while Apple's was 38.6%. 

That said Blackberry still has some room to go on the cost side.  If we keep working our way through the income statement for Q1 2013, Blackberry spent $383 million on R&D (14.3% of sales) while Apple spent $1010 million on R&D (1.9% of sales).  Next if we look at Selling, General and Administrative costs, Blackberry spent $523 million (19.5% of sales) verses Apple's $2,840 million (5.2% of sales). 

At the end of the day, the operating margin was 31.6% at Apple in Q1 compared to Blackberry's 6.3%.  Clearly Blackberry has a huge amount of opportunity, especially on the SG&A side.  They just have to work harder, grow market share and their operating margin will increase. 

To be honest about his analysis, I find it amazing how much the market hates Apple stock at this time.  Both Apple and Blackberry have solid businesses is a very fast growing segment of the world economy.  Both companies seem to be selling at distressed prices today given the above facts.  I wonder if Prem and his team shouldn't consider both investments especially given the theme of growth in the smartphone market. 

Stay tuned for part two... (Click Here for Part 2: Get Defensive)

Best Regards,
Kevin Graham

Disclosure: Long FFH.



  1. I have no problem with BAC quarter results today. A quality franchise that is doing well and moving forward. It will be here for many years to come. I rather buy BAC here than Blackbery. Did Fairfax buy BAC? If they didn't while it was under $10 those guys can't be that smart. I would have told them to bet everyhing you got. Remember when BAC was $5?! But Still good here.... Oh ya

    Jake: I would say bet everything you got.
    Como: Everything?
    -From Raging Bull

  2. I have no problem with the BAC results either. If you look at their efficiency ratio it was something like 76% compared to 58% for Wells Fargo. Lots of expenses to wring out the company, particularly in LAS and legal.

    Did you notice they settled 3 class action suits also. Once the $8.5 billion BONY settlement is approved sometime this year, they are clearly on the other side with respect to legal issues. Then the profit machine will come roaring back. They have a huge deposit base that is very low cost.

    The math isn't hard but having patience can be hard for some. And No FFH doesn't own any BAC. They own large positions USB, WFC and a token amount in a number of other banks.

    Best Regards,