TIVP085 (Video): Fairfax Financial (FFO.TO): The Berkshire Of The North w/ Kyle Grieve and Shawn O'Malley

25:21And for everyone else, there's two ways you can join us if you're interested. A general admission ticket gets you full access to the conference itself, a stock pitch presentation from Kyle and an intrinsic value portfolio with Daniel and me, plus guest speakers that we'll be announcing in the coming weeks. Or if you want the full experience, our VIP ticket package that gets you all day conference access, plus a seat at our Saturday night exclusive dinner with William Green and the rest of our inner circle community. and it will definitely be one of the more special evenings we host all year. So if you've ever wanted to spend a weekend talking shop with serious investors in the financial capital of the world, this is it.

26:04Find tickets in the full agenda at theintrinsicvalueconference.com. That's theintrinsicvalueconference.com. And if you'd rather join us as a member and get the conference plus the full weekend included, apply to the Intrinsic Value Mastermind at theinvestorspodcast.com slash mastermind dash application. All the links are in the show notes below. Hope to see you in New York. Float is like really effectively free leverage, right? That's what you're describing, especially if you have a profitable combined ratio, meaning that you're underwriting insurance profitably. And so you're enhancing your purchasing power with float, which means that you're buying more assets than you'd otherwise be able to, and then getting to keep the rewards for doing so.

26:50That's free leverage. And you mentioned something there that I think we should chat a little bit more about. And that's how Fairfax's combined ratio has turned from something of liability earlier into being really a major boost for the business today. That's right. So the turnaround really started many years before the numbers, I think, started showing up. So we have to actually rewind back to 1996. So Fairfax acquired Scandia America, which was a reinsurance business. They ended up renaming it Odyssey. But when they bought it, it had about$250 million of gross premiums and$290 million of equity.

27:24And by 2020, that number swelled to$4.3 billion in premiums and$4.8 billion in equity. So this was arguably the best acquisition that Fairfax had ever made. But during this time, Fairfax had to fix a number of issues with some of its other acquisitions. So TIG, Crum and Forrester, arrived carrying just these very, very large reserve deficiencies. They had to spend years fixing how they underwrote insurance just to bring their combined ratios down, which definitely made Fairfax's numbers look kind of uglier until they were able to fix those things. Another lever that they really pressed on was leveraging their decentralized business model and putting the right people in place to lead those insurance businesses.

28:03So Prem trusted the managers of the insurance businesses and gave them time to fix things. Fairfax has presidents who have stayed on literally for decades. They show this in their shareholder letter. And I think this really helps insurance companies focus on the long term rather than chasing risky premiums just to boost kind of your short term performance numbers. If managers of insurance companies are only around for a good or bad cycle, it's actually really hard to evaluate them. You need managers in these businesses to stay for multiple cycles so you can see how good they are at fixing things because repairing these businesses won't really show up until years down the road.

28:40And if you're the parent company and you get impatient with your subsidiary presidents and subsidiary managers, you might fire them and later learn that they're actually doing a really good job. That's exactly right. And I think Buffett talks a lot about this, about being a disciplined insurance underwriter. And the reason being when insurance is sparse, when people aren't willing to go out and underwrite properly, what you can basically do is you can make business by selling for the wrong price. And unfortunately, what happens in the future is if you do that, well, then you're going to be hit with a number of large claims down the road.

29:14And that can literally just break an entire insurance business. So I want to move on here a little bit and look at Fairfax's competitive advantages, because I think on the face of it, it's not really a business that looks like it has any obvious modes. You know, insurance is most definitely a commodity business. And it's also very, very competitive. So when you look at it that way, I mean, insurance doesn't really seem like the type of business that anyone would want to get into. And like I said, you know, if you aren't running an insurance business properly, and you're not disciplined, you can literally implode and destroy the entire business.

29:46So besides that, though, I would say there still are a number of advantages that Fairfax specifically has, but they're also available to competitors to some degree, I just don't think that they can take advantage of it. So the first advantage, like we already been talking about here for the last few minutes is the combined ratio, which is trended in the right direction due to very, very effective management. The fact that Prem has access to an ever larger float and can earn higher and higher returns on it than most insurance companies is also just a massive advantage. Just to give you an idea, the float has grown to about$40.8 billion up from$13 million in 1985.

30:18The second advantage is the capital allocation track record, which spans over 40 years. So their long-term return on investments is about 7.7%. And even though that number has trended down somewhat since the early days, I think it's one that they can reasonably maintain for quite a long period of time. If the average insurance company earns a return of, let's say, 4%, which is closer to the longer term return of bonds, then this is just a very, very big advantage because it means that an insurance company will just earn more money simply by being part of Fairfax rather than remaining as a single entity.

30:48I would say, though, that there are other companies out there that come to mind that probably do a better job of generating higher returns on float. It's obviously Berkshire Hathaway, but also Markel comes to mind too. And so underwriting insurance profitably, if we haven't said it enough, is just so hard to do. And like you said, it's a commodity business. But then to expect to be able to do excellent investing on top of that is really just almost like an unreasonable thing to ask of most companies. And that's why most companies can't do it well. And that's why it's such a special thing to find companies like Fairfax and Berkshire and Markel, where they have this formula for writing insurance well and also simultaneously being great investors.

31:30That's right. And I think you just brought up the kind of key point there where in order for these businesses to really, really succeed, you need both of those. You need the talented operators of the insurance businesses and you need people who can invest really, really well. And it's very, very important both of those kind of work in conjunction. And even if you do have really, really good investors, they're still handicapped to some degree because regulators basically won't allow you to invest 100 % of a float, for instance, into just equities. I don't think there's any place that does that.

32:00Just different jurisdictions have different regulations, but you have to obviously be really, really, really careful with that money because if a whole bunch of claims come in, you have to pay that out and you can't just be gambling on the stock market. You have to be able to have that float available to be paid out. So the last competitive advantage that I want to mention here isn't really a traditional one either. And that's just the culture, I think, that Prem Watts has built inside of Fairfax. So throughout the years, Prem has acquired some just incredible operators. Fairfax has an exhaustive list of presidents who have been with their company for literally multiple decades, both before and after being acquired by Fairfax.

32:34And, you know, I think it's kind of easy to see why. Given Fairfax's decentralized nature, it often buys insurance companies that were already very well run. All Fairfax requires is that they really just keep running them well, and then Fairfax takes care of growing their flow. And Fairfax also tends to internally promote their executives. So this is really good for culture because if you are inside of Fairfax and you're just great at what you do, if a promotion becomes available, you know that you're probably going to have a really, really good chance at getting it because Fairfax is unlikely to look for an outsider to fill that position.

33:07The best example of acquiring talent was actually from Odyssey. Fairfax got Andy Barnard and Brian Young. So as of today, Brian Young is the president of the Fairfax Insurance Group, a position that was previously held by Andy Barnard, who then moved to the role of chairman of the group. And, you know, they've worked together for 35 years and 25 of them have been under Fairfax. So I probably have my own biases because TIP has sort of a decentralized structure, you know, the company that we work at here. And we also hire from within. So like I said, I have my biases toward thinking that it's a pretty good model.

33:41But yeah, there is a lot of evidence that giving talented people the space and the discretion to just do their jobs well without being micromanaged and without multiple layers of middle management and all these other different forms of bureaucracy that you tend to get better business outcomes. So it is pretty cool to see that Fairfax has a similar structure to that. I like to switch gears here and look at Fairfax's debt situation. So through much of Fairfax's history, they haven't really feared debt and have used it to actually help fund a lot of their M &A. So as of today, they have about$14 billion of debt.

34:18And this is split among the holding company, insurance and reinsurance companies and non-reinsurance companies. But with cash, their net debt position is about$11.6 billion. But this cash position doesn't actually include the insurance float, which is currently valued at 73 billion. So even though the cash available for investments for Fairfax is pretty low, they're actually still in a very, very good financial position. Fairfax has always carried debt to fuel its acquisitions. But when you have an ROE as high as they do, it makes sense to purchase businesses with a little leverage. I'm focused on a few key metrics to evaluate Fairfax's financial health.

34:53First is just their interest coverage ratio. And this is simply operating earnings divided by their interest expense. Right now, that sits at a very comfortable level at about 10x, but it's actually trended a little lower over the years from 14 times in 2023. Now, total debt to capital has ranged from about 26 % to 33 % and currently sits right in between that number. And I think sticking within that range makes a lot of sense as they can continue to add new businesses, whether that's insurance or non-insurance to their portfolio to help continue driving more and more growth, or they can buy out minority shares in the businesses that they already do own once they know that it's a really, really good fit and that the business model has been validated.

35:30It does feel like it would be fair to call Fairfax a serial acquirer. And one of the hallmarks of serial acquirers is using debt consistently to finance further acquisitions. So where do you see debt going in the future? I mean, is it likely to just simply keep trending upward or is there a chance that they actually deleverage in the future and increase their equity value relative to the debt holdings? I think that given they've had this kind of debt to capital number that stays in a pretty tight range around 30%, my assumption is that probably is going to stay that way into the future. So as long as they're continuing to generate profits and increase their shareholders equity and capital base, I assume they'll continue to take on moderate amounts of debt.

36:13Now, the good thing about this for Fairfax is that they can raise debt quite easily and don't have to dilute shareholders in the name of growth. So since 2018, diluted shares outstanding have trended downward from about 28 million to about 23 million. And the businesses they bought over the decade have had various pricing tags, some as low as$103 million for Singapore Re. Then you have some larger kind of billion dollar plus acquisitions, such as Allied World Insurance for 4.9 billion and Gulf Insurance for 1.4 billion. So they definitely do need access to leverage to buy some of these bigger deals.

36:46I could see how Fairfax would definitely need access to more capital to make more acquisitions since the pipeline for doing so does not seem to be slowing down anytime soon. Plus, as you mentioned, they can buy out minority stakes in businesses that they already partially own. They've already deployed some capital in these minority buy-ups, if you want to call it that, at Allied World, Gulf Insurance, and BRIT, and raising their ownership levels in all three effectively by deploying capital to buy more skin in the game with those businesses. And so they actually just closed a$1.65 billion deal for Kennedy Wilson Holdings as well, I believe.

37:26That's right. And speaking of acquisitions, I actually think this is probably a good time to assess the capital allocation of Fairfax, because this is a very, very important part of the thesis. So I think there's just a lot of positives here. First is the 18.7 % compounded annual gain in book value per share over 40 years. I think this alone just shows you that they have deployed capital very effectively and have continue to grow profits at a very strong rate. So ROE, return on equity, is a primary metric that they use here to analyze the capital efficiency. And it's a very, very positive story with ROE at 19 % for fiscal year 2025.

38:00Now they have a stated goal of 15 % ROE. So if they can do that, which they've been doing for well over 40 years here, I think you'll likely earn returns that track this ROE number. Those are definitely really strong and healthy numbers, especially post 2021 coming out of COVID. And they've maintained a range right around that 15 % number, it seems like, but they clearly had some weakness leading up to the pandemic. So can you just explain what was going on there? Yeah. So ROE actually went negative because of something I mentioned earlier, which was the erroneous thinking that other GFC type events were right around the corner that Fairfax could benefit from.

38:39So these investments into the CDSs were expensive and directly consumed much of Fairfax's operating earnings. Additionally, the market actually did really well during this time. So the opportunity cost of shorting the market was very, very high. So during that time, the book value decreased a couple of years in 2011, 2013, and 2016. But that wasn't the only reason for the depressed operating metrics. 2011 was a brutal year due to a multitude of catastrophic event like the Japanese earthquakes and tsunami. And this caused their combined ratio to go up significantly up to about 114%. I want to harp on one of the things you mentioned earlier, and that's how much respect Prim Watsa has for both Buffett and Henry Singleton, who's lesser known, but still an incredible investor.

39:20And so I know Fairfax has done some really interesting things in terms of capital allocation to help increase shareholder value with Odyssey. That's the insurance business that we've discussed a few times today. Yeah, they did some really, really interesting financial engineering, which I think helps explain just how savvy they are with capital allocation. So with Odyssey, they actually ended up selling off just a 10 % stake in the business at one time. So here's the nifty financial engineering though. They sold the 10 % stake in Odyssey at a book value of 1.7 times. Now that number might not mean anything to people who don't follow insurance, but that's actually a pretty high multiple for an insurance company.

39:58And once Prem realized that he could earn the premium by selling off a piece of Odyssey at a high valuation, he just jumped on it. But the real reason he did this was to increase Fairfax financial shareholders ownership stakes. So the proceeds from this divestiture were used to buy more Fairfax shares, which at the time of the deal, were actually trading for only 0.9 times book value. And this is just capital allocation at its finest. You see something expensive and then you buy something cheap. It sounds really easy, but it's very, very rare to see in reality. So that's the key point there that you mentioned, Cal.

40:28It sounds simple, but you just you don't see it happen. And it's a nuanced conversation why. But I think one of the reasons you don't see it happen is that when a business is trading cheaply, it also just becomes harder for that business to sell pieces of itself at a premium price. But since Fairfax in some ways is really a sum of the parts play, even if Fairfax as a consolidated conglomerate doesn't have the best numbers, it doesn't mean one of its subsidiaries is not just absolutely blowing it out of the park. Right. And another really interesting strategy Fairfax took to raise even more money for buybacks was their use of these things called total return swaps or TRS.

41:08So you can think of a TRS as kind of a derivative, kind of like an option, but with a few differences. And the main one being that you take part in the gains of the upside and you take part in the potential losses if the value of the TRS goes down. But you don't actually have to own the stock. You just kind of put down a deposit. it. So what Fairfax did was during COVID-19, they bought these total return swaps in Fairfax's stock. Now, they knew at that time that Fairfax was undervalued, having just gone down about 50 % in price. And from that time, Fairfax recovered very, very well over the years, netting Fairfax about$2 billion in cash from these total return swaps.

41:44And much of that cash was then used to repurchase even more shares of Fairfax. That's very, very cool. I think that's super interesting the way they approach it. And one of the underappreciated aspects of buybacks is the timing of when they're done. Doing buybacks on your stock at an all-time high is actually not the right time to do it, even though a lot of companies do it then, because chances are that your shares are overvalued. And so really, if you're going to be very precise and tactical about your buybacks, you want to do them when pessimism for your business is at an absolute bottom. You are completely correct, John.

42:21Fairfax shows a great chart showing just how their share account has meaningfully shrunk over time. And the most meaningful number is just how many shares they bought at prices that are a fraction of today's price of about$2 ,340. They bought back shares in 2019 at an average price of just$473. In 2020, they bought back shares valued at about $500. I think this just kind of goes to show you that they're very good at buying back shares and understanding Fairfax's value and kind of pulling the trigger when Fairfax is at a depressed price level. So one other thing that caught my eye when looking at Fairfax was they do pay a dividend.

42:55And Kyle, I know you're not the biggest fan of dividends, nor would I say that I am in most circumstances, especially when that business can deploy capital at high rates of return, meaning that ultimately they would create more value by reinvesting and paying out dividends. but I digress. The upside is that Fairfax's dividend is a very small percentage of earnings that they pay out and the dividend yield is only 1%. You know me very well, Sean. So obviously, I'm not crazy about dividends either. Over the past 12 months though, they paid about$350 million in dividends. And so like you just said, that's money that could have been used to fuel the M &A engine.

43:33But it's also a small enough number that I think I'm okay with it, provided that the yield doesn't continue to rise. And the numbers support that the yield is actually continuing to trend down. So I'm not super concerned here about the dividend. The dividends have actually decreased over the past three years while profits have increased. So the fact that they pay a dividend is definitely not a deal breaker for me when it comes to Fairfax Financial. Dividends can be seen in different ways. For instance, when insiders hold large amounts of shares, dividends actually can be seen as an alternative form of taking a salary.

44:06And so if So if business has a reasonable dividend and management can take lower compensation correspondingly, that is maybe not necessarily a bad thing for all shareholders. Yeah. And that's exactly the case, I would say, with Fairfax. So Prem Watsa has had a salary of about$600 ,000 since the year 2000, and it hasn't changed at all since then. And he also receives no bonuses, no profit participation, nor does he participate in any equity or pension plans. So, you know, I think this is a very reasonable deal for a leader who has compounded his business at high rates for over four decades. But I also think it shows that Prem understands how to create alignment between himself and the shareholders.

44:43So Prem Wassa, through a holding company, as well as his personal ownership, has 43.3 % voting rights of Fairfax Financial. Fairfax has been through a period where it was attacked by shorters. So this large voting stake helps kind of the business stay protected from potential short attacks in the future. But Prem's economic stake is somewhere around 10 % of the total shares. And with his current holdings, he makes somewhere around$19 million per year in dividends. So I would say that this is definitely part of the reason that Fairfax pays a dividend as it helps compensate the CEO, who you can argue is very, very underpaid relative to how much value he's created at Fairfax.

45:20Yeah, I mostly like it. I would say that with one caveat, Prem doesn't have a performance incentive. And I like managers to have a performance incentive aligned with creating shareholder value. And so I think we can assume that the incentive here is sort of implied that with the majority of Prim's net worth being in Fairfax's shares, he is naturally incentivized to continue increasing Fairfax's value. and since he doesn't hold any options, he takes part in both the upside and more importantly, the downside of any declines in Fairfax's share price, which will of course mirror its intrinsic value over time.

45:58But how about the rest of the management team? I assume they have different compensation packages, but maybe we can go over that in some more detail here. Yeah, so it's probably not a huge surprise, but the remaining executives are making a very reasonable base salary kind of in that 600K to$1.5 million per year range. There's nothing obvious to me here that would raise any red flags, but most businesses have red flags in their kind of short and longer term incentive plans. So let's look there in a little more detail. So I can already see your eyes rolling here, Sean, you know, as Fairfax does have an options-based award, but this system reminds me a lot of Lifco's options plan in that the options that Fairfax grants are actually non-dilutive, a characteristic that's incredibly rare in most corporations.

46:41So Fairfax's equity-based awards are based on subordinate shares that have already actually been issued. So you can kind of think of it as Fairfax buying these shares on the open market, then granting them to their employees. So once they grant, no dilution is actually taking place. And the vesting schedule is quite long with 50 % vesting in five years and the other 50 % vesting in 10 years. Fairfax has no pension plan. So these options kind of serve as its replacement. So I think I like the long-term nature of the options along with the non-dilutive effects. but they still are to some extent time-based awards.

47:13Now, I will commend them for having these expiration dates for executives that go out past 2040. I mean, I think that's quite impressive and something that I don't think I've ever seen before. Now, I really do admire it. If more of our portfolio companies took this approach to non-dilutive stock awards, where you actually have to buy real shares using cash rather than just printing shares magically, I think we'd see compensation expenses dramatically reined in. And it would put more of a pinch on cash flows. But I also think boards would be much more careful about the comp packages that they structure.

47:46And that is really the true benefit. That's right. And so just to briefly go over the other short term incentive plan, it pays out about double of base salary and it's discretionary in nature. It's made up of both cash and options. And these bonuses consider the performance of the executive in light of Fairfax's guiding principles. So for 2025, they gave about a 250 % bonus as they had record results across the entire board. So the circular mentions a couple of things. It mentions underwriting profits, interest in dividend income, as well as a high rate of achievement in compounding the book value per share.

48:21So my assumptions are that's kind of what they're being paid off of. Now, normally I don't like incentive plans that are really so vague because I kind of like to be clear about what management needs to do in order to get their bonus. But I think when you look at Fairfax's guiding principles, it's pretty hard to argue that following them to a T won't produce stellar results and won't increase the intrinsic value of the company. They mentioned things like compounding book value at 15 % annually, focusing on the long-term over quarterly results, being open with communications with shareholders, and then just having a lot of honesty and integrity.

48:57And really just a lot more characteristics that you'd be thrilled to have when you're investing in a business. I'm probably being a stickler, but I always have mixed feelings when you can earn back your entire salary and more just on short-term targets. And on one hand, I mean, that could mean that the salary is very modest, which would be a good thing for shareholders. Or it could mean that it's just way too easy to get paid off of short-term targets, or maybe that the payout on short-term targets is so generous that it's a distraction from or sort of a detriment to these longer-term targets that matter more for shareholders.

49:30But for the most part, I think it's a very good incentive structure overall. And part of the guiding principles is based on risk and minimizing risk as much as possible, which I think is a very intelligent approach, of course, because many companies engineer really effectively their own demise by taking large risks to boost short-term results to meet quarterly earnings targets from Wall Street, but actually really positioning business to be more vulnerable longer term. Yeah, I like the focus on risk mitigation here too. And I think that having it as a guiding principle is very admirable. And since the business has been around for so long, I think it's quite clear that they follow these principles very, very closely.

50:12But I think we should get into the real risks to Fairfax because they most definitely exist. So I mentioned earlier that insurance isn't really a moaty business. I don't think that's a hot take by any means. And even the non-insurance businesses aren't exactly wide moat businesses either, as they range from mattress stores to restaurants to retail. So let's get started with the largest risk that I see for Fairfax, which is shocks to the investment portfolio. During the year when Fairfax struggled from 2010 to 2016, the reason wasn't that they were underwriting bad insurance. It was actually that their portfolio suffered drastically due to the equity hedges.

50:46But on top of that, if global equity markets were to experience large drawdowns, say in the 10 % area, Fairfax estimates a$1 billion decrease in net earnings. A 20 % drop would decrease net earnings by nearly$2 billion. dollars. This reminds me a bit of a business that you pitched earlier this year in Wise. And I know they've recently taken a hit to their investment income growth, and that was due to global interest rates dropping from effectively 3.9 % to call it 3%. So for businesses that are connected to global equity markets or interest rates and are really tied to those, I mean, this can provide a major boost, but it also can be a significant detractor from future returns.

51:25interest rates giveth and they taketh. And so I also think if the business is safe though during these times and has the right capital base and liquidity, then it tends to sort of even out to the upside over a long enough time horizon. And since Fairfax does have the cash and liquidity on hand, as well as the ability to generate profits from other areas of the business outside of just income from investments and float, then they should be able to withstand a hit to global markets. And that's the key right there. If you have a long-term time horizon for these businesses, the best time to pick them up is actually when their share prices are weak due to cyclical market exposure.

52:05So the thing I like about a business like Fairfax is that the market corrections tend to be quite short-lived. So if you buy near the bottom, you won't have to wait around for years for the cycle to turn as it usually turns within 12 months and often much quicker. Now, the next risk that I'd focus on here is one that you can probably assume, and that's key man risk. So it's very similar to businesses that I've covered recently in SpaceX with Elon Musk or QXO with Brad Jacobs. I think Prem Watsa is a pretty big part of the thesis here with a pretty big caveat. So with QXO and SpaceX, those aren't businesses that I think are anywhere close to as decentralized as how Prem has made Fairfax.

52:42So this makes me think the better example might be more like Constellation Software and Mark Leonard. I think Constellation would never have made it to where it is today without Leonard. But the decentralized nature of the business that he built also means that the engine is going to keep humming along even after he's gone, which he now is not a big part of the business. And Prem also controls 43 % of the votes. So for some businesses, you might run the risk that the CEO steps down to, let's say, become the chairman. And then a new CEO comes in who's really just a figurehead while the chairman now runs the show.

53:11So Coca-Cola in the 1980s was like this before the power struggle finished in favor of Roberto Goizeta. But I just I think that he's done a really, really good job of making it. So he's still important. But I think because of how decentralized it is, I think that the business is going to continue to run very, very well, even after he's gone. Primwaza is now 75 years old. So if Primwaza wants to leave or needs to leave, where would they turn to find a suitable replacement? So the board reviews this annually. So I don't think it's going to really come as much of a surprise for shareholders once Prim decides to step down.

53:46you know, Fairfax has said that they already have someone in place that would be more than suitable to take over many of his responsibilities. Now, there's no definitive answer to who would take over. But given that Fairfax has nearly always promoted from within, it would likely be someone a little younger than Prem who has been with the business for a long period of time. Now, Peter Clark, who is the company's president and chief operating officer appears to be at the top of that list. So as a president, all company officers report directly to him. And he's been with Fairfax for nearly 30 years.

54:16But even more importantly, he's had roles in Fairfax, such as the vice president, the chief operating officer, the chief risk officer, the chief actuary, and he's been a member of Fairfax's executive and investment committees. So, you know, he's one of these executives who's adept in both insurance and investing, which I think make him a great choice to lead the business once Prem decides to step down. It's worth noting that Watts has actually stepped back as the vice chairman of Hamblin Watts Investment Council in 2019. So the investments have actually been running smoothly without participation from WhatsApp.

54:46It would be great to see Prim leading the company into his 90s like Buffett and Munger, but that's probably not a realistic standard to grade people on. So anyways, now with Fairfax being an insurance company, there must be some risk embedded inside of that. From the research I've done on Berkshire Hathaway previously, of course, the biggest risks were around the insurance side of things and and specifically insurance reserving for losses and catastrophe risk. And so how do you see Fairfax having a similar risk with its insurance companies? How do you think about that? Yeah, totally. You know, if you screw up the underwriting part of insurance and end up having to pay a larger amount of claims relative to the premiums that you charged, like I've already mentioned, you can break the business.

55:30So you need to have insurance reserves stocked up to pay out any claims from any major catastrophes. And if you're under-reserved, that can spell an insurance company's doom. So in the early 2000s, due to a couple of insurance acquisitions, they brought in books that were pretty much poorly under-reserved. In 2001, Fairfax actually lost money for the first time due to the losses from the World Trade Center and reserve deficiencies amid a very poor insurance market. But since COVID, Fairfax has done a really good job with its KPI. Prior year development or PYD. So PYD refers to how an insurance reserves for claims from past accident years change as those claims actually settle over time.

56:09So when an insurer writes a policy, it has to estimate and set aside money, which are reserves, for claims that it expects to pay, many of which won't be paid out for many, many years. And those estimates are never exactly right, so the insurer has to revise them in later years. And as a result, you get a redundancy or a deficiency. Now, you want a redundancy, as this means that the original reserves were more than enough. And once the claims are settled, you can actually release the reserves, which go straight to earnings. In a deficiency, you are under-reserved and the insurer has to add more money to cover the shortfall.

56:40This raises the combined ratio and obviously negatively affects profits. But since 2020, Fairfax's PYD has been favorable, adding back hundreds of millions of dollars each year, which helps increase profits and make sure the company is underwriting properly. Okay. All right. Well, we've covered a lot of the ground. I think it's that time of the show where we try and talk about the intrinsic value of Fairfax Financial. How did you value this business? Yeah, so Fairfax is a very, very interesting business to me. When I released my episode on a great book covering the business called The Fairfax Way on TIP783, which I'll link to in the show notes, I often wondered to myself why exactly I don't own Fairfax because I can honestly say I don't think I've ever written a book that made me want to buy a business more than that book did.

57:27You know, when I think about Fairfax, it checks off pretty much every single box I look for. high capital efficiency, check. High insider ownership, check. Aligned incentives, check. Long history of creating shareholder value, check. Large one way for growth, check. And since I've released that episode, you know, I keep asking myself, why don't I personally own it? And I think the reasons that I give are becoming harder and harder to justify. The one area of the business that I'm not craziest about is the exposure to catastrophes. While I think Fairfax is a very well-run business, this is one of the reasons that I tend to stay away from insurance companies.

57:57I really find it hard to own businesses that are facing these really, really massive headwinds that are completely out of their control. And if Berkshire didn't have the absolute fortress balance sheet that they have, I would probably feel differently about it. But we have seen how utility liabilities and wildfires have weighed on Berkshire for sure. And I'm not sure that admittedly, I mean, do you think this is a risk that they're able to hedge much by selling to reinsurers? or does the buck really stop with them and they have the most exposure? Yeah, I mean, they do have some of the reinsurance businesses.

58:32So they clearly understand that part of the business and can deploy capital in some parts in that way to help reduce risk. But I don't want to digress too much. I want to go over my base case here for Fairfax. So the thing about Fairfax that's interesting is that the business of Fairfax is quite complex, but the actual evaluation, I think, is kind of simple, which is kind of surprising to me. So basically what you do with an insurance business is you tend to use book value to evaluate them. So a natural capital efficiency number that directly impacts book value isn't return on invested capital, but it's actually return on equity.

59:04That's why we discussed ROE here today. And then you basically apply a price to book ratio to that terminal value and there's your terminal value and you're good to go. So I assume that Fairfax stays true to its long-term goal of achieving about a 15 % return on equity. And this is a number that provides additional margin of safety, given that the five-year average ROE is nearly 21%. I assume that their ability to allocate capital remains top-notch and that the insurance and non-insurance businesses continue to turn a profit and are run very, very well, which they seem to be doing here. So with these assumptions, it gives me two numbers, the book value and the business's net earnings.

59:40From there, it's a pretty simple path to calculate the ending book value, which I'm using at the end of 2030. I get a book value of about$2 ,424. Then I assume the terminal multiple remains at the same number that it has today at around 1.3 times book. And this is a number somewhere around the midpoint of the last decade's multiple, but that was also severely dragged down by COVID. So I think the business continues to grow at about a 15 % ROE. And this is a pretty reasonable multiple to put on it. So applying that, I get a terminal value, including dividends of about$4 ,600 Canadian, which offers about a 14.7 annual per return.

1:00:15Just for context for listeners as you think about Kyle's assumptions here, Berkshire trades at one and a half times book value. So actually the multiple you're using comparatively is pretty reasonable and cheaper than Berkshire's. And already I can tell you that if they can achieve that 15 % ROE target, I'm pretty confident the stock is attractively priced. But how about we hear the bear case before we make any decisions about wanting to add the business to our portfolio? That's right, Sean. And for the bear case, it's equally quite simple. So I assume that they just have a couple of weaknesses in the returns of their portfolio, which drops their ROE to about 11%.

1:00:51Now, ROE has gotten to this point, historically speaking, leading up to COVID. So it's definitely not out of the realm of possibilities. Perhaps they maybe decide to chase profits in some other segments that drag down profits for a time. Now, with the reduction in ROE, I apply a lower price to book ratio of just one times. And with these assumptions, I get a value including dividends of about$3 ,000 Canadian. And this is still an annual return of 5.3%. So I think this shows that this business does have really, really good downside production. Another thing to keep in mind is that this book value means that the business is trading somewhere around liquidation value.

1:01:26You can argue that some of the assets would be marked down further, reducing the liquidation value. But even this is probably wrong. So Fairfax actually holds some of its investments that are not marked to market, and they believe are heavily, heavily undervalued. So I think this business is pretty cheap in this scenario, and you still will make a positive return. point being there, there's a double whammy. If returns disappoint, the company is also going to be punished with a lower multiple. That's something you want to account for whenever you're modeling a bear case and that's going to crush your returns.

1:01:56So I apply a 55 % probability to my base case, a 25 % probability to my bear case, and about a 20 % probability to my bull case. With all that, I get a business that's worth about$2 ,400 at a 20 % margin of safety. Now, this is a touch above the current price of$2 ,300. But if you'd like to take a closer look at how I arrived at these numbers, please subscribe to the Intrinsic Value Portfolio Newsletter, which will give you direct links to the model. So you can play around with it yourself a little bit and see if you have a different view on the value based on your own assumptions. So, I mean, really, I mentioned that this business is one that I've thought a lot about owning.

1:02:31And am I making a mistake and not owning it? Probably. But I think to the point that I made earlier about the insurance cyclicality, that kind of scares me off. And then the other thing that kind of gives me pause is simply just the complexity of the business. I mean, there's just so many different areas of the business that you have to understand. It's one of these businesses where you essentially have to place a lot of trust in Prem Wassa to do what's right. And I mean, that's probably a good place to put trust. I mean, he's been doing this now for four decades, but I just kind of can't get over the hump of the difficulty of kind of understanding all the different moving parts of this business.

1:03:10So for me, I think I'm okay with passing on this business for now. I will definitely be paying very, very close attention to it though, because based on what's happened with this business and based on what can happen with catastrophes, the profits of the business can get hit pretty, pretty hard. And in that sense, if this business were to come down significantly, which it could, like, you know, if this business came down to say$1 ,500, I don't know if I could pass up not adding it, but that's just my opinion. Sean, how about you think? What do you think? Yeah, you could do a whole lot worse than investing in Fairfax.

1:03:43And if I was in maybe a more conservative stage of my financial life, perhaps closer to retirement, I would probably see Fairfax as a great way to have some equity exposure with probably more limited downside than let's just say the median stock out there on the major stock exchanges. But at the same time, I don't see any reason to get fantastically excited about the return prospects. I mean, with pretty high confidence, I can guess they'll be decent, but it's not likely to be a home run. And that's why we've been trimming our Berkshire position today too, to fund investments in companies like Uber, where we feel much more strongly that the business is severely undervalued and the company has tremendous untapped earnings potential.

1:04:25So boring investing is good investing. But when you have some truly enviable software companies selling at steep discounts to their 52-week highs and objectively some of the lowest valuations that they've traded at in many years, companies like Adobe, Intuit, and Salesforce, and so on, I find that to be more compelling to turn over those rocks and look at them, which is what I've been doing. And I sort of feel like Fairfax and Berkshire are always there to fall back on, but they're probably not my first choice at the moment of being the most interesting things to put capital in. Well, folks, that's it for today, but I'd like to leave you with a quote here by Prem Watsa.

1:05:05Our earnings are lumpy. We have never had guidance in 23 years because we have ups and downs and take a long-term view. In 22 years, we have lost money just twice, but our book value and equity has grown dramatically. Now, it's pretty rare for a CEO to discuss his business with such transparency, but I think that you will find that Prem is basically an open book when it comes to Fairfax. And this is a characteristic we look for in all businesses we want to own for the long-term. And with that, I'll see you next time. Just a quick note before you go, this episode would not be possible if it weren't for our friends at Fiscal AI.

1:05:38It's our complete stock research terminal that Daniel and I use on every single episode and with every company we dig into, pulling 20 years worth of financials, digging into segment data, grabbing quotes from the latest earnings calls, and making use of real-time institutional-grade data all in one place. And if you want to try it yourself, well, head to fiscal.ai slash T-I-V-P. That'll include two weeks of Fiscal Pro for free and 15 % off if you upgrade to a paid plan. That's fiscal.ai slash T-I-V-P. Thanks for listening. Thanks for listening to TIP. Follow the Intrinsic Value Podcast on your favorite podcast app and visit theinvestorspodcast.com for show notes and educational resources.

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1:07:14Thank you.