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Fairfax Financial: Unappreciated Earnings Power

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Analysis

Our analysis reveals that investors are not fully recognizing the true earnings potential of Fairfax due to their focus on past issues.

Despite certain historical challenges, Fairfax is well-positioned in the insurance industry, which has experienced significant growth. Additionally, the company’s investment portfolio primarily consists of short-duration fixed income assets, making it less vulnerable to rising interest rates.

If Fairfax executes consistently over the next 12-18 months, we anticipate a higher valuation similar to its peers, resulting in significant investment returns over the next five years.

If market conditions do not improve, management will likely continue buying back shares, leading to accelerated earnings growth.

Introduction

In June 2016, we previously discussed Fairfax and concluded that it had the potential to generate substantial profits even in adverse scenarios. While the stock has underperformed the market, the company’s performance has exceeded expectations. We remain long-term investors.

Our investment strategy focuses on buying equities for long-term ownership and generating a minimum return on equity of 10%. We believe that a company’s long-term business results determine its stock returns, and we analyze companies with the perspective of the whole enterprise.

Overview

Fairfax Financial (OTCPK: FRFHF, FFH) is a diversified financial conglomerate involved in insurance, fixed income investing, and partially owned business ventures. The company’s key sources of earnings include:

  • Insurance underwriting
  • Fixed income investing
  • Partially owned businesses

Losses on Hedges

In 2010, Fairfax implemented an equity and deflation hedging program, resulting in significant losses. Despite these losses, the company maintained solid underlying returns on equity (ROE) and demonstrated resilience during difficult times.

After adjusting for hedging losses, Fairfax’s compounded book equity grew at a rate of approximately 12% since 2016, falling slightly short of the targeted 15% CAGR. Nevertheless, the company’s ability to achieve a 10% ROE, even with significant losses, indicates its underlying strength.

Currently, Fairfax is no longer engaging in hedging and has returned to its core business of selling insurance, investing in fixed income assets, and acquiring value stocks.

The ‘BlackBerry Problem’

Investors have often been critical of Fairfax’s investments in certain companies, exemplified by the ‘BlackBerry Problem.’ However, these investments form part of the company’s strategy to acquire undervalued assets and work towards improving their earnings potential.

While not all investments may generate significant returns, Fairfax’s approach has proven successful in the past, with notable gains from investments such as Bank of Ireland. The company focuses on buying assets at attractive prices and patiently waiting for earnings growth or exit opportunities.

Looking Forward

Insurance

Fairfax’s insurance business has shown consistent growth, backed by favorable market conditions and rising premium rates. The company’s large-scale operations in the insurance industry are profitable and highly valued in comparison to its peers.

The favorable underwriting conditions are expected to continue, although at a more moderate pace. Inflationary pressures and climate change risks are factors affecting the industry, but Fairfax is well-positioned to navigate these challenges.

Fixed Income

Fairfax’s fixed income portfolio has great potential for higher returns due to the steep rise in interest rates. The company has adjusted its portfolio by investing in medium-term securities, allowing it to benefit from continued higher interest rates.

Additionally, Fairfax’s recent purchase of loans from Pacific Western Bank demonstrates its ability to seize premium investment opportunities, resulting in increased interest and dividend income.

Partially Owned Businesses

Fairfax’s ownership stakes in various businesses offer substantial potential for earnings growth. The company strategically aims to gain full ownership of these businesses through patient and opportunistic acquisitions.

Investors should consider Fairfax’s partial ownership of businesses in the context of its long-term investment strategy. The ongoing performance of these businesses is influenced by multiple factors, and patience is crucial in realizing their full potential.

Investment Return Potential

We anticipate that Fairfax has the potential to deliver 2x – 3x returns to investors over the next five years. With achievable ROEs above 13%, the company is well-positioned to attract a higher valuation, leading to substantial investment returns.

Risks

There are several risks to consider, including catastrophes in the insurance industry, potential softening of insurance pricing, fluctuations in interest rates, and risks associated with partially owned businesses. Investors should also monitor the company’s debt levels.

Conclusion

In summary, Fairfax Financial offers a strong investment opportunity that is currently undervalued by the market. The company’s diversified operations, combined with its disciplined investment strategy, position it for long-term success. With a focus on underlying earnings growth and patient capital allocation, Fairfax has the potential to generate significant returns for investors.

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