We Study Billionaires - The Investor’s Podcast Network - TIP317: Intrinsic Value Assessment of Fairfax w/ Jake Taylor (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. Hey, how's everyone doing out there? On today's show, we bring back our friend Jake Taylor from Farnham Street Investments and the author of The Rebel Allicator. Jake takes us on a deep dive intrinsic value assessment of the company Fairfax Financial Holdings. The purpose of these episodes is to give the audience a thorough discussion and analysis of companies so they can pick up on the key considerations and questions for other companies and a similar sector or even for just general analysis of a stock.

Starting point is 00:00:30 Jake is a superb thought leader in someone that demonstrates exemplary critical thinking skills, and you'll see all that throughout this episode. So without further delay, here's our chat with Jake Taylor. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Hey, guys. Welcome to The Amherstas podcast. I'm your host, Dick Broderson, and as always, I'm accompanied by my co-host, Preston Pesh.

Starting point is 00:01:12 We are here today with Jake Taylor, CEO of Philem Street Investments. Jake, thank you so much for joining us here today. Thanks for having me back on the program. You know, Jake, we are excited to invite you back here on the show, and our listeners probably remember you from the outstanding analysis you did of Berksie Hathaway back on episode 289. We'll be talking about a different company today, namely Fairfax Financial Holdings, so simply called Fairfax, and later we'll be transitioning into talking about Fairfax Africa. But please do not be fooled, guys.

Starting point is 00:01:46 Even though we're talking about different companies, Berkshire and Fairfax might have a few similarities too. So, Jake, kicking this episode off, perhaps you could start by providing an overview of Fairfax. Sure. It was founded in 1985 by this Canadian immigrant name Prem Watsa. And it's primarily a PNC property and casualty insurance company. And it has a lot of decentralized insurance companies around the globe that are part of its company. And what's kind of nice is also that they profess to have a value investing approach to the money that they manage. Their stated goal is to compound book value at 15% per annum. And since 1988,

Starting point is 00:02:29 they've done it at 18.5%. So they've been achieving their goals for a long time, which you can't say about too many companies. The other thing I like is that, you know, the culture is what they call fair and friendly. There's never any hostile takeovers or anything like that. And they do draw a lot of comparisons to Berkshire, but they are definitely a little bit different. I already mentioned there that there are a few similarities between Berkshire and Fairfax. I mean, you even mentioned a few of them yourself, you know, they're fair and friendly. I would imagine Born Buffett would call it differently, but, you know, he's not a big fan of hostile takeovers either, very decentralized organization. But what are some of the other similarities and perhaps differences that you

Starting point is 00:03:12 see, too? The biggest difference is really in the size of the operations. I mean, Berkshire is an elephant and Fairfax is an ant. And to give you an idea, Berkshire's float is six times the size of Fairfax. They have similar underwriting profits last year, kind of surprisingly, but book value is 30 times X for Berkshire. Their cash flow from operations is 30 times. Their price to book also is 2x, right? So it's more expensive. And enterprise value is actually 75 times X.

Starting point is 00:03:44 So they're quite a bit different in the size of the company. And I'd say in general that Berkshire has a lot more operating businesses between the railroad and the energy and probably a higher quality business than what Fairfax has amassed so far. But in general, their underwriting, their cultures, their investment approaches are relatively close together. So, Jake, just as you can't say Berkshire Hathaway without saying Warren Buffett, you can't say Fairfax without saying Prem Watsa. Prem Watsa is a legendary investor for us, insiders of the value investing community. But he's not much known outside of that community. And could you please just provide an introduction to our audience about Prim Watsh.

Starting point is 00:04:28 So. Prem is known as the Canadian Warren Buffett. One of the differences is that he's actually 20 years younger than Buffett, so he's only 70. But his background is he grew up in India, got a degree in chemical engineering from IIT Madras, and then he immigrated to Canada with eight rupees in his pocket. And he worked and put himself through the MBA program at Ivy Business School, which is in Western Ontario. And now after founding Fairfax, he owns about 10% of the company. He's a billionaire. So it's really one of those rags to riches stories. The other thing that I've noticed from going to the shareholders meeting for a number of years now is that Prem is an incredible cheerleader of his teams. He speaks so highly of everybody. You can see why everyone shows up to work wanting to impress

Starting point is 00:05:14 him. I mean, Warren is good about that, but like the energy that Prem conveys is even stronger. And the other difference is between going to like a Berkshire meeting and Fairfax is, I remember the first time I went to the Fairfax meeting. Within five minutes, I'd already met Prem and got a picture taken with him and moved on in the meeting and it's very small. And Berkshire, you can't get within 100 feet of Buffett because there's security and there's just a million people crowding around him. So a very different experience. And that speaks back to the size of the companies. So Jake, I think it's so important to really kind of understand the essence of the assets and liabilities on a company's balance. sheet. What for Fairfax really stands out to you on their balance sheet? Well, I think that Fairfax should be analyzed just like any other insurance company. And so we think about that. They take money

Starting point is 00:06:06 now in premiums. What do they end up doing with it? How do they transform those premiums into assets and then eventually use those to pay back claims? You know, what's left over after that? So when I look at at Fairfax's balance sheet, they have about $10 billion in cash, about $15 billion in bonds and about $5 billion. dollars in stocks. And then below that, you'll have, call it $3 billion in what I call joint ventures, which are just investments that they're making that they have to recognize on their balance sheet as ownership, about $700 million in derivatives, and then $2.5 billion that's invested in Fairfax India and Fairfax Africa. And then you have about $12 billion in intangibles and other assets. Now, against that, you have $7 billion of debt and about $40 billion of predicted insurance

Starting point is 00:06:53 liabilities. So they have about $30 billion in what I would call liquid assets and then versus about $47 billion in liabilities that have to eventually be paid. So obviously those two numbers don't exactly match up and you're going to need some kind of asset growth to meet those future liabilities. What's a little bit funny is that Prem and team have been maligned as bad stock pickers lately. But what's interesting is that only $1 and $6, I would say, of the liquid securities is actually inequities. It's a little bit ironic. actually, they've actually been helped by these regulatory handcuffs of insurance and had to be weighted into a lot of bonds. And that's actually kind of helped their investment results. So it's a little bit funny to see people who, you know, they have an incredibly long good track record. But, you know, sort of like what have you done for me lately, like a lot of value guys have struggled a little bit. And so they actually been bailed out a little bit by the fact that they have so many bonds based on their insurance operations. Fairfax has an impressive track record, like you also mentioned before, 18.5% measured in US dollars.

Starting point is 00:07:58 And that is since the present management took over in 1985. Now, whenever you look at the printwatz's lit us to shareholders, you can't help but see some similarities to Buffett's led us to his shareholders, which is amazing reading itself. If you want to learn more about insurance, if you want to learn more about Fairfax. But it's also quite clear, like if you look at the number, like if you look at the number, of the track record, like where that 18.5% came from. Like, it came from the very beginning, not so much recently. And you could also argue that one reason why this declined performance has happened is because Fairfax myocab is only 10 billion plus. So that obviously limits

Starting point is 00:08:36 the universe of potential investments. But even if we account for that, it doesn't really explain why Fairfax has been trailing the S&P 500 since the financial crisis. So I'm curious, Jake, what are your thoughts on why has Fairfax suddenly started to underperform? You're right about the book value growth over that time period, and just to provide a little context around that. When they took over, it was a $1.52 in book value in 1985. And now it's roughly $486. So over that same time period, the share price is compounded at 16.6 per annum. It's helpful to break up. In an insurance company, there's really two key variables. The first one is their combined ratio, which is the premiums that they accept versus the losses that they have to pay out, basically how profitable are your insurance operations.

Starting point is 00:09:24 And then the second thing is what do you do with the money that you get? It's the return on the investment. So it's helpful to break up Fairfax into multiple time periods to trace the history. So if you look at 1986 to 2005, their combined ratio was 105%, which means they were losing money in their insurance operations. but their investment returns were around 10% per annum. So, you know, you had bad underwriting, but great investment results. Then 2006 to 2010 combined ratio is 99% and investment returns were 11%. And a lot of that had to do actually with Prem made that same bet that a lot of guys got very famous for making, which was basically shorting housing, the housing bubble.

Starting point is 00:10:05 He had the CDS's on housing. So you could almost say that this was sort of the golden age for Fairfax. they had good underwriting and they had really good investment returns. And it could also sort of point to the idea that Fairfax probably does better during downturns and maybe not so good during bull markets. So 2011 to 2016, combined ratio of 96%. Fantastic. Investment returns 2.3% very anemic. What happened? Well, Prem was concerned, especially in the later part of that period, with where the market was, and he had a lot of hedges on. And that's a little bit of equivalent to driving around with the parking brake on. So what's interesting is they actually still have $100 billion of notional value in these deflation hedge bets, CPI linked, that are carried in the books at only $7 million.

Starting point is 00:10:50 So they've been written down almost to zero these hedges. But you could imagine an alternate universe where maybe the market crashes in 2016, and it looks very much like that 2009-2010 period again. And they look like geniuses and no one's questioning their track record at all. So, 2017 to 2019, combined ratio 99% and investment returns 5.6%. So not bad. That's sort of like middling. But that's still going forward, that's going to take a little while to get to that 18% or to maintain that 18% they've had if you're only getting, call it 1% on your operations and 5% on your investment book. So obviously, it's going to take more to get back up to what they've been doing. My understanding is that in general, the insurance price,

Starting point is 00:11:36 market has hardened quite a bit lately, and that's a good sign for the premiums that Fairfax will be accepting. So there's potential that there's probably good underwriting happening right now. The other thing to look at is that their bond book that they have is very short duration. Most of it is less than five years. And it has this a blended rate of 3.6%. So if you have locked in 3.6% for the next five years, it will be tough to get to 15%. But they run their operations very conservatively, and they're not the only ones who have been hurt by these low interest rate in the environment. I mean, every bank and every insurance company is suffering through this. But, you know, they're very conservative. And they've tended to lately take more owners debt and

Starting point is 00:12:17 preferred than pure equity. So they've limited their downside a little bit while also accepting some smaller upsides, which we've actually seen Burshire be doing more lately as well. So the other thing that it's important to note is that over the last five years, it really hasn't been the S&P 500, it's been the S&P 5. And what I mean by that is Microsoft, Amazon, Google, Facebook, and Apple have accounted for plus 250% over the last five years. The rest of the S&P 500, those other four, the S&P 495 are up 25% total over the last five years. So if you missed those five stocks, which Fairfax did, you're going to look bad against the S&P 5, because there just wasn't much else to be had.

Starting point is 00:13:05 And especially, you know, they've been more internationally focused than a lot of other companies and also more resource focused, natural resource focus, which I think, I don't know if that's like a Canadian thing. It seems like everybody in Canada likes natural resource companies. So that explains a lot of why we would say they've underperformed the S&P 500. But I'm not even sure if S&P 500 is an appropriate benchmark for Fairfax's operations. Because there's so much more global, I would probably pick more of a global index. like maybe MSCI or something, and maybe even more bond exposure as well.

Starting point is 00:13:38 Because, I mean, they just have a more full book. You know, they're not ever going to be 100% U.S. equities, right? And that's what S&P 500 kind of represents as a benchmark. I really like how you phrased that there. I used to own stock in Fairfax quite a few years ago, but to me, the role it had in my portfolio was very much protecting my downside risk. That was very much how I saw it. And so I guess you could say the same thing about Berkshire.

Starting point is 00:14:01 The upside is one should probably not be too blinded by the 18.5 or the 16.6 you mentioned before, depending on whether you look at book value growth or stock price growth. But the downside protection, especially whenever you go in and look at the balance sheet and the different types of investments Primwater has made. Moving on here with the episode, Jake, we've been emailing back and forth here before the interview and you originally wanted to talk about Fairfax Africa because that was where you saw the most value. However, now that we all... talking about Fairfax, the parent company, do you see any value there? And perhaps could you provide a range of the intrinsic value if we want to put the stock on our watch list?

Starting point is 00:14:44 As maligned as price to book is as a factor these days by investment professionals, I still think it's a very appropriate place to start for valuing banks and insurance companies. So the current price to book of Fairfax is 0.69. So call it 70 cents on the dollar. Now, if you go back and over the last 15 years, the average price to book that Fairfax is traded at is 1.16. And the standard deviation of the price to book over that 15 years is 0.13. So I thought, let's just take a base case being what's the long run average that Fairfax has historically traded at and we'll multiply by that price to book and what would that tell us that we should expect for the share price. So 1.16 gives us a $485 share price, which is plus 68% roughly from where we are today.

Starting point is 00:15:37 That's actually not that bad. Like, Fairfax is cheap right now. Now, just for fun, like, and I don't typically do this because I, you know, I recognize that the investment world has much fatter tails than what a standard deviation. It doesn't conform to standard deviations, but this is just a starting point. But, you know, one standard deviation to the upside, I would say, get you to 1.3 price to book. which implies a $540 price, which is 88% from where we are today. And then let's say one standard deviation downward gets us to basically like one times price

Starting point is 00:16:07 to book. And that's a $430 price, which is about 50% up from where we are. So it's definitely cheap. If you think that Prem and company have any talent still, I think you're getting a pretty good bet and you're paying a reasonable price for that bet. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo. at the height of the summer. You got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists, investors, and builders

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Starting point is 00:20:21 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So, Jake, let's go ahead and transition into the second part of the interview here where we're going to talk about Fairfax, Africa. Talk to us a little bit about this company. Let me start with, I think last. time that I was on, I gave the story about, you know, talking to Charlie Munger and how he told me

Starting point is 00:20:47 that I should be fishing where the fish are and not fighting all the other cod fishermen for where everyone else is looking. So, you know, I sat down and I'm staring at a globe and I'm spinning it. And what do I see? I notice Africa. And it's staring me right in the face. So I started doing some research and I'm going to share some numbers with you about Africa that I think are quite interesting. And really a bet on Africa is a bet on three things. things, demographics, geography, and infrastructure. So there's a saying that demographics are destiny. The UN projects that there will be 1.3 billion people added to Africa by 2050, and that they

Starting point is 00:21:27 will have a one billion person middle class. That's six times the size of the U.S. middle class. So that's an incredibly big population to be servicing goods and services. There's going to be a lot of people living very reasonable lives in Africa by 2050, is what I would guess. The other thing is that Africa is very young. So the median age right now in the U.S. is 35, China 37, Europe 42, Japan 46. The African median age is 20. And 70% of Africa's population is under 30 years old. So they are incredibly young. And they're young and they're hungry. And I think those are two good recipes for eventually making large economic strides.

Starting point is 00:22:08 So the other thing is, it's reason that there will be 90 cities in Africa of one million plus population by 2030. There's this interesting book by Jeffrey West called Scale, where he talks about how the doubling of the size of a city more than doubles the output of both wages and patent output. It's due to density and network geometries. Now, you also get more than a doubling of crime and illness and other things. You could sort of say that cities make a doubling of everything that's human. but it's a 1.15 times multiplier. So imagine 90 cities with more than a million people working, solving problems. It's actually a very exciting time, I think, for Africa.

Starting point is 00:22:48 Now, let's talk about geography of Africa. If you look at a map, the Mercator projection greatly distorts reality. Africa is huge. It's a further flight from Cairo to Johannesburg than it is from the U.S. to Europe. It's over an eight-hour flight. Africa has three times the landmass size of Europe. It's 11 million square miles. And I think, you know, a lot of us think about Africa, we say like, oh, it's all desert, right?

Starting point is 00:23:11 Well, that's actually wrong. It has 60% of the world's arable land. So it's not hard to imagine that eventually they figure out how to, you know, being geographically located between the east and the west. They could be a very advantageous place to be sort of the world's breadbasket. Now, there are 180 trillion cubic feet of natural gas off of Mozambique alone, which is 20 years worth of European demand. And that's just Mozambique. The other thing is that there's one fifth. of the penetration testing compared to OECD soil. So they just haven't dug into the African soil like they have all the other rest of the countries. So who knows what other kind of buried treasures are in there, whether it's petrochemical or rare earth minerals. There's all kinds of opportunities there. We just don't even know yet.

Starting point is 00:23:56 Now, let's talk a little bit about infrastructure. In the U.S., we use 19 times the electricity measured in kilowatt hours per capita than Africa does. US has 6.2 times the rail density. The bricks, which are Brazil, Russia, India, China, have five times the road density of Africa. So there's lots and lots of opportunity for useful infrastructure to be built to improve the quality of life there. And what's interesting is that one hypothesis is that technology is really going to help out because you're going to be able to avoid a lot of the potential sunk cost of infrastructure that we currently have.

Starting point is 00:24:29 So imagine skipping over landlines and going right to cell phones. Africa already actually has the most mobile payment accounts of any continent. So they've taken banking to their phone faster than we have in the U.S. So a little quiz here. How many African companies are there with more than $1 billion of revenue? Oh my God. I have absolutely no idea. Okay. So the average guess is 50, but the actual number is more than 400. So to give you a little context, there are 400 people per retail establishment in the U.S. There are 60,000 people in Africa per retail establishment. So it doesn't take a lot of us foresight to imagine a simple business like Walmart or McDonald's or 7-Eleven being able to grow rapidly in that kind of environment under the right conditions.

Starting point is 00:25:21 So let's take all those numbers. What do we do with them, right? I think we have a reasonably sound argument for that there are some strong tailwinds, but how do we participate in that? So that's when I happen to see that Fairfax had launched a fund specifically to invest in Africa. And I trust them to do the due diligence on the ground that I'm not able to do 10,000 miles away. And I know that they have sort of a value tilt, which is what I'm drawn to. And they'll be investing on my behalf in Africa. Now, Fairfax, the parent company, owns 59% of Fairfax Africa.

Starting point is 00:25:56 So they have invested almost 60% of the funds that are in that fund came from the parent company. Now, there's a transaction that's going to be coming up soon that they're voting on that will diminish them down to 32% most likely if it gets approved, but they're still going to retain 53% of the voting rights. So they're still in charge of this thing. But it's not perfect, right? There are some issues. Nothing's ever perfect.

Starting point is 00:26:20 So to operate the fund, Fairfax, the parent company, charges management fees on the fund. and it's a half a percent for uninvested money and 1.5 percent on invested money. And for that fee, they have to provide a CEO and a CFO and manage these investments. Now, there's also Fairfax can earn performance fees, which is 20 percent above a 5 percent hurdle measured every three years. The good news is today, that hurdle is a long ways away from where we are. It's actually, they're not eligible for any performance fees until it's back up to $11.81, which is like light years away from where we are today. So this new transaction with this company called Helios is my understanding is the economics will now be shared with Helios and that Fairfax is effectively outsourcing more of the boots on the ground to a group that's been doing this since 2004. The other thing you can do is actually buy Fairfax, like what we were talking about as a hedge to your expense structure in Fairfax Africa, because now you're owning the fees that are being paid.

Starting point is 00:27:20 So there's a lot to like here. And we'll get into a little bit more probably in a minute about valuation, but that's a good place to stop. I used to own Fairfax. I also used to own shares in Fairfax Africa, but I remember my thesis for that was very different. I saw a lot of the same growth factors as you saw. And I wasn't too concerned about the downside protection. Also, my position was a lot smaller in Fairfax Africa. But what I really liked about Fairfax Africa in preparing also here,

Starting point is 00:27:52 for the interview and reading through their financial statements. As opposed to a company like Berks the Hathaway, it's a lot simpler to go through the individual investments one by one, simply because there aren't too many. At Las Meroa where Fairfax, Africa, owns more than 4% stake, would be an obvious place to start, but I also remember reading up on South African grain storage, Nigerian banking, topics that definitely started outside of several accoutes to say the least. please talk to us about how you analyze Fairfax Africa's investments and also the process of widening your server competences. Let's talk about Circle of Competence for a minute. It's really about finding and interpreting information and how do you do that. I think, you know, I don't know if you know this, but 18% of the matter in the universe is visible and the other 82% is dark matter.

Starting point is 00:28:44 And I've wondered if that same ratio actually applies to these businesses that we study. Maybe we get a glimpse at, at 18% of the relevant facts based on what's reported to us. But there's another 82% of this person doesn't like this person inside the company or this competitor's coming for the company and we don't even know it. There's all kinds of very relevant facts that we probably don't have access to. And there's always more than we can know than being outside passive shareholders. And this is especially true if you're 10,000 miles away from where all the action is happening. So that requires a lot of trust in management. And to be honest, it's been a little rough for Fairfax Africa so far.

Starting point is 00:29:24 You have to take a very, very long view and trust that, you know, these guys did not get really dumb overnight all of a sudden. And then the other thing, too, is that the price that you pay, you can mitigate a lot of problems with the price that you pay. So, in fact, there's a great quote by Buffett. It says that price is my due diligence. So if you get enough, low enough price, it requires less hurdle of having to understand every single little intricate moving piece of inside of an investment thesis. So really the bigger question

Starting point is 00:29:54 is, how stupid do you think the Fairfax guys are? And do you trust more the recent market quotes that they have to mark their book to? Or do you trust their long-term analysis of what they're working on? So really, it's a question of how efficient do you think markets are. So let's look at some of the numbers here that are inside Fairfax Africa. Their public investment in Atlas Mara, they've put in $159 million. They're carrying. carrying it on the books at $34 million. So that's an 80% haircut. Their investment in CIG, they put in $55 million, they're carrying it at $6 million. That's a 90% haircut. Their loan book, 87 million carried it 79% or 79 million. That's a 10% haircut. The private equity side,

Starting point is 00:30:38 AGH, 87 million carried at 63 million. That's a 28% haircut. Phil Africa. That's a 35% haircut. grow capital, 75% haircut. So all total, they have $509 million that they've deployed, and it's carried on the books at $299 million. So that's a 41% haircut. So you have to ask yourself, is fair value really that 41% loss? Or do these guys know what they're doing? And these are just more short-term quotational losses. That's really, I think, one of the key things of untangling this investment. So, Jake, when you're looking at a company like this, how do you account for the currency risk that the company is going to obviously go through for the local currency that they're dealing with versus converting that back into dollar returns? Yeah, I mean, that's a great point. In just the first six months of 2020, Fairfax Africa recognized $26 million in losses just from foreign exchange.

Starting point is 00:31:40 I think my counter to that would be that no fiat currency is a layup in today's world. The dollar is the reserve currency now, but that's not etched in stone. There could be a day where maybe that FX actually helps. And for me personally, I have plenty of assets and liabilities denominated in dollars in my portfolio, so I don't mind getting some other exposure to other currencies. All the research I've done on hedging indicates that it tends to balance out with the costs over time and that there's no real advantage to it. The other thing, too, is that a weaker currency can actually be a plus sometimes because

Starting point is 00:32:15 it can make your exports more attractive in a country. So, there can often cause a little export economic boom because of a devaluation. So it's not 100% clear that, you know, it's all a problem. And like I said, there's no fiat currency that is really backed by much of anything these days. So if someone knew where the great currency was that could solve all these problems, you know, I'd be all ears. The Fairfax Africa is a fairly new stock having only traded since February 2017.

Starting point is 00:32:44 And as you also mentioned before, Jake, the performance of the stock hasn't been as hoped. Having said that, do you see Fairfax Africa as a long-term compounding company? Or is it more similar to what Warren Buffett would call a cigar butt? Yeah, I mean, it's not liquidating, so I wouldn't really consider it in the cigar butt category. but it definitely qualifies as a 50 cent dollar, I think, and I'll walk through the math on that. So right now, the book value is $6.62 per share, which equates to $390 million total. And, you know, we talked already about how dramatic the mark-to-market losses are in there. Those are shown in that $390 billion.

Starting point is 00:33:28 So inside of that, you have $86 million of cash, $161 million of bonds and loans, and $136 million in stocks. Now, currently, there are 59 million shares outstanding, and let's call it a $3.30 cent price-ish. That's a $200 million market cap implied. So we're already at a price to book of 0.5. Now, I would say that is it a compounder? Potentially, if and when the businesses start to catch, you know, you start getting some investment returns, the underlying businesses is within the structure start to compound, that will be reflected eventually. But this is an incredibly long-term opportunity. And this is a perfect thing for what I call like a coffee can approach.

Starting point is 00:34:14 You buy some of this, you stick it in a coffee can, you bury it in your backyard, you don't look at it for 20 years, and you come back and you're surprised to see what happened. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:37:35 This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. So, Jake, talk to us about the catalyst that has recently caused the price to go down. And then what do you think the catalyst will be for a recovery? Yeah, I mean, the recent catalyst, I have to assume, has been like the rest of the world has recognized the economic impacts of COVID.

Starting point is 00:38:03 And for whatever reason, the U.S., especially tech, like we talked about, have kind of remained blissfully unaware of it. So it's been beaten up lately. Now, a potential positive impact might be the Helios investment part. And a little background on them. They're an African PE firm, basically, that started in 2004, and they run about $3.6 billion on their platform of funds. So they're taking over operations, sharing economics with Fairfax. And I'm hopeful that this will give maybe even more opportunity to find interesting investments within Africa for Fairfax Africa, because the guys running it

Starting point is 00:38:38 have been doing this for longer than the previous managers who were doing this. So that was announced on July 10th, this potential change, and the stock is flat in that time. So no one seems to care. I don't think anyone's looking at it. You have to recognize that this is a very low volume stock. It trades less than $20,000 per day. So anytime you have an incredibly low volume stock, you have to really take every single current market price with a very large grain of salt, because there's just not many dollars behind the market movements. So Mr. Market, it's a very light load for Mr. Market to move the price around when the volume is that low. All the more reason why the coffee can is probably the smart play. It's a good point you mentioned. Having invested

Starting point is 00:39:22 in Fairfax, Africa, I remember whenever I wanted to get out of the stock and it was in a downward trend at the time. And because of it's so thinly traded, it can be very expensive to hit any of those bits that you see out there on the screen. So it's definitely something to consider for investors. I also want to say that it should also be seen as an opportunity, especially for retail investors, if there's anyone sitting out there with their billions and billions of dollars, this is probably not the stock that they want to build, or at least if they want to, it's going to take years and years to build that performance, and then they can probably never get out of it unless they sell like a block to print Watson himself. But it's just something that's worth noticing. And it's just

Starting point is 00:40:02 like, whenever you hear about this liquidity and, you know, someone had been buying Apple stocks or Google stocks and whatnot, it's sort of like difficult to explain like the pain that can be involved with liquidating a position or even building a position in something that's so thinly traded. So anyways, it was just a quick note that I wanted to mention. Use limit orders. Be careful. Yes, use limit orders. Definitely be careful. Wise words for a stock like this. So the stock today is trading at $3.20. What is your process for estimating the intrinsic? value of Fairfax Africa.

Starting point is 00:40:40 So let's start with $86 million on the balance sheet in cash. Now, I'll let you make your own discounts to that if you think that it's being mismanaged and that that $86 million isn't worth what it is in those guys' hands. But I'm going to count it as $86 million at the top. And so far, they've laid out $509 million in investments and it's carried it at, call it $300 million. So as a thought exercise, let's assume that the market was overly pessimistic that basket of securities. And we remarked those assets to only a 20% loss.

Starting point is 00:41:15 So we're moving that number back up to 400 million from 300 million. Now, 400 million plus the 86 million in cash, that gives us a 486 million dollar value. Now, remember, the current price to book is 0.51. And I would say as a base case, let's assume that you can just get one times price to book on this, which seems appropriate if it's a reasonably managed fund. So we're adding back that 20% that we considered an overly pessimistic mark to market. And at a $486 million book value, that would give us a $486 million price, which is 143% from where we are today.

Starting point is 00:41:56 Now, let's take an overly bearish case. We don't add back anything. We keep book value at $390 million. We take the worst price to book it's ever traded at, which was in early 2020, which is actually 0.3 price to book. And that gives us $117 million implied value. That's 40% down from where we are today. I would say that's probably a little bit overly bearish.

Starting point is 00:42:19 But just for fun, let's put some bookends on this. Now let's make a little bit of a bullish case for this. Let's assume that these guys with a 35-year track record are not as, dumb as the market is making them look right now. And we do a full add back of that $509 million that's been laid out already. Let's just assume that it goes back to par, basically. We put the $86 million in cash back in. And by the way, we're not assuming any returns on any investment here. This is just to go back to par, right? So it's still relatively conservative. That gives us a $595 million book value. And the highest price to book that it's ever traded at was in 2017, which was

Starting point is 00:42:55 1.47 times. So let's use that as our multiple. And that gives us an $875 million market cap, which is plus 338% from where we are today. So let's assume that as sort of a blended probability that our base and our bear and our bull cases were all equally likely, 33% chance of any of those three happening. Well, that implies a 146% expected return on those blended probabilities. So, you know, There's a lot of potential upside here if they can sort of get things together and maybe the market stops discounting everything as hard as it has been for the things that they own. You sort of have two layers of cheapness. You have the underlying which has gotten beaten up and very cheap. And then you have the bigger, the wrapper that it comes in, which is the fund, which is also discounted heavily.

Starting point is 00:43:45 So there are a few different ways to win if you get any kind of a version of the mean. Use limit orders. Coffee can it. buy it for your grandkids and come back in 2050 and the world has changed dramatically and Africa is a very reasonable place to do business. And there's something I find to be personally very rewarding about the idea that there are so many other people in the world who are hopefully going to have much better life experiences in places where historically it has been a pretty rough place to have been born. So let's all hope like it wouldn't it be nice to

Starting point is 00:44:20 root for Africa to get a chance again to be kind of in the sun. It would be poetic justice for them. And I think it's always nice when you can root for both a good outcome for humanity and also for your portfolio. Well said, Jake. Okay, we would really like to ensure that everyone feels that they're completely on board. We've been like talking back and forth about a limit order this and limit order that. And for a lot of people listening to this, perhaps new to investing, they're like, what do you mean? Like in order, don't you just buy or sell? But there are different types of orders. So why is it that a limit order is so important for a company like Fairfax Africa? Well, let's say that you just put in a what's called a market order. That just means

Starting point is 00:44:59 that the brokerage account will go and fill that order no matter what the price. They're going to buy whatever shares are available at whatever price, and they're going to get your 50 shares if you put in 50. Now, if you put in a limit order, it will buy as many as it can up to that particular price. So with something that's as thinly traded as Fairfax Africa is, even if you're not a big investor, you can move the price around quite a bit and change the economics and the bet that you're making without even realizing it. If you were to, let's say, push the price up 50% because you weren't paying attention to your order, now all of a sudden, you bought shares that were 50% more expensive and they probably don't fit the math that you did before you put in the order.

Starting point is 00:45:41 Right. So I would say, especially in today's high frequency trading world where everyone is trying to front run everyone, I'd never put in market orders for anything, even liquid stocks. I always put in limit orders. And it's just, it's a better way of being disciplined. And, you know, sometimes it bites you in the butt because you don't get as much filled as you wanted. And the price moves away from you and you go, dang it. I probably would have paid a little bit more to get those extra shares, but I didn't. And that happens. But, The other side is the very bad outcome where you bought a bunch of shares at a price much higher than you were anticipating. And now you're like, oh, that was not what I was aiming for. Jake, we really, really enjoy having you on the show. And we look forward to the next time that we're going to be able to do something like this. But in the meantime, give people a handoff where they can learn more about you. You know, on Twitter, I'm probably more active there than I should be. But I'm at Farnham, Jake 1.

Starting point is 00:46:37 You know, I do the Value After Hours weekly podcast with our mutual. friend, Toby and Bill Brewster. If you want to learn more about our investment company, it's www. farnum-street.com. And all of our letters are public. I try to spend a lot of time writing good letters because I want to go back and be able to read them 20 years from now, not be embarrassed by what I wrote. And then lastly, you know, I have my book came out last year called the Rebel Allicator. And it's a good gift for young people if they're interested in business and investing. I actually, you know, I wanted to condense a decade plus worth of learning that I'd been doing about business and investing and write something for my kids.

Starting point is 00:47:15 And then I figured, you know, why not help everyone else out with it? So that might be a good gift idea for that young person in your life. Yeah, and I can definitely echo that sentiment. I read your book, The Rebel Al-Kill. It was a great book. And actually, our friend, Sean Murray, one of our hosts here on the network, did interview you about that book. And we'll make sure to link to that in the show notes. And I guess that the listener would probably notice a few similarities to a few investors that we follow closely here, including Warren Buffett and Childamonger and a few other people. So it's definitely a book worth picking up, not just for you being a seasoned investor, but also if you want to give wisdom to the new generation of investors. Jake, thank you

Starting point is 00:47:57 so much for your time. We know you're super busy, so thank you so much for taking time out of your busy schedule to be speaking with Preston here today on the Amherstas podcast. Always a pleasure, guys. Thanks for having me on. All right, guys, so at this part and time on the show, we'll play a question from the audience, and this question comes from Tim. Hey guys, Tim from Kentucky here. Firstly, I love your podcast. Secondly, just wanted to ask you a quick question about preferred stock, specifically

Starting point is 00:48:24 preferred stock issued by banks. I understand that if interest rates rose, the value of the preferred stock would go down, but might it also be the case that there could be... a benefit to the stock because the banks would benefit in the rising interest rate environment. Thanks for any insight you can provide. So, Tim, I think it's such a great question because we talk about bonds and stocks, but we seldom talk about preferred stocks, which is sort of a hybrid between the two. So please allow me to clarify for the audience what we mean when we talk about preferred stocks.

Starting point is 00:49:01 A preferred stock is similar to a bond in the sense that it pays dividends. dividends for a bond called coupons, but the two concepts are not too far away from each other. One important difference is that preferred shareholders receive their fixed payment before the common shareholders, but after the bondholders receive their coupons. And also, most often preferred share does not have a term, meaning that the shares out on the market and it does not mature in theory. In practice, the issue will often bite back at some point in time in the future. whenever the conditions are beneficial for the company. And then what are the similarities to common stock?

Starting point is 00:49:42 Well, they have similarities in the sense that it's a piece of equity in the business. However, that piece of equity will only materialize should that company default. And prefer shareholders would in that case receive their claims to the business before the common stockholders, but after the bondholders. And keep in mind that most often it is only bondholders who would be paid fully or just partly in the case of bankruptcy. So that extra layer of safety really shouldn't matter much for you

Starting point is 00:50:09 in most cases. As you correctly pointed out, the value of your preferred stock goes down whenever the interest rate go up and the intuition is easy to grasp. After the rate hike, the market can get a higher yield on bonds or other preferred stocks, whereas you already committed

Starting point is 00:50:25 your money into this preferred stock which would relatively make the value of your preferred stock less valuable. To a second part of your question about whether it will be good for the bank if rates went up. The answer is also yes. So in that sense, you can argue that the news of a high interest rate as an investor in preferred stocks for a bank, it's still bad, but it's not as bad as in many other industries. And you can even make the same claim for a company like Fairfax that we just talked about here today. Their insurance business,

Starting point is 00:50:53 everything else equal to be better off for the higher interest rate. However, the implication for you as an investor in preferred stock is that the investment you made in the bank is, everything else equal, better protected, since the bank will make slightly more money with a high interest rate, which would limit your risk of defaulting on your preferred share. However, for you as an investor, please do not see this as a tie score. The interest rate effect on your preferred stock, which is not in your favor, is vastly more important that what you will gain from that stock now being able to conduct business in a slightly more friendly environment. So, Tim, this has been fun here in this question because I haven't even thought about preferred stock in a very long period of time.

Starting point is 00:51:37 typically when you see preferred stock issued, you're dealing with venture capital and people coming in with enormous resources and they're coming in to have very special and particular interests met for the large and substantial amount of capital that they're providing for a company that desperately needs that capital. But for the preferred stock that's out there on the public markets that pretty much anybody can gain access to through the, through the appropriate broker. I'm, it's just not, it's just not a market that I participate in. And so when this question came up, I really remember, so Stiggin, I don't know if people are familiar with this, but

Starting point is 00:52:22 Stiggin, I wrote a, like a summary guide to security analysis. And I distinctly remember writing some of these sections in the book because, when we were doing the summary guide, because Ben Graham was also not a very big fan of preferred stock for the general public that they had access to that were being sold. So in chapter 14 of security analysis, this is where Ben Graham starts talking about preferred stock. And so I'm reading a section from our summary guide, our security analysis summary guide. Anyone can look for this on Amazon if you're interested in having this. It's actually kind of a useful little book to have alongside security analysis if you're trying to actually get through the book. But this is what Stig and I concluded in our summary guide about Ben Graham's writings on preferred

Starting point is 00:53:17 stock. So this is how it goes. Although Graham has periodically mentioned preferred stock before this chapter, this is the first opportunity where he clearly defines his opinions on its role in financial markets. Graham makes no hesitation in identifying his distrust for preferred stock. He claims preferred stock takes the least favorable element of bonds and packages it together with the least favorable elements of common stock. That's really kind of the quote that I really wanted to read for you. The other thing that I tell you is when you really do start digging in the preferred stock, there's two types, there's cumulative and then there's non-cumulative preferred stock. Non-cumulative basically provides the option for management to not even pay the

Starting point is 00:54:03 the dividend that's associated with it. So although that's a pretty small portion of the overall preferred stock that's out there, that's also something that I think you should ensure you look into and fully understand before you buy any. In general, I think the reason Graham has this quote, it's pretty obvious, is because you're getting a security that acts exactly like a bond, but it's behind the, you know, if the business fails, you're behind all those bondholders that are sitting in front of you. On top of that, you don't have any voting rights.

Starting point is 00:54:35 On top of that, you don't have any earnings rights, especially if it's non-cumulative. So I don't want to steer you away from this, but at the same time, I want you to be very cautious of this. I think that it really requires a lot of analysis. It requires a lot of thinking about what risks you're actually assuming and what could actually be paid out to you when you're behind the bondholders if the company would go into a liquidation event. And with the way interest rates are going these days and how they've really kind of polarized a lot of bond yields down really low and beyond what would be normal for any type of market condition, I'd be really skeptical that the yield that you're receiving on the dividends of a preferred stock are actually representative of the risk that you'd be assuming in the event that we would go into a big, you know, liquidity event and bankruptcies and things like that. So just some thoughts to think about. A very interesting question.

Starting point is 00:55:44 I really haven't addressed this one in a long time. I know I have some videos out there on YouTube addressing preferred stock. So those are out there as well. And I go into a lot more detail how they work and, you know, how you can filter for them to find certain preferred stock. There's, I might have two or three videos on it. I can't even remember because it was so long ago. But if you search for my name and preferred stock on YouTube, they'll be sure to come up. So Tim, for asking such an interesting question, we're going to give you free access to our TIP finance tool. On our tool, we have a filtering mechanism that helps you find really good value picks. We also have a momentum tool that assists.

Starting point is 00:56:27 All sorts of really neat and interesting things there. It helps you do intrinsic value calculations based on the free cash flows that the company's kicking off and your estimates are what those might be in the future. And it's really easy to use. So we're excited to be able to give that to you for anybody else out there listening to this. If you want to get your question played on the show, go to Ask theInvesters.com. And if your question gets played on the show, you get free access to our TIP finance tool. All right, guys. Preston, I really hope you enjoyed this episode.

Starting point is 00:56:54 of The Investors Podcast. We will see each other again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvesterspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP317: Intrinsic Value Assessment of Fairfax w/ Jake Taylor (Business Podcast)

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