We Study Billionaires - The Investor’s Podcast Network - TIP832: Fairfax Financial (FFO.TO): The Berkshire Of The North w/ Kyle Grieve & Shawn O'Malley

Starting point is 00:00:00 You're listening to TIP. The fact that they compounded at 18% a year for over 40 years now, that's just unbelievable. I mean, it has to be one of the most under the radar long-term success stories that we've ever come across. Right. And to think it all started with acquiring a nearly bankrupt Canadian trucking insurance business with just $13 million in float and has now grown that to nearly $41 billion. And the bet they put on the housing bubble during the GFC was like, absolutely incredible trade, right? I think they netted over four and a half billion dollars. And so really, the big short should have been about them, not Michael Berry.

Starting point is 00:00:38 Since 2014, with more than 200 million downloads, we have interviewed the world's best investors, studied deeply the principles of value investing, and uncovered many compelling investment opportunities. We focus on understanding businesses and intrinsic value, investing accordingly, and sharing everything we learn with you. This show is not. investment advice, it's intended for informational and entertainment purposes only. All opinions expressed by hosts and guests are solely their own, and they may have investments in the securities discussed. Now for your hosts, Sean O'Malley and Kyle Greve. This episode is brought to you by Accenture. When your advertising operations fall out of sync, everything else follows. Spotify and Accenture

Starting point is 00:01:35 are working together to reinvent the rhythm of ad sales using automation, analytics, and smarter workflows to simplify campaign delivery and access better data across the business. The result? Less time spent on operations, more time connecting brands with the moments and fandoms that matter most. Learn more at Accenture.com slash Spotify. Daniel and I researched the gold standard of value investments when we looked at Berkshire Hathaway last year and fittingly, we added it as a position to the intrinsic value portfolio that we run. So we have some experience looking at insurance-based holding companies. And Berkshire Hathaway is one of the best, simply because they have the world's best capital

Starting point is 00:02:19 allocator leading the business and Warren Buffett. And he led it for many, many decades. But I'm excited to look at another insurance business that tends to run much more under the radar than Berkshire, simply because its CEO, Prim Wazza, doesn't quite have the same cult-like following as Buffett and lives in Canada, too. not the U.S., so maybe that's a factor. And, you know, for a lot of diehard investors, though, going to this company's annual shareholder meeting is just as important as going to Berkshires. That's right. And this business is Fairfax Financial, and it's compounded its book value

Starting point is 00:02:55 at over 18% per year since 1985. Now, interestingly, one of the biggest tenants in value investing is that price follows intrinsic value over the long term. And Fairfax has done just that, compounding its share price at 18% as well. And since 1986, when, Fairfax had positive earnings per share, it has compounded its earnings per share at about 15% and just insanely high rate for any business over a 40-year time period. And speaking of Berkshire, Hathaway, they've compounded book value at just a touch under 20% a year since inception. So Fairfax is really not too far behind.

Starting point is 00:03:30 And Fairfax is interesting because it really has so many parallels to Berkshire from having an incredibly well-aligned CEO who prioritizes shareholders to running a centralized organization to taking advantage of float from insurance. There's just a lot of parallels that stand out between the two businesses. Yeah, they really do. You know, Prem Watsa has often been called the Canadian Warren Buffett, and I doubt Prem would ever say that himself, as he seems to be a very humble person. But I think he's taken a lot of inspiration from Warren Buffett and Berkshire Hathaway.

Starting point is 00:04:00 If you just look up, you know, the annual reports, there's a very striking similarity between the two, and I don't think that's really a coincidence. But of all the managers I've really analyzed closely, I think I might have a hot take here in some circles, but I'd actually say Prem is a manager that is definitely most similar to Warren Buffett that I think I've ever come across. In business, you seem to see many managers, you know, spelt the lessons from Buffett and Munger. But when you dig into what they really do, I think they are more or less just paying lip service to them rather than actually implementing their principles into how they conduct

Starting point is 00:04:31 themselves in business and in life. And when you look at Prem Watsa, he aligns just so close. see to Buffett, and he's been such an exceptional steward of shareholders' capital for over four decades now. We'll be going over many more similarities between Fairfax and Berkshire today. But let's begin here by looking at exactly where Fairfax Financial came from. How did this company come about to even be mentioned in the same breath as Berkshire? Yeah, so Fairfax began with a very simple idea.

Starting point is 00:04:58 So Prem learned that if you run an insurance company, you get access to a float. And the great thing about that float is that you're basically collecting premium. up front, so you can then invest that money for a time before the claims are paid out at a later time. Now, Prem worked very hard to get to Canada from India. And when he arrived, he started working as an investor. And in 1985, he took control of a near bankrupt Canadian trucking insurer owned by Markell. So he renamed it Fairfax. Now, the reason that he chose Fairfax was simple. He wanted to treat people fairly, hence fair. The F is for friendly deals. He doesn't take part in any hostile takeovers. And then the AX part is for acquisitions, which is obviously

Starting point is 00:05:35 very, very integral to Fairfax's business model. But his blueprint wasn't only based on Warren Buffett. He also studied Henry Singleton of Teledyne to help him better understand how to properly allocate capital, not just in mergers and acquisitions, but also in the intelligent use of buybacks. When Fairfax was young, his goal was to maintain a 20% ROE. And the business model, you know, it was quite simple, just leave the managers alone to run their insurance businesses, then invest the flow. But from my understanding, Fairfax had this interesting chapter in its history that occurred after the Great Financial Crisis and it was sort of a black mark on an otherwise incredibly successful history. And similar to Michael Burry, Fairfax made a fortune

Starting point is 00:06:14 betting against the housing bubble, but that win had some pretty hefty implications for multiple years after the great financial crisis. Exactly. So what they ended up doing was using these collateralized debt swaps or CDS's on major insurance-related businesses like AIG, Swiss Re, and Munich decree. Now, this was definitely a macro bet since they had a very good understanding of the assets that were inside of these businesses' specific portfolios. So basically what happened, they just didn't like what they saw inside of their portfolios. You know, these CDS's could be seen as Fairfax's own form of insurance in the event that these businesses suffered catastrophic losses. But the bets didn't really work out well at the beginning. It took nearly five years and $500 million

Starting point is 00:06:57 for the bet to eventually pay off, which netted Fairfax $4.6 billion during the GFC once a finally hit, which was about four times what Michael Burry made from his great financial crisis bet. That was obviously documented in the movie The Big Short that we just discussed. But the problem, unfortunately, was that Prem kept thinking that there was just another catastrophe right around the corner after the GFC had already happened. So he kept hedging by shorting the S&P 500 and the Russell 2000. And those hedges unfortunately wiped out nearly all of operating income between 2010 and 2016. And on top of that, book value also slowed to a crawl at just 2% growth per annum.

Starting point is 00:07:33 Watsa, however, is luckily very, very open, I think, with his shareholders, and he eventually admitted that he made a mistake and he swore off shorting for good. Shorting is tough. It takes an unbelievable amount of skill to do right over a long period of time. You basically have capped upside and unlimited downside. And I think once you gain a reputation for crying wolf and actually be right, then you tend to overweight the likelihood of another crisis. And so just recently, Burry actually close.

Starting point is 00:08:03 He's done as fun. And he's made a lot of calls since 2008 that didn't work out nearly as well. And in many ways, I think we're all emotional byproducts of the era that we invest in. And so a lot of people today, including myself, haven't really seen a true financial crisis while investing. So I feel like I almost certainly underestimate the risk of another crisis because it's hard for me to imagine it. And every time the markets have dipped in what the last 16 years, they've pretty promptly rallied back. So I can totally see how when managing billions of dollars and living through something like the great financial crisis, you carry some of these scars that affect how you invest for a long time afterward. Yeah, I think that's actually completely correct. And if you even look,

Starting point is 00:08:45 you know, back in time at the difference between Warren Buffett and even Benjamin Graham, Benjamin Graham, you know, part of his entire system was built on the fact that he lived to the Great Depression. So he always thought that another Depression was right around the corner. And luckily for Buffett, he was very, very young. And I don't even think he remembered anything that happened during the Great Depression. So I think you're 100% correct, depending on when you're brought into the market. I think fully, fully affects how you invest into the future. But I want to look here at exactly what Fairfax does. So Fairfax you can think of is basically a holding company with multiple segments. So they have kind of these three primary segments. The first one is

Starting point is 00:09:19 the property and casualty insurance and reinsurance business. So this segment covers their insurance and reinsurance businesses that are all over the world, not just in North America. And when I say around the world, I really mean, you know, all sorts of interesting places. You got Barbados, South Africa, Greece, Kuwait, Hong Kong, Bangkok, Luxembourg, Warsaw, Brazil, and Argentina, among many other places as well. Then you have the life insurance and runoff section, and then you have the non-insurance business. So this includes restaurants and retail segments and Fairfax India, Thomas Cook India, and a bunch of other fully owned private businesses. Now, I really like the non-insurance part of this business. So I actually own a restaurant franchiser that exited to recipe

Starting point is 00:09:58 which is a restaurant business with about $3.5 billion in system sales. So I followed that segment a little closer than the others. And the other assets in the non-insurance businesses that I find really interesting are Fairfax India. And then Hamlin-WATSA Investment Council or HWIC. So Fairfax India is actually a TSX listed company. It's kind of like a mini Fairfax. Only its holdings are only in India. And Fairfax owns about 43% of their business.

Starting point is 00:10:25 So that business invest in both public and private businesses as well. And they also invest in debt, too. I don't think we've really covered any franchise businesses. So it's not a model I'm super familiar with, but just to comment on Fairfax India, I remember listening to a stock pitch about Fairfax India about a year or two ago, since it does trade separately on the Toronto Stock Exchange. And it was really compelling. It sounds like they own some really unique monopoly type assets, like airports,

Starting point is 00:10:53 or maybe it was like the land around the airports. I don't remember exactly. but I want to discuss the Hamlin Watts Investment Council a little more. And so it seems kind of like the Buffett Munger setup where they made a lot of the investments together, along with other superstar capital allocators like Ted Westler and Todd Combs, who were a part of the team at Berkshire. That's right, Sean. So HWIC is the investing arm of Fairfax, like I mentioned.

Starting point is 00:11:22 But really interestingly, Fairfax was actually born out of HWIC and not the other way around. So HWIC today is a wholly owned subsidiary of Fairfax, which basically acts as the investment arm of multiple parts of Fairfax's operations. So they invest funds for the Fairfax holding codes, the property and casualty insurance and reinsurance businesses, the insurance and runoff companies as well as for Fairfax India. So if you look at Fairfax investments, you can get a pretty good idea that they are deeply leaped in value investing. The businesses just tend to be quite cheap. So one of their positions, Metland Energy, trades for a P of 0.2x. You heard that correctly, 0.2 times earning. So when I was looking at it, I actually had to double check to see if it was

Starting point is 00:12:03 an error. So, you know, they follow traditional value in principles, whether that's the preservation of capital above returns, using a margin of safety, focusing on thorough business analysis, buying out of favor businesses when they're obviously pretty cheap. And then, you know, just holding cash when the market isn't offering opportunities, which is something that a lot of businesses tend to have a hard time doing. I tend to be pretty wary of businesses that have an investment arm because they can sometimes charge pretty exorbitant fees and there can be actually conflicts of interest that make these relationships not exactly shareholder friendly, but given what you've said so far about Prim Wata and how aligned he is with shareholders, I assume he's

Starting point is 00:12:43 found a way to make the arrangement work. Yeah, he has, I think. So HWIC does earn fees from the entities whose money that it manages. So in 2025 and 2024, those fees were about 233 million and 186 million. So this business is generating revenue, but the important caveat is that HWIC is fully owned by Fairfax. So while one subsidiary is paying a fee to the other business, Fairfax, the parent company is getting the fees at that parent level, which means that no money is really moving. It just kind of nets out. So HWIC is basically just a vehicle for investing money at better returns than its insurance companies could generate by themselves. That's kind of how I look at it. HWIC makes money by earning returns for Fairfax subsidiaries, not by, you know, charging these exorbitant fees.

Starting point is 00:13:27 The exception to this is in Fairfax India, where Fairfax does charge them a fee. The fee is paid in cash or in Fairfax India shares based on a management fee and a performance fee that's tied to a target for increase in the book value of Fairfax India. If it's not already clear, Fairfax is not going to be the simplest business conglomerate for us to break down, but neither is Berkshire. And when you talk about this internal, independent asset management arm, it sort of reminds me of capital G at Alphabet, and that's a $7 billion fund that Alphabet runs. And they've had 16 of their portfolio companies actually IPO, which I think is pretty impressive. It'll definitely recognize a few of them. One of their early investments was actually in Lyft. Yeah. So I think you're completely correct

Starting point is 00:14:11 about Fairfax being kind of a difficult business to look at. I mean, it's not a simple business that just has one product or one service that it sells. It has, obviously, it's based around insurance, which is great, but yes, there's a lot of moving parts here. So hopefully I can make it simple for everyone to really understand well. And so Hamlin-Watson Investment Council is just one of many non-insurance businesses that Fairfax owns. But I think it's worth looking at some more of these assets as the non-insurance businesses have a market value more than $4 billion. And so you've spoken about Recipe in Fairfax, India.

Starting point is 00:14:48 But how are the economics of this segment overall? I mean, are these good businesses to be in? Yeah, you know, the non-insurance segment definitely makes some money for Fairfax, but it's actually pretty low margin. So in 2025, it reported $397 million in operating profit, which is a nice improvement from $241 million in the prior year, but the segment has margins of just 4.6%, you know, pretty razor thin. The business model for the non-insurance seems to be based on, you know, taking these kind

Starting point is 00:15:18 of controlling stakes in misprice assets, then trying to improve them, finance them with non-recourse debt, and then, you know, just take advantage of being decentralized, let management do its thing to help increase the value of that business. This can then add book value to Verfax, or they can sell partial or full parts of these businesses at a profit or to fund other high returning areas of the business that we'll get into later on today. One of their biggest successes on the non-insurance side was with a business called Digit. And so Fairfax owns 49% of that business and has made an annual return on that of 41.5% a year since 2017, which is outstanding. And what I like to see is that Fairfax

Starting point is 00:15:58 takes a concentrated approach with this position because it makes up over 50% of their investments in India. And so to me, this indicates that Fairfax is very willing to let its winners run. And, you know, this is a key principle of how we're trying to run our intrinsic value portfolio. You know, Alphabet, for example, has doubled since we first invested in it. And Reddit has gone up by a similar amount. And we haven't really sold either of those positions because while the stock prices have gone up, they've dramatically increased their intrinsic value. The underlying business has kept up with the stock price. And so as long as we're, we're going to be able to, we continue to think that they're great businesses to own, why would we want to sell and have to

Starting point is 00:16:39 try and find equally good businesses to replace them? That's not an easy thing to do. And so it's really tempting to lock in your profits when you've made gains. But if there's one thing we've learned from studying legend investors and covering so many companies on that show, it's that holding onto your winners really can be what differentiates a good investor from a great one. Yeah. And I think that, you know, Prime has probably shown that he is a great investor. And you can obviously see that right here with Digit, which was just a massive winner for them. So Digit is really interesting because it kind of intersects insurance with India and to some degree technology.

Starting point is 00:17:15 So Fairfax has invested about $140 million in that business and it's carrying value now is a touch over $2 billion. So one area I think I should highlight is that Fairfax owns non-insurance businesses in kind of three different ways, which can be kind of confusing. So they list their investments as common stocks that are mark to market, common stocks that equity accounted and then common stocks that are consolidated. So just briefly, let me kind of try to break this down for you in a simple way. So the first group is stocks where Fairfax owns just a small piece, you know, just kind of too small to have any real say into what goes on in that business.

Starting point is 00:17:48 So their earnings either go up or down along with the stock price plus whatever dividends that they get paid from that business. The second group are larger stakes, so where Fairfax definitely has some influence, but it's not a majority shareholder. And the third group consists of companies that Fairfax actually controls and runs their day-to-day operations. For these, instead of just taking a slice of the profits, Fairfax actually combines that company's entire financial results with its own. And then it sets aside that portion that belongs to any other owner, so it doesn't get mixed with Fairfax's numbers.

Starting point is 00:18:18 Let's take a quick break and hear from today's sponsors. When you're a mid-sized business, you need every competitive advantage you can get. Like an AI solution that works for you, not against you. SAP Grow is built with AI embedded apps. at its core, working across every system, and it's ready to go from day one so you can hit the ground running. Bring it with SAP Grow, AI Cloud ERP for any size business. So this is something that really surprised me when I first began to study accounting as an investor, which is that there are so many different ways to account for the value of a company's investments

Starting point is 00:18:55 and the income that those investments produce in GAP accounting. So if it's a publicly traded company, you own a small position in it, then the fluctuations in the stock price of that holding are treated as losses or gains that impact the income statement. Whereas if you own a significant minority stake or a majority stake, that completely changes the accounting where you either record your share of the underlying company's earnings as your own earnings or claim all of it and deduct out the minority interest. And so point being, there's a huge difference in recording the changes in stock price of your holding company as income, even if you haven't sold and locked in any of the gains, and recording a percentage of the underlying companies operating earnings,

Starting point is 00:19:40 right? Those are wildly different things. And the idea, to some extent, is to try and reflect the difference in business influence that you're truly a passive owner of and businesses where you can significantly influence the operations because you have so much more voting power or even have majority control of the business. So now I think we need to discuss the insurance business in more depth here because that segment is really what I consider to be the motor of Fairfax. So the underwriting profits from insurance for 2025 were $1.8 billion of Fairfax's operating profits, so we're about 32%.

Starting point is 00:20:15 So it's generating a substantial profit for Fairfax and has risen from 18% in 2021. So I mentioned earlier that Fairfax started out as more of an investment company that utilized the float to grow. But in Fairfax's early years, the insurance businesses just weren't really that great in terms of the quality. So from 1986 until 2005, Fairfax's average combined ratio actually exceeded 100%. For those unfamiliar with the combined ratio, let me just break it down very quickly. You can think of it as a report card for how well an insurance company does its job of collecting premiums and paying out claims. And so let's say you collect $1 million from customers for their insurance.

Starting point is 00:20:54 What matters are two things, the money you pay out and claims ultimately, and also the money that you spent running the business, the overhead costs. And if those two things add up to less than $1 million, well, congratulations, you made a profit just from writing insurance. But if they add up to more than $1 million, you lost money on the insurance underwriting part of things, which you generally try to then make up for with the income you receive from investing the flow. in the meantime. So you get to hold that million dollars, you get to keep, let's say, any interest that's earned on it. And that is what can make insurance businesses overall be profitable if the actual underwriting isn't. But if you can profitably underwrite insurance and earn income from float, well, those two things combined make for a very, very special business. And in insurance, this is captured by that combined ratio that we've mentioned. So if the combined ratio is

Starting point is 00:21:53 under 100%, the company is making money from writing insurance. But if it's over 100%, that means the company is losing money. So it's really as simple as under 100 good, over 100 bad, almost. And over the last decade or so, Fairfax's combined ratio, about 97%. And so what that technically means is that for, let's say, every dollar that they collect as premiums, they're making three cents in profit. So they collected a dollar premiums, but they only had to pay out 97 cents. Exactly. And I think this really matters because the combined ratio affects the insurance flow, obviously. When an insurance company collects premiums, it holds them until it eventually has to pay it out as insurance claims. But there is a gap in that time. It could be years until it needs to be paid out. In the meantime,

Starting point is 00:22:37 that money is generally invested in low returning assets like bonds for most insurance companies. So the combined ratio tells you what the float costs the company. If it's below 100%, which it has been for Fairfax since 2006, you're essentially getting paid to hold other people's money. which is just a great situation and exactly what Buffett took advantage over his entire career with Berkshire Hathaway. For most other insurance companies, though, the float makes just single-digit returns. A great example is Alled World, an insurance company that Fairfax bought in 2017 for about $5 billion.

Starting point is 00:23:09 So the insurance company had been great with an average combined ratio of 91%, but its float had a track record of just about 4% returns. That's because most insurance companies are run by insurance operators. So investing in low-risk bonds ends up being a pretty simple low-risk process that doesn't require equity specialists to come in and manage the portfolio. And then you can contrast that with the approach that Buffett took as really being a stock investor first and taking that float and investing it into wonderful businesses. Exactly.

Starting point is 00:23:43 But as we know with Hamlin-Watt's Investment Council, they clearly have the right people in place to earn very high returns on the float while keeping risk relatively low, which you have to do. So since Fairfax today now aims for an ROE of 15%. We can just see how they'd get that with a business like Allied. So if you can increase the returns on the float, you don't need to make any incremental returns on the underwriting profits, and you'll actually still earn a really high return on equity on that investment. So according to the great book, the Fairfax Way,

Starting point is 00:24:11 Fairfax believed it could earn a 20% ROI on Allied simply by just increasing the floats return from 4% to 7%. 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 and you'd otherwise be able to, and then getting to keep the rewards for doing so. That'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

Starting point is 00:24:44 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 an Odyssey. But when they bought it, it had about $250 million of gross premiums and $290 million of equity. And 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, Crumman Forrester, arrived carrying just these

Starting point is 00:25:30 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. So Prem trusted the managers of the insurance businesses and gave them time to fix things. Fairfax has presidents who stayed on literally for decades. They show this in their shareholder letter, which helps insurance companies focus on the long term,

Starting point is 00:26:03 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. 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.

Starting point is 00:26:40 And I think Buffett talks a lot about this about being a disciplined insurance underwriter and 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. And 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.

Starting point is 00:27:14 the 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. So 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. The disadvantage, like we already been talking about here for the last few minutes, is the combined

Starting point is 00:27:48 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. The second advantage is a capital allocation track record, which spans over 40 years. So their long-term return on investments is about 7.7 percent. And even though that number is trended down somewhat since the early days, I think it's

Starting point is 00:28:17 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. I would say, though, that there are other companies out there that come to mind that probably do a better job with generating higher returns and float. It's obviously Berkshire Hathaway, but also Markell comes to mind too. And so underwriting insurance profitably, if we haven't said it

Starting point is 00:28:50 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 Markell, where they have this formula for writing insurance well and also simultaneously being great investors. That'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.

Starting point is 00:29:29 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. Just different jurisdictions have different regulations. But you have to obviously 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

Starting point is 00:30:08 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. And, 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 that they really just keep running them well, and then Fairfax takes care of growing their float. 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,

Starting point is 00:30:46 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. The 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

Starting point is 00:31:19 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. But yeah, there is a lot of evidence that, you know, giving talented people the space and the discretion to just do their jobs well without being micromanagement, without multiple layers of middle management and all these other different forms of bureaucracy that you tend to get better business outcome. So it is pretty cool to see that Fairfax has a similar structure to that. That's right. So 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.

Starting point is 00:32:05 So as of today, they have about $14 billion of debt. And this is split among the holding company, insurance and reinsurance companies and non-insurance companies. But with cash, their net debt position is about $11.6 billion. But this cash position doesn't actually include the insurance flow, 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.

Starting point is 00:32:30 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. First 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

Starting point is 00:33:09 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. It does feel like it would be fair to call Fairfax a serial acquire. And one of the hallmarks of serial acquires is using debt consistently to finance further acquisition. 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 de-leverage 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

Starting point is 00:33:51 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. Now, 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 of 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

Starting point is 00:34:29 for $4.9 billion and golf insurance for $1.4 billion. So, you know, they definitely do need access to leverage to buy some of these bigger deals. I can 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. And plus, as you mentioned, they can buy out minority stakes in businesses that they already partially own. And so they've already deployed. And so they've already deployed some capital in these minority buyups, if you want to call it that, at Allied World, Gulf Insurance, and Britt, 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

Starting point is 00:35:12 just close a $1.65 billion deal for Kennedy Wilson Holdings as well, I believe. That'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 continued to grow profits at a very strong rate. So REOE 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.

Starting point is 00:35:52 Now, 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-2020 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?

Starting point is 00:36:21 Yeah, so ROE actually went negative because of something I mentioned earlier, which was the erroneous thinking that other, you know, GFC type events were right around the corner that Fairfax could benefit from. So these investments into the CDS's 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 years in 2011, 2013. and 2016.

Starting point is 00:36:49 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. And so I know Fairfax has done some really interesting things in terms of capital

Starting point is 00:37:16 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 pretty high multiple for an insurance company. And 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

Starting point is 00:37:56 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, we're 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. This episode is brought to you by FIFA World Cup, launch edition on Netflix. It's a fast, fluid game where your phone is the controller

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Starting point is 00:40:54 Always earn high regular interest rates that grow the more you save and invest. Conditions apply. Visit scotiabank.com slash h-I-SA to learn more. Scotia Bank. You're richer than you think. So that's the key point there that you mentioned, it sounds simple, but you just don't see it happen. And it's a nuanced conversation wide. But I think one of the reasons you don't see it happen is that when a business is trading

Starting point is 00:41:22 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. That's 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

Starting point is 00:41:50 or TRS. So 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. 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.

Starting point is 00:42:28 And 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 approached that. And one of the underappreciated aspects of buybacks is the timing of when they're done. Doing buybacks in your stock is 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

Starting point is 00:43:00 bottom. You are completely correct, Sean. Fairfax 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.

Starting point is 00:43:34 So one other thing that caught my eye when looking at Fairfax was they do pay a dividend. And 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 them 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, you know, 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, you know,

Starting point is 00:44:14 that's money that could have been used to fuel the M&A engine. But, you know, 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 number of 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. And so if a business has a reasonable dividend and management can

Starting point is 00:44:53 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 Premwatra had a salary 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 his shareholders. So Prem wasa through a holding company, as well as his personal ownership, has 43.3% voting rights of Fairfax Financial. Fairfax has been through a period

Starting point is 00:45:35 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.

Starting point is 00:46:04 Yeah, I mostly like it. I would say that with one caveat, Prim 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,

Starting point is 00:46:24 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. But how about the rest of the management team? I assume they have different compensation packages, but maybe we can go over that and 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.

Starting point is 00:46:58 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, as Fairfax does have an options-based award. But this system reminds me a lot of Lyftco's options plan in that the options that Fairfax grants are actually non-dilutive, a characteristic that's incredibly rare in most corporations. So 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

Starting point is 00:47:42 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, you know, I think I like the long-term nature of the options along with a non-dilutive effects, but they still are to some extent time-based awards. Now, I will commend them for having these expiration dates for executives that go out past 2040. I mean, I think that's quite impressive in 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-delutive stock awards, where you actually have to buy real shares using cash rather than just printing shares magically,

Starting point is 00:48:18 I think we'd see compensation expenses dramatically rained 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. And 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 its 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.

Starting point is 00:48:49 So for 2025, they gave about a 250% bonus as they had record results across the entire board. So the circular mentions a couple things. It mentions underwriting profits, interest in dividend income, as well as a high rate of achievement in compounding the book value per share. So 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.

Starting point is 00:49:30 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, and 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

Starting point is 00:50:06 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. But for the most part, I think it's a very good incentive structure overall. And part of the guiding principles is based on risk in 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

Starting point is 00:50:52 for so long, I think it's quite clear that they follow these principles very, very closely. But 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 moody 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, you know, 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. But on top of

Starting point is 00:51:31 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. 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.

Starting point is 00:52:11 interest rates giveeth and they takeeth. 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. You know, if you have a long-term time horizon for these businesses,

Starting point is 00:52:45 the best time to pick them up is actually when their share prices are weak due to cyclical market exposure. So 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 of 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

Starting point is 00:53:11 or QXO with Brad Jacobs. I think Prem Watson 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. So 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

Starting point is 00:53:54 really just a figurehead while the chairman now runs the show. So Coca-Cola in the 1980s was like this before the power struggle finished in favor of Roberto Goizetta. But 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. Prim Wausa is now 75 years old. So if Prim Wausa 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 Pram decides to step down. you know, Fairfax has said that they already have someone in place that would be more than suitable

Starting point is 00:54:36 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. But even more importantly, he's had roles in Fairfax such as the vice president, the chief operating officer, the chief actuary, and he's been a member of Fairfax's

Starting point is 00:55:11 executive and investment communities. 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 Wata has actually stepped back as a vice chairman of Hamblin Watt's Investment Council in 2019. So the investments have actually been running smoothly without participation from Wausa. It 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.

Starting point is 00:55:40 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 risk were around the insurance side of things and specifically insurance reserving for losses and catastrophe risk. And so do you see Fairfax having similar risk with its insurance companies? How do you think about that? Yeah, totally.

Starting point is 00:56:08 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. So 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. 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

Starting point is 00:56:37 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. So 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.

Starting point is 00:57:18 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. This raises a combined ratio and obviously negatively affects profits. But since 2020, Fairfax's P-Y-D 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.

Starting point is 00:57:49 How did you value this business? Yeah, so Fairfax is a very, very interesting business to me. When I release my episode on a great book covering the business called The Fairfax Way on TIP 783, 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. You know, when I think about Fairfax, it checks off pretty much every single box I look for. High capital efficiency, check.

Starting point is 00:58:18 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. I really find it hard to own businesses that are facing these really, really massive headwinds that are completely out of

Starting point is 00:58:49 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. But 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. So 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.

Starting point is 00:59:28 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 required. on invested capital, but it's actually return on equity. That'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

Starting point is 01:00:07 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 is net earnings. From 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

Starting point is 01:00:40 1.3 times book. And this is a number somewhere around the midpoint of the last decades multiple, but that was also a severely dragged down by COVID. So I think the business continues to grow at about a 15% R.O.E. 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. Just for context, for listeners, as you think about Kyle's assumptions here, Berkshire trades at one and a half times book values. Actually, the multiple you're using comparatively is pretty reasonable and cheaper than Berkshires. And already I can tell you that

Starting point is 01:01:15 if they can achieve that 15% ROE target, I'm pretty confident this 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%. Now, 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,

Starting point is 01:01:54 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. You 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 the 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 to disappoint, the company is

Starting point is 01:02:32 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. So I apply a 55% probability to my base case, a 25% probability to my bare case, and about a 20% probability to my bullcase. 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

Starting point is 01:03:08 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 and 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 Premwasa to do what. it's right. And I mean, that's probably a good place to put trust. I mean, he's been doing it

Starting point is 01:03:44 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. So 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.

Starting point is 01:04:19 Sean, what do you think? Yeah, you could do a whole lot worse than investing in Fairfax. And if I was in maybe a more conservative stage of my financial life, perhaps closer to retirement, I would probably see Fairfax is 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.

Starting point is 01:04:47 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. So 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 that in many years, companies like Adobe, Intuit and Salesforce and so on,

Starting point is 01:05:26 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. Our earnings are lumpy. We have never had guidance in 23 years because we have ups and downs and take a long-term view.

Starting point is 01:05:53 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. of 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. Now playing on Netflix, The Hawk. From the mind of Will Farrell. Oh, mama. I'm back. Comes a new original series. Get ready. Get ready. That's it. Did I stutter? When an iconic pro golfer. Lonnie. Lonnie. Hocked out! Takes one last swing of greatness. You were a big shot golfer. I still am a big shot golfer. No one. Dad, I'm not.

Starting point is 01:06:35 Hawk now. We'll stand in his way. That's how it's done. The Hawk now playing. Only on Netflix. Thanks for listening to TIP. Follow the Investors Podcast on your favorite podcast app and visit the Investorspodcast.com for show notes and educational resources. This podcast is for informational and entertainment purposes only and does not provide financial, investment, tax or legal advice.

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