Does Prem Watsa have to prove himself to you?
The man in charge of Fairfax Financial Holdings Ltd., often called "Canada's Warren Buffett," is richer and smarter than you or I, as some readers have pointed out when I've written pieces skeptical of the doings at his insurance-and-investing concern. However, by the end of 2016, Fairfax's book value has shown little growth from several years before. The big culprit last year was the choice, in the waning weeks of 2016, to unwind long-standing multibillion-dollar wagers that the U.S. equity market was poised to decline.
This is prompting analysts to question the prospects for Fairfax shares, with the phrase "show me" appearing in at least one recent note. But investors continue to bet on Prem: Despite the shares' decline from 52-week highs, they're actually trading at a higher price-to-book-value multiple than the historical average. In the midst of this disconnect, one thing seems clear: With the company ending its pessimistic U.S. equity bets and going all-in on Donald Trump, Fairfax is less of a contrarian play than perhaps ever before.
Like Mr. Buffett's Berkshire Hathaway, Fairfax Financial has insurance companies comprising its core operating business, with investments providing a significant, additional part of the company's results. While Fairfax has a number of holdings – wholly owned businesses, or stakes in public companies – a big part of the Fairfax portfolio has been two bearish positions.
One, which Fairfax still held at year end, are derivative contracts purchased for $670-million (U.S.), now worth $83.4-million, that could pay Fairfax tens of billions of dollars if the consumer price index in the United States or the European Union goes negative – in other words, deflation. The second was a series of swaps, with a face value of $7.6-billion, that shorted the Russell 2000, S&P 500 and S&P/TSX 60 equity indexes – only profitable as stocks declined.
With the election of Mr. Trump, Fairfax quickly unwound its short bet, dumping half the stock swaps on Nov. 11 and the remainder by year-end. The result was a realized loss of $2.66-billion in the quarter and a 10-per-cent decline in the company's book value. In a statement, Fairfax said the company "recognize[ed] fundamental changes in the U.S. which obviated the need for defensive equity hedges." (The CPI derivatives are still in place, possibly because they're harder to unwind.)
The practical effect of the decision is to end Fairfax' status as a bearish bet on North American equities. And with so much "dry powder" to invest – Fairfax has about $10-billion of cash and short-term bonds at year-end – the company can now "shift back into offence on the investment front," notes Cormark Securities analyst Jeff Fenwick, who has an "outperform" rating and $700 (Canadian) target price on the shares, versus Tuesday's close of $598.
However, Mr. Watsa, known for going against the grain, seems instead to be joining in the market exuberance, irrational or not. (I am on the record that I believe the so-called Trump rally is unjustified; to date, I am either very wrong or right way too early.) Will Fairfax indeed be able to deploy its cash into investments that will bring its next gains back to the 8-per-cent range that the company has achieved in the past?
A number of analysts are suggesting the heresy that we shouldn't be so sure. While book value – the excess of assets over liabilities – is surely a backward-looking measure, it's worth noting that this measure of Fairfax's worth hasn't moved meaningfully since 2010. (It's analyst Tom MacKinnon of BMO Nesbitt Burns, author of the "show me" storyline, who made this observation in a recent report, where he places a "market perform" rating and $660 target price on the shares.)
CIBC's Paul Holden believes Fairfax's insurance business had a return on equity of about 6.4 per cent in 2016, a full two percentage points below the average for comparable U.S. and international insurers. That, combined with the investment outlook, prompts him to forecast growth in Fairfax's book value per share of just 3 per cent to 4 per cent over the next two years. Yet the current price represents 1.3 times book value, a premium to the 10-year average of 1.1 times. "We think the outlook for growth does not support a premium relative to its historical average," he wrote in cutting the stock to an "underperformer," with a 12- to 18-month target price of $600.
And Morningstar's Brett Horn, who has a "fair value" on Fairfax shares of $597 and, as an American, has the luxury of being less polite, says, "the company has now essentially locked in the poor book value growth it has experienced in recent years and incurred substantial opportunity costs as it sat out the bull market. We think investors attracted to the stock due to a belief in Watsa's ability to produce [outperformance] on the investment side should consider his track record over the past decade, which includes some big wins but also substantial losses."
Right now, it may be a warning unheeded. For a company whose CEO has built his reputation on contrarian bets, there's a certain irony that the contrarian play today is to stay away from Fairfax shares.