Circle Of Competence Issue #15
What are you reading this week? Send me your reading recommendations in an email or tweet at @competence_co. Have a great week!
HIGHLIGHTED COMPANY - FAIRFAX FINANCIAL HOLDINGS
I finally finished going through Prem Watsa's Fairfax Financial shareholder letters this week and wanted to write a small summary on his rise to investing fame. He is the current Chairman and CEO of Fairfax Financial and controls 42% of share votes via his ownership. He is often referred to as the 'Canadian Warren Buffett' due to his long track record of compounding shareholders' capital in the insurance industry. Later this week, I will publish my scratch notes in a separate post on the site, for those who are interested.
Let's start with a little history shall we? Born in 1950, Watsa attended high school and undergrad in India and later attended the Richard Ivey School of Business at the University of Western Ontario for his MBA. After he worked at Confederation Life for a few years, he started Hamblin Watsa Investment Counsel with his boss Tony Hamblin in 1984. Interestingly enough, Hamblin Watsa (as a Fairfax subsidiary) still manages all of the 'float' generated by Fairfax Financial's insurance subsidiaries.
In 1985, Watsa, with help from outside capital, helped recapitalize Markel Financial, which was a small trucking insurance firm that was near insolvency. From there, he helped grow the business from roughly $10M in revenues in 1985 to $14B in 2017. He compounded book value at 19.5% and the stock value (not including dividends) at 18.1%. What a record! $1,000 invested with Watsa in 1985 would have compounded into roughly $205,000 over 32 years, not including dividend payouts! A constant $1,000 invested annually over his 32 year track record (total of $32,000 invested) would be worth an astounding ~$1.1 million!
While he has made his mistakes (overhedging his equity exposure from 2010-2016 cost shareholders $4B!), he has always written extensively and honestly about the company's operations, choosing to disclose everything to shareholders that he would wish to know, were he in their shoes. I particularly enjoyed his discussions on bubbles, economic risks, and valuation risks in various financial markets over the years (the 1998 letter on the tech bubble, the 2003-2006 period on housing and collateralized debt obligations which exploded later, his call on China's huge debt burdens in early 2010's, and his views on deflation, though they did not come to fruition as expected - or at least not yet!). So what makes Watsa such a great long-term investor? Here are my thoughts after reading through his 32 annual letters:
1. His patience, especially in the occasional years where Fairfax posted a loss.
2. His ability to sacrifice short-term performance for protection. Many times in Fairfax's history, Watsa has chosen to hedge certain exposures due to either financial markets risk (high valuations) or macroeconomic risks (deflation and interest rate risk). This lead to lower short term performance, but also 1) protected the company's investment portfolios from large sudden declines and 2) at times allowed for large one time gains when the underlying risks being hedge against actually occurred - such as the 2008 period when his credit default swaps became worth billions when the financial crisis hit.
3. His ability to issue shares to fund acquisitions at fundamentally sound prices. Issuing shares in acquisitions can be a sign that management does not care about current shareholders more than the current acquisition or it could be a savvy capital allocation move. The caveat is that it takes time and careful observation to know which is the case. It is clear from reading Watsa's shareholder letters - and understanding that he is the largest shareholder - that his acquisitions have been fairly savvy moves using equity as a currency over the long run.
4. His focus on strong deal structures early on in the company's history. I found it particularly interesting how almost all of his insurance acquisitions that he writes about early on from 1985-1995 are contingent on reserve developments. In other words, if the premiums that were written by the previous owners turn out to be badly underwritten, then Fairfax is indemnified (or not on the hook) from those losses. This protects their downside on deals that subsequently go bad, while allowing them full access to the float that has already been generated by the insurance company prior to the acquisition.
5. His focus on profitable underwriting, realizing that this was the key to outsized returns over the long run. This has been a key to Buffett's long-term success at Berkshire and Watsa was wise to understand that he could have capital that was essentially costless or even profitable to invest (combined ratio of 100% or less on the investment float from premiums written).
6. His ability to attract talented individuals to the Fairfax family.
7. His ability not to miss the forest for the trees. Watsa understands how bubbles typically play out, and this is an essential talent for the most successful investors. As Buffett has always said, "if you don't know who's the patsy at the poker table, chances are it is you!"
8. His focus on keeping a clean balance sheet and using leverage at opportune times. Watsa keeps a low debt to capital ratio most of the time, which allows him to both 1) write more insurance premiums and take more risk in this area and 2) lever up if an attractive acquisition candidate materializes.
9. His shameless copying of Berkshire Hathaway's decentralized and insurance-based business model. As Munger has repeatedly said, "we aren't sure why more people haven't tried to copy us." Watsa has done it to great effect.
For those who are looking to learn more about the property/casualty industry, how long-term value investors think, and in general what to look for in an owner-operator like Watsa, I highly recommend reading through these letters. They are like windows into the mind of one of the greatest businessmen and investors alive today.
DEPARTMENT OF GENERAL FINANCE
Buffett and Dimon have always railed against the focus on short term results over the long term view, and in this short op-ed for the Wall Street Journal, they explain their reasons. I found it interesting that Matt Levine, who writes the newsletter "Money Stuff" at Bloomberg, did not quite see it the same way as Buffett as Dimon, positing that it was easy for shareholders to relax on quarterly guidance from management when their savings and investments were in the care of Buffett and Dimon who have long track records of success, but much harder to allow laxity in guidance to managers who do not boast of such records and have nothing more than their word to lean on. I tend to agree with Matt Levine on this - I think the onus falls on the investor to keep management in check, but remain committed to the long-term perspective.
This is Matt Levine's short termism piece in response to Buffett and Dimon's op-ed above. He makes some salient points.
Highly recommend this interview with Buffett and Dimon on several broad topics with Becky Quick on CNBC.
I have written extensively about John Elkann and his family's company, Exor, on Circle of Competence (see Week 11 and Week 9), and this seems to be a new direction for the company. Although the $100M fund represents a small portion of company assets, I do wonder whether this will bear fruit given their lack of experience in tech and startups. However, Elkann has a deep network, and this might serve him well in the relationship oriented playing field that is venture capital.
Very interesting article about David Einhorn's reinsurance vehicle, Greenlight Re, which is used to write reinsurance contracts and generate funds for Einhorn to then invest in his hedge fund, Greenlight. It highlights a short thesis by a small hedge fund, Sunesis Capital, which I have linked to below this article.
Now this is some good stuff. I love reading short theses, but this one is particularly fun. I see a lot of merit in Sunesis' points in that there are incentives only to write more business at bad prices in order to prop up the business's designation as an insurance company and not a PFIC, which would cause its preferential tax status to be dropped. This will be an interesting story to follow.
Interesting article from my friend, Richard Miller (analyst, Morgan Stanley FIG group), showing how insurers are finding new and creative ways to bring in profits in the private funds market. In particular, infrastructure seems to be the play at the moment, with a LOT of money flowing into these types of funds.
This will be a wonderful story to follow, from the political opinions that will be given, to the investment cases made, to the public debate that will be had. It is interesting to note the parallels between the monopolies of yore (Western Union, Standard Oil, Carnegie Steel, etc.) and those of today in the article.
Interesting article by Jason Zweig on Michael Batnick's new book about the greatest investors' biggest mistakes.
A very compelling read from Shane Parrish’s Farnam Street blog on a commencement speech given by Charlie Munger. Munger's speech is packed full of good advice on living a truly successful life! My favorite quotes:
"Work with and under people you admire, and avoid the inverse when at all possible."
"You'll be most successful where you're most intensely interested."
"Use setbacks in life as an opportunity to become a bigger and better person. Don't wallow."
DEPARTMENT OF ECONOMICS
PIMCO shares its outlook for the global economy over the next 3-5 years with this new piece and views a recession within that time frame as more likely than not.
Rates are on the rise around the economy, driven by monetary tightening at the Federal Reserve.
DEPARTMENT OF STARTUPS AND TECHNOLOGY
I tend to both agree and disagree with Christopher Mims' take here. Yes, I agree that there have been gross misuses of power at private and public companies where founder-CEO's essentially control the company and board of directors through their insane supervoting share structures (Theranos, Uber, Snap, and the list goes on). However, at the same time, are buyers not free in their purchase decisions? If one buyer wishes to purchase a share of Snap, regardless of the fact that that share has NO VOTING RIGHTS, who am I to stop them? I sure as anything will not be buying what these salesmen, er, CEO's are selling!
These supervoting shareholder structures can be good if they reside in the right hands, or not so good if they reside in poor management. For example, Fairfax Financial is controlled by Prem Watsa, the CEO and Chairman who controls 42% of the votes. Have shareholders done well with him in command? How about Warren Buffett, who owns 36% of Berkshire Hathaway? So, as in all investment opportunities, know the management, know the business, know the risks, and caveat emptor!
Peter Thiel once stated, "We wanted flying cars but instead we got 140 characters." Well, there seems to be a lot of interest in electric flying vehicles these days and this one is backed by Google's Larry Page.
The Robots are coming to Big Farming. Interesting article on how AI is impacting the agricultural industry - might Deere be making a tech push?
The Robots are coming to Big Pharma. This is such a big trend that will continue to grow exponentially over the next 10 years in my opinion - the automation of physical tasks in nearly every industry.
Although I would walk the headline back a bit, this article is an interesting solution to decarbonizing our current environment by simply recycling CO2 into hydrocarbons such as gasoline, jet fuel, and diesel fuel. Interesting read.
DEPARTMENT OF REAL ESTATE
Interesting article on why the humble real estate agent isn't as easily disrupted as other middlemen in the 21st century. My favorite quote:
"Why hasn’t the internet cut out the agent, even as houses sell to internet companies with the click of a button? In part because consumers aren’t really trying to inject any startup pizzazz into the largest (and most complex) transaction of their lives. Local knowledge remains invaluable. That, and it’s hard to develop regular clients. This isn’t Seamless. In real estate, a satisfied customer isn’t coming back anytime soon.
Excellent New York Times piece on modular housing and how it can be used to help alleviate the problem of low supply and high costs for building new housing in densely populated areas.
DEPARTMENT OF PODCASTS
I enjoyed this short interview with Jonathan Tepper, Rhodes Scholar and founder of Variant Perception Research. He makes some great points about the lack of inflation and wage growth today as well as how investors should think about competition in industries in which they invest. Great discussion also on what constitutes natural monopolies including a few examples today. Recommend this one on the way to work!
Interesting episode on creating and structuring partnerships, identifying your niche in the real estate markets, and other great tips for getting started in real estate investing.
DEPARTMENT OF LETTERS
This has been an interesting saga to follow in Carl Icahn's portfolio. His position in SandRidge Energy has grown to 13% of the company and he issued this letter warning the board of directors and executives NOT to accept their accelerated stock grants, should they be voted out of their jobs by shareholders, due to the fact that 1) this would be a very bad look for the company's officers, 2) this would amount to stealing from shareholders and 3) he would seek legal remedies to the fullest extent. This should be an interesting situation to follow as the annual meeting is June 19th, 2018.
What are you reading this week? Send me your reading recommendations in an email or tweet at @competence_co. Have a great week!