Stig Brodersen  1:22  

Jake, we are excited to invite you back here on the show. Our listeners probably remember you from the outstanding analysis you did of Berkshire Hathaway, back in Episode 289. We’ll be talking about a different company today, namely Fairfax Financial Holdings. Simply called Fairfax.

Later we’ll be transitioning into talking about Fairfax Africa. Please do not be fooled guys. Even though we’re talking about different companies, Berkshire and Fairfax might have a few similarities too. 

Jake, kicking this episode off, perhaps you could start by providing an overview of Fairfax.

Jacob Taylor  2:00  

Sure, it was founded in 1985 by this Canadian immigrant named Prem Watsa. It’s primarily a P&C, property and casualty insurance company. It has a lot of decentralized insurance companies around the globe that are part of its company. 

What’s kind of nice is that they also profess to have a value investing approach to the money that they manage. Their stated goal is to compound book value at 15% per annum. Since 1985, they’ve done it at 18.5%. They’ve been achieving their goals for a long time, which you can’t say about too many companies. 

The other thing I like is that the culture is what they call fair and friendly. There are never any hostile takeovers or anything like that. They do draw a lot of comparisons to Berkshire, but they are definitely a little bit different.

Stig Brodersen 2:52

I already mentioned there that there are a few similarities between Berkshire and Fairfax. You even mentioned a few of them yourself, the fair and friendly. I would imagine Warren Buffett calling it differently. He’s not a big fan of hostile takeovers, either very decentralized organization. What are some of the other similarities and perhaps differences that you see?

Jacob Taylor 3:13

The biggest difference really is in the size of the operations. Berkshire is an elephant and Fairfax is an ant. 

To give you an idea, Berkshire’s float is six times the size of Fairfax. They had similar underwriting profits last year, kind of surprisingly. Book value is 30 times X for Berkshire. Their cash flow from operations is 30 times. Their price-to-book also is 2x, right? So it’s more expensive. Enterprise value is actually 75 times x. 

Therefore, they’re quite a bit different in the size of the company. I’d say in general that Berkshire has a lot more operating businesses between the railroad and the energy. Probably a higher quality business than what Fairfax has amassed so far, but in general, their underwriting, their cultures, their investment approaches are relatively close together.

Preston Pysh  4:07  

Jake, just as you can’t say Berkshire Hathaway without saying Warren Buffett, you can’t say Fairfax without saying Prem Watsa. Prem Watsa is a legendary investor for us insiders of the value investing community. However, he’s not much known outside of that community. Could you please just provide an introduction to our audience about Prem Watsa?

Jacob Taylor  4:29  

Prem is known as the Canadian Warren Buffett. One of the differences is that he’s actually 20 years younger than Buffett. He’s only 70, but his background is he grew up in India and got a degree in chemical engineering from IIT Madras. 

Then, he immigrated to Canada with eight rupees in his pocket. He worked and put himself through the MBA program at Ivey Business School, which is in Western Ontario. Now, after founding Fairfax, he owns about 10% of the company. He’s a billionaire, so it’s really one of those rags to riches stories. 

The other thing that I’ve noticed from going to the shareholders’ meeting for a number of years now is that Prem is an incredible cheerleader of his teams. He speaks so highly of everybody. You can see why everyone shows up to work wanting to impress him. Warren is good at that but  the energy that Prem conveys is even stronger. 

The other difference is between going to a Berkshire meeting and Fairfax, I remember the first time I went to the Fairfax meeting. Within five minutes, I’d already met Prem and got a picture taken with him and moved into the meeting. It’s very small. 

At Berkshire, you can’t get within 100 feet of Buffett because there is security and there’s just a million people crowding around him. So, it’s a very different experience and that speaks back to the size of the companies.

Preston Pysh  5:48  

Jake, I think it’s so important to really kind of understand the essence of the assets and liabilities on a company’s balance sheet. What for Fairfax really stands out to you on their balance sheet?

Jacob Taylor  5:59  

Well, I think that Fairfax should be analyzed just like any other insurance company. We think about that and they take money now in premiums, what do they end up doing with it? How do they transform those premiums into assets, and then eventually use those to pay back claims? What’s left over after that?

When I look at Fairfax’s balance sheet, they have about $10 billion in cash, about $15 billion in bonds, and about $5 billion in stocks. Then below that, you’ll have, call it, $3 billion in what I call joint ventures, which are just investments that they’re making that they have to recognize on their balance sheet as ownership. About $700 million in derivatives and then $2.5 billion that’s invested in Fairfax India and Fairfax Africa, then you have about $12 billion in intangibles and other assets. 

Now, against that you have $7 billion of debt and about $40 billion of predicted insurance liabilities. They have about $30 billion in what I would call liquid assets versus about $47 billion in liabilities that have to eventually be paid. 

Obviously, those two numbers don’t exactly match up and you’re going to need some kind of asset growth to meet those future liabilities. What’s a little bit funny is that Prem and team have been maligned as bad stock pickers lately. However, what’s interesting is that only $1 in $6, I would say, of the liquid securities are actually in equities. 

It’s a little bit ironic, actually. They’ve been actually helped by these regulatory handcuffs of insurance and had to be weighted into a lot of bonds. That’s helped their investment results. So it’s a little bit funny to see people who have an incredibly long good track record but sort of like, “What have you done for me lately?” 

A lot of value guys have struggled a little bit. They have actually been bailed out a little bit by the fact that they have so many bonds based on their insurance operations. 

Stig Brodersen  7:49  

Fairfax has an impressive track record, like you also mentioned before: 18.5%, measured in US dollars. That is since the present management took over in 1985. 

Now, when you look at Prem Watsa’s letters to shareholders, you can’t help but see some similarities to Buffett’s letters to his shareholders, which is amazing if you want to learn more about insurance and if you want to learn more about Fairfax.

However, it’s also quite clear, if you look at the numbers of the track record, where that 18.5% came from. It came from the very beginning and not so much recently. You could also argue that one reason why this decline in the performance has happened is because Fairfax’s market cap is only $10 billion plus. That obviously limits the universe of potential investments. 

Even if we count for that, it doesn’t really explain why Fairfax has been trailing the S&P 500 since the financial crisis. I’m curious, Jake, what are your thoughts on why Fairfax has suddenly started to underperform?

Jacob Taylor  8:52  

You’re right about the book value growth over that time period. Just to provide a little context around that. When they took over, it was $1.52 in book value in 1985. Now, it’s roughly $486. So over that same time period, the share price has compounded at 16.6. per annum.

It’s helpful to break up… In an insurance company, there are really two key variables. The first one is their combined ratio, which is the premiums that they accept versus the losses that they have to pay out. Basically, how profitable are your insurance operations? 

Then the second thing is what do you do with the money that you get? What is the return on the investment? It’s helpful to break up Fairfax into multiple time periods to trace the history. 

If you look at 1986 to 2005, their combined ratio was 105%, which means they were losing money in their insurance operations, but their investment returns were around 10% per annum. Bad underwriting but great investment results.

Then 2006 to 2010, the combined ratio was 99%. Investment returns were 11%. A lot of that had to do actually with… Prem made the same bet that a lot of guys got very famous for making, which was basically shorting the housing bubble, the CDS on housing. 

You could almost say that this was sort of the golden age for Fairfax. They had good underwriting and they had really good investment returns. It could also sort of point to the idea that Fairfax probably does better during downturns and maybe not so good during bull markets. 

From 2011 to 2016, combined ratio of 96%, fantastic. Investment returns, 2.3%, very anemic. What happened? 

Well, Prem was concerned, especially in the later part of that period with where the market was. He had a lot of hedges on. That’s a little bit equivalent to driving around with the parking brake on. 

What’s interesting is they actually still have $100 billion of notional value in these deflation hedge bets, CPI linked, that are carried on the books at only $7 million. So they’ve been written down almost to zero, these hedges. 

However, you could imagine an alternate universe where maybe the market crashes in 2016. It looks very much like that 2009 to 2010 period again. They look like geniuses and no one’s questioning their track record at all.

From 2017 to 2019, combined ratio 99% and investment returns is 5.6%. So not bad, that’s sort of like middling, but that’s still going forward. That’s going to take a little while to get to that 18% or to maintain that 18% they’ve had if you’re only getting, call it 1% on your operations and 5% on your investment book. Obviously, it’s going to take more to get back up to what they’ve been doing. 

My understanding is that, in general, the insurance pricing market has hardened quite a bit lately. That’s a good sign for the premiums that Fairfax will be accepting. There’s potential that there’s probably good underwriting happening right now.

The other thing to look at is that their bond book that they have is very short duration, most of it is less than five years. It has this blended rate of 3.6%. If you have locked in 3.6% for the next five years, it will be tough to get to 15%.

However, they run their operations very conservatively and they’re not the only ones who have been hurt by these low interest rate environments. I mean, every bank and every insurance company is suffering through this. 

Though they’re very conservative and they’ve tended to lately take more owners’ debt and prefer pure equity. They’ve limited their downside a little bit while also accepting some smaller upsides, which we’ve actually seen Berkshire doing more lately as well. 

The other thing too that is important to note is that over the last five years, it really hasn’t been the S&P 500. It’s been the S&P five. What I mean by that is Microsoft, Amazon, Google, Facebook, and Apple have accounted for plus 250% over the last five years. The rest of the S&P 500. 

Those other S&P 495 are up 25% total over the last five years. If you missed those five stocks, which Fairfax did, you’re going to look bad against the S&P 500, because there just wasn’t much else to be had. 

Especially, they’ve been more internationally focused than a lot of other companies and also more resource focused, natural resource focus, which I don’t know if that’s like a Canadian thing. It seems like everybody in Canada likes natural resource companies. That explains a lot of why we would say they’ve underperformed the S&P 500. 

However, I’m not even sure if S&P 500 is an appropriate benchmark for Fairfax’s operations because they are so much more global. I’d probably pick more of a global index, maybe MSCI or something. Maybe even more bond exposure as well, because they just have a more full book. They’re not ever going to be 100% US equities, right? 

That’s what S&P 500 kind of represents as a benchmark.

Stig Brodersen 13:48

I really like how you phrase that there, Jake. I used to own stock in Fairfax, quite a few years ago. To me, the role it had in my portfolio was very much protecting my downside risk. That was very much how I saw it. I guess you could say the same thing about Berkshire.

The upside is one should probably not be too blinded by the 18.5% or the 16.6% you mentioned before, depending on whether you’re looking at book value growth or stock price growth. The downside protection, especially when you go in and look at the balance sheet and the different types of investments Prem Watsa has made. 

Moving on here with episode, Jake, we’ve been emailing back and forth here before the interview. You originally wanted to talk about Fairfax Africa, because that was where you saw the most value. 

However, now that we are talking about Fairfax, the parent company, do you see any value there? Perhaps could you provide a range of intrinsic value if we want to put the stock on a watch list?

Jacob Taylor  14:44  

As maligned as price-to-book is as a factor these days by investment professionals, I still think it’s a very appropriate place to start for valuing banks and insurance companies. 

The current price-to-book of Fairfax is point .69, so call it 70 cents on the dollar. Now, if you go back and look over the last 15 years, the average price-to-book Fairfax has traded at is 1.16. The standard deviation of the price to book over that 15 years is .133. 

I then thought, “Let’s just take a base case being what’s the long run average that Fairfax has historically traded at? Then we’ll multiply by that price to book and what would that tell us that we should expect for the share price.”

So 1.16 gives us a $485 share price, which is plus 68%, roughly from where we are today. That’s actually not that bad. Fairfax is cheap right now. 

Now, just for fun and I don’t typically do this because I recognize that the investment world has much fatter tails than what a standard deviation… doesn’t conform to standard deviations, but this is a starting point.

One standard deviation to the upside, I would say, get you to 1.3 price-to-book, which implies a $540 price, which is 88%, from where we are today. Then let’s say one standard deviation downward gets us to basically like one times price-to-book, and that’s $430 price, which is about 50% up from where we are. 

It’s definitely cheap. If you think that Prem and company have any talent still, I think you’re getting a pretty good bet. You’re paying a reasonable price for that bet.

Preston Pysh  16:22  

Jake, let’s go ahead and transition into the second part of the interview here. We’re going to talk about Fairfax Africa. Talk to us a little bit about this company.

Jacob Taylor  16:31  

Let me start with I think last time that I was on, I gave the story about talking to Charlie Munger and how he told me that I should be fishing where the fish are, and not fighting all the other cod fishermen for where everyone else is looking. 

I sat down and I’m staring at the globe. I’m spinning it and what do I see? I noticed Africa, and it’s staring me right in the face. I started doing some research. I’m going to share some numbers with you about Africa that I think are quite interesting and really a bet on Africa is a bet on three things: demographics, geography and infrastructure. 

There’s this saying that demographics are destiny. The UN projects that there will be 1.3 billion people added to Africa by 2050. That they will have a 1 billion person middle class. That’s six times the size of the US middle class. That’s an incredibly big population to be servicing goods and services. There are going to be a lot of people living very reasonable lives in Africa by 2050 is what I would guess.

The other thing is that Africa is very young. The median age right now in the US is 35, China is 37, Europe is 42, Japan is 46. The African median age is 20, and 70% of Africa’s population is under 30 years old. They are incredibly young. They’re young and they’re hungry. I think those are two good recipes for eventually making large economic strides. 

The other thing is there will be 90 cities in Africa of 1 million plus population by 2030. There’s this interesting book by Geoffrey West called “Scale,” where he talks about how the doubling of the size of a city more than doubles the output of both wages and patent output. It’s due to density and network geometries. 

Now, you also get more than a doubling of crime and illness and other things. You could sort of say that cities make a doubling of everything that’s human. But it’s a 1.15 times multiplier. So, imagine 90 cities with more than a million people working, solving problems. It’s actually a very exciting time, I think, for Africa. 

Now, let’s talk about the geography of Africa. If you look at a map, the Mercator projection greatly distorts reality. Africa is huge. It’s a further flight from Cairo to Johannesburg, than it is from the US to Europe. It’s over an eight hour flight. Africa has three times the landmass size of Europe. It’s 11 million square miles. 

A lot of us think about Africa, we say, “Oh, it’s all desert, right?” But it’s actually wrong. It has 60% of the world’s arable land. It’s not hard to imagine that eventually they will  figure out how being geographically located between the East and the West, they could be a very advantageous place to be sort of the world’s breadbasket. 

Now, there are 100 and 80 trillion cubic feet of natural gas off of Mozambique alone, which is 20 years worth of European demand. That’s just Mozambique. 

The other thing is that there’s one fifth of the penetration testing compared to OECD soil. So, they just haven’t dug into the African soil like they have all the other rest of the countries. Who knows what other kind of buried treasures are in there, whether it’s petrochemical or rare earth minerals? There are all kinds of opportunities there. We just don’t even know yet. 

Now, let’s talk a little bit about infrastructure. In the US, we use 19 times the electricity even measured in kilowatt hours per capita than Africa does. The US has 6.2 times the rail density. The BRICS, which are Brazil, Russia, India, China, have five times the road density of Africa. So, there are lots of opportunities for useful infrastructure to be built to improve the quality of life there.

What’s interesting is that one hypothesis is that technology is really going to help out because you’re going to be able to avoid a lot of the potential sunk cost of infrastructure that we currently have. 

Imagine skipping over landlines and going right to cell phones. Africa already actually has the most mobile payment accounts of any continent. They’ve taken banking to their phone faster than we have in the US.

A little quiz here, how many African companies are there with more than $1 billion of revenue?

Preston Pysh  20:40  

Oh, my God! I have absolutely no idea.

Jacob Taylor  20:44  

Okay, so the average guess is 50, but the actual number is more than 400. 

To give you a little context, there are 400 people per retail establishment in the US. There are 60,000 people in Africa per retail establishment. It doesn’t take a lot of foresight to imagine a simple business like Walmart, McDonald’s or 7-11 being able to grow rapidly in that kind of environment under the right conditions. 

Let’s take all those numbers. What do we do with them? I think we have a reasonably sound argument for that there are some strong tailwinds, but how do we participate in that, right?

That’s when I happen to see that Fairfax had launched a fund specifically to invest in Africa. I trust them to do the due diligence on the ground that I’m not able to do 10,000 miles away. I know that they have sort of a value tilt, which is what I’m drawn to. They will be investing on my behalf in Africa. 

Now, Fairfax, the parent company, owns 59% of Fairfax Africa. So they have invested almost 60%. The funds that are in that fund came from the parent company. 

Now, there’s a transaction that’s going to be coming up soon that they’re voting on that will diminish them down to 32%. Most likely, if it gets approved, but they’re still going to retain 53% of the voting rights. They’re still in charge of this thing. 

However, it’s not perfect, right? There are some issues. Nothing’s ever perfect. So to operate the fund Fairfax, the parent company, charges management fees on the fund, and it’s a half a percent for uninvested money and 1.5% on invested money. For that fee, they have to provide a CEO and a CFO and manage these investments. 

Now, Fairfax can earn performance fees, which is 20% above a 5% hurdle measured every three years. The good news is today, that hurdle is a long ways away from where we are. They’re not eligible for any performance fees until it’s back up to $11.81, which is light years away from where we are today. 

This new transaction with this company called Helios is… My understanding is the economics will now be shared with Helios and that Fairfax is effectively outsourcing more of the boots on the ground to a group that’s been doing this since 2004. 

The other thing you can do is actually buy Fairfax, like what we were talking about as a hedge to your expense structure in Fairfax Africa, because now you’re owning the fees that are being paid. There’s a lot to like here and we’ll get into a little bit more probably in a minute about valuation, but that’s a good place to stop.

Stig Brodersen  23:18

I used to own Fairfax. I also used to own shares in Fairfax Africa. However, I remember my thesis for that was very different. 

I saw a lot of the same growth factors, as you saw. I wasn’t too concerned about the downside protection. I also might push this in *inaudible* a lot smaller in Fairfax Africa. 

What I really liked about Fairfax Africa, in preparing also here for the interview and reading through their financial statements, as opposed to a company like Berkshire Hathaway, it’s a lot simpler to go through the individual investments one by one. Simply because there aren’t too many. *inaudible* Fairfax Africa owns more than 4% stake would be an obvious place to start. 

However, I also remember reading up on South African grain storage, Nigerian banking, topics that definitely started outside my circle of competence, to say the least. 

Please talk to us about how you analyze Fairfax Africa’s investments and also the process of widening your circle of competence.

Jacob Taylor  24:19  

Let’s talk about the circle of competence for a minute. It’s really about finding and interpreting information. How do you do that? I don’t know if you know this, but 18% of the matter in the universe is visible, and the other 82% is dark matter. 

I’ve wondered if that same ratio actually applies to these businesses that we study, maybe we get a glimpse at 18% of the relevant facts based on what’s reported to us. Then there’s another 82% of this person doesn’t like this person inside the company, or this competitor is coming for the company and we don’t even know it. 

There are all kinds of very relevant facts that we probably don’t have access to. There’s always more than we can know than being outside passive shareholders. This is especially true if you’re 10,000 miles away from where all the action is happening. 

That requires a lot of trust in management. To be honest, it’s been a little rough for Fairfax Africa so far. You have to take a very, very long view of trust that these guys did not get really dumb overnight, all of a sudden. 

Then the other thing too is that the price that you pay, you can mitigate a lot of problems with the price that you pay. In fact, there’s a great quote by Buffett, he says that, “Price is my due diligence.” So if you get a low enough price, it requires less hurdle of having to understand every single little intricate moving piece of inside of an investment thesis. 

Really, the bigger question is, how stupid do you think the Fairfax guys are? Do you trust more recent market quotes that they have to mark their book to? Or do you trust their long term analysis of what they’re working on? It’s a question of how efficient do you think markets are? 

Let’s look at some of the numbers here that are inside Fairfax Africa. Their public investment in Atlas Mara, they’ve put in $159 million. They’re carrying it on the books at $34 million. So that’s an 80% haircut. Their investment in CIG, they have put in $55 million, they’re carrying it as $6 million. That’s a 90% haircut. Their loan book is $87 million, carried at $79 million, that’s a 10% haircut.

The private equity side, AGH is $87 million, carried at $63 million. That’s a 28% haircut. Philafrica, that’s a 35% haircut, grow capital is 75% haircut. So all total, they have $509 million that they’ve deployed, and it’s carried on the books at $299 million. That’s a 41% haircut. 

You have to ask yourself, is fair value really that 41% loss? Or do these guys know what they’re doing and these are just more short term quotation losses? That’s really, I think one of the key things of untangling this investment.

Preston Pysh  27:04  

Jake, when you’re looking at a company like this, how do you account for the currency risk that the company is going to obviously go through for the local currency that they’re dealing with versus converting that back into dollar returns?

Jacob Taylor  27:20  

Yeah, that’s a great point. In just the first six months of 2020, Fairfax Africa recognized $26 million in losses just from foreign exchange. 

I think my counter to that would be that no fiat currency is a layup in today’s world. The dollar is the reserve currency now, but that’s not etched in stone. There could be a day where maybe that FX actually helps. 

For me, personally, I have plenty of assets and liabilities denominated in dollars in my portfolio, so I don’t mind getting some other exposure to other currencies. All the research I’ve done on hedging indicates that it tends to balance out with the costs over time and that there’s no real advantage to it. 

The other thing too, is that a weaker currency can actually be a plus sometimes because it can make your exports more attractive in a country. So there can often cause a little export economic boom because of a devaluation. It’s not 100% clear that it’s all a problem.

 

Like I said, there’s no fiat currency that is really backed by much of anything these days. If someone knew where the great currency was that could solve all these problems, I’d be all ears.

Stig Brodersen 28:28

Fairfax Africa is a fairly new stock, having only traded since February 2017. As you also mentioned before, Jake, the performance of the stock hasn’t been as hoped. Though having said that, do you see Fairfax Africa as a long term compounding company? Or is it more similar to what Warren Buffett would call a cigar butt? 

Jacob Taylor 28:51

It’s not liquidating so I wouldn’t really consider it in the cigar butt category. However, it definitely qualifies as a 50 cent dollar, I think. I’ll walk through the math on that. 

Right now, the book value is $6.62 per share, which equates to $390 million total. We talked already about how dramatic the mark-to-market losses are there. Those are shown in that $390 billion. 

Inside of that, you have $86 million of cash, $161 million of bonds and loans, and $136 million in stocks. Now, currently, there are $59 million shares outstanding, and let’s call it a $3.30 price ish. That’s a $200 million market cap implied. We’re already at a price-to-book of 0.5. 

Now, I would say that this is a compounder? Potentially, if and when the businesses start to catch, you start getting some investment returns. The underlying businesses within the structure start to compound, that will be reflected eventually.

However, this is an incredibly long term opportunity and this is the perfect thing for what I call a coffee can approach. You buy some of this, you stick it in a coffee can. Then you bury it in your backyard. You don’t look at it for 20 years and you come back, then you’re surprised to see what happened.

Preston Pysh  30:12  

Jake, talk to us about the catalyst that has recently caused the price to go down and then what do you think the catalyst will be for a recovery?

Jacob Taylor  30:22  

Yeah, the recent catalyst, I have to assume has been like the rest of the world has recognized the economic impacts of COVID. For whatever reason, the US, especially tech, like we talked about, have kind of remained blissfully unaware of it. So it’s been beaten up lately. 

Now, a potential positive impact might be the Helios Investment Partners. A little background on them. They’re an African PE firm, basically, that started in 2004. They run about $3.6 billion on their platform of funds. They’re taking over operations and sharing economics with Fairfax. 

I’m hopeful that this will give maybe even more opportunity to find interesting investments within Africa for Fairfax Africa, because the guys running it had been doing this for longer than the previous managers who were doing this. That was announced on July 10th, this potential change. 

The stock was flat at that time, so no one seemed to care. I don’t think anyone’s looking at it. You have to recognize that this is a very low volume stock, it trades less than $20,000 per day. 

Any time you have an incredibly low volume stock, you have to really take every single current market price with a very large grain of salt, because there are just not many dollars behind the market movements. It’s a very light load for Mr. Market to move the price around when the volume is that low. All the more reason why the coffee can is probably the smart play.

Stig Brodersen  31:46  

It’s a good point. You mentioned having invested in Fairfax Africa. I remember when I wanted to get out of the stock, and it was in a downward trend at the time. Because it’s so thinly traded, it can be very expensive to hit any of those bits that you see out there on the screen. So it’s definitely something to consider for investors. 

I also want to say that it should also be seen as an opportunity, especially for retail investors. If there’s anyone sitting out there with their billions and billions of dollars, this is probably not the stock that they want to build, or at least if they want to, it’s going to take us years to build that performance. Then, they could probably never get out of it unless they sell like a *inaudible* himself, but it’s just something that’s worth noticing.

It’s just like when you hear about this liquidity and someone had been buying Apple stocks, or Google stocks or whatnot, it’s sort of like difficult to explain, the pain that can be involved with liquidating a position or even building a position in something that’s so thinly traded. Anyway, it was just a quick note that I wanted to mention.

Jake Taylor  32:48  

Use limit orders. Be careful.

Stig Brodersen  32:51  

Yes, use limit orders. Definitely be careful. Wise words, for a stock like this. The stock today is trading at $3.20. What is your process for estimating the intrinsic value of Fairfax Africa?

Jacob Taylor  33:08  

Let’s start with $86 billion on the balance sheet in cash. 

I’ll let you make your own discounts to that if you think that it’s being mismanaged and that $86 million isn’t worth what it is in those guys’s hands. However, I’m going to count it as $86 million at the top. So far, they’ve laid out $509 million in investments and it’s carried it at, call it $300 million. 

As a thought exercise, let’s assume that the market was really pessimistic of that basket of securities. We remark those assets to only a 20% loss. We’re moving that number back up to $400 million from $300 million. Now, $400 million plus the $86 million in cash, that gives us a $486 million value. Remember that the current price-to-book is .51. 

I would say as a base case, let’s assume that you can just get one times price-to-book on this, which seems appropriate if it’s a reasonably managed fund. We’re adding back that 20% that we considered an overly pessimistic mark-to-market and adding a $486 million book value, that would give us a $486 million price, which is 143% from where we are today. 

Let’s take an overly bearish case. We don’t add back anything. We keep book value at $390 million. We take the worst price to book it’s ever traded at which was in early 2020, which is actually .3 price-to-book and that gives us $117 million implied value. That’s 40% down from where we are today. I would say that’s probably a little bit overly bearish but just for fun, let us put some bookings on this. 

Now, let’s make a little bit of a bullish case for this. Let’s assume that these guys with a 35-year track record are not as dumb as the market is making them look right now. We do a full add back of that $509 million that’s been laid out already. Let’s just assume that it goes back to par basically. We put the $86 million in cash back in. 

By the way, we’re not assuming any returns on any investment here. This is just to go back to par, right? So it’s still relatively conservative. That gives us a $595 million book value. 

The highest price-to-book that it’s ever traded at was in 2017, which was 1.47 times. Let’s use that as our multiple and that gives us a $875 million market cap, which is plus 338%, from where we are today. 

Let’s assume that as sort of a blended probability that our base and our bear and our bull cases were all equally likely 33% chance of either of any of those three happening. Well, that implies 146% expected return on those blended probabilities. There’s a lot of potential upside here, if they can sort of get things together. Maybe the market stops discounting everything as hard as it has been for the things that they own. 

You sort of have two layers of cheapness, you have the underlying which has gotten beaten up and very cheap. Then you have the bigger, the wrapper that it comes in, which is the fund, which is also discounted heavily. There are a few different ways to win if you get any kind of reversion to the mean.

Use limit orders. Coffee can it. Buy it for your grandkids and come back in 2050 and the world has changed dramatically where Africa is a very reasonable place to do business.

There’s something I find to be personally very rewarding about the idea that there are so many other people in the world who are hopefully going to have better life experiences in places where historically has been a pretty rough place to have been born. So let’s all hope.

It would be nice to root for Africa to get a chance, again, to be kind of in the sun. It would be poetic justice for them. I think it’s always nice when you can root for both a good outcome for humanity and also for your portfolio.

Stig Brodersen  37:00  

Well said, Jake. Okay, we would really like to ensure that everyone feels that they’re completely on board. 

We’ve been talking back and forth about limit order this, limit order that. For a lot of people listening to this and are perhaps new to investing, they ask, “What do you mean by limit order? Don’t you just buy or sell?” There are different types of order. Why is it that a limit order is so important for a company like Fairfax Africa?

Jacob Taylor  37:22  

Well, let’s say that you just put in what’s called a market order. That just means that the brokerage account will go and fill that order, no matter what the price. They’re going to buy whatever shares are available at whatever price and they’re going to get your 50 shares if you put in 50. 

Now, if you put in a limit order, it will buy as many as it can up to that particular price. With something that’s as thinly traded as Fairfax Africa is, even if you’re not a big investor, you can move the price around quite a bit and change the economics and the bet that you’re making without even realizing it. 

If you were to, let’s say, push the price up 50%, because you weren’t paying attention to your order. Now, all of a sudden, you bought shares that were 50% more expensive. They probably don’t fit the math that you did before you put in the order. 

I would say, especially in today’s high frequency trading world where everyone is trying to front run everyone, I’d never put in market orders for anything, even liquid stocks. 

I always put in limit orders. It’s a better way of being disciplined. Sometimes it bites you in the butt because you don’t get as much filled as you wanted. The price moves away from you and you say, “Ah, dang it! I probably would have paid a little bit more to get those extra shares but I didn’t.”

That happens but the other side is the very bad outcome where you bought a bunch of shares at a price much higher than you were anticipating. Now you will say, “Oh, that was not what I was aiming for.”

Preston Pysh  38:48  

Jake, we really, really enjoy having you on the show. We look forward to the next time that we’re going to be able to do something like this. In the meantime, give people a hand off where they can learn more about you.

Jacob Taylor  38:59  

On Twitter, I’m probably more active there than I should be. I’m at @farnamjake1. 

I do the “Value: After Hours” podcast with our mutual friend Toby Carlisle and Bill Brewster. 

If you want to learn more about our investment company, it’s www.farnam-street.com. All of our letters are public. I try to spend a lot of time writing good letters because I want to go back and be able to read them 20 years from now and not be embarrassed by what I wrote. 

Then lastly, my book came out last year called ‘The Rebel Allocator.” It’s a good gift for young people if they’re interested in business and investing. 

I actually wanted to condense a decade plus worth of learning that I’d been doing about business and investing and to write something for my kids. Then I figured why not help everyone else out with it? So that might be a good gift idea for that young person in your life.

Stig Brodersen  39:49  

Yeah, I could definitely echo that sentiment. I read your book. I liked it. It was a great book. Actually our friend, Sean Murray, one of the hosts here on the network, did interview you about that book. We’ll make sure to link to that in the show notes. 

I guess that the listener would probably notice a few similarities to a few investors that we follow close to here, including Warren Buffett and Charlie Munger, and a few other people. So, it’s definitely a book worth picking up, not just for you being a seasoned investor but also if you want to give wisdom to the new generation of investors. 

Jake, thank you so much for your time. We know you’re super busy. Thank you so much for taking time out of your busy schedule to be speaking with Preston and me today on The Investor’s Podcast.

Jacob Taylor  40:32  

Always a pleasure, guys. Thanks for having me on.

Stig Brodersen  40:35  

All right, guys. So at this point in time in the show, we play a question from the audience. This question comes from Tim.

Tim  40:42  

Hey, guys, Tim from Kentucky here. Firstly, love your podcast. Secondly, just wanted to ask you a quick question about preferred stock, specifically preferred stock issued by banks. 

I understand that if interest rates rose, the value of the preferred stock would go down, but might it also be the case that there could be a benefit to the stock because the banks would benefit in the rising interest rate environment? Thanks for any insight you can provide.

Stig Brodersen 41:12  

Tim, I think it’s such a great question, because we talk about bonds and stocks, but we seldom talk about preferred stocks, which is sort of a hybrid between the two. So, please allow me to clarify for the audience what we mean when we talk about preferred stocks. 

  

Preferred stock is similar to a bond in the sense that it pays dividends. Dividends for a bond are called coupons, but the two concepts are not too far away from each other.

One important difference is that preferred shareholders receive their fixed payment before the common shareholders but after the bond holders receive the coupons. Also, most often preferred shares do not have a term, meaning that the share is out in the market, and it does not mature in theory. 

In practice, the issue will often buy back at some point in the future, whenever the conditions are beneficial for the company. 

Then what are the similarities to common stock? Well, they have similarities in the sense that it’s a piece of equity in the business. However, that piece of equity will only materialize should that company default and preferred shareholders with that case receive the claims to the business before the common stockholders, but after the bondholders.

Keep in mind that most often it is only bondholders, who would be paid fully or just partly in the case of bankruptcy. That extra layer of safety really shouldn’t matter much for you in most cases.

As you correctly pointed out, the value of your preferred stock goes down whenever the interest rate goes up. The intuition is easy to grasp. After the rate hike, the market can get a higher yield on bonds, or preferred stocks, whereas you already committed your money into this preferred stock, which would relatively make the value of your preferred stock less valuable.

To the second part of your question about whether it will be good for the bank if rates spins up? The answer is also yes. In that sense, you can argue that the news of a high interest rate as an investor in preferred stocks for a bank, it’s still bad, but just not as bad as many other industries. 

You can even make the same claim for a company like Fairfax that we just talked about here today. Their insurance business, everything else equal, will be better off for the higher interest rate. 

However, the implication for you as an investor in preferred stock is that the investment you made in the bank is, everything else equal, better protected, since the bank will make slightly more money with a high interest rate, which would limit your risk of defaulting on a preferred share. 

However, for you, as an investor, please do not see this as a tie score. The interest rate effect on your preferred stock, which is not in your favor, is vastly more important than what you will gain from that stock now being able to conduct business in a slightly more friendly environment.

Preston Pysh  43:56  

Tim, this has been fun hearing this question because I haven’t even thought about preferred stock in a very long period of time. 

Typically, when you see preferred stock issued, you’re dealing with venture capital and people coming in with enormous resources. They’re coming in to have very special in particular interests met for the large and substantial amount of capital that they’re providing for a company that desperately needs that capital.

However, for the preferred stock that’s out there on the public markets that pretty much anybody can gain access to through the appropriate broker. It is just not a market that I participate in. 

When this question came up, I really remember… Stig, I don’t know if people are familiar with this, but Stig and I wrote a summary guide to “Security Analysis.” 

I distinctly remember writing some of these sections in the book because when we were doing the summary guide… because Ben Graham was also not a very big fan of preferred stock for the general public that they had access to that were being sold. 

In chapter 14 of “Security Analysis,” this is where Ben Graham starts talking about preferred stock. I’m reading a section from our summary guide. Anyone can look for this on Amazon if you’re interested in and having this. 

It’s actually kind of a useful little book to have alongside “Security Analysis” if you’re trying to actually get through the book. But this is what Stig and I concluded in our summary guide about Ben Graham’s writings on preferred stock. This is how it goes: 

“Although Graham has periodically mentioned preferred stock before this chapter, this is the first opportunity where he clearly defines his opinions on its role in financial markets. Graham makes no hesitation in identifying his distrust for preferred stock. He claims preferred stock takes the least favorable element of bonds, and packages it together with the least favorable elements of common stock.”

That’s really kind of the quote that I really wanted to read for you. 

The other thing that I tell you, is when you really do start digging in the preferred stock, there are two types. There’s cumulative and then there’s non-cumulative preferred stock.

Non-cumulative basically provides the option for management to not even pay the dividend that’s associated with it. Although that’s a pretty small portion of the overall preferred stock that’s out there, that’s also something that I think you should ensure you look into and fully understand before you buy any. 

In general, I think the reason Graham has this quote, it’s pretty obvious is because you’re getting a security that acts exactly like a bond, but it’s behind the… if the business fails, you’re behind all those bondholders that are sitting in front of you. On top of that you don’t have any voting rights and you don’t have any earnings rights, especially if it’s non-cumulative. 

I don’t want to steer you away from this but at the same time, I want you to be very cautious of this. I think that it really requires a lot of analysis. It requires a lot of thinking about what risks you’re actually assuming and what could actually be paid out to you when you’re behind the bondholders, if the company would go into a liquidation event. 

With the way interest rates are going these days, and how they’ve really kind of polarized a lot of bond yields down to down really low and beyond what would be normal for any type of market condition, I’d be really skeptical that the yield that you’re receiving on the dividends of a preferred stock are actually representative of the risk that you’d be assuming in the event that we would go into a big liquidity event, bankruptcies, and things like that. Just some thoughts to think about. 

Very interesting question. I really haven’t addressed this one in a long time. I know I have some videos out there on YouTube addressing preferred stock. Those are out there as well and I go into a lot more detail how they work. 

For example, how you can filter for them and to find certain preferred stocks. I might have two or three videos on it. I can’t even remember because it was so long ago. If you search for my name and preferred stock on YouTube, they’ll be sure to come up. 

Tim, for asking such an interesting question. We’re going to give you free access to our TIP Finance tool. On our tool, we have a filtering mechanism that helps you find really good value picks. 

We also have a momentum tool that assists all sorts of really neat and interesting things there. It helps you do intrinsic value calculations based on the free cash flows that the company is kicking off and your estimates of what those might be in the future. It’s really easy to use. We’re excited to be able to give that to you.

For anybody else out there listening to this, if you want to get your question played on the show, go to asktheinvestors.com. If your question gets played on the show, you get free access to our TIP Finance tool.

Stig Brodersen  49:18  

Alright, guys, Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro 49:25  

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