Tag: FFH

Fairfax gets a short selling hit piece

Muddy Waters put out an interesting hit piece on Fairfax, accusing the corporation of using accounting tricks to overstate its true book value by about USD$4.5 billion. FFH’s stated equity in September 2023 was USD$21.6 billion. This accused mark-down isn’t gigantic, but considering that Fairfax is trading at a healthy valuation over book (about 1.5x 1.2x) a valuation with a constant P/B multiple metric would result in an approximate 20% haircut all other things being equal. The stock is down about 10% today as I write this.

Skimming through the presentation, the bulk of the accusation is centered around the accounting of purchases of various subsidiaries and not taking or being able to cleverly avoid write-downs.

Fairfax is a massively complex entity and the stated financial position of various entities, whether in Fairfax or in other entities that try to do private market equity (or even real estate valuation for commercial REITs!) is ultimately up to a management judgement using some semi-standardized variables. The reality of these valuations are achieved when the entity involved tries to liquidate the venture in question.

The other accusation revolved around the application of IFRS 17 and the subsequent accounting adjustment in contrast to other insurance firms. Among other items, IFRS 17 applies a discounted value to the expected liability component of an insurance contract payout. Muddy Waters accuses Fairfax of being an outlier in relation to some other insurance firms. I have no good way of evaluating this other than that if a company anticipates its insurance payouts longer in the future, the stated liability reduction will be greater.

Finally, from the IPO to present, I did note that Farmer’s Edge was a disaster, including that of Fairfax, and its privatization offer is probably some attempt to internalize Fairfax’s upcoming loan loss on that venture. The amount, relative to the whole Fairfax consolidated entity, is small beans but blowing a high 8-digit figure of money is not chump change for most mortals like you and I!

I’ve looked at Fairfax here and there over the past couple decades and while there was a reasonable valuation case to be made when it was in the 400-500s, I found the stock to trade rich lately, even without the news of this particular short selling report. Ultimately the firm’s ability to dredge out cash flows from its insurance operations (which the metrics are quite excellent if they are to be believed!) is what is going to matter, not necessarily the stated book value of the various subsidiaries and minority investments on its balance sheet – if your assets are generating (this is a made-up number) $2 billion dollars cash a year, it doesn’t matter whether you keep them on your balance sheet at $20 billion or $30 billion – you’re getting $2 billion of cash – just that your return on assets metric will get skewed as a result.

Of course, if you compensate your management on the increase in book value per share instead of free cash flow, you will likely get a result where your management will pull out every derivative contract trick on the planet to artificially goose up the book value number. I suspect this may be the case if the report has any validity.

Either way, I have no position in Fairfax, and not too much interest either aside from watching this as a financial spectator.

Dangers of investing in dual class structures

Apparently some institutional shareholders are feeling the political pressure of the company’s ridiculously high executive compensation schemes. They’re voting against the “say on pay” resolution on the upcoming AGM.

Major Bombardier Inc. shareholder and supporter Caisse de dépôt et placement du Québec is voting against the company’s executive pay practices at its coming shareholder meeting.

It’s one of a number of major North American pension plans that intend to rebuff Bombardier’s compensation program. Some, including the Caisse, have grown sufficiently discontented to oppose reappointing directors to the company’s board.

Bombardier, like most major Canadian companies, submits its compensation program to shareholders for a non-binding “say-on-pay” vote at its annual meeting. Canada Pension Plan Investment Board (CPPIB), British Columbia Investment Management Corp. (BCI), as well as two major pensions from California and one from Florida, also say they are voting “no” Thursday.

At issue this year is Bombardier paying former chief executive Alain Bellemare a severance package of US$12.35-million when he was terminated in March, as well as promised future special payments and potential severance packages to other top executives when a deal to sell the company’s train division closes in 2021.

This is purely political posturing to the public to justify holding Class B shares (2.1 billion outstanding) in the company. Bombardier’s Class A shares (309 million outstanding) have 10 votes each, which give its holders effective control of the company. Bombardier’s Class A shares are currently trading at about a 30% premium over the Class B shares, so the market does ascribe some value to the voting component.

There is little remedy for the subordinate shareholders other than to sell if they wish to voice their opinion. This happens in any dual-class share structure company, where typically the founders get the supervoting majority to stack the board. You have cases like Berkshire (NYSE: BRK.A) and Fairfax (TSX: FFH) where you are being a silent partner to Warren Buffett/Prem Watsa, but you also have cases like Dundee (TSX: DC.A), which have made disastrous capital allocation decisions in the past decade (will they get their act together for the next one? Insiders are at least buying now). There are also firms like Biglari Holdings (NYSE: BH), where the controlling shareholder basically has open contempt for its subordinate shareholders – don’t like me? Go ahead and sell! Zuckerberg at Facebook (Nasdaq: FB) also has expressed the same sentiment – my way or the highway.

In all of these cases, investors, especially institutional ones, should know what they have gotten into. This doesn’t mean they can’t complain, but when it comes to exercising power to compel the board of directors to tell management to change their practices, the influence is very weak since controlling shareholders will always be able to replace potentially dissenting directors with those that favour their interests. In the case of Bombardier, who wants to give up $150-$190k for being a human rubber stamp?

(By the way, this board is far too large).

The only way to get any sort of leverage on an entrenched board is to own enough of the debt in a distressed situation, and then you will be able to get enough attention of management by the time the maturity comes to extract better terms. But these situations are rare, and they more often end up with management engaging in asset stripping and other extraction activities to the detriment of both shareholders and debtholders alike before they finally lose control.

Torstar Acquisition

In January, which felt like a very long time ago, I wrote about Torstar. In fact, at one point I owned shares in the company, but during the CoronaCrisis, I dumped my small stake (which to my mystification, was one of the few companies to receive a bid at the time) simply because the rest of the stock market was on sale.

What is ironic, however, is that a couple business days ago, I put in an order to buy in the low 30’s, but never got hit.

A couple trading days ago (Monday, May 25, 2020), the stock rocketed up from about 33 cents up to 48 cents on about 150,000 shares of volume (this is really unusual for Torstar stock, which is very slow moving):

On first glance, this appears like blatant insider trading. How could it not?

Today (May 26, 2020), the stock buying tapered and some people clearly not in the know dumped stock:

And finally, Tuesday evening, the announcement that NordStar will be buying Torstar for 63 cents per share, cash. NordStar is run by a prominent former Fairfax executive (that still sits on the board). Fairfax already owns about 40% of the non-voting Class B shares and got the consent of the Class A owners, who cashed out at a price that is magnitudes different than how things were a decade ago.

I am guessing Fairfax’s involvement will be acquiring some media clout for a relatively inexpensive price. At 63 cents per share, NordStar is paying $51 million (minus FFH’s ownership, $33 million) in exchange for a company with $69 million in unrestricted cash on their balance sheet, with relatively little on the liability side on their balance sheet. The big black eye is the 56% equity investment in VerticalScope, which is barely generating cash but has a $150 million debt on their balance sheet (I suspect when the ownership changes, that NordStar will be jettisoning this anchor in short order). Operationally speaking, however, I suspect advertising revenues are going to continue to crash and it will be interesting to see how NordStar can re-purpose this investment.

Finally, it isn’t quite clear how much influence Fairfax will have in this, but something makes me suspect there is more behind the scenes.

While I am slightly unhappy that I did not get some Torstar shares in the low 30’s (I was rather late to pulling the trigger), the number of shares I was looking to purchase would not have been material even if I had received an execution on my order. Basically I was caught sleeping and this was another instance of a company that had pulled away from my limit orders.

At least I can take this thing off my watchlist now.

Book Review: The Outsiders – and outsized returns

The Outsiders: Eight unconventional CEOs and their radically rational blueprint for success – by William Thorndike.

I’ll recommend this book. Although it is becoming somewhat dated (copyright date was 2012), it gives the reader a 50,000 foot above the skies satellite view of some hand-picked CEOs that were able to strongly defeat the GE Jack Welch / S&P 500 record during multi-decade periods. They shared a single characteristic – they were able to allocate capital with discipline and ruthless efficiency. Operationally they were able to delegate to competent individuals and decentralization to the point of abdication was another theme.

If this book was written today and for Canadian CEOs, I would think Mark Leonard of Constellation Software (TSX: CSU) is an obvious candidate. He has delivered 42% compounded annual returns over the past decade, and 38% since going public in May of 2006 – notably still earning this return through the 2008-2009 economic crisis.

Reading (mostly written by) Mark Leonard’s Shareholder Q&A letters is fascinating insight on the company and how management thinks. It is indeed a shame that I never heard of this company until it was far, far too late. Sadly they are looking at future returns in the upper teens from their current size.

I have also taken great pleasure of reading Tyler’s compilation of quotations by TransForce’s (TSX: TFII) CEO Alain Bedard, which is a trucking and logistics company. TFII has performed at 22% compounded annually over the past decade, and about 13% since going public in October 2002 (in both cases dividend-adjusted). For a low margin business such as trucking, this is needless to say impressive.

There is a bit of retrospective bias in this book, however. Most individuals would probably regard Prem Watsa of Fairfax (TSX: FFH) as being a very good CEO, but his dividend-adjusted CAGR over the past decade has been 9%, and over the past 20 years has been 6%. Compare this with CEO Duncan Jackman of E-L Financial (TSX: ELF), which has been approx. 9% over both the past 10 and 20 year period. E-L Financial, in my opinion, is the least attention-seeking publicly traded corporation with a market cap of over a billion dollars.

For the sake of comparison, the TSX’s performance (dividends reinvested) over the past 10 years has been 6.6%. The main index (dividends not reinvested) over the past 17.7 years (which is how far the data goes back when they did a major change to the index) is 4.5% – adding in dividends would be another 3% or so. So a 9% CAGR performance is a slightly overperformance over the TSX, but posting returns into the teens and better is clear outperformance.

Preparing for a year 2000-type scenario

I am relatively convinced that although the economy appears to be muddling along with a low real growth rate, the markets are pricing in a growth trajectory that is optimistic. We are likely to see increased volatility in the future.

There are some good doomsday type stocks, but perhaps none would be better than Fairfax Financial (TSX: FFH), who have continually prepared for a gloomier future. They have hedged their entire equity portfolio against the S&P 500 and also have purchased CPI-linked derivatives that would profit in the event of a deflation. From Prem Watsa’s annual report, he believes that any credit event in China would cause commodities to collapse (they consume 40-50% of most commodities from iron ore to copper) and it would have an impact on the mining industry. He goes on to state that world iron ore capacity has increased by more than 100% in the last ten years, mainly due to increased Chinese demand.

The excesses in the Chinese real estate market are quite well known and have been reported extensively in the past, but just like what happened in the USA from 2004-2008, it might take some time before any credit events emerge. In addition, the Chinese government has proven to be very adept at managing the situation.

While I don’t profess to if or when such a credit event will happen, if it does occur, it would be very adverse for Canadian investors holding equity and debt in such entities. Fairfax is an interesting bet for a doomsday scenario, but at CAD$470/share they are considerably priced above book value (which is US$339 at the end of 2013 or about CAD$374 at current currency rates). Given the performance of Fairfax’s businesses, one would expect a modest premium over book, but 25% over book seems a bit heavy to swallow. The company also sold 1 million shares at CAD$431 (CAD$417 after expenses) in November, but this was also in relation to their purchase of Blackberry convertible debentures.