Fairfax Financial Got Bullish on U.S. Equities in 4Q

By Chris Blumas | Stock Analyst

 Fairfax Financial (FFH) had another stellar year in 2008. Prem Watsa and the management team at Fairfax helped guide the firm to its second consecutive year of record profitability. This is no small feat given the carnage that has unfolded around the globe over the last two years.

Since a pair of Bear Stearns hedge funds collapsed in the second half of 2007, financial institutions around the globe have been rocked to their core. The main reason behind Fairfax's remarkable results during one of the most chaotic periods in modern history was the performance of its investment portfolio. Over the last two years, the firm has generated almost $4.4 billion in net investment gains and increased book value by 85% while many of its competitors realized massive losses, had their credit ratings downgraded, and retrenched their operations. Fairfax continues to sit on ample cash reserves, has excess underwriting capacity, and has never been in better shape financially.

The investment portfolios of Fairfax and its main operating affiliates,  Odyssey Re  and Northbridge Financial, are managed exclusively by Hamblin Watsa Investment Counsel. Hamblin Watsa is a wholly-owned subsidiary of Fairfax with an enviable long-term track record and a penchant for value investing. Over the last two years, investments in U.S. Treasury bonds, credit default swaps, and equity short positions have protected Fairfax's investment portfolio and generated considerable gains as the stock prices of many financial institutions have fallen off a cliff. As a result, Fairfax and its affiliates have been outliers in an industry where risks have proven to be highly intertwined.

While not currently a member of the Ultimate Stock-Pickers' Investment Management Roster, we think that Fairfax's independent thinking and frequently contrarian investment approach can provide investors with powerful insights into portfolio strategy and capital allocation. Ironically enough, the fourth quarter of 2008 was just such an instance, with the company making a dramatic departure from its long-standing bearish stance on the global equity markets. Based on information gleaned from Fairfax's fourth-quarter earnings release, as well as from its 13-F filing, the company took full advantage of the market mayhem to reallocate its investments, removing the hedges protecting its equity portfolio and investing more than $1 billion in U.S. equities when further de-leveraging and panic selling had left few buyers in sight. After adjusting for the firm's controlling interest in Odyssey Re, we estimate that Fairfax's U.S. equity portfolio increased to $3 billion at the end of the fourth quarter.

With insurance premiums collected in both good times and bad, companies that underwrite property and casualty insurance have the ability to buck the trend of forced selling in a depressed market as long as their underwriting results remain sound. Unlike their counterparts in the mutual fund industry, many of which were forced to sell equities during the fourth quarter in order to meet an onslaught of client redemptions, the portfolio managers at Hamblin Watsa actually did very little selling during the quarter. Instead, they took advantage of the market weakness to add a number of new names to the portfolio and increase their ownership stakes in several long-term holdings.

The five largest new positions at quarter-end were  Kraft Foods (KFT) (of which Hamblin Watsa purchased $294 million),  Intel (INTC) ($235 million),  General Electric (GE) ($195 million),  Magna International (MGA) ($159 million), and  Wells Fargo (WFC) ($103 million). Fairfax also added to existing positions in  Johnson & Johnson (JNJ) ($460 million) and  Dell  ($270 million). Although none of these names shows up on our Ultimate Stock-Pickers Top Purchases list, there were six managers that were either building (or adding to) positions in Johnson & Johnson, versus three sellers. Kraft Foods was being purchased by two managers (and was sold by none), Intel saw three purchases (versus one selling manager), Dell had one acquirer (and no sales), and General Electric had three purchasers (versus two sales). Fairfax's new money purchase of Wells Fargo may have been too early, in our view, given that there were only three purchasers versus six sellers during the quarter, and the stock has traded down more than 30% since the beginning of the year, despite trading in line with the market throughout much of the fourth quarter.

That said, it is still refreshing to see a long-term value investor like Fairfax aggressively purchasing high-quality businesses in the face of one of the worst markets since the Great Depression. After taking a deeper dive into Fairfax's investment portfolio, we have noticed a number of unique features that we thought would be of interest to investors. As you can see from the table below, Fairfax had more than three-quarters of its total equity portfolio (excluding Odyssey Re), invested in its top 10 holdings. It also had more than 50% invested in its top five holdings. This concentrated approach toward portfolio construction is a sharp contrast to the average mutual fund manger, which typically owns hundreds of individual securities.

Fairfax (FFH) U.S. Equity Portfolio (as of 12/31/08)
	% of Portfolio (12/31/08)	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Fair Value Estimate ($)	Price/ Fair Value
Johnson & Johnson (JNJ)	15		Low	Wide	50.90	80	0.64
Pfizer (PFE)	11		Medium	Wide	13.38	26	0.51
Kraft (KFT)	10		Medium	Narrow	22.97	37	0.62
Dell	9		Medium	None	10.96	17	0.64
Intel (INTC)	8		Medium	Wide	15.16	23	0.66
GE (GE)	7		High	Wide	12.09	22	0.55
Frontier Comm	5		High	Narrow	7.05	9	0.78
Magna Int'l (MGA)	5		Very High	None	34.77	61	0.57
Wells Fargo (WFC)	3		High	Narrow	19.83	29	0.68
Alcoa	3		High	Narrow	8.63	5	1.73
Data as of 04-28-09 (except '% of Portfolio').

A quick glance down the list also highlights the fact that Fairfax prefers to make somewhat larger bets on firms that have, at least in our view, proven business models and established brands. According to Morningstar's stock rating system, most of the securities listed in Fairfax's top 10 holdings are currently undervalued on an absolute basis and possess an economic moat of some variety. In fact, five of the top 10 holdings had 5-star ratings, our highest rating of value relative to the current stock price, such that going forward we would not be surprised to see Fairfax add to a number of these positions--especially with insurance premiums continuing to roll in the door despite the challenging economic conditions.

With the company in the unique position of not having to deal with the impact of investor outflows, and the markets (according to our research) continuing to offer bargain prices on solid franchises, we think that Fairfax's disciplined and frequently contrarian investment strategy leaves it well-positioned to take advantage of the market weakness, building on an investment portfolio that has traditionally generated solid investment returns for its shareholders.

Disclosure: Chris Blumas doesn't own shares in any of the companies mentioned above.