A Few Investment Ideas from Fairfax's 13-F

By Chris Blumas | Stock Analyst

It was a busy first quarter for the team at Hamblin Watsa Investment Counsel, the wholly owned investment management subsidiary of  Fairfax Financial (FFH), a recent addition to the Ultimate Stock-Pickers' Investment Manager Roster (which we had highlighted back in April for its relatively large purchases of U.S. equities in the fourth quarter of last year). Unlike the majority of the other insurance firms on our list, which we talked about in recent articles dedicated to  Berkshire Hathaway (BRK.A) (BRK.B),  Alleghany , and  Markel (MKL), Fairfax was actively buying and selling securities during the quarter. The firm's biggest moves involved two beaten-down financial firms, which although not currently trading at prices we'd consider buying them, were deep 5-star names during the first quarter. A much closer look at Fairfax's actions sheds some additional light on how the firm continues to outpace the market and helps us produce a few more stock ideas our analysts believe are worth buying right now.

Fairfax Continues to Outperform
In a three-month period that saw the S&P 500 Index (SPX) decline by nearly 12%, Fairfax's actively managed U.S. equity portfolio declined just 7% to $2.8 billion. (Our total portfolio figures for Fairfax exclude the firm's controlling stake in  OdysseyRe , which, while worth $1.6 billion at end of the first quarter, remains a fairly static position within the portfolio and, as such, skews the composition of the firm's more actively managed investments.)

During the quarter, the company trimmed its stake in each of the top five holdings from the previous quarter, a list that included  Johnson & Johnson (JNJ),  Pfizer (PFE),  Kraft Foods (KFT),  Dell , and  Intel (INTC), two of which--Kraft and Intel--were new money purchases during the fourth quarter of last year. While the selling was balanced among most of these investments, Fairfax aggressively trimmed its position in Intel, reducing the number of shares held by more than 50% during the quarter. The company also completely eliminated stakes in  Abbott Laboratories (ABT),  AstraZenca PLC (AZN),  Mohawk Industries (MHK), and  Progressive (PGR) from its portfolio.

Fairfax Bets Big on Two U.S. Banks
So what did Fairfax do with the cash it raised through these asset sales? The firm sank more than $230 million into  US Bancorp (USB) and raised its stake in  Wells Fargo (WFC) by almost 500% to $285 million. During the first quarter, the share prices of these financial institutions had fallen off a cliff, declining by 42% and 52%, respectively, from the beginning of the year. At the end of the quarter, these two investments alone accounted for 18% of the firm's portfolio (excluding the impact of OdysseyRe on Fairfax's holdings). Such a large bet requires a strong belief in the viability of these banks, which, like many other U.S. financial institutions, have been pummeled by the collapse in the credit and real estate markets.

The biggest concern for most investors with the U.S. banks has been credit quality and capital adequacy. In late February, federal regulators launched stress tests of the largest domestic banks. US Bancorp passed the stress test and was deemed to be sufficiently capitalized. Nevertheless, the bank raised $2.5 billion in additional common equity and has been given permission to repay funds received as part of the government's Troubled Asset Relief Program (TARP). Our analysts covering the banking sector view this move as a distinct positive and a sign of the bank's strength, and they believe that US Bancorp's conservative lending practices and large fee-based payment processing and wealth management businesses should allow the bank to deliver operating profits that are more consistent than its peer group.

For Wells Fargo, the stress tests revealed an equity shortfall of almost $14 billion that was quickly reduced with a stock offering that raised $8.6 billion. The bank expects to make up the remaining shortfall through internal measures before the government's deadline in early November. Our analysts continue to believe that Wells Fargo's business model and superior execution provide it with formidable competitive advantages that should allow it to continue gaining market share through the industry downturn. Fairfax's big bet on these two banks during the first quarter was further bolstered by additional purchases in both names by Berkshire Hathaway. As we noted in a recent article, Berkshire increased its stake in these two banks during the first quarter, with Warren Buffett expressing confidence in the operating models of each of these organizations--even with the considerable stress and uncertainty facing the banking industry--at his company's annual meeting.

Strong Performance from Top Holdings
Since the end of first quarter, each of the top 10 holdings in Fairfax's investment portfolio has appreciated significantly with the average investment up 25% and Wells Fargo leading the way with a whopping 80% return.

Johnson & Johnson continues to be Fairfax's largest investment holding. This 5-star stock stands alone as a leader across the major health-care industries. Our analyst Damien Conover believes that the company's ability to maintain a diverse revenue base, a robust research pipeline, and exceptional cash-flow generation affords it a wide economic moat. The strong cash generation has enabled the firm to increase its dividend for the past 45 years and allows the company to capitalize on acquisition opportunities that will augment future growth.

The only other 5-star name in the top 10 holdings is Pfizer, which our analyst Damien also covers and which he believes will be more of a cost-reduction story than a top-line growth company over the next several years. The company's sheer size provides it with the largest economy of scale in the pharmaceutical industry, and that was even before the  Wyeth  acquisition was announced. He believes that the integration of Wyeth will not only strengthen Pfizer's diverse drug offerings, but offer substantial opportunities for further cost savings for the pharmaceutical giant.

Another 5-star health-care name that does not show up in Fairfax's top 10 holdings, but does bear watching, is  GlaxoSmithKline PLC (GSK). Five of our top managers currently have positions in the pharmaceutical firm, which Damien believes has the size and scale to remain a solid competitor in the market for prescription drugs and vaccines. While generics are impacting Glaxo's growth in the near term, he feels that the company is laying the foundation for improved future growth with the launch of several new vaccines, and that the firm's focus on innovation and expansive list of patent-protected drugs provide it with a wide economic moat.

Fairfax Financial Top 10 Holdings as of March 31, 2009
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	% of Total Portfolio
Johnson & Johnson (JNJ)		Low	Wide	56.33	0.70	13%
Wells Fargo Company (WFC)		High	Narrow	25.13	0.87	10%
US Bancorp (USB)		High	Wide	18.33	0.59	8%
Dell, Inc.		Medium	None	13.14	0.77	8%
Pfizer Inc. (PFE)		Medium	Wide	14.62	0.56	8%
Kraft Foods, Inc. (KFT)		Medium	Narrow	26.22	0.71	8%
Magna International (MGA)		Very High	None	39.41	0.65	5%
Level 3 Communications, Inc.		Very High	None	1.35	1.04	5%
Burlington Northern Santa Fe		Medium	Narrow	75.26	0.84	4%
Frontier Communications Corp.		High	Narrow	7.06	0.71	4%
Stock price data and Morningstar ratings as of 6-11-09. Total portfolio percentages are based on holdings and market values from the most recent quarter end and exclude the impact of the firm's stake in OdysseyRE (ORH).

A Few New Names in the Top Holdings
US Bancorp wasn't the only Fairfax holding to break into the list of top 10 holdings this quarter, as  Burlington Northern ,  Level 3 Communications , and  Frontier Communications  all increased enough in size to qualify. That said, Burlington Northern was the only name where Fairfax was actively purchasing shares, as it boosted its ownership stake by 60% during the quarter. The company trimmed its position in Frontier and held firm with Level 3, with both names benefiting from price appreciation during the period. Fairfax did, however, purchase more than $100 million in convertible preferred shares of Level 3, which when combined with Fairfax's common stock holdings would have put the telecommunications firm among the top five holdings at the end of the quarter with an aggregate value of $226 million.

Fairfax also had several new money purchases during the first quarter, including  BCE (BCE),  Leucadia National (LUK), and  Methanex (MEOH). While each of these positions remains relatively small, Fairfax has proved to be an aggressive buyer at the right price, so we wouldn't be too surprised to see the firm adding to these positions if the stock prices come down some. At this point, however, none of them are trading at prices that our analysts would consider buying, but we'd encourage investors to read through Morningstar's take on these firms, as well as the other names mentioned in this article, to get a better feel for some of the moves that Fairfax was making in the most recent quarter.

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