Two Conviction Purchases and a Big Sale at Fairfax

By Chris Blumas | Stock Analyst

Following up on last week's theme of looking at the holdings, purchases, and sales of the four insurance companies on our Investment Manager Roster, we've taken a much deeper look at the moves made by  Fairfax Financial (FFH) during the second quarter and have come away with several ideas we believe investors should consider investigating further.

Unlike the three other insurers on our list of top managers-- Berkshire Hathaway (BRK.A) (BRK.B),  Markel (MKL), and  Alleghany --Fairfax has been aggressively purchasing and selling securities in its equity portfolio since the start of the third quarter of last year. As you may recall, the company flew in the face of fear during last year's fourth quarter, removing the hedges protecting its stock portfolio and investing more than $1 billion in U.S. equities. Fairfax not only established new positions in  Kraft Foods (KFT),  Intel (INTC),  General Electric (GE),  Magna International (MGA), and  Wells Fargo (WFC), but also significantly increased what had been existing positions in  Johnson & Johnson (JNJ) and  Dell .

During the first quarter of 2009, the insurer trimmed its stake in each of its top five holdings--Johnson & Johnson,  Pfizer (PFE), Kraft Foods, Dell, and Intel--from the previous quarter. While the selling was fairly balanced, 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 (AZN), and  Progressive (PGR).

With all of the cash produced by these sales, Fairfax turned around and made big bets on two U.S.-based banks,  US Bancorp (USB) and Wells Fargo. At the end of the first quarter, these two holdings accounted for close to one-fifth of the firm's stock portfolio (excluding, that is, the impact that  OdysseyRe  has on Fairfax's equity holdings). Given the more than 50% increase in US Bancorp's stock price since the end of March, and the near doubling of Wells Fargo's stock value during the same time period, it's difficult to argue against these moves by Prem Watsa and the investment management team at Fairfax.

Fairfax Shakes Things Up Again in 2Q
Even as the S&P 500 Index (SPX) increased by 15% during the second quarter, Fairfax continued to outperform the broader market as the value of its equity portfolio (excluding the firm's controlling stake in OdysseyRe) rose by almost 30%. While Fairfax left many of its stock positions in place, the insurer dedicated money to at least one new name,  Merck (MRK), and significantly increased it stake in both Dell and General Electric during the quarter.

Fairfax also added to existing holdings in  New York Community Bancorp (NYB),  SandRidge Energy , and US Bancorp. To help pay for these purchases, Fairfax significantly reduced its position in Pfizer, trimmed its stake in  BCE (BCE), and completely eliminated its holdings in  GlaxoSmithKline (GSK),  Sanofi-Aventis (SNY), and IDT Corporation . Fairfax's high-conviction approach to stock investing resulted in even more concentration among its top 10 holdings, which accounted for 80% of its equity portfolio at the end of the second quarter (versus 73% at the end of the first quarter and 77% at the start of the year).

Fairfax Financial Top 10 Holdings as of June 30, 2009
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	% of Total Portfolio
Wells Fargo (WFC)		High	Narrow	26.91	0.87	14%
Dell		Medium	None	15.25	0.90	14%
Johnson & Johnson (JNJ)		Low	Wide	59.69	0.75	11%
US Bancorp (USB)		Medium	Wide	20.95	0.75	8%
Kraft Foods (KFT)		Medium	Narrow	27.99	0.76	7%
Magna International (MGA)		Very High	None	41.86	0.69	7%
General Electric (GE)		High	Wide	13.45	0.61	6%
Level 3 Communications	Not Rated	Not Rated	Not Rated	1.16	N/A	6%
Burlington Northern		Medium	Narrow	82.54	0.92	4%
Intel (INTC)		Medium	Wide	19.42	0.84	3%
Stock Price and Morningstar Rating data as of 09-03-09. 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).

Fairfax Significantly Raises Its Stake in Dell ...
Aside from increasing its stake in Dell by 10.9 million shares (from 23.8 million to 34.8 million) during the second quarter, Fairfax benefited from a significant runup in the price of the company's stock, which increased 45% from the end of March to the end of June. This lifted the insurer's holding in the producer of personal computers, servers, and other hardware from its fourth largest, at around 8% of the equity portfolio at the end of the first quarter, to second largest at the end of the second quarter, accounting for close to 14% of Fairfax's equity holdings. Much like it has done with Wells Fargo, which became the largest holding in the firm's portfolio during the second quarter, Fairfax is betting big on Dell, with these two top positions accounting for more than a quarter of the company's equity portfolio.

Fairfax might be on to something here, as our analyst, Rick Hanna, thought that Dell's most recent results were modestly encouraging on several fronts. Total revenue increased 3% from the first quarter, driven largely by increased sales to public-sector customers as government stimulus spending and sales to education customers proved particularly solid. 

Hanna believes, though, that it may be too early to give the all-clear signal for a return to improved enterprise spending, which is still in decline and accounts for around three-quarters of Dell's annual revenue (that is, when counting its large enterprise, public, and small and medium business segments). Somewhat offsetting the weak demand environment is the fact that the company continues to make good progress on its cost reduction and cash flow improvement initiatives. Net cash and free cash flow remained strong during the second quarter, with Dell maintaining slightly less than $5 per share in net cash and a little more than $1 per share in free cash flow.

...And More than Doubles Its Bet on General Electric
Much like Dell, Fairfax's investment in General Electric more than doubled during the second quarter, as a combination of share price appreciation and further investment in the firm saw the stock climb the ranks from the 12th largest holding at the end of the first quarter to the seventh largest holding at around $215 million (or 6% of the total portfolio) at the end of the second quarter.

Morningstar analyst Daniel Holland thinks General Electric avoids the typical characterization of a conglomerate by combining businesses with strong synergies and opportunities for information-sharing across business lines. After shedding underperforming business lines during the past couple of years, the firm now has energy infrastructure square in its sights. Despite these positive moves, the company's financial unit, GE Capital Services, still saw profits fall in 2008 as rapidly deteriorating capital markets and weaker consumer spending impacted the segment's operations. While similar factors are likely to persist through 2009, especially as General Electric shrinks its asset portfolio and opts for longer-term funding in lieu of commercial paper, investors should benefit from a better-capitalized bank with higher asset quality over the long run.

Aside from Dell and General Electric, Fairfax also added to its stake in US Bancorp; although nowhere near the magnitude of the addition the insurer made during the first quarter. While Fairfax made no other additions to the securities making up the rest of its top 20 holdings, which account for around 97% of its equity portfolio, it did make at least one new money purchase during the quarter.

While the stake in Merck was rather small (at less than 0.1% of the equity portfolio), given Fairfax's high-conviction approach and willingness to concentrate its investments, we think the initial move could portend an increasingly significant role for the pharmaceutical firm in subsequent quarters. Our Merck analyst, Damien Conover, had been lukewarm on Merck's future prior to it acquisition of  Schering-Plough  (announced in March of this year), but feels that the addition of Schering's powerful pipeline, along with the cost savings expected from the integration, should position the company for long-term growth.

The Insurer Also Made One Big Sale
At the end of the first quarter, Pfizer was one of Fairfax's five largest holdings, accounting for around 8% of the equity portfolio. That all changed during the second quarter, as the insurer reduced its stake significantly--to the point where Pfizer hardly even registers at 0.1% of the portfolio at the end of June.

While Pfizer analyst Damien Conover takes a divergent view on the investment merits of Pfizer, he does acknowledge some of the risks and challenges that are currently facing the company. With several of its blockbuster drugs nearing the end of their patent-exclusivity periods, the new drug development necessary to fill these gaps has become a very high hurdle. It also doesn't help that the cholesterol drug Lipitor accounts for around a quarter of Pfizer's total sales, largely dictating the sales trajectory for the entire firm.

That said, it's difficult to determine the rationale behind the sale without explicit statements from the investment managers at Fairfax. It is, however, interesting to note that this transaction runs completely contrary to the moves made by Bruce Berkowitz and the management team over at  Fairholme (FAIRX), another one of our Ultimate Stock-Pickers. Over the last five quarters, Fairholme's position in Pfizer has gone from zero to roughly 15% of its equity portfolio, with Berkowitz firmly believing that the pharmaceutical firm is being misunderstood by the market. While Lipitor might make up 25% of total sales and carry higher-than-average gross margins, the company's pending acquisition of  Wyeth  should help insulate Pfizer from this issue (as Lipitor will represent only 13% of the total sales of the combined firms).

Our analyst believes that Pfizer is a high-quality company trading at an extremely attractive price and agrees with Berkowitz that the market is overlooking the firm's long-term potential. Besides, nobody invests this much in a single stock without a strong feeling that the upside dramatically outweighs the downside, which only makes us all that more curious about the rationale behind Fairfax's decision to wind down its stake in the pharmaceutical firm.

Disclosure: Chris Blumas does not own shares in any of the companies mentioned above.