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  • Chris Mayer

The Horse Story

We simply call it, “the horse story.” A friend of mine and I, who I meet regularly for lunch, invoke it often.


At a recent lunch, we agreed “Everything is the horse story!”


What is the “horse story”?


I first read it in a book by my favorite philosopher, Alan Watts (1915-1973). Below is my rendition of the story.


The parable is about a farmer. And one day, the farmer forgets to latch the barn door and his horse escapes.


“That’s bad news,” his neighbors tell him.


But the farmer is more circumspect. “Maybe,” he says.


The next day, the horse returns... with several other wild horses as well.


“Wow, that’s great,” the neighbors say.


“Maybe,” says the farmer.


The next day the farmer’s son breaks his leg after being thrown by one of the new horses.


“That’s rotten luck,” the neighbors say.


“Maybe,” says the farmer.


The next day, there is a war and men come to the village to draft soldiers. The farmer’s son does not have to go.


“What good luck,” the neighbors say.


“Maybe,” says the farmer.


And so on it goes.


“Bad” news may, in fact, lead to a “good” outcome down the road. And vice versa. I use quotation marks because I agree with Kurt Vonnegut, who said, “The truth is, we know so little about life, we don’t really know what the good news is and what the bad news is.”


We all have stories of apparent early setbacks with a stock where eventually things worked out quite well longer-term. Or vice versa, when our first earnings report with the stock looked great, the stock popped and yet we wound up losing money longer-term. It’s the horse story.


You can relate (almost) everything that happens to the horse story. It might be particularly helpful to keep in mind these days as trade wars and other macro concerns make stock prices dance. It keeps me more circumspect about things that seem “good” or “bad.”


In fact, I try not to use those words. There are no “good” or “bad” days in the market. It depends on how you frame it.


This reminds me of something Buffett wrote years ago along similar lines:


So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls-but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")


“Valuation Unfair”


That was the headline for a Raymond James initiation on Fairfax Financial Holdings (FFH), published on June 19th. The stock was C$638 per share then. RayJay wrote, “The current valuation of 1.06x book value per share is too low.”

Well, as I write, the stock is about 9% lower and book value is higher after a strong Q2 report. The valuation stands at 0.94x book value per share.


The stock has not often traded below book value in the last decade. I just pulled annual price-to-book data for FFH from Sentieo. Here it is:

Source: Sentieo


Of course, it’s not so simple as just looking at price-to-book or investing would be really easy. First, FFH has a portfolio of securities that bounces around and can move the needle on book value. In Q2, FFH enjoyed net gains from common stocks alone worth about $5 per share in book value. August took a bite out of that. But there is also a substantial bond portfolio. And private investments.


All in all, it’s tough to model FFH’s gains and losses on investments – which, as I pointed out, have a big impact on book value. FFH’s investment performance in recent years has been – to borrow one of our President’s favorite terms – sad. So there’s that.


Second, book value alone is not worth much without context. For example, a stock that earns a consistent 15% return on equity should command a substantial premium to book value. A stock that earns 5% probably deserves a discount.


Over its lifetime, FFH has been brilliant: a near 19% annual growth rate in book value per share. But over the last decade, FFH’s ROE has been erratic and underwhelming – often coming in at single-digits. Whatever mystique and power the FFH name had has long been bled off the valuation. There is no premium now in FFH shares. In fact, I’d say FFH’s reputation – and that of its chief, Prem Watsa – is at low tide.


Most of the investors I’ve talked to about FFH will bring up Watsa almost immediately as, basically, someone they no longer trust to make good decisions or deliver good returns. I can understand why. (The baffling macro bets of some years ago cost FFH shareholders billions of dollars. Watsa said he not would make such bets again. But the damage was done.)


The insurance side of the operation has been strong for FFH in recent years. But even there, operations are below Watsa’s target of a 95% combined ratio. FFH’s Q2 number was 96.8%. Profitable – anything below 100% is profitable – but below target.


So, as you can see, the valuation is not such a cut-and-dried matter. FFH has had some issues. Nonetheless, we own the stock at a price below book value.

The most important reason is that the downside seems low. The valuation protects you, the company appears well-financed and management seems honest and well-intentioned. These are not small things.


Moreover, I think the assets collectively could generate a ~10%-type ROE. Watsa has made a public goal of hitting 15%. (FFH’s ROE was 15% in the second quarter, thanks to investment gains). He says a 95% combined ratio and a 7% return on FFH’s investments gets to a 15% ROE.


But in a low-interest rate environment, and given a large bond portfolio, a 7% return seems unlikely. But possible. Sustaining a double-digit ROE is key. (FFH can reach 10% by following a number of roads. For example, one road requires a ~95% combined ratio and ~5% return on its portfolio. That seems do-able.)


Anyway, a consistent 10% would grow book value at a decent clip and then you’d likely get an additional lift from the valuation even if the stock moved just to 1.2x book. As RayJay reports, a comparable set of North American insurers with an 11% ROE trades for 1.7x book value per share.


I admit, FFH is not exciting. It’s not fake meat or pot or sending billionaires into space. But it shouldn’t hurt you and has potential to deliver a very nice return. The current disappointing share performance could be, in the spirit of the horse story, a gift.


Thanks for reading.


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Published September 4, 2019

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