Muddy Waters Research, the U.S. short-seller best known in Canada for its 2011 takedown of Sino-Forest Corp., set its sights Thursday on Fairfax Financial Holdings Ltd. FFH-T, alleging the company has overstated its balance sheet by US$4.5-billion in part by failing to adequately write down a series of bad investments.
The firm, led by chief executive officer Carson Block, flagged transactions or accounting choices involving 13 Fairfax investments, subsidiaries or joint ventures, each of which had a positive impact on the balance sheet of US$100-million or more. Four of the investments Muddy Waters attacks involve transactions with the Ontario Municipal Employees Retirement System, or OMERS.
Muddy Waters also questioned how Fairfax implemented a recent insurance industry accounting standard, IFRS 17, saying it obtained far better results than typical property and casualty insurers.
Muddy Waters says 60 per cent of the increase in Fairfax’s book value since 2017 “is the product of abusive accounting often from value destructive, non-substantive transactions.” The book value, the excess of a company’s assets over its liabilities, is overstated by 18 per cent, the firm argues.
In a statement, Fairfax said it “disagrees with the allegations and insinuations contained in the report, and would like to assure all shareholders that Fairfax has prepared its financial statements and reporting in accordance with all applicable accounting principles.” Fairfax said it will address questions about the report during its Feb. 16 earnings conference call.
Fairfax shares were down as much as 13.6 per cent in morning trading, partially recovered, then slid again to close down 11.9 per cent on the Toronto Stock Exchange.
Muddy Waters, as a short-seller, profits when a stock falls. Short-selling is a bet that the share price will drop, with an investor borrowing shares, selling them and repaying the loan by returning new shares, hopefully bought at a lower price.
Muddy Waters issued a devastating report in June, 2011, claiming Chinese-Canadian timber company Sino-Forest was a fraud. The company, which claimed to be one of the leading tree growers in China, slid into bankruptcy less than 12 months later. But Mr. Block’s most recent Canadian short report, a 2018 thesis on a lawsuit against Manulife Financial Corp., was a swing and a miss.
This will not be Fairfax CEO Prem Watsa’s first dance with the shorts: In 2006, Fairfax sued a group of prominent hedge fund managers, contending they had orchestrated a multiyear campaign to spread disinformation about Fairfax’s business model. Twelve years later, a judge dismissed the case.
Mr. Watsa has often been called “the Warren Buffett of Canada” because Fairfax follows a business model similar to Buffett’s Berkshire Hathaway Inc.: Use premiums from its wholly-owned insurance companies to make investments outside of that industry, preferably in undervalued businesses. Both companies are typically valued as a multiple of book value, meaning any increase in the measure ought to drive the companies’ share prices higher.
One of the complex deals Muddy Waters questions is a November, 2021, transaction in which OMERS and the Canada Pension Plan Investment Board’s credit investments department each bought a 4.995 per cent interest in Odyssey Group Holdings Inc., Fairfax’s U.S.-based reinsurance and insurance subsidiary, for a total of US$900-million. At that price, Fairfax was able to record a gain in book value of US$429-million.
As part of the transaction, Fairfax received an option to repurchase the interests of CPPIB and OMERS. Because of that repurchase opportunity, “we believe that, in substance, this is a financing transaction,” not a true sale of equity, Muddy Waters says.
Muddy Waters says Fairfax had entered an almost identical deal in August, 2021 with OMERS, also receiving a repurchase option, then booking a US$115-million gain.
OMERS and CPPIB declined to comment.
In other circumstances, Muddy Waters says, Fairfax has either failed to write down the value of distressed investments or entered into transactions to prop up their value on its balance sheet.
Muddy Waters says
- Fairfax is carrying a stake in EXCO Resources Inc., a Dallas-based energy company, on its books at US$18.26 per share, versus a US$8 market value.
- Fairfax has “consistently overvalued” its stake in restaurant company Recipe Inc. Fairfax took the business private at a 53 per cent premium in October, 2022. By paying close to the shares’ carrying value on its balance sheet, it avoided a writedown.
- While Fairfax wrote down a stake in Farmers Edge Inc. in 2022 by US$133.4-million, it still carried it at US$71-million on Dec. 31, 2022, when the market value was about US$5-million. (Fairfax, which also made a $75-million loan to Farmers Edge, has proposed privatizing the company at a price that values it at US$10.6-million.)
Those three valuation choices prop up the value of the balance sheet by US$245-million, US$251 million and US$124-million, respectively, Muddy Waters says.
Several sell-side analysts who cover Fairfax issued reports Thursday saying their “buy” recommendations remained intact.
CIBC World Markets Inc. analyst Nik Priebe said the short report covers “the minutiae of accounting treatment applied to past transactions, while overlooking the substantial build of earnings power that has occurred over the past few years.”
Ryan O’Flanagan, director of institutional equity sales at Cormark Securities Inc., said all of the transactions were fully disclosed by Fairfax and fair value accounting allows companies to make judgements, ultimately approved by auditors.
He added that Fairfax has consistently traded at a roughly 20 per cent discount to the price-to-book value multiples of the company’s peer group. “Perhaps the market has already been building in some judgement about book value?” he said.