Everything about Fairfax seems to be contrarian these days – its CEO, its portfolio, even its share price.
While fully hedged in preparation for a market correction that has yet to arrive, Fairfax Financial Holdings Ltd.'s stock has nevertheless risen to a new post-crisis high.
But analysts expect that Fairfax's third-quarter results, which the company is scheduled to release on Thursday, will reveal a big loss on the company's investment portfolio.
A rising stock price is in part a reflection of strength in its core insurance business. But persistent losses in its investment business could cap Fairfax's valuation roughly where it is, at least for now. "It may be challenging to argue for a multiple much above current levels," said Jeff Fenwick, an analyst at Cormark Securities.
There has been a cyclical upswing in the long-stagnant U.S. property and casualty insurance business, which, for Fairfax, is often overshadowed by the investing strategy of the company's famously contrarian chief executive Prem Watsa, and now by his attempt to take BlackBerry Ltd. private.
But modest underwriting gains can only go so far. Until such time as markets destabilize and stocks relent, Mr. Watsa remains a bear in a bull market.
"It doesn't seem like there's a change in attitude just yet," Mr. Fenwick said. "He's happy to be wrong for a couple of quarters, or a year, or even two years, if they believe the long-term macro view is still correct. They want to remain protected against any major swings in the market that can hurt them."
Mr. Watsa rose to prominence as an astute investor for anticipating the financial crisis. He invested heavily in credit default swaps, which made Fairfax more than $2-billion (U.S.) when a number of financial institutions plunged.
Similarly, for the past three years, the company has positioned itself for a downturn by hedging its entire portfolio. It does so by maintaining short positions on equity index swaps. The problem is, the company's primary hedged index, the Russell 2000, is up more than 30 per cent on the year.
The stock rally has been generating some rather nasty mark-to-market losses on Fairfax's portfolio. Mr. Fenwick estimates third-quarter net investment losses of $550-million.
The hedges are much more than wiping out what could be decent returns on some of the company's equity stakes. Fairfax's 10 largest common stock holdings increased by more than 7 per cent in the third quarter. Its investment in the Bank of Ireland, the rescue of which Fairfax led in 2011, alone appreciated by about $200-million over last quarter.
"We are maintaining our defensive equity hedges due to our concern about the financial markets and the economic outlook," Mr. Watsa has taken to repeating as something of a mantra.
The bond market is also working against the company's investors. As yields rose in the United States through the last two quarters, Fairfax's portfolio of municipal and state bonds produced big net losses – $500-million in the second quarter and, as estimated in a report by CIBC World Markets analyst Paul Holden, $190-million in the third quarter.
Recurring investment losses might be unfamiliar to some shareholders of Fairfax, which generated an average return of 10 per cent over the last 25 years. "The company operates to break even on underwriting and to generate long-term book value growth through its investment portfolio," Mr. Holden said.
The reverse is now playing out. Underwriting margins have improved, driving an expansion of valuations in a sector that has closely matched book value for four or five years.
While Fairfax's book value has declined by about 7 per cent year to date, according to Mr. Holden, share price is up by 31 per cent, reaching its highest level since 1999. As a consequence, the stock has risen quickly from 1.0 times book value to 1.2 times.
"Ultimately we think the primary reason to own Fairfax is for [book value per share] growth, which is currently lacking," Mr. Holden said. "Investors are paying a higher premium today for the possibility that BVPS growth resumes at some point in the future."
The third quarter also saw BlackBerry enter into Fairfax's possible future, through a $4.7-billion plan to acquire the smartphone maker. Analysts see little downside to the offer, with limited exposure for Fairfax if the investment proves to be a flop.
And, of course, there's always the chance that Mr. Watsa pulls it off.
"We have to give credit to Prem Watsa for creating a lot of wealth over many years by taking asymmetric risks," Mr. Holden said. "We have to believe that he sees the potential for outsized gains from privatizing BlackBerry."