Fairfax Financial Holdings Limited annual letter to shareholders for the year ended December 31, 2015.
To Our Shareholders:
Fairfax had another excellent year in 2015 even though it was not obvious in the numbers, as book value per share increased by only 4.5% (including the $10(1) per share dividend paid in 2015) to $403 per share because of our very cautious view of financial markets. All of our concerns about the financial markets may be coming to a head in early 2016, as I write this report to you. More on that later.
Fairfax Financial Holdings – Insurance Companies Performance
Our underwriting results in 2015 were the best in our 30-year history, with record underwriting profit of $705 million and a record low combined ratio of 89.9%. We earned $568 million after tax ($23.15 per share) in 2015, thereby increasing common shareholders’ equity from $8.4 billion at December 31, 2014 to $9.0 billion. Here’s how our insurance companies performed in 2015:
As you can see from the table, all our major insurance companies again had combined ratios less than 100% with Zenith at 82.5%, OdysseyRe at 84.7%, Fairfax Asia at 87.9%, Northbridge at 91.8%, Brit (which we acquired on June 5, 2015) at 94.9% and Crum & Forster at 97.7%. Under Andy Barnard’s oversight, our decentralized insurance operations led by Kari Van Gundy at Zenith, Brian Young at OdysseyRe, Mr. Athappan at Fairfax Asia, Silvy Wright at Northbridge, Mark Cloutier at Brit and Marc Adee at Crum & Forster had an outstanding year. Our other insurance and reinsurance operations also did well. We now have an extremely disciplined underwriting-focused insurance organization operating all over the world with a very entrepreneurial (i.e., decentralized) structure. I am very excited about the future of our insurance and reinsurance operations!
2015 marked the completion of the first 30 years for Fairfax. And it has been quite a ride! As you know, we began with one small insurance company in Canada with about $10 million in premiums, less than $10 million in capital and a book value per share of $11?2. Here’s our record:
Our book value per share has compounded at 20.4% (21.2% including dividends) per year and our stock price at 19.4% per year. The compound rate of growth in our stock price over 30 years is the best in the property and casualty industry (there are only 12 public companies with a 30-year track record), second best among all companies in Canada and in the top ten companies in the S&P 500.
This was accomplished with much hard work and a small but wonderful group of officers, Presidents and investment principals, supported by a great group of Directors and lots of good fortune – and with no vision statement! As I have said in the past, we just waited for the telephone to ring – and ring it has!
When you consider all the challenges we faced over this time period, you can understand why we are so grateful for this performance and deeply humbled. We particularly want to thank our extraordinary group of long term shareholders who have supported us and encouraged us over all these years.
While we are very thankful for our results, we are even more grateful for the fair and friendly culture that we have embedded in Fairfax. The foundation for our culture and the people who are attracted to it is our Guiding Principles, shown (as they are each year) in the Appendix. Very simply, we think of business as a good thing. By providing outstanding service to customers, looking after and nurturing employees, providing a return for shareholders and then reinvesting a portion of the profits in the communities we serve, we think business can be a calling. The key, we think, is to be focused on the long term and never compromise honesty and integrity in any relationship. Our Guiding Principles have served us well over the past 30 years and are the rock on which our company is built. They will never change!
Below we show you, for successive five-year periods over the past 30 years, the compound growth in our book value per share (including dividends paid) together with the average combined ratio and total return on investments:
As the table shows, there have been two five-year periods when our annual book value growth was below 5%: 2001 – 2005, which was part of our seven lean years, and recently, 2011 – 2015, due to the defensive measures we adopted because of our concern about financial markets. You can see that our average combined ratios for the last two five-year periods have been excellent (i.e., float at no cost) but the average total return on our investment portfolio in the last five years has been the lowest in 30 years. This has been by design as we worried about the speculation in financial markets and the potential for a 50-100 year financial storm. And we wanted to be sure to survive that! We expect to make up (in a hurry!) for the low average total return on our investment portfolio over the past five years and, combined with disciplined underwriting results, return to average annual growth in book value per share of 15%.
In spite of poor book value growth over the past five years, the intrinsic value of our company has increased very significantly even though it is not shown in the book value numbers. First of all, our underwriting operations have become very valuable since Andy Barnard’s appointment as President and COO of our insurance operations about five years ago. We now have over 140 profit centres in our companies; have established from across our companies the Executive Leadership Council, working groups of many specific functions (such as claims, underwriting and loss prevention) and the Fairfax Leadership Workshop (about 100 have participated); and while maintaining a very decentralized structure, have significantly increased the discipline, coordination and communication in and among our various underwriting operations. Our insurance underwriting operations have become strong generators of underwriting profits while providing outstanding service to our customers. It all culminated in record underwriting profit of $705 million in 2015. During the last five years, we have added to our underwriting operations with the acquisition of First Mercury and Brit Insurance, expanded into pet insurance through Hartville and Pethealth, and expanded internationally into Eastern Europe, Brazil, Malaysia, Indonesia, Sri Lanka and Vietnam. RiverStone, our runoff company which we acquired long ago to look after our own runoffs, has established itself as one of the premier runoff companies in the world and has made many highly profitable runoff acquisitions. A few years ago, at our annual shareholders’ meeting, Andy Barnard said that his goal was for our insurance operations to be as well known as our investment operations. Well, early in 2016, he achieved that objective as Fairfax and I were named Insurance Leader of the Year by St. John’s University, which I accepted on behalf of all our insurance leaders, past and present.
Fairfax Financial Holdings – Portfolio Review
In the last five years, we have established Fairbridge Capital, our India investment management office, acquired Thomas Cook India (and in it Quess and Sterling) and created Fairfax India which raised $1 billion in its initial public offering. We have a strong, successful and growing Indian operation, built on the Fairfax guiding principles, with unlimited potential in India. Also during this five-year time period, we began investing in the restaurant business, and today with our investments in Cara, the Keg and McEwan we are the third largest restaurant group in Canada, behind only Tim Hortons and McDonalds, with over 1,100 restaurants, Cdn$2.4 billion in system sales and over 40,000 people employed.
As well during the last five years, all of our major insurance operations, with the exception of Fairfax Asia (we hope Mr. Athappan never retires!), have seamlessly transitioned, upon their CEO’s retirement, to new CEOs chosen from within the organization. We hope that we can promote from within the group for every successor CEO of our major companies. Also, for the first time in our history, we have named a President for Fairfax. Paul Rivett is a joy to work with, he is totally team oriented and no one works harder! Peter Clarke, our Chief Risk Officer, and David Bonham, our Chief Financial Officer, have also blossomed as officers in the last five years. Fairfax’s culture is in strong hands!
So you can see why I feel our intrinsic value has increased significantly over the past five years, and why I think that you will see it in spades over the next five years as it gets reflected in book value growth.
During 2015, we continued to expand our insurance operations worldwide. At Fairfax Asia, under Mr. Athappan, we acquired a 35% strategic investment in BIC Insurance, the insurance subsidiary of the second largest bank in Vietnam, BIDV Bank. We expect to increase our interest over time. We were warmly welcomed by the Chairman of BIDV Bank, Mr. Tran Bac Ha, and by Mr. Tung, who runs BIC Insurance. We expect this to be a longlasting partnership in Vietnam. BIC writes $70 million in premiums and has had a combined ratio of 99.0% over the last three years. In 2015, we were able to purchase the QBE insurance operations in Ukraine. This will be an addition to Peter Csakvari’s Fairfax Eastern Europe operations. The Ukrainian operations write $5 million in premiums and had a combined ratio of 94.5% over the last ten years. We created an insurance company, Colonnade, in Luxembourg, under Peter Csakvari, to write all our Eastern European insurance business, which had gross premiums of $36.5 million in 2015. Colonnade also has an EU insurance licence. Bijan Khosrowshahi works directly with Peter Csakvari and also does an outstanding job overseeing our Middle East partnership.
Late in 2015 we agreed to acquire 80% of Eurolife, a life and property and casualty insurance company which is the third largest insurer in Greece and which distributes its products through Eurobank’s network, for $347 million – at about its underlying book value. We got to know Alex Sarrigeorgiou in the last few years and were very impressed with him, his management team and their track record. The company writes A306 million in premiums – A248 million in life insurance and A58 million in property and casualty. Over the past ten years, the property and casualty operations have had a combined ratio of 60.0% while the life insurance operations produce stable earnings with plain vanilla products. Eurolife had net income in 2015 of A48.4 million, 45% from life and 55% from P&C. We welcome Alex Sarrigeorgiou and the over 300 employees of Eurolife to the Fairfax family. As we did with Brit, where OMERS purchased 30% from us to help us finance the acquisition, we expect OMERS to buy 40% of Eurolife’s shares at close to help us finance the acquisition. In the case of both Brit and Eurolife, we expect to be able to acquire the interests back within the five years after closing, after providing OMERS with an acceptable return. The team at OMERS has been a pleasure to deal with.
It has been 16 years since we began our partnership with ICICI Bank in India with the formation of ICICI Lombard. Recently, the Indian government permitted foreigners to increase their ownership interests in insurance companies to 49%. ICICI Lombard, as you know, is the largest non-government insurance company in India (there are four government-owned companies that are slightly larger). We have had a wonderful partnership with the Bank, first with K.V. Kamath and more recently with Chanda Kochhar, who runs the Bank. Chanda decided to sell 9% so that we could take our ownership interest to 35% and ICICI Bank will come down to 64%. That’s the good news! The bad news is that the 9% cost us $234 million or five times book value. While many of you may think I am losing it, we think, over time, ICICI Lombard will be worth every dollar we have invested in it – and more! It is an outstanding company. Our total investment in ICICI Lombard stands at $347 million.
Early in 2015, we purchased a 7.2% stake in Africa Re. Africa Re writes about $700 million of business across Africa and has a ten-year average combined ratio of 92.8%. Africa Re is owned by a combination of African states, African insurance and reinsurance operations and foreign investors (who are restricted to a 25% total foreign ownership). Fairfax is represented on the Board of Africa Re by Jean Cloutier. Africa Re provides us with a great introduction to a continent in which we currently do little business.
In April, Crum & Forster purchased The Redwoods Group, a full service national program administrator and managing general underwriter. It manages nearly $50 million of property and casualty packaged insurance business focused on YMCAs, Jewish community organizations and residential camps with an average combined ratio below 95% for the last ten years. Redwoods was founded in 1997 by Kevin Trapani and is operated by Kevin (CEO) and his wife Jennifer (CUO). We welcome Kevin, Jennifer and their almost 70 employees to the Fairfax family.
In June, Hudson Insurance purchased Euclid Managers, a longstanding program partner specializing in tech and media E&O business. Euclid produces $15 million in premiums on an annual basis. The combined ratio for the program over the past decade has produced excellent underwriting profits. Euclid is led by John Whall, Laura Johnson and Thomas Franklin. We welcome all 11 members of the Euclid team.
In September, Fairfax invested A70 million in FBD Group through a ten-year convertible bond with a coupon of 7% and a conversion price of A8.50 per share. We have followed FBD for some time, recognizing its deserved reputation as a leader in farm insurance in Ireland. This investment underlines our belief in the strength of Ireland’s ongoing economic recovery and in FBD’s core franchise in the farming and agri-business sectors. FBD writes A363 million in premiums and has had an average combined ratio of 94.4% over the last ten years, notwithstanding a couple of difficult years lately. Fiona Muldoon has recently taken over as CEO of FBD and we are confident she will do very well over the long term.
In October, Crum & Forster acquired Travel Insured International (‘‘TII’’). TII is a leading travel insurance provider specializing in writing and servicing travel insurance, including emergency assistance, trip cancellation and trip interruption, in the United States and internationally. TII produces $50 million of premiums at an average combined ratio of 89%. Crum & Forster has been the exclusive carrier for TII for the last three years. We welcome Jon Gehris, TII’s CEO, and his 110 employees to the Fairfax family.
Also in October, Crum & Forster purchased Brownyard Programs. Brownyard is a leading national provider of insurance products for the private security industry, with programs that include security guard, private investigation, burglar/fire alarm, background screening and armoured car companies. Brownyard produces $15 million of premiums at an average combined ratio of 90%. We welcome Bruce Brownyard, Brownyard’s founder and President, and his 11 employees to Fairfax.
In December, Brit made an investment in Ambridge Partners, one of the world’s leading managing general underwriters of transactional insurance products. These products insure losses as a result of breaches or inaccuracies in warranties and indemnities relating to M&A, restructuring activities, business financing and tax issues. Ambridge, which has been a partner of Brit for the last nine years, produces $128 million of premiums and is highly profitable. We welcome Jesseman Pryor (CEO), Jeffery Cowhey (President) and their team of 29 employees to Fairfax.
Fairfax India has just completed its first year in business. Under Chandran Ratnaswami’s leadership, and with John Varnell as Chief Financial Officer and Harsha Raghavan and his management team at Fairbridge, Fairfax India has made three investments. All of these investments are in companies with great track records and run by honest, exceptional CEOs with a long term focus. The table below shows the investments made:
All of these investments were purchased at approximately ten times normalized free cash flow. The potential for all of them is very significant, and we look forward to a long relationship with them. Please read Fairfax India’s annual report for more details (www.fairfaxindia.ca).
The results of Thomas Cook India and its subsidiaries over the last four years are shown in the table below:
The bad news first. An unusual confluence of events and negative surprises in 2015 resulted in the halving of the total earnings at Thomas Cook India and its subsidiaries. Thomas Cook saw a decline of 11% in its inbound business because of a significant drop in arrivals from France, the United Kingdom and Russia as a result of weakness in their economies. This effect was compounded by increased expenses due to investment in technology, human resources and new offices. Sterling Resorts, led by Ramesh Ramanathan, incurred increased expenses in human resources and marketing, had to account for an unexpected cost of stamp duty relating to its merger with Thomas Cook, and wrote down a significant receivable. Fortunately there were no such surprises from Quess.
Now for the good news. Under Madhavan Menon’s leadership, Thomas Cook’s outbound business and its meetings incentives events and conferences business increased their passenger counts by 16% and 28% respectively and their revenues by 5% and 31% respectively. Also, Thomas Cook completed the acquisition of Kuoni India, one of its major competitors, making the combined company the leading and largest travel operator in India with tangible economies of scale, an excellent strategic fit and strong synergies. Kuoni’s inbound business is a highly profitable leisure destination management service that consistently delivers strong earnings. In addition, Thomas Cook acquired Kuoni Hong Kong which, as the largest premium outbound travel operator in Hong Kong, will give Thomas Cook access to the growing Chinese travel market and enable it to grow the cruise business in India.
Ajit Isaac and Quess again had an excellent year, with revenue growing 59% and net earnings growing 18%. The number of associates on the payroll grew 30% to 108,000. In addition to acquiring Brainhunter (Canada) and our own MFX IT Services, Quess completed two other smaller acquisitions in 2015, in Sri Lanka and Dubai. In December, its Board of Directors approved an IPO for Quess to raise $60 million by way of an initial public offering. This exciting process is underway and listing is targeted for May 2016.
Chairman MK Sharma retired from the Thomas Cook Board after approximately seven years. We thank him very much for his exceptional service. Madhavan will become Chairman and Managing Director and Mahesh Iyer, who has been with the company for eight years, will take over as COO.
Interestingly enough, all of the above companies made major acquisitions in 2011 and loaded up their balance sheets with debt! They are trying to clean up their balance sheets by selling subsidiaries at very low prices – and at huge losses from their purchase price.
Unfortunately, we have seen this movie many times over our 40-year career. As we have said a few times before, the collapsing commodity prices will not spare Canada. Canadian housing prices, particularly in Toronto and Vancouver, have gone up significantly, driven by lax policies at CMHC (Canada’s equivalent to Fannie Mae and Freddie Mac). Canadians have accessed their increasing real estate wealth through lines of credit easily available from the banks.
Sounds familiar? This is exactly what happened in the United States before the financial crisis in 2008/2009. If history is any guide, this will reverse and we continue to be shocked at the massive debt levels incurred by young people (below 45 years old), with no financial buffer against hard times as the C.D.
Howe report, Mortgaged to the Hilt, shows. China devalued its currency on August 11, 2015 by 1.9% – the biggest move in 21 years. The Chinese government is trying frantically to support four major markets: its exchange market, its stock market, its bond market (no debt defaults allowed) and of course, the biggest real estate bubble we have ever witnessed. In 2015, China’s foreign exchange reserves dropped for the first time in 20 years – by almost $800 billion from the high. Early in 2016, the trend continues! The high yield bond market, mainly due to oil and mining issues, is moribund. Spreads have increased dramatically – particularly for energy issues! Of course, distress in the energy area is being transmitted to the pipelines and then to the banks and bond markets that funded significant pipelines and transmission expansions and acquisitions.
Distress is spreading into other areas of the high yield market. Recently, three high yield funds, one very prominent, were not able to redeem for cash and closed down – similar to the Bear Stearns real estate funds in June 2007. This may well be the Hyman Minksy moment!
Record emerging market bond purchases by mutual funds reaching for yield is another bomb waiting to explode. For example, Venezuela has some $115 billion in U.S. dollar bonds outstanding with $8.6 billion maturing in the remainder of 2016. Oil and gas accounts for 25% of its economy and 96% of its exports, and inflation is running at 181%. A default would have a significant impact on bond mutual fund redemptions which would cause major losses to the retail investor – and potentially a run on these funds. Many emerging market countries in Latin America, Africa and Asia have similar challenges.