Fairfax Short Report: My Initial Thoughts

Not dramatic

Hi! I just came back from work and quickly read the Fairfax Financial short report from Muddy Waters Research. As many of you know Fairfax is a big position for me which I initiated in late 2022 and is up big, there’s a video on my channel and an article on this blog.

The initial market reaction to the short report has been -12% and the stock is still up YTD, this signals the weakness of the claims in the report and the strength of Fairfax’s fundamentals as perceived by the market. With other short reports, stocks can open down -50%. Fairfax has denied the claims in a press release.

DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument. Please do your own research. My analysis could be totally wrong and the stocks could have negative returns.
DISCLOSURE: I own shares of Fairfax Financial

First of all, the short report does not say that there is any fraud in Fairfax’s accounting. The report does not question the cashflows either. The report is really claiming that Fairfax’s accounting has been too aggressive and inflating book value, and I agree that in some instances, it could have been, but not on all the situations they mentioned.

In the worse case scenario, Fairfax’s book value should be -18% lower according to the report. Right now Fairfax’s book value is 876 USD, so Muddy Waters says it should be 157 USD lower. Please note that Fairfax is expected to earn around 150 USD in 2024 thanks to the insurance and the bond earnings, so even in that case, it is still cheap.

Reality is probably somewhere in the middle, it’s not as bad as Muddy Waters says, but they might have done some aggressive transactions. Please note that it is also true that Fairfax has understated it’s book value in many other occasions, for example, they sold the pet insurance segment at a much higher price than it was in the books for years (this was omitted in the report, of course). Additionally, book value will not change after the report because Fairfax has not committed fraud, it is all legal.

Now, let’s look at the biggest “transactions” that Muddy Waters claims that inflated book value.

IFRS 17 (-1,242 million): Regulators required Fairfax to adjust it’s insurance liabilities which resulted in a 15% gain in book value. Muddy Waters argues that other insurers did not see such big gains, however, he misses that the reason Fairfax had such big of a gain, was because the duration of the bond portfolio was much lower than others. The duration of the bond portfolio must be taken into account in the comparisons. So I think Muddy has this one wrong. It was explained by Fairfax in several occasions.

GoDigit (-1,100 million): Digit is partly owned by Fairfax and in theory, it will IPO at some point. When Digit raised capital at a 3.5 billion valuation, Fairfax had a gain in book value. It could be that in the future Digit is valued at less and Fairfax has to take an impairment, but they did raise money at that valuation, so what is the problem?

I will not go one by one through all the other smaller transactions (<500m): But many of them are Fairfax taking companies private after they under-performed or buying huge stakes that make them not mark-to-market. It is true that this might have protected book value from mark-to-market losses, but it is not illegal, just aggressive.

I am not saying that Muddy Waters is right or wrong, I just think that this is not material enough for shorting Fairfax Financial given the fact that it is now trading at around 6x cashflows, irrespective of the book value. It could be that the real book value is a bit lower (not 18%, but maybe let’s say 10%). OK, it could be, but if the company is going to earn a pile of cash in the next three years, it has a ROE of 15-20% and a price to book of 1.1x, how is it a good short?

I am sure Fairfax has been agressive with some transactions, and conservative with some others. I just feel that Muddy cherry-picked all the negative transactions and complied them while ignoring the long thesis which is playing out great. Short sellers profit from panics, and they could not cause a big panic this time.

Is what Fairfax did a bit questionable in some cases? Yes, but is it illegal? No. Will they make a pile of cash in the next 3 years? Yes.

P.S: We all know that Fairfax has not reached is 15% growth in book value target for quite some years, he has not found out nothing that we did not know, it was mostly due to bad capital allocation and low interests rates. The comparison with GE is laughable aswell. Looks like he is looking at the past and not at the future. Fairfax is not a good short, in fact, it has been a pretty good long.

What have I done? I have not added or sold shares, since I completed my position in mid 2023 at much lower prices.

Kind regards,
Oscar.