Friday, November 27, 2009

lessons from annual reports: 2008--- Prem watsa

To Our Shareholders:

While 2007 was a record year for us, 2008 was even better! We earned approximately $1.5 billion1 after tax or $79.53 per diluted share. Book value grew by 21.0% to $278.28 per share (excluding the $5.00 per share dividend paid in 2008) and we ended the year with over $1.5 billion in cash and marketable securities at the holding company level. We were net cash at the holding company level, as our cash and marketable securities exceeded holding company debt and other obligations.

Since we began 23 years ago, book value has compounded by 25% while our common stock price has followed at 23% per year. The last two years have made up significantly for the biblical seven lean years that you have suffered. In the seven lean years (1999-2005), we made no money on a cumulative basis. In the three years since (2006-2008), we have earned $2.8 billion after tax and book value per share has more than doubled. While we are pleased that our forecast of “the seven lean years are over” did come true, we much prefer the Noah principle, “Forecasting doesn’t count, building an ark does”!

The results for our major subsidiaries are shown below:
Return on
Net Average
Combined Earnings Shareholders’
Ratio after Tax Equity
Northbridge 107.3% 45.7 3.6%
Crum & Forster (US GAAP) 114.6% 332.8 27.1%
OdysseyRe (US GAAP) 101.2% 549.0 20.5%

Excluding the effect of foreign currency movements, the impact of an unusual reinsurance commutation and lawsuit settlement at Crum & Forster, and catastrophe losses related to Hurricanes Ike – the third costliest hurricane in U.S. history – and Gustav, the combined ratios of Northbridge, Crum & Forster and OdysseyRe (the latter two on a US GAAP basis) were 100.1%, 97.0% and 93.7% respectively, and Fairfax’s consolidated combined ratio (on a Canadian GAAP basis) was 96.2%. Overall, these were extraordinary results, both absolute and relative to the industry, especially given the investment environment. Northbridge’s results were mediocre because of charges recorded on investments for other than temporary impairments and mark-to-market losses, the gains on Canadian Federal Government bonds being less than on U.S. Federal Government bonds, and higher combined ratios.

The table below shows our major subsidiaries’ growth in book value over the past seven years (per share for Northbridge and OdysseyRe), adjusted by including distributions to shareholders.

2001 – 2008
Annual Compound
Growth Rate
Northbridge 19.2%
Crum & Forster (US GAAP) 18.9%
OdysseyRe (US GAAP) 21.2%

Our investment team has produced exceptional returns in many of the years over the past 23 – but none like in 2008! The investment environment in 2008 was brutal as the 1 in 50 or 1 in 100 year storm in the financial markets that we feared arrived in the fall. All major stock markets worldwide were down about 50% and all corporate and non-Federal Government bond spreads widened to historically high levels. There were very few places to hide, let alone prosper! Fortunately, after many years of caution, we were perfectly positioned with a cash and government bond position of approximately 75% of our investment portfolio, our stock positions fully hedged, and our large holdings of credit default swaps. The total return (including unrealized gains) in our investment portfolios, including our CDS position and hedges, was 16.4%. Total interest and dividend income and net investment gains in 2008 (including at the holding company) were $3.3 billion after recording almost $1 billion in other than temporary impairments and over $500 million of mark-to-market losses (primarily on convertible bonds). Interest and dividend income dropped in 2008 from $761 million to $626 million because of the collapse in short term interest rates, but total net investment

gains increased to $2.7 billion – again, after the $1.5 billion of impairment and mark-to-market charges mentioned above – from $1.6 billion in 2007. These are exceptional results and no other company in the industry has even come close to matching them! A standing ovation for our investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami, Sam Mitchell, Paul Rivett, Frances Burke and Enza La Selva.

Our performance in 2008 did not go unnoticed by the rating agencies. A.M. Best upgraded Crum & Forster to an “A” rating after upgrading Northbridge to an “A” rating and Fairfax to an investment grade rating in 2007. DBRS upgraded Fairfax to investment grade in 2008 and Standard & Poor’s followed early in 2009. By the way, we do not know of another publicly traded financial institution, of any size, that has survived after being downgraded to non-investment grade status.

In November of 2008, after the stock markets had dropped 50% from their highs, we decided to remove the equity hedges on our portfolio investments. Also, as the yield on long (30-year) U.S. Treasuries began to drop below 3%, we sold almost all our U.S. Treasuries (at year-end we had only $985 million left, compared to $6.4 billion on December 31, 2007), having realized net gains of $583 million in 2008 on sales of U.S. Treasuries. Both the equity hedges and the U.S. Treasuries have done an outstanding job in protecting our capital. Our U.S. Treasury bond position was to a large extent replaced by $4.1 billion in U.S. state, municipal and other tax-exempt bonds (of which $3.6 billion carry a Berkshire Hathaway guarantee) with an average yield (at purchase) of approximately 5.79% per annum. During the fourth quarter of 2008, we also increased our cash and short term investments by $752 million and invested an additional $2.3 billion in common stocks. The annualized pre-tax equivalent interest and dividend income has increased significantly for our company by virtue of our significant holdings of tax-exempt bonds and as we have taken advantage of the significant widening in corporate and non-Federal Government spreads.

In previous annual reports, we have discussed the holding of some common stock positions for the very long term. Last year we identified Johnson & Johnson as one name and said that Mr. Market may give us more opportunities in the future. As shown in the table below, at the end of 2008 we had taken advantage of the major decline in stock prices to purchase additional positions in outstanding companies with excellent long term track records which we contemplate holding for the long term.

Shares Owned Cost per Share Amount Invested Market Value
Johnson & Johnson 7,585,000 $60.68 460.3 453.4
Kraft Foods 10,723,571 26.61 285.4 287.6
Wells Fargo Bank 3,515,100 21.93 77.1 103.6

Late in the fourth quarter of 2008, after receiving a $350 million dividend from Crum & Forster, we decided to take Northbridge private at a fair price for all minority shareholders. Our Cdn$39.00 per share offer was unanimously recommended by the Independent Committee of the Board of Northbridge, which had retained Scotia Capital as its financial advisor. As many of you will remember, we took Northbridge public in 2003 at Cdn$15.00 per share. At Cdn$39.00 per share, in the approximately five and a half years that Northbridge was public, Northbridge minority shareholders earned a 20%+ compound annual rate of return, including dividends (versus 5% for the TSX 300). We took Northbridge public at 1.2x book value and private at 1.3x book value, in an environment where the whole P&C industry (including us) was selling at approximately book value. Northbridge had never traded at Cdn$39.00 per share before. You can see why we considered the offer a fair price for Northbridge’s minority shareholders.

As you know, necessity is often the mother of invention – by taking Northbridge public in 2003, we created the largest commercial lines P&C company in Canada from four relatively small companies. Under Mark Ram’s leadership (Mark has been with us since he graduated from the Ivey Business School in 1991), we are very excited about Northbridge’s long term prospects.

In the past year, we have had significant share repurchases in the group. Fairfax repurchased 1.07 million shares at an average price of $264.39 per share (total cost of $282 million), more than offsetting the 0.9 million shares issued on the conversion of the $189 million of 5% convertible debentures that we called for redemption in early 2008. Northbridge repurchased 2.3 million shares at an average price of Cdn$29.04 per share in 2008, while OdysseyRe repurchased 9.5 million shares at an average price of $37.06 per share after repurchasing 2.6 million shares at an average price of $35.83 per share in 2007. Fairfax also retired Cdn$50 million of preferred shares in 2008.

We think that Fairfax has developed two significant strengths over the past 23 years. One, our worldwide investment management capabilities, has been evident, especially in a year like 2008.


1. buy gold, treasuries and hedge and sell stock equities before the market fall

2. Accumulate stocks of companies that have good long term prospects after the market fall and also during normal market conditions.

3. Important to understand annual reports before investing long term and also consider following the stock trends for buying and selling.

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