Fairfax Financial Stock Is Cheaply Valued (TSX:FFH:CA)

Fairfax Financial Holdings (FRFHF) has rallied 66% over the last 12 months and thus it has outperformed the S&P 500 (+12%) by an eye-opening margin. The vast outperformance has resulted from the impressive business momentum that the company enjoys this year. After such a steep rally, to a new all-time high, it is only natural that many investors may feel that it is time to take their profits. Nevertheless, the stock remains cheaply valued.

Business overview

Fairfax Financial Holdings is a holding company that offers property and casualty insurance, reinsurance and investment management services in North America and international markets. The company also has stakes in many companies all over the world. Fairfax has a market capitalization of $21 billion and hence it is a much smaller company than Berkshire Hathaway (BRK.B) but it has a business model that is similar to the gigantic conglomerate of Warren Buffett. Fairfax collects premiums from its insurance business and then it invests these premiums on securities with high returns on investment.

Many financial companies, such as banks, have incurred material losses in their investment portfolios due to the surge of interest rates to a 15-year high this year. The surge of interest rates has caused a sharp correction in the values of long-term bonds. Consequently, the banks that invested excessive amounts in long-term bonds before 2022, at nearly record-low yields, have incurred significant mark-to-market losses in their investment portfolios.

Fairfax has proved much better than average in this respect, as short-term government bonds comprise 74% of its investment portfolio and short-term corporate bonds comprise 15% of its investment portfolio. Thanks to this structure of its portfolio, Fairfax has seen many of its securities mature since early last year and thus it has been able to reinvest its funds at much higher rates. In its latest conference call, Fairfax stated that its interest and dividend income in the second quarter was $465 million, which was more than double the amount in the prior year’s quarter. This is a testament to the prudent management of the company, which was not caught off-guard by the surge of inflation last year.

Moreover, Fairfax currently enjoys impressive business momentum in most of its insurance lines. It has posted a solid combined ratio well below 100% for many quarters in a row, including a combined ratio of 93.9% in the most recent quarter. The company also grew its gross insurance premiums 10% in the second quarter thanks to strong demand for its products and material price hikes. Even better, management expects the strong business momentum to remain in place for the foreseeable future.

Overall, Fairfax enjoys two strong tailwinds right now, namely the strong sales growth in its insurance divisions and the fast-growing interest and dividend income thanks to the investment of funds at high interest rates. Thanks to these tailwinds, management recently stated that it expects the annual operating income to exceed $3.0 billion for the next three years. After interest expenses, overhead costs and taxes are subtracted, the guidance of management corresponds to annual earnings per share of at least $100 over the next three years. Indeed, analysts seem to agree on the outlook of management, as they expect Fairfax to achieve all-time high earnings per share of $137.43 this year and $120.45 in 2024.

While some financial companies have been caught off-guard by the surge of inflation and interest rates, Fairfax is ideally positioned to benefit from these factors thanks to the short duration of its investment securities. Moreover, financial companies should be evaluated based on the growth of their book value over the long run. Fairfax has grown its book value per share by 10.0% per year on average since 2013. This is certainly a strong growth rate for a financial company.

Valuation

Fairfax has reported earnings per share of $78.18 in the first half of this year. As business tailwinds remain intact and the company has exceeded the analysts’ estimates by a wide margin in 3 of the last 4 quarters, one can reasonably expect Fairfax to meet or exceed the analysts’ consensus for earnings per share of $137.43 this year. This means that the stock is currently trading at only 6.0 times its expected earnings this year. Such a price-to-earnings ratio is exceptionally low.

The exceptionally cheap valuation has resulted primarily from the blowout earnings this year, as the company will probably not be able to maintain such high earnings in the upcoming years, when interest rates are likely to moderate. Indeed, analysts expect the earnings per share of Fairfax to decrease 12% next year, to $120.45. Nevertheless, it is important to realize that the stock is trading at only 6.8 times its expected earnings in 2024. In other words, the stock is remarkably cheaply valued even when its valuation is based on its earnings in 2024.

In addition, as mentioned above, management recently stated that it expects earnings per share of at least $100 for the next three years. If management proves correct in its guidance, the stock is now trading at less than 8.2 times its expected earnings in 2025. To cut a long story short, Fairfax is trading at an extremely cheap valuation level, given its excessive earnings expected throughout 2023-2025.

Risk

While everything is rosy on the horizon for Fairfax right now, investors should be aware of the highly volatile performance record of the company. For instance, the company incurred a single-digit decrease in its book value in 2016, 2018 and 2020 and incurred hefty losses in the first quarter of 2020 due to the collapse of global financial markets amid the coronavirus crisis. Whenever the global economy takes a turn for the worse and a bear market shows up, Fairfax is likely to be negatively affected due to the sensitivity of its investments to the prevailing economic environment.

This means that the stock of Fairfax is not suitable for investors who cannot tolerate high stock price volatility. Moreover, given the exceptionally favorable environment of multi-year high interest rates, even the risk-tolerant shareholders of Fairfax should probably take their profits if the stock approaches the level of $1000, which will correspond to approximately 10 times earnings per share of about $100, which are expected by management in 2025.

Final thoughts

The stock of Fairfax has doubled in less than two years thanks to its booming insurance business and the fast-growing interest and dividend income of the company amid 15-year high interest rates. Despite its steep rally, the stock remains attractively valued. Therefore, the stock can offer an additional upside of 22% from its current price.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.