Management, Strategies, Trends Faux Buffett People Are So Anxious to Find the Next Berkshire Hathaway That They're Buying Artfully Constructed Copies

Management, Strategies, Trends Faux Buffett People are so anxious to find the next Berkshire Hathaway that they're buying artfully constructed copies.

TO HIS BELIEVERS, Prem Watsa, 47, looks like Canada's version of Warren Buffett. An immigrant from India, he espouses Ben Grahamian principles and writes folksy annual reports. He has modeled his company, C$1.5 billion (1996 revenues)Fairfax Financial Holdings Ltd., after Buffett's Berkshire Hathaway. Just like Berkshire, Fairfax doesn't pay dividends and never does a stock split. At C$372, the company is the most expensive stock on the Toronto Exchange.

Yep, Fairfax is also into insurance. Like Buffett, Watsa understands how a smart investor can exploit the float. Fairfax, accordingly, owns ten property and casualty insurers, whose huge reserves he uses to play the stock and bond markets.

Watsa can point to a Buffett-style return. Fairfax's book value per share has risen at a 40% annual rate since Watsa, who started out in the late 1970s as a money manager at a Toronto life insurer, took over in 1985.

There's one big difference. Berkshire Hathaway's shareholders are a bit breathless, having priced Berkshire shares at twice their liquidating value. Fairfax's holders seem to live in tulip-bulb territory. They think Fairfax is worth three times book. The shares have more than quadrupled since 1994. That makes Watsa's 15% of the company worth C$648 million.

All this is great news for investors who got in early. New investors, who may be dazzled by Watsa's record, should proceed with caution. The tremendous growth in book value per share at Fairfax comes from decidedly un-Buffett-like transactions. Buffett increases his book value by buying solid companies and letting them grow. Watsa does it by issuing new shares. In the last two years he has increased the number of common shares outstanding by 25%.

Whenever a company trading at a premium to book value issues new shares, whether from a secondary offering or in the course of an acquisition, the book value per share goes up. Why?

With the book value per share at about C$120, the issuance of a new share at the market price of C$372 creates C$252 of surplus value, which is spread around to all shareholders. When the dust settles, the book value per share winds up north of C$120.

It's a neat trick. Imagine that there are exactly 1,000 shares outstanding and a company has a net worth of C$120,000, or C$120 per share. The company sells another 1,000 shares at C$200. Now the company's net worth becomes C$320,000, or C$160 a share. Wow! A 33% increment to net asset value.

If you were naive enough to think that the gain in book value from C$120 to C$160 represents genius on the part of management, you might be tempted to bid the shares up well beyond their already steep price of C$372. And then the clever managers could sell still more shares at a still higher price. Tulip-bulb time.

Since 1993 Fairfax has peddled almost C$500 million worth of stock, mostly to pay for acquisitions of three sickly reinsurance outfits: Compagnie Transcontinentale de Reassurance, Skandia America Reinsurance Corp. and Sphere Drake Holdings Ltd. So sickly are they that they sold out to Watsa at discounts below book value.

When you buy for less than book value these days, you don't get prime properties. Each of these acquired companies has problems. None makes any money on its underwriting. Skandia and Sphere Drake both have hefty long-term asbestos and environmental liabilities. CTRand Skandia also have significant exposure to bad debt on what they hope to recover from their own reinsurers.

Watsa hopes to protect himself against these risks with the C$230 million reserve he carries on his books in the form of negative goodwill. That came from buying the insurers below book value. Watsa can play this reserve two ways:as a cushion to offset future underwriting problems, or to add to earnings when and if he deems future risks insignificant. But remember: Either way, it's just a bookkeeping item.

Fairfax has no shortage of underwriting headaches already. Including this year, it has had an underwriting loss in four of the last five years. An underwriting loss means that insurance policies yield less in premiums than they are projected to cost in eventual claims and other costs. The only thing saving Fairfax from red ink is investment income. Contrast Berkshire Hathaway, which has turned a profit on its underwriting in each of the past five years.

Just how good are Fairfax's profits? Not great. Pretax income last year was C$18.40 a share, but C$13.37 of that represented pretax capital gains. Back out the capital gains, and you have an insurer trading at 74 times pretax earnings. Moreover, Fairfax's net income was increased by C$2 per share--the effect of tax-loss carry forwards and nontaxable offshore investment income. Those tax benefits can't last forever.

Nor can the capital gains. As of June only 14% of Watsa's C$4.2 billion portfolio was in common stock, down from 25% in 1992. Watsa deserves kudos for participating in the bull market and may prove to be prescient in getting out now. But his shares do not deserve a huge premium on the theory that he can keep pulling capital gains out of the hat.

What's Watsa's take on all this? We don't know. The guy keeps a low profile. We mean really low. He never grants interviews and hasn't been photographed by the press since the early 1980s. John Varnell, Fairfax's chief financial officer, says only this: "We prefer to let the results speak for themselves." They do speak, but not perhaps the message Watsa wants to convey.

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