Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial) is, of course, one of the most successful investment opportunities of all time. Over the past six decades, shares have produced compound annual returns of around 20%, roughly double the return of the S&P 500 (SPY, Financial). The pace of these returns, however, is slowing. Over the past five years, shares have returned just over 70%. That's still a market-beating performance, but not what Berkshire investors have long been used to.
There is a reason Berkshire's returns are slowing down: the law of large numbers. Now valued at $700 billion, it is simply more difficult for the company to grow at breakneck speeds. It is, after all, easier for a $20 billion company to double in size than a $700 billion company. Fortunately, there is a Berkshire clone that is valued at just $20 billion. And as we will see, there is plenty of reason to believe it can replicate Berkshire's historical performance.
How to find the next Berkshire
Before we look at the next Berkshire, it is important to review what made the company so successful. Founded by famed value investor Warren Buffett (Trades, Portfolio), the company has a time-tested strategy that it has used for decades. At its core, the company is an insurance operator. There is often some underwriting profit, but the company's founding trick was to invest the “float” of the insurance policies. That is, insurance purchasers pay their premiums in advance, collecting that money back when there is a claim. In the meantime, Berkshire can invest these funds, called float, essentially earning free money.
There is a second part of Berkshire's successful business model, and that is the ability to invest wisely. Buffett became famous for his acumen in this regard, investing in dozens of companies that eventually became blue-chip stocks.
So there you have it. The secret to Berkshire's success is two-fold. Run profitable insurance companies that throw off plenty of float, then invest that float in highly profitable ventures. Seems easy, but only a few operators have had as much success as Buffett. One of those investors is Prem Watsa (Trades, Portfolio), founder of Fairfax Financial Holdings Ltd. (TSX:FFH, Financial) (FRFHF, Financial), a company many believe to be the next Berkshire Hathaway.
A perfect Buffett clone
As you may have guessed, Fairfax runs a portfolio of insurance companies, and like Buffett does for Berkshire, Watsa is in charge of investing Fairfax's float. How successful has he been in years past? Luckily, we have several decades of hard data to validate his supposed acumen.
As you can see in the chart above, both Buffett and Watsa have produced market-beating returns over the past two decades, a feat few investors have accomplished. To be sure, Buffett still has a long-term edge, but closer inspection shows his returns have slowed down compared to Fairfax. As you can see in the chart below, Fairfax stock, due to its small size, can exhibit much greater swings in value. This should be no surprise due to the law of large numbers. But it is also true on a granular scale. Many of Fairfax's top holdings, such as BlackBerry Ltd. (BB, Financial), have market caps in the low billions. Most of Berkshire's top picks are valued in thehundreds of billions. Fairfax's portfolio, therefore, can easily double or even triple in value over a given year. Berkshire's top picks would struggle to replicate this potential.
So Fairfax has a long-term record of market-beating using the same model of success as Berkshire. Its size, meanwhile, has allowed it to outpace Berkshire's performance in recent years. But what will the years ahead look like?
Fairfax is still primed for success
Since 1985, Fairfax has compounded book value per share at 18.5%. The share price has closely followed this performance over the long run. Looking ahead, there is reason to believe the performance can continue. Over the last five years, Fairfax has transformed its insurance operations to become one of the largest property and casualty companies in the world. As with Berkshire, it all operates in a decentralized structure, with each management team making decisions that they feel is best. This new scale has created an opportunity to produce underwriting profits, as represented by the combined ratio. At a combined ratio of 100%, the insurance arms are roughly breaking even. If that figure is under 100%, they are producing profits. Fairfax's scale is allowing them such profits.
So, at a core level, Fairfax is more profitable than ever. From a portfolio perspective, however, things look equally bright. The investment portfolio has grown alongside underwriting profits and, more impressively, management deployed billions in cash to buy back shares when they were near multiyear lows. This reduced shares outstanding at impressive entry points, all while Watsa positioned the company for a strong resurgence.
As with Berkshire, Fairfax has a lengthy portfolio, and the details can be reviewed in its latest annual letter. From a top level, however, shares do not appear to be overly expensive despite a recent runup. The dividend generates a yield of only 1.2%, but when combined with the company's aggressive share repurchase program, total investor yield is closer to 5%. And as with Berkshire Hathaway, Fairfax has nearly always posted positive returns on equity in comparison to its cost of capital. Over the past decade, for example, Fairfax generated average ROE in excess of 10%, while WACC almost always stayed at or below 5%.
Book value is likely the best way to gauge how pricey shares are today. While cash flow and earnings may be volatile due to the investment portfolio, book value provides a rough idea of how all the businesses in the conglomerate are valued. In that regard, shares today still trade a bit below book value, a discount to Berkshire Hathaway, and the recent runup was not due to a rising valuation premium, but underlying performance.
What exactly drove this performance?
Here's what Watsa is betting on
Fairfax's fixed income portfolio remains very conservative, as is the case for most insurance conglomerates. About 74% is in government securities and only 15% in short-dated corporate bonds. That stability is combined with a reliable and growing insurance arm, with gross premiums last quarter of $8 billion, up 10% year over year, and a company-wide combined ratio of 94%, which generated a surprisingly strong underwriting profit of $337 million. Premiums were up across the board, especially so in Asia. Growth for Fairfax Asia was up 60% last quarter, driven by Singapore Re and Pacific Insurance, both which are seeing improvements in pricing and operating efficiencies.
Within the company's publicly traded equities portfolio, there is a diverse set of investments. Two of the top five picks, which collectively represent most of the equity portfolio, represent technology companies, but the others span real estate, international banking and resource mining. Keep in mind, however, that the rest of its portfolio heavily concentrates itself across energy and banking, so you must have a positive macro view on these sectors.
Critically, Watsa is extremely bullish on Indian equities, and has more than a billion dollars of exposure to the growing country. The company's 54% interest in Bangaladore airport stands as a great example of Watsa's thinking.
“As I have said many times in past annual reports, the crown jewel (and largest) of Fairfax India's investments is the Bangalore International Airport,” he explained in the latest annual letter. “In 2022, Hari and his team did the impossible – they built the most beautiful airport in the world (Terminal 2 or T2) in a record four years, of which two were interrupted by COVID! In my mind, there is no airport in the world like T2 and it will be an inspiration for travellers arriving in Bangalore, the state of Karnataka and India. It will show the world anything is possible in India.”
With a strong record of financial performance, a portfolio aimed at high-growth countries and sectors and a valuation that does not even reach book value, Fairfax continues to be a promising pick. If you are interested in a proven winner that also has the potential to be the next Berkshire Hathaway, Fairfax should be at the top of your watchlist.
