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Prem Watsa, the man in charge of Fairfax Financial Holdings Ltd. (TSX:FFH) needs no introduction.
Since taking over Markel Financial in 1985 (and renaming it Fairfax shortly thereafter), Watsa’s performance has been among the all-time greats. The company’s book value has grown by an amazing clip of 20% annually.
No, that’s not a typo. Those are the kind of results that get your name mentioned in the same breath as the legends.
Here’s how he does it. Fairfax owns several insurance companies that take in millions worth of premium payments. At some point in the future, most of these premiums will be paid back out in claims, leaving a period of time where the insurer can use them. Most insurers keep the majority of this cash in ultra-safe government bonds. The rest can be put into other assets like stocks or real estate. Watsa uses his to gobble up undervalued stocks.
These premiums—called the float—give the insurer a form of leverage that’s essentially free depending on how good the underwriting was in the first place. The float dollars can be invested alongside the original capital to really supercharge returns, especially if you’re good at investing in the first place, like Watsa.
If you invested a dollar for a decade at a 10% annual return, you’d end it at about $2.50. But if you could supplement that with a dollar of insurance float, you’d end up with $5 after a decade, all while (hopefully) not having to pay back that extra dollar in the first place.
Combine that leverage with a man of Watsa’s ability, and you have the recipe for a lot of success.
But should you buy now?
A decade ago, Watsa wasn’t nearly as well known as he is today. He was still delivering great returns to investors, but without guys like me analyzing his every move.
In fact, Fairfax shares spent much of the time between 2000 and 2008 languishing below book value. The company had to deal with a short selling attack by a number of hedge funds, as well as some challenging insurance results. It was only after investors saw the billions Fairfax made from betting against subprime mortgages that the market started to give the company respect. Shares have gone steadily higher since 2008.
Because of this, Fairfax currently trades at about twice its book value. After spending most of a decade languishing below book, does this mean that Fairfax is now fairly valued after all that time being undervalued? Or does that indicate that shares are a little expensive at these levels?
As much as I admire Watsa, I’m not sure Fairfax is worth twice its book value. Which is why I’d be looking at a different way to play this stock.
Enter with preferred shares
Even if Fairfax is overvalued, one thing is certain: it has plenty of cash flow available to pay its debts.
While investors wait for the common stock to return to normal levels, why not buy the preferred shares? The series E (TSX:FFH.PR.E) currently yield 4.8%, paying a dividend of $0.1818 per quarter.
These shares also offer another advantage, which is the potential for capital gains in the future. Originally issued at $25 each, they currently trade hands for just over $15 each. This is because they’re fixed reset preferreds, which is just a fancy way of saying the interest rate resets every five years.
These shares just reset back in March and pay a yield of just 2.91% on the original $25 price. But because investors now are buying at $15, they get a much higher yield, as well as $10 worth of potential upside when these shares are eventually paid off by the parent. This isn’t likely to happen at any time over the next five years, but is a nice potential reward for hanging on.
The real attraction is the dividend. A 4.8% yield is nearly three times higher than the dividend on the common stock, and is about as solid as dividends get. In a world where getting more than 2% from other traditional sources of income investments is difficult, these preferred shares look like a pretty good choice.
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Fool contributor Nelson Smith has no position in any stocks mentioned.