How to Survive a Bear Raid

Joan Cheos jerked awake... The phone was ringing in the middle of the night. Again.

"Get out now," the voice on the other end of the line warned. "Fairfax is a fraudulent company. Save yourself!"

Cheos was the executive assistant to Prem Watsa, the CEO of Fairfax Financial Holdings, one of Canada's largest insurance companies.

This wasn't the first strange call she had received. Cheos, who was battling cancer at the time, was understandably rattled by the barrage of mysterious phone calls. And she wasn't alone... Someone was harassing other Fairfax employees as well.

Fairfax was the target of an elaborate "bear raid" – a coordinated attack designed to depress a company's stock price. Except this bear raid had morphed into something more sinister... a systematic persecution of Fairfax employees.

In The Divide: American Injustice in the Age of the Wealth Gap, author Matt Taibbi notes: "Fairfax was in an alley fight with an organized group of aggressors who had moved outside the usual realm of quarterly results and analyst reports and SEC disclosures."

The episode began in 2002 when Jim Chanos started shorting shares of Fairfax. Shorting – as regular subscribers know – is that a stock will fall. And Chanos, who heads the hedge fund Kynikos Associates, is one of the best at it.

Chanos famously shorted Enron before it went bust. But he made his reputation sniffing out accounting irregularities in "serial acquirers" – companies that make one acquisition after another.

In the early 2000s, Chanos noted that Fairfax, which had been gobbling up companies throughout the 1980s and '90s, seemed to fit the profile of some of his most successful shorts.

In the summer of 2002, Chanos had an e-mail exchange with Dan Loeb, who runs the hedge fund Third Point Management. Chanos told Loeb that he believed Fairfax was committing accounting fraud and its shares were "going to zero."

When a guy with Chanos' track record starts throwing around those kinds of accusations, people take notice. Other high-profile hedge-fund managers – including Loeb, Steve Cohen of SAC Capital Advisors, and Adam Sender of Exis Capital Management – also shorted Fairfax.

Some of the managers dubbed the campaign the "Fairfax Project."

The shorts got help from John Gwynn, an analyst at a small investment bank, Morgan Keegan, that counted SAC and Exis Capital as important hedge-fund clients.

Gwynn wrote a very negative report on Fairfax, suggesting that it needed $5 billion more capital to adequately cover potential insurance claims. Many of the hedge-fund managers knew that the bearish report was coming. Some even violated securities laws by trading on this "material, non-public information" before it was published.

By mid-January 2003, speculators had sold short 2 million Fairfax shares. So for every dollar that the stock price dropped, the short sellers as a group made $2 million. In the three trading days after the report's January 16 release, Fairfax's U.S.-listed shares declined as much as 25%. The Canadian-listed shares lost as much as 52% of their value at one point as investors panicked. Perhaps in response to the bogus reports, Standard & Poor's (S&P) cut Fairfax's credit rating in February.

The short sellers made huge profits by betting on a decline in Fairfax's stock. But the profits were temporary. On March 10, 2003, Fairfax issued its 2002 annual report. The 130-page document thoroughly detailed the company's material business issues... or lack thereof. It also confirmed the company's stellar year in 2002.

The annual report started a massive "short squeeze" in Fairfax shares.

When a stock has a high short interest, an increase in the price can force short sellers to "cover," or close out their positions. They have to buy the stock to do so. And as more and more short sellers capitulate, the buying pressure sends the stock surging.

From March 2003 to early February 2004, Fairfax's U.S.-listed shares rocketed more than 260% higher.

The shorts were getting eviscerated. They needed a new strategy. And so the second phase of the Fairfax Project began...

The perpetrators began to orchestrate attacks to disgrace Watsa, tarnish Fairfax's reputation, and crush employee morale.

A few of the hedge-fund managers hired henchmen to deploy a range of dirty tricks... like calling Watsa's cancer-stricken assistant in the middle of the night.

They spread a false rumor that the Royal Canadian Mounted Police were pursuing Watsa, who had allegedly fled with stolen company funds. Employees of one of the hedge funds showed up at Watsa's home and questioned his family about his whereabouts in a threatening manner.

Someone even sent a letter to Watsa's pastor at St. Paul's Anglican Church in Toronto. The letter suggested that Watsa, who was on the church's investment committee, was swindling the parishioners' money.

Major shareholders, trading desks, brokerage houses, ratings agencies, and research analysts all made frantic calls to Fairfax seeking answers.

The harassment stretched out over years... And it took its toll. Fairfax's stock traded sideways for much of 2004 and 2005, and it began to drift lower in 2006.

To put an end to the assault, Fairfax filed suit against the hedge funds and Morgan Keegan on July 26, 2006. The lawsuit accused the gang of engaging in a massive, illegal stock market manipulation scheme, which included spreading false or misleading information about Fairfax. The suit claimed $6 billion in damages, including reputational harm, increased costs, and missed acquisition opportunities...

For Watsa and Fairfax, the lawsuit had mixed results. The judges dismissed many of the defendants due to technicalities. So there was no $6 billion in restitution. None of the hedge funds were punished for the attack or had to surrender any gains made from their Fairfax shorts.

But they got the message, and they left Watsa and Fairfax alone from then on.

The only person held accountable for the assault on Fairfax was Morgan Keegan's John Gwynn, whose 64 negative reports on the insurance firm were the linchpin of the whole bear raid. The investment bank ultimately fired Gwynn for leaking information to the hedge funds.

For Watsa and Fairfax, the story has gone much better...

Since July 2006, Fairfax's U.S.-listed shares have produced a 500% total return. By comparison, Canada's S&P/TSX Composite Index is up only 81% over the same period. Fairfax now even has an investment-grade credit rating. S&P upgraded it in early 2009... during the last credit crisis.

In the end, Fairfax and Prem Watsa weathered one of the most vicious bear raids in history. The company's existence today serves as a testament to its strength and the devotion of its employees. And more than anything, it's a story of the survival and supremacy of "the world's best business."

Today, we're going to tell you more about Watsa, Fairfax, and why now is the perfect time to go long the firm that – just 10 years ago – was the most hated stock on Wall Street.

'The Best Business in the World'

Fairfax Financial is in what we have long called "the best business in the world"... property & casualty (P&C) insurance and reinsurance.

We came to appreciate P&C insurance after years of studying and writing about the best investors in the world – like the legendary Warren Buffett, Benjamin Graham (Buffett's college professor and mentor), and lesser-known investors like Shelby Davis, who spent 40 years turning $50,000 into $1 billion by focusing solely on insurance companies.

When the world's best investors flock to a single industry... it's smart to learn what they find so compelling. Buffett's 2011 Berkshire Hathaway shareholder letter provides a quick snapshot of a successful P&C insurer (emphasis added):

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call "float" – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit... If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it.

The power of the P&C model lies in the interplay of the three bolded metrics (float, underwriting profit, and investment income). People pay insurers premiums, but the events insured by these premiums – say, an auto accident or a medical-malpractice lawsuit – will only be triggered in the future, if they are ever triggered at all. If over time, the total amounts collected (premiums) exceeds the total amounts paid (claims), then the company is generating an underwriting profit.

But the real secret is the float – the premiums collected but not yet paid. The insurer gets to invest the float and keeps all of the investment gains for itself.

As of 2015, Buffett's insurers held nearly $88 billion in float while earning an underwriting profit of $26 billion over 13 years. Imagine if you were given $88 billion to manage and got to keep the gains for yourself (a lousy 2% return would yield nearly $2 billion a year)... And imagine if, in addition to that investment income, you also got to keep $26 billion over the course of 13 years simply for the privilege of holding and investing the capital.

In every other financial-services business – banking, money management, brokering, etc. – using the capital of others costs you money, usually in the form of interest on deposits or loans. But a successful P&C insurer effectively gets paid to invest other peoples' money for its own benefit.

That's the beauty of the P&C insurance and reinsurance model.

Of course, not every insurer enjoys this ideal set of circumstances. Indeed, if you don't earn an underwriting profit, then your float effectively costs you money... in which case you're no better off than the banks, which borrow money to make loans and invest. It's worth noting that the insurance industry as a whole operates at an underwriting loss.

In our proprietary insurance rankings (see gray box for details), we're looking for companies that display Berkshire-like underwriting discipline.

Of course, we're not the only ones who have been watching Buffett. Hedge funds and other so-called "alternative capital" have been trying to follow Buffett's model by starting their own reinsurance companies. For example, high-profile hedge-fund manager David Einhorn launched a reinsurer called Greenlight Capital back in 2007. Even Dan Loeb – a participant in the Fairfax bear raid – launched Third Point Reinsurance back in 2011.

These companies have always been extremely popular with newsletter writers, who often cited these funds as "the next Berkshire Hathaway." The idea was simple: Smart investor + insurance = the next Berkshire Hathaway. But it's not that simple. There is very little precedent for starting a successful reinsurer from scratch. (It's worth noting that that's not how Warren Buffett and Berkshire Hathaway entered the insurance business.)

You see, an insurer's most crucial asset is the confidence its customers have in its ability to pay potential claims. As we've warned subscribers on multiple occasions – the market does not inherently trust hedge-fund guys to cover their most important risks. That's why, as we predicted, both Greenlight and Third Point have struggled to gain a foothold in the industry. Neither have mastered profitable underwriting. And both trade for less than their initial public offering (IPO) prices over a period where the insurance markets – and stock market in general – have flourished.

Prem Watsa, on the other hand, entered the insurance business 30 years ago. He was a huge fan of Ben Graham, Buffett's mentor, even naming his son after him. Watsa built Fairfax Financial Holdings "the Buffett way," by purchasing companies with long-standing insurance businesses.

He started by partnering with the Markel family – the Virginia-based insurance titans we've covered several times over the years. In May 1987 – about 20 years before Buffett's letters made P&C and reinsurance "cool" – Watsa reorganized his partnership with Markel, and he renamed his firm Fairfax Financial Holdings Limited (the Fairfax name is short for "fair, friendly acquisitions").

From 1985 to 2010, Watsa's firm increased its book value per share by nearly 250 times – primarily via acquisitions. That's compounded annual growth of 25% per year over 25 years. And while we certainly don't condone the bear-raid tactics, you can certainly see why Chanos thought Watsa's results were too good to be true.

In a way, they were.

In January 2003, Gwynn's initial accusation was that Watsa and Fairfax were under-reserved by $5 billion. If true, that would essentially mean Fairfax had been an irresponsible underwriter for many years and lacked the capital to cover its risks. If Fairfax was, in fact, under-reserved by $5 billion, the firm was in peril.

Then, on January 30, 2003 – just two weeks after the bombshell report – Gwynn released another report. In this one, he admitted that his estimates of reserve deficiencies were exaggerated... by more than $2 billion.

Fairfax ultimately did have to restate its financial results for several prior years, but not for the reasons Gwynn predicted. On the surface, Chanos and the other short sellers seemed to be vindicated. However, the restatement was a noncash accounting error that would lower shareholders' equity by only about 5%. The SEC subpoenaed Fairfax but later said no enforcement action was warranted.

The accounting issue was serious, but it wasn't fraud. Fairfax was certainly no Enron.

Since we began tracking Fairfax in our Stansberry Data rankings, the firm has consistently been ranked in the top 25, but hasn't yet cracked the top 20. These are solid results, but they're not exceptional. Here's why Fairfax has struggled to crack the list of truly elite insurers:

Underwriting – Over the past 10-15 years, Fairfax's underwriting has been poor. About 60% of the time, the company makes money underwriting. But its discipline is not nearly as consistent as the top firms we track. In fairness, part of this lukewarm performance are a result of acquiring a couple of struggling insurers in the late 1990s, which took several years to straighten out.

However, the company's underwriting has improved in recent years. Last year, Watsa promoted Andrew Barnard, the star underwriter at Fairfax subsidiary OdysseyRe, to rein in underwriting throughout the company. So far, it's working. Last year's results were the best in company history.

Investment Returns – Watsa's investment returns have been very good. In fact, Fairfax has grown its investment base as well as any company we monitor. But Watsa hedges his portfolio by using derivatives to make large bearish bets.

Watsa considers these bets "hedges," but they can actually be quite risky. Sometimes these bearish bets work out – when Watsa aggressively shorted the U.S. mortgage market in the mid-2000s. But sometimes they don't – like in 2013, when Fairfax lost more than $3 billion using options to bet against U.S. markets.

In the end, Watsa's investment results have been good... But they would have been a lot better if he hadn't been so aggressive making bearish macro bets. More on this in a moment.

Book-Value Growth – As we mentioned earlier, for 25 years, Fairfax's book-value growth was fantastic – with a compounded growth rate of 25% per year. That's better than nearly anyone... in any industry.

However, scale was bound to catch up with Fairfax eventually. It's a lot harder to "move the needle" at a big company. Over the past five years, the compounded growth rate of Fairfax's per-share book value has been just 2% per year annualized. Watsa has explained that this disappointing growth has been primarily due to the aggressive bearish hedging bets, "as (Fairfax) worried about the speculation in the financial markets and the potential for a 50-100-year financial storm."

Shareholder Returns – One of the things we track in our P&C rankings is how generous the companies are to shareholders. We love dividends and stock buybacks. Fairfax pays a decent dividend (around a 2% yield at current prices), which works out to about $1.5 billion paid out over the past five years. But any benefits of this generous dividend policy is offset by loads of stock issued to fund the aggressive acquisition strategy.

Almost every Prem Watsa article written in the past 15 years compares him to Warren Buffett. But the comparison can go too far...

Watsa's Fairfax is far more concentrated on insurance than Buffett's Berkshire Hathaway, with well over 90% of Fairfax's operating income coming from insurance, compared with only around 22% for Berkshire Hathaway. Furthermore, as we mentioned above, Watsa has made some very un-Buffett-like bearish macro bets that have eaten into Fairfax's investment gains. When Buffett uses derivatives to make macro bets, it's generally to establish bullish positions.

Still, Watsa and Fairfax have made some timely non-insurance investments in recent years. Investments in feedstock makers Alltech and Ridley Inc. have been huge winners for Fairfax. Ridley alone has returned nearly 350%. A huge stake in the Bank of Ireland has also done well, as has an investment in real estate firm Kennedy Wilson. (Of course, Watsa's high-profile investment in mobile-device company BlackBerry has yet to play out, nor has a huge bet on Eurobank.)

We've always admired Fairfax and gone on record in various publications stating that we'd love to buy the company for the right price. So we were thrilled – but not at all surprised – to learn that Watsa's Fairfax was purchasing...

The Best Insurance Company We Don't Already Own

It is very unusual for a top-10 insurer to trade cheap enough to recommend...

Since 2012, only eight companies have made the cut. Our last insurance recommendation came back in April 2015 – 21 months ago. That issue was dedicated to Allied World Assurance (AWH), a company started by three industry giants in the wake of this century's greatest tragedy:

Before the World Trade Center towers stopped smoldering, the CEOs of three major insurance firms... began to design a new insurance venture. At the head of the deal was the legendary Hank Greenberg, the CEO of AIG – which, in 2001, was the single-most respected insurance company in the world. Greenberg pulled in Swiss Re CEO Walter Kielholz and Chubb CEO Dean O'Hare.

When disaster strikes, thinly capitalized or poorly run insurers are run out of business. The survivors can charge higher rates in the competition-light period that follows. Customers – with the tragedy fresh in their minds – are willing to dole out extra money for the peace of mind that comes with knowing their risks are insured by the best.

Industry stalwarts like to form new companies when favorable conditions for pricing insurance follow tragedy. The reason is simple: A new firm has no pre-existing policies and no legacy liabilities. As long as you underwrite conservatively, it's a nearly foolproof way to make insane amounts of money.

The new venture was named Allied World Assurance and was headquartered in the insurance capital of the world – Bermuda.

As you may recall, these industry veterans – who had a combined 200 years of P&C experience – rushed Allied World to market in time for the January 2002 reinsurance-contract season. The new company was initially backed by major insurers and the world's most important investment bank – Goldman Sachs.

In our Stansberry Data Insurance Monitor, we only evaluate companies with at least 30-40 quarters of operating history, which is generally long enough to evaluate management through the good times and bad. Given its pedigree, it's no surprise that Allied World surged into the top 10 of our Monitor as soon as we began rating it... exactly 10 years after its IPO.

Of course, we don't automatically recommend every company in our top 10. To make it into our portfolio, companies need to be trading for a great price.

We have studied every major Buffett insurance acquisition, noting that his most successful transactions come when he can buy the target for a 50%-60% discount to the total of float plus book value (what we call "float + book"). The problem is Buffett, Watsa, and the Markel brothers are the only insurance executives that disclose float... And even then, data aggregators like Bloomberg don't publish the number.

We broke through this challenge by building the only model we know of – certainly the only one available to the public – which aggregates the float calculation for every publicly traded P&C insurer. This allows us to not only rank float growth, but also ensure we never pay too high a price.

Over the years, we've trounced the market by limiting our insurance recommendations to only those companies trading at huge discounts to float + book. In April 2015, we enthusiastically recommended shares of Allied World Assurance while they traded for an incredible 58% discount to the company's float + book. As we noted at the time, we saw a potential near-term catalyst to propel the stock higher:

As we researched this company, we reached out to some of our industry contacts. Bermuda is a small island... one of those places where everybody seems to know everyone else. There is a lot of buzz – confirmed in the main news outlets on the island – that great reinsurers with a market cap of less than about $10 billion (like Allied) are ripe for consolidation and acquisition... So, even though we'd be happy to own this company for decades, there's a reasonable chance we'll have to settle for a quick profit here. And nobody ever went broke by taking a big profit quickly.

Of course, many of you know what happened next. Allied World shares sagged over the next year, with shares bottoming around $31 during the overall market swoon of February 2016. That triggered our trailing stop, and we booked a loss of 21% – the only loss we've ever suffered in our insurance portfolio.

The drop was puzzling. Granted, results for the second half of 2015 were underwhelming. But insurance is a long-term business, so we don't pay much attention to the quarterly earnings game for P&C firms. But the market does...

In February 2016, we noted the following in Stansberry Data:

On February 4, we stopped out of Allied World for a 21% loss. As you can see on the Monitor table, though, the company still ranks among the best in pretty much every metric we track.

In the past year, we've spent a lot of time covering the headwinds facing the P&C insurance sector – including low interest rates, alternative capital flooding the market, and soft pricing cycles. The iShares U.S. Insurance Fund (IAK) – a broad index of U.S. insurers – has dropped more than 8% in the 10 months since we recommended Allied World.

We expect our highly ranked companies to hold up much better in market downturns – and, in general, that's exactly what has happened... It's interesting to note that shares of our top 10 companies are up 2% over a period in which the overall insurance sector is down 8%.

In the 10 months since we recommended Allied World, it was the only company in our P&C top 10 to fall more than the overall market... Given how cheap Allied World shares are today, it's not clear to us why the market has decided to sell off the company more than its peers. But we're going to honor our stop losses and move on. So, we're closing our Allied World position in the Stansberry's Investment Advisory portfolio. Make sure you mind your personal stop loss position, too.

We often get e-mails from readers teasing us about Allied. The company was an active "Buy" recommendation for 10 months, so many readers got a better price than we reported in our model portfolio... And they did not stop out when we did.

Those readers were able to hang on to their Allied World shares and were rewarded for their patience. The company remained in our top 10 in almost every insurance metric we rank. Eventually, the market caught on to what we knew all along: Allied World is a great company – despite the temporary hiccup in late 2015.

After we stopped out, shares surged from $31 to $46 – nearly 50% in nine months. But here's the incredible thing: Because of its exemplary record for growing float, shares were nearly as cheap in December 2016 as they were when we recommended Allied World in April 2015, despite the meteoric rise in share price.

We weren't the only ones who noticed Allied's incredible run of consistent, great performances, or the fact that it is one of the cheapest insurers anywhere. Prem Watsa also noticed.

And so, as we were contemplating a re-recommendation of Allied World for an upcoming issue, Prem Watsa beat us to it. On December 19, Fairfax announced it would acquire Allied World for $54 per share – an additional 17% premium over the already appreciated shares. It's no surprise. Fairfax's impressive book-value growth has been driven primarily by Watsa making timely purchases of promising insurers.

It took a little longer than our Bermuda sources predicted... But Allied World is indeed getting snapped up.

These are two companies we've long admired, and the merger brings out a unique combination of complementary skill sets. This merger is clearly a good marriage. Consider this:

• As we explained, Allied World ranks in the top 10 of almost every metric we rank... the exception is Investments/Investment Growth, where it ranks a disappointing 30th. Of course, this happens to be the exact metric in which Watsa and Fairfax have historically excelled.

  Speaking of investments, it's also worth noting that Watsa is bullish on what the Trump presidency could mean. While there are many unknowns, an administration that lightens federal regulation, increases infrastructure spending, and creates some international tax breaks – three to-do items often mentioned by Trump's team – would be positive for the P&C industry. And, of course, rising interest rates will also help investment performance, given insurers' reliance on various fixed-income securities. Citing the administration change, Watsa no longer carries the expensive hedges that have traditionally dragged down his returns.

• Meanwhile, Fairfax's underwriting results will certainly improve with Allied World in the fold. Allied has always been a much better underwriter than Fairfax – earning overall underwriting margins of 13% while making an underwriting profit in nearly every quarter we've evaluated.

  We've already noted that Watsa, Barnard, and Fairfax have made great strides in underwriting profitability. And Watsa has given Allied's team "full freedom" to continue to operate autonomously.

  Given these developments, we expect Fairfax to rise in our underwriting rankings over the next several quarters.

• Lastly, we also expect Allied to provide a boost to Fairfax's book-value growth. Allied's per-share book value has grown 13% annualized for the past 10 years. We expect that growth to continue in the high-single-digit range for years to come.

From a valuation perspective, now is a great time to buy. Fairfax is down about 13% since October, although its shares have bounced back since announcing the acquisition. The stock's beta is an incredibly low 0.44 – which means shares are not correlated with the overall market. That makes it a great hedge. You don't often get an opportunity like this to "buy the dips" with Fairfax.

Fairfax is currently one of the cheapest companies we monitor, trading at a 57% discount to float + book. Incredibly, after the huge run-up in price, Allied World is trading at a 52% discount – right in our sweet spot. Watsa, as usual, is getting a great deal. And unlike some of his past insurance bargains, this time he's getting one of the best – not some turnaround.

This is a rare opportunity to get two great companies with one stock purchase. We know many of you still own Allied shares... If so, hang on to those Fairfax shares that land in your brokerage account. If you stopped out of Allied – or never got in – now is a great time to take advantage of this opportunity.

Fairfax Financial Holdings is a Canadian company that trades on the Toronto Stock Exchange (the "TSX"), under the symbol (TSX: FFH). It also trades in the U.S. over the counter (OTC) under the symbol (OTC: FRFHF).

Fairfax's TSX listing is highly correlated to its OTC shares. But you should know that more shares trade hands on the TSX. In periods of market stress, it can be easier to enter and exit the position on the TSX. Also, you might get a tighter spread (difference between the bid and ask) on the TSX – which could make a difference in your entry and exit price.

On the other hand, depending on your broker, you may experience higher fees to purchase a foreign-listed security. Please contact your broker for details. There may be some advantages in one or the other depending on your individual situation. Generally, one is as good as the other. For our purposes, we will track the U.S. OTC shares.

Action to take: We recommend you Buy Fairfax Financial Holdings (OTC: FRFHF) up to $520 per share. Use a 25% trailing stop once you've opened a position.

Good investing,

Porter Stansberry
with Brett Aitken, Bryan Beach, Mike DiBiase, John Engel, Alan Gula, Dave Lashmet, Bill McGilton, Bill Shaw, and David Xia
January 6, 2017