Prem Watsa's Fairfax 2023 Annual Shareholder Letter: Part 2

Continued from part one.

We discuss our investments in more detail in the section on Investments. The long-term potential of our investments continues to be very significant.

The table below shows the dollar and percentage contribution (expressed as a percentage of our approximately $60-billion average investment portfolio) of the various components of our investment return in 2023. Please note, neither our gain on the sale of Ambridge nor the gain on the consolidation of Gulf Insurance are included in the investment return.

Interest and dividend income from our total portfolio almost doubled in 2023 to $1.9 billion from $962 million in 2022 due to rising interest rates. Interest and dividends as a percentage of our fixed income portfolio for the last five years are shown below as well as the yield on our fixed-income portfolio.

This increase in interest and dividend income happened because we did not reach for yield when interest rates were low in the 2019-2021 time period. In fact, over half our fixed-income portfolio was in cash and short-dated treasuries, yielding almost no interest. Our interest and dividend income is now running at $2 billion annually and can be expected to be maintained at that level for the next four years. Profit of associates continued at $1 billion while fluctuations in stock and bonds added almost $2 billion in 2023. Please note the total return on our investment portfolio of 8.4% in 2023 was just above our 38-year average of 7.7%!

Below is a table that shows successive periods over our 38 years of operations, with the compound growth in our book value per share (including dividends paid) together with the average combined ratio and average total return on investments:

As we have discussed previously, our growth in book value consists of two major variables – the combined ratio of our insurance companies and the total return on our investment portfolio. For each of the last four time periods above, starting in 2006, our insurance companies have produced average combined ratios below 100%. In the last three years, our investment returns have turned upwards (still less than our average of 7.7% for the last 38 years), which has resulted in book value growing at 26.6% per year (last two years under IFRS 17). We hope to grow book value at 15% per year in the future.

India

As I said last year, Prime Minister Modi has taught the average Indian to dream. Anything is possible! The Indian economy is expected to grow at 7% for the foreseeable future, the highest growth rate for a major economy. In the next four years, India is expected to be the third largest economy behind the U.S. and China and ahead of Japan and Germany. Mr. Modi is expected to easily win re-election in May of this year – perhaps even getting a larger majority than in his second term. This will establish India clearly as a business-friendly nation, with great prospects for the future. It is very unlikely that India will go back to its socialist ways that were in place when I left India 51 years ago!

While I was writing this shareholder letter to you, I came across an outstanding report on India by Jefferies' Head of Equity India Research, Mahesh Nandurkar titled “India's March Onto the Global Stage,” which recommended India for seven reasons:

1. India will be the third largest economy by 2027.
2. Continued reforms lay the foundation of approximately 7% long-term GDP growth.
3. Nearly US$10 trillion market cap by 2030.
4. Supportive global geopolitics.
5. Rising entrepreneurship / vibrant start-up ecosystem driving innovation.
6. India now becoming a services exports hub.
7. Strong corporate culture and a history of strong market returns.

Also, Amitabh Kant, former CEO of NITI Aayog (public policy think tank of Government of India), has written an outstanding book “Made in India”, a 75-year history of business and enterprise in India – particularly since Mr. Modi was elected in 2014. Because of the size of its population, and the business-friendly policies adopted by Prime Minister Modi, India will be the best economy to invest in for the next few decades.

The table below shows our investments in India and how they have performed up to December 31, 2023:

• Includes dividends received ($12 million) and spinoff of Quess ($330 million)
• Cost shown for Quess represents its market value on December 5, 2019, the date it was spun off from Thomas Cook India

Thomas Cook's (LSE:TCG, Financial) business rebounded in 2023 as travel recovered, with revenues up and a pre-tax profit of $34 million, up from a loss of $2 million last year. Thomas Cook stock price was up 90% in the Indian stock market in 2023. We sold 40 million shares at $1.67 to repay the $60 million we invested last year in the company. Future prospects for Thomas Cook look excellent in the years to come.

Sterling Holiday Resorts (BOM:523363, Financial), a subsidiary of Thomas Cook India, remains a premier Leisure Hospitality Brand in India with 49 resorts, 46 destinations and more than 2,800 rooms, in addition to offering Vacation Time Share. Under the leadership of Vikram Lalwani, Sterling had record results in 2023 with 20% growth in revenue and 35% growth in EBITDA. Sterling's future looks very bright.

Quess (NSE:QUESS, Financial), spun out of Thomas Cook in 2019, is the largest domestic private sector employer in India with over 557,000 employees (10% growth in 2023). Quess is India's leading integrated business services provider. It has a pan-India presence along with an overseas footprint in North America, South America, the Middle East and Southeast Asia. It serves over 3,000 clients across India, North America, APAC and the Middle East. Quess continued to show excellent growth in its core business. While some segments of its businesses are still recovering from the effects of the pandemic, revenue from its operations grew 13% to $2.25 billion. It reported a lower profit before tax of $33 million, compared to $36 million reported in 2022. Quess is incubating certain product-led businesses, on which it incurred about a $9 million loss during 2023. Quess's business model is well-aligned to benefit from the strong economic growth in India. Under the leadership of chairman and founder Ajit Isaac and a long-serving senior management team, Quess continues to consolidate its position in the market with more clients and good growth. Better times are ahead for Quess as it moves forward with its plan to demerge into three separate entities, a significant strategic initiative announced by Quess in February 2024. While it remains a market leader in its core workforce management business, each of the demerged entities will be a market-leading player with the ability to leverage opportunities that come their way through its renewed focus. We expect that this strategic initiative will benefit all shareholders in the years to come.

In Fairfax India's (TSX:FIH.U, Financial) 2023 annual report, Chandran Ratnaswami, our CEO, has said that “including $1.7 billion in unrealized gains on its existing portfolio, it has achieved a 13% annualized return since inception in 2015 – 22% on listed investments and 10% on our private investments which are conservatively valued. Since its inception, Fairfax India has also generated realized gains, including dividends and interest, of $724 million and has never lost money on a monetized investment. We have achieved an annualized return of 28% on partially monetized investments and 17% on fully monetized investments. Including its stake in NSE, whose sale will close in 2024, the realized gain since inception was $900 million, an annual return of 20%. Most of Fairfax India's investments are in outstanding companies with a history of strong financial performance, led by founders and management who are not only excellent but also adhere to the highest ethical standards.”

While the book value per share of Fairfax India is $21.85, the underlying intrinsic value is much higher. As Fairfax India's shares continue to trade at a discount to book value, we have bought back, since inception, 22.0 million shares (or 14% of shares outstanding) for $285 million at an average price of $12.93 per share. That includes the 2.9 million shares we bought in 2023 for $37 million at an average price of $12.97 per share.

DBRS upgraded Fairfax India from BBB (low) to BBB, reaffirming the company's strong financial position. Every three years, Fairfax India pays a management fee (in cash or shares) to Fairfax for investment services, based on performance. In 2023, at the end of the third three-year period, Fairfax earned an incentive fee of $110 million which will be paid in cash as it was more advantageous for Fairfax India to pay it in cash versus shares. In the first two control periods, Fairfax had no choice but to take our incentive fee in shares! (Which we were delighted to do!)

As you have read many times, the crown jewel (and largest) investment in the Fairfax India portfolio is Bangalore International Airport (BIAL), run by Hari Marar. Not only is it the most beautiful airport in the world, it also is self-sustaining in energy, water and soon, biodegradable waste and offers seamless boarding (your face is your boarding pass). Terminal 2 (or T2) is designed to provide the highest level of passenger experience, while also making it an unforgettable destination for passengers with its memorable visual impact, sustainable practices and technology. Fairfax India had purchased 54% of BIAL in 2017/2018 for $653 million and added another 10% in 2023 (from Siemens) for $250 million for a total investment of $903 million for 64% of BIAL.

In 2023, passenger numbers in BIAL surpassed 2019 levels with total passengers of 37.2 million (32.7 million domestic and 4.5 million international) versus 33.7 million passengers in 2019. Passenger traffic is expected to increase to 90 million by 2038. Also, BIAL is developing real estate at Airport City on 460 acres adjacent to the airport.

Despite the unprecedented events that impacted operations and financial performance in 2020, 2021 and 2022, BIAL generated an average ROE of 14% for the second control period and an ROE of 17% for the combined first and second control periods. ROE in 2023 was 14%.

The valuation of Fairfax India's 64% interest in BIAL increased to $1.6 billion in 2023 from $1.2 billion in 2022, implying an equity value of approximately $2.5 billion. With no assigned value for the 460 acres in Airport City, BIAL is carried on Fairfax India's books at 9.5x normalized free cash flow for the company.

Please read Chandran's letter to shareholders in the Fairfax India 2023 Annual Report for a lot of excellent information on Terminal 2 and our other investments in India. Chandran, Sumit and Gopal continue to do an outstanding job in building Fairfax India.

Some brief comments on our major investments in India follow:

Under Nirmal Jain's and his partner, R. Venkararaman's leadership, IIFL group of companies have done extremely well. We bought our position of 27% in IIFL Holdings for $288 million in December 2015 and then a second piece in February 2017. IIFL split into four companies in 2017 and 2019. To date, we have completed total sales of $421 million, received dividends of $78 million, and at the end of 2023 continued to hold remaining IIFL group investments with a fair value of $612 million, aggregating to over $1 billion in value and representing an annualized return of 21%

Due to poor global demand for PVC, Sanmar's revenues declined to $965 million from $1.4 billion and EBITDA to $96 million from $224 million. We expect this to pick up significantly as India continues to grow. India's consumption of PVC per capita at 2.6 kilograms is still significantly less than in China (16 kilograms) or the U.S. (13 kilograms). Vijay Sankar, its CEO continues to do an outstanding job.

CSB Bank (BOM:542867, Financial), under Pralay Mondal, who took over as CEO in 2022, had the best year in its history. CSB's revenues increased 27% in 2023 from $196 million to $236 million, while net income increased by 10% to $69 million from $66 million. Non-performing loans dropped to 1.2%. Capital continues to be strong with a capital adequacy ratio of 23%. Net interest margin of 5.2% and a loan-to-deposit ratio of 83% are all excellent indicators of CSB's performance in 2023.

Fairfax India acquired a 1% stake in NSE for $27 million. NSE is the largest stock exchange in India with a market share of over 93% in cash equity trading and over 98% in equity derivatives trading. Early in 2024, we expect to close the sale of our investment in NSE for proceeds of $189 million, generating an annualized return on the investment of 33%.

Fairfax India owned a 67% stake in Fairchem for an investment since inception of $38 million. In November 2021, Fairfax India sold 14% of Fairchem for $46 million, recouping more than its entire investment while still owning 53%, valued at $103 million on December 31, 2023.

Seven Islands Shipping had its best year ever in 2023! Its revenue increased by 34% to $166 million, net income increased by 310% to $84 million and shareholders' equity grew by 50% to $213 million, generating an ROE of 39%. Since the time we acquired our interest in Seven Islands for $84 million, it has generated free cash flow of $209 million, for an average annual free cash flow on investment of about 25%.

The investment in NCML has not lived up to our expectations. A confluence of market situations (including the implementation of GST, the demonetization of some currency, a banking crisis for the farm sector, a failed farm reform bill, and, finally, the pandemic) impacted the rural economy and severely constrained NCML's business. It has taken a long time to recover from these setbacks. 2023 was another difficult year: although revenue increased by 8% to $33 million, net loss increased to $19 million from a loss of $12 million in 2022. With the appointment of Sanjay Gupta as CEO in 2022, a significant part of NCML's restructuring will be completed by 2024. Under Sanjay's leadership, NCML's work on capital allocation and business strategies should help it return to operating profitability in 2024. We continue to be positive on the long term outlook of NCML and India's agriculture sector.

As I mentioned last year, under Ajit Isaac's leadership, Fairfax and Quess have committed to fund the construction of CMC Vellore's new 350-bed children's hospital in Tamil Nadu. This hospital will be dedicated to delivering top-notch care and ensuring inclusivity with minimal financial strain on its patients. Building plans are finalized and construction will commence in the coming weeks once final approvals are received. On completion in 2026, this world-class facility will enable CMC Vellore to develop and provide specialized pediatric services and training programs for India.

Having surpassed our initial goal of installing 1,000 dialysis machines across India last year, we are now up to 1,200 machines installed at 325 centres. This has enabled the delivery of more than two million free dialysis sessions. There is a great need for this life-saving service, especially the access to free or subsidized dialysis in India's rural communities. With Thomas Cook India and Madhavan Menon leading the effort, we plan to install another 800 machines over the next couple of years.

As we do regularly, we show you our unconsolidated balance sheet so that you can better see where your money is invested.

• Equity shown for the Insurance and Reinsurance Operations excludes minority interests, investments in other consolidated operations, investments at the holding company and intercompany debt.

The table shows you our insurance companies, which are decentralized and separately capitalized, with our consolidated non-insurance companies shown separately with the majority of them held in our insurance companies' investment portfolio and the rest in our holding company.

As you can see, we have $24.6 billion ($1,069 per share) invested in our insurance companies – up from $866 per share last year. And that is at book value – the intrinsic values are much higher in our view.

Our consolidated non-insurance businesses (and your investment per share in them) are shown separately in the above table. They are significant and in our view worth more than the amount at which they are carried on our balance sheet. We expect each of these non-insurance operations to generate a 15% annual return or better over the long term. Please note our cash and investments of $1.8 billion in our holding company is for protection from the unexpected. We also hold investments in associates and consolidated non-insurance operations at the holding company level.

Below, we update the table on our intrinsic value and stock price. As discussed in previous annual reports, we use book value as a first measure of intrinsic value.

The table shows, excluding dividends, the change in book value in U.S. dollars and our stock price in Canadian dollars. As I have said before, we think our intrinsic value far exceeds our book value. As shown in the table, there have been many years when our book value has increased significantly and our stock price has gone up more: please note 1993, 1995, 1996, 1998, 2003, 2008, 2014, 2021 and 2022 and now, 2023. In the last three years, our book value has grown at more than 20% annually and our stock price has followed suit. Perhaps more years like this are yet to come!

Last year, I said that for our stock price to match our book value compound growth rate of 17.8%, our stock price in Canadian dollars should be $1,375. Well, we went through that early this year!

Here is how our stock price has done over the periods ending in 2023, compared to the TSX and S&P 500 (all including dividends):

Insurance and Reinsurance Operations

Allied World delivered the best single company underwriting performance in Fairfax history, posting a combined ratio of 89.5% and yielding $482 million of underwriting profit. Under the expert guidance of Lou Iglesias, Allied World expanded dramatically over the last four years. Its expense ratio, at 22%, continues to provide a significant competitive advantage. Fairfax is very grateful to Lou, John Bender, Wes Dupont and the entire team at Allied World for their terrific efforts!

Outstanding as always, Odyssey Group chipped in $397 million of underwriting profit off a combined ratio of 93.4%. Odyssey's positive result in 2023 extended its streak to 12 consecutive years of underwriting profit, no mean feat in an ever-challenging industry. Gross written premium declined in 2023, due to the termination of one exceptionally large transaction, but Odyssey is well-positioned, with its diversified global footprint, to resume its expansion where market conditions warrant. No CEO at Fairfax has contributed more underwriting profit to shareholders than Brian Young, ably assisted by Carl Overy, Chris Gallagher and the entire Odyssey family.

Northbridge once again produced another strong result in 2023, with a combined ratio of 91.1% and underwriting profit of $180 million. With Silvy Wright at the helm, Northbridge has been an important and reliable force at Fairfax. Enjoying an exceptional reputation in the Canadian marketplace, it continues profitably growing in the commercial property and casualty space. Federated led by George Halkiotis, its direct writing subsidiary, continues to expand and came in at an 87% combined ratio.

We are delighted to report that Brit, now under the exacting eye of Martin Thompson, far surpassed any previous year during Fairfax ownership. Underwriting profit of $240 million and a combined ratio of 91.9% contributed materially to our success in 2023. Brit's results include the favourable performance of its innovative Ki Syndicate, which Mark Allan continued to build out during the year.

Crum and Forster is now three times its size since Marc Adee took over in 2015, and it has reported an underwriting profit in all nine of those years. In 2023, the combined ratio rose to 97.7% and the underwriting result declined to $87 million, due largely to Crum's Hawaiian-based unit and the devastating fires in Maui. Crum heads into 2024 with a collection of compelling businesses and a strong head of steam.

Among our North American companies, Zenith has had the hardest road to hoe. We estimate Workers' Compensation rates have declined cumulatively over the last seven years by close to 40%. Yet, due to its outstanding customer service, portfolio management skills and favourable loss trends, Zenith has maintained underwriting profitability over the last 11 years. Kari Van Gundy and team generated $46 million of underwriting profit and a combined ratio of 93.8% in 2023.

Our Fairfax Asia group reported a combined ratio of 93.9% and underwriting profit of $26 million. Amongst the various companies of Fairfax Asia, Singapore Re, under the able and energetic guidance of Phillipe Mallier, was the stand-out, contributing $21 million to the result. Overall direction of Fairfax Asia continues to be under Mr. Athappan, with assistance from his son, Gobi, and Ravi Prabhakar.

Fairfax LatAm, managed by Fabricio Campos and team, had another fine year, with a combined ratio of 94.9% and underwriting profit of $15 million. Each of the four companies in Fairfax LatAm produced a positive underwriting result.

Fairfax Brasil, under Bruno Camargo, rebounded in 2023 and generated $7 million of underwriting profit off a combined ratio of 94.8%

In Eastern and Central Europe, Peter Csakvari's Colonnade delivered its 6th consecutive year of underwriting profits, coming in with $11 million of gain and a combined ratio of 94.9%. Our separate units in Ukraine, ARX and Universalna, maintained their profitability despite extraordinary conditions, contributing $5 million and $2 million underwriting results, respectively. And Polish Re reported a 10th straight year of profits, with a $4 million underwriting gain in 2023.

In South Africa, Bryte rebounded to produce an underwriting profit of $8 million with a combined ratio of 97.2%. In 2024, Edwyn O'Neill is passing the reins of CEO to JP Blignaut, while he takes on the role of Chairman with pan-African responsibilities.

In Greece, the property and casualty operations of Eurolife produced an underwriting loss of $15 million with a combined ratio of 123%. Catastrophic fires and floods added 24 points to the loss ratio in 2023. Run by Alex Sarrigeorgiou, Eurolife also writes a large profitable book of life insurance.

Finally, our underwriting result was topped off by a $29 million contribution from Group Re, largely reflecting the Fairfax Internal Reinsurance Vehicle (FIRV), whereby we retain a portion of the outgoing reinsurance our decentralized operations purchase from third parties.

A review of our international operations is not complete without acknowledging the contributions of Bijan Khosrowshahi. In addition to overseeing Colonnade and Fairfax LatAm, Bijan has facilitated collaboration amongst all of our international groups via a biweekly forum he chairs. And, importantly, he has been instrumental in the Middle East with Gulf Insurance Group, the newest member of the Fairfax family following our buyout of KIPCO.

All of our major insurance companies are well capitalized even though we have grown significantly in the last six years, as shown in the table below (further details are provided in the MD&A).

On average, we are writing at 1.0x net premiums to statutory surplus vs 1.2x in 2022.

The net premiums written and combined ratio of our companies which we have owned since 2014 (last 10 years) and our major companies acquired since then are shown in the table below.

(1) Brit since acquisition on June 5, 2015, Allied World since acquisition on July 6, 2017.

The table below shows the average annual redundancies for the past 10 years (business written for 2013 onwards) for our companies which we have owned since 2013.

Riverstone, led by Nick Bentley and Bob Sampson, continues to manage our run-off operations. Nick, Bob and the rest of the team do an outstanding job dealing with some of our most difficult claims in a very challenging U.S. legal system, while continuing to deal with emerging latent-type claims. In 2023 Riverstone strengthened reserves by $260 million, primarily related to asbestos liabilities on both their direct and assumed portfolios, talc, ULAE and uncollectible reinsurance. Our net run-off reserves of approximately $1.5 billion, which contain almost all our asbestos and latent exposures, are approximately 5% of our total net reserves. With developing science and laws addressing key liability and coverage issues as well as the challenging U.S. legal system (including social inflation, nuclear verdicts, third-party litigation funding) the volatility around future outcomes remains high, especially on emerging claims. That said, we believe we have one of the premier run-off teams in the industry who are working diligently to contain losses while paying claims when due.

We have updated the float table we show you each year for our insurance and reinsurance companies.

Float is essentially the sum of insurance contract liabilities and insurance contract payables, less reinsurance contract assets held and insurance contract receivables, on an undiscounted basis excluding risk adjustment. Our long-term goal is to increase the float at no cost, by achieving combined ratios consistently well below 100%. This, combined with our ability to invest the float well, is why we feel we can achieve our long-term objective of compounding book value per share by 15% per annum. This no-cost float is perhaps one of Fairfax's biggest assets and will be a key reason for our success in the future. In 2023, our underwriting profit was a record $1.5 billion and our “cost of float” was a 4.9% benefit. In the past 10 years, the largest benefit we had was 5.5% in 2015, which corresponded to a combined ratio of 90% and an underwriting profit of $705 million. We showed you earlier the growth in our float per share and, as we said, this is a huge plus for Fairfax.

The table below shows you the breakdown of our year-end float for the past five years:

Our float increased 14% in 2023 and 54% in the last five years as our insurance and reinsurance operations expanded significantly in the hard market. The float in runoff continued to decrease as claims are paid.

The table below shows the sources of our net earnings (the gain on Ambridge and consolidation of Gulf Insurance is shown separately):

In 2023, we had record operating income of $3.9 billion because of record underwriting profit of $1.5 billion, interest and dividend income of $1.7 billion and share of profits from associates of $762 million. As we suggested earlier, there is no certainty in life, but we feel this level of operating income may be repeatable in the next few years. Net gains of almost $2 billion consisted of net gains on equity exposures of $1.2 billion and bond gains of $0.7 billion.

Continued in part three.