How to Invest with the "Warren Buffett of Canada"

Ask investment buffs why they spend so much more time researching and picking securities than most people, and they'll probably tell you they want the best performance possible from their portfolios. They certainly don't want to track the S&P 500, and they may not even be satisfied to beat it by a percentage point or two over time. They want to CRUSH it.

It's a tall order, to be sure. Maybe two or three out of every 10 investors are fortunate enough to beat the market in any given year, let alone consistently over long periods of time.

This is why so many investors closely watch and try to emulate stock-picking greats like Warren Buffett, Carl Icahn and others. Like most of us, these giants of investing may or may not beat the market in any given year, or even for several years. But over longer stretches... watch out.

 

This certainly describes Prem Watsa, Chairman and CEO of Toronto-based Fairfax Financial Holdings Ltd. (Toronto: FFH).

Watsa, age 61 and originally from India, began to earn a reputation as the "Warren Buffett of Canada" back in the late 1980s and early 1990s, not long after he took the reins at Fairfax. Indeed, he sold ahead of the crash of 1987 and foresaw the collapse of Japan's stock market in 1990. He also predicted the mortgage crisis of 2008 and prepared for it by selling or hedging equities and buying credit default swaps, which enable the holder to be compensated for loan defaults. Then, in late 2008 when virtually no one wanted anything to do with the stock market, he began investing heavily in equities again.

As a result, his $19.8 billion portfolio has posted returns that have soundly beaten the S&P 500 in the long-term, as the table below illustrates.

Clearly, Watsa is cut from the same mold as Buffett and other value-oriented investors who love to "be fearful when others are greedy, and be greedy when others are fearful." His company, Fairfax, is also quite similar to Buffett's. Although it's in the insurance business -- reinsurance and property/casualty, to be precise -- investment returns are the key driver of the stock price. The insurance business exists to generate cash for Watsa to invest, sort of the way Berkshire Hathaway (NYSE: BRK-B) provides a platform for Buffett's investing activities.

One of Watsa's biggest moves recently: On Jan. 27, he announced that he'd doubled his stake in struggling Blackberry maker Research in Motion Ltd. (Nasdaq: RIMM) to 26,848,500 shares (currently worth about $349 million). Through Fairfax, he now owns just over 5% of the company. Watsa is also on the company's board of directors. Research in Motion is down about 7% since Watsa doubled his position in the stock, but it's still far too soon to say whether or not the move will pan out.

His top five holdings as of the end of 2011 are listed in the table below. The recent additions of Research in Motion have since put that stock pretty much on par with Johnson & Johnson (NYSE: JNJ) in terms of portfolio weighting.

Although Fairfax is most famous for the investing acumen of its CEO, the insurance business is what keeps the doors open. And the thing is -- that business isn't as strong as it could be.

Of Fairfax's $7.5 billion in total revenue last year, $5.4 billion, or 72%, came from insurance premiums (investing activity accounted for the rest). Sounds good, right? Well, not so much when you consider the company's combined ratio -- a measure of profitability used by the insurance industry -- has averaged just over 100% for the past 10 years. This means Fairfax's insurance business is actually a bit in the red, since the combined ratio has to be under 100% for an insurer to be considered profitable. In 2011, for example, when Fairfax's combined ratio was 105%, losses from insurance operations totaled $230 million.

To be fair, the entire property and casualty insurance industry has had it rough for about a decade now, suffering through a soft market characterized by overcapacity and declining premiums. Hurricane Katrina and a number of other multi-billion-dollar disasters, not to mention the financial crisis, have also cut deeply into profits. Still, the performance of Fairfax's insurance business would still have to be described as below-average, since many competitors' combined ratios have been more in the 95-98% range.

Risks to Consider: Though it generates the necessary cash for Watsa to invest, Fairfax's insurance business could be better and is likely a drag on stock returns. This situation could worsen if the company is hit with more insurance claims than expected.

> Even with its below-average insurance business, Fairfax Financial Holdings is a worthy stock to hold for those looking to invest with the "Warren Buffett of Canada." The stock's long-term performance speaks for itself, and it reflects Watsa's ability to generate great returns by investing the premiums Fairfax receives from its insurance customers even though the insurance business is currently losing money by paying out more in claims, salaries and operational expenses than it collects in premiums. Plus, Fairfax has been seeking to improve its insurance business by acquiring more profitable operators, such as Zenith National Insurance Corp., a workers' compensation provider with a combined ratio averaging 95% during the past 30 years. (Zenith was acquired in May 2010 for $1.3 billion.)