Muddy Waters Attacks Fairfax With Unfair Facts

One thing I was well known for during my investing days was critiquing the sell side analysts. I’m sure many will tell you how they dreaded seeing an email response from me after they published a report.

I had what I thought were fairly low expectations – the report should be factually accurate, the analysis should be better than a college student could do, and they should be evenhanded in their assessment, rather than overemphasize data points that supported their thesis while ignoring obvious counterpoints that contradicted it.

You would be surprised how often research didn’t meet that standard which made me the scold of the sell side.

But there were special times when an analyst had an agenda, and would put something out so misleading and slanted, that I would send more than an email. I would follow up with a phone call to call them out for being disingenuous. They really didn’t like those calls.

Why do I bring this up? You may have seen the research report last week from Muddy Waters (MW) targeting Fairfax.

I am not here to defend Fairfax. I purposely kept my distance from them as I didn’t think an outside analyst could do a proper assessment of them given the complexity without more effort than necessary (meaning it would be a distraction from my focus on other companies).

You Give Short Selling A Bad Name

I am here to call out Muddy Waters. For those who don’t know, they are a high profile short seller. They have made plenty of good calls, but they are not perfect. The Fairfax report is an example of them being far from perfect.

Worse, it is fodder for everything short sellers get, (often) unfairly, accused of…spreading malicious rumors or misleading information topped off with rank speculation and conjecture to drive down a stock, even when they know it’s not true or relevant.

I obviously don’t have insight into what the analyst who wrote this report believes, but I can tell you that the presentation is highly sloppy and misleading and tries to create a bogeyman when there isn’t one there.

Before I get into the details, I should say that when I first heard MW put out a Fairfax report, I was immediately curious. I assumed they had done their homework and had found something interesting.

Given Fairfax is known to be a complicated company, I wouldn’t have been surprised if they unearthed something.

Yet, when I saw the report, it was incredibly disappointing. It was devoid of substance and largely a hit job on Fairfax, finding mischief where none (or little) existed. It’s the sort of thing you see sometimes from third tier research boutiques trying to make a name for themselves.

Reviewing the Case

So, to be clear, I’m not going to go page by page and deconstruct every argument. I don’t have the time for that, it would be way too long for this format, and, frankly, that’s valuable enough content that it could arguably drag me into this fight in a way I don’t want to be.

My goal here is to show the broader pattern of MW trying to create controversy through scary sounding statements that, for the most part, aren’t that big a deal, if they’re even true.

This is going to be longer than a normal post as I’ll try to at least address all the major points, but hopefully people will find enough value in it to stick through to the end.

The Book Value Red Herring

On p.3 MW outlines their thesis – Fairfax has inflated book value through accounting mischief and thus is, at best, overrated, and at worst, a fraud. MW makes “adjustments” to book based on their own assumptions, which may or may not be credible.

Much of the presentation is going through these adjustments. Some of them are silly. Some are likely accurate. But they miss the big picture.

Who gives a damn about reported book value at an insurer? In fact, if there is one thing MW proves, it’s that you should ignore book value as a standalone metric, because it is so easily manipulable and so dependent on discretionary assumptions.

The book value changes MW wants to implement have little to no impact on Fairfax’s capital. Thus, they are nothing more than cosmetic.

Companies already exclude all kinds of things from book value when they report financials – goodwill, f/x, investment losses, tax NOLs, etc.

Book value alone tells you next to nothing. It only matters in conjunction with ROE.

Quick example: If I earn $5 and my BV is $25, I have a 20% ROE. That is really good, so I get a high multiple on that book.

If I use aggressive accounting to take gains to increase book to $50, but my earnings stay at $5, my ROE falls to 10%. I now get half the multiple on twice the book value.

Thus, my stock value does not change!!! There is nothing to see!

Nothing MW alleges changes Fairfax’s earnings power, so, even if they are right, there is no ramification for the value of the stock!!!

Yet, they built a whole report on the thesis that Fairfax is a short because the BV is overstated! This is amateur hour!

The Details

OK, so I convinced you not to worry so much about book value, but you still have questions, right? Like, did their transactions really unfairly inflate book value because, if so, doesn’t that cast doubt on the integrity of the management?

This is a fair question. My answer is, as best as I can tell, most of what is described in the report I have seen, in various forms, at other companies. Don’t take that as an endorsement, but it’s also not something shocking or scandalous.

I’ll briefly review each of their main points below, but will keep it short so as to not make this overwhelming. Hopefully that is enough for the reader to get a sense of the types of arguments they are making without having to get too deeply into the weeds.

AWAC

So the report starts off with a slide on Allied World. My initial reaction was, oh good, this will have something to do with AWAC. That will be easy to analyze.

But all it was is a page of their combined ratios and AWAC is never mentioned again. Yet, somehow, MW asserts deteriorating margins at AWAC are why Fairfax pursued all these supposedly shady transactions. They give absolutely zero support for this allegation.

Recipe

Recipe is a restaurant chain Fairfax owns. MW alleges Fairfax didn’t write down its fair value. Their argument for this is that Fairfax used the price they paid to take Recipe private.

Normally, a market transaction is the exact price you want to use for accounting. So what is MW’s problem? They think the business has done poorly since the transaction so should be written down further.

What??? That’s utter BS. You don’t overrule a transaction price without good reason. At some point, if there is clear evidence of further impairment, Fairfax will need to take it.

But MW just makes up their view of fair value with threadbare support. Totally disingenuous.

Quess

Quess is an Indian investment. MW doesn’t like that Fairfax changed reporting so that they no longer consolidate it and instead use the equity method, among other things.

Are there times when companies push the envelope on equity method? Sure. Could this be one of them? Maybe. I don’t know the business well enough to say, but MW doesn’t provide compelling evidence to support why it’s wrong.

Rather they assert that it’s wrong and then demand writedowns. If they are right, they did very little to support it, and it’s not a serious offense anyway.

Plenty of companies delay taking impairments longer than I may want. Guess what? Usually the market figures it out and it’s already in the stock price, so when the charge comes, the stock doesn’t care.

EXCO

EXCO is an energy company. Again, MW doesn’t like that Fairfax carries it under equity method and demands they use it’s public market value, which is lower. But if that’s not the required accounting treatment, why would they do differently?

More importantly, it’s a non sequitur. Investors can very easily look at the public market value of EXCO and adjust on their own. Fairfax’s stock surely reflects the lower stock price of EXCO. Do they think the market is dumb?

But wait, it gets even more absurd. Then, MW chastises Fairfax for continuing to buy more EXCO at prices above the current market price.

So, either you have to believe they purposely threw more cash at something they knew was overvalued or maybe, just maybe, they bought more because they believe the price used for book value will prove correct in due course, and the stock price will eventually reflect that.

Grivalia

This is a property company where Fairfax is a minority owner. Grivalia merged into another company of which Fairfax had a minority stake. Fairfax received shares in the new company at a higher valuation and booked a gain.

MW doesn’t like this, so they lower the value to what it was before the merger. This seems highly arbitrary. Again, they purport to know the value of other companies better than Fairfax does.

Riverstone

This is the runoff vehicle with OMERs. MW alleges OMERS overpaid for its stake in the JV and thus Fairfax shouldn’t have booked the gain on it’s stake. What in the world???

So let me get this straight? Fairfax fools OMERS into giving them cash at an inflated value just so Fairfax can book a gain? And OMERS was powerless to stop this??? Do they realize how stupid this sounds?

Fairfax Africa

This is another case where MW doesn’t like Fairfax deconsolidating an investment and again suggests they chose to invest more cash at inflated values to avoid a book value loss.

If Fairfax’s motive is to hide book losses, pretty much the dumbest way you could do that is to use actual cash that you know will decline in value. The more likely answer is that Fairfax made a bad investment decision, but it wasn’t intentional. MW can’t entertain this possibility though.

APR Energy

This was an energy investment that Fairfax sold in 2020. MW alleges Fairfax sold it because it knew the business was in trouble and was looking to avoid another writedown.

Hello??? Earlier, the argument was it’s bad when they were buying too high and not admitting losses. Now, it’s bad that they’re selling too high? Sorry, this is getting beyond ridiculous and into the absurd.

Also, they now think it’s bad that Fairfax wrote down the goodwill, when in other places they criticize them for not impairing goodwill. Which is it???

Then, they allege this was a round trip transaction with no actual evidence, just more conjecture.

Eurolife

This is another OMERS deal where they accuse Fairfax and OMERS of being in cahoots to drive up Fairfax’s book value through duplicitous transactions. Yet, they never explain OMERS’ motive.

Odyssey Re

Fairfax sold 10% of Odyssey to…OMERS and CPPIB. Of course, this makes it suspicious! Twice as suspicious because now CPPIB is in on the plot!

Do they understand this would be a national scandal if two of the largest investors in Canada were helping a large Canadian company cook its books?

They shouldn’t be short Fairfax in that case. They should be filing class action lawsuits on behalf of every pensioner!

Anyway, MW thinks Fairfax sold its stake in Odyssey at too high a price to enable it to take a phony gain.

Brit

This is the Lloyd’s insurer Fairfax bought. Once again, OMERS buys a minority stake and has been convinced to overpay out of charity and goodwill.

Never once explained is why they would voluntarily do this. Nor do they consider that there might have been other bidders than OMERS because it is likely Fairfax ran a process and had other bids. No, the market price must be wrong cause MW says so!

Digit

This is an Indian insuretech. Like most insuretechs, it hasn’t done well. Of course, this must be malfeasance.

Ironically, MW accuses Fairfax of not writing up Digit’s value fast enough during the boom. That’s right. They were too slow to realize gains. And of course, this was malevolent. It couldn’t be because they didn’t believe in the bubble valuation and didn’t want to take full credit for it?

IFRS 17

IFRS 17 went into effect last year and caused all insurers to discount their liabilities. This changed book values for every insurer – some up, some down – depending on how things netted out. The net effect differs based on the liability duration, credit risk, and other assumptions.

This is not controversial…unless you’re MW. They complain that Fairfax had a larger gain that other P&C insurers. But that’s not surprising.

The comps they used are short duration insurers who would naturally have little impact. I suspect if they added insurers with longer duration liability profiles or more complex balance sheets, they would find Fairfax is probably in-line. More straw men.

Farmers Edge

This was a bad investment Fairfax made as it dropped to nearly zero. Fairfax impaired it, but MW wants a bigger write-off because they know better.

Gulf Insurance

Fairfax owned 43% of Gulf Insurance and bought most of the remainder at a premium to the market price. This allowed for a gain on the existing stake.

Of course, MW thinks they only bought in the rest to achieve that gain. So, once again, Fairfax intentionally spent cash to overpay for something just to drive the book value up and MW suggests the whole gain should be disallowed.

I’m beginning to think MW doesn’t understand how markets work. If you want to gain control of an asset, you have to pay a premium for it. What is fraudulent about that?

The Jury Finds…

To be clear, I am not saying MW is wrong or off base on every allegation. Similarly, I am not saying Fairfax always acted in good faith.

The truth is I don’t know with certainty, and I am not going to issue a scorecard on who I think has a better case for each topic.

What I will say is, if MW is right on some of these charges, they did a terrible job of making the case. Their arguments are wholly unconvincing, as I have hopefully shown to some degree.

It is a compilation of straw men, red herring, false flags, baseless conjecture, and whataboutism. That’s not how you convince me your case has merit.

So I think Fairfax is owed the benefit of the doubt to defend their practices and for people to judge with an open mind rather than presume them guilty.

If MW chose instead to argue that Fairfax isn’t as good at investing as the market perceives, and therefore deserves a lower valuation, I could at least understand that. They did a better job of showing that Fairfax has made some bad investments than proving accounting mischief.

Lessons

What have we learned from all this?

First, always examine the motive of someone writing an advocacy piece. Which this is, as MW has a short position they are trying to make money on.

Second, you can’t have it both ways. When you don’t write something down, it’s bad!!! But when you do write something down…that’s also bad!!! This isn’t debate club, man. Which is it, already?

Third, market transactions are the best arbiter of value, even above public market prices. Stock markets are wrong all the time and, often, manic as the marginal buyer sets the price.

In a sale (or large investment), a lot more diligence is done and a lot more is at stake. Therefore, that sales price has more credibility than me buying 100 shares of something.

Fourth, if you are going to make allegations, you either need to have evidence or motive. Ideally, both. Throwing around half assed conspiracy theories is reckless and irresponsible.

Fifth, if you are going to allege all these secret handshake transactions, you need to explain why the other party is going along, especially if they don’t benefit.

Sixth, lots of insurers are slow to take writedowns. Guess what? The market figures it out! Life insurers took over a decade to admit their variable annuity DAC was unrecoverable.

So what? We all knew and it was reflected in…low multiples to book because the market didn’t believe the book. This brings me to the main issue…

When Accounting Issues Matter

There are only three times I care about accounting decisions:

1. If the company is overstating earnings
2. If it exposes a company as undercapitalized and needing to raise capital
3. If it misrepresents debt, EBITDA, or equity in such a way that a bond covenant could get tripped.

Otherwise, I really don’t care and neither should you or Muddy Waters.

Nothing in their report impacts any of #1, 2, or 3 so, even if they are right about every one of their allegations, it shouldn’t impact the stock price.

The truth is they likely know this and don’t care. They are hoping to scare people with headlines and that nobody will actually read the report to realize it’s mostly noise.

Lots of analysts hoped nobody would read their actual work beyond the headlines either. Lots of companies too. Can’t tell you how many times IR told me “nobody ever asked about that disclosure in the 10-K before”.

The bad news is I actually read things, so if you are going to publish crappy work, I may see it and call you out on it.

Postscript

I realize there is a non-zero probability this ends up being seen by someone at Muddy Waters. If so, and someone wants to discuss, I am happy to have an open and honest dialogue. Click on the contact link to send me a message, and I’ll make sure to respond.

Also, for others who may want to borrow parts of this analysis for their site or publication, I would appreciate a short note to let me know but, at a minimum, please remember to cite properly and, ideally, include a link.