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2024 First Quarter Commentary


For printable version which includes all graphs and tables, click here.​​​​


Patience and Perseverance: An Investing Advantage


“Our favorite holding period is forever.” - Warren Buffett


“The big money is not in the buying and selling but in the waiting.” - Charlie Munger


We have discussed the importance of patience and perseverance in our commentaries since we started writing them over 20 years ago. Long time horizons are of critical importance for taking advantage of investment opportunities and receiving the benefits of compound interest. Last quarter we included the chart below from J.P. Morgan. We show it again because of the important message it conveys – the longer your investing time horizon, the more likely you are to experience strong returns in stocks along with fairly low variation.


The probability of a positive return in stocks improves as the holding period lengthens (see nearby chart). This is the reason that we recommend only investing money in stocks that you will not need for at least five years. This observation contrasts with the actions of most stock investors. The average holding period for stocks continues to fall (see chart below). In the 1960’s, the average holding period for a New York Stock Exchange (NYSE) traded stock was 8.3 years. The current figure is less than 11 months. This short holding period differs strikingly from FRM’s average holding period of somewhere around 10 years. We believe this demonstrates our disciplined approach, which is focused on a long-term owner-oriented perspective to stock investing and not on the vagaries of other participants in the market.


Financial markets are full of people with differing goals and objectives and even more so, very different time horizons. Benjamin Graham, often referred to as the “father of value investing,” wrote that “in the short-run, the market is a voting machine but in the long-run it is a weighing machine.” A voting machine counts votes. Votes are based on the sentiment of people at any given time. Sentiment can change, sometimes quickly, and it is difficult to measure accurately. A weighing machine is much more precise and concrete. It is easy to measure weight accurately. Graham is suggesting that in the short-term stock prices are driven by sentiment while in the long-term they are driven by something you can measure more concretely – the financial fundamentals of the underlying company. Staying focused on the long-term with a commensurate time horizon gives FRM the opportunity to take advantage of the short-term shifting in investor sentiment. This includes opportunities to buy from pessimistic shareholders, to sell to overly optimistic buyers, or more often, to hold on to the shares of the companies we own and wait patiently as they continue to execute on their business plans and grow their intrinsic value (i.e., their financial fundamentals.)


The following three sections are current examples of where we believe patience and perseverance are benefiting your FRM stock portfolios in the face of shifting market sentiment and prices being driven by stock traders with different time horizons. They include: 1) a prominent short-seller releasing a report on Fairfax Financial Holdings (TSX:FFH; OTC:FRFHF), 2) challenges relating to the current “patent cliff” facing pharmaceutical companies, and 3) the 2024 U.S. Presidential Election.


Muddy Waters Shorts Fairfax Financial


Muddy Waters and its founder, Carson Block, rose to prominence in 2011 after releasing a research report on a leading Chinese forestry company, Sino-Forest Corporation. The report alleged accounting irregularities that inflated Sino-Forest’s assets and earnings. Muddy Waters was quickly proven correct with the Sino-Forest stock price falling more than 80% and the company declaring bankruptcy less than a year after the report’s release. Since that time, Muddy Waters and Carson block have used the prominence gained from the Sino-Forest report to publicly release their short targets and attempt to profit from the subsequent decline in the targets’ stock price. The time horizon for Muddy Waters’ trading is decidedly short.


Fairfax is a holding company for global property and casualty insurance and reinsurance operations and other diversified investments. The stock has been one of our largest holdings for over 20 years. Our time horizon on Fairfax is decidedly long. We have written extensively about the company in past commentaries, most recently in our 2nd Quarter 2023 Quarterly Commentary. Fairfax also has a history with short-sellers targeting its stock, most recently back in 2006. We actually had short-sellers contact us wanting to borrow our clients’ shares. We declined at that time, but we haven’t forgotten the experience.


On February 8 of this year, Muddy Waters released a short report on Fairfax, and Carson Block was given airtime on CNBC’s ‘Squawk Box’ to make his case against Fairfax. The company’s stock price went down almost 12% that day, back to where it started 2024 around $920 per share. It was a harrowing day for your portfolio’s largest position to say the least!


Muddy Waters released the report on Fairfax a week before the company was scheduled to release their 2023 year-end results. The release of the report was well-timed since Fairfax was in their regulatory mandated quiet period before announcing earnings results and were therefore prohibited from discussing material financial information. Fairfax did respond by categorically denying and refuting all of Muddy Water’s allegations and insinuations as false and misleading but had to wait until their earnings call to address specifics.


The report released by Muddy Waters was 72 pages long and contained 14 specific allegations against Fairfax related to various accounting assumptions and treatment of transactions. The report’s conclusion is that Fairfax has overstated their book value by 18%. Many of the allegations suggest that the current value of certain assets is lower than the carrying value that Fairfax shows on its balance sheet. We believe Fairfax has done a good job of disclosing the nature of their assets and accounting assumptions so that investors can make their own informed judgements as to the value of each asset. We further believe that the company has adhered to the accounting rules they are bound to follow, the International Financial Reporting Standards (IFRS). The largest allegation of book value overstatement by Muddy Waters was related to Fairfax’s adoption of IFRS 17. The new accounting standard was required to be adopted on January 1, 2023. Fairfax has publicly addressed IFRS 17 on several occasions and detailed how it would increase its book value: “Although IFRS 17 brings considerable changes to the measurement, presentation and disclosure of the Company’s insurance and reinsurance operations, it will not affect the Company’s underwriting strategy, its prudent reserving, management’s use of the traditional performance metrics of gross premiums written, net premiums written and combined ratios, or the amount of the Company’s cash flows.” IFRS 17 addresses how insurance companies should deal with reserving. Reserves are what insurance companies set aside from premiums to settle future claims. IFRS 17 requires the discounting of claims reserves to their present value, which Fairfax had not done previously. The implementation of IFRS 17 caused Fairfax to experience a larger increase in their book value than many of their insurance competitors. Muddy Waters highlighted it as suspicious. We would highlight it as a positive for Fairfax. The company has had more conservative accounting focused on the long-term and only started discounting future claims reserves when forced to do so by regulators.


The report did not address any of the assets that Fairfax has on its balance sheet that are carried at values well below where the market values them. Also, Muddy Waters did not mention the record earnings for 2023 of $173.24 a share. Further, the report did not highlight the hard market in insurance contracts that Fairfax was positioned to take full advantage of over the last several years (a hard market is a good market for writing insurance contracts when premiums increase and coverage terms are restricted). Finally, the report did not mention how Fairfax’s presciently managed its bond portfolio to substantially increase interest income over the past two years. We continue to own Fairfax and remain optimistic about the company’s future prospects. The shares closed the first quarter trading at $1,041.43 with a price to trailing 12-month earnings of a very low six times.


Patent Cliff: Look out Below?


Perhaps surprisingly for some, we have been long-time investors in the pharmaceutical sector. Though ultimately a sector that has historically grown much faster than the overall economy, the pharmaceutical industry is one where valuation levels swing from optimism-driven highs to pessimism-driven lows. It is a sector where a variant perspective is what initially led us to invest. Many of you have heard about (and plenty will hopefully remember!) our initial purchase of Merck on September 30, 2004 the day that Vioxx was removed from the market, and the market cap fell by $26 billion. This was our first opportunity to add exposure to the growing pharmaceutical industry at a value price! (See our 2nd Quarter 2019 Quarterly Commentary for a more in-depth description of our initial Merck purchase.)


We expanded our pharmaceutical exposures in 2007 and 2008 when pessimism surrounding the pharmaceutical “patent cliff” drove some company valuations to attractive levels. Sales of branded drugs generally decline dramatically in the immediate years following patent expiration, generally by 50%+ in the year following and sometimes up to 80% in the 2-3 years after patent loss. By 2007, talk of the upcoming 2010-2012 “patent cliff” in the pharma industry was shaping valuations, which had dropped to 16.2x earnings after peaking over 33x earnings during the tech-fueled stock market bubble of 1999-2000. Interestingly, Pfizer, owner of the #1 grossing medicine of the day (cholesterol treatment Lipitor), traded for the lowest price to earnings of any large pharma peer at only 9.9x earnings, well below the aforementioned industry average of 16.2x. Lipitor represented 28.6% of Pfizer’s 2006 revenues, and they were scrambling to find a replacement for their top-selling drug, which was to lose exclusivity in 2011. It was at this point that we initially added Pfizer to client portfolios.


Pfizer had announced workforce cuts, and news articles were rampant with doom and gloom opinions about the pharmaceutical industry’s future. A January 2007 Forbes article about Pfizer’s 10% personnel reduction summarized the prevailing view about the entire pharma industry:


“This generic ‘cliff’ is the largest in the history of pharmaceutical companies.”

“Between 2010 and 2011, Big Pharma will lose 28% of current sales.”

“The problem for Pfizer and its peers is not just that older drugs are going off patent but that new ones are not making up the difference.”


Truly, there was cause for concern. The top 10 blockbuster drugs of 2006 represented ~20% of the pharmaceutical industry’s total branded sales, and seven of the ten were due to lose exclusivity by 2013 . Pfizer’s cholesterol drug, Lipitor, was the highest grossing drug of 2006 and as mentioned above represented over 28% of Pfizer’s sales. The second highest grossing drug was blood thinner Plavix, which was ~19% of largest owner Bristol-Myers Squibb’s sales. The third biggest drug at that time was acid-reflux treatment Nexium, which was ~20% of maker AstraZeneca’s revenue. The fear permeating the industry was that the drug companies could not possibly discover new drugs that could fill the void of the sales that would inevitably vanish when these blockbuster drugs lost patent exclusivity.


The nearby chart shows the ultimate sales trajectory of the top blockbusters of 2006. Sales did peak out and decline rapidly as less-expensive generics entered the marketplace. However, as long-term investors who could take an alternative perspective, we were able to use the pessimism about the patent cliff to grow our exposure to this truly “growth” sector. Though we didn’t know how they would do it or which companies would be the winners of tomorrow, we added diversified exposure to several pharmaceutical companies during the attractive valuations of 2007-2008. Our total portfolio exposure to pharma went from only owning our initial 2% position in Merck at the end of 2004 to owning four companies (Merck, Sanofi, Eli Lilly and Pfizer) totaling ~14% of our portfolio at the end of 2011. While overall growth did stagnate for a few years from 2009 to 2013, eventually drug companies were able to innovate and create even larger blockbuster drugs that more than replaced the sales of the stars of the late 2000s as we show in the second chart nearby. We believe that pharmaceutical companies have demonstrated time and time again that they are innovators. They spend substantial research and development dollars every year to solve the next unmet need. They uniquely have the expertise and infrastructure to react rapidly to new healthcare threats that emerge such as the COVID-19 virus. Just in the last two years, an entirely new class of drugs developed to treat type 2 diabetes has been adapted to treat chronic obesity. We believe pharmaceutical companies will continue to be innovators. Sentiment about the future of the industry swings from highly optimistic to highly pessimistic, but for long-term investors, we believe we can take advantage of these swings to add exposure to high quality, innovative companies at reasonable valuation levels.


Today, pharmaceutical companies represent just over 9% of our portfolio. While we are trimming in certain cases to limit position sizes (existing clients should see the Merck write-up below), we are happy to have diversified exposure to a number of very attractively valued growth businesses with the capability of producing life-changing drugs to treat a wide range of health challenges the world is facing. There is once again talk of a pending “patent cliff” as two top-selling drugs, AbbVie’s Humira and Merck’s Keytruda, will have expired by 2028. (We note that both of these two drugs, which will both likely exceed Pfizer’s Lipitor in ultimate lifetime sales, became blockbusters subsequent to the 2010-2012 patent cliff fears.) We continue to actively monitor the sector looking for new opportunities to add exposure to this “growth” industry at value prices.


The 2024 U.S. Presidential Election


In our 3rd Quarter 2020 Quarterly Commentary we started a section about the 2020 election with this: “Every four years, we seem to receive more questions and concerns about the upcoming presidential election, so we decided to address it head-on in a totally unpolitical way. As long-term investors, we do our best to keep our eyes on the horizon, which is generally the unique long-term investment goals of each of our clients.” The only thing that has changed since the last election cycle is how early the questions have begun regarding the presidential election’s impact on markets.

We recently saw a poll from Nationwide’s ninth annual Advisor Authority survey that 45% of investors believe the results of the 2024 U.S. presidential election will have a bigger impact on their portfolios than the U.S. economy will. Further, 32% believe that the economy will plunge into a recession within 12 months if the political party they do not support wins the election. We do not know who will win the 2024 election, and we do not know if a recession will begin after the election, or before the election, or at any other time for that matter. When we observe the stock market returns in past presidential election years, they do not differ much from returns in non-election years. We also observe no discernable pattern in returns based on which party wins (see chart below). We continue to have a long time horizon and stay focused on the financial fundamentals of the companies we own and hope to own.


Form ADV


We recently updated our Form ADV Part 2A and 2B informational brochure and reported no material changes from the previous version. If you would like a copy of this brochure, please contact our Chief Compliance Officer, Abby McKelvy, at (501) 534-2675.


Disclosure


Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.


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