FFXDF - Fairfax India: Diversifying Your Portfolio With Exposure To India At A 27% Discount

Summary

• Fairfax India is at a 27% discount from book value for a solid portfolio of Indian businesses.
• There's strong support from Fairfax Financial Holdings, an Experienced business operator that weathered the storm in 2008 and 2022.
• There appears to be significantly aligned interest between advisor and management team, and investors.
• Bangalore International Airport Limited is taking the lead on value creation for investors.

Have you been looking for ways to diversify your portfolio? Have you been looking for ways to gain exposure to the growing economy in India? Have you been looking for a solid manager that can help you compound your investments over a long horizon? I hope to provide some answers to these questions through my analysis below.

Introduction

Fairfax India Holdings Corporation (FFXDF) (TSX: FIH-U.TO) (“Fairfax India”) is an investment holding company whose primary objective is to achieve long-term capital appreciation by investing in public or private equity or debt instruments in India and Indian businesses.

Fairfax India was launched in 2015 and has been supported by its parent company, Fairfax Financial Holdings Limited (TSX: FFH.TO) (“Fairfax”). Fairfax, itself, is engaged in property and casualty insurance and reinsurance and the associated investment management. During 2008 financial crisis, while the rest of the market was sinking, Fairfax was one of the few companies that was able to hedge its way out of the financial crisis. Similarly, in 2022 when the S&P 500 index dropped by 19.44% on a calendar year basis, Fairfax’s stock gained by about 30.6%. These examples demonstrate the sophistication and business prudence in Fairfax’s management team and strategy in my view.

Fairfax’s wholly owned subsidiary, Hamblin Watsa Investment Counsel Ltd. (“advisor”), is responsible for sourcing and advising on all Fairfax India’s investments.

As India is becoming a new superpower of the world, Fairfax India provides investors with prudent exposure at a discount to India’s rising economy and businesses. Fairfax India is an excellent option to help diversify an investor’s portfolio.

Valuation

Since inception in 2015, Fairfax India’s book value per share has risen from $10.00 per share to $18.75 as of September 30, 2022, a whopping 87.5% overall return or roughly 8.1% annualized return reflecting, but slightly outpacing India's GDP growth rate in the same period.

Source: India , Fairfax India’s Annual Report for 2021

Given $18.75 book value per share as of September 30, 2022, Fairfax India’s share is currently trading at $13.66 as of January 27, 2023, representing about 27% discount.

India’s economy is expected to continue growing at a rapid pace at roughly between 5% and 7% in the next three years. India’s middle class is slowly taking shape with rising income and increased access to credit that can boost domestic consumption. India’s maturing capital market as well as increased foreign investment provide capital for sustained growth.

Given that a significant portion of Fairfax India’s income (dividends, capital gains on disposition, interests) is earned outside of Canada such as India and Mauritius, Fairfax India also benefits from a much lower corporate tax rate than the typical Canadian corporate tax rate of 26.5%. If we note that Fairfax India doesn’t pay a dividend, this means that until an investor sells shares of Fairfax India realizing capital gains, Fairfax India’s portfolio value is impacted only at a much lower scale by corporate income taxes in India and Mauritius.

Relationship with Fairfax

Investor’s interest is well aligned with Fairfax India advisor’s interest. Fairfax is the controlling shareholder of Fairfax India. Prior to February 16, 2022, through ownership of subordinate voting shares, Fairfax owned 37.92% equity interest in Fairfax India. However, through ownership of multiple voting shares, Fairfax owned 94.61% voting interest in Fairfax India. On February 16, 2022, Fairfax purchased an additional 5,416,000 subordinate voting shares to increase its equity interest and voting interest in Fairfax India to 41.8% and 94.94% respectively. In addition to having 41.8% equity interest in Fairfax, in the offering of $500 million unsecured senior notes on February 26, 2021 by Fairfax India, Fairfax also provided $58.4 million at the same terms as other participants. This illustrates that Fairfax sees great value in Fairfax India and has strong interest to continue propelling its growth by supporting existing portfolio Indian businesses and identifying other strong Indian businesses to invest in.

In addition, Fairfax India has repurchased and canceled about 2.5 million shares or about 2.2% shares outstanding in the nine months ending on September 30, 2022 demonstrating its management’s belief that its shares are significantly undervalued.

In addition, the structure of Fairfax India advisor’s performance fee is unique and aligns with the long-term nature of Fairfax India’s strategy. The 20% performance fee is based on growth of book value per share that is above 5% minimum hurdle. Such performance fee is not calculated and paid on a quarterly or annual basis, but on a three-year triannual basis. Performance fee is only accrued every quarter, but calculated and paid every three years. This shows that the advisor has a long term interest in Fairfax India’s performance and is not worried about short-term fluctuation of investment portfolio value. As a result, it is less likely that Fairfax India makes a short-sighted investment decision that is not in the best interests of its shareholders.

Key Investments

Now let’s take a look at some of the key investments in Fairfax India’s portfolio.

Bangalore International Airport Limited

First up is Bangalore International Airport Limited ("BIAL"). BIAL is a highly profitable airport in Bangalore, India. BIAL was awarded Best Regional Airport in India and South Asia' during 2022 by Skytrax. It currently has two terminals and two runways and is in the process of adding a third terminal. It was opened in 2008 to act as an alternative to the HAL Airport serving the third most-populated city in India. BIAL is the third-busiest airport in India serving about 18.8 million passengers in the first nine months of 2022.

Fairfax India owns an effective equity interest in BIAL of 49% by itself and through Anchorage. BIAL’s wholly owned subsidiary, Anchorage (a flagship investment vehicle for Fairfax India’s airport and other infrastructure related assets), holds about 43.6% of BIAL. As mentioned in the 2021 Annual Report, Fairfax India has plan to complete an IPO of Anchorage in the near term to realize the value of its underlying assets such as BIAL (values 100% of BIAL’s underlying shares for at least $2.9 billion).

As of September 30, 2022, Fairfax India’s 49% equity interest is valued at about $1.25 billion representing about 39% of its total portfolio.

Airport typically tracks the performance of an economy. When India’s economy is growing, people are likely to travel more through airports boosting the value of assets such as BIAL.

Sanmar Chemicals Group

Second up is Sanmar Chemicals Group (“Sanmar”). Sanmar is one of the largest suspension polyvinyl chloride ("PVC") manufacturers in India. Sanmar also manufactures caustic soda, calcium chloride, chloromethanes, refrigerant gases, industrial salt and specialty chemical intermediates. In addition to chemicals, Sanmar also engages in engineering technologies and shipping businesses. Sanmar has grown into a large private conglomerate since 1970s with over $1 billion in annual sales.

In 2019, Sanmar settled $300 million bonds from Fairfax India at 13% with $433.9 million. Fairfax India re-invested $198 million into Sanmar to increase its equity interest from 30% to 43% at an effective valuation of $1 billion for the entirety of Sanmar group.

As of September 30, 2022, Fairfax India’s 43% equity interest is valued at about $320 million.

Sanmar’s businesses support and ride on the trend of the industrialization and modernization of India in many aspects from pharmaceutical, agriculture, transportation, and other industries. Sanmar also provides international businesses an alternative to China in terms of PVC supply.

IIFL Group

The last business I will mention here is IIFL Group. Fairfax India initially invested in IIFL Group in 2015. On January 31, 2018, IIFL Group completed reorganization that resulted in three separate entities, IIFL Finance, IIFL Wealth, and IIFL Securities.

IIFL Finance is not a bank and it offers home loans, gold loans, business loans, microfinance, construction and real estate finance, and capital market finance. As of September 30, 2022, IIFL Finance managed about $7 billion in assets. Its well-diversified asset portfolio mitigates the risk of asset concentration and exposure to cyclical movements. As the credit system opens up in India, IIFL Finance is at the forefront to capitalize this opportunity.

IIFL Wealth provides asset management services for high net worth individuals, affluent families, family offices and institutional clients. As of September 30, 2022, IIFL wealth has about $33 billion assets under management. Fairfax India entered a forward sales agreement to sell 9.8% of its equity interest in IIFL Wealth. On November 22, 2022, Fairfax India completed the sale of the 9.8% equity interests in IIFL Wealth for total proceeds of $172 million. Fairfax India will have approximately 3.8% of equity interests remaining in IIFL Wealth. As India’s economy grows, the number of clients and asset base that IIFL Wealth will be able to serve will increase.

IIFL Securities is a full-service retail and institutional brokerage. At September 30, 2022, IIFL Securities managed assets of approximately $15 billion.

Overall, Fairfax India invested about $282 million in IIFL Group since 2015 and has recouped $172 million from the sale of 9.8% equity interest in IIFL Wealth. As of November 22, 2022, IIFL has a cost base of about $110 million in IIFL Group with 22.3% equity interest in IIFL Finance, 3.8% equity interest in IIFL Wealth, and 27.8% equity interest in IIFL Securities. Considering the sale of 9.8% equity interest in IIFL Wealth, Fairfax India’s investments in IIFL businesses total about $511.7 million representing 16% of Fairfax India’s total portfolio.

Investments in BIAL, Sanmar, and IIFL companies in total represent about 65.5% of Fairfax India’s portfolio, according to Fairfax India’s Interim Report for The Quarter Ended September 30, 2022

Risks

While the above analysis presents an optimistic picture of Fairfax India for investors, there are several risk factors that shall be considered.

Foreign Currency

Fortunately, the Indian Rupee has remained relatively flat against the US Dollar since September 30, 2022. However, if the United States continue to raise interest rates at a faster pace than India, the Indian Rupee will be continuously devalued against US Dollars. Any devaluation of Indian Rupee will result in foreign currency loss for Fairfax India’s investments.

China Re-Opening

Fairfax India’s portfolio company, Sanmar, has enjoyed the increased PVC price in 2021 and 2022 due to the reduced output of PVC from China. However, as China is re-opening and PVC production is recovering to pre-pandemic level, Sanmar could face an increased competition and reduced price in PVC.

Investment and Advisory Fee

Although Fairfax India advisor’s performance fee is based on a three-year long term horizon, Fairfax India advisor charges a steep investment and advisory fee on a quarterly basis. The investment and advisory fees are calculated and payable quarterly as 0.5% of the value of undeployed capital and 1.5% of Fairfax India's common shareholders' equity less the value of undeployed capital. Assuming that the undeployed capital is $0, such investment and advisory fee would represent 1.5% of common shareholder’s equity. As of September 30, 2022, the common shareholder’s equity is $2.6 billion. As a result, the annual investment and advisory fees amount to about $39 million on an annual basis. This would represent about 1.17% based on total assets (equity and bonds) invested or 2.06% based on total market capitalization as of January 27, 2023. Whichever way you look at the investment and advisory fees, it is significantly higher on expenses compared to Vanguard’s Total International Stock ETF (VXUS), which has an expense ratio of merely 0.07%.

If Fairfax India significantly outperforms India’s stock market, this investment and advisory fee will likely be worth it, but if Fairfax India merely tracks or underperforms against the India’s stock market, an investor would be much better off obtaining this diversification and exposure to India through Vanguard’s ETF.

Management Bias

Given that over 50% of Fairfax India’s investments are private Indian businesses currently, although Fairfax’s disclosure is very disciplined and far beyond what’s required on how market values for private Indian businesses are calculated, one can’t underestimate the potential for management bias in inflating book value per share to artificially paint a more optimistic picture, possibly increasing the investment and advisory fees and performance fees.

Conclusion

As India continues to grow becoming a superpower of the new world order, Fairfax India is set to capitalize on the value appreciation of its portfolio companies. Investors can obtain a solid portfolio of Indian businesses through Fairfax India to gain further diversification at a steep discount of 27% from its book value. However, Fairfax India must outperform India’s broad economy and stock market significantly to reward investors in the long term given its hefty investment and advisory fees. Going forward, I will aim to check in every quarter on Fairfax India to provide with readers an update.

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