Keith Smith of Bonhoeffer Fund discussed the successful use of leverage to boost long-term equity returns at Best Ideas 2026. Current opportunities discussed include Meritz Financial Group (Korea: 138040), Fairfax Financial Holdings (Canada: FFH), and Fidus Investment Corporation (US: FDUS). Historical examples include Berkshire Hathaway, Fairfax, and Shelby Davis.

Keith shares insights into a strategy that is often misunderstood and frequently shunned by conservative market participants: the successful application of leverage. While the history of finance is littered with stories of leverage gone wrong, Keith argues that a distinct group of value investors — from Shelby Davis to Warren Buffett — has utilized it as a primary engine for generational wealth creation. The presentation moves beyond the simplistic view of margin debt to explore the nuances of “structural leverage,” where the focus shifts to the arbitrage between the cost of liabilities and the yield of high-quality assets.

Keith deconstructs the mechanics behind this approach, illustrating how negative-cost float and low-fixed-rate debt can transform average investment returns into spectacular compounders. He challenges the notion that leverage is inherently reckless, positing instead that safety comes from the durability of the underlying cash flows and the terms of the borrowing, rather than the absence of debt itself. He dissects Buffett’s investment in Japanese trading houses as a masterclass in locking in spreads to secure returns with minimal equity exposure.

To ground these concepts in reality, Keith walks through real-time case studies of companies executing this playbook across the globe, from Korea to Canada. He analyzes the “virtuous circle” of underwriting profits fueling investment portfolios in the insurance sector and examines how Business Development Companies (BDCs) are navigating the risk-reward spectrum in private credit. This session offers a practical framework for identifying management teams that treat capital allocation as a spread business, aiming to replicate the success of historical greats in a modern market environment.

Thesis summary: Meritz Financial Group

Meritz is a Korean holding company that integrates a property and casualty (P&C) insurer with a brokerage firm to finance high-yield real estate debt. Keith notes that the company utilizes insurance float from long-term healthcare liabilities and brokerage deposits to fund investments in the double-B to single-B credit region, which academic studies identify as the optimal risk-reward location. The firm has transitioned its portfolio toward first-lien loans, which now comprise approximately 90% of origination, while maintaining expertise in distressed asset workouts. This structure allows the insurer to achieve scale and underwrite risk while the brokerage arm sources high-yielding assets, providing a 100 basis point advantage over P&C competitors.

The company has delivered a ten-year average ROE of roughly 21% and an incremental return on capital of 21%. Keith points out that as interest rates rose, investment yields improved from 3.7% to 4.6%, further supporting the company’s high investment leverage of roughly 9x. The business generates consistent float growth of around 4% annually, with deposit growth rates outpacing this figure. This operational leverage is supported by a combined ratio in the 90% range and a dominant market share in the long-term healthcare insurance sector.

Management alignment and corporate governance are central to the thesis, with the entrepreneurial chairman owning a majority of shares. Keith explains that Meritz was an early adopter of performance-based compensation and equity ownership in Korea, with management incentives tied to TSR and ROE targets. Top executives receive approximately 5% of net income, and dilution is kept modest at roughly 1.2%. The capital allocation strategy prioritizes share repurchases when the rate of return on investments exceeds the estimated 9% cost of capital; otherwise, the firm returns cash via dividends.

Valuation remains compelling given the company’s growth profile and capital efficiency. Keith highlights that the shares recently traded at approximately 5x earnings and 1.8x book value, despite the company generating the highest ROE in its peer group. With organic growth estimated at 4% plus operational leverage and annual buybacks of 5-6%, the firm offers a rare combination of high asset returns, low loss ratios, and substantial leverage at a discounted multiple.

Thesis summary: Fairfax Financial Holdings

Fairfax operates as an insurance holding company focused on property and casualty insurance, reinsurance, and investment management, with a 50-year history of acquiring underperforming insurers and improving their operations. Keith notes the company targets a 15% ROE and a combined ratio below 100% across the underwriting cycle. The business benefits from a “hard” insurance market, which has supported recent sales and earnings growth. The company utilizes a decentralized structure where acquired subsidiaries, such as Brit and Allied World, provide diversification across catastrophe risks and niche markets, with data and AI increasingly utilized to enhance underwriting efficiency.

A core component of the thesis is the investment of float, debt, and equity into a balanced portfolio, currently allocated approximately 74% to fixed income and 26% to equity. The shift toward a “higher for longer” interest rate environment has allowed Fairfax to lock in yields around 4-5% on the fixed income book, an increase from previous levels of 1.9%. Keith highlights that this fixed income yield, when applied to a portfolio levered 2.6 times, generates positive returns even without contribution from the equity book. The portfolio also includes exposure to emerging markets like India and Greece, leveraging the management team’s specific geographic expertise.

Recent performance reflects successful turnaround efforts, with acquired entities purchased at roughly 1.7x written premiums now valued lower relative to their premiums due to operational improvements. The company has achieved a 10-year average ROE of 15% and a Return on Incremental Invested Capital (ROIIC) of roughly 21%. Keith points to a cycle where higher investment returns allow the company to accept slightly higher combined ratios than competitors while maintaining profitability, thereby capturing market share. Reserve redundancies appear adequate, providing a safety margin and validating the conservative nature of the underwriting.

The company is led by Prem Watsa, who has served as CEO since 1985 and maintains alignment with shareholders through a 6.7% equity stake; total management ownership stands at approximately 9%. Executive compensation is weighted toward performance-based incentives with minimal cash draw, and stock grants result in low dilution. Capital allocation priorities include organic growth, acquisitions, and share repurchases, with the company buying back 4-5% of shares annually over the past five years.

Fairfax shares recently traded at a P/B of roughly 1.4x and an earnings multiple of 8.6x, representing a discount compared to peers such as WR Berkley and Intact Financial. Keith suggests that even with conservative assumptions—3% organic growth and 3% annual share repurchases—the stock implies potential annual returns of 20-30%. The valuation reflects a discount often applied to the company’s complex structure, despite evidence of improved underwriting discipline and an investment portfolio benefiting from the current rate environment.

Thesis summary: Fidus Investment Corporation

Fidus operates as a Business Development Company (BDC) focused on providing senior financing to lower middle-market firms for growth, acquisitions, and restructurings. Historically a mezzanine lender, Keith notes that the company has successfully transitioned its portfolio composition toward first-lien floating rate debt, which now comprises 72% of loans compared to just 30% five years ago. The firm differentiates itself through robust proprietary deal flow, sourcing 67% of investments internally rather than relying on widely syndicated transactions. This origination strategy allows Fidus to target growing enterprises rather than the flat or declining businesses often found in broader high-yield underwriting.

The investment strategy emphasizes defensive growth sectors, with 50% of loans structured against intangible assets such as recurring software revenue. Credit quality remains stable, evidenced by a steady portfolio interest coverage ratio of 3.0x and non-accruals limited to 0.3%. Keith highlights that while Fidus targets the B to double-B underwriting sweet spot to generate yield, it maintains conservative leverage with a debt-to-equity ratio of 0.7x. The company focuses on relationship continuity, retaining approximately 30% of follow-on business from existing clients, which helps mitigate the churn typically associated with BDC portfolios.

A key differentiator in the Fidus model is the systematic inclusion of equity positions alongside debt instruments. The firm holds equity stakes, typically ranging from 2% to 12%, in approximately 80% of its borrowers. This structure provides capital appreciation upside often absent in standard BDC models, where lenders typically bear downside risk without participating in equity value creation. Keith attributes roughly 300 basis points of annual return to these investment gains, driving a five-year TTM ROE of 13.6%, which exceeds the CCFLX benchmark of 10.2%. This approach has allowed Fidus to grow NAV over time, a rarity in a sector where high distributions often lead to declining book values.

Shares recently traded at approximately 8.4x earnings, implying an earnings yield of nearly 12% and a dividend yield of 10.9%. While the stock recently traded near its book value (P/BV ~1.01x), Keith argues that the combination of a high current yield and modest NAV growth supports a total return profile that warrants a higher multiple. Applying the Graham formula suggests a fair value multiple closer to 10.9x. The thesis anticipates a potential re-rating as the market recognizes the improved safety profile of the first-lien transition and the sustained ROE outperformance relative to larger peers.

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About the instructor:

Keith Smith, the fund manager, brings over 20 years of valuation experience to the Bonhoeffer Fund. He is a CFA charterholder and received his MBA from UCLA. Keith currently serves as a Portfolio Manager at Bonhoeffer Capital and was previously a Managing Director of a valuation firm and his expertise includes corporate transactions, distressed loans, derivatives, and intangible assets. Warren Buffett and Benjamin Graham’s value-oriented approach of pursuing the “fifty-cents on the dollar” opportunities, underpins Keith’s investment strategy. The combination of his experience and track record led Keith to commit most of his investable net worth to the Bonhoeffer Fund model.

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