|Shares Out. (in M):||10||P/E||0.0x||0.0x|
|Market Cap (in $M):||4,440||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||1,511||EBIT||0||0|
|TEV (in $M):||5,950||TEV/EBIT||0.0x||0.0x|
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“Investing is simple, but not easy” – Warren Buffett
Markel is a core holding in our portfolio that we have been adding to at current prices; it is a high conviction position that we plan to continue upping in size, without hesitation, should the shares become even cheaper.
I work for a FO, with a clear bias toward investments that we can own in an almost perpetual fashion. As such, we place a great emphasis on quality, growth and stewardship. For whatever its worth, ever since becoming a member of VIC, I’ve noticed that we operate with quite a distinct time frame and mindset than most members of the club.
I sometimes compare our investment process to the way a savvy, wine connoisseur might shop for wine. Not all wines improve with age; in fact, some have an upper limit and will sour with time. Choosing the right wine, as an investment, requires constant monitoring of the aging potential and a determination of the maturity stage at any given time. Once the groundwork in finding a good vintage and harvest is completed, however, holding it as it slowly matures can be a very pleasurable and lucrative experience.
Now, don’t get me wrong, the analogy between wine and investing quickly breaks down for many reasons. I don’t necessarily view wine as a good investment – it isn’t a form of productive capital, after all. But conceptually some of the ideas and values that a wine investor possesses can be of great benefit to long-term oriented investors.
We believe Markel, like a classic vintage of wine, is a wonderful business that will continue to age and mature with grace. We give the organization an A on the stewardship front – with the board, executives and employees owning ~10% of the company and a stock-heavy compensation and incentive structure driven by profitability, not size.
There are a large number of intangible factors that suggest evidence of a strengthening organizational culture where talent is attracted, evaluated and retained as much for what they do, but importantly, by what they don’t do - a critical attribute on the insurance and investment sides of the business.
An investor friend, who also owns shares of MKL, recently described MKL as having characteristics of a self-reinforcing business model – arguing that these type of businesses can defy mean-reversion because the likelihood of future success increases as time passes. These dynamics, he says, rely mostly on qualitative aspects, which propel continued above-average performance. In a recent presentation he gave he identified the factors that drive these dynamics within the insurance, investing and structure of Markel attributing its success to a circular interdependent relationship between talent, culture, underwriting, longevity and employee ownership.
I couldn’t agree more with this analysis. I realize that most investors will express skepticism to the idea that a team of people – i.e. management – can serve as a durable competitive advantage, but in my experience there certainly are unique organizations where human capital is the biggest asset.
At today’s price, and considering where MKL is in its stage of growth, we believe the risk/reward is extremely attractive. Quite simply, we believe the soft pricing and interest rate environment will turn soon enough, and moderate premium growth will resume after five years of modest yearly declines. But more importantly, the seasoned management and investment team will continue compounding business value as it benefits from its continued evolution into a long-term-oriented, value-based holding company. The magic of marrying conservative underwriting with a low-beta, long-term, equity-biased investment portfolio is something we believe is fundamentally underappreciated by the market and by other insurers.
For those of you unfamiliar with the company, Markel is a diversified specialty insurer, mainly focusing on niche business lines with good pricing, repeat customers, and consistent underwriting profits – all of which serve as a backbone to a remarkably well-managed investment portfolio, headed by famed value investor, Tom Gayner, who has compounded portfolio per share at a 13% CAGR over last 20 years (he has 2/3 of his net worth in MKL stock).
In contrast to big insurance companies that write business in large, highly regulated, standard actuarial based categories like life insurance, Markel has developed an edge in more arcane, often complex, products where risks don’t fit predefined criteria.
It basically seeks out policies that are “hard to place”, meaning that risks can’t be underwritten with “off the shelf” products generally offered by plain vanilla broker/insurers.
“Examples of niche markets that we have targeted include: wind and earthquake exposed commercial properties, liability coverage for highly specialized professionals, horse mortality and other horse related risks, personal watercrafts, high-valued motorcycles, aviation and energy related activities. Our market strategy in each of these areas of specialization is tailored to the unique nature of the risk, coverage and services required by insureds. In each of our niche markets, we assign teams of experienced underwriters and claims specialists who can provide a full range of insurance services.”
Over time, the unique nature of their underwriting has provided a stable client base that has become increasingly sticky – favoring Markel for its product quality and customer service. In other words, their bread and butter, is to write business in less commoditized and thus more profitable markets.
On the investment side, MKL is one of the rare insurance holding companies that actually invest their capital and float with a perpetual time frame in mind (of course, it pays attention to liability and asset duration like all insurance companies) – with a higher proportion of equity investments, which they can do by holding onto more capital to buffer volatility. By allocating a growing capital base into companies with strong moats, and great long-term prospects, MKL in effect becomes one of the best vehicles to exploit a true time-arbitrage with prudent leverage effects.
One aspect we like about the recently announced acquisition of Alterra Capital Holdings (ALTE), which I discuss in more detail below, is the fact that it will raise investments per share – which we believe Markel will put to work in exactly the type of companies we, within our FO, want to own for the long run, given our mandate as long-term oriented investors.
Markel’s acquisition announcement prompted the stock to sell-off, as hedge funds put on their arbitrage bets, and Mr. Market quickly judged it to be a value destroying transaction.
Without question, the purchase of Alterra is a transformative acquisition that will nearly double MKL’s size. It will diversify the firm across a number of reinsurance and other international offerings, some of which have worse competitive dynamics than the specialty market.
However, we believe concerns are overblown and we don’t consider this a repeat of the under-reserved purchase of Terra-Nova – which admittedly was painful, as integration issues and its turnaround wiped out underwriting profits for many years, hurting shareholders. But you live, you learn, and it is simplistic to just extrapolate that experience to this transaction. The fact is this particular acquisition couldn’t be more different – it isn’t a turnaround, it is well managed, and will be accretive on a per share basis.
Alterra was first put together as an amalgamation of Chubb's legacy reinsurance business and the former Max Capital Group. The firm's book is made up of nearly 60% reinsurance, with the remainder of premiums coming from a combination of specialty insurance, Lloyd's of London underwriting, insurance for large corporate clients, and global insurance.
Moreover, the purchase price paid by Markel seems fair. It doesn't appear that the firm is overpaying for the assets or the book of business it is receiving.
The historical combined ratios for both companies demonstrate a healthy historical track record of risk management and disciplined underwriting. Alterra’s five-year average was 91.9% vs. Markel’s 96.2%.
Post merger pro-forma Markel will be writing $4.4 billion in annual gross premiums and will have $6 billion in equity and $16 billion investment portfolio. The acquisition will shift the business mix more toward long-tail, with a pro-forma 50/50 mix of long and short tail, and 67% insurance plus 33% reinsurance. The B/S actually delevers Markel slightly with total debt / capital dropping from 28% to 25%, and net premiums / equity staying about the same at around 0.58x.
In addition to the standard benefits of scale, cost savings, quality of business and diversification benefits, one of the primary advantages of the acquisition will come from re-allocating Alterra's investment portfolio. As most Berkshire groupies can attest, float in the right hands can be incredibly powerful. Markel has compounded book value per share at a 17% CAGR for the past twenty years.
The large balance sheet and underinvested portfolio will provide dry-powder for expanding Markel Ventures, its private equity subsidiary, and mimic the successful Berkshire formula into smaller, mid-market companies. Here is a brief description of the criteria Markel uses when making controlling investments:
“The long-term goal of Markel Ventures is to build a great company comprised of solid businesses with talented management teams.
In evaluating each of these opportunities, we follow the same four-part checklist that we have used for the last two decades, whether investing in privately held companies or publicly-traded securities. We look for:
1) Profitable businesses with good returns on capital
2) Talented management teams and a culture of integrity
3) Reinvestment opportunities and capital discipline
4) Fair prices
The Markel Ventures business model is unique relative to the world of traditional private equity investing and buyouts. Our acquisitions are financed with little or no debt using “permanent” capital. This means that our investments are long term in nature with no plans for an exit in the future. Therefore, business owners that partner with Markel Ventures do not have to worry about operating in a leveraged environment and can focus on running their businesses profitably over the long term.”
Their existing portfolio can be seen here: http://www.markelcorp.com/markelventures/Documents/Markel%20Ventures%20Overview.pdf
Markel Ventures, while off to a slow start, has started to dividend up free cash up to MKL parent to reallocate in a tax efficient manner. This still is a small proportion of the overall business, but over time this should be a meaningful driver of value.
The liquid investment portfolio, according to Gayner, is positioned in a barbell manner with low duration fixed income and cash-like securities increasing, with the other end of the portfolio invested in equities and cashflow producing businesses.
A few of the names in the portfolio are Berkshire, CarMax, Diageo, Walgreens, Wal-Mart, Disney are a few of the top positions in the equity portfolio. Their turnover is below 10% implying a 10+ year holding period.
In terms of the stock price, we think any purchases below 1.40x book will produce good IRRs over a long-term, multi-year period. Today, at $460 you can buy Markel at ~1.14x pro-forma book, which is historically on the very low end of its valuation.
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