MKL is a specialty property and casualty (P&C) insurance company that has compounded book value per share at an annual pace of 23% from its 1986 IPO through year-end 2009. At the current stock price of $360 per share, the company's price-to-book-value multiple of 1.15x is only about 60% of the historical average, because the industry is suffering from poor business conditions and is therefore highly out of favor. I will argue that MKL will compound book value per share at 13-17% annually over the long term, and that its P/B multiple eventually should expand by 70%.

The company was founded in the 1920s by Sam Markel to provide insurance to the transportation industry. Throughout its history, MKL has pursued a niche strategy, which is described below. Today, the company writes about $1.7 billion of premiums annually and has a book value of $3 billion. MKL currently is run by a third generation of the Markel family, which continues to concentrate the vast majority of its net worth in MKL common stock.

UNDERWRITING

Because insurance is a highly commoditized product, competition is based primarily on price, and is so intense that P&C insurance companies generally lose money on their underwriting operations. They make up for it, however, by profitably investing the funds that sit on their balance sheets before claims must be paid (termed "float"). As might be expected, industry's return on equity is paltry, registering on average in the mid-single-digits.

History shows, however, that it is possible to underwrite profitably on a sustainable basis, under certain unusual circumstances. First, it is important to be in niche areas, in which specialized knowledge and experience are necessary to properly assess risk. In this market, which is known as the specialty market, competition is more manageable (though still intense) and customer relationships tend to be more important than in the standard market.

Steve Markel, Vice Chairman, has described the company's approach this way:

If you can think of some insurance product that you need, and you could get a policy for it quickly and easily, well Markel doesn't do that. On the other hand, if you were to answer "no" two or three times to an insurance questionnaire, now that's getting closer to what we like to do. What we do is insure things that are rather complicated and unusual, like children's summer camps, bass boats with overpowered engines, weddings and event cancellations, vacant properties, new medical devices, new technology, or the red slippers Judy Garland wore in the Wizard of Oz.

The second factor necessary for profitable underwriting is discipline, which means turning away prices that are not expected to produce an underwriting profit. This is harder than it may sound. In P&C insurance, premiums are low 70-80% of the time. These so-called "soft markets" persist for years, and disciplined underwriting would dictate that companies shrink their top lines to preserve capital for more attractive conditions ("hard markets").

However, few individuals, and even fewer organizations, are able to behave this way. It is uncomfortable to turn away business and cede market share to competitors. Doing so is even more difficult for employees who would be putting their own jobs on the line by shrinking the operation. Moreover, the adverse consequences often will be delayed for years, as claims develop. It is unusual for people or organizations to think beyond the next 12 months or so.

MKL is one of a relatively small class of insurers that maintain a disciplined underwriting culture. This is best illustrated by a comparison of the company's combined ratio with that of the P&C industry. The combined ratio is the ratio of expenses (including underwriting losses) to revenues (earned premiums). As mentioned before, the industry loses money on underwriting, resulting in a combined ratio greater than 100%.

Below are the historical combined ratios of MKL and the P&C insurance industry. Over the period, MKL averaged 96%, while the industry averaged 106%.

MKL               P&C industry 

1986                78%                 108%

1987                85%                 105%

1988                84%                 105%

1989                78%                 109%

1990                81%                 110%

1991                106%               109%

1992                97%                 116%

1993                97%                 107%

1994                97%                 108%

1995                99%                 107%

1996                100%               106%

1997                99%                 102%

1998                99%                 106%

1999                101%               108%

2000                114%               110%

2001                124%               116%

2002                103%               108%  

2003                100%               100%

2004                97%                 98%

2005                101%               101%

2006                87%                 92%

2007                88%                 96%

2008                99%                 105%

2009                95%                 101%

INVESTING

In addition to underwriting, the other way an insurance company makes (or loses) money is by investing. In most cases, the largest single source of investment funds is the float, which as mentioned before is the policyholders' money that is temporarily held by the insurance company, before claims must be paid. In MKL's case, the total investment portfolio has been approximately 3x shareholders' equity (a ratio referred to as investment leverage).

The leverage afforded by the float the key to the power of the business model. The ROE contributed by the investment portfolio is equal to the investment leverage multiplied by the after-tax return on the investment portfolio. For example, assuming 3x investment leverage, a 4% after-tax investment return would translate into a 12% ROE.

Like most insurance companies, MKL matches its reserves with high-quality fixed income instruments. Unusually, however, MKL will invest up to 80% of its shareholders' equity in stocks. The rationale is that it is appropriate to match infinite-duration funding (equity) with infinite-duration securities (equities), and it is advantageous to do so because over the long-term, equities are likely to generate better returns than fixed income instruments.

MKL's investment operation is overseen by Tom Gayner. Gayner follows a conservative, disciplined, value-based approach to investing. Like MKL itself, he emulates the example of Warren Buffett. Over the two decades ending in 2009, Gayner achieved a compound annual return of 10.7%, which is 250 bps in excess of the S&P 500 with dividends reinvested. He has developed a deservedly prominent reputation within value investing circles.

RETURN ON EQUITY

Estimating MKL's normalized ROE is, then, a straightforward, though not precise, exercise.

                                    % of equity     Annual after-tax return           ROE contribution

Fixed income              235%               3-4%                                        7-9%
Equities                       65%                 6-8%                                        4-5%   

Blended portfolio       300%               4-5%                                        11-15%           

On top of the 11-15% ROE contribution that can be expected from the investing side, the underwriting side should contribute a few points of ROE as well. Therefore, I believe it would be reasonable to peg MKL's normalized ROE at 13-17%.

An important observation about MKL's returns, besides that they are roughly double that of its industry, is that they are remarkably consistent. Two facts illustrate this point:

1)      Since MKL went public in 1986, book value per share declined in only 3 years: 1990, 1999, and 2008. In each case, a new high was achieved within one year.

2)      Since 1986, the minimum trailing 5-year compound annual growth of book value per share (measured at the end of each fiscal year) was 10%. This occurred during the five years ended December 31, 2008, which coincided with a "perfect storm" for the three drivers of profitability: interest rates, stock returns, and insurance market conditions.

VALUATION

Insurance companies are typically valued on a multiple of book value, and typically trade fairly close to book value, because they generally do not earn economic profits. By contrast, as a result of its superior ROEs, MKL's average multiple of trailing book value over the past two decades was 2x. Today, the ratio is 1.15x.

By continuing to follow its proven formula of disciplined underwriting and investing as it has done successfully for over two decades, MKL will continue to compound book value per share at 13-17% annually over the long term, in my view. I also believe that in the next several years-likely when a hard insurance market emerges-the multiple will expand to the historical 2x. The return from owning the stock will be the compounding of book value per share plus 70%+ from multiple expansion. Therefore, even if the multiple expansion does not occur for a long time-5 years or more-the stock could still return in excess of 20% annually over the investment period.

It is worth noting that there are at least two other ways to think about the value of an insurance company, both of which lend credibility to the significant premium to book value at which MKL historically has traded.

1)      Net investments per share. If an insurance company has a long track record of favorable reserve developments and profitable underwriting, then the float is, in effect, perpetual financing for which there is no (or negative) cost. As such, the insurance company can be thought of as a publicly traded investment portfolio, the value of which would be the value of the investments, less debt (i.e., net investments). In MKL's case, net investments per share as of September 30, 2010 was $742, equal to 2.4x book value.

2)      Free cash flow. As with any company, the intrinsic value of an insurance company can be derived from free cash flow. There are numerous reasons that this is not common practice. For example, insurance earnings are highly volatile and impossible to predict from quarter to quarter. Moreover, companies that build value over time through unrealized gains (such as in MKL's equity portfolio) have earnings power that does not flow through the income statement.

MKL's current normalized free cash flow can be calculated by applying its normalized ROE (13-17%) to the most recent book value per share. This yields a range of $41-53 per share ($313 * 13-17% = $41-53). This implies that MKL currently trades at 7-9x free cash flow. The historical P/B multiple of 2x implies reasonable P/FCF multiples of 12-15x.