MARKEL CORP MKL
August 10, 2019 - 2:52pm EST by
valueinvestor03
2019 2020
Price: 1,145.00 EPS 53.46 0
Shares Out. (in M): 13,823 P/E 21.3 0
Market Cap (in $M): 15,822 P/FCF 0 0
Net Debt (in $M): 3,626 EBIT 0 0
TEV ($): 19,448 TEV/EBIT 0 0

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Description

 

 

Introduction

Markel is certainly not a novel idea but I think it is worth a look right now. After being somewhat of a pet stock of the value investing community a couple of years ago, the sheen seems to have worn off. The stock price peaked almost a year ago at $1,228 but currently stands at $1,147, just barely above the level of two years ago. The stock price has gone nowhere for probably a few reasons including poor reinsurance pricing despite significant industry-wide catastrophe losses, lackluster results from Markel Ventures, low interest rates, a relatively high starting valuation, and most notably, the complete blowup of the $200+ million CatCo acquisition made in late 2015 (and this doesn’t include Markel’s lost investment in the CatCo funds). At the end of 2018, Markel’s book value per share had only compounded at a 7% rate over the previous five years, the lowest rate in over two decades. I think the perception that Ventures is a collection of somewhat mediocre industrial businesses, the CatCo debacle and recent mediocre results has maybe caused even long-time admirers to question the ability of management to allocate capital and thus the company’s ability to compound in the future. It is no secret that Markel’s management has structured the company in a manner similar to Berkshire, which requires excellent capital allocation to succeed. However, despite the recent rough patch, I think there is a high likelihood that the company can continue to compound at an acceptable rate for a long time. The current valuation is undemanding, the company will learn and improve from the CatCo wipeout, and on closer inspection, the Ventures investments overall have been a good use of capital.

Overview

Markel Corporation (MKL) is a financial holding company based in Richmond, Virginia. The company was founded in 1930 to sell insurance to taxicabs and buses and remained a family business until its IPO in 1986. Today the company underwrites specialty insurance products in a variety of markets around the world. Markel repeatedly states that its financial goals are to “earn consistent underwriting and operating profits and superior investment returns to build shareholder value…. over a long period of time.” Over time, MKL has clearly achieved these goals. Since its IPO, the company has been remarkably successful having compounded shareholders’ capital at nearly 20% compared with roughly 10% for the S&P 500. These stellar returns have come primarily from three sources: profitable underwriting, strong investment returns and leverage. The company has historically earned underwriting profits from its insurance businesses which is an accomplishment in an industry that consistently shows collective underwriting losses. Its long-term investing record is impressive. I believe MKL has several enduring characteristics which have enabled it to produce outstanding results and will enable it to continue producing above-average returns for stockholders over the long run despite the slowdown of the past couple of years.

Markel Overview

Property and casualty (P/C) insurers in the US fall primarily into two categories: admitted and Excess & Surplus (E&S). For admitted companies, the state’s regulators monitor the finances of the insurers, forms are highly regulated, products and coverages are largely uniform with relatively predictable exposures and companies tend to compete based on price. Examples of admitted companies are Geico (selling auto insurance) and Allstate (selling homeowner policies). However, there are some cases where admitted carriers will not accept a risk because it may be too unusual, too big, or for other reasons. In these cases, those seeking to ensure such risks can obtain a policy from an E&S insurer, which provides policies even though they are not regulated in the particular state where the policy is sold, and these policies are generally free from the coverage and rate regulations imposed on admitted insurers. This gives specialty insurers greater flexibility in designing and pricing their policies, which allows them to accept hard-to-place risks that generally do not fit the underwriting criteria of admitted, or standard, carriers. Due to the greater flexibility and less competition, specialty insurance markets tend to focus less on price and more on value-based considerations such as availability, service, and expertise.

Markel writes on both an admitted and E&S basis but focuses on specialty markets (in both admitted and E&S) where it believes it can add value with specialty product offerings in niche markets. In 2017, Markel was the 3rd largest E&S writer in the US as measured by direct premiums, which is up from 6th place in 2013. Markel also participates in the reinsurance market. Reinsurance is when an insurer contracts with another insurer or group of insurers to take on a specific amount of risk which it has underwritten. Typically, Markel’s reinsurance contracts provide for automatic reinsuring of a type or category of risk underwritten by the ceding insurers (cedents). Generally participation is in the form of a treaty with a number of other reinsurers, each with an allocated portion of the treaty with terms and conditions being substantially the same for each participating reinsurer. In 2017, Markel was the 35th largest reinsurer in the world as measured by gross premiums. Most of Markel’s business is placed through insurance and reinsurance brokers. During 2018, approximately 25% of Markel’s gross premiums were accounted for by its top three independent brokers.

Prior to 2018, Markel categorized its insurance business into three segments: US, International, and Reinsurance, with US representing the majority. However, beginning in 2018, the company changed its reporting to two segments: Insurance (which includes the former International segment) and Reinsurance. In 2018, the total gross premium volume of $5.8 billion was comprised of 82% insurance and 18% reinsurance. In 2017 and 2018, Markel’s net retention of gross premiums written was 84% and 83%, respectively. Currently Markel’s top ten reinsurers represent 61% of its reinsurance recoverable balance.

Insurance Segment

The Insurance segment is written through Markel’s Assurance, Specialty and International divisions. The Assurance division (44% of Insurance premiums) writes commercial and Fortune 1000 risks on an E&S and admitted basis. US insurance regulations generally require an E&S account to be declined by admitted carriers before an E&S company may write the business. This business is typically more restrictive and more expensive than coverages in the admitted market. The Specialty division (28% of US insurance premiums) writes specialty coverages for niche markets primarily on an admitted basis. These are risks that, although are unique and hard-to-place in the standard market, must remain with an admitted insurance company for regulatory reasons. Unique risks written in the admitted market cover insureds engaged in similar, yet highly specialized activities which require an insurance program not otherwise available from standard insurers or insurance products that are overlooked by large admitted carriers.

The International division (24% of Insurance premiums) writes risks that are characterized by either the unique nature of the exposure or the high amount of coverage required by the insured. Most of Markel’s International operations are conducted through Markel’s Lloyds of London syndicate. Risks written in the International division are written on either a direct basis or a subscription basis. Risk written on a subscription basis means that loss exposures are typically insured by more than one insurance company, or Lloyd’s syndicate, due to the high limits of insurance coverage required. When Markel writes business in the subscription market, it prefers to “participate as lead underwriter in order to control underwriting terms, policy conditions and claims handling.”

Product offerings in the Insurance segment include:

·        General and Professional liability

·        Property

·        Personal

·        Marine & Energy

·        Workers’ compensation

·        Other product lines

Specific types of coverage the segment offers, which demonstrate Markel’s niche focus include:

·        Environmental products including environmental consultants’ professional liability, contractors’ pollution liability and site-specific environmental impairment liability

·        Professional liability for a multitude of professions

·        Medical facilities such as home health agencies and senior living facilities

·        Data breach and privacy liability and electronic media coverage

·        Coverage for fine art on exhibition and in private collections, precious metals, jewelry, and cash in transit

·        Railroad related products including commuter and scenic and tourist railroads

·        Youth and recreation-oriented organizations and camps and child care operations

·        Museums and historic homes

·        Wineries

·        Small fishing ventures, charters, boat rentals, ocean cargo, boat dealers, yachts, and marina owners

·        Animal boarding and breeding and training facilities

·        Equine-related risks such as horse mortality, theft, infertility, and transit

·        Mortality coverage for farms, zoos, animal theme parks and safari parks

·        Accident and health coverage for sports groups

·        Property damage and business interruption related to political violence including terrorism and civil war

·        Indemnity, directors’ and officers’ liability, errors and omissions, etc. targeting US and international public companies as well as large professional firms

Reinsurance Segment

The Reinsurance segment includes property and casualty treaty reinsurance products offered to other insurance and reinsurance companies globally including both quota share and excess of loss reinsurance. These products are typically written on a participation basis, meaning that each reinsurer shares proportionally in the business ceded under the reinsurance treaty. The reinsurance business was acquired in 2013 with the acquisition of Alterra. In 2018, reinsurance premium volume was 43% casualty, 33% property, and 24% specialty.

Primary product offering include:

·        Property

o   Includes coverage for natural disasters as well as property including buildings, equipment and contents

·        Casualty

o   General liability, professional liability, workers’ compensation, medical malpractice, errors and omissions, and environmental liability

·        Auto

o   Provided to national and regional carriers

·        Specialty

o   General aviation risks worldwide

o   Onshore and offshore marine and energy risks on a global basis

o   Crop insurance

o   Coverage for government entities including schools, public housing authorities, municipalities, counties, water and sewer districts, parks, etc.

There have been significant catastrophe events the past two years which has elevated the overall combined ratio. In fact, 2017 was the highest loss year ever with total reinsurance industry payouts of $240 billion. For Markel, the reinsurance combined ratio was 132% due mostly to losses from hurricanes Harvey, Irma, and Maria as well as earthquakes in Mexico and wildfires in California. The following year, 2018, was the fourth worst year in terms of industry losses and Markel’s reinsurance combined ratio was 113%. Up until most recently, reinsurance rates had not risen to adjust to the industry’s increasing losses; however, renewals in 2019, especially for hurricane exposures in the southeastern US have begun to see double digit rate increases and further increases are likely for 2020.

Underwriting

Historically Markel has been a strong underwriter of risk. Over the past five- and ten-year periods, Markel’s combined ratio has averaged 96% and 97%, respectively. This compares to the industry at 100% and 101% during those time frames. Markel pursues underwriting profits, not float; float is just a positive byproduct. Markel has been able to achieve such a strong underwriting record due in large part to the company’s culture which has ingrained a disciplined mindset. Having a strong historical combined ratio demonstrates that the company refuses unprofitable business, yet this is a difficult model for most insurance companies to follow.

From the 2018 Annual Report:

 

We routinely review the pricing of our major product lines and will continue to pursue price increases in 2019, when possible. However, when we believe the prevailing market price will not support our underwriting profit targets, the business is not written. As a result of our underwriting discipline, gross premiums volume may vary when we alter our product offerings to maintain or improve underwriting profitability.

Most managements are reluctant to turn away business while others are growing or Wall Street’s quarterly projections need to be met. In other cases, incentive systems can be skewed to reward volume over profits. Because the consequences for foolishly priced policies may not become apparent for long periods of time, management can easily give in to unwarranted optimism and go with the flow rather than soberly assess risk. However, Markel historically has not succumbed to these pitfalls. The company consistently states that it will not write business if it doesn’t believe it can achieve its underwriting profit targets.

According to the 2006 Annual Letter:

 

Whether it is our underwriting or investing operations, we believe that our discipline over long periods of time is what distinguishes us from our competitors…At Markel, underwriting discipline represents both a philosophy and a process. Our philosophy is to work to achieve consistent underwriting profits in all products in all insurance market conditions. The process by which we achieve underwriting profits can be slightly different by underwriting unit but generally includes finding the answers to four questions: Can we assess the risk we are taking? Can we design the appropriate coverage for our client? Can we price the risk to earn an underwriting profit? Can we assess trends that may increase our risk in the future?

Historically, the company has been a conservative estimator of loss reserves, preferring to overestimate initially and reduce reserves in the future as events unfolded favorably rather than vice versa. It had this to say about loss reserving in the 2006 Annual Letter:

 

For decades, we’ve maintained a philosophy of attempting to establish loss reserves at levels which are more likely to be redundant than deficient. We also refer to this philosophy as attempting to establish a margin of safety. It’s impossible to set loss reserves perfectly since they represent an estimate about the future outcome of unknown events. Given this uncertainty, we do our best to understand what drives these outcomes, monitor these drivers closely and try to be conservative. We attempt to create a margin of safety so that loss reserves will ultimately prove adequate.

Investments

In addition to underwriting, Markel’s investing track record also stands out. First, it invests a larger percentage of its equity into stocks as compared to other P/C insurers, and second, it has produced outstanding results. It has historically invested around 100% of its float in fixed income and cash. The value of Markel’s stock portfolio comprises 66% of book value and just over 100% of tangible book value as of June 30, 2019.

Markel doesn’t equate volatility with risk. It views its equity as permanent capital and seeks to maximize its value in the long run by investing in the common stocks of quality businesses (and private businesses) run by talented managers. Markel’s investment portfolio has been managed by Tom Gayner (age 57), who is a student of the Warren Buffett style of value investing. Gayner laid out his equity investing style in Markel’s 2012 Annual Letter:

   

“Over the years, we’ve never made decisions based on our forecasts of what was ahead for the economy, governmental policies, tax rates, currency values, interest rates, technological changes or other incredibly important but fundamentally unknowable future developments. Instead, we’ve simply looked at individual companies, one at a time, and asked ourselves a few questions. By considering four basic types of questions about individual companies and securities we try to develop enough confidence to make a decision. Our first question is, “Is this a profitable business with good returns on capital without using too much debt?” Second, we ask ourselves, “Is the management team equally and sufficiently talented and honest?” Third, we ask, “What are the reinvestment dynamics of the business and how do they manage capital?” and finally we ask, “What is the valuation and what do we have to pay to acquire ownership in the business?” While these are four simple questions, the process of thinking deeply about them tends to produce robust results over time as demonstrated by our long-term record. Those questions also tend to encompass consideration of some of the macroeconomic factors that tend to cause so much worry and anxiety for so many investors.”

In addition to a value orientation, Gayner has typically kept his portfolio relatively concentrated. For example, currently, the equity portfolio’s largest two positions are Berkshire Hathaway at 10.6% and CarMax at 5.7%. As of March 31, the top ten holdings were over 40% of the portfolio based on the 13F. Gayer also means it when he says that he is a buy and hold investor as Berkshire Hathaway has been owned for nearly 30 years and the top ten holdings of KMX, BAM, DIS, and MAR have been held for at least 15 years.

Markel’s stock portfolio has handily beaten the S&P 500 during the 30 years Gayner has been investing at Markel. In recent years when most active (not to mention value) managers have lagged the S&P 500, Gayner has posted very strong relative performance. His equity portfolio has outperformed the S&P 500 in eight of the past nine years. One positive aspect of Markel that has helped to produce strong investing results is that it can dollar-cost average. In a WSJ article from May 22, 2015, Tom Gayner specifically mentioned that Markel’s insurance operations are so consistently profitable that cash has flowed into the investment portfolio every single month since he joined the company in 1990. This has enabled him to regularly invest in his favorite holdings, both stocks and bonds, whenever he wishes. And now, Ventures is becoming a significant contributor to those incoming cash flows as well. Along these lines, Tom Gayer highlighted Markel’s allocation flexibility in the Q2 2015 conference call:

“We continue to actively hunt for opportunities in both arenas, and I'm optimistic we'll find treasures in both markets. That's one of the true beauties of Markel in that we are able to pursue the highest and best returns no matter where they might be. We have a full 360-degree view of insurance, industrial and public and private debt and equity markets, and we're comfortable in deploying capital into any and all of them as circumstances arise.”

Markel Ventures

In addition to its insurance and investing operations, Markel also has a third component of its business which was established in the early 2000s called Markel Ventures, which owns controlling or 100% stakes in operating businesses. It is no secret that Tom Gayner has stated in the past that Markel is pretty much running the same playbook as Berkshire with its focus on buying operating companies. Markel has put significant capital to work into Ventures in the past few years to the point where Ventures is now a substantial component of the company. Over the past five years (the same time frame where growth in book value per share was the lowest in decades) Markel has invested a total of about $3.2 billion into Ventures acquisitions and ILS deals (e.g. Nephila, CatCo, and State National), notably, with no stock issuance. Just in 2017 and 2018, Markel made acquisitions totaling nearly $2.5 billion. I think one of the reasons Markel’s stock price has been stagnant for the past couple of years is the perception that the Ventures businesses are lower quality and that this has been a poor use of capital. Also, Markel’s historical disclosures around Ventures leave much to be desired. However, upon closer inspection, I think the Ventures acquisitions have generally worked out well.

Since the first Ventures acquisition, Markel has invested just less than $1.4 billion (excludes ILS acquisitions) in acquiring operating businesses, including Brahmin Leather Works in October 2018. In 2018 Ventures EBITDA was over $220 million on over $1.95 billion in revenue. The $220 million is adjusted to remove the non-recurring impact of remediation costs, earnouts, and an impairment. Deducting capital expenditures at 3% of revenue (which is in line with the historical ratio of depreciation as % of revenue) and taxes at 21%, the resulting unlevered free cash flow is approximately $130 million, or 9.5% of the total capital invested. Plus, this includes the total cost of Brahmin ($173 million upfront cash) but less than two months of ownership. Accounting for a full year of Brahmin, the result is a double-digit unlevered rate of return which is pretty darn good. For the first six months of 2019, Ventures revenue totaled $1.1 billion and EBITDA $160 million, good for a 14.5% EBITDA margin. Gayner has stated that Ventures will likely have an EBITDA margin in the 13% range based on the current portfolio. Although the Ventures companies are boring, operating in industries such as leather goods, house plants, baking equipment, dredges, homebuilders, manufactured housing communities, auto transport equipment, etc., Markel has generated value through acquiring and operating these businesses. Gayner said the following about Markel’s non-insurance businesses at the 2019 Markel Omaha Brunch:

"We do have hundreds of millions of dollars coming in of cash flow that is not connected to our insurance business. One of the fun things about being at Markel is the non-insurance things that we are doing create opportunity and credibility for the insurance business by day to day execution of that, which creates investable cash flow which we use to our mutual benefit and it is a multiplicative thing. And again, there are very few organizations that have the architecture and structure in place where instead of isolating the streams and having them operate in completely, one-off, siloed ways, by joining these streams you are not adding one and one and getting two, you are multiplying 1.2 times 1.2. And any multiplicative process which is more than one point zero creates a geometric value explosion, not just a linear mathematical one."

In summary, Ventures is important because it gives Tom Gayner and Markel an additional area in which to allocate capital rather than solely the public markets for debt and equity, plus having an additional stream of cash flow makes the entire organization more resilient. As Ventures continues to grow, it will benefit the insurance organization by potentially allowing it to write larger policies and retain more of the business it writes. Hopefully growth in Ventures will allow for more insurance to be written increasing premiums, float, and cash flow. Buffett has spoken numerous times how Berkshire’s size and non-insurance businesses benefit its insurance operations.

Although I wouldn’t yet characterize Ventures and Markel as a “geometric value explosion,” the track record is strong and, if the past few years are any indication, Ventures will continue to grow and its presence will benefit the insurance operations. Plus, as it grows to more companies in more industries, there will be many opportunities for add-on deals and internal organic growth.

ILS

Markel ventured into the insurance-linked securities (ILS) market in 2015 with its $200+ million acquisition of CatCo, which managed $2.7 billion in retrocession and reinsurance portfolios at that time. In addition to the purchase price, Markel invested $200 million in CatCo funds. Co-CEO Richie Whitt said the following on the Q4, 2015 conference call:

“I think there clearly are synergies there. CATCo and our reinsurance operations share many of the same clients. And the clients have needs at times for traditional reinsurance and other times they may decide a capital market solution is a better fit for what they're trying to achieve. So, having the ability to write both traditional products, as well as the capital market-backed products, especially CATCo, it has a rather unique product structure. I think that just helps us better serve the clients that are out there. Since the acquisition or after the announcement of the acquisition, we've seen interests from people who were not previously clients of CATCo. So, there's going to be opportunities for our guys on the reinsurance side and CATCo guys to work together to make sure we're serving those client needs.”

Based on more recent commentary around the ILS business, Markel strongly believes in its future. At the recent Omaha Brunch, Gayner and Ritchie Whitt pointed out that the amount of capital in the insurance industry is relatively small compared to the global capital markets yet the industry has retained nearly all the catastrophe risk on a relatively small capital base. As a result, that risk can be spread out into the capital markets efficiently considering the uncorrelated nature of the returns and the overall win/win nature (in theory) of the transaction. Markel believes there will be tremendous amount of capital that will flow into the ILS market and it likely wants to hedge its traditional reinsurance business by making sure it has a seat at the table.

I don’t know what specifically happened at CatCo other than what the company has announced and what was written in the complaint by Tony Belisle (former CatCo CEO, Case 1:19-cv-00189-LM) against Markel. However it is not surprising that the worst year in catastrophe loss history was enough to cause major problems which may have been exacerbated by under-estimating reserves. As announced in the Q2 call, the CatCo investment has been completely written off and the firm is being wound down. This was a very expensive mistake for Markel but I’m sure they learned quite a lot about the ILS industry, probably more than they would without this sort of outcome. Current AUM for CatCo and Nephila combined is $13.7 billion as of June 30 and total revenue was $104 million for the first six months of the year. Markel also announced it is forming a new retrocessional ILS platform in Bermuda which will offer a broader range of ILS capabilities and will built from the ground up. I guess they figure a better approach to build the type of ILS business they want is to build rather than buy, which makes a lot of sense given the institutional knowledge as well as the culture of conservative underwriting.

Valuation

Rather than thinking of Markel’s current book value multiple, I think it is more helpful to think in terms of what the company can earn in the future relative to the price today. For example, consider what Ventures and the investment portfolio could earn, on average, over the next few years.

Securities Portfolio, Value, % Total Return, Return ($)

Fixed maturities, $10,258,640, 3.0%, $307,759

Equity securities, $6,875,933, 8.5%, $584,454

Short-term/cash, $4,025,038, 1.5%, $60,376

Total portfolio, $21,159,611, 4.5%, $952,589

Markel Ventures profit: $150,000

Total Market profit: $1,102,589

Equity value $15,822,014

Yield 7.0%

 

This table includes assumptions about what Markel may earn on its securities portfolio, on average, over the next few years. These assumptions assume a rate environment like recent years but lower stock returns. The 4.5% overall return is lower than the historical return since 2012 of 5.5%, during which the average return on fixed income and equities was 2.9% and 14.9%, respectively. This excludes any contribution for the ILS businesses which I’ve excluded because frankly it is too difficult to make a reasonable assessment at this point given the ILS difficulties thus far, recent deal for Nephila, and the build out of the new ILS platform. However, keep in mind Markel paid over $970 million for Nephila. Also, this assigns no value to program services business from State National which is a relatively recent acquisition with $70 million in fee revenue for the first six months of 2019. Markel paid over $900 million for State National in late 2017 and it generated nearly $100 million program services fee revenue in 2018. This analysis assumes that Markel will continue to operate at an underwriting profit, but just enough to cover its relatively small interest payments and corporate overhead. Markel’s cash flow from operations was over $800 million the past two years, which aligns with the table above considering it includes unrealized equity gains.

Risks

Interest Rates

One of the primary issues facing insurers today is low interest rates. Obviously, the higher the interest rate, the higher the cost of float (other things being equal) that an insurer can accept and still be profitable overall when factoring in the return on the investment portfolio. However, in the current environment with the rates of interest on investment grade credit so low, there is little room for error in underwriting.

The duration of Markel’s fixed income portfolio (excluding cash and investments with an original maturity of less than 12 months) was 6.1 as of December 31, 2018. As of June 30, 2019, the fixed income portfolio totaled $10.3 billion which compares with $4 billion in cash and short-term investments. Markel has a lot of dry power which has hampered results as rates have remained low but will benefit the company if/when rates rise. Markel has purposefully kept duration lower than it otherwise would and it appears to be positioning the portfolio for a rise in rates. The company’s policy is to match the duration of its liabilities with its fixed income investments, including currencies.

Given Markel’s fixed income portfolio duration and assuming no change in stock values, a 100 basis point upward movement in the yield curve would cause book value to decline by approximately 6% and a 200 basis point move would result in a 12% decline. Given the current positioning of Markel’s portfolio and its investment philosophy, it would benefit from rising rates although book value will decline because the company will adjust its portfolio and interest income will significantly increase, likely offsetting the initial decrease in book value. The greater risk may be rates staying lower for longer which would depress future returns.

Equity Market Decline

Currently Markel has a $6.9 billion equity portfolio which amounts to 66% of shareholders’ equity and just over 100% of tangible book value. Given its significant position in equities, a severe bear market would hit shareholders’ equity. In 2008 the stock portfolio fell 34% and the return on the overall investment portfolio was negative 9.6%, yet book value per share declined 16%. The bond portfolio produced a small gain in 2008 as a significant portion of Markel’s fixed income was invested in corporate and municipal debut that, while highly rated, did not appreciate as much as US Treasury securities. If a major selloff occurred, Markel’s book value will fall, but given the quality of the companies it owns, permanent impairment is a low risk in my opinion. Plus, Markel now has a much more sizable Ventures segment which produces a diversified stream of cash flows.

Reinsurance Pricing

In comments made at the 2015 Berkshire Hathaway Annual Shareholders’ Meeting, Buffett had negative things to say about the reinsurance industry: “It’s a business whose prospects have turned for the worse and there’s not much we can do about it. The reinsurance industry in the next 10 years will not be as good as it has been in the last 30.” Buffett made these statements because he believed increased competition would continue to lead to inadequate rates and he was correct. In recent years, tens of billions of dollars have been put to work in reinsurance from various institutional investors and hedge funds. Hedge fund managers including David Einhorn, Dan Loeb, and John Paulson have set up offshore reinsurers for the favorable tax treatment as well as access to float. Growth in the ILS market has also increased competition and put pressure on rates. Future competition may negatively impact Markel’s reinsurance operations by leading to reduced float if Markel is unable to write profitable business. However, with the recent major catastrophe years, the supply of reinsurance has contracted. Both Paulson and Einhorn have decided to wind down their reinsurance vehicles as the industry proved too competitive and investment results lagged. However, reinsurance rates are finally starting to rise in response to the recent industry losses and so far in 2019, Markel is seeing nice growth in reinsurance premiums.

Prospective Market Returns/Valuation

Except for underwriting and Ventures, the profits earned by Markel are a direct result of the capital gains and income from the stock and bond portfolios. As we are ten years into an equity bull market and the 10-year sits below 1.8%, prospective returns going forward will likely be lower than the past decade. I don’t think it is possible that Markel can compound in value at a rate close to its historical rate of 20%. And while I am confident that Tom Gayner and Markel will produce results over the long-term that exceed the indices, no doubt Markel’s absolute results will suffer during periods of poor market performance. Also, there could be future blowups with investments in Ventures or other businesses. Markel’s management team obviously makes mistakes and they will make more in the future. But based on the track record, the good will likely outweigh the bad.

Positives

Management/Culture

Markel’s annual letters provide a great window into the way the company’s leadership thinks. The letters consistently emphasize what the company calls the “Markel Style,” or the way that the company does things. This consistent focus on characteristics like market leadership, value creation, challenging beliefs, spontaneity and flexibility, and distain for bureaucracy repeatedly reinforce the company’s culture. In addition, the letters accentuate how management view themselves as partners with shareholders rather than just hired hands. Although the ownership is not large in percentage terms, cousins and board members Anthony and Steven Markel collectively own $244 million of Markel stock. Tom Gayner owns over $47 million, including restricted stock holdings. Historically management has emphasized long-term thinking and rewarded long-term success. A significant portion of executive bonuses is tied to growth in book value per share and stock returns over rolling five-year periods. As stated in the 2014 Annual Report: “We also think that orienting ourselves towards long-term thinking offers us a huge advantage. With a long-term focus, difficult decisions oftentimes become easier and more obvious.”

Investing Acumen/Flexibility

As previously discussed, Markel’s investing track record is very strong. Markel’s equity returns have bested the S&P 500 for three decades. This has helped to produce very strong returns for the stock over the long-term as Markel has historically invested a significant portion of its equity in stocks. As Tom Gayner is only 57 years old, I expect him to be investing for Markel for many more years. In addition to Mr. Gayner’s expertise, Markel has several lasting characteristics which will benefit its investing over time:

·      Given Markel’s profitable underwriting which brings cash into the investment portfolio on a consistent basis, it has the ability to dollar-cost average into positions over time. This provides obvious benefits in a falling market as investments can continue to be made as prices become more attractive.

·        Given that Mr. Gayner sees himself as a capital allocator and is in a position to invest in almost anything, Markel has a lot of flexibility to allocate capital to its best use. Ventures gives Markel more options for allocation capital as well as another stream of incoming cash flow. Buffett has remarked on how at various times in the past public equities were much more attractive than purchasing controlling stakes in private companies, or vice versa. No doubt this will continue to be the case in the future and Markel will be able to capitalize as opportunities arise.

·        Success in investing comes about the same way as success in insurance underwriting, which is having the ability to determine when you are being appropriately compensated for the risk you are assuming and having the discipline and patience to pick your spots. Given its historical successes in both investing and underwriting, the company has shown it has the discipline to only accept risks it is well compensated for. Having a strong capital allocator with many asset classes at his disposal creates a lot of optionality.

Niche Markets

Historically Markel has focused on competing in insurance markets with a specialty focus on hard-to-place risks. As mentioned previously, Markel has a significant presence in the E&S business in the US. It has developed this business over a long period of time which has provided it with valuable knowledge, experience, and customer relationships which enable it to be a formidable competitor in these specialty markets. As mentioned previously, Markel insures things like horses, zoos, summer camps, professional athletes, event cancellations and many other non-standard risks. Given its experience, market share, and size, Markel will likely be a strong competitor for a long time with a high likelihood of continued underwriting profits and share gains in the E&S market. Plus, Markel is currently seeing low to MSD rate increases in its professional and casualty which has resulted in organic growth so far in 2019. To that extent that premium growth continues, this will generate valuable growth in float and investment income.

Conclusion

Although stock returns over the past couple of years have lagged the market and Markel’s foray into the ILS business has been rocky, I believe the model still works and now is a good time to buy the stock. The stock price got too high by mid-2016 after more than doubling since 2011. That combined with the CatCo blow up, significant catastrophe losses, and maybe doubts about the significant investments in Ventures and ILS the past couple of years has weighed on the stock price. Although future returns won’t be as high as those of the past due to the company’s size and low interest rates, the stock currently trades at a high single digit yield and I don’t think it is a stretch to compound at a double-digit rate going forward, especially once they get the ILS business figured out and the cash generation of Ventures become more obvious. Given the strong management team, wide menu for capital allocation, and diversified stream of cash flows, there is a lot of optionality to increase future returns.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Improvement in ILS operations
  • Continued premium growth
  • Strong performance in Ventures
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    Description

     

     

    Introduction

    Markel is certainly not a novel idea but I think it is worth a look right now. After being somewhat of a pet stock of the value investing community a couple of years ago, the sheen seems to have worn off. The stock price peaked almost a year ago at $1,228 but currently stands at $1,147, just barely above the level of two years ago. The stock price has gone nowhere for probably a few reasons including poor reinsurance pricing despite significant industry-wide catastrophe losses, lackluster results from Markel Ventures, low interest rates, a relatively high starting valuation, and most notably, the complete blowup of the $200+ million CatCo acquisition made in late 2015 (and this doesn’t include Markel’s lost investment in the CatCo funds). At the end of 2018, Markel’s book value per share had only compounded at a 7% rate over the previous five years, the lowest rate in over two decades. I think the perception that Ventures is a collection of somewhat mediocre industrial businesses, the CatCo debacle and recent mediocre results has maybe caused even long-time admirers to question the ability of management to allocate capital and thus the company’s ability to compound in the future. It is no secret that Markel’s management has structured the company in a manner similar to Berkshire, which requires excellent capital allocation to succeed. However, despite the recent rough patch, I think there is a high likelihood that the company can continue to compound at an acceptable rate for a long time. The current valuation is undemanding, the company will learn and improve from the CatCo wipeout, and on closer inspection, the Ventures investments overall have been a good use of capital.

    Overview

    Markel Corporation (MKL) is a financial holding company based in Richmond, Virginia. The company was founded in 1930 to sell insurance to taxicabs and buses and remained a family business until its IPO in 1986. Today the company underwrites specialty insurance products in a variety of markets around the world. Markel repeatedly states that its financial goals are to “earn consistent underwriting and operating profits and superior investment returns to build shareholder value…. over a long period of time.” Over time, MKL has clearly achieved these goals. Since its IPO, the company has been remarkably successful having compounded shareholders’ capital at nearly 20% compared with roughly 10% for the S&P 500. These stellar returns have come primarily from three sources: profitable underwriting, strong investment returns and leverage. The company has historically earned underwriting profits from its insurance businesses which is an accomplishment in an industry that consistently shows collective underwriting losses. Its long-term investing record is impressive. I believe MKL has several enduring characteristics which have enabled it to produce outstanding results and will enable it to continue producing above-average returns for stockholders over the long run despite the slowdown of the past couple of years.

    Markel Overview

    Property and casualty (P/C) insurers in the US fall primarily into two categories: admitted and Excess & Surplus (E&S). For admitted companies, the state’s regulators monitor the finances of the insurers, forms are highly regulated, products and coverages are largely uniform with relatively predictable exposures and companies tend to compete based on price. Examples of admitted companies are Geico (selling auto insurance) and Allstate (selling homeowner policies). However, there are some cases where admitted carriers will not accept a risk because it may be too unusual, too big, or for other reasons. In these cases, those seeking to ensure such risks can obtain a policy from an E&S insurer, which provides policies even though they are not regulated in the particular state where the policy is sold, and these policies are generally free from the coverage and rate regulations imposed on admitted insurers. This gives specialty insurers greater flexibility in designing and pricing their policies, which allows them to accept hard-to-place risks that generally do not fit the underwriting criteria of admitted, or standard, carriers. Due to the greater flexibility and less competition, specialty insurance markets tend to focus less on price and more on value-based considerations such as availability, service, and expertise.

    Markel writes on both an admitted and E&S basis but focuses on specialty markets (in both admitted and E&S) where it believes it can add value with specialty product offerings in niche markets. In 2017, Markel was the 3rd largest E&S writer in the US as measured by direct premiums, which is up from 6th place in 2013. Markel also participates in the reinsurance market. Reinsurance is when an insurer contracts with another insurer or group of insurers to take on a specific amount of risk which it has underwritten. Typically, Markel’s reinsurance contracts provide for automatic reinsuring of a type or category of risk underwritten by the ceding insurers (cedents). Generally participation is in the form of a treaty with a number of other reinsurers, each with an allocated portion of the treaty with terms and conditions being substantially the same for each participating reinsurer. In 2017, Markel was the 35th largest reinsurer in the world as measured by gross premiums. Most of Markel’s business is placed through insurance and reinsurance brokers. During 2018, approximately 25% of Markel’s gross premiums were accounted for by its top three independent brokers.

    Prior to 2018, Markel categorized its insurance business into three segments: US, International, and Reinsurance, with US representing the majority. However, beginning in 2018, the company changed its reporting to two segments: Insurance (which includes the former International segment) and Reinsurance. In 2018, the total gross premium volume of $5.8 billion was comprised of 82% insurance and 18% reinsurance. In 2017 and 2018, Markel’s net retention of gross premiums written was 84% and 83%, respectively. Currently Markel’s top ten reinsurers represent 61% of its reinsurance recoverable balance.

    Insurance Segment

    The Insurance segment is written through Markel’s Assurance, Specialty and International divisions. The Assurance division (44% of Insurance premiums) writes commercial and Fortune 1000 risks on an E&S and admitted basis. US insurance regulations generally require an E&S account to be declined by admitted carriers before an E&S company may write the business. This business is typically more restrictive and more expensive than coverages in the admitted market. The Specialty division (28% of US insurance premiums) writes specialty coverages for niche markets primarily on an admitted basis. These are risks that, although are unique and hard-to-place in the standard market, must remain with an admitted insurance company for regulatory reasons. Unique risks written in the admitted market cover insureds engaged in similar, yet highly specialized activities which require an insurance program not otherwise available from standard insurers or insurance products that are overlooked by large admitted carriers.

    The International division (24% of Insurance premiums) writes risks that are characterized by either the unique nature of the exposure or the high amount of coverage required by the insured. Most of Markel’s International operations are conducted through Markel’s Lloyds of London syndicate. Risks written in the International division are written on either a direct basis or a subscription basis. Risk written on a subscription basis means that loss exposures are typically insured by more than one insurance company, or Lloyd’s syndicate, due to the high limits of insurance coverage required. When Markel writes business in the subscription market, it prefers to “participate as lead underwriter in order to control underwriting terms, policy conditions and claims handling.”

    Product offerings in the Insurance segment include:

    ·        General and Professional liability

    ·        Property

    ·        Personal

    ·        Marine & Energy

    ·        Workers’ compensation

    ·        Other product lines

    Specific types of coverage the segment offers, which demonstrate Markel’s niche focus include:

    ·        Environmental products including environmental consultants’ professional liability, contractors’ pollution liability and site-specific environmental impairment liability

    ·        Professional liability for a multitude of professions

    ·        Medical facilities such as home health agencies and senior living facilities

    ·        Data breach and privacy liability and electronic media coverage

    ·        Coverage for fine art on exhibition and in private collections, precious metals, jewelry, and cash in transit

    ·        Railroad related products including commuter and scenic and tourist railroads

    ·        Youth and recreation-oriented organizations and camps and child care operations

    ·        Museums and historic homes

    ·        Wineries

    ·        Small fishing ventures, charters, boat rentals, ocean cargo, boat dealers, yachts, and marina owners

    ·        Animal boarding and breeding and training facilities

    ·        Equine-related risks such as horse mortality, theft, infertility, and transit

    ·        Mortality coverage for farms, zoos, animal theme parks and safari parks

    ·        Accident and health coverage for sports groups

    ·        Property damage and business interruption related to political violence including terrorism and civil war

    ·        Indemnity, directors’ and officers’ liability, errors and omissions, etc. targeting US and international public companies as well as large professional firms

    Reinsurance Segment

    The Reinsurance segment includes property and casualty treaty reinsurance products offered to other insurance and reinsurance companies globally including both quota share and excess of loss reinsurance. These products are typically written on a participation basis, meaning that each reinsurer shares proportionally in the business ceded under the reinsurance treaty. The reinsurance business was acquired in 2013 with the acquisition of Alterra. In 2018, reinsurance premium volume was 43% casualty, 33% property, and 24% specialty.

    Primary product offering include:

    ·        Property

    o   Includes coverage for natural disasters as well as property including buildings, equipment and contents

    ·        Casualty

    o   General liability, professional liability, workers’ compensation, medical malpractice, errors and omissions, and environmental liability

    ·        Auto

    o   Provided to national and regional carriers

    ·        Specialty

    o   General aviation risks worldwide

    o   Onshore and offshore marine and energy risks on a global basis

    o   Crop insurance

    o   Coverage for government entities including schools, public housing authorities, municipalities, counties, water and sewer districts, parks, etc.

    There have been significant catastrophe events the past two years which has elevated the overall combined ratio. In fact, 2017 was the highest loss year ever with total reinsurance industry payouts of $240 billion. For Markel, the reinsurance combined ratio was 132% due mostly to losses from hurricanes Harvey, Irma, and Maria as well as earthquakes in Mexico and wildfires in California. The following year, 2018, was the fourth worst year in terms of industry losses and Markel’s reinsurance combined ratio was 113%. Up until most recently, reinsurance rates had not risen to adjust to the industry’s increasing losses; however, renewals in 2019, especially for hurricane exposures in the southeastern US have begun to see double digit rate increases and further increases are likely for 2020.

    Underwriting

    Historically Markel has been a strong underwriter of risk. Over the past five- and ten-year periods, Markel’s combined ratio has averaged 96% and 97%, respectively. This compares to the industry at 100% and 101% during those time frames. Markel pursues underwriting profits, not float; float is just a positive byproduct. Markel has been able to achieve such a strong underwriting record due in large part to the company’s culture which has ingrained a disciplined mindset. Having a strong historical combined ratio demonstrates that the company refuses unprofitable business, yet this is a difficult model for most insurance companies to follow.

    From the 2018 Annual Report:

     

    We routinely review the pricing of our major product lines and will continue to pursue price increases in 2019, when possible. However, when we believe the prevailing market price will not support our underwriting profit targets, the business is not written. As a result of our underwriting discipline, gross premiums volume may vary when we alter our product offerings to maintain or improve underwriting profitability.

    Most managements are reluctant to turn away business while others are growing or Wall Street’s quarterly projections need to be met. In other cases, incentive systems can be skewed to reward volume over profits. Because the consequences for foolishly priced policies may not become apparent for long periods of time, management can easily give in to unwarranted optimism and go with the flow rather than soberly assess risk. However, Markel historically has not succumbed to these pitfalls. The company consistently states that it will not write business if it doesn’t believe it can achieve its underwriting profit targets.

    According to the 2006 Annual Letter:

     

    Whether it is our underwriting or investing operations, we believe that our discipline over long periods of time is what distinguishes us from our competitors…At Markel, underwriting discipline represents both a philosophy and a process. Our philosophy is to work to achieve consistent underwriting profits in all products in all insurance market conditions. The process by which we achieve underwriting profits can be slightly different by underwriting unit but generally includes finding the answers to four questions: Can we assess the risk we are taking? Can we design the appropriate coverage for our client? Can we price the risk to earn an underwriting profit? Can we assess trends that may increase our risk in the future?

    Historically, the company has been a conservative estimator of loss reserves, preferring to overestimate initially and reduce reserves in the future as events unfolded favorably rather than vice versa. It had this to say about loss reserving in the 2006 Annual Letter:

     

    For decades, we’ve maintained a philosophy of attempting to establish loss reserves at levels which are more likely to be redundant than deficient. We also refer to this philosophy as attempting to establish a margin of safety. It’s impossible to set loss reserves perfectly since they represent an estimate about the future outcome of unknown events. Given this uncertainty, we do our best to understand what drives these outcomes, monitor these drivers closely and try to be conservative. We attempt to create a margin of safety so that loss reserves will ultimately prove adequate.

    Investments

    In addition to underwriting, Markel’s investing track record also stands out. First, it invests a larger percentage of its equity into stocks as compared to other P/C insurers, and second, it has produced outstanding results. It has historically invested around 100% of its float in fixed income and cash. The value of Markel’s stock portfolio comprises 66% of book value and just over 100% of tangible book value as of June 30, 2019.

    Markel doesn’t equate volatility with risk. It views its equity as permanent capital and seeks to maximize its value in the long run by investing in the common stocks of quality businesses (and private businesses) run by talented managers. Markel’s investment portfolio has been managed by Tom Gayner (age 57), who is a student of the Warren Buffett style of value investing. Gayner laid out his equity investing style in Markel’s 2012 Annual Letter:

       

    “Over the years, we’ve never made decisions based on our forecasts of what was ahead for the economy, governmental policies, tax rates, currency values, interest rates, technological changes or other incredibly important but fundamentally unknowable future developments. Instead, we’ve simply looked at individual companies, one at a time, and asked ourselves a few questions. By considering four basic types of questions about individual companies and securities we try to develop enough confidence to make a decision. Our first question is, “Is this a profitable business with good returns on capital without using too much debt?” Second, we ask ourselves, “Is the management team equally and sufficiently talented and honest?” Third, we ask, “What are the reinvestment dynamics of the business and how do they manage capital?” and finally we ask, “What is the valuation and what do we have to pay to acquire ownership in the business?” While these are four simple questions, the process of thinking deeply about them tends to produce robust results over time as demonstrated by our long-term record. Those questions also tend to encompass consideration of some of the macroeconomic factors that tend to cause so much worry and anxiety for so many investors.”

    In addition to a value orientation, Gayner has typically kept his portfolio relatively concentrated. For example, currently, the equity portfolio’s largest two positions are Berkshire Hathaway at 10.6% and CarMax at 5.7%. As of March 31, the top ten holdings were over 40% of the portfolio based on the 13F. Gayer also means it when he says that he is a buy and hold investor as Berkshire Hathaway has been owned for nearly 30 years and the top ten holdings of KMX, BAM, DIS, and MAR have been held for at least 15 years.

    Markel’s stock portfolio has handily beaten the S&P 500 during the 30 years Gayner has been investing at Markel. In recent years when most active (not to mention value) managers have lagged the S&P 500, Gayner has posted very strong relative performance. His equity portfolio has outperformed the S&P 500 in eight of the past nine years. One positive aspect of Markel that has helped to produce strong investing results is that it can dollar-cost average. In a WSJ article from May 22, 2015, Tom Gayner specifically mentioned that Markel’s insurance operations are so consistently profitable that cash has flowed into the investment portfolio every single month since he joined the company in 1990. This has enabled him to regularly invest in his favorite holdings, both stocks and bonds, whenever he wishes. And now, Ventures is becoming a significant contributor to those incoming cash flows as well. Along these lines, Tom Gayer highlighted Markel’s allocation flexibility in the Q2 2015 conference call:

    “We continue to actively hunt for opportunities in both arenas, and I'm optimistic we'll find treasures in both markets. That's one of the true beauties of Markel in that we are able to pursue the highest and best returns no matter where they might be. We have a full 360-degree view of insurance, industrial and public and private debt and equity markets, and we're comfortable in deploying capital into any and all of them as circumstances arise.”

    Markel Ventures

    In addition to its insurance and investing operations, Markel also has a third component of its business which was established in the early 2000s called Markel Ventures, which owns controlling or 100% stakes in operating businesses. It is no secret that Tom Gayner has stated in the past that Markel is pretty much running the same playbook as Berkshire with its focus on buying operating companies. Markel has put significant capital to work into Ventures in the past few years to the point where Ventures is now a substantial component of the company. Over the past five years (the same time frame where growth in book value per share was the lowest in decades) Markel has invested a total of about $3.2 billion into Ventures acquisitions and ILS deals (e.g. Nephila, CatCo, and State National), notably, with no stock issuance. Just in 2017 and 2018, Markel made acquisitions totaling nearly $2.5 billion. I think one of the reasons Markel’s stock price has been stagnant for the past couple of years is the perception that the Ventures businesses are lower quality and that this has been a poor use of capital. Also, Markel’s historical disclosures around Ventures leave much to be desired. However, upon closer inspection, I think the Ventures acquisitions have generally worked out well.

    Since the first Ventures acquisition, Markel has invested just less than $1.4 billion (excludes ILS acquisitions) in acquiring operating businesses, including Brahmin Leather Works in October 2018. In 2018 Ventures EBITDA was over $220 million on over $1.95 billion in revenue. The $220 million is adjusted to remove the non-recurring impact of remediation costs, earnouts, and an impairment. Deducting capital expenditures at 3% of revenue (which is in line with the historical ratio of depreciation as % of revenue) and taxes at 21%, the resulting unlevered free cash flow is approximately $130 million, or 9.5% of the total capital invested. Plus, this includes the total cost of Brahmin ($173 million upfront cash) but less than two months of ownership. Accounting for a full year of Brahmin, the result is a double-digit unlevered rate of return which is pretty darn good. For the first six months of 2019, Ventures revenue totaled $1.1 billion and EBITDA $160 million, good for a 14.5% EBITDA margin. Gayner has stated that Ventures will likely have an EBITDA margin in the 13% range based on the current portfolio. Although the Ventures companies are boring, operating in industries such as leather goods, house plants, baking equipment, dredges, homebuilders, manufactured housing communities, auto transport equipment, etc., Markel has generated value through acquiring and operating these businesses. Gayner said the following about Markel’s non-insurance businesses at the 2019 Markel Omaha Brunch:

    "We do have hundreds of millions of dollars coming in of cash flow that is not connected to our insurance business. One of the fun things about being at Markel is the non-insurance things that we are doing create opportunity and credibility for the insurance business by day to day execution of that, which creates investable cash flow which we use to our mutual benefit and it is a multiplicative thing. And again, there are very few organizations that have the architecture and structure in place where instead of isolating the streams and having them operate in completely, one-off, siloed ways, by joining these streams you are not adding one and one and getting two, you are multiplying 1.2 times 1.2. And any multiplicative process which is more than one point zero creates a geometric value explosion, not just a linear mathematical one."

    In summary, Ventures is important because it gives Tom Gayner and Markel an additional area in which to allocate capital rather than solely the public markets for debt and equity, plus having an additional stream of cash flow makes the entire organization more resilient. As Ventures continues to grow, it will benefit the insurance organization by potentially allowing it to write larger policies and retain more of the business it writes. Hopefully growth in Ventures will allow for more insurance to be written increasing premiums, float, and cash flow. Buffett has spoken numerous times how Berkshire’s size and non-insurance businesses benefit its insurance operations.

    Although I wouldn’t yet characterize Ventures and Markel as a “geometric value explosion,” the track record is strong and, if the past few years are any indication, Ventures will continue to grow and its presence will benefit the insurance operations. Plus, as it grows to more companies in more industries, there will be many opportunities for add-on deals and internal organic growth.

    ILS

    Markel ventured into the insurance-linked securities (ILS) market in 2015 with its $200+ million acquisition of CatCo, which managed $2.7 billion in retrocession and reinsurance portfolios at that time. In addition to the purchase price, Markel invested $200 million in CatCo funds. Co-CEO Richie Whitt said the following on the Q4, 2015 conference call:

    “I think there clearly are synergies there. CATCo and our reinsurance operations share many of the same clients. And the clients have needs at times for traditional reinsurance and other times they may decide a capital market solution is a better fit for what they're trying to achieve. So, having the ability to write both traditional products, as well as the capital market-backed products, especially CATCo, it has a rather unique product structure. I think that just helps us better serve the clients that are out there. Since the acquisition or after the announcement of the acquisition, we've seen interests from people who were not previously clients of CATCo. So, there's going to be opportunities for our guys on the reinsurance side and CATCo guys to work together to make sure we're serving those client needs.”

    Based on more recent commentary around the ILS business, Markel strongly believes in its future. At the recent Omaha Brunch, Gayner and Ritchie Whitt pointed out that the amount of capital in the insurance industry is relatively small compared to the global capital markets yet the industry has retained nearly all the catastrophe risk on a relatively small capital base. As a result, that risk can be spread out into the capital markets efficiently considering the uncorrelated nature of the returns and the overall win/win nature (in theory) of the transaction. Markel believes there will be tremendous amount of capital that will flow into the ILS market and it likely wants to hedge its traditional reinsurance business by making sure it has a seat at the table.

    I don’t know what specifically happened at CatCo other than what the company has announced and what was written in the complaint by Tony Belisle (former CatCo CEO, Case 1:19-cv-00189-LM) against Markel. However it is not surprising that the worst year in catastrophe loss history was enough to cause major problems which may have been exacerbated by under-estimating reserves. As announced in the Q2 call, the CatCo investment has been completely written off and the firm is being wound down. This was a very expensive mistake for Markel but I’m sure they learned quite a lot about the ILS industry, probably more than they would without this sort of outcome. Current AUM for CatCo and Nephila combined is $13.7 billion as of June 30 and total revenue was $104 million for the first six months of the year. Markel also announced it is forming a new retrocessional ILS platform in Bermuda which will offer a broader range of ILS capabilities and will built from the ground up. I guess they figure a better approach to build the type of ILS business they want is to build rather than buy, which makes a lot of sense given the institutional knowledge as well as the culture of conservative underwriting.

    Valuation

    Rather than thinking of Markel’s current book value multiple, I think it is more helpful to think in terms of what the company can earn in the future relative to the price today. For example, consider what Ventures and the investment portfolio could earn, on average, over the next few years.

    Securities Portfolio, Value, % Total Return, Return ($)

    Fixed maturities, $10,258,640, 3.0%, $307,759

    Equity securities, $6,875,933, 8.5%, $584,454

    Short-term/cash, $4,025,038, 1.5%, $60,376

    Total portfolio, $21,159,611, 4.5%, $952,589

    Markel Ventures profit: $150,000

    Total Market profit: $1,102,589

    Equity value $15,822,014

    Yield 7.0%

     

    This table includes assumptions about what Markel may earn on its securities portfolio, on average, over the next few years. These assumptions assume a rate environment like recent years but lower stock returns. The 4.5% overall return is lower than the historical return since 2012 of 5.5%, during which the average return on fixed income and equities was 2.9% and 14.9%, respectively. This excludes any contribution for the ILS businesses which I’ve excluded because frankly it is too difficult to make a reasonable assessment at this point given the ILS difficulties thus far, recent deal for Nephila, and the build out of the new ILS platform. However, keep in mind Markel paid over $970 million for Nephila. Also, this assigns no value to program services business from State National which is a relatively recent acquisition with $70 million in fee revenue for the first six months of 2019. Markel paid over $900 million for State National in late 2017 and it generated nearly $100 million program services fee revenue in 2018. This analysis assumes that Markel will continue to operate at an underwriting profit, but just enough to cover its relatively small interest payments and corporate overhead. Markel’s cash flow from operations was over $800 million the past two years, which aligns with the table above considering it includes unrealized equity gains.

    Risks

    Interest Rates

    One of the primary issues facing insurers today is low interest rates. Obviously, the higher the interest rate, the higher the cost of float (other things being equal) that an insurer can accept and still be profitable overall when factoring in the return on the investment portfolio. However, in the current environment with the rates of interest on investment grade credit so low, there is little room for error in underwriting.

    The duration of Markel’s fixed income portfolio (excluding cash and investments with an original maturity of less than 12 months) was 6.1 as of December 31, 2018. As of June 30, 2019, the fixed income portfolio totaled $10.3 billion which compares with $4 billion in cash and short-term investments. Markel has a lot of dry power which has hampered results as rates have remained low but will benefit the company if/when rates rise. Markel has purposefully kept duration lower than it otherwise would and it appears to be positioning the portfolio for a rise in rates. The company’s policy is to match the duration of its liabilities with its fixed income investments, including currencies.

    Given Markel’s fixed income portfolio duration and assuming no change in stock values, a 100 basis point upward movement in the yield curve would cause book value to decline by approximately 6% and a 200 basis point move would result in a 12% decline. Given the current positioning of Markel’s portfolio and its investment philosophy, it would benefit from rising rates although book value will decline because the company will adjust its portfolio and interest income will significantly increase, likely offsetting the initial decrease in book value. The greater risk may be rates staying lower for longer which would depress future returns.

    Equity Market Decline

    Currently Markel has a $6.9 billion equity portfolio which amounts to 66% of shareholders’ equity and just over 100% of tangible book value. Given its significant position in equities, a severe bear market would hit shareholders’ equity. In 2008 the stock portfolio fell 34% and the return on the overall investment portfolio was negative 9.6%, yet book value per share declined 16%. The bond portfolio produced a small gain in 2008 as a significant portion of Markel’s fixed income was invested in corporate and municipal debut that, while highly rated, did not appreciate as much as US Treasury securities. If a major selloff occurred, Markel’s book value will fall, but given the quality of the companies it owns, permanent impairment is a low risk in my opinion. Plus, Markel now has a much more sizable Ventures segment which produces a diversified stream of cash flows.

    Reinsurance Pricing

    In comments made at the 2015 Berkshire Hathaway Annual Shareholders’ Meeting, Buffett had negative things to say about the reinsurance industry: “It’s a business whose prospects have turned for the worse and there’s not much we can do about it. The reinsurance industry in the next 10 years will not be as good as it has been in the last 30.” Buffett made these statements because he believed increased competition would continue to lead to inadequate rates and he was correct. In recent years, tens of billions of dollars have been put to work in reinsurance from various institutional investors and hedge funds. Hedge fund managers including David Einhorn, Dan Loeb, and John Paulson have set up offshore reinsurers for the favorable tax treatment as well as access to float. Growth in the ILS market has also increased competition and put pressure on rates. Future competition may negatively impact Markel’s reinsurance operations by leading to reduced float if Markel is unable to write profitable business. However, with the recent major catastrophe years, the supply of reinsurance has contracted. Both Paulson and Einhorn have decided to wind down their reinsurance vehicles as the industry proved too competitive and investment results lagged. However, reinsurance rates are finally starting to rise in response to the recent industry losses and so far in 2019, Markel is seeing nice growth in reinsurance premiums.

    Prospective Market Returns/Valuation

    Except for underwriting and Ventures, the profits earned by Markel are a direct result of the capital gains and income from the stock and bond portfolios. As we are ten years into an equity bull market and the 10-year sits below 1.8%, prospective returns going forward will likely be lower than the past decade. I don’t think it is possible that Markel can compound in value at a rate close to its historical rate of 20%. And while I am confident that Tom Gayner and Markel will produce results over the long-term that exceed the indices, no doubt Markel’s absolute results will suffer during periods of poor market performance. Also, there could be future blowups with investments in Ventures or other businesses. Markel’s management team obviously makes mistakes and they will make more in the future. But based on the track record, the good will likely outweigh the bad.

    Positives

    Management/Culture

    Markel’s annual letters provide a great window into the way the company’s leadership thinks. The letters consistently emphasize what the company calls the “Markel Style,” or the way that the company does things. This consistent focus on characteristics like market leadership, value creation, challenging beliefs, spontaneity and flexibility, and distain for bureaucracy repeatedly reinforce the company’s culture. In addition, the letters accentuate how management view themselves as partners with shareholders rather than just hired hands. Although the ownership is not large in percentage terms, cousins and board members Anthony and Steven Markel collectively own $244 million of Markel stock. Tom Gayner owns over $47 million, including restricted stock holdings. Historically management has emphasized long-term thinking and rewarded long-term success. A significant portion of executive bonuses is tied to growth in book value per share and stock returns over rolling five-year periods. As stated in the 2014 Annual Report: “We also think that orienting ourselves towards long-term thinking offers us a huge advantage. With a long-term focus, difficult decisions oftentimes become easier and more obvious.”

    Investing Acumen/Flexibility

    As previously discussed, Markel’s investing track record is very strong. Markel’s equity returns have bested the S&P 500 for three decades. This has helped to produce very strong returns for the stock over the long-term as Markel has historically invested a significant portion of its equity in stocks. As Tom Gayner is only 57 years old, I expect him to be investing for Markel for many more years. In addition to Mr. Gayner’s expertise, Markel has several lasting characteristics which will benefit its investing over time:

    ·      Given Markel’s profitable underwriting which brings cash into the investment portfolio on a consistent basis, it has the ability to dollar-cost average into positions over time. This provides obvious benefits in a falling market as investments can continue to be made as prices become more attractive.

    ·        Given that Mr. Gayner sees himself as a capital allocator and is in a position to invest in almost anything, Markel has a lot of flexibility to allocate capital to its best use. Ventures gives Markel more options for allocation capital as well as another stream of incoming cash flow. Buffett has remarked on how at various times in the past public equities were much more attractive than purchasing controlling stakes in private companies, or vice versa. No doubt this will continue to be the case in the future and Markel will be able to capitalize as opportunities arise.

    ·        Success in investing comes about the same way as success in insurance underwriting, which is having the ability to determine when you are being appropriately compensated for the risk you are assuming and having the discipline and patience to pick your spots. Given its historical successes in both investing and underwriting, the company has shown it has the discipline to only accept risks it is well compensated for. Having a strong capital allocator with many asset classes at his disposal creates a lot of optionality.

    Niche Markets

    Historically Markel has focused on competing in insurance markets with a specialty focus on hard-to-place risks. As mentioned previously, Markel has a significant presence in the E&S business in the US. It has developed this business over a long period of time which has provided it with valuable knowledge, experience, and customer relationships which enable it to be a formidable competitor in these specialty markets. As mentioned previously, Markel insures things like horses, zoos, summer camps, professional athletes, event cancellations and many other non-standard risks. Given its experience, market share, and size, Markel will likely be a strong competitor for a long time with a high likelihood of continued underwriting profits and share gains in the E&S market. Plus, Markel is currently seeing low to MSD rate increases in its professional and casualty which has resulted in organic growth so far in 2019. To that extent that premium growth continues, this will generate valuable growth in float and investment income.

    Conclusion

    Although stock returns over the past couple of years have lagged the market and Markel’s foray into the ILS business has been rocky, I believe the model still works and now is a good time to buy the stock. The stock price got too high by mid-2016 after more than doubling since 2011. That combined with the CatCo blow up, significant catastrophe losses, and maybe doubts about the significant investments in Ventures and ILS the past couple of years has weighed on the stock price. Although future returns won’t be as high as those of the past due to the company’s size and low interest rates, the stock currently trades at a high single digit yield and I don’t think it is a stretch to compound at a double-digit rate going forward, especially once they get the ILS business figured out and the cash generation of Ventures become more obvious. Given the strong management team, wide menu for capital allocation, and diversified stream of cash flows, there is a lot of optionality to increase future returns.

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

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