Description

Summary and Valuation:

Markel represents good value in a very expensive market.  While the stock has performed well thus far in 2021, it has basically gone sideways since the start of 2018.  Meanwhile, its core insurance operations have demonstrably improved and a conservative management team is very optimistic about the business looking forward.  Co-CEO Tom Gayner is a Hall of Fame investment manager—over virtually any period the equity portfolio has outperformed the S&P and done so with tax efficiency. Finally, Markel Ventures, the private equity portfolio developed over the last 16 years, is now meaningful and a rewarding contributor to the enterprise.

Markel has been analyzed on VIC three previous times, beginning in 2010. All are worth reading for interesting background on the company.   Each report focuses on price/book (now 1.32X) as the main valuation tool—not surprisingly, as management highlights growth in book value as an important barometer of success.  And in fact, growth in book value and stock performance (both measured in rolling five year periods), are the two determinants of incentive compensation for corporate officers.  At the same time, Gayner and Richie Whitt (also Co-CEO) have expressed the belief that intrinsic value is less and less captured by book value—though still suggesting that the growth of book value is an important barometer of progress.  And Markel has started to buy back stock in recent years, halting the program with the start of the pandemic but beginning again earlier this year.  As with Berkshire Hathaway, I think this reflects a strong belief in a meaningful discount to underlying value rather than simply jumping on a fashionable trend in corporate America.

So what is underlying value?  A crude, but I believe effective, answer flows from capitalizing operating earnings, or EBITA (leaving out investment returns) and adding the value of the equity portfolio.  I think it is fair to isolate the equities as management continually asserts that the fixed-income investments more than supports the insurance reserves.  I leave out interest expense:  Cash and short-term investments at the holding company are slightly greater than debt, although there is a negative arbitrage on these funds.  More than offsetting that, and also because rates are so low, I also ignore earnings on the insurance fixed-income (extremely conservative) investments—but note that this is a pool of over $13 billion or almost $1000/share  My forecast for operating earnings this year is $900MM, or $65/share. Management believes they will do significantly better, as I will explain below. Using a 12 multiple, which I think is conservative, that’s $785/share.  The equity portfolio at the end of Q1 is $7.53 billion, or $547/share—for a total of $1332/share.  Interesting but not compelling to this audience.  

But let’s dream a little: In the 2020 Annual, management set out a goal to grow over the next 5 years to $10 billion in insurance premiums and hit a 90 combined ratio (C/R)—articulated as 10/5/1:  $10 billion premiums in 5 years with $1 billion in operating profits. This sounds, and could well be, quite ambitious.  But having followed Markel from afar for many years, it was the trigger for my enthusiasm and ownership.  If Markel can hit this target, and also achieve mid single-digit growth in other operations and the equity portfolio, underlying value would build in the mid to high teens annually.  At the same time,  the company would produce over $4 billion in cumulative after-tax free cash flow—or about 25% of the current market cap (though some of this would be needed to support higher premium levels).

Management has repeatedly discussed the concept of three engines:  Insurance, Investments and Markel Ventures.  I hope I am wrong, but I think returns on the equity portfolio over the next few years are likely to be disappointing compared with the past two decades (9.4% CAGR over the last 20 years; 14.7% over the last 10).  It’s very hard to forecast the pace of future acquisitions for Markel Ventures—I think the businesses in aggregate have been a good use of corporate capital and now are very cash generative.  So with the hand in place, insurance—both underwriting operations and potentially ILS/program business—is most likely to be the key growth engine over the medium term.

Insurance:

Markel has a long record of superior insurance underwriting.  Since 2000, the combined ratio has exceeded 100 in only 6 years, of which 3 were 2000-2002.  Over the last 10 years, the C/R has averaged 96.7—superior to the industry. Importantly, Markel has a long history of favorable reserve development, which speaks to the inherent conservatism of the company.  By and large, Markel is focused on specialty lines and, as is the case with every good P/C company that I know, rewards professionals on profitability over volume. 

The insurance market is in the third year of hardening, a condition caused by many factors including low fixed-income returns and a series of devastating catastrophes around the world.  Ironically, in the investor call discussing Q4:19 results in February 2020, when we now know that the COVID genie was out of the bottle, Gayner stated that they were “now at a point where insurance operations were enjoying rapid and profitable growth.”  By mid-year 2020, he noted that writing more and better priced insurance looks like the best use of capital, adding that he thought the hard market was sustainable and wanted to participate as much as possible (even selling equities—in hindsight poorly—in the spring of last year to make certain that the company could support growing premiums).

Last year the C/R was 98, which includes 6 points of COVID losses and 3 points of cat losses. The ratio hit 92 in Q1 and management is still optimistic about hitting 90 for 2021 as a whole, driven by the double-digit rate increases now flowing through on most business lines.  At a 90 C/R, my estimate above for 2021 corporate operating earnings would rise to $1,180MM, or $86/share.  Using the methodology outlined above, this would drive current intrinsic value to $1580/share.  On that basis the discount is really meaningful.

Markel Ventures:

Starting in 2005, Markel has purchased an array of industrial businesses.  Taken as a whole, they are now a significant part of the company:  in 2020 EBITDA totaled $367MM, though I prefer to look at EBITA, which was $314MM. My EBITA estimate for this year is $375MM, based on economic strength and a full year of Lansing Building Products, which was acquired last spring.  In the 2020 Annual, management notes that they have a net investment of $1.5 billion in aggregate in Ventures and adds, “We think any reasonable analyst would conclude these businesses are worth far more than what we paid and that they contribute to the resiliency and value of the Markel Corporation in tangible and intangible ways.”  They cite a four part test (actually they say this is the same process used for public equities) in evaluating companies:  1) good returns on capital without too much leverage; 2) values in sync with MKL; 3) growth prospects; and 4) a fair price.  For several years management has suggested that private market prices were lofty and an impediment to new acquisitions.  At the same time, like Berkshire, MKL seeks to provide a good home for business owners who may prefer to trade price for stability and continuity.  So by answering the phone, as they describe it, they have bought a significant business in each of the last 3 years, with Lansing, at $550MM, the largest industrial purchase to date.  Of course I can’t model future acquisitions, though I think it highly likely that MKL will have acquired at least 2-3 companies over the next few years.  I have penciled in mid-single digit EBITA growth.  Disclosure could be improved here.

ILS/Program Services:

Markel entered the insurance linked securities market in 2015 with the acquisition of CATCo.  As fully described in the 2019 VIC report, this was a disastrous (though fortunately small) purchase and it is now in the rear view mirror.  Subsequently, in 2017 MKL bought State National, which provides fee based services to managing general agents and in 2018 bought Nephila, a pioneer in ILS.  These were substantial deals:  State National was $919MM and Nephila $975MM.  Management believes that ILS will become increasingly important to its customers and has the potential to be a major and profitable growth engine for the company. State National is doing well; I think the jury is still out on Nephila.  As Gayner said on the Q1 call, “[we have] gritted teeth determination to improve operations in our insurance linked securities operation” and in the 2020 Annual management describes “meaningful profitability” as attainable this year and “demonstrating the wisdom of these initiatives.”  In 2020 these businesses earned $115MM pre amortization and CATCo runoff expenses which are mostly non-recurring.  Based on nothing more than the positive comments from management, I estimate $125MM in EBITA for 2021 and mid-single digit growth going forward.  

Conclusion:

As its Annual Reports show, Markel likes to look at itself in five year periods.  So knowing that I will certainly be wrong, my approach here has been to look forward 5 years and try and gauge the intrinsic value of the company.  I’ve tried to show here that MKL can be a good stock without heroic assumptions and a terrific long-term holding if insurance operations improve to the degree management believes is possible.  In either case, I think the downside is significantly less than the market as a whole.  

Catalyst

Continued improvement in insurance operations.