by Travis Johnson, Stock Gumshoe | November 20, 2009 5:00 pm
This month I actually did a lot of pondering about which idea rattling around in my head would be most useful to share with my favorite folks, the Stock Gumshoe Irregulars (yes, that’s you!). For a while I was considering an obscure closed end fund that owns a big chunk of a private insurer, but the value didn’t seem to be there.
Then I thought I might recommend a combo play on “what works in America” beginning to work in China and Brazil, specifically Brazil Fast Food (BOBS) for fast food franchising exposure in Brazil and Nepstar (NPD) for chain drug stores in China … but those are both quite speculative. I don’t like to make macro bets, but I feel cautious enough about the investing environment that I hesitate to profile a firm like China Nepstar right now — I may still do so in the future, and they’re not as expensive as they were when they went public, but it’s still hard to focus on a firm with very tight margins that trades at a 30+ PE ratio right now. I’ll take my chances and assume that there will be a hiccup sometime soon that makes those shares look cheaper.
Then I looked over which solid companies were trading at good valuations, and I found that Markel, my favorite insurance company, just trickled down to a price/book value of under 1.2 (it’s 1.19 right now, actually). That’s a rare value, and has always been a great time to buy these shares in the past (though I’ve rarely been patient enough to buy them that cheap — my position in this company is longstanding and currently underwater), so I thought we should focus on this fairly big, relatively safe insurer that has a steady growth strategy, an incredible commitment to being fair to stockholders, and a nice big portfolio of large cap stocks that I think will continue to serve them well.
Now, to be clear, I have owned Markel for a long time, and overall I’m still carrying a paper loss on those shares. The most recent purchase I made, however, was just about a year ago, at almost the same share price that it’s trading at now (right around $328). At the time, Markel had a price/book value of about 1.4 or so, as low as I’d seen it in a long time, and the book value was uncharacteristically falling (and about to fall more) due to the huge hurricane losses in 2008 and the terrible investment returns that their portfolio experienced during the market crash.
There are several reasons why I think it makes sense to buy Markel right here: Market Positioning of their business and corporate culture; valuation; treatment of stockholders; and investment performance and strategy.
Market Positioning and Corporate Culture
Markel, though it also now includes many other divisions and significant reinsurance operations, is a specialty insurer at its heart, meaning it has a number of specialized niches that allow them to avoid the commoditized insurance markets and write specific policies that can be profitable. If you want to insure a hairdresser, or a summer camp, or a floating oil rig or a go-kart track, fly fishing club, or homeles shelter, Markel is likely to be a leading company that you’d look to. And there won’t be a Gecko advertising that it’s got better rates for insuring your horse breeding barn or tree-trimming business, so competition is much more limited than in the broader insurance markets — and it’s also not nearly as regulated.
That market positioning, combined with a historically very profit-sensitive corporate culture, gives Markel a hard-headed focus on writing profitable insurance. Almost every time you hear a Markel executive speak they’ll tell you that they’re turning down business because it’s not going to be profitable. The way insurance companies often get into trouble is by focusing on driving sales instead of driving profits — you can book as many policies if you want if you’re willing to offer the lowest price, and for many insurance companies agents and executives are rewarded for doing just that: Driving sales higher, no matter what (that’s an exaggeration, but not a huge one). Markel, however, values extremely conscientious underwriting and they care most not about how sales are this quarter, but about how the book value of the company is growing over a five-year period … and that’s how they reward their executives, based on growth in long-term book value. That kind of focus percolates down to every salesman in the company, so there’s no urgency to write business just to keep busy — Markel wants to write only the policies that they think will be profitable.
Of course, they’re not always right — but that focus is valuable and rare in large insurance companies, in my opinion, and it helps Markel to be one of the most stockholder-friendly companies I know … more on that in a moment.
Markel has grown through acquisitions over the years, mostly picking up small specialty insurers in the US, but also expanding overseas through the London markets, and that continues — they just finished acquiring a Canadian partner company, and I’m sure they’ll be looking for other opportunities to expand when competitors and companies that could expand their offerings show weakness in a tough market.
I should also note that they don’t always integrate acquisitions perfectly well, and that building like this, through specialists with very defined policies and histories, can be tough, but they appear in general to bring people into the “Markel way” pretty well. Big and spread-out operations often require attention, and they are just finishing up what they’re calling a “reorganization” of their wholesale business, creating a much more streamlined operation (they’re calling it the One Markel Initiative) that will bring the business closer to the wholesale agents through a regional sales system. I have no idea whether it will work, but they believe that the “heavy lifting” has been done and that they’re about ready to drive organic sales growth by bringing greater exposure for all of their product lines to more customers nationwide. Tony Markel assessed this potential, even in what he expects to be a tough market, by saying that “there are a number of things going on in our operations to give rise to a great deal of optimism regarding profitable growth in 2010.”
Insurance companies are often valued based on their book value and on their underwriting performance, neither of which necessarily goes hand in hand with quarterly earnings.
An insurance company has essentially two ways of being profitable: they can underwrite profitably — meaning that they collect more in earned premiums in a given year than they pay out in claims; or they can take a loss on the underwriting but make a profit on the investable float.
The “float” is what has enabled Warren Buffett to become the wealthiest man in the world, and it’s what makes insurance such a spectacular business over the long run — the float is the money that you collect in premiums but that you don’t have to pay out in claims. It carries a liability with it, since you have to have that cash available if a claim does come in, but during the time that no claims are filed on those funds you are free to invest the money and pocket the returns. If you’re a good investor, float is irresistible — instead of having to borrow money to get leverage for your best investing ideas, you are (assuming that the insurance company makes wise choices) effectively being paid to take on extra money in your investment portfolio.
This underwriting performance is typically expressed using something called the “combined ratio,” which can be understood (this is a slight simplification) as the percentage of premiums taken in that you have to pay out as claims — if you’re over 100, then you’re losing money on the insurance business during that time period; if you’re under 100, then you’re making money on the insurance. There are several places to learn more about this if you’re interested, including a quick Motley Fool article here.
Insurance companies generally strive to have a combined ratio below 100, of course — it’s better to make money than to lose it. But they also want to grow, which often means competing with other companies, some of whom are often willing to break even on policies so they build market share and invest the float. Part of the reason that Markel took a big hit last year was that their combined ratio soared above 130 following the awful Texas hurricanes — they described those losses for most of their business as “well within both our expectations and the level at which we can achieve very good returns on our capital,” but they certainly lost money.
Now, what every insurer wants to see is a “hard market” — a market where they can raise premiums, not a soft market where competition is dropping premiums into unprofitable territory. Unfortunately, the “hard market” is a bit like a desert oasis — often seen in the distance by insurance executives, but frequently revealed to be a mirage as aggressive companies in the business forget about those massive hurricane losses from last year and start slashing prices to win new business. Nasty economies, unfortunately, are also not necessarily conducive to “hard” insurance markets — desperate companies eager to stay afloat, and employees desperate to keep their jobs, can be a tough match for small businessmen who have to shave every dime of their insurance costs to keep operating … and as companies go out of business or neglect to expand, the market shrinks because less insurance is required.
Will we enter into a “hard market?” Markel announced that they saw signs of that a year ago, and they have been very disciplined in not slashing their premiums, keeping them pretty much flat through 2009, but they have lost business as a result, and they report that competition is still tight and expected to remain so in 2010. Earned premiums in both the last quarter and in the year-to-date period were down significantly from year-ago numbers (down 14% for the quarter, year-over-year), but they were substantially more profitable this past quarter thanks to the lack of major catastrophes and the performance of their investment portfolio — they booked a profit of $6.02 per share in the third quarter, and reported a combined ratio of 96 (that compares with a ratio of 124 a year ago, 22 points of which were directly related to underwriting loss on hurricanes Gustav and Ike).
I’ve liked Markel for a long time, and it has long been a favorite of those who try to sniff out the “next Berkshire Hathaway” (as have somewhat similar companies like White Mountain and Alleghany, neither of which I like as much). It has also often been touted as a Motley Fool favorite, among others, but I’ve resisted profiling it in this space because though I always had confidence (and still do) that they will be able to grow shareholder value over an extended holding period, I couldn’t confidently say that the shares were cheap.
Now, with a price of just under 1.2X book value, I can say with some confidence that they’re cheap — if Markel were to return to historic peaks of well above 2X book value (no guarantee of that, of course), the shares could easily be well over $500 … and more importantly, given their historic performance and their solid underwriting discipline, it seems unlikely to me that the shares will fall much further absent a complete collapse of the stock and bond markets. And if we do see such a collapse, as we did briefly in March this year, I’m confident that Markel will hold up better than most. During the first quarter of this year, at the March lows when we all thought the world might come to an end, Markel briefly traded for a hair less than book value, but that’s about as low as it has ever gotten and it didn’t stay there for very long — and I don’t expect we’ll see those depressed lows again. Markel’s book value at $274 per share is at an all-time high right now, the share price is far below all-time highs.
Markel is not a company that can be very effectively valued based on just a snapshot, however — and that’s what this current record book value number is, the value of their assets minus liabilities as of September 30. The temptation is to look at the performance of the stock and bond markets since then and note that Markel’s investment portfolio has probably been growing, possibly increasing book value if the underwriting performance was profitable … but while that may be true, I don’t like to count on it to make an argument. I don’t know for sure that the book value will be higher in December than it was in September, I’d rather look at their historical performance and valuation:
If you look at earnings, Markel has lost money in several years out of the last ten, they’ve earned as much as $40 a share in some years, and lost almost $6 a share last year and almost $15 a share in the nasty 2001 market. If you take the average of all those years, losses and 2009 included, you get about $12 a share in average historical earnings — the company has grown significantly during that time, too, so you wouldn’t necessarily use that historical number, but if you consider that as a baseline the PE ratio on those average earnings is now about 27. The current forward PE ratio, based on analyst estimates according to Morningstar, is about 18, so it doesn’t look so cheap based on earnings.
But when you look at book value, which most people consider a more reliable measure for insurance company valuation, and which Markel focuses on almost exlusively, the valuation is much more compelling. Markel’s book value is based on the size of their investment portfolio and their cash at hand, and growth in that book value comes from operating profitably and compounding the portfolio through wise investments.
Over the last ten years Markel has certainly had some ups and downs — but these have been the Price/Book ratios as of the end of each year: 2.3, 1.8, 1.4, 1.7, 1.8, 2.2, 1.8, 2.0, 1.9, 1.4.
What should stand out among those numbers is that through some awful insurance markets, some huge catastrophes, some bad periods of investment returns over the past ten years, Markel has never ended the year with a price/book valuation as low as it is now.
The core thing that shareholders should expect from any company is that the firm will focus on metrics and performance that impact the long term value of the company, and that compensation will be tied to that kind of long term business success. Unfortunately, we’ve seen far too many corporations focus on beefing up short term earnings by taking risks or tinkering with the accounting in order to boost executive bonuses, and granting stock options by the handful.
Markel does this differently — executive compensation and bonuses are based on the rolling five-year growth in book value of the company. Last year, most of the top execs earned about half of what they had in 2007 — the year was lousy for Markel, so they got paid less. That’s a rare but refreshing thing to see — and it tells me that though the shares can be volatile and may move dramatically based on the company’s performance, the company will be managing their business, not managing the stock price by forcing the C-suite execs to go on CNBC to puff up their chests and talk about a “great quarter.”
And a note about “Mini Berkshire” and their investment strategies
Markel has often been called, by me as well as others, a mini Berkshire Hathaway — because they are an insurance company, which is the heart of Buffett’s empire, because they have refused to split the stock and focused on long term book value growth (Buffett would use the squishier term, “intrinsic value”), and because they clearly idolize Buffett and even show up at Berkshire Hathaway annual meetings. Throw that in with an investment strategy that is somewhat Buffett-esque under Tom Gayner’s portfolio management (he was often suggested as a possible replacement for Buffett, back in 2006 when he was more of a well-known value investing star — and he’s even a Buffett colleague, they both serve on the board of the Washington Post Co.), and you can see the similarity. They even use a lot of the same language in addressing shareholders as “owners” and reporting to them in annual letters that focus on their effort to build value.
The last little key in that argument is that Markel is continuing to evolve as an investor — not only do they hold a lot of equities, which are primarily the same kinds of stocks that Buffett likes, big world-beating companies that look undervalued such as CarMax and Wal-Mart, and Berkshire Hathaway itself, but they have also in recent years been expanding into private equity, buying entire private companies.
Now, they haven’t done this on anywhere near the level that Berkshire has, especially recently (Markel doesn’t have enough cash to buy a railroad, I’m afraid), but they continue to show interest in the area. This started back in 2005, when they bought a local bakery (AMF) near their Virginia headquarters, and just recently they made the next move in this area, buying a small Texas institutional furniture company called Panel Systems, Inc. and restating their interest in continuing to look at these kinds of investments — they now have a separate subsidiary that they call Markel Ventures that will apparently be the holding bin for these private equity investments, so we may be able to look forward to more toe-dipping into this water in the years ahead. Given the fact that they’ve essentially made two such purchases in five years I wouldn’t count on this changing the company’s profile anytime soon, but I do think it merits attention as an indicator of their intent — they’ve said that they appreciate, particularly, the ability to allocate cash and set executive compensation at their subsidiary companies, two areas where they believe many public companies work against shareholder interests … and that sounds very much like a Buffett sentiment.
Limited downside, potentially significant long term upside, and a niche business that’s careful with shareholder money and disciplined in writing new business, with a focus on building book value for the long haul as they compound profits year over year over year. That’s Markel, and I think that’s a buy for long-term (5+ years) money.
Finally, If you’re someone who requires or prefers income from your investments (Markel does not pay a dividend), you could also consider splitting a Markel position — put half into the equity and half into their exchange traded bonds that yield about 7.5% (ticker is MKV). If you buy 13 shares of the bond (about $325 worth, it’s a $25 principal note) for every one share of stock ($327 at Friday’s close) you would get an effective overall yield of about 3.75% on your Markel exposure and soften the volatility of the holding, reducing both downside and upside exposure.
I think it’s very reasonable for long term investors to buy Markel up to a price/book value ratio of 1.3 (I’ve paid more than that every time I’ve bought shares). That would get you shares in the high $350s, well above where it’s currently trading.
Before committing your own money to this or any other investment, I would urge you to research it fully — to get started one should read at least the last annual report, particularly the letter to shareholders, and the most recent conference call transcript. Beyond that, Markel is somewhat of a value investor darling, so you’ll find no shortage of other investment punditry on these shares in any of the investment news sites you frequent.
Full disclosure: In case it’s not clear, I do currently own shares of Markel; I also own shares of Berkshire Hathaway, but do not own any other investments mentioned above and will not trade in any stock mentioned for at least three days following publication of this article.
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