This teaser ad from Nicholas Vardy’s Alpha Investor has been circulating at least since last October, but it appears to be getting more “life” in it these days — or, at least, we’re getting more readers asking about it. The ad hasn’t changed, though the stock has moved up a bit over the last six months (it’s now at 1.4X book value, not the 1.3X book he teased, for example). What follows has not been updated or revised since October 15, 2014 when it first appeared, though I did update the Irregulars Quick Take box to share my most recent thinking on the company (which I’ve owned for years).
I haven’t written about a teaser pitch from Nicholas Vardy in a while, and I’ve been keeping an eye out for stocks I’d like to have on my “watch list” to maybe buy if we continue to see prices fall across the market… so this one about a “Buffett Clone” caught my eye. Who wouldn’t want to buy in early on a “Buffett Clone?”
Of course, predictions of the “Next Warren Buffett” or “Next Berkshire Hathaway” are legion — that’s one of those evergreen themes that always catches an investor’s eye, so it’s naturally one of the things that copywriters use to get your attention. We’ve seen pitches promising the next Berkshire since the very first days of Stock Gumshoe seven and a half years ago, and they were certainly around before that.
So is Vardy pitching one of the “tried and true” stocks that have been promoted as the next Berkshire over the years, like Loews or Markel or Leucadia or Brookfield or Greenlight Re or Fairfax Finanicial, or is he breaking new ground? Let’s check out the ad for his Alpha Investor Letter and sift through his clues for our answer…
Here’s how the ad opens:
“… there’s a company that follows Buffett’s Berkshire Hathaway so closely…
“That it’s often referred to as a ‘cult.’
“The situation sounds wild, I know.
“But it’s really just wildly profitable.
“That’s because this bizarre company has cloned Berkshire’s entire business model — including its secret revenue stream….
“In fact, this company could be Berkshire’s twin in terms of generating this additional stream, were it not for one more crucial difference.
“I say ‘crucial’ here because it has resulted in this cult-like company beating Berkshire’s returns by 70% over the last 16 years.
“I have to admit, Based on performance like that, I’d drink the Kool-Aid, too.
“Especially when my research has revealed this company’s about to widen its 70% profit gap over Berkshire Hathaway.”
Vardy goes into a bit of a spiel about what that “secret revenue stream” is, too, and it turns out he’s just talking about float. Any investor who has been involved with insurance stocks is probably familiar with float and the role it plays in insurance stocks, but the simple way to think of it is this: Float is the money that has been paid in by policy holders (you paid your car insurance) and has not yet been paid out in claims (you haven’t had an accident yet).
Insurance is a competitive business in most lines and types, so over the long term a lot of insurance companies more or less break even on their insurance operations or even lose a bit of money — they have to pay out in claims and overhead roughly as much as they receive in premiums. But even if that’s true, even if they can’t make a lot of profit on the actual insurance contract, they can still make a nice profit from the float — they can invest the float, sometimes for years depending on what kind of insurance it is (some insurance has a “long tail” … like medical expenses paid out for decades on worker’s compensation claims, some is pretty short, like annually renewing auto insurance), and those investment earnings are theirs to keep. That is indeed the “secret” of Warren Buffett’s success — he bought National Indemnity early on, then GEICO, and then invested the huge pool of cash generated by those insurance companies. While you might pay 5% or more to borrow from your broker to buy stocks on margin, Buffett, with profitable insurance companies in his pocket, was able to often be paid to use other peoples money to grow his portfolio.
Sorry if I go on and on on this topic, but I like insurance stocks and have invested in quite a few of them… so I’m kind of hoping that Vardy’s got a new and appealing one to bring to us. Let’s check out his clues:
“Make Berkshire’s ‘Unfair Advantage’ Yours, too
“Mimicking the original…
“Our company runs a similar business at their core, too.
“They call it a ‘specialty’ insurance company. How ‘special?’
“They’ve insured unusual items such as Judy Garland’s ruby-red slippers….
“They insure special events like weddings.
“Plus, they are the only insurance company that insures a particular kind of high-value horse….
“… their new European acquisition has been a called a ‘transformative deal,’ nearly doubling the size of its investment portfolio.”
Bummer. Not new. This is Markel Corp (MKL).
Which has indeed outperformed Berkshire Hathaway for some long time periods, though the two have traded fairly close to each other a lot of the time — Vardy uses the example of 1998-present to call attention to the fact that his secret stock (Markel) has beaten Berkshire by 70%… and that’s true, but only if you go from mid-1998 to the present. 1998 was the year that Berkshire acquired General Re, a major acquisition, so if you instead go from January 1998 to the present MKL and BRK.A have been pretty much neck-and-neck with near-300% gains. Neither pays a dividend or buys back much stock, so it’s just a story of compounding earnings over those decades and I’d say it’s pretty much a wash.
Markel and Berkshire Hathaway are both large personal holdings of mine, both great companies, and I agree that Markel probably has more growth potential mostly because it’s so much smaller ($9 billion market cap, dramatically tinier than the $200+ billion Berkshire Hathaway) — it also has more risk in a downturn, it is less diversified than Berkshire (Markel has some non-insurance investments in Markel Ventures, but they don’t own huge businesses like Berkshire’s railroad or utility company) and does not have the same massive cash hoard or brand name that Berkshire does (GE and Goldman Sachs called Warren Buffett for help in 2008, not Markel CEO Tom Gayner, so it was Berkshire who got the sweet financing deals they were offering). And really, it’s a little silly to compare them too closely because Berkshire’s not an insurance company anymore — it’s more like half an insurance company tied to a massive industrial conglomerate.
That’s clearly what Markel wants to be too, to at least some degree — Markel invests a lot more in equities than most insurance companies do, which is part of the reason that I like them, and Markel Ventures is their small investment arm that they launched in 2005 to buy up whole companies, sort of what Berkshire Hathaway does but on a much smaller scale. They focused initially on companies near their headquarters in Richmond, VA, and have particularly bought up a couple different makers of baking equipment… so it’s not sexy, but it does help to diversify away from the public markets (you can see all their Ventures companies here… they’ve recently been generating about $20 million a year in net income, which is substantially less than 10% of their net income over the past year, so it’s worth watching but not of primary importance). Markel has emulated Berkshire in other ways, too, they’ve often held their shareholder meeting in Omaha right around the time of Berkshire’s annual meeting, since they appeal to many of the same investors, and Tom Gayner, who has run Markel’s investment portfolio for many years, advocates a similar “great cash-generating companies at good prices” value philosophy to Buffett.
The transformative acquisition for Markel was Alterra, a global insurance and reinsurance company they acquired in 2013 … and that created a huge buying opportunity for Markel at the time they announced the deal (in late 2012). It was transformative in part because of the opportunity it’s giving Markel to work with a MUCH larger portfolio — Markel and Alterra were similar-sized companies, but Alterra had a lot more “float” than Markel, and they were investing it much, much more traditionally (most insurance companies are understandably risk averse and have portfolios that are dominated by investment-grade and government bonds). So Markel had and has the opportunity to diversify that larger portfolio, though the flip side is that they also added a substantial amount of reinsurance risk to their portfolio — and reinsurance companies typically have lower profit margins and get lower valuations from Wall Street.
That was the case for Markel for a few months — the lower valuation from Wall Street — but it bounced back quickly after that buying opportunity and has generally been rising since along with the bull market. MKL topped out at near $660 a share at the end of August and is now around $635. So is it a can’t-miss buy here?
Well, I’d hesitate to say that about any stock — but it is one of my largest personal holdings, and I expect MKL to continue to do well. Insurance markets have been widely reported to be “softening” of late, after “hardening” up a bit in the prior couple of years (“hard” markets are those with higher prices for insurance, less competition, “soft” markets are when the insurance industry gets too competitive and everyone climbs over each other to lose money on new policies… most markets for property and casualty insurance have been “soft” most of the time).
The property and casualty business, which is what most of us think about when we think of insurance stocks (that means we’re excluding life insurance, mortgage insurance, health insurance, all of which have very different dynamics), has had a pretty good couple of years following Hurricane Sandy — there have been some substantial insured losses, including tornadoes, and the “polar vortex” that brought an unusually expensive winter this past year, but we haven’t had a mega-event like a large hurricane. That, combined with the big inflow of money into insurance from hedge funds, has kept the supply of insurance high and the cost fairly low… but interest rates have cooperated for a couple years and the stock market has vigorously cooperated, so most insurance companies have done well. Insurance stocks, on average, had a great 2013 and a pretty flat 2014.
Markel is going to present us with more “discount buying” opportunities in the future, I assume, but it’s at a reasonable price now — like most insurance companies, investors typically value Markel based on their book value per share and growth in that book value. There will be times when the book value bumps down, whether that’s because the market falls and their $3.5 billion equity portfolio slips, or because interest rates rise and their fixed income portfolio (still by far the largest part of their portfolio at about $10 billion) loses some value, or because of a bad catastrophe that has them losing money for a couple quarters (or worse).
Right now, Markel is priced at a premium but not a historically unreasonable premium… the book value per share is $511, so at $635 MKL trades at about 1.25X book value. It has rarely traded below 1.2X book value, and I’d be excited to load up on shares if it gets down to $600 or so (that would be 1.15X book), but I likely wouldn’t sell my MKL shares even if they spiked to 1.5X book. This is among my largest (roughly a 5% position now) and favorite long-term holdings, largely because the company has proven that they can wisely compound book value — and part of that is because they have the right incentives in place, employees get bonuses based on the trailing five-year growth in book value per share, not based on some short-term measure like quarterly or annual earnings.
Most of the insurance companies you’d likely investigate will look cheap based on earnings most of the time — sometimes, as with Greenlight Re, for example, they look ridiculous — GLRE has a trailing PE of less than five. But those earnings are not that useful a guide for insurance investors, earnings fluctuate wildly based on profitable, catastrophe-free years, release of reserves or windfall investment returns, so most investors stick with book value or compound annual growth rate (CAGR) in book value. That’s the indicator of what the assets are worth and how they’ve performed over time, and the most useful metric for analyzing or valuing the actual operating side of the business, the insurance company, is the combined ratio. Combined ratio is the number you get by adding up all the incoming premium revenue and subtracting the claims paid and the operating expenses, it’s expressed as a ratio whereby 100 is the “break even” baseline, where premiums equal expenses plus claims, and it’s a standard industry metric so companies generally disclose it prominently in their quarterly press releases and filings. Anything above 100 and the insurance operation is losing money and effectively “paying” for the use of the float, anything below 100 and they’re getting the float for free or being paid to invest the float.
Markel has, on average, had an underwriting profit (combined ratio below 100) about 75% the time in the last couple decades — though many of their more spectacularly profitable years were, understandably, when the company was far smaller a decade or more ago. As they’ve grown and added more companies and more business lines, they’ve gotten into areas that are less specialized — historically, a lot of their underwriting profit has come both because they’ve always been disciplined and tried to underwrite profitably (many insurance companies have intentionally lost money in order to earn business in the past, though that’s less prevalent now with interest rates so low — when they could earn 6% risk free on long bonds, losing 3% on underwriting to get more capital to buy those bonds was a “no brainer”) and because they’ve underwritten business with little competition, like summer camps and hairdressers and other specialty areas. Markel’s letters to shareholders provide a good summary of their annual performance, so if you want an overview you can see their 2013 letter here — more recent basics are in the June quarterly press release here — they’ve taken a hit from the winter and from some asbestos stuff this year and the combined ratio was at 98 for the first half of the year, which is worse than last year (doubly worse, since last year also had a couple points added to the combined ratio with the Alterra acquisition costs). Their third quarter earnings will come out in about three weeks.
My personal investment theme in this sector has been that I believe interest rates will rise and “shock” insurance companies into having to “harden” the market and compete less vigorously, which will benefit all the insurers… but it would benefit the insurance companies who have more flexible investment mandates the most, companies like Markel that allocate more to equities than most traditional insurance company portfolio managers and therefore wouldn’t be as negatively exposed to rising interest rates in their bond portfolios (portfolios are market to market, so when interest rates rise and bonds lose value, insurers would be expected generally to take a hit to the portfolio value and report that as a loss). The companies I own to follow this theme have done fine, Markel best among them, but interest rates have not risen to pressure insurers yet, really, and I failed to recognize the big influx of capital into the insurance industry that’s keeping the market fairly soft. I still expect this theme to work out over time, but there’s no specific catalyst that will make it happen this year.
I’ve been adding more to smaller holdings in insurance lately than to Berkshire or Markel, including Greenlight Re (GLRE) and Third Point Re (TPRE), both of which are part of the “problem” of new hedge fund money coming into the insurance business, and both of which are now dipping below book value (partly because book value will likely have fallen on the quarter when they next report, given weak investment performance last quarter). Property and casualty insurance (if you include Berkshire) is between 15-20% of my equity portfolio, so this is certainly a focus of mine, and an area where I think good, steady long term growth is still possible from companies who can combine decent underwriting with good investment management. Whether it works for the rest of this year, with equities falling hard at the moment, I don’t really know — but even with a few nasty hurricanes thrown in I expect that this sector will work out well for the next decade, and I do still think that Markel is the cream of the crop in specialty insurance.
But it’s your money, of course, so what do you think? Do you expect Markel to do better than Berkshire Hathaway? Expect good times ahead for insurance? Or has the end of the bull market in bonds signaled the end of insurance riches? Let us know with a comment below.