“How Has This ‘Buffett Clone’ Beaten Berkshire’s Returns by 70% Since 1998?”

Checking out Nicholas Vardy's teaser for a "Secret Revenue Stream" company

By Travis Johnson, Stock Gumshoe, March 18, 2015

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).

—from 10/15/14—

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?’

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“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 shareholde