Quite a few of our readers have sent in questions about this ad over the last day or two, which actually gives me a bit more hope for humanity — after all, this kind of promise of a “wealth compounding machine” should be much more compelling than the high-risk, highly-speculative “Double in a week” ideas that get thrown our way every few minutes from the great investing punditocracy.
Doesn’t mean the ad is sober or rational, of course, they rarely are — just that long-term compounding returns are what most of us should be looking for, not quick hits or exciting moves. We can’t resist the speculative trades, of course — whether it’s a gold miner drilling to increase its reserves or a biotech stock waiting for FDA approval — but those are for the “play money,” most of us shouldn’t risk our financial well-being on those kinds of investments.
The ad is for Nicholas Vardy’s Alpha Investor Letter, whose teaser pitches we’ve looked at quite a few times over the years (you can always browse our Tracking sheets to see how these kinds of teaser picks have perfoemd), and the spiel this time is about a company with a “secret” revenue stream that has crushed the market (and has beaten Berkshire Hathaway). So that sounds pretty impressive. What kind of clues do we get?
“… for the 29 years that this company’s been traded publicly, its shares have appreciated an average of 17.5% each year….
“This ‘compounding machine’ outgained Dow 8,430% to 760.6%.”
And how, pray tell, did it earn those returns? We’re told that it did so by in the same sector as Berkshire Hathaway, so it’s likely either an insurer or a conglomerate of some kind. And we get some more clues:
“So how did it deliver those outstanding gains for almost three decades, through some of the worst market plunges ever?
“Two words: ‘The Float.’
“You see, The Float is the never-ending source of this company’s secret revenue stream…
“It’s responsible for the company posting annual gains of 17.5% for the last 29 years… for beating the Dow’s returns 11 to 1, and for kicking Buffett’s butt since 1998.
“More importantly, this revenue compounding machine is only getting better at using its Float.”
Ahh, so, yes, this definitely has something to do with insurance. “Float” is a term popularized by Warren Buffett, and it refers to the money an insurance company has taken in in premiums but has not yet had to pay out in claims — that money hasn’t been “earned” yet, because claims could be staked on it over some varying period of time if insurable things happen, but the insurer gets to invest that money and enjoy whatever investment returns they can garner from the extra capital.
And some of that float will turn into earnings as long as the insurer is good at pricing risk, so there’s a double whammy — it’s like extra money that you can use for investing leverage, but instead of paying for the leverage (as you would do by using margin in your brokerage account, for example), you’re paid to use that leverage as long as the insurance combined ratio is below 100 (the combined ratio is a measure of profitability for insurance companies — premiums plus operating expenses: claims… anything above 100 means the insurance company is losing money on its core insurance operation for that period, below 100 means they’re making money). Some insurance companies have spent many years losing money on insurance but making it back by using the float and the excess capital to invest, but it’s obviously far better if you can make money on the insurance and invest the float and the rest of your portfolio well.
Then we get some more clues:
“over the last five years, this company’s share price has increased 133%. That’s an average annual gain of 26.7%…
“At that rate, you could double your money every three years…
“Plus, it’s a remarkable 50% improvement over the company’s historical average gain of 17.5%.”
So since this is an industry I follow fairly closely, I’m pretty sure I’ve got an answer for you … but let’s check just a few other clues to be sure…
“… they’re referred to as a “specialty” insurance company. How ‘special’ are they?
“Well, to begin with, they insure special events like weddings.
“However, they get into a whole different kind of ‘special’ as well, considering…
“They’ve insured items such as Judy Garland’s ruby-red slippers from the Wizard of Oz… and even high-value thoroughbred horses…
“And they’re constantly expanding their insurance business by snatching up other insurance companies.
“Which means they acquire that company’s Float as well…
“Giving them even more funds to invest with.
“In fact, their recent European acquisition was called a ‘transformative deal,’ nearly doubling the size of their investment portfolio.”
And Vardy pushes the comparison to Berkshire — noting that this pick is better because it’s so much smaller (just 3% the size of Berkshire Hathaway), is not a “one person show” like Berkshire, which relies overly much on Warren Buffett, and because performance is improving.
He calls out the recent results in that regard — saying that earnings beat expectations by 109% in the December quarter and 74% in the March quarter… and that “the CEO is on record as saying that he believes his company’s worth to be TWO TIMES its book value.”
So yes, friends, this is again a tease about… Markel (MKL), which most of you probably know has been my favorite insurance company for a long time. It was one of the first “Idea of the Month” pieces I shared with the Irregulars way back when in the early days of Stock Gumshoe, and I’ve owned it for almost as long as I’ve owned Berkshire Hathaway shares (both have been in my portfolio for a decade or more).
And Markel has indeed had exemplary performance over the past three years — though that’s partly just because it was irrationally depressed by some acquisitions in 2012 and 2013 that the market wasn’t crazy about, including the transformative deal to acquire Alterra that almost doubled Markel’s size (and, yes gave them a much larger portfolio to invest).
That quote from the CEO, by the way, refers to Steve Markel — who is not the CEO now, but perhaps he was for a little while when he said that he thought the company should be valued at 2X book value. That quote is from 2008, when Markel had just fallen from about 2X book to 1.5X book in that weak market.
I agree that Markel ought to be valued at something like 2X book based on their strong performance and stable underwriting, but I don’t think that’s going to happen again anytime soon. When Markel first got a nice strong premium stock price of over 2X book value it was just coming out of a couple of fantastic years, it was really just starting to get glowing comparisons to Berkshire Hathaway and was referred to as the “next Berkshire” by the Motley Fool and others, partly because it was then just starting to do some “alternative” investing outside of the stock market, and Tom Gayner (now CEO, then portfolio manager) was just getting some attention for his value investing performance as he deployed Markel’s portfolio.
There is a tremendous amount to like about Markel — they have strong leadership, they invest well and without taking huge chances (but they do put more into equities than many insurance companies do, which provides them with an edge), they make sure to focus on profitable underwriting, and they reward their executives and employees based on the same metric that should matter most to investors (most of their incentives are set up to reward executives based on the rolling five-year growth of book value per share). And, like Berkshire Hathaway, they’ve built a meaningful (though still really small) portfolio of operating businesses that they own outside the stock market, which they call Markel Ventures — that’s not moving the needle for the corporation yet, and these are not high-growth businesses, but Markel Ventures is starting to have a little impact on performance now, roughly ten years after they launched the initiative.
Over the past five years, during which the property and casualty insurance industry started to improve a little bit, with some fits and starts, and during which falling interest rates and strong equity markets made Markel’s float ever more valuable, the stock has moved from trading at a price/book valuation of 1.1 to about 1.6, a fairly dramatic move.
The book value per share has continued to compound, and has risen nicely (partly because, like Berkshire, they don’t pay a dividend so can keep growing the book value), up more than 80%, but the stock has risen almost twice as fast, up well over 140%.
My concern with Markel’s valuation now is that this outperformance, with the stock rising far faster than book value rises, has come almost entirely in the past year or so, which doesn’t give me much confidence that the shares are going to hold on to this premium valuation. I don’t have any reason to expect the stock to drop at a particular moment, but I certainly don’t think the past few years of incredibly strong stock performance will be repeated — the stock went up 27% a year not because the book value went up 27% a year, but because the book value (which we can think of as representing “operational performance”) went up perhaps 10% a year (still impressive) and the premium over book value that investors were willing to pay over that book value (which we can perhaps think of as representing “investor sentiment”) went up by 40% or so.
Doubling your money in the next three years in Markel seems very unlikely to me — though it is, of course, possible, and it will be wonderful for my portfolio if that happens. I didn’t expect it to double in the past three years either, to be clear, since it’s pretty hard to predict when a stock will suddenly rise in the eyes of investors and earn a strong premium valuation after a period of weakness.
I think the shares will end up being pretty sensitive to a falling stock market or to continued super-low interest rates, since both of those are negatives for insurance companies looking for returns on their portfolio… and, of course, we could always have a big hurricane or other insured disaster that brings down the shares of most insurance companies, at least for a little while (though big disasters tend to be good for insurance companies in the end, since they lessen price competition and force them to be firm on pricing in the aftermath).
Which doesn’t mean I’m selling. I’m not. You can’t have my MKL shares. Markel is a high-conviction hold for me, and has been for a long time – and if the market suddenly does agree that the shares deserve to trade at 2X book value, I’ll be delighted to hear that and won’t disagree, just as I haven’t complained as the price/book valuation rose sharply over the past few years… I just think there’s a low probability of that happening.
I last wrote in some detail about Markel when I attended their “Markel Brunch” in Omaha following the Berkshire Hathaway meeting, and I said essentially the same thing then — the shares are more or less at the same price now as they were in May, in the low $900s, and I have been gradually moving up my “buy” price for Markel over the years as book value has increased and operational performance has improved, and as I’ve come to accept that paying up to 1.3X book (or even a trifle more) for the shares is probably reasonable for patient investors, but as of the last quarter that I wrote briefly about a few weeks ago I was still stubbornly holding on to the notion that I want a sub-$800 price before I buy more shares ($780 or so would be about 1.3X book right now).
So, yes, I find myself again being perhaps too conservative and too negative about a company that I really like, that I will probably hold for at least another decade, and that I think has tremendous power as a compounding machine.
And that’s just because no matter how great a company is, and no matter how well-managed or how solid the business plan, the price you pay matters. If you’re a younger investor and just starting out, then sure, you can buy a share of Markel at a pretty rich valuation near $900 and be watchful, and the stock will probably be much higher in ten years (and maybe you’ll have the cash to buy more on some future dip). But if you’d be worried about a 10% or 20% decline, I think there’s a very good chance that we’ll see that from Markel in the not too distant future, and that you’ll have the chance to buy at a better price.
My personal experience with Markel can be used to show both the merits of being patient and buying at the right price, and the merits of paying whatever you have to and owning it for a long time regardless of price — I overpaid for my first few shares in 2006, paying almost 2X book value for a small insurance company that had just shot to the attention of individual investors and was being called “the Next Berkshire” everywhere you looked, and after researching the company I held with conviction because I thought they were doing things right… but that position was in the red for a couple years, and required a lot of patience because I bought near a peak. I then bought a much larger position after the shares collapsed in late 2012 on the Alterra deal, when Markel was actually cheap for a brief while, trading right at book value.
And yes, Vardy has teased Markel before, too, and I was a bit cautious about the valuation then (in 2014 and 2015), and you would have beaten the market by just squinting your eyes a bit and buying MKL either of those times. I’m more worried about Markel’s valuation now than I was then, but I certainly don’t have a crystal ball.
So you can make your own call about if, when and how to own Markel… but I guess I’d just say that I’m the same person I was a decade ago and look at it the same way, I want to own Markel shares because it’s a great company that’s got very strong long-term performance and a great culture and incentive structure… but even though I want to own it today, I’d rather buy in bulk when Wall Street is angry at them and the stock gets cheaper.
Sounds a little odd? Well, no one ever said I was normal. Probably I would have just been better off buying a few shares a year every year, and not trying to time the valuation — but where’s the fun in that?
P.S. I shared a brief excerpt from a Morningstar article when I wrote about Markel a few months ago, so I should probably let you know that Morningstar still places a “fair value” of $715 on MKL shares and remains skeptical about the valuation the stock has been getting, some of which is ascribed to that continuing presence of a “next Berkshire” halo. Back in April, Morningstar’s analyst suggested WR Berkley (WRB) as a similarly high-quality specialty insurer with a better valuation (the two have been within a couple percentage points of each other since, though WRB has done slightly better — and to be fair, MKL has grown book value per share twice as fast as WRB over the past five years and has had a dramatically stronger long-term stock performance). Here’s a quote from the current analyst report:
“Markel’s second-quarter results show the company continuing to perform well. Book value per share, Markel’s preferred metric, was up 7% for the first half of the year. While the current environment remains favorable to the company, we believe the twin tailwinds of a strong equity market and strong reinsurance profitability that have buoyed Markel in recent years are unlikely to be maintained….
“Markel has built a reputation as a ‘mini-Berkshire,’ and while we think it has developed a solid franchise, we believe the premium the market awards the company based on this narrative is not fully justified. We prefer insurers that focus on producing superior underwriting results. Markel’s performance on this front is decent, but not good enough for us to award the company a moat.”
Disclosure: In case it’s not clear from the above, I own shares of both Markel and Berkshire Hathaway (both remain in my top five individual equity positions). I will not trade in any stock mentioned for at least three days, per Stock Gumshoe’s trading rules.