Alleghany Corporation: A Boring “Mini/Baby-Berkshire” (analysis)

Last Updated on December 4, 2020 by Oddmund Groette

Berkshire Hathaway needs no introduction, but what many investors might not know is the existence of several “Mini-Berkshires” or “Baby-Berkshires”, companies that are much smaller but in many ways similar both in business model and mindset of the management. One of these companies is Alleghany Corporation which is traded on the NYSE and has the single ticker code “Y”.

In this article I argue briefly why I went long this stock during the Covid-19 crisis in March 2020:

Summary: Why I believe Alleghany is a good long-term investment:

  • Skin in the game. The Kirby family has been in the driver’s seat since 1937, and the family still controls about 25% of the shares, to my knowledge. They have shown excellent stewardship. Weston Hicks, the current CEO, owns almost 1% of the company.
  • The prime reason for investing in Alleghany is to invest alongside a prudent and competent management team that faces the same financial risk as outside shareholders. Management is conservative and aims for survival, they are in the same boat as outside shareholders.
  • Management has managed to attract a long-term oriented shareholder base. As a result, the share price usually trades around intrinsic value. Because Alleghany aims to have knowledgeable shareholders, they spend considerable time writing an educational yearly shareholder letter which explains the business in detail.
  • Alleghany has managed to transform itself many times since the Kirby’s took control back in 1937.
  • Shown ability to survive, as indicated by the single letter ticker code Y.
  • Smart capital allocations, no sticky regular dividend, but allocates capital based on what makes economic sense at the time.
  • Can make money three ways: underwriting profits, from the “float” and operational profits from the businesses they own.
  • Insurance is very competitive, commodity-like, but disciplined underwriters can thrive in downturns when the weak players face problems. Alleghany is likely one of these disciplined underwriters.
  • Decentralized structure, just like Berkshire, at the parent level the main focus is capital allocation.

The main goal:

The aim is to grow book value per share by 7-10% a year over the long-term while maintaining a conservative balance sheet and prudent risk profile. With the 10-year treasury rate and inflation both near 2.0%, even the low-end of this range, if delivered consistently over time, should create significantly increased purchasing power for shareholders.

Since Weston Hicks took over as CEO in 2004, after a period of divestments, the book value has grown at 8%, just in line with their target.

The share price has grown at a steady pace, in tandem with the book value growth:

Alleghany’s share price and three-year rolling CAGR. The share price is on the left scale, which is logarithmic. CAGR on the right axis. Source: Yahoo!finance and my own calculations.

A brief history of Alleghany:

Alleghany is named after the small town in Virginia, but has left the city a long time ago, and is now headquartered in New York City. The company was founded in 1929 as a railway company and is one of the very few companies that has managed to both survive and thrive over such a long period of time. According to the research by Hendrik Bessembinder from 2017, the median life of a publicly listed company has been only seven years between 1926 and 2016. Most companies end up acquired, restructured or bankrupt.

Alleghany is not aiming for spectacular gains, to achieve that you need to take risks and leverage. Instead, the focus is on moderate growth with a focus on survival and small amounts of debt. Since its modest foundation, the company has transformed itself many times, and we can argue Alleghany is a bit more “opportunistic” than the other “Berkshires”. At the turn of the century, the main assets of Alleghany consisted of a position in Burlington Santa Fe, which Warren Buffett and Berkshire later “stole” from them, bonds and cash. Most of the operating assets were divested during the 1990s, and management started investing in insurance companies from 2002.

The current business:

Alleghany mainly consists of three businesses:

The main part is insurance and reinsurance. The biggest subsidiary is TransRe (Transatlantic Holdings), acquired in 2012 for less than the book value when they presumably outbid Berkshire Hathaway. TransRe is mainly a reinsurer, and thus has a bit erratic earnings as reinsurance is exposed to catastrophe losses. Approximately 67% of TransRe’s net written premium was from North America, 20% from Europe, 8% from the Asia Pacific, and 5% from Latin America. So far TransRe has provided Alleghany with 1.6 billion in dividends since 2012, which is a CAGR of 9.1%.

The two other companies of the insurance part are RSUI, a wholesale specialty commercial insurance underwriter acquired in 2003, and CapSpeciality, acquired in 2002. The latter is the worst performer within the insurance segment with a mediocre combined ratio which is due to high expenses, ie. the costs of underwriting, not the claims itself. One of the reasons is the surety business which has high distribution costs (surety is about 15% of revenue). Boston Omaha, another “Mini-Berkshire”, is aiming to become a market leader in surety (I will write about Boston Omaha later).

The combined ratios have been like this:

TransRe RSUI CapSpeciality
2010 99.1
2011 104.4
2012 90.9 99.2 114.2
2013 89.9 80.2 119.7
2014 89.6 78.3 105.8
2015 89.5 80.4 102.6
2016 93.3 81.6 97.9
2017 106.9 107.9 98.3
2018 105.4 94.1 97.7
2019 100.9 87.7 108.4

The last three years have been weak for reinsurance with competitive pricing and cat-losses.

The second segment of Alleghany is Alleghany Capital. This segment focuses on investing in companies run by entrepreneurial founders or managers. Unlike private equity funds, which generally invest the capital of limited partners for short periods of time, Alleghany Capital does not have a predetermined investment time horizon based on a fundraising life-cycle and intends to own its companies indefinitely. There is no “asset strip” or aggressive cut costing for a sale and a quick return. The use of financial leverage is modest to ensure that each company is positioned for long-term success and survival. Currently, seven companies are under this umbrella, and this segment is basically the same as Markel’s Ventures. 2019 showed over two billion in revenues and equity worth about 900 million.

The third segment is Roundwood Asset Management, which manages the public equity investments for the insurance subsidiaries. Investments are concentrated on few positions with low turnover, aiming for above long-term market returns. So far, the group has managed satisfactory returns and has outperformed the S&P 500 over the last five years. The biggest equity positions at the end of 2019 were:

  • Microsoft
  • Visa
  • Roper
  • Alphabet
  • Comcast
  • Thermo Fisher
  • Marsh & McLennan
  • Schlumberger
  • CSX

Alleghany is obviously in a taxable position, thus the aim is to find companies that can compound for decades ahead.

Management and skin in the game:

Because of the financial distress during the Depression, an investor group took control of the company in 1937: Allan Kirby, Robert Young and Frank Colby. The Kirby’s are still heavily involved today and three generations of them have been very influential.

3.2% of the shares are owned by directors and executives, where the chairman Jeff Kirby owns 2.3%. I would say this is significant ownership.

The Investment portfolio:

During 2018 and 2019 Alleghany reduced its exposure to equities. At the end of 2019 the investments looked like this:

Investments at the end of 2019: Millions %
Common stock 2501 0.14
Preferred stock 4.1 0.00
US government obligations 1215 0.07
Municipal bonds 2308 0.13
Foreign government obligations 691 0.04
US corporate bonds 3359 0.19
Foreign corporate bonds 1377 0.08
Mortgage backed securities 5261 0.30
Short-term investments 915 0.05
Sum: 17631.1

Shareholder letter of 2019 and the future:

Alleghany is one of those rare companies that write a very informative shareholder letter, a letter I strongly encourage to read every year. Below you find some comments both from the shareholder letter and from myself.

The property and casualty industry premiums often follow loss costs with a lag, usually about 2-4 years. The recent years have witnessed a spike in cat losses, and thus we can expect a rise in the premiums in the coming years. Alleghany writes that they already see a rise in the premiums in the 4Q 2019, and management expects significant price increases from 2Q 2020:

  • Primary insurance premiums are increasing (reinsurance usually follows).
  • Consistent low interest rates demand more disciplined underwriting and pricing throughout the industry.
  • Reinsurers are realizing the price competition over the last decade has gone too far.
  • Alternative capital markets (ILS, which Alleghany has been negative to) have begun to recognize that it was supporting a deficient pricing environment in property catastrophe exposure.
  • Premiums need to rise to offset the potential risk and response to climate risk.

The alternative capital market (ILS) is estimated to total about 92 billion USD, while the traditional reinsurance market has a capital base of 532 billion. Alleghany believes ILS is here to stay, but that the investors up until now have been lured by their managers as losses multiplied in 2017/18. In the letter of 2018, Alleghany wrote that ILS investors are suffering from a lack of skin in the game from the managers, and it was just a question of time until the investors got their fingers burnt. Investors in ILS funds are becoming more discerning, and managers are becoming more selective and demanding, thus easing the pressure on the premiums. On a side note, the other “mini-Berkshire”, Markel, has ILS as one of their business segments, and they have written off one of their subsidiaries completely (CATCo).

Alleghany believes deflation is the risk going forward, not inflation. The main reason for this is more elderly and fewer working people to support them. The letter even says that “helicopter money” will increasingly be necessary to prevent deflation from overwhelming the economy. That turned out to be a pretty accurate statement, as helicopter money is handed out to fight the economic recession due to Covid-19. A second reason for deflation might be disruption from technology as more and more “blue-collar” jobs need some kind of education or college degree. Five categories of jobs – administrative and clerical (including call centers), retail, food service, truck driving and transportation, and manufacturing – comprise a significant portion of all employment in the United States for high school graduates and are at risk of continued disruption by automation. The third reason is alternative lending (p2p, which I don’t recommend.) When banks expand consumer loans there is an increase in the supply of money, as new demand deposits are created. By contrast, when a consumer borrows from a peer-to-peer lender, no new money is created; the borrower adds to its cash position but the lender, which is usually not a bank, reduces its cash position. A fourth reason may be peak globalization, which is reinforced due to Covid-19 after the letter was written. It seems very likely that trade tensions will continue! In short, negative real interest rates hurt productivity, as it subsidizes the purchase of existing assets rather than encouraging investment in new productive assets. The future winners are companies involved in technology-driven productivity improvement, and those relying on global trade for competitive advantage will increasingly be challenged.

The main implication of the scenario above, if it happens, is consistently low interest rates. This of course decimates the income from the float, one of the important pillars for many insurers. This puts pressure on insurers with high combined ratios, especially those underwriting at a loss solely to profit on the float, and might in turn put them out of business, and this in turn makes the insurance market less fragmented. However, at the end of the day, most costs need to be borne by the end-user.

Alleghany remains cautious toward stocks due to low expected future returns. At most, they expect 7%, but more likely in the 3-5% range. Thus, Alleghany has a low equity exposure at the end of 2019, but this might have changed during the Covid-19 spectacle.

Valuation:

At the end of the day what you pay for the company is obviously a critical part of future expected returns. From 2010 until 2016 Alleghany mainly traded around the book value, but after 2016 valuation has increased to over 1.1, and ended 2019 with a book value of 611 and a share price of 800, thus a premium to the book of 1.3, the highest premium since 2007, and even higher than Berkshire’s (!).

As of writing, we can only “guess” what the current book value is. Alleghany’s share price has fallen 25% YTD, compared to S&P’s more modest 13% drop. We also have to include the 15 USD special dividend paid in March 2020 which reduces the book value similarly. All in all, I estimate the book value to be in the 540-575 range, today’s share price is 570, and thus Alleghany has seen its premium fall closer to book value. We have to wait for the 1Q in early May to know the exact book value.

Conclusion:

Alleghany will not set the world on fire, but most likely still reward the patient shareholders. I’m long Alleghany, Markel and Berkshire, and it might be relevant to ask why I invest in all three (?): My main reason to invest in both Markel and Alleghany is their modest size compared to Berkshire. Alleghany has currently a market cap of eight billion, which is substantially below Markel’s 14 and Berkshire’s 480. Furthermore, I believe Alleghany to be the most conservative among the three, however, a little question mark behind TransRe and the reinsurance risk, which is a bigger share of the business than the other two.

I prefer to invest alongside managements that have real skin in the game, and additionally, Alleghany has a culture and history of prudent risk-taking. Based on this I have initiated a position, and I expect to own the shares for a long time.

 

Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

 

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