Thoughts/Analysis On Markel (The “Mini/Baby” – Berkshire)

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 Markel Corporation which is traded on the NYSE and has the ticker code “MKL”.

Previously I have written about other “Berkshires”:

• Alleghany
• Constellation Software

One of the common denominators for all these “Mini/Baby-Berkshires” is that they write a very useful shareholder letter, well worth the time every year. They write to educate their shareholders, or potential shareholders, and to attract and keep a knowledgeable shareholder base. I believe this is one of the most underrated aspects in running a public company. I quote Mark Leonard in Constellation Software:

I’m coming around to the belief that if our stock price strays too far (either high or low) from intrinsic value, then the business may suffer: Too low, and we may end up with the barbarians at the gate; too high, and we may lose previously loyal shareholders and shareholder-employees to more attractive opportunities…..A long-term orientation requires a high degree of mutual trust between the company and all of its constituents…..A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true…..It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell. If a stock is over-priced and sophisticated investors sell, they are generally replaced by unsophisticated investors who are ultimately disappointed. This may lead to a stock price that over-corrects and in turn precipitate either a takeover bid, or more insidiously, a significant and predatory share buyback.

Back to Markel: The shareholder letter of 2019 is written in tandem by co-CEOs Tom Gayner and Richard Whitt.

I have been a shareholder for many years, and my main reason for investing is their management, which I believe is honest and competent. Below is a recap:

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

• Skin in the game. Directors and executives own 2.21% of the company. They have shown excellent stewardship. Steven Markel, the new Chairman, owns 106 000 shares. Tom Gayner owns 25 200 shares and Richard Whitt 7 100. I believe this is sufficient to say they have skin in the game.
• The prime reason for investing in Markel is to invest alongside a prudent, honest 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 Markel aims to have knowledgeable shareholders, they spend considerable time writing an educational yearly shareholder letter which explains the business in detail.
• Shown ability to survive, they have been in business since 1930.
• Smart capital allocations, no sticky regular dividend, and Markel has the ability and capacity to reinvest earnings at acceptable marginal/incremental returns.
• 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. Markel is likely one of these disciplined underwriters.
• Decentralized structure, just like Berkshire, at the parent level the main focus is capital allocation.

Markel’s business:

As with the other “Berkshires” the structure is one of decentralization and autonomy. The local managers are running their businesses autonomously from central headquarter, but send much of the profits to headquarters for allocation. This business plan has worked really well since the IPO in 1986: both book value and the share price have risen 15% annually since then, a pretty remarkable achievement and certainly among the best.

Is this performance likely to continue? Markel is still relatively small with a market cap of 14 billion, compared to Berkshire’s 490 billion. In other words, the runway and reinvestment opportunities should be ample.

Markel has three ”engines” to power the revenue and income: Insurance/reinsurance, Markel Ventures and investment activities.

Markel’s first engine: Strong underwriting discipline

Markel does insurance (primary), reinsurance and Insurance-Linked Securities (ILS).

The insurance business is very competitive, commodity-like, which often means “boom and bust” cycles: After a period with increased losses and claims, insurers increase premiums and vice versa. Alleghany estimates that we are entering a period with increased profitability for insurers because of the increased cat-losses in 2017 and 2018. Historically, many insurers have been operating just to get income from the float and thus underwriting at break-even or even at a small loss. Markel has proven to be disciplined and reliable underwriters, measured by their historical combined ratio:

1989	78
1990	81
1991	106
1992	97
1993	97
1994	97
1995	99
1996	100
1997	99
1998	98
1999	101
2000	114
2001	124
2002	103
2003	99
2004	96
2005	101
2006	87
2007	88
2008	99
2009	95
2010	97
2011	102
2012	97
2013	97
2014	95
2015	89
2016	92
2017	105
2018	98
2019	94.0

The average ratio is 97.5. That is not an outstanding number, for example higher than WR Berkley and RLI, but better than average in the sector which is closer to 100 (break-even).

Markel wrote 1.1 billion of reinsurance premiums both in 2018 and 2019, compared to 4.7 and 5.3 billion (primary) insurance premiums. Reinsurance has been the weak link in their business, albeit positive results over the years, and the 2019 letter states they are working very hard to improve the results. Just like Alleghany, Markel has increased premiums in 2019 and continued increasing so far in 2020 by refraining from unprofitable deals. The focus is on profitability, not on capturing market shares or volume. Markel has shown the ability to refrain from deals if they believed it offered a bad risk/reward.

Over the last years, ILS has become part of the Markel’s insurance segment with the purchase of CATCo in 2015, State National in 2017 and Nephilia in 2018. CATCo turned out to be a disaster and is written-off completely, and the learning curve has been pretty steep. Still, Markel reiterates in the 2019 letter that they expect increasing returns from these operations over time.

ILS is a bit different than insurance and reinsurance. The difference is that Markel earns a management fee for providing price/premiums, manage the claim process, handle the legals and the regulations. But Markel is not obliged to provide capital, and thus the return (or lack of return) flows to the external capital providers who are the ultimate risk-takers. Alleghany is skeptical toward ILS for this simple reason: the manager doesn’t necessarily have any skin in the game. However, Markel demonstrates so far that they stand side by side with outside investors by putting up their own capital alongside theirs, and have subsequently suffered losses on that capital with the outside investors. But according to the 2019 letter, Markel’s long-term aim is to mainly be a provider of services, not capital.

History will tell us who is right or wrong, but the appetite for ILS has been more subdued in 2018 and 2019 as many investors have got their fingers burnt. Markel believes the disruption in ILS growth is a temporary circumstance. In the long run, they continue to believe in the ILS mechanism and its ability to provide better, faster, and cheaper insurance solutions (in many circumstances). Why is that? Markel argues in the 2019 letter that ILS investors in many cases demand a lower return on their capital than traditional insurance companies because external providers tend to focus on returns not being correlated to other assets as well as the absolute level of returns themselves.

Nephilia, acquired in 2018, has pioneered the ILS market for over 20 years and is today the market leader.

Insurance is of course not a market that is growing fast, and we can expect growth to be more like the GDP growth. However, the insurance market is very fragmented and Markel is still a small player in a big pond.

Markel’s second engine: Markel Ventures

Markel Ventures, started in 2005, provides a stream of cash flow over and above, and different to, that provided by the insurance operations. The ultimate goal is that these companies should perform well and autonomously. In the 2019 letter, Gayner says he is extremely pleased with the results thus far. The last few years have been a “sellers” market and valuations have been to high to justify acquisitions. However, the goal is that Markel’s reputation as a quality owner and “hands-off” owner attract sellers.

The table below summarizes the EBITDA performance (EBITDA is the preferred method Gayner uses):

	Revenue	EBITDA	EBITDA margin
2009	85,700	46,000
2010	165,000	20,000	0.12
2011	318,000	37,000	0.12
2012	489,000	60,000	0.12
2013	686,000	83,000	0.12
2014	838,000	81,000	0.10
2015	1,000,000	91,000	0.09
2016	1,200,000	165,000	0.14
2017	1,700,000	188,000	0.11
2018	1,900,000	170,000	0.09
2019	2,055,000	263,900	0.13

The Ventures segment is a tool to let surplus capital flow up to headquarter for further allocations to where it makes sense. Because of Markel’s much smaller size than Berkshire, Markel has opportunities that simply do not exist for Berkshire. Smaller businesses can grow faster, but I believe the quality of the owned companies of Berkshire is better.

	2019	2018	2017	2016	2015	2014	2013
Revenue	2,055,020	1,915,497	1,337,152	1,214,558	1,047,521	838,125	686,452
Expenses	1,886,603	1,835,099	1,218,362	1,101,260	1,005,501	799,502	633,924
Operating income	169,378	80,398	118,790	113,298	113,510	42,020	52,528
Net income to shareholders	92,901	35,258	103,559	56,172	11,027	9,557	23,820
	2019	2018	2017	2016	2015	2014	2013
Cash	256,758	164,336	165,172	105,316	120,889	106,552	61,742
Goodwill	606,777	497,338	424,982	237,767	254,086	215,967	191,629
Intangibles	473,122	431,457	400,589	234,113	261,333	237,070	182,599
Total assets	2,550,835	2,124,506	1,900,728	1,206,223	1,231,765	1,186,350	936,448
LT debt	929,243	684,099	554,282	294,702	322,375	359,263	217,119
Shareholder’s equity	950,086	860,931	837,060	621,639	579,981	553,972	501,370
Relative revenue:
Products	0.78	0.78	0.71	0.73	0.72	0.69	0.72
Services	0.22	0.22	0.29	0.27	0.28	0.31	0.28
Products relative operating income	0.70	0.62	0.67	0.81	1.13	0.98	0.78
Services relative operating income	0.30	0.38	0.33	0.19	-0.13	0.02	0.22

Markel’s third engine: investments and “float”

2019 stands as a record breaking year. In our equity portfolio we earned a return of 30% and in our fixed income operations we earned a return of 6.5%. The total investment portfolio produced a return of 14.6%. This is the highest total return from the portfolio in 24 years.

Total investments stood at 22.3 billion, where the vast majority are managed in-house at an extraordinarily low cost estimated to 8 basis points to total assets. Compare that to actively managed mutual funds!

This table summarizes their performance:

	Equity		Difference
	performance	S&P 500	to S&P 500
1993	13.1	7.6	5.5
1994	28.7	10.1	18.6
1995	-3.3	1.3	-4.6
1996	29.7	37.6	-7.9
1997	26.9	23	3.9
1998	13.3	28.58	-15.28
1999	-10.3	21.4	-31.7
2000	26.4	-9.1	35.5
2001	16.9	-11.89	28.79
2002	-8.8	-22.1	13.3
2003	31	28.68	2.32
2004	15.2	10.88	4.32
2005	-0.3	4.91	-5.21
2006	25.9	15.79	10.11
2007	-0.4	5.49	-5.89
2008	-34	-37	3
2009	25.7	26.46	-0.76
2010	20.8	15.06	5.74
2011	3.8	2.11	1.69
2012	19.6	16	3.6
2013	33.3	32.39	0.91
2014	18.6	13.69	4.91
2015	-2.5	1.38	-3.88
2016	13.5	11.96	1.54
2017	25.5	21.83	3.67
2018	-3.5	-4.38	0.88
2019	30	28.8	1.20

Markel allocates the insurance liabilities to fixed income holdings (the reserves), aiming to capture the spread between the cost of those funds and what can be earned on “plain vanilla” high quality fixed-income investments. In 2019 the combined ratio was 94%, meaning the cost of the reserves stood at a negative 6%. This money/capital is invested in the fixed income markets. However, in the 2019 letter, Gayner writes that the low and sometimes negative interest rates seen in current bond markets are a growing and troubling development. The positive is that the negative cost of funds generated in the insurance operations is more negative than the rates in the credit markets, but Gayner is worried about the pressure on the spreads.

What is “surplus” from the insurance liabilities is invested in the much more risky equity markets, but with higher future expected returns. Gayner looks for this when picking stocks:

• Good rates of return on capital with modest leverage.
• Management teams that have talent and integrity.
• Companies that have opportunities to reinvest capital and grow organically or via acquisitions.
• The shares must be acquired at “fair” prices.

Gayner writes they are wary of investing in an environment dominated by low and negative interest rates, as this is unlikely to produce historical results (headwinds). Markel would rather sell bonds than buy in this market:

Capital markets are like the Wild West right now and anything goes. In an environment where anything goes, something is going to go wrong. We don’t have any specific predictions or forecast. We just remain as extraordinarily disciplined and long term oriented as we know how to be in the face of the unprecedented challenge of producing positive investment returns in a low/negative interest rate world.

The allocation to equities has gradually increased over the last years:

	2019	2018	2017	2016	2015	2014	2013
Fixed maturities/bonds	9,970,909	10,043,188	9,940,670	9,891,510	9,394,468	10,422,882	10,142,536
Equity/stocks	7,590,755	5,720,945	5,967,847	4,745,841	4,074,475	4,074,475	3,251,798
Shareholder’s equity	11,070,867	9,080,653	9,504,148	8,460,927	7,834,150	7,594,818	6,673,577
Goodwill	2,308,548	2,237,975	1,777,464	1,142,248	1,167,844	1,049,115	967,717
Intangible assets	1,738,474	1,726,196	1,355,681	722,542	792,372	702,747	565,083
Tangible BV	7,023,845	5,116,482	6,371,003	6,596,137	5,873,934	5,842,956	5,140,777
Equity investments to BV	0.69	0.63	0.63	0.56	0.52	0.54	0.49
Equity investments to tangible BV	1.08	1.12	0.94	0.72	0.69	0.70	0.63

Markel’s capital allocation:

The first priority is to allocate in their existing businesses (invest/reinvest organically). This means first and foremost insurance and Markel Ventures. This is the least risky as they both know their managers and businesses.

The second priority is to acquire new businesses, which of course involves more risk than growing organically. CATCo comes to mind, but Gayner writes that overall the result is a net positive.

The third priority is to invest in publicly listed equities, which they have done very successfully in the past.

The fourth choice is to buy back shares. Historically, only modest amounts have been bought back.

The 2019 letter doesn’t mention dividends, and we can safely say this is out of the question. I would say luckily, as reinvesting at high rates of return is by far the best method of growing the share price. As an investor, you can sell shares to create “income”.

Alan Kirshner

The 2019 letter ends with a tribute to Alan Kirshner. He has been the Chairman of the Bord and employed in Markel for 60 years, but retired at the end of 2019. He was the brain and author of the “Markel Style” description when Markel IPO’ed in 1986. Steven Markel takes over as Chairman.

How has Markel’s investment portfolio performed in 2020?

As of the close of 13^th of April 2020 the 20 biggest equity positions have declined 11.5%. These 20 positions are about 70% of the portfolio, and if we assume the 30% rest performed as the market, it means the portfolio has slightly underperformed S&P 500’s 14% decline YTD.

This was the 20% biggest holdings and weightings at the end of 2019:

Berkshire	12.1
Carmax	7.2
Brookfield Asset Management	5.6
Disney	4.5
Marriott	4
Diageo	3.8
Home Depot	3.3
Alphabet	3
Amazon	3
Visa	3
United Health Group	2.9
John Deere	2.9
Walgreens Boots Alliance	2
Blackrock	1.8
RLI	1.8
Analog Devices Inc	1.71
Texas Instruments Inc	1.54
Automatic Data Processing	1.52
Johnson and Johnson	1.5
Apple Inc	1.48

Carmax, Disney and Marriott have taken a severe beating.

Markel’s valuation:

Historically Markel has traded at a premium to book values. Up until the GFC in 2008/09, it was around 2x, but since then it’s been mostly around 1.5x, even as low as 1.25x in 2012. As of writing the stock is trading at 950 and the reported book value from the end of 2019 was 802. I can only guess what the book value is right now: we know the value of the equity portfolio (slightly worse than the S&P 500) but the fixed investment portfolio has different holdings where some have risen (government debt) while others might have fallen (corporate debt). All in all, I expect the book value to have declined, but we need to wait until Markel reports 1Q 2020 in early May.

Risks of investing in Markel:

The dreaded word “risk” applies to all insurance companies. I believe the main risks are these:

• Obviously increased claims, especially in the reinsurance segment, are a risk for all insurers.
• Loss of personnel. I believe Tom Gayner is pivotal for Markel.
• Inflation: FED is now issuing “helicopter money” and an increase in inflation means the cost of replacing assets is higher than the premiums received. Usually claims are paid out years later than when premiums were received. We have had low inflation for almost 40 years, and many investors and managers have “forgotten” how an inflationary environment is.
• Likewise, deflation could be just as bad as inflation. If interest rates turn negative insurers actually have to pay to keep the float and their future liabilities. At the end of the day the cost will be borne by the end-user, but there will be a lag.
• Governments can force insurers to pay claims, even if there is no contractual obligation to do so. During Covid-19 it has been speculated many authorities are trying to “force” insurers to pay for claims where no legal contracts exist.
• Markel is in a taxable position and an increased tax rate is of course negative. The US deficit is growing, and this can only be paid by taxes or inflation.

Conclusion:

Markel has proven itself to be a reliable and good performer in all of its three “engines”. In addition, Markel grows organically and is one of the few companies that can retain and invest earnings at acceptable marginal/incremental returns: There is no inefficient “rewarding” of shareholders via a taxable dividend. The runway is still long, the insurance market is fragmented, Markel is just one of many insurers and CIO/CEO Tom Gayner has still most likely many years left. I expect around 10% annual returns over the next two decades.

 

Disclaimer: 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.