Why We Own Markel (MKL)
Summary: On Markel and Structural Alpha
The common stock of Markel Corp. (MKL) represents an extremely attractive long-term investment. The recent
acquisition of Bermuda reinsurer Alterra (ALTE) has created structural alpha at Markel that will result in long-term
economic returns superior to those of the legacy company without a proportional increase in risk.
Markel’s relatively small capital base had previously constrained the dollar returns of its investment portfolio, as CIO
Tom Gayner was limited in the proportion of shareholders’ equity deployable in common stocks. By acquiring Alterra,
however, the $5.1B market cap Markel increased its supply of low-cost float by 66% to $8.9B – in spite of a soft
market and without compromising on underwriting standards – and can now begin to optimize capital allocation
across the enterprise. More specifically, Gayner can invest an increased percentage of significantly more float in
higher-return securities. The ALTE acquisition will also dramatically increase annual gross premiums written by
Markel’s insurance operations.
Assuming continued excellence in underwriting at Markel, expanded investment operations and increased premium
volume will increase the company’s return on equity (ROE), leading to increased growth in book value per share and
the rate at which intrinsic value will compound - with little incremental increase in risk. Value drivers in the company
are (1) investment returns, (2) the cost of float and (3) the degree to which assets are funded by liabilities, including
float, as opposed to equity.
The intrinsic value of Markel can be estimated via numerous methods and averages at approximately $1,300 per
share, compared to the recent trading price of $531. That gap should close due to both increased ROE and multiple
expansion. Catalysts in addition to float growth and increased premiums include a rise in interest rates, meaningful
growth in Markel Ventures, new acquisitions and equity investments, share repurchases and/or upward revisions by
credit rating agencies. In addition, Markel now has a leadership position in the emerging alternative reinsurance
market and stands to benefit considerably as reinsurance becomes a viable asset class among institutional investors.
A margin of safety exists in the talent, integrity and risk aversion of management - as evidenced by the company’s
conservative investment philosophy and loss reserving practices. The risk of significant and permanent capital loss is
Background on Markel
It is a peculiar conceit of our age that in spite of the tens of billions in personal wealth created from scratch by Warren
Buffett at Berkshire Hathaway, so few have attempted to replicate it. After all, the blueprints for the Most Successful
Wealth Generation Machine of all time are free to download, easy to read and even include witty, voluminous notes
from the architect himself. Nonetheless, to date, more than 500 million people have attempted to digitally sling fat
cartoon birds into snickering pigs, and very few have even bothered to try to build a Berkshire Hathaway of their own.
Perhaps Huxley was right.
In any case, among the discerning few is the management team of Markel, a diverse financial holding company that
underwrites a variety of specialty insurance products for niche markets. While Markel has certainly customized those
original Berkshire blueprints, management’s intentions are clearly derivative and admirable.
Markel’s recent acquisition of Bermuda reinsurer Alterra is analogous to Berkshire Hathaway’s 1998 acquisition of
General Re in the following sense: with a significantly increased capital base, management now has considerable
flexibility to invest both the premiums paid by insurance policyholders (float) and the regulatory capital (shareholders’
equity) that underpins the insurance operation’s promise to repay policyholders. The ALTE deal affirms that Markel is
now an investment business financed by an insurance company. The company will over time employ a tremendous
amount of free Other People’s Money into excellent businesses both public and private.
While somewhat constrained in terms of allocation across its portfolio, Markel has historically invested exceptionally
well. On a weighted annual tax equivalent basis, over the last ten years CIO Tom Gayner has averaged 9.2% returns
on Markel’s equity investments – an achievement that would put him in the top ten of large cap domestic equity
mutual fund managers over the same time period. Over the same period, Gayner returned an average of 5.3% a year
in the fixed income portion of Markel’s investments, for a total annual portfolio return over the last ten years of 6.2%.
So, you know, we want to keep feeding that guy the ball all night long.
Not to be overlooked is Markel’s insurance business. It is, in short, highly disciplined and deeply respected,
emphasizing long-term financial strength over short-term profits. For the past five years, Markel’s combined ratios
have averaged 98% per annum, underscoring the company’s ability to consistently underwrite at a profit in even the
dreariest of markets. By way of contrast, its peers lost money in underwriting over the same period, averaging a
combined ratio of 103% over the same period of time.
Markel, like Berkshire, is a rare company – both by corporate culture and results. The combination of excellent
investment returns and disciplined underwriting at Markel have led to a 20-year compound annual growth rate in book
value per share of 17%. And near the end of 2012, Markel announced a transformative acquisition, the significance of
which still seems vastly unappreciated by the market.
To better frame what is transpiring at Markel, some context is in order.
Insurance companies like Berkshire and Markel make money two ways; writing insurance policies to collect
premiums, and investing the float - money that the insurance company holds after accepting premium payments but
before paying out claims. For a typical insurer, the premiums it brings in do not cover the losses and expenses it must
pay. That leaves it running an “underwriting loss” – the cost of float – which is functionally equivalent to interest on
conventional debt. If, however, the insurance company can underwrite profitably and consistently, that float
essentially becomes free to hold, forever, like an interest free loan that never has to be paid back. And then the float
can be invested in long-term securities, like stocks, to really compound.
Because nothing ever goes perfectly, however, regulators, credit rating agencies and disciplined Chief Investment
Officers require minimum levels of equity capital in insurance companies to support given amounts of reserves. A
detailed discussion of reserving at insurance companies involves actuaries, models and state insurance regulators,
but in the abstract, the key point is that, all things being equal, more capital means more reserves means more
flexibility when it comes to investing – and that means better investment returns.
Prior to the ALTE deal, Markel’s largest source of investment funds was loss reserves, typically invested in fixed
income of various durations to be able to provide funds to meet insurance claims. The next biggest source of funds
for Tom Gayner was shareholders’ equity, which can be invested with an infinite time horizon. And typically a portion
of that equity would also be invested conservatively in fixed income - primarily to provide a margin of safety with
regards to insurance claims obligations. But by boosting shareholders’ equity by $2.6B in the acquisition of Alterra,
Markel has given itself considerably more discretion in its future investments.
To continue the previous investment firm analogy, prior to the Alterra deal, Markel had historically invested its own
equity in other equities and its float in long-only fixed income - similar to, say, a near-year target date mutual fund.
Post acquisition, however, Markel is more akin to a judiciously leveraged long-only hedge fund. Only it keeps all the
fees to itself. And its investors love this.
Why Is This A Great Business?
Multiline insurance enterprises are complex businesses in constant competition. Nonetheless, under the right
circumstances, the reinvestment dynamics of a well-run insurance company inside a holding company like Markel can
be incredibly attractive.
Property and casualty insurance in general can be a good business for several reasons. Profits can be generated
several ways, whether from investments or insurance operations, and capital requirements are usually minimal, with
few outlays required for fixed assets or working capital such as inventory. As a result, the business can scale easily
and have significant operating leverage.
In addition, the best insurers and reinsurers essentially self-generate permanent capital to invest by issuing policies
for premiums and investing those premiums (net of operating expenses) until claims are paid. As long as a (re)insurer
continues to operate, new premiums will replace reserves as claims are paid out, and to the extent that shareholders’
equity is growing, it can support ever increasing reserves - if the underwriting opportunities are available. And that
availability is tied to (re)insurance events, rather than asset values or lender issues.
With regards to Markel specifically – despite its complexity, because the company has a history of underwriting at a
profit and earning excess investment returns, we can fairly easily catch a glimpse of the kind of business it could be.
By calculating its investment leverage ratio (total invested assets divided by shareholders equity), we can determine it
currently has 2.6 dollars in its investment portfolio for every dollar of book value. This number is currently low,
incidentally, as the ten-year average is 3.1x. Even given that depressed 2.6x level, though, achieving a 6.0% annual
after-tax return on the investment portfolio would result in a 15.6% increase in book value per share. And if you
include underwriting profits in that figure, then Markel’s returns could approach 20% fairly easily.
The acquisition of Alterra also appears to be an excellent fit. ALTE has a similar underwriting discipline and was
acquired at just over 1x book value. The deal will be accretive to annual gross premiums written, book value, and
return on equity. In addition, Markel’s investment portfolio went from $8.9B to $15.8B pro-forma, and the company
stands to accrue significant additional value by re-allocating Alterra’s $6.7B investment portfolio. Notably, $6.3B of
Alterra’s total portfolio was invested in fixed income, with the remainder allocated to alternative strategies. On a proforma
basis, only 17% of the new Markel’s investment portfolio was in equities. If Tom Gayner increases the equity
allocation of the combined investment portfolio from that pro-forma 17% to the historic ten-year average of 23%, then
on the new $15.8B combined investment portfolio, he will have created $950M to buy equities. In other words, one of
the most talented investors of will soon be looking to deploy an amount of new capital equal to 19% of his company’s
current market cap.
Alterra was also among the first reinsurers to begin to exploit systematic inefficiences in the reinsurance market,
specifically by expanding its capacity “on-demand” to write retrocession cover. The retrocession market – providing
reinsurance to reinsurers - is highly opportunistic and can provide substantial returns. It is also indicative of an
ongoing convergence between the capital markets and the reinsurance markets. While a detailed analysis of the
alternative reinsurance market is beyond the scope of this report, investors can look to Alterra’s post-Japanese earthquake “sidecar” vehicle New Point as indicative of a novel way to extend additional capacity quickly to the
reinsurance market and to profit handsomely from it. While still early, it appears that Alterra (and now Markel) has the
relationships, infrastructure and proficiency to effectively arbitrage the reinsurance market and strategically lever third
party capital to further boost returns.
To read the rest of the report and see my valuations of Markel, please click this link to view the entire write-up in PDF form. And please let me know if you have any questions.