On December 19th Markel (MKL) share prices decreased from the previous day's closing price of $486.05 to a closing price of $436.24 after the merger announcement with Alterra (ALTE). Simultaneously, ALTE shares rose from $23.15 to $28.18.
There is a rumor many investors are not confident with the merger and that is the supposed explanation for the drop. This is an unlikely scenario, especially for a high quality company such as MKL.
In fact, the merger is more likely to increase the intrinsic value of MKL. This merger benefits current MKL shareholders and so the sharp decline is unlikely to be the result of a poor merger.
The most likely explanation for Wednesday's price behavior involves arbitrage. MKL agreed to pay $10 cash and .04315 shares of MKL for each share of ALTE based on the December 18th closing price of $486.05. This equates to MKL paying a total of $30.97 for each share of ALTE ($10 cash + .04315 x $486.05).
For a stock arbitrageur to make a profit, ALTE would need to be purchased below $30.97. Additionally, that same arbitrageur must mitigate the downside risk of MKL shares by short selling $20.97 dollars worth of MKL for each share of ALTE owned. Short selling MKL is necessary in order to lock in a price for the time period it takes to complete the merger.
The combination of arbitrageurs buying ALTE shares and short selling MKL would explain the rapid appreciation of ALTE and decline of MKL in a single day.
The interesting part is that the arbitrageurs do not care about the intrinsic value of MKL, they are only interested in offsetting volatility risk until the deal closes in 1Q 2013. This means the MKL shares were artificially suppressed while the arbitrageurs obtained their short positions. It has nothing to do with the intrinsic value of MKL.
The next interesting part is the merger itself. If the merger goes through, the MKL shareholders will receive a better deal than the ALTE shareholders. Let's look at some of the rough figures.
MKL is paying slightly over book value for ALTE but gets an additional $4.8 billion dollars worth of insurance float. The total combined assets of MKL after the merger will increase to roughly $15.5 billion (float plus equity but excluding debt) of which the current MKL shareholders will own 69% versus the 31% received by ALTE shareholders. Doing the math means that current MKL shareholders end up with an additional $2 billion worth of insurance float that they did not have before the merger.
In qualitative terms, MKL also gains because their insurance portfolio will become better diversified, they can begin to scale their business more, and they can take on larger clients with an increased base of equity.
To summarize, MKL will gain in intrinsic value after the merger. Until the deal closes in 1Q 2013, the market value will be held artificially low by the arbitrageurs who are shorting the shares to lock in their gains.
This is an excellent buying opportunity for MKL. Not only has the price come down, the intrinsic value has increased. I suspect the shares will rise in market value after 1Q 2013 when the arbitrageurs cancel their short positions with the shares they receive. The first or second quarterly report will show that the intrinsic value has indeed risen and the recent volatility is due to temporary circumstances unrelated to the value of the company.
Additional disclosure: Before the MKL price decline on December 19, MKL constituted 0% of my portfolio. After the price declined significantly I made MKL a permanent member of my portfolio where it now constitutes 28%. I eat my own cooking.