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One of the larger holdings in the Against the Sky Portfolio is Markel (NYSE: MKL), a specialty property and casualty insurer. Before the market decline, Markel had built an impressive track record of both underwriting profits and investment returns. With some stability returning to the market, Markel may be poised to return to its historic price to book value. This would result in some very nice gains for Markel investors.

About the Company

Markel competes in three areas of specialty insurance. These are Markel's Excess and Surplus Lines, Specialty Admitted, and the London Insurance Market. The Excess and Surplus Lines writes property and casualty insurance for nonstandard and and difficult to place risks. Markel's Specialty Admitted line also writes more unique and specialty insurance where the customer requires an admitted insurance company. The London Insurance line also writes specialty property, casualty, marine, and aviation insurance and reinsurance.

The specialty market by definition has less competition, which allows for more risk but also more profit. Markel has been around since the 1920s, however, and has the expertise and experience to successfully underwrite these types of insurance products.

Investment Thesis

Insurance companies have two main drivers for growth, underwriting profits and investment returns. Markel has been successful at both. Since 2003, Markel has reported an underwriting profit in every year but one. Combined ratio is a measure of underwriting profit, if it is below 100%, it means the company was profitable on an underwriting basis.


- 2003 2004 2005 2006 2007 2008
Combined Ratio 99% 96% 101% 87% 88% 99%

Investment returns in the Markel portfolio may be the most significant driver of growth for the company. Markel, like any insurance company, gets to invest its “float” between the time the premium is paid and when a claim is paid. Markel, however, has produced strong returns historically on its capital excess. The table below shows all annual investment income as well as realized and unrealized profits on its investment portfolio.


Year Investment Returns
2003 $326,238
2004 $315,438
2005 $177,413
2006 $467,904
2007 $297,340
2008 ($468,358)

2008 was a difficult year to be an investment manager. It was a year when nothing worked. Uncertainty about 2009 investment returns has resulted in Markel being priced at a discount to its historical price to book ratio.

Valuing Markel

Up until year-end 2007, Markel had traded between 1.72x and 2.50x book value. In the second quarter of 2008, Markel had traded as high as 1.91x book value, and in the first quarter of 2009, Markel traded as low as 0.95. The chart below shows Markel’s book value compared to its high and low market price.

Click to enlarge:
MarkelBV

You can see the compression over the past year as the economic crisis and investment losses compressed Markel’s price to book multiple. Since year-end, Markel has shown improvement in its book value, rising from $222 at year-end to $239 at the end of the second quarter. The third quarter should bring more investment gains and improved book value. Based on the current price of around $344 per share, Markel is trading at 1.44x book value. If Markel were to trade at its more traditional price to book value of around 2.0x, shares would be worth $478 per share, or a 40% increase from Monday’s price.

Conclusion

As the market has stabilized for both equity and debt securities, questions about Markel’s investment returns should diminish. Strong underwriting profits and investment returns should continue to drive growth in Markel’s book value, which increased from $118 in 2002 to $262 per share before the current economic crisis. As Markel is a large holding of the Against the Sky Portfolio, I will likely not add shares, but I will look to trim holdings should Markel trade a 2.0x book or more. This would equate to a share price of $478.

Disclosure: I currently hold shares of Markel.

Source: Rising Market Could Mean Big Returns for Markel