Markel Corporation (NYSE:MKL) is a premier niche property & casualty (P/C) insurance company that has slowly made a name for itself in the industry over the last few decades. The construct of the company's operations looks a lot like Buffett's Berkshire Hathaway [(NYSE:BRK.A) (NYSE:BRK.B)] in that it is a holding company with three main segments: insurance, investments, and noninsurance subsidiaries. The purpose of this article is to examine the overlooked competitive advantages Markel has in each of these segments. On a sum of the parts basis, Markel's intrinsic value is as much as double its current market capitalization.
In an industry where it is perfectly acceptable to operate at sustained losses, Markel's insurance segment is run with extreme discipline with a focus on profitability at all costs (is that an oxymoron?). This is unlike most of the industry, whose M.O. is to chase market share during soft markets only to increase rates and chase profitability during hard markets. This focus on profitability versus market share is evidenced by Markel's combined ratios averaging under 96% per year over the last decade (with only two unprofitable years), versus industry averages of 100% or more (State Farm, by far the largest insurer in the nation, produced underwriting losses in 8 of the 11 years ending 2011, and is considered to be well-managed).
2013 average combined ratios for the industry are expected to be anywhere from 103-107%. Companies in the P/C industry are essentially accepting losses on their insurance business in hopes that they will more than offset those losses by earning profits on their float, before they have to pay out that float in claims. Markel's disciplined approach to insurance has produced a perpetual float which is effectively free money, with which they are free to invest indefinitely. This is a great thing, assuming that the investments are profitable. Enter Tom Gayner…
Tom Gayner is the President and Chief Investment Officer at Markel, and his investment performance over the years is nothing short of phenomenal. In the 15 year period ending 2011, Gayner's picks in Markel's equity portfolio have had a cumulative return of 253% versus S&P's cumulative return of 124% over the same period. It is easy to see that Markel's strict adherence to underwriting profits is a perfect match to Gayner's capital allocation prowess. Gayner takes that free money from the insurance business and invests it with an infinite time horizon, not having to worry about selling out of positions to cover claims from unprofitable underwriting. You can see how this has turned Markel into a compounding machine, growing book value per share at 16% per year over the last 20 years. Gayner invests using principles much like Buffett's. He looks for: honest and talented management; companies with high returns on capital and profitability and the ability to take profits and continually reinvest them at high rates of return; all of the above at a fair price. Seems like that's been working out for him so far.
The final segment of Markel's money-making machine is Markel Ventures (MV). MV is a group within Markel that actively invests in controlling interests in other public or private companies. This segment started in 2005 and, again, serves a purpose a lot like that of Berkshire Hathaway. MV provides a market for business owners looking for liquidity, but are not necessarily ready to quit altogether. MV retains the owners as managers after acquiring their business and creates a win-win for both parties: The owner (seller) finds liquidity for their investments, and continues to run their business within a mutually-respectful, laissez faire culture. Markel gets a wonderful business for a good price, with owner-operators already in place. MV has a lot of room to grow for the future. For now, it only makes up a tiny fraction of the total value of Markel (contributing $60 million in EBITDA in 2012), but if Tom Gayner's history is at all indicative of the future, expect to see big things out of this segment.
Markel's recent acquisition of Alterra for approximately $3.1 billion is noteworthy for a number of reasons. First, Alterra is a well-run insurance company with a history of underwriting profits. Their focus on profitability will integrate well with Markel's way of doing business. Second, Alterra will expand Markel's reach into more global and reinsurance markets and provide the scale needed for bigger underwriting deals. Third, Alterra contributed about $7 billion to Markel's investment portfolio. The total investment portfolio for the combined entity is now $14.5B. This is a lot of play money for Tom Gayner to create value with. And finally, Markel acquired Alterra at slightly over book value. This may prove to have been a bargain in the near future.
Markel historically has traded at anywhere between 1.5 and 2x book value per share. Right now, the PB ratio sits at 1.2. The reason for this cheapness, I believe, is a combination of a few things: 1) the industry as a whole trading at low valuations due to excess capacity, leading to market share chasing, leading to underwriting losses; 2) the market's timidity towards Markel's acquisition of Alterra; 3) low interest rates; and 4) generally weak economic growth, resulting in low demand for insurance products, and therefore, a soft market. However, the excess capacity and soft market can't last forever, and eventually rates must start to increase again as claims are filed. Catherine A. Seifert of S&P Capital IQ reports that "record catastrophe losses both in the U.S. and around the world will extract billions of dollars of excess underwriting capacity from the insurance marketplace, causing insurance rates to rise." As claims from these catastrophes come in, they will drive out the insurers who wrote business at a loss, leaving Markel in a more consolidated market and smelling like a rose. As mentioned earlier, I believe Markel's acquisition of Alterra to be very complementary to their core strategy of writing at a profit, plus the addition of investments to Markel's portfolio will add exponential value for years to come with Gayner in charge. As interest rates begin to rise, insurer's investment portfolios will begin to earn higher rates of return from their bond holdings, leading to an industry-wide increase in multiples on earnings and book value. A reversion to historical ratios of around 1.75x book will produce a value per share of approximately $790, which is an upside of 51% to its current share price of $522.88. A P/B ratio of 2 will obviously produce an almost doubling of the share price to around $1,050/share.
Interestingly - and very useful to us - Tom Gayner has offered his take on how to value Markel in the past. In the January 2012 edition of Gurufocus.com's Guru Investor Digest, Gayner lays out the methodology on how to value his firm:
"I would not put a specific number on it, but the mentality that I would have in thinking about it is, I would think about [A] our insurance businesses with a normalized amount of premium volume, and a normalized amount of underlying profitability. That gives a normalized amount of operating earnings from the insurance company. [B] Then I would look at our net investments per share, which was total investments minus all the debt. I would then think to myself, well, if this insurance company continues to operate at an underwriting profit, and at least stays the same size, then all of the net investments per share are actually working for the shareholder, so that value should be added. [C] Then the third thing I would think about is the Markel ventures set of companies and what the operating cash flows and operating earnings are on a normalized basis and assign a multiple of that. I would divide that by the number of shares outstanding, and get a sense of what Markel each share is worth."
So, taking Mr. Gayner's words to heart, let's value Markel. Let's start with [B] first, from above. From the most recent 10-Q, net investments per share are just a tick under $1,000 per share ($1.7B in cash, and $14.5B in investments, offset by $2.2B in total debt, divided by 14M shares outstanding). Stop right there… Markel's net investment holdings alone equal 187% of its current market cap. Even if we assumed that Markel's insurance and other businesses only broke even and that Markel's investments could earn 5% after tax per year for 10 years, we could arrive at a value of almost $1,300 per share:
We could actually conclude our analysis here, assuming that Markel's insurance business and other ventures break even, and buy a $0.50 dollar. But let's keep with Gayner's analysis…
Using [A] from above, let's analyze Markel's insurance business. Earned premiums for the last 3 years have been $1.7B, $2B, and $2.1B, for 2010, 2011, and 2012, respectively. Their most recent quarter shows premiums of $784M, which includes premiums from Alterra's business. If we annualize that, we come up with $3.1B in premiums for 2013, estimated. To be conservative, let's assume $2.5B in premiums for a normalized year. This lines up conservatively with the below chart from their 2012 10-K:
At a net profit margin of 3%, insurance earnings from $2.5B in premiums are $75M in a normalized year (Markel's London Insurance Market Segment alone contributed $82 million in underwriting profits last year). Assigning a multiple of 10, we arrive at a $750 million value for Markel's insurance business, or $53.19 per share.
Finally, in [C], we'll value Markel Ventures. Markel Ventures contributed $13.5 million in profits in 2012. This is a growing segment, but we'll keep it simple and assign a multiple of 10 to this, arriving at a $135 million value to MKL, or $9.57/share.
Adding all three segments, we arrive at a Sum of the Parts Valuation of $1,051 per share.
Other Key Financial Data:
Disclosure: I am long MKL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.