Are You Thinking Of Buying Berkshire Hathaway? Consider Baby Berkshire Instead

Summary

• Markel Corp. always outperformed Berkshire Hathaway in the course of its history.
• Because of the difference in their capitalization, it is highly likely that it will keep on outperforming Berkshire in the long run.
• Business at Markel has a lot of space to grow, while Berkshire must strive to find new acquisition targets.
• Warren Buffett will not be chairman forever and his successors will almost certainly be unable to match his unique gift for investments.
• As a direct consequence, Berkshire’s intangible assets and goodwill may decline in the future. Markel does not have this problem.

Source: Berkshire’s annual letter

A few days ago, Berkshire Hathaway (BRK.A) (BRK.B) released its annual report. Markel Corporation (NYSE:MKL) has not published it yet, but it released its full year results.

As the readers of Warren Buffet’s letters already know, in 2015, he decided to slightly change the comparison criteria he had been using to evaluate Berkshire’s performance. He had always just compared BH’s book value appreciation against S&P 500 appreciation.

Since 2015, he has been taking into account also Berkshire stock price appreciation. The official reason for the change was that book value could not completely reflect the intrinsic value of the company (arguably, when we also consider good will and intangibles), but the real reason was that, for the first time in history, S&P 500 total return in the previous 5 years had surpassed Berkshire’s book value total return, whereas its stock price delta still performed better.

What is remarkable now is that, in the course of the last 10 years, as reported in its last annual report, even Berkshire stock price total return was beaten by S&P 500, a milestone in the company’s history.

Year	Annual percentage change Berkshire	Annual percentage change S&P 500
2008	(31,8)	(37)
2009	2,7	26,5
2010	21,4	15,1
2011	(4,7)	2,1
2012	16,8	16
2013	32,7	32,4
2014	27	13,7
2015	(12,5)	1,4
2016	23,4	12
2017	21,9	21,8
Compounded annual gain	9%	10%

Click to enlarge

Source: Berkshire’s annual letter

The reason is quite clear: Berkshire is too big!

Why Berkshire’s best years are not in sight

That’s right. Berkshire is too big; its huge capitalization of about half trillion dollars makes it what I usually call an index company. Its stocks are good for index ETFs and funds, but not so good for individual investments.

In fact, there is a sort of physical limit to stock growth. If a company is very big, it could be hard to find substantial space for business growth. It could be even harder to do it against the will of the anti-trust entities.

Personally, I rarely own shares of companies exceeding a double digit billion-dollar cap. I would prefer to buy an ETF to avoid risks as well as hours of due diligence, therefore, saving time and energy.

With Berkshire we have an additional problem, which is not solvable, because it is linked to the inner structure of the company.

Berkshire is basically an insurance company that uses its float to invest in the equity market

Since Warren Buffett credo is value investing, he never owns more than a dozen companies for 90% of his publicly quoted companies’ portfolio. Now, this is where it gets tough: let’s say you have a $100B budget and you are committed to using no less than 10% of that budget for each purchase, then your hunting territory will be limited to a tiny fraction of the companies that are listed in the public stock exchanges. If you don’t want to overpay your shares, on average, you will need to only bet on the very fat guys. It could be hard to find value out there.

The same goes with acquisitions. It is increasingly difficult for Berkshire to find private companies to buy. I think that, in the near future, we will witness Berkshire implementing the same suggestion W. Buffett gave individual investors several times: 10% bonds and 90% cheap index ETF.

Ten years from now, Berkshire Hathaway will be a huge holding company, with some insurance companies in its pocket, no more and no less. Its biggest competitive advantage will eventually vanish. Given the lack of investment opportunities, it will most likely even start to pay dividends in order to deploy its enormous cash.

This last option could sound good for some investors, but it is drastically against Buffettology itself.

Now let’s talk about Markel

Although Berkshire is likely to be on the path of giving up its terrific long-term performance in the years to come, there is another company that will continue to grow at the same pace, using the same business model structure as Berkshire’s, but enjoying a relatively low capitalization. I am talking about the so-called baby-Berkshire: Markel Corp.

Markel’s intent is not a secret to anyone and that is to copy the Berkshire Hathaway business model. In other words, using the float of a solid insurance business (which yields an underwriting profit 80% of the time) to acquire private companies or to invest in securities. They even hold their annual meeting at the Omaha Hilton Hotel, just a day or two after Berkshire Hathaway’s annual shareholders meeting in the same town.

The company is co-managed by Tom Gayner: a Buffett fan and smart disciple.

Actually, for being a copycat, Markel performed very well. Here is a direct comparison between the two companies during the course of the last 10 years:

Source: Yahoo Finance

Berkshire vs. Markel

In this table, I put some key figures for the two companies, data in billion dollars, collected as of Dec. 2017:

	Berkshire	Markel
Float	114	9
Equity Securities	164	6
Fixed Inc Maturity Securities	21,35	10
Cash and Short Term T-notes	115	4,5
Intangibles and Goodwill	112	3,1
Total Assets	700	32,8

Click to enlarge

Source: Berkshire Hathaway and Markel official filings, Author’s elaboration

We can note that Markel’s float is about 28% of total assets, compared to 16% for Berkshire. That reveals Markel’s bigger exposure to its insurance business.

I like that, because insurance is the key of the two companies’ business model. They are not simply holding companies, but rather insurance companies that invest their float on equities and acquisitions.

Cash and short-term T-notes, compared with equity securities, are more or less the same for both companies, but fixed maturity securities are much bigger for Markel (170% vs. 13% of equity securities for Berkshire).

This reflects Markel’s more conservative approach and it is also partly due to the recent acquisitions of Alterra and State National, which had numerous bonds and treasuries in their investment baskets.

This over-exposure to bonds could lead to a better performance in the future, as management will eventually shift a bigger part of its portfolio to equity stocks.

Goodwill and intangibles, as percentage of total assets, are much bigger for Berkshire (16% vs. 9.5%). Today, this difference can be explained with Buffett and Munger being in charge, but I cannot guarantee that this would be a realistic scenario when they retire.

The bottom line is that Markel is well-positioned for future growth in all respects. Its business is well balanced and strong. Even during a difficult year, like the last one for insurance companies, due to several dramatic catastrophes, Markel managed to deliver an excellent profit for its shareholders. The net unrealized investment gain of more than $760M together with the income of the fast-growing Markel Ventures operation, which exceeded $100M in 2017, easily offset the net loss brought by the insurance segment.

On the other hand, by comparison, Berkshire appears to be scrambling a little bit after Markel.

Even the P/B value ratio, which is cheaper for Berkshire, does not differ that much, if we consider only the tangible assets. Markel is only 12% more expensive than Berkshire according to this metric.

Conclusions

Berkshire Hathaway has been a legend for all investors. Due to its terrific performance, it earned the well-deserved fame of a modern institution in the financial environment.

Nevertheless, several signs are telling us that its future performance will not be as good as the past ones.

If you are as intrigued as I am by the Berkshire’s business model, you should buy Markel instead, a company that shares the same investment philosophy, but without the size-problems of its larger twin.

After all, a Markel’s buy-out would not be that extravagant for Berkshire in the future. Maybe it is already on Mr. Buffett’s to do list.

Analyst’s Disclosure: I am/we are 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.