Seeking Alpha

I Was Wrong: Alleghany Corporation Is Indeed A Buy

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About: Alleghany Corporation (Y)
by: Gio Danisi
Gio Danisi
Long only, value, long-term horizon
Summary

I have partially revised my initial thesis about Alleghany Corp.

The company's long-term prospects are as good as Markel’s and its shares are cheap.

I still think that the company’s investment strategy can be improved, and such, improvement would be a terrific catalyst.

A couple of months ago, I wrote an article about Alleghany Corp. (NYSE:Y), a small Berkshire Hathaway clone (BRK.A, BRK.B), where I tried to compare its long-term prospects with those of another famous mini-Berkshire: Markel Corp. (NYSE:MKL).

I must admit: my final considerations were quite trenchant. I raised some doubts on the competence of Alleghany’s management and concluded that the best way for the company’s stockholders to get more value was to seek a merger with its competitor, remarkably managed by Thom Gayner and Richard Whitt.

However, after a very informative conversation I had with Alleghany’s CEO Weston Hicks, followed by a total reconsideration of the company’s business model and operations, I am taking back my words. Although, in fact, I am still hoping for a future merger between MKL and Y, in the meantime, I have decided to start a long position on the latter, which means I am now a shareholder of both companies.

Alleghany has a compelling M&A activity

In my earlier article, I admitted that Y is a reliable insurance company, as its metrics are even better than MKL’s.

Combined Ratios Compared

Markel

Alleghany

Industry Average

2014

95%

89%

97%

2015

89%

89%

98%

2016

92%

83%

101%

2017

105%

106%

104%

2018

98%

103%

102%

Total

95.8%

94%

100.4%

Source: Company reports (Author’s elaboration)

However, my argument was based on the fact that its capital allocation activity was poor due to a great deal of wrong investments in the stock market and due to its erratic strategy.

What I failed to outline, however, was that the main bulk of Y’s capital allocation decisions involved its M&A activity and private equity operations. The M&A activity, in particular, has been terrific since W. Hicks became the company’s CEO.

The two biggest acquisitions he made were RSUI and TransRe, the two insurance companies responsible for the outstanding results shown in the table above.

RSUI was bought for less than $700 million and it has now an equity capital of about $1.8 billion, after having paid Alleghany cumulative dividends for over $1 billion in the last 15 years.

TransRe cost $3.5 billion in 2012 and it has now an equity value of about $5.3 billion, after having paid cumulative dividends for $1.4 billion in the last seven years.

Alleghany’s ability to limit the downside in case of unsuccessful events was even evident when the firm made bad deals with Employers Direct (subsequently known as PacificComp), which ended with a loss of around $50 million, and with the Ares Management (NYSE:ARES), which was eventually sold for a nice profit!

The private equity operations are very promising too, with booming results in the last quarters:

Source: Company presentation

As for the ILS segment, the management confirmed its involvement in this promising business, through its Pillar investment (about $1 billion of AUM) and Pangaea and Bowline, which recently completed a $250 million issuance of cat bonds. Therefore, we can infer that the company’s current take on the ILS business sounds like an “Adelante con juicio” statement.

All in all, Alleghany has nothing less than Markel and is traded at a significant discount, if we consider that MKL’s price-to-book value is currently at 1.45, Berkshire’s at 1.35 and Y’s at just 1.25, despite being the smallest of the three at the time I am writing this.

My personal view on how to increase value for Alleghany’s shareholders

Yet, the missing part in my investment thesis is Alleghany’s approach to the public equity market. I still think, in fact, that the company has significant room for improvement when it comes to choosing the right stocks to own. Moreover, as far as its publicly listed investments are concerned, Y should adopt the same attitude it has towards the private equity business: buy and hold for the long run.

I am sure the management realizes this and would be able to transform a potential problem into an important catalyst for future growth.

Actually, I don’t even think precious resources should be wasted with trying to pick the right stocks. Instead, a passive approach could be more appropriate in Alleghany’s case (as well as in Markel’s case).

Cheap REIT funds, like Vanguard Real Estate ETF (VNQ) or Vanguard Global ex-U.S. Real Estate ETF (VNQI), could be an interesting option.

In fact, REITs usually prosper in a low-interest rate environment, while insurance companies mostly benefit when rates go up. This trade-off is particularly remarkable, in my view: Alleghany should seek this kind of diversification.

Consequently, a decent portfolio could be structured in this way: one-third in VNQ, one-third in VNQI, one-third in the Vanguard S&P 500 ETF (VOO). Alternatively, with respect to general exposure to the equity market, my favorite option is the VanEck Vectors Morningstar Wide Moat ETF (MOAT), which invests directly in companies to which it allocates a large moat (a conservative choice considering that a strong moat usually prevents companies from crashing during recessions).

Another considerable area of improvement, in my opinion, is the relative size of Alleghany’s investments. At the moment, Y allocates about 21% of its equity to cash and short-term investments, 165% of equity to debt securities (corresponding to roughly 130% of the company’s insurance float) and just 24% of the book value to equity securities.

Moreover, these proportions may change from time to time as the management adjusts its allocations trying to "time" the securities’ trend.

Instead, I would maintain an agnostic approach, acknowledge that it is objectively impossible to anticipate the market’s ups and downs, and therefore, maintain a fixed proportion (eventually re-evaluated each year) of the assets with less bonds (just the state-mandatory 100% of the float) and more equity securities.

Current Allocation

“Ideal” allocation

Cash + Short-Term Investments

0.21 x Book Value

0.15 x Book Value

Debt Securities

1.30 x Float

1.00 x Float

Equity Securities

0.24 x Book Value

0.65 x Book Value

Source: Author's elaboration

Furthermore, I would finance any future private equity and/or private transaction acquisition mostly with a combination of debt and issued shares, depending on the market’s borrowing costs, as well as Alleghany’s price-to-book value at the moment of the deal.

Bottom line

When the facts change, I change my mind. What do you do, sir?

That was what John Maynard Keynes once said.

His words can’t be more appropriate here, although I am not a big fan of drastic U-turns when it comes to investment decisions.

In this case, I couldn’t easily pass up the chance to review my initial thesis, having personally witnessed how much Alleghany’s top management cares for this company.

It’s crucial that the interests of the investor (or business owner, as I prefer to consider myself) are aligned with those of the people who actively run the company. The second most important consideration is that such management is humble, honest and constantly oriented toward the long-term benefit of its stockholders.

Two months ago, I concluded my article stating:

I simply don’t see the reason to divest even a small part of my Markel’s shares to buy Alleghany.

Now, that reason is here!

Buy and hold Alleghany if you chose to be an “entrepreneurial” (or infinity) investor.

Disclosure: I am/we are long Y. 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.