Markel Corporation (NYSE:MKL), now nearing a hundred years in age, has provided investors with impressive returns for several decades. Although it was founded in 1930 to insure jitney buses, Markel did not go public until 1986 at $8.33 per share. Its stock price has compounded at a 15% annual rate since then, beating the S&P 500's total return of 10%.
Despite the continued success of Markel, like any other stock, it cannot be purchased at any price. Book value per share, despite being a less relevant metric today than it once was, has grown long-term at a high single-digit to low double-digit rate, but for the last ten years, the stock has mostly not kept pace with the S&P 500.
Markel total return to investors and change in book value compared to the total return of the S&P 500 over various time periods. All market prices (Markel's and S&P 500's) are as of 4/30/2020 while book value is as of the end of the first quarter of 2020. The S&P 500 total return assumes dividends are reinvested. Source: Author.
Obviously the recent declines of the book value and share price of Markel have a disproportionate impact on more recent comparisons. But, declining interest rates have been a big part of the relative underperformance of Markel over the last decade.
Investment yields are set to begin declining again as interest rates have tumbled this year. But, Markel is also slowly positioning itself quite differently today than it has in the past. With consistently profitable underwriting, historically strong investment results, and a growing amount of value attributable to its non-insurance operations and insurance-linked securities, Markel still has the potential to have a bright future and a recent sell-off in the stock represents an attractive entry point. Unlike much of the stock market, which has regained a considerable amount of its March losses, Markel remains roughly 38% below its February high of $1,341 per share.
Rather than relying on a single model to value Markel, four models are presented below to gauge Markel's current attractiveness. These models are discussed following a company overview to provide the proper context and a brief discussion of first quarter results. While models are necessarily driven by assumptions, they point to a fair value of roughly $1,200 per share. Perhaps more importantly, even under the most conservative of the valuation techniques for Markel, the shares are worth no less than roughly $1,000 providing an important margin of safety in the current uncertain environment.
Overview: Markel's Sources of Value
Markel has four large sources of value: insurance underwriting, investments, insurance-lined securities and program services, and Markel Ventures.
Markel is still primarily an insurance company. That means its underwriting operations and investment portfolio are still two of its most important sources of value.
Underwriting operations comprise primary insurance within the United States, primary insurance internationally, and reinsurance.
For many years Markel has focused on underwriting niche areas of the insurance world. Excess and surplus lines and specialty admitted segments continue to be the heart of Markel's U.S. underwriting. The less commoditized nature of the business means that those with sufficient expertise in pricing specialty coverage and helping customers find an appropriate risk management strategy can earn above-average profits. Markel is currently the second-largest excess and surplus lines underwriter in the United States behind AIG (AIG).
The company purchased Terra Nova in 2000 in part to create an international platform to write specialty insurance similar to what the company had domestically. After a very difficult period of increasing prices and reserves and rationalizing business lines, Markel did create a profitable international operation. The international business also extends beyond specialty markets and includes a Lloyd's syndicate.
The reinsurance business mostly came through the 2012 Alterra acquisition after a toehold in reinsurance came through the Terra Nova acquisition. Reinsurance is a tough business. It is difficult to imagine Markel having much of any advantage, as the industry is chronically awash in capital. Since reinsurers essentially sell their balance sheet companies with large capital bases can find it possible to develop sustainable competitive advantages, but that does not currently describe Markel. The company believes that they will enjoy some advantage over time from the fact that reinsurance is a small piece of the company overall, which will mean less of an incentive to chase undisciplined growth. Some truth may exist in that line of thinking, but many reinsurers are parts of larger organizations that also write primary coverage.
Thankfully, the more profitable specialty lines comprise a much larger part of Markel's overall book of business than reinsurance. Of about $5 billion in earned premiums in 2019, $3.1 billion came from underwriting primary business in the United States, $1.1 billion came from underwriting primary business internationally, and $900 million came from reinsurance.
Markel also needs to invest the float that comes in from its insurance operations. At the end of last year, insurance float was $12 billion. Markel additionally had close to $9.5 billion of its own capital invested in the insurance portfolio or held in cash. Roughly 21% of the portfolio was held in cash or short-term investments, 45% in fixed maturities, and 34% in equity securities.
The company has historically chosen to invest policyholder float in fixed maturities of high-quality issues that have a duration that matches insurance liabilities closely. Currently, the duration of the fixed maturity portfolio is a little less than six years and the average credit rating is "AA". Municipal bonds make up 42% of the portfolio, followed by mortgage-backed securities at 27%, foreign governments at 15%, corporate bonds at 9%, and government and government-sponsored bonds at 6%.
Markel also has historically seen the portion of its investment portfolio not committed to covering policyholder liabilities as being available to invest in equity securities. Currently, equity securities are about 60% of shareholders equity. The largest equity investments are listed below.
Markel's largest equity holdings and their weighting in the equity portfolio as of 3/31/2020. Source: Author, via form 13F-HR.
In addition to offering traditional insurance products, Markel has invested heavily in establishing a major share of the insurance-linked securities market (ILS) as well as a related fronting operation. ILS allows investors to provide capital to and assume risk from insurance markets through financial instruments that provide returns to investors based upon the occurrence of contractual events. Markel first entered the market when it purchased CATCo at the end of 2015. At the time CATCo had $3.6 billion in assets under management, but heavy catastrophes and poor loss reserving subsequently caused major headaches for Markel and they placed the unit into run-off, with $2.8 billion remaining under management at the end of last year. The larger Nephila Capital was purchased in 2018 and Lodgepine Capital was established in 2019 and should launch its first product this year. At the time of the Nephila acquisition, Markel had a 20% share of the ILS market.
To help facilitate the ILS market, Markel has also purchased State National, a company whose main business is fronting and managing programs for others. Simplistically, ILS markets are made possible by investors investing capital into a fund managed by a special purpose entity who can then use that capital to reinsure risks from insurers. But, to issue insurance policies, these special purpose vehicles need an entity with insurance licenses and the ability to navigate the insurance regulatory landscape. State National allows Markel to be in the business of fronting insurance in other ways as well. When Tesla launched an insurance product, State National agreed to front the product, essentially lending their insurance licensing to Tesla and helping that company navigate the insurance regulatory environment in exchange for a fee.
Whereas Markel's insurance businesses are in the business of assuming the risks of others, its ILS and program services businesses are in the business of making it easier for others to assume risk and are paid fees for doing so.
Finally, Markel Ventures is a vehicle for wholly or majority-owned businesses acquired through private transactions. Markel Ventures began in 2005 with the acquisition of AMF Bakery Systems for $14 million. In explaining its decision to invest, the company noted that the valuations for acquisitions of private businesses had reached unsustainably high levels and that it desired to have a platform in place should the situation reverse. True to their word, it was in 2009 that the acquisition activity of private businesses accelerated. About $2 billion has now been cumulatively invested.
Markel Ventures adds another avenue for the company to deploy capital, thereby increasing the odds that an attractive opportunity will exist for investment, whether the opportunity is in public or private markets. The company says it is currently targeting companies with annual cash flows of $25 million or more. Depending on the industry, that could mean future acquisitions should in the range of $200 million - $500 million could be expected.
The largest acquisition to date has been Costa Farms, for $417 million in August 2017. Costa is based in Miami and sells indoor and outdoor plants, supplying many large retailers including Wal-Mart (WMT), Amazon (AMZN), Costco (COST), and The Home Depot (HD).
VSC Fire and Security appears to have been the second-largest acquisition, made for $225 million this past November. VSC is a distributor of fire protection and safety products as well as a contractor providing inspection and installation services.
Finally, the third-largest acquisition has been of Brahmin Leather Works for $193 million in October 2018. Brahmin designs and sells luxury handbags through eleven retail stores, its own website, as well as through other retailers, such as department stores.
Markel's acquisition of Lansing Building Products is currently pending but should close in the second quarter. Lansing will buy another company at the same time Markel acquires a majority of Lansing. Combined, those transactions are worth $547 million, meaning once the deal closes Lansing will become Markel Ventures' largest subsidiary.
First Quarter Performance
Covid-19 had a material impact on Markel's underwriting performance in the first quarter. Underwriting losses totaled $240 million driven by $325 million in pandemic related losses. The losses are primarily from the international segment where, unlike the United States, standard policy language did not typically have pandemic exclusions.
Readers of Markel's letters to shareholders through the years know that the company is nearly fanatical about proper reserving and seeks to reserve in a way that makes reserve redundancies more likely than not. The $325 million hit to underwriting performance in Q1 was not the result of actual claims, but an increase in incurred but not reported reserves. Those reserves were estimated by reviewing actual policy language and estimates of industry-wide losses. It is certainly possible that those reserves will prove inadequate and further underwriting losses from the pandemic will appear later this year and there is also some chance that the $325 million set aside will prove to be more than sufficient. Time will tell.
Premiums grew strongly in the quarter (+11%), benefiting from what was shaping up to be a good year for property and casualty insurance. On the first quarter earnings conference call, the company stated that new business (particularly small business-driven new business) has been down over the past six weeks but that renewals have stayed strong. Those two factors have netted to roughly flat premiums so far in the second quarter.
Investment results were hit by declines in equity markets, which produced $1.7 billion in losses. Markel's equity portfolio declined by 22% and Markel's total investment portfolio had a taxable equivalent loss of 7% in the quarter. That compares to an about 20% decline in the S&P 500. Markel did not buy the dip and was a modest net seller of equities in the first quarter.
ILS revenue was flat in the first quarter, Nephila continued growing while CATCo continued shrinking as it further runs off its business. While no major changes to the business are expected in the short-term, further declines in interest rates and a stock market that is not that far from all-time highs could provide a growing tailwind for the market since it gives investors the opportunity to invest in an uncorrelated asset class. In addition to being an asset manager, Markel also invests in its own ILS funds. These investments are part of the equity securities portfolio and amounted to $131 million at the end of the first quarter, up from $46 million in the prior quarter. An additional $90 million was invested in CATCo funds to facilitate the return of capital to other investors.
Markel Ventures' financial results through the first quarter do not yet include the effects of pandemic related disruptions since results are reported with a one month lag. Reported revenues were 12% higher than a year ago due to the purchase of VSC Fire & Security in November. That acquisition will continue providing a non-comp benefit for the remainder of the year. Non-comp revenues will also appear from Lansing once that deal closes.
All in all, despite definite uncertainty regarding the near term impacts to underwriting and Markel Ventures, first quarter book value per share declined by 12%. That is not to say that intrinsic value necessarily also declined by 12%, particularly since the book value of Markel Ventures is not marked to market. But, it does demonstrate the conservatism of the overall company, particularly in regards to how its fixed income portfolio is managed.
Investors were not pleased with Markel's first quarter results and the stock is down 7% since its release. Since the losses in the equity portfolio were no surprise and any impact to Markel Ventures did not show up in the Q1 report, it would seem that the underwriting loss and uncertainties on the Covid-19 reserving is what surprised investors and prompted the negative reaction.
To be sure, Markel will not escape the effects of the current pandemic and the company's intrinsic value has declined over the last two months. But, the company also has a long history of building wealth and managing the company conservatively. Its cumulative price declines from its February 20th all-time high is now 38%. Despite a bounce, Markel's stock is only up 12% now from its recent lows of March 23rd.
Four valuation models are presented below in order to more precisely gauge the attractiveness of Markel currently as an investment.
Historical Price to Book Valuation
Price to book is the most useful valuation metric for most insurance companies because fixed income and equity securities get marked to market in financial statements. The estimated economic goodwill associated with underwriting plus the tangible book value of the company should equal the intrinsic value. Some insurance companies, such as Progressive (PGR), have a great deal of economic goodwill and trade at multiples of their tangible book value, while others, such as many reinsurers, have little and generally trade closer to tangible book. Over time, though, intrinsic value for a particular insurer tends to track to a relatively consistent multiple of book value.
Markel's ownership of Markel Ventures, ILS managers, and State National make the price to book ratio less relevant as time goes on. Not only do increases in the value of those businesses not get reflected on the balance sheet, but purchase accounting requires that many acquired companies be carried on the balance sheet for less than even their cost.
Still, the price to book ratio is not completely irrelevant, just increasingly limited. Since not all of the company's current value creation is being captured in accounting book value it is likely that the historical relationship between intrinsic value and book value will somewhat understate current intrinsic value.
Tracking Markel's price to book ratio at the end of each year for the last decade produces an average of 1.36x. Adjusting book value for changes in the value of Markel's equity portfolio since the end of the first quarter would imply a fair value of close to $1,000 per share today.
Markel's fair value over the last decade if the price to book value relationship was held constant at 1.36x vs. Markel's share price (top) and Markel's share price, book value per share, and price to book ratio at the end of each year, the end of the first quarter, and currently (bottom). Book value per share is estimated to be $730 per share after including changes in the value of equity securities during the month of April. Source: Author.
The two-column approach takes the investments of the company (first column) and then adds to that figure the value of the company's non-investment related earnings streams (second column) by applying an appropriate multiple to them.
This is an approach that is often used in valuing Berkshire Hathaway (BRK.A) (BRK.B). Warren Buffett guided investors down the path of using the two-column approach in his 2010 letter to shareholders.
The below chart is one attempt at using this same approach to value Markel.
Markel valued using a two-column approach, 2010-Present. Investments, Debt, and Net Investments in millions. Shares outstanding, Markel Ventures Adjusted Operating Income, Other Adjusted Pre-Tax Income, Underwriting Pre-Tax Income, and Non-Investment Pre-Tax Income in thousands. Source: Author.
The investments total includes cash and restricted cash and uses the rough estimate of ~$21 billion after increases in the stock market in April. Consolidated debt is then netted against this number to get a net amount of investments. Presently this figure is ~$1,264 per share.
Markel Ventures adjusted operating income is calculated by adding back amortization of intangible assets to pre-interest and pre-tax income. Put another way, the figure equates to EBITDA less depreciation. Despite VSC still being non-comp in the financial statements, the present figures are cut by about 10% from the trailing twelve months figures at Q1's end in the 5/1/2020 calculation in order to account for destruction of value from the pandemic.
Similarly, the "Other" adjusted operating income is the pre-tax income with impairment and intangible asset amortization added back from the ILS and State National businesses along with some miscellaneous income and expenses such as the consulting business gained from the acquisition of Abbey Protection several years ago. Finally, underwriting pre-tax income is added to the final figure.
Multiples for the business are set at 10x pre-tax income prior to the reduction in the United States corporate tax rate in 2017 and 12x after that change. Both multiples in their respective time periods should produce an equivalent after-tax multiple of 15x.
These assumptions produce a current value of ~$1,500 per share. Because underwriting profitability can be volatile year to year, this approach will cause some variability in estimates of intrinsic value as well. A clearer approach may be to do the identical calculation using a five-year moving average of insurance underwriting profits. That calculation is shown below, which results in an intrinsic value for Markel of ~$1,650 per share.
An adjusted two-column method to valuing Markel that averages underwriting earnings over rolling five-year periods. Investments, Debt, and Net Investments in millions. Shares outstanding, Markel Ventures Adjusted Operating Income, Other Adjusted Pre-Tax Income, Underwriting Pre-Tax Income, and Non-Investment Pre-Tax Income in thousands. Source: Author.
The two-column approach is an approach used by many and it is presented here as there is some logical merit in this method. But, for Markel, it is an approach that will almost always result in overestimating intrinsic value as the chart below helps to demonstrate.
Markel's fair value over the last decade using a two-column approach and averaging underwriting earnings over rolling five-year periods compared to share price. Source: Author.
The reason is that Markel's fixed income portfolio is large and must be invested in relatively low rates of return. Holding these safe, liquid, and low-return securities is simply part of Markel's business. The capital cannot be used for other purposes should be treated as such.
Markel holds cash and investments equal to about 4x annual premiums. If a 95% combined ratio, 21% tax rate, and 2.5% after-tax investment return are assumed then valuing Markel using a two-column approach would result in an earnings multiple on the insurance business of ~30x. It is unlikely that a rational buyer would pay that much for an insurance business.
After considering a valuation likely to understate Markel's intrinsic value and then one likely to overstate its intrinsic value, a sum-of-the-parts valuation is now considered, which is more likely to be closer to the true value of the company. A version of a sum-of-the-parts analysis was endorsed by co-CEOs Thomas Gayner and Richard Whitt, III in the most recent letter to shareholders.
The parts that need to be summed together are the individual sources of value at the company: insurance underwriting, investments, Markel Ventures, and ILS and program services.
Each of these individual pieces can be valued differently by different observers, but here are some straightforward means of valuing each of them.
Markel has had underwriting profits in most years, but their level is erratic simply due to the nature of assuming risk. To capture more normalized levels of underwriting profitability, a five-year average combined ratio is used and applied to current earned premiums. A relatively low after-tax earnings multiple is then applied (12x) because of the volatility of the earnings stream.
This simple approach values the underwriting operations at $1.8 billion currently.
The value of the investment portfolio to shareholders is determined by the size of that portfolio and the expected return from that portfolio.
Over the last ten years, 4% has been returned annually from fixed maturities and 15% from common stocks, resulting in a near 7% taxable equivalent total return from the portfolio (before any foreign currency effects). It seems to be a foregone conclusion that future returns will not match this. Interest rates are extremely low historically and equities continue to be expensive by most valuation metrics.
The chart below shows Markel's actual taxable equivalent investment returns by year going back to 2010 along with five-year rolling averages of investment returns by category.
The bottom figures are estimates of what an intelligent investor may have expected forward returns to have been over the past decade. As equity multiples have increased and interest rates have decreased, so should forward return expectations. At present, only 2.5% fixed income returns and 6.0% equity returns are expected, resulting in an after-tax return estimate of 2.8%.
These investment returns are capitalized by using an earnings multiple that is relatively competitive to equities, currently 20x, which is somewhat less than the actual multiple of the S&P 500, depending on the earnings that are used. Those assumptions produce a value of $11.8 billion.
Over time, these assumptions suggest that Markel's investment portfolio is only worth about half of its books value to shareholders.
Markel Ventures' value is fairly easy to estimate. The operating income plus intangible asset amortization shown below are the same figures presented for the two-column approach to valuing Markel and the earnings multiple used is the same as the multiple used above in capitalizing investment income.
Estimating the impact of the pandemic on Markel Ventures is quite difficult. A large and short-term hit to earnings need not alter the value of the businesses a great deal, but of course it is possible that deterioration to fundamentals lasts longer than a short time. From the valuation that would have been placed on Markel Ventures at the end of the first quarter, a roughly 10% haircut is given for the current valuation. A similar haircut was used for the two-column approach by reducing adjusted operating income from $223 million to $200 million.
It should be mentioned that VSC's contribution to Markel Ventures has not fully shown up on the income statement yet with the deal having only closed late last year. So, the haircut to the Markel's current earnings power given in the below valuation is somewhat higher than the roughly 10% reduction in earnings.
It is also noteworthy that as of the end of the first quarter the acquisition of Lansing Building Products had not yet closed, but should sometime in Q2. That means the cash that will be used is still included as part of cash and investments and the value of the business is not a part of the Markel Ventures current valuation.
Finally, the ILS and program services businesses are the toughest to value at Markel. They hold tremendous opportunity and are key to the company's future, but it has taken time to put the pieces of the puzzle together and a lot of learning has taken place over the last several years.
Although in the future this segment, like any other, should be based on its earnings power, for now it is valued based upon the historical cost to Markel. That includes the unrelated to ILS (but included in the "other" category) Abbey Protection (Note: only a portion of Abbey Protection is actually allocated to the "other" category with the remainder a part of insurance underwriting), acquired in 2015, and Markel CATCo (2015), State National (2017), and Nephila Capital (2018). It is true that CATCo is now in run-off, but the $206 million that was spent to acquire that business was relatively small and much of the lost value should hopefully be replaced by Lodgepine.
Summing together the various sum-of-the-parts assumptions and subtracting debt yields an intrinsic value of ~$1,100 per share.
Historically, Markel's stock has tracked a sum-of-the-parts value fairly closely. The model suggests that the stock was cheap in the early part of the decade before turning expensive up until 2018.
Markel valued on a sum-of-the-parts basis versus share price. Source: Author.
Multiple of Economic Earnings
Markel suffers three major distortions to its reported net income. First, unrealized gains and losses from securities now flow through to the income statement and distort reported net income.
Second, acquisition accounting distorts reported net income by requiring the amortization of many intangible assets. Whether or not those charges to income are appropriate depend upon whether the intangible assets being amortized are actually being used up by the business. In the case of Markel's businesses, overwhelmingly these intangible assets are not being used up.
Finally, because of Markel's large equity portfolio, retained earnings of investees are not counted in Markel's GAAP calculations of net income.
The chart below adjusts for these factors. Also, as was the case in considering Markel's sum-of-the-parts value, insurance underwriting income is calculated using rolling five-year average combined ratios.
On the basis of what could be referred to as Markel's economic earnings, it has not been cheaper since 2012. Today's 14x multiple on trailing earnings may prove to be partially a mirage as Markel Ventures' net income and the retained earnings of equity investees decline throughout this year.
But, if Markel's attractiveness is being weighed in comparison to the S&P 500, earnings across that index will also be affected. Using a market multiple on Markel's economic earnings implies a value of ~$1,300 per share.
Markel has actually historically traded relatively close to a market multiple on economic earnings over the past decade.
How economic events develop this year is unclear, to say the least. That uncertainty means less precision in estimating the intrinsic value of any company at the moment.
But, in valuing Markel, investing in the S&P 500 has been assumed to have been the opportunity cost in developing each of the models. Averaging all four of them together gives an intrinsic value of more than $1,200 per share. That $1,200 per share estimate can be interpreted as the estimated price that would deliver future returns roughly equal to an investment in the S&P 500. The sum-of-the-parts valuation, which is the best way of valuing Markel, values the company at closer to $1,100 per share. Another approach would be to not consider the valuation models likely to give low (historical price to book multiple) and high (two-column approach) valuations. Discarding those two models and instead averaging together the remaining models also yields a value of ~$1,200 per share.
Reassuringly, even using a historical price to book multiple values Markel at a price fairly higher than its last trade. That is important because Markel's value over time should rise relative to its book value as more value creation becomes increasingly difficult for GAAP accounting to capture.
With Markel's history of value creation and conservative management, a price equal to less than 1.2x book value and roughly 14x economic earnings makes Markel a smart bet currently. History suggests that today is the best time in nearly a decade to purchase shares.