Last month, I made the trip up to Richmond, Virginia to attend the Markel (MKL) annual meeting. I’ve owned a few shares of Markel since early 2014 but have yet to write an article about the company (partly because John Huber did such a good job in 2014 – you can read his article here; if you listened to him and bought the stock, you’ve made 60% in just over two years).
While John's writeup was very good, I thought it would be helpful (for my own personal knowledge) to finally sit down and put together some of my thoughts on Markel in writing.
Business
Markel is principally a specialty insurer focused on servicing insureds in niche markets with hard-to-place risks (such as short-line railroads, summer camps, vineyards, wedding insurance and classic collector cars, to name a few). The company has successfully focused its efforts in markets where it has underwriting expertise and the unique knowledge to meet customer needs (both of which would be difficult for new competitors to replicate from a fresh start), combined with the discipline required to avoid new business when risks are inadequately priced.
As an example, consider the company’s experience with its physician product (offered through the Shand / Evanston unit) in the early 2000s. When the market and rates improved from 2001 through 2003, the book of business increased sevenfold. Then, as competitors become more aggressive and drove rates lower, the company let the book of business decline more than 30% in two years. This is just one example of disciplined underwriting in Markel’s insurance business (one of the advantages of writing insurance in numerous niche markets is that it provides some protection against heightened competition in any one business line).
In addition to specialty insurance, Markel competes in the reinsurance business. The business grew significantly in 2013 with the $3.1 billion acquisition of Alterra. In 2015, reinsurance accounted for ~20% of the company’s gross written premium volume ($1 billion of business), on which Markel reported a 10% underwriting margin. The results have been good in recent years, though that can change pretty quickly in reinsurance. It will be interesting to see how Markel performs over the coming years in the increasingly competitive reinsurance business.
Over the past decade, Markel’s insurance businesses have consistently written at an underwriting profit (average combined ratio of 95%) as well as at a lower combined ratio than the industry average. This record includes favorable reserve development in every one of the last 10 years, reflective of the company’s conservative underwriting assumptions (as always, the right incentives play an important role in this outcome: none of the underwriters at Markel receives incentive compensation unless his or her book of business produces an underwriting profit).
Markel has more than $18 billion in investments (inclusive of $3 billion in cash and equivalents) with float predominantly invested in high quality bonds (90% “AA” or “AAA”) and shareholders’ funds invested in equities; in total, that’s roughly $1,280 per share of investments (or 2.3x book value). The duration of the fixed income book has been kept shorter than the company’s insurance liabilities in recent years, reflecting management’s belief that the risk/reward balance on long-term bonds was unattractive. Avoiding long bonds means less interest income in the near term, which materially impacts reported profits (net investment income accounts for the majority of Markel’s pretax profits, with interest from fixed income securities accounting for ~80% of net investment income). By my math, there’s nearly $200 million in “trapped” income that will find its way onto the income statement if net investment income returns to historic levels (measured as a percentage of the investment portfolio); with time, this should meaningfully boost the bottom line.
Over the past decade (through 2015), the company’s equity book has generated returns of 11.2% annualized – roughly four percentage points higher than the Standard & Poor's 500 return over the same period (and meeting its previously stated long-term goal of double-digit returns from the equity portfolio). Given the inherent leverage from the company’s insurance operations, excess returns in the investment book can meaningfully move the needle on long-term value creation.
Large, long-term holdings in the equity portfolio include Warren Buffett's Berkshire Hathaway (BRK.A, BRK.B), CarMax (KMX) and The Walt Disney Company (DIS). The company’s blueprint is similar in investing and insurance: a long-term focus plus disciplined decision-making. In both fields, most participants struggle to stay the course through periods of business decline (measured by written premiums in the insurance business) or underperformance (measured relative to indices like the S&P 500 in equity markets). At Markel, past results prove they’re willing to buck the trend when necessary (an insurer can live with declining premium volumes – but not inadequate pricing).
Finally, the company has a collection of noninsurance businesses called Markel Ventures; these efforts started with the 2005 acquisition of AMF Bakery Systems, a designer and manufacturer of high speed bakery equipment with ~$50 million in revenues. The day-to-day operations of the Markel Ventures businesses are managed locally; strategic decisions, such as large capital expenditures or bolt-on M&A, are made in conjunction with the team in Richmond.
Five years ago, the Markel Ventures business reported less than $200 million in revenues; in 2015, the Ventures businesses collectively reported more than $1 billion in revenues (with adjusted profitability climbing at an even faster pace). The adjusted profits for Ventures in 2015 exceeded its revenues in 2009; the noninsurance businesses are no longer a footnote for Markel.
Ownership and incentives
The directors and executive officers of Markel directly own more than 300,000 shares of common stock – worth nearly $290 million, or $16 million per person, at current prices.
In recent years, nonequity incentive plan compensation and stock awards have accounted for the majority of total compensation for named executive officers (NEO's) at Markel. For both categories, payouts are based on five-year average growth in book value per share. In order to reach the target payout (100%), which is paid as a percentage of the executives’ base salary, book value needs to increase at a 12% annualized rate (this hurdle was moved down from 16% in 2014, reflective of the low interest rate environment and the company’s size). Below target, the payout falls off quickly: if the five-year annualized growth rate in book value per shares is less than 10%, the payout is less than 50% of target. When appropriate, targets are adjusted to directly incentivize executives with control over certain outcomes (for example, 50% of the bonus for the chief underwriting officer is tied to the combined ratio and growth in insurance premiums).
Associates outside of the C-suite are also incentivized to focus on long-term value creation; let me walk through an example of the company’s unique employee loan program to show you how.
At Markel, an employee can borrow up to 100% of their base salary to purchase company stock. Purchases through the loan program include a 5% share bonus. The loans are payable within 10 years and bear interest at 3% annually. The program strongly incentivizes long-term ownership: if the shares are sold, the rate on the loan immediately adjusts to the prime rate plus 7%.
Finally, participants in the loan program receive an incentive payment that’s based on the trailing five-year compounded growth rate in per share book value. For example, if book value increases at a 12% CAGR, employees in the loan program receive an incentive payment equal to 3% of their original loan balance. Note that this hurdle has been lowered over time, just as in the executive compensation plan; employees across the board are held to the same standard.
If we use the 12% CAGR for an example, an employee could borrow $100,000 through the loan program, purchase $105,000 worth of Markel stock (5% bonus) and pay back roughly $85,000 (net) over the course of 10 years (at the 3% incentive level). If the stock price kept pace with the increase in book value, those shares would be worth $325,000 at the end of the decade.
Conclusion
The combination of consistent underwriting profits and solid investment results has resulted in an impressive track record: over the past 10 and 20 years, Markel’s per share book value has increased at a compounded annual growth rate of 12% and 14%, respectively (employees that participated in the loan program have made an absolute killing). While success introduces the headwind of large numbers, management has the leeway to go wherever it wants in its search for value; an unconstrained opportunity set is a huge boon for continued growth.
At the end of the first quarter of fiscal 2016, book value was $590 per share. At $950 per share, Markel trades at 1.6x book value. Personally, I’m quite happy owning Markel at current levels.
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