Markel (NYSE:MKL)

Trading at a 30% discount to value?

As outlined in my previous Decision Journal Entry 3, my strategy going forward involves allocating any additional capital I have to high-quality compounders. With that in mind, I am pleased to introduce the first stock that falls within my circle of competence. Markel Corporation, a company characterized by its exceptional qualities as a strong compounder, boasts a long-term oriented and shareholder-friendly management team.

For those who may not be familiar with Markel, let me provide a brief summary of their operations:

Markel operates mainly in 3 businesses:

1. Insurance

2. Investments

3. Markel Ventures

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INSURANCE

If you're unfamiliar with how insurance works, let me provide you with some information. Let's say you're a passionate car enthusiast who recently purchased a classic vehicle like the iconic 1965 Ford Mustang. Considering the significant investment you've made, it's only natural to seek insurance coverage to protect your car against accidents, fire damage, or theft. To obtain this coverage, you would approach an insurance provider and pay a monthly fee, known as a premium, to ensure that you can receive reimbursement, known as a claim, in case any unfortunate incidents occur.

For an insurance company, the revenue they generate primarily comes from the premiums collected from customers. On the other hand, their total expenses consist of the costs associated with acquiring new customers (operating expenses) as well as the claims they pay out for insurance coverage. In the insurance industry, there is a widely-used profitability metric called the combined ratio, which evaluates the financial performance of an insurance company. It is calculated by dividing the total expenses by the premiums collected. If the resulting ratio is below 100%, the company is operating at a profit; conversely, if it exceeds 100%, the company is operating at a loss.

Returning to the discussion of Markel, it's worth noting that they hold the third position in the industry as the 3rd largest operator, commanding a 5.1% share of the Excess & Surplus (E&S) line. They trail closely behind industry giants such as Berkshire Hathaway's Alleghany and AIG. Excess & Surplus lines represent a specialized market that provides insurance coverage for risks that standard carriers are unwilling to insure. Succeeding in this segment often requires an in-depth understanding of each specific coverage, along with its conditions and exclusions.

One remarkable aspect of Markel's performance lies in their consistently low 5-year average combined ratio, standing at approximately 94%. This signifies that their past insurance operations have proven to be inherently profitable. It's important to note that in the insurance industry, there is typically a lag between when policies are written and when most claims are actually filed. Therefore, the profitability of Markel's insurance operations can be attributed to this lagging factor, where claims often emerge a few years after the policy is initially written.

If you take the time to read through all the Annual Letters to Shareholders (which I highly recommend doing), you'll discover that Markel nurtures a culture that empowers their insurance agents to decline writing policies that are unlikely to be profitable. This is mainly due to the fact that their compensation packages are directly linked to the profitability of the insurance they underwrite. As a result, it is in their best interest to prioritize writing the most profitable policies possible.

However, this approach does present a potential challenge. If agents choose not to write insurance, it can lead to a lack of revenue generation, which may put their job security at risk. Nonetheless, Markel has explicitly stated their commitment to retaining employees even during soft markets when competition intensifies. This is primarily because Markel's operating expenses are relatively low compared to the expenses incurred from underwriting unprofitable policies.

By maintaining this balanced approach, Markel demonstrates a strategic focus on profitability and prudent risk management, ensuring that their insurance operations remain sustainable and resilient even during challenging market conditions.

Additionally, Markel's track record of surpassing the industry's growth rate underscores their ability to seize opportunities and expand their market presence. This growth trajectory reflects their competitive edge and their adeptness at capturing market share within the E&S industry.

Considering these factors, I am optimistic about Markel's future prospects and their ability to maintain a strong position within the E&S market.

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INVESTMENTS

In the case of Markel, the premiums collected from insurance policies are typically invested in bonds that align with the anticipated duration of potential claims on those policies. This investment strategy ensures that funds are available when needed to fulfill claim obligations.

Any remaining profits, along with cash received from equity investors, are allocated towards investments in common stocks or utilized for the direct acquisition of businesses through Markel Ventures.

The following is Markel’s investment philosophy for common stocks and private businesses, essentially a repeat of Warren Buffet’s philosophy as is their insurance operations:

1. Good returns on capital and not too much debt

2. Run by managers with equal measures of talent and integrity;

3. With reinvestment opportunities and/or capital discipline,

4. Reasonable valuations.

Markel’s Investment Portfolio: Link

Tom Gayner has been the manager of Markel's equity portfolio since the 1980s and has established a strong track record of outperforming the market in most years. His exceptional investment acumen and long-term focus have contributed to his reputation as a brilliant investor. Gayner's investment philosophy centers around holding investments for extended periods, allowing compounding to work its magic over time. With one of the best money managers overseeing the portfolio, I have a level of reassurance that Markel's investments are in capable hands.

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VENTURES

Markel Ventures is a division of Markel that specializes in acquiring full ownership of companies while allowing their original owners to continue operating the businesses. Within Markel Ventures' portfolio are businesses like Brahmin Handbags, Buckner Heavylift Crane, Captech, and others, predominantly comprising capital-intensive industries. The following are the financials of the aggregate of Markel Ventures:

Revenues:

2022 - $4.8 Billion

2021 - $3.6 Billion

2020 - $2.8 Billion

EBITDA:

2022 - $0.5 Billion

2021 - $0.4 Billion

2020 - $0.36 Billion

Revenues within Markel Ventures have shown notable growth, indicating a positive trend. Furthermore, EBITDA has also experienced growth, albeit at a slightly slower rate. It's worth noting that Markel's successful investment strategy implemented in their equity portfolio is replicated in their private equity business as well. This replication provides the expectation that similar successful investment practices will continue to be applied in the future.

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VALUATION

In this conservative analysis, we will refrain from projecting Markel's financials into the future and focus solely on evaluating the discount at which it is currently trading compared to its intrinsic value.

a) Valuing the “Float“ (Insurance Operations):

When examining Markel's "float," which represents the funds they can invest prior to paying out claims to policyholders in the future, it is important to consider their cost of float. A negative cost of float, indicated by a combined ratio below 100%, implies that Markel is effectively being paid to manage the policyholder's funds.

The negative cost of float is an advantageous position for Markel, as it enables them to access capital at essentially no cost. So, taking an average of their operating income from insurance operations for the past 5 years, they have generated $200 million as a result. Applying a multiple of 7x as an assumption, their “float“ is worth at least $1.4 billion.

Note: If the insurance operations were not positive, there cannot be a positive value assigned to the float. In fact, the value of the float should be taken entirely as a liability.

b) Valuing the Investment Portfolio:

The value of the investment portfolio can be derived from the available balance sheet, which currently stands at approximately $20 billion.

c) Valuing Markel Ventures:

Based on Markel Ventures' current EBITDA of $500 million, applying a conservative multiple of 7x would yield a valuation of at least $3.5 billion.

d) Net Cash Position:

From the balance sheet, it can be observed that Markel has cash holdings of around $4 billion and total debt of $4 billion, resulting in a net cash position of zero.

By summing the values obtained in a), b), c), and d), we arrive at a total valuation of approximately $25 billion. Presently, the stock is trading at about $18 billion, providing a considerable margin of safety.