This post contains my evaluation of Markel (MKL). A lot of the material in the evaluation was taken from SEC filings, various news reports spanning the past 15 years, some interviews with people knowledgeable about the company, and my own analyses. I think Markel is an excellent company, with a future that is still bright after decades of great performance, and is trading at a fairly attractive evaluation.
Markel Description
Markel (MKL) is a U.S.-based specialty insurer with a focus on niche markets. MKL competes in three segments of the specialty insurance marketplace: Excess and Surplus Lines (E&S), Specialty Admitted, and the London markets. For 2008, E&S counted for 53% of gross premiums, the London market for 31%, and the Specialty Admitted the remaining 16%.
MKL’s “A Excellent” financial strength rating was reaffirmed by A.M. Best Company in June 2009. As of August 2008, MKL was the seventh largest E&S writer in the U.S. measured by direct premium writings.
History
Markel was founded by Samuel Markel as an insurance agency in the 1920s, before forming as a mutual insurer writing public transportation policies. In the interest of diversifying operations and growing capital, the company sold a 30% stake for $2.5 million in 1978 to Hogg Robinson Group Limited, a Lloyd’s brokerage firm. In 1980, Essex Insurance Company was incorporated and licensed to underwrite E&S lines. The company reorganized as Markel Corporation, which owned the company’s seven operating entities. In December 1986, MKL made an initial public offering, with a market value of almost $15 million ($8.33 per share). MKL’s share price has grown at a roughly 18.3% annualized rate since then.
MKL has made a number of acquisitions throughout the years, always trying to be very selective. However, its most recent large acquisition of Terra Nova back in 2000 has been a source of recurring unfavorable developments. These unfavorable developments should be at an end now that Terra Nova has been fully integrated into the Markel culture.
More recently, Markel in at the end of 2007 announced a new roadmap for its future with the primary goal of getting closer to their customers with the full array of their product offerings. To achieve this goal Markel is transitioning its wholesale business units to a regional structure with five different regions. Each regional office will be responsible for serving all the needs of the customers located in their regions. With the regional teams focused on customer service and marketing, MKL will have a central product line group that is responsible for underwriting guidelines, pricing, and program design. The product line group’s focus will be to ensure the regional teams have the necessary products and the expertise to underwrite the risk.
Markel’s Strengths
I believe Markel exhibits four strengths that have been key to its long-term success.
- Focus on the small, niche markets
- Underwriting discipline
- Shareholder-friendly management
- Value-oriented investing discipline
The Small and Niche Markets
MKL focuses on E&S lines, lines where the risks are tricky and difficult to assess. In order for an account to be eligible for E&S, it must be rejected by three admitted insurers, which are insurers licensed to do business in the state or country in which the insured exposure is located. If an account is eligible for E&S, this allows the insurer to underwrite unique loss exposures with more flexible policy forms and unregulated premium rates. MKL does not want to get involved in commodity insurance (e.g., auto) as it is a lot harder to compete against the lowest-cost providers.
MKL offers about 100 different insurance products. For example, MKL is the leading provider of insurance to summer camps. MKL also insures such things as horses, dude ranches, child day care centers, fishing and gun clubs, and gymnastics and martial arts schools. “Any area that gives standard insurance companies heartburn we want to figure out how to get actively involved in,” Steven A. Markel has said.
Underwriting Discipline
If you can borrow money at negative rates and invest the money at a high rate of return, the money just has to pile up over the long term. This is what a good insurance company does and it does this by profitable underwriting.
Underwriting discipline and profitability are a part of MKL’s corporate profile. MKL has shown in the past that it is willing to walk away from business or drop entire lines if it no longer is profitable. MKL has also said many times that it is conservative when it comes to loss reserves, choosing to keep them at levels that are redundant, not deficient.
MKL incentivizes its underwriters based on profitability, not on premium. As you can see from the past twenty years, MKL has done an excellent job with its underwriting with only six years of a combined ratio larger than 100%:
| Gross Written Premiums | Combined Ratio | Book Value per Share | |
|---|---|---|---|
| 2008 | 2,213 | 99% | 222.20 |
| 2007 | 2,359 | 88% | 265.26 |
| 2006 | 2,536 | 87% | 229.78 |
| 2005 | 2,401 | 101% | 174.04 |
| 2004 | 2,518 | 96% | 168.22 |
| 2003 | 2,572 | 99% | 140.38 |
| 2002 | 2,218 | 103% | 117.89 |
| 2001 | 1,774 | 124% | 110.50 |
| 2000 | 1,132 | 114% | 102.63 |
| 1999 | 595 | 101% | 68.59 |
| 1998 | 437 | 98% | 77.02 |
| 1997 | 423 | 99% | 65.18 |
| 1996 | 414 | 100% | 49.16 |
| 1995 | 402 | 99% | 39.37 |
| 1994 | 349 | 97% | 25.71 |
| 1993 | 313 | 97% | 27.83 |
| 1992 | 304 | 97% | 20.24 |
| 1991 | 406 | 106% | 15.59 |
| 1990 | 412 | 81% | 10.27 |
| 1989 | 44 | 78% | 11.69 |
| 1988 | 43 | 84% | 9.22 |
MKL has often discussed the math of underwriting at a profit coupled with 4 to 1 leverage (investments to equity) means that a 5% after-tax return on the investment portfolio leads to a 20% gain (or more depending on the underlying profit) in book value. In recent years MKL has fallen short of its 4 to 1 leverage goal.
Shareholder Friendly
Except for a stock split shortly after the company went public—which was necessary to maintain the company’s listing on the NASDAQ—MKL has never split its shares. The company also does not provide earnings guidance to Wall Street. These two items are very important as it shows that MKL is more serious about creating shareholder value than most other companies.
In fact, Markel is probably one of the only companies with an active strategy of cultivating a long-term, value-oriented base of shareholders. Every year after the Berkshire stockholder’s meeting, MKL has a brunch the following Sunday for its own shareholders and anyone who is interested. There are clear benefits to having such a base of shareholders as they are 1) not likely to bail out of the stock with the inevitable bumps in the road that come with running a business and 2) are more likely to provide a more accurate price for the stock.
In regards to management compensation, MKL believes that to the extent that company resources are spent for executives, they are not available to the company or its shareholders. Thus, MKL has always believed that the company and its shareholders should always have first call on these resources. Additionally, MKL does not use compensation consultants and MKL does not use stock options to compensate executives. Executives are given cash bonuses only after achievement of superior returns based on a five-year compound average growth in book value per share. All senior managers at MKL are expected to invest in the company and own a multiple of their salary in MKL stock. At the end of 2007, MKL associates owned 10% of outstanding shares. MKL even provides low-interest loans to employees to buy stock
Value-Oriented Investing Discipline
Tom Gayner is the Chief Investment Officer of MKL. Gayner is a value investor who started out as an accountant who then became a broker and analyst at a small firm in Richmond, Virginia. In 1990 he joined MKL and since then has helped MKL’s investment portfolio compound at almost 17% annually. For the equity portfolio, Gayner looks for companies with four characteristics: profitability; management integrity and smarts; an ability to reinvest returns on capital; and a fair price.
Ten to fifteen years ago, MKL typically had a little over 20% of its investment portfolio in equities. MKL reduced this to about 15% during the 90s when they felt valuations were getting crazy. As of September 30, 2009, equities made up about 18.66% of the total investment portfolio.
In the past five years, Markel has started to make some investments in private companies. The benefit to private investments is that MKL can acquire a much greater portion of a private company than a company that is publicly traded. The current total value of these private investments is about $76 million which is just a tiny portion of the total investment portfolio, but is likely to grow if MKL continues to find attractive opportunities and cultivate the investments it has already made.
- In 2005, MKL acquired a majority stake in AMF Bakery Systems, a Richmond-based manufacturer of high-speed equipment for large bakeries.
- In 2008, MKL acquired a 40 percent stake in First Market Bank and a controlling interest in Parkland Ventures, a mobile-home park operator.
- In November 2009, MKL acquired Panel Specialists Inc., a Texas company that makes panels, wall systems, casework, furniture, and countertops and other stone-related products. Their customers include project managers, architects, and builders within five specialized divisions with annual revenues are over 30 million dollars.
- In December 2009, MKL announced it had acquired a majority interest in Baltimore-based Ellicott Dredge Enterprises LLC. Ellicott has designed and manufactured over 1,500 dredges, more than any other manufacturer, and has served customers in over 80 countries. Ellicott Dredge is the only dredge builder which designs and builds all key components of the dredging system. Ellicott also built all of the dredges used in the original construction of the Panama Canal.
The investment returns have been quite good over the long term. For the year ended December 31, 2008, MKL’s weighted average 10-year annual return was 4.7% versus a return of about -0.78% for the S&P 500. MKL has labeled its private business investments as “investments in affiliates” and they too have performed well even during the financial meltdown of 2008.
| Years ended December 31, | Weighted avg. 5-year annual return | Weighted avg. 10-year annual return | |||||
| 2004 | 2005 | 2006 | 2007 | 2008 | |||
| Equities | 15.20% | -0.30% | 25.90% | -0.40% | -34.00% | 0.40% | 3.60% |
| Fixed Maturities | 4.80% | 3.90% | 5.20% | 5.60% | 0.20% | 3.90% | 5.00% |
| Investments in affiliates | - | - | 13.20% | 8.10% | 3.40% | - | - |
| Total portfolio | 7.90% | 1.50% | 11.20% | 4.80% | -9.60% | 2.80% | 4.70% |
| Ending portfolio balance (in millions) | $6,317 | $6,588 | $7,535 | $7,788 | $6,908 | ||
Risks
Short of another all-out world war, there is probably nothing that will destroy demand for insurance, so I see very little that can kill the company. However, there are two scenarios that could cause a lot of temporary pain for shareholders:
- MKL makes another large acquisition like Terra Nova that hurts them
- Multiple catastrophes occurring in the same year or in consecutive years
In regards to Terra Nova, some background information is necessary. There have only been two times in MKL’s history where management bet the company. The first time was in the early 90s when MKL transitioned from a regional specialty insurer to a national specialty insurer. The second big bet was with the Terra Nova acquisition where MKL sought to move from a national to a global specialty insurer.
With the Terra Nova acquisition, MKL simply overpaid for the insurance business. Coupled with previous bad underwriting by Terra Nova, the integration costs, and molding the underwriters to conform to MKL’s standards, the acquisition was not as good as it was envisioned. However, MKL did acquire a $1.5 billion investment portfolio, which they retooled. I have been told by MKL’s Vice President of Investor Relations, Bruce Kay, that the returns off of the acquired portfolio offset some of the reserve strengthening MKL had to do, which is of some consolation.
In regards to the way MKL thinks about catastrophes, MKL has changed its thinking after hurricane Katrina. Before Katrina, MKL was heavily reliant upon modeling in order to determine expected losses. So when Katrina hit and MKL got a 101% combined ratio for that year, 12 of those points coming from the hurricane, MKL decided to do away with the models. Instead of using models, MKL identified around 50 wind gates, areas of the country that are most susceptible to high damage costs due to wind (e.g., Galveston, New Orleans, Gulfport, Pensacola, Miami, etc.). After identifying the total aggregate values for each of these wind gates, MKL has actively managed their loss exposure by preventing certain geographic areas from underwriting additional coverage and from understanding where they can continue to underwrite coverage. Scale and geographic dispersion are the two requirements for an insurance company to withstand catastrophes. I believe MKL has both the scale and geographic dispersion to withstand catastrophes and is in a better position as a result of its changes after Katrina.
Ownership
I find it helpful to look through 13-HR filings to see who else owns the stock as it can be an indication of the quality of the stock and the quality of the shareholders. If there are many well-respected owners, it is more likely the stock is a good one. With MKL, there are many successful and well-respected investors who own MKL like Chuck Akre, the folks at Southeastern, and the folks at Ariel.
Valuation
As of 9/30/09 MKL’s book value per share was $274.33 and has enjoyed an average price to book ratio of about 1.8 for the past nine years. Applying a 1.8 multiple to the current book value per share we get a share price of $493.79.
If you are interested in what the future share price of MKL may turn out to be, here is a chart that assumes a 10% annual growth rate in book value. I think a 10% rate is a fair estimate as book value per share has compounded at 11.8% annually since 1997.
| 10% BVpS growth rate | 1.5 P/B Ratio | 1.8 P/B Ratio | |
|---|---|---|---|
| 2009 | 274.33 | 411.5 | 493.79 |
| 2010 | 301.76 | 452.64 | 543.17 |
| 2011 | 331.94 | 497.91 | 597.49 |
| 2012 | 365.13 | 547.7 | 657.24 |
| 2013 | 401.65 | 602.47 | 722.96 |
| 2014 | 441.81 | 662.72 | 795.26 |
| 2015 | 485.99 | 728.99 | 874.79 |
| 2016 | 534.59 | 801.89 | 962.26 |
Valuing Markel on a normalized earnings basis, the company appears to be just slightly undervalued. Throwing out the high P/E of 2004, the average high P/E is 18.82 for the other years with positive earnings. Applying this average multiple to estimated 2009 earnings of 21.96 per share, we get a stock price of $413.29 per share. Applying this same multiple to estimated 2010 earnings, we get a stock price of $353.06 per share.
| Diluted Normalized EPS | High P/E | Low P/E | |
|---|---|---|---|
| 2001 | -14.73 | NM | NM |
| 2002 | 7.53 | 29.49 | 22.72 |
| 2003 | 12.31 | 22.66 | 16.37 |
| 2004 | 16.41 | 65.63 | 11.4 |
| 2005 | 14.8 | 18.76 | 11.1 |
| 2006 | 39.4 | 11.8 | 6.46 |
| 2007 | 40.64 | 13.66 | 11.19 |
| 2008 | -5.95 | NM | NM |
| 2009E | 21.96 | 16.53 | 9.51 |
| 2010E | 18.76 | ||
| 2011E | 23.83 | ||
Catalysts
- Large increases in book value due to good investments and profitable underwriting
- If MKL divulges more detailed info regarding the performance of their investments in private businesses, this could be a very positive signal to investors and shareholders of the direction in which MKL is going
0 Response to “Markel (MKL) Evaluation”