Some Thoughts on Markel’s Intrinsic Value

Posted on Posted in Industry-Insurance, Investment Ideas & Company Research

I thought I’d write a post with some quick thoughts on Markel’s value. I recently had a few conversations with a friend regarding how to think about the return on equity that Markel produces relative to the investment return that you will receive as a shareholder. For example, I’ve had a couple questions from clients similar to this: “It’s great that Markel can produce 15% ROE over time, but will we receive 15% if we’re paying above book value?” The current price of Markel is somewhere around 1.3 times book, so this is a relevant question.

First off, I wrote a much more detailed post with my thoughts on Markel earlier this year, so I won’t rehash why I think Markel is a great business here. If you’re interested in what I think about Markel as a business, please check out that post.

But back to the question: If Markel produces X% ROE, will I get X% on my investment if I’m paying above book value?

To answer the question, I need to explain how I think about Markel. Although I’ve referenced Markel’s book value growth over the past few decades, I don’t really value Markel relative to book value. In fact, I don’t usually value anything relative to book value. I’m interested in earning power.

Buffett once made the following comment regarding Wells Fargo:

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

Buffett was talking about banks, but the same concept applies here. Unless Markel gets liquidated, book value is not really relevant. What is relevant is how much value Markel can wring from that equity capital.

So I think about Markel like I think about most other businesses: using a price relative to earning power, not book value. And one way to think about it is this: As long as you are paying a fair price for Markel—one that is equal or below intrinsic value—and Markel can grow intrinsic value at 12-14% per year, then you should expect 12-14% shareholder returns over a long period of time.

And you could look at the P/B ratio of 1.3 to determine valuation, but what I do is compare the P/B ratio to the ROE, which essentially values the business using a price to earnings ratio rather than price to book.

Think about it this way… Markel is priced at 1.3 times book. If Markel produces 13% ROE over time, then you’re paying 10 times earnings at the current price (At the risk of stating the obvious, let’s review simple math and invert our P/B thinking with a quick example of Stock XYZ. Let’s say XYZ has:

  • Book value of $100 per share
  • P/B ratio of 1.3
  • ROE of 13%

In this case, XYZ is priced at $130 per share (P/B of 1.3 times $100 book value), and is producing $13 per share in earnings (13% ROE on $100 book value). So the stock (at $130 per share) has a P/E ratio of 10.

So, if Markel’s ROE averages 13% over time, then at 1.3 times book (roughly the current valuation), Markel currently has a P/E ratio of just 10. If Markel produces 15% ROE over time, then you’re getting the stock at just 8.7 times earnings at the current price. Again, this is probably obvious, but I thought some explanation might be necessary since everyone always likes to talk about P/B ratios when it comes to financial companies. This makes some sense since financial companies’ earning power is somewhat tethered to the amount of capital they have, but what really matters is earning power, not book value.

So I think about the value in terms of price relative to earning power, not directly in terms of price relative to net worth on the books. Markel earns much more on its net worth than most other insurance companies, so I think price to earning power is much more relevant way of thinking about valuation.

Note: Please keep in mind that Markel is priced around 10 times earnings (normal earning power) at the current level, but these are comprehensive earnings, not GAAP earnings, as some of the earnings come from unrealized gains that don’t flow through the income statement.

A Simple Way to Think About Markel

So I’ll lay out a very simple way that I think about Markel (update numbers):

  • $17.6 billion investments
  • $2.3 billion debt
  • $1250 investments per share
  • $510 equity per share
  • 5% after tax investment return = $63 per share in investment earnings

Markel over time has been a consistently profitable insurance business. I’m assuming they will make enough money to pay the relatively small interest charges on the debt along with all other expenses associated with the insurance company.

So in this example, we have a business that produces 12.3% returns on equity, and $63 per share in earnings.

So here is what we have if Markel produces the numbers above:

  • $63 per share earning power
  • P/E of 10.8

Instead of thinking about the return on Markel’s investment portfolio, you could also think about Markel in terms of book value compounding or return on equity. Basically, over time Markel has compounded book value at better than 15% annually, which means that their comprehensive return on equity (including unrealized gains) has been in the neighborhood of 15%.

Also, it’s worth noting what Markel said in the 2013 annual report:

“We believe that the five year change in book value is now just as important a measurement to consider when thinking about the value of your company as the book value itself.”

Basically, they don’t really view book value as a relevant proxy for intrinsic value, but they do view the growth of book value over time as a decent proxy for the growth of intrinsic value over time.

And growing book value (producing high returns on equity over time) is something that Markel has excelled at:

MKL vs. BRK and SP 500

In other words, don’t look at the static value on the books—look at the growth of that value over a long term time period (5 years or more). This will give you a better view on how Markel is doing at growing intrinsic value.

So all of this boils down to a few questions:

  • How fast is Markel compounding intrinsic value?

I would say that if they can produce 12% ROE, they’ll be able to grow intrinsic value at around 12% over time. It’s a back of the envelope way to think about it, but it’s been true over decades, and I think it will be true going forward. One can argue about what their ROE will be going forward. I predict it will be better than 12%. But for now, let’s say the insurance company just breaks even after paying interest and we get 12% ROE, and thus 12% growth in intrinsic value going forward.

The next question is naturally:

  • What price do we have to pay in order to ensure that our investment returns match the intrinsic value compounding?

The answer here is quite simple: In order for our investment returns to match the 12% compounding of intrinsic value, we need to just make sure we pay a price that is at or below the current intrinsic value.

How do we determine this? My method is simple. I think about what a rational private owner would be willing to pay for a business that has compounded intrinsic value at between 15-20% annually for decades, and will likely compound intrinsic value at a rate of 12% for a period of time going forward. And while this answer could have a wide range of values, my guess is that this private buyer would be willing to pay more than 10.8 times earnings, which is where Markel is currently priced.

So to me, it’s that simple. It’s not scientific, and there are no spreadsheet models. I like to keep Ben Graham’s comment in mind that you don’t need to know the exact weight of a 350 lb man to know that he’s fat.

To me, a business that produces 12% (my guess is this is quite conservative) returns going forward and is currently available at 10 or 11 times earnings is a bargain.

My guess is someone would probably pay at least 12-15 times earnings for this type of business.

So to sum it up, Markel has historically compounded its book value at 20%. I think the growth of book value, not the current point in time value, is what’s relevant in thinking about the intrinsic value. As for the current price, Markel is priced around 1.3 times book value, but the way I think about this is simply that 1.3 times book at 12% ROE is simply 11 times earnings.

I think Markel is worth much more than 11 times earnings, and even if I’m wrong, I’m getting a business that is compounding at 12%.

Not bad. Although this would be a satisfactory result, my guess is that we’ll get:

  • Slightly better than 12% returns because of profitable underwriting over time
  • Higher valuation at some point in the future

I don’t need those two things to happen, but if they do, the results from owning Markel at this level should be quite good.

If not, we will be satisfied owning a business that is prudently managed, safe, cheap, and compounding value at a good clip.

Disclosure: John Huber owns Markel for his own account and for accounts he manages for clients. 

9 thoughts on “Some Thoughts on Markel’s Intrinsic Value

  1. John,

    I enjoyed reading this. I have a few disjointed thoughts:
    1) Equity is important in the sense that it’s what drives their earnings, you mentioned this in passing, but I wanted to reinforce it. To grow earnings they need to insure at higher rates, take more risk, or raise capital. Insurance is regulated and I believe there’s a minimum capital level, so earnings are constrained by capital. If they’re over capitalized and have capacity then it’s not an issue, I’ve never looked at the company to know where they stand.
    2) On ROE, why should they earn higher rates verses their peers? The Median ROE for the industry is 10.52%, and the operating ROE median is 9.8%. So Markel is performing better than peers, the question is why?

    I read an article yesterday where the author was discussing returns on equity and moats, he had a great point. That margins, high returns etc appear on the financial statements, but they are the result, not the cause of out performance. So the question is what does Markel do better that allows them to earn higher returns? Secondly why can’t their competitors do the same thing and take some of the market from them over time?

    3) The peer P/B is 1.24, so they seem to trade in line with industry peers on a P/B basis.

    4) What are your thoughts on bond yields? From a few headlines I browsed it looks like earnings are dropping across the board due to high yielding bonds rolling off and being replaced by lower yieldings bonds.

    A lot of random thoughts, but I’d be interested in your view.

    Nate

    1. Hey Nate,

      First off, huge fan of the blog. I’ve enjoyed reading many of your posts and analysis.

      As for Markel:
      1) There are few things about the company that makes it unique from traditional insurance companies. The main one is that the company operates in specialty insurance which is insurance for unique situations (ie. Markel provides insurance for horses). Due to the unique nature of this kind of insurance, it allows these companies to operate in niches and customers focus more on service and availability rather than price. This expands the moat of companies that have good relationships with customers and that provide many different products. This also means that specialty insurance industry is more prone to cyclicality.

      When it comes to the US, specialty insurance companies are non-admitted, which means they don’t participate in the state guaranty fund and have overall less regulations. Instead the company pays fees to the state to operate there.

      Markel adheres to the profitable growth ideology. They underwrite insurance products which they think will give a good return and require little reinsurance, instead of focusing on increasing the number of premiums written.

      2) Based on traditional ROE, the company is lagging significantly compared to the industry. This is because a lot of their assets are in stocks rather than bonds and short term investments. Thus the returns for these never show up on the income statement unless it’s dividends or selling equities. That’s where comprehensive income and Thomas Gayner’s (CIO) value investing acumen comes into play. Over time, the company has had significant return on it’s equity holdings and that’s what differentiates it from other insurance companies. Not many insurance companies have a significant portion of investments in stock, let alone get good returns on them. So yes competitors can easily copy the company in following this equity investment route, but can they copy the returns?

      3) P/B is not very useful for an insurance company because based on accounting practices, the company’s float is a liability, while in reality it provides a great opportunity for growth and additional returns. If you look at the company’s combined ratio, float and cost of float, they have done a tremendous job at it. Consider float as a revolving credit facility and companies that have a negative cost of float over time is kinda like if the credit facility had a negative interest rate. Paying less money over time, while investing in the intermediate and getting some good returns.

      4) As for bonds, there is some risk there. According to the 2013 Annual Report, if interest rates increase 2% the fair value of their fixed income portfolio and shareholder’s equity decreases ~10%. Since then, the company has been letting it’s short term bonds run out and have been instead increased their longer term (5+ year) bond portfolio. Also an important thing to note is that an increase in interest rates effects the company’s book value, not intrinsic value because the company normally holds their fixed income until maturity.

    2. Hi Nate… Thanks for your comment. You raise good questions/points. And it’s correct that an insurance company’s earning power is tied to the amount of capital it has to deploy (similar to banks, which I know is an area of expertise for you). But like banks, ROE can vary widely from company to company. Just like how Wells Fargo can always seem to generate (or at least always has for decades) better ROE than its peers, Markel has done the same in insurance.

      I wrote a more detailed post as to why I think this is the case… I think there is a link in the article to a post I did in April that discusses more of Markel’s advantages (in my opinion). One big reason is management. When you talk to management, or read their letters, it becomes clear that they possess a shareholder friendly, long term view. They are incentivized to produce underwriting profits (as opposed to revenue). And not only that, but underwriters are judged based on long term (5 years for example) performance.

      But I think even more important than how they are paid is the culture of the firm. It’s hard to get this from the financial statements, but I think that a conservative, ownership mentality exists at Markel that can’t really be replicated easily at other firms. This probably stems from the fact the company started in 1930 and has been a family owned and controlled business for decades. It went public in 1986 to provide some liquidity for cousins and some family members, but even then it really operated more like a family partnership than a public corporation.

      So I think the culture creates a mindset that focuses on maximizing shareholder value vs job security/paychecks, etc…

      I think this is why Markel has been able to compound book at 20% or so since 1986 vs probably 10% or so for the average insurance company.

      As for competitors, I think it’s really hard in a commodity business like banking or insurance to do the things that are necessary in the short run that will create maximum value in the long run. I actually think running an insurance business is very similar to value investing… it is a fairly straightforward business–simple, but not easy. It takes patience, and discipline, but it can be a very good business if you have the ability to look past short term underperformance (in soft markets it’s especially difficult for executives to sacrifice current revenue even if they know they are taking more risk writing business).

      I think this culture/mindset is very difficult to replicate unless it’s been ingrained into the culture of the business for a long time.

      On the valuation–Markel isn’t cheaper than comps using a P/B comparison, but I think it’s a much better business, and likely more valuable at the current price than most others. As I mentioned in the post, I kind of think about it on it’s own absolute value… If I think the value will compound at 12% going forward (at least for a period of years), and I am paying only 11 times earnings, that’s a pretty good value.

      As for the bonds, I don’t have any idea when/if rates rise, but if they do, earnings should actually increase over time when interest rates rise. But in the meantime, just like banks, low rates put pressure on earnings (similar to NIM at a bank… low rates create lower margins). I think Markel has a pretty asset sensitive balance sheet, meaning that eventually I think higher rates will improve earning power as they reallocate into higher yielding bonds. Of course, if rates don’t rise then it will continue to put a lid on earning power from the investment portfolio as you suggest.

      Also, their equity portfolio is quite small relative to historical standards, and I think if/when we ever get a market decline, Gayner will likely be shifting the portfolio more into stocks. Currently, only around $3.5 billion of nearly $18 billion investment portfolio and $7 billion equity is in stocks. Gayner wants to eventually get the stock portfolio equal to about 80% of shareholder equity, but I think he’s probably just taking his time given the market conditions.

      Anyhow, those are just some thoughts. Thanks for your comment Nate.

  2. Hey John,

    Nice post.
    Regarding your saying –
    “In order for our investment returns to match the 12% compounding of intrinsic value, we need to just make sure we pay a price that is at or below the current intrinsic value.”

    I don’t think it’s right to say that ‘intrinsic value’ gets compounded at 12% annually. If that was the case it wouldn’t really be the intrinsic value, because it’s obvious that it’s way better than what anyone can get from the average market, or in other words, it’s much better than most people required rate of return.

    Intrinsic value of any business should get compounded at the long term average rate of return of the market or industry in which it operates.

    That becomes clear as we understand that the value which gets compounded at 12% per annum in Markel’s case is shareholder’s equity; and it may even be only intangible shareholder’s equity. So, of course this is why the business is selling for more than it’s shareholder’s equity, as people are willing to get less than 12% compounding per annum.

    Kind regards,

    Michael

  3. Thanks John another interesting post on what is I believe a very well run business.

    Your analysis does make one very important implicit assumption when you equate ROE with growth in intrinsic value and that is that the company can continue to reinvest earnings at that same rate of return (i.e. 12%). As Markel operates in smaller niche “excess and surplus” lines (and is a very disciplined underwriter and conservative reserve-er) I believe the opportunity to continue to invest at the same high rates that have been achieved historically only gets harder as the company gets larger.

    I am not making a judgement call on the exact rate you have assumed (the 12%) as I know that is more conservative than what has been achieved historically but I would like to hear your thoughts on how/where Markel can deploy that capital to continue to achieve those types of returns on equity?

    Is this something worth considering or are you sufficiently comfortable that this management team will find a way of doing it given they have achieved even better growth in book value historically?

  4. Hi John

    Excellent post and lot of good reasonings. I have been reading your post for long time now and always wait for the next post. I also read your article on Gurufocus yesterday about MKL and it is indeed, a great learning …. a lattice network. Thank you very much for your time and sharing insight.

  5. Hi John, great blog…

    I agree no one would argue 11x is expensive for MKL. But here your explicit assumption is they will be making 5% after-tax investment return. How likely is that considering the fixed income and equity environment we are in?

    Any thoughts? Thanks…

  6. A Simple Way to Think About Markel

    510 x .123= 62.73 earnings
    p/e x earnings (10.3 x 62.73) = 680
    Where are you getting the 680 dollars that you are dividing to get the PE ratio? are you using the current price?

    Kindly,
    Roberto

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