2023-11-24 04:58:18 ET
Summary
- Markel's fixed-income portfolio is profiting from higher interest rates, with recurring interest and dividend income growing 70% during Q3.
- Despite already holding over 70 times his base salary in Markel shares, CEO Tom Gayner has continued to acquire shares in the open market.
- The stock is trading in its low valuation range from both a book value and net income perspective.
- I expect Markel to outperform the market with a 24% stock price increase in 2024 and an 18% CAGR over five years.
There are not so many stocks that investors can confidently hold with the expectation of strong performance over decades, but I am of the opinion that Markel Group (MKL) is one of those.
In this article, I will look at what allows a company to compound at a 15% annual growth rate for over 36 years, and more importantly, what should investors expect in the future.
Markel's Background
Markel was founded in 1930 to insure jitney buses by Sam Markel, who was joined by his four sons and helped draft the Motor Carrier Act of 1935 that regulated the growing bus and truck industries.
After gaining a national reputation as an industry leader, it expanded to Canada in 1951 by founding Markel Service Canada, Ltd., which later reorganized into the current Fairfax Financial ([[FRFHF]], FFH:CA ).
Markel became a publicly listed company in 1986 at an initial price of $8.33 per share with a market cap of ?$30M, and expanded through acquisitions in the insurance industry and by opening an office in London, gaining access to the international specialty insurance market.
In 2005, Tom Gayner, the current CEO of Markel, became aware of a company for sale named AMF Bakery Systems, which was also located in Richmond, Virginia. Gayner knew the CEO and after analyzing the opportunity, Markel decided to diversify from the insurance business, copying Warren Buffett's playbook and allocating part of the insurance funds to other businesses. Since then, it has been building its three-engine system.
Three-Engine System
The three-engine system provides diverse income streams, a wider range of opportunities to deploy its cash flows, and greater diversification the long-term growth.
Insurance
Markel is not a classical insurance company, where competition and regulations are higher. In contrast, it is highly specialized and most of its earned premiums come from specialty insurance products that provide coverage for hard-to-place risks in niche markets such as earthquake-exposed commercial properties, equine and horse club insurance, classic cars, and marine, among others.
To successfully operate in niche markets, many of the larger accounts are highly customized and Markel leverages its expertise by assigning teams of experienced underwriters and claims specialists.
Through a higher degree of specialization and extensive experience in its particular markets, Markel generates significantly higher returns than the average insurance industry.
While the average combined ratio for the overall property and casualty insurance industry between 2013 and 2022 was at 99.4%, during the same period Markel had an average combined ratio of 95%, which is an outstanding overperformance.
Source: Author (Data from Markel Group's Annual Reports)
As shown in the chart above, Markel has been consistently growing its earned premiums since 2010 and only had two years with underwriting losses (combined ratio above 100%). It is important to note the 2017 abnormal level of natural catastrophes such as hurricanes Harvey, Irma, and Maria, and the Mexico City earthquakes had significant impacts and the company has reduced its exposure to natural catastrophe risks.
Source: Author (Data from Markel Group's 2022 and 2014 Annual Reports
During the recent years, Markel has reduced its premium volume in the property segment, which is mainly related to catastrophe-exposed risks.
Investments
To boost its profits, Markel uses the cash provided by the insurance business to invest in equities and fixed-income securities, maintaining a mix that ensures future claims coverage.
Source: Markel Group 2022 Annual Report
Over the long term, the fixed income operations provide lower returns compared to the equity portfolio, but they have the highest level of short-term liquidity and are matched with the expected pay to insurance policyholders. The portfolio has an average rating of "AAA," with 99% of the securities rated "A" or better.
In equity operations , Markel's portfolio has outperformed the S&P 500 ( SPY ), averaging a 14.4% annual return over the last 10 years and a 12.5% over the last 20 years.
Source: Author (Data from Markel Group's Annual Reports)
The portfolio currently holds 133 positions, but 50% is concentrated in 14 companies.
Source: Dataroma
To achieve these superior returns over such a long time frame, investment decisions are guided by four key aspects:
- Good returns on capital and low debt.
- Run by talented, reliable, and trustworthy management.
- Reinvestment opportunities and good capital allocation.
- Reasonable valuation.
Seems fair to me. Although one might not agree with all of their holdings or might be missing some company that could fit in the portfolio, it is important to remember they are stewards of capital, so their investment perspective is not the same as mine or yours, and they need to look for a balance between beating the market and not being too defensive.
Markel Ventures
The third engine is Markel Ventures, a portfolio of businesses that operate independently in a variety of industries such as building materials, food, cranes, trailers, or fire suppression and security systems, among others.
Markel has built the portfolio by acquiring entire businesses or a controlling interest, and from its own start-ups, investing ?$3.4B since 2005. These businesses returned $1.5B to Markel over the years, and revenues have been consistently growing.
Source: Author (Data from Markel Group's Annual Reports)
Capital Allocation
To allocate its multiple sourced cash flows, Markel conducts a four-step process:
- The first choice is organic growth, prioritizing the people inside the organization with a proven track record that brings up opportunities to expand an existing business.
- Secondly, they look for acquisitions in the insurance or Markel Ventures segments.
- If there is still capital unallocated, Markel looks for publicly traded equities that meet their criteria.
- Finally, if they believe Markel shares are undervalued, they buy back their own shares.
I believe this is the best capital allocation possible, and it's worth noting that Markel doesn't distribute dividends, but in case there is capital unallocated they buy back shares, a more tax-efficient way to return capital to shareholders.
Management
Markel is currently led by Tom Gayner (age 61), who joined the company in 1990 in an asset management role, became Chief Investment Officer in 2010, and co-CEO in 2016. He started to learn accounting at a young age since his father himself was an accountant, and before joining Markel gained experience in sales and accounting, working at PricewaterhouseCoopers LLP.
I can't recommend enough reading his annual letters and listening to his multiple interviews, since I believe they are highly enlightening for anyone interested in business and investing.
Markel's executive team has extensive experience and has been in the company for many years. The President of the Insurance division joined the company in 2002 and the President of Markel Ventures in 2004.
The board of directors includes Markel family members who have been in the company since 1975 ( Steven Markel ) and well-known names such as Lawrence Cunningham , who is a director and Vice Chairman at Constellation Software, Inc. ([[CSU:CA]], [[CNSWF]]).
Compensation Structure
The compensation structure is as good as it can be, incentivizing long-term decision-making and shareholder value creation.
Executive management receives a base salary ranging from $0.5M to $1M, and a variable compensation based on the compound annual growth rate ((CAGR)) in book value per share, and the CAGR in the stock price over five years. Variable compensation compromised ?75% of total compensation during 2022 and is mainly received in equities vesting over three years.
For every extra point of accomplished CAGR over 5 years, management compensation increases.
Source: Markel Group 2023 Proxy Statement
This compensation structure avoids short-term thinking and taking unnecessary risks to earn incentive compensation.
We don't forecast future economic conditions or geopolitical circumstances. We focus on what we can control and do. We do our best to prepare ourselves to survive and persist no matter what comes our way.
Over decades, we've lived and grown despite bouts of inflation, deflation, dollar strength, dollar weakness, wars, energy shocks, political shocks, labor shortages, natural catastrophes and more.
(Source: Thomas S. Gayner, Chief Executive Officer. 2022 Letter to shareholders)
Ownership
The stock ownership guidelines require that the CEO maintain a stock ownership of at least five times the base salary and other members of senior management at least one to three times the base salary, depending on the position.
Overall, the board and executive members as a group own 1.75% of Markel's shares, being the largest individual shareholders the Chairman of the Board Steven Markel (?$150M), his cousin Anthony Markel who started in 1964 and retired recently (?$116M), and Tom Gayner (?$70M ).
Although I would like the combined management team to own a higher percentage of the shares, it is important to note it is an almost $20B company, and highly I value the fact that the CEO owns 70x of its base salary .
Financials and Valuation
Markel's accounting shouldn't be looked at from a GAAP perspective, since unrealized profits and losses on the equity investment portfolio are accounted as revenues.
To evaluate the company, we can use the market cap to book value ratio, which has been useful over many years, but as Tom Gayner and Warren Buffet have recently stated, it is becoming a less reliable method given the increasingly asset-light nature of many businesses. From a book value perspective, the stock is currently trading at its low long-time range.
In Markel's case, I prefer to use market cap divided by underwriting profit, net profit from Markel Venture's businesses (adjusted for intangible amortization) plus interests and dividends received, increased by the average long-term profits from equity investments.
As shown in the table presented above, since 2013 the average last twelve months ratio to total profit has been at 9.5x.
If we take into account the data for 2023, during the first nine months Markel has generated an underwriting profit of $283M, dividends and interest income totaling $521M, and a $392M adjusted profit from Markel Ventures. The equity portfolio is currently valued at $8.57B.
By annualizing the income from the insurance segment, dividends and interests, and the profit from Markel Ventures, plus a 12.5% return from the equity portfolio, which has been the average over the last 20-year period, we arrive at a total income figure of $2.54B.
Given the current market cap is at $19B, we get a market cap to total profit ratio of 7.5x, suggesting significant undervaluation when compared to the historical average.
Other factors that support my thesis are that the CEO has been purchasing shares in the open market during 6 of the last 7 quarters, investing approximately all of its after-tax salary, and Markel has increased the pace of its share buybacks, reducing the share count by 1.83% during the last twelve months, higher than the average annual decrease of 0.5% observed over the last seven years.
Considering that our investment decisions should not rely solely on historical performance, let's take a look at future expectations for Markel.
Expected Growth
In the upcoming years, I anticipate that underwriting profits in the insurance segment will experience a growth rate of 10%, which is slightly lower than the long-term average of 12%, given the higher interest-rate environment and increasing price competition in the insurance business.
On the other hand, the fixed-income portfolio will produce higher income due to the higher interest rates. My assumption is a 7% growth rate in this segment, above the 4.6% CAGR since 2004, since the historically low-interest rates we had during the last decade which are reverting to the mean, but below the 9% CAGR in the gross premium volume during the same period.
Markel Ventures has been growing its revenues at 25% CAGR over the last ten years, and I will be cautious by projecting a 15% CAGR going forward.
Finally, for the equity portfolio, I expect the same 12.5% CAGR that Markel has achieved over the last two decades, since I believe it is a fair assumption given that we had the 2008 great financial crisis in between.
With these assumptions, I expect Markel to generate almost $3B of total profit in 2024 and $4.6B in five years. Without including any share buybacks and valuation reverting to the 9.5x market cap to the total income average during the following years, I expect Markel's market cap to be at $28.4B in 2024 and $43.7B in five years, with a share price of $1,775 for 2024 (24% return) and $3,290 for 2028 (18% CAGR).
If we do not assume valuation reverting to the mean, the market cap should be at $34.5B in five years, providing a 12.7% CAGR.
Risks
As always, there are no risk-free investments, so let's take a look at what investors should monitor at Markel.
Natural Disasters
Although Markel has a diversified business portfolio, at its core it is an insurance company with exposure to windstorms, hurricanes, earthquakes, and so on.
As we can see from the chart above, the impact of natural disasters has been increasing over the last decades. Even though it is hard to predict the frequency of natural catastrophes going forward, the trend is clear and studies suggest that climate change will increase weather-related disasters.
As commented before, Markel has been reducing its exposure, but this is not the only factor to take into account. Also, the analytical models used to fix prices and capital reserves must be accurate.
Product Development and Competition
The insurance business is highly competitive. There are some regulatory entry barriers and the industry is consolidating, which makes it more difficult for smaller companies to compete, but the sector is undergoing rapid and significant technological changes due to the increasing use of data, so Markel's future on the insurance business will be highly dependent on its ability to adapt, develop new products, and increase efficiency.
Inflation
Inflationary pressures have primarily two effects on Markel's financials. Within the insurance segment, elevated inflation increases the cost associated with claims payments, particularly in longer-tail product lines.
Additionally, this new economic environment influences reserves, which are based on the estimated ultimate cost of settling claims. This, in turn, diminishes Markel's capacity to allocate capital toward higher-yielding sources, such as the equity portfolio or Markel Ventures.
Liquidity Risk
Finally, the aspect that I believe is easier to monitor, but at the same time highly relevant, is Markel's liquidity and its capital allocation.
It is mandatory for Markel's shareholders to supervise the percentage of its investments allocated into highly liquid assets since a major event could force the company to sell assets to cover the claims, which could result in realized investment losses.
For now, I feel safe with Markel's balance sheet and management's incentives, nevertheless, it remains essential for them to sustain a balance between maximizing returns and ensuring long-term resilience.
Conclusions
As Tom Gayner said, just as a poker player can't judge the success of a specific play based on its immediate outcome, but should consider it over the long term due to statistical variation, Markel's success shouldn't be judged by the most recent stock performance.
Markel has a long track record of value creation, and management is taking the right steps towards the future. Moreover, the current stock price appears undervalued, supported by historical data, expectations, and recent share purchases by its CEO.
I view Markel as a long-term investment that can be kept without spending much time looking at the share price or the latest quarterly figures, but just letting it grow over time knowing the capital will be in good hands, and assigning it a strong buy rating expecting a 24% stock price increase for 2024 and an 18% CAGR over five years.
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Markel Group: Outstanding Business For 2024 And Beyond