2023-09-20 10:24:36 ET
Summary
- Markel has a strong track record of compounding book value at a 15% CAGR, but recent years have seen slower growth due to poor execution, this is changing.
- The Insurance segment is expected to see increased profitability due to structural changes and improved pricing in the reinsurance segment.
- Markel's efforts in the ILS segment are showing promise, with Nephila reaching an inflection point and expected to drive growth in revenues and profits.
In this article, I will discuss why I'm assigning an initial buy rating for Markel ( MKL ).
Markel stock performance since 1997 (Seeking Alpha )
Over the past 36 years, Markel stock has compounded at a 15% CAGR with book value following suit handily beating the S&P 500 over this time. This was driven by all three engines; Insurance, Investments and Ventures growth compounding in value. However, over the past 5-6 years the growth in book value has slowed considerably from a mid-teens rate to 7% on average. The failure of the CATCo acquisition, poor performances from Nephila and the Reinsurance segment, along with low interest rates producing very little investment income all contributed to the slower increase in book value.
Over the next 5-10+ years, I believe the business fundamentals of Markel will improve and outperform those of the aggregate S&P 500 driven by contributions from all 3 of the engines and superior capital allocation from Tom Gayner, CEO of Markel.
Insurance
I believe the Insurance segment is set for increased profitability over the next 5-10 years, due to structural changes the company has made over the past few years.
Since 2017 the Insurance segment has been dealing with increased Natural Catastrophe losses with 2017, 2018 and 2021 all placing near the top of the list for industry loss records mainly due to hurricanes, earthquakes and wildfires. This was particularly noticeable in the Reinsurance segment which has consistently posted a combined ratio at or above 100 , with natural catastrophe losses and poor pricing environments persisting, this poor performance from reinsurance has hidden the Insurance segment profitability.
Pricing in the reinsurance segment has started to improve to a point of adequacy and I expect this to lead to the Reinsurance segment posting a combined ratio consistently below 100 over the next 5-10 years. I think this has been demonstrated over the past 2 years with Markel significantly improving their overall insurance profitability, resulting in a combined ratio of 90 and 92 in 2021 and 2022 respectively. Other changes that Markel have made include; reducing their exposure to natural catastrophe risk, this progress has been demonstrated by the little impact Markel has seen from the recent Hurricane Ian, over the long term this will lead to more consistent results rather than the wild swings in combined ratio that have been recorded over the last 5 years. Markel has improved their expense ratio, which I expect to continue as Markel realises rate leverage and continues focusing on cost controls. Finally Markel has a particular focus on disciplined growth, This focus on disciplined growth has allowed Markel to underwrite insurance in the most attractive areas of the market while pulling away from unattractive parts. This kind of behaviour requires the right incentives which Markel has, Markel underwriters are rewarded based on profits rather than premium growth, which allows the company to act responsibly. This discipline is especially valuable in todays nuanced market, where different insurance lines are experiencing different levels of rate improvement and competition, It allows Markel to put more effort where profits can be achieved and stay away from poor rates of return.
In 2020 Markel laid out its 10-5-1 plan , to achieve $10 Billion in premiums written and $1 Billion in underwriting profit (combined ratio of 90) in 5 years (2025). The insurance market has begun to slow over the past few quarters which I believe makes it difficult for Markel to achieve this goal, despite this short term slowdown, I think the company will achieve this 10-5-1 goal at some point close to the target and over the longer term I expect the insurance segment to continue to deliver both growth and profits to Markel thanks to the continual improvements they have made.
ILS
I believe that Markel's efforts in the ILS segment are beginning to show fruit and will be a growth drive for the company going forward, with a little trust.
Markel entered the ILS market in 2015 with their acquisition of CATCo, this turned out to be a poor acquisition with CATCo not producing acceptable returns, the operation was wound down in 2019 and the book is still in runoff today. The two other acquisitions Markel made however were slightly more successful. State National, acquired in 2017 is performing very well for the company and has proved to be a very good use of capital with continued strong growth since being acquired.
Nephila is an ILS investment manager that Markel acquired in 2018. Returns from Nephila have been below my expectations, due to a series of larger than expected natural catastrophe losses in recent years, including 2021, which was the second largest year for natural catastrophes on record. Nephila has been reacting by increasing rates for covering these exposures for multiple years. I believe that these actions have now caused Nephila to turn a corner from a drag on performance to a driver of growth in both revenues and profits over the coming years, This was demonstrated by the 48% growth and a more than double in operating income in the ILS segment for 2022 suggesting this inflection point is now.
Markel will earn profits from the Nephila operation when Nephila's customers earn the results they expect from their investments in the ILS securities purchased. This will trigger incentive fees for Nephila, which are a share of the returns achieved by its customers. Since Markel's acquisition of Nephila, the returns they've produced for their customers remain largely below the thresholds where compensation takes place.
Markel remains committed that Nephila will produce good results over the long term and has asked for investors' trust and patience until that day. I believe that Markel has the track record, integrity and knowhow for investors to trust their judgement on this, however if it doesn't work out I believe Markel will be relatively unscathed as Nephila is only a small part of the business today.
Ventures
Markel Ventures is the segment within Markel that I have most hope for over the long term, I believe that it will become the largest segment of growth for the company and will drive significant shareholder value.
In 2018 Markel recorded $1.9 Billion in revenue, in 2022 this had grown to $4.8 billion, this is a 20% CAGR. This strong result is in spite of high valuations which has prevented Markel from buying more companies during this time, however they did make a few acquisitions where they found value over this time. During the Q2 2023 earnings call CEO Tom Gayner noted that the number of inbound calls coming to Markel has increased over the last few months. This is a positive sign and a hint that Markel may be adding some new companies to the portfolio in the back half of 2023 and throughout 2024, when looking at an investment opportunity, Markel has 4 criteria a business must meet, Tom Gayner laid this out in his 2013 Letter to Shareholders and it remains true today, these are:
As long-term readers of this report will know, we follow four part discipline when it comes to making our equity investments. First we seek profitable businesses with good returns on total capital that don’t use too much leverage. Second, we look for management teams with equal measures of talent and integrity. Third, we look for businesses that can reinvest their earnings and compound their value or that practice sound capital management techniques such as good acquisitions, dividends, and share repurchases. Fourth, we seek these attributes at fair and reasonable prices.
This four part process guides all of our business decisions when it comes to investing in publicly traded equity securities and privately held businesses, as well as personnel and management evaluations and decisions within our existing operations. - CEO, Tom Gayner.
This disciplined approach to buying businesses has been time tested ever since Markel bought AMF bakeries in 2005, to my knowledge all Markel Ventures purchases have been somewhat successful (not including the ILS insurance acquisitions), and although I expect there to be some mistakes over the long term I believe the long term track record will reflect a very satisfactory result for Markel Shareholders.
Investments
Markets investment portfolio can be split into two segments.
The equities portfolio has compounded at a very healthy rate over the last decade in the mid-teens percentage and over the long term Markel has outperformed the S&P 500 by 100 basis points for over 30 years. I'm not predicting that this will continue going forward however I do expect the portfolio to at least match the S&P 500 over the long term given managements strong track record.
The Fixed income portfolio has had relatively low returns over the same period driven by low interest rates. I expect this to change and to provide incremental income to Markel at no additional cost going forward as the company's current bonds reach maturity and are reinvested back into higher yielding bonds. Markel reported $329 million in investment income in the first half of 2023, up from $189 million in the same period last year, despite this increase they expect this investment income to continue to rise by several hundred million over the next few years as low yielding bonds mature and replaced by higher yielding ones, this will result in more capital to be invested elsewhere in the flywheel.
Superior Capital Allocation
Despite some missteps in capital allocation over the last 5 years most notably In ILS acquisitions. I still believe the long term track record demonstrates that Tom Gayner is a world class capital allocator and that this above average capital allocation will continue well into the future.
Markel invests its capital into 4 areas:
- Investing in its own businesses.
- Investing in publicly-traded equities.
- Buying additional Insurance or Markel Ventures businesses.
- Repurchasing its own shares.
Recently Markel has been doing all 4 of these at the same time, most notably they have been buying back their own stock at the fastest rate in the company's history, retiring 1.5% of shares outstanding in Q2 alone.
This is a hint that Markel believes that its shares are undervalued by quite some margin. CEO Tom Gayner has also personally bought Markel shares in 5 of the last 6 quarters another sign that management has faith In the long term trajectory of the business.
Valuation
In Markel's 2022 annual letter Markel laid out a two-part valuation method:
- Investment portfolio value : Markel takes the total value of its investment portfolio and subtracts out all debt. This gives an indication of the value of the balance sheet part of Markel.
- Earnings power of Insurance and Markel Ventures operations : Markel takes the normal, annualized earnings from these operations and multiplies that by a consistent and reasonable multiple year-by-year. This provides an indication of the total value of Markel's income statement.
TTM Book value per share (Tikr.com )
For Simplicity, which is often a better way of doing things, I am going to use book value for part 1 of this valuation method. Markels book value per share is just over $1000 /share, I will use $1000.
2. for earnings power I will use FCF/share, TTM FCF/share is $ 190 , I will apply a conservative multiple of 6x to this due to the inherent lumpy nature of Insurance operations, this results in a value of $1,140 for the operating businesses.
In total this gives a fair value of $2,140, or a 42% upside from todays $1,500 share price, I expect the intrinsic value to continue compounding over time further increasing returns.
Conclusion
I believe that Markel is a good stock to buy for a long term investor, as explained in my article I believe that headwinds from the past several years should start to subside and allow the 3 engines to continue compounding book value at a double digit rate over the next 5-10+ years. I believe the stock is undervalued and presents an upside of 42% not including any future growth in the business, which I expect to be extremely conservative.
For further details see:
Markel Set To Resume Historical Growth Rate As Headwinds Subside