The Rational Walk
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Markel Corporation at $800/share June 18, 2015

MKLLogoMarkel Corporation is a financial holding company engaged in the specialty insurance and reinsurance markets as well as in a growing number of industrial and service businesses that operate outside the insurance marketplace.  Markel seeks to actively invest its shareholder equity and insurance float in a combination of common stocks and fixed income investments in order to achieve higher returns than would be possible in a traditional fixed income portfolio.

In many ways, Markel has attempted to emulate the model long embraced by Berkshire Hathaway in which an insurance business provides low or no-cost “float” representing safe leverage for shareholders.  Many companies seek to be “mini-Berkshires” but Markel has perhaps come the closest in terms of matching rhetoric with reality and producing long term returns demonstrating the wisdom of their approach.  Although round share price numbers alone are not meaningful as indicators of value, breaching $800 per share is a milestone for Markel and as good a time as any to examine whether the shares might still represent a reasonable value.

Overview

Although Markel’s management has been open regarding its emulation of Berkshire Hathaway’s business model, the company is at a much earlier stage of its diversification into non-insurance subsidiaries and still must be evaluated primarily as an insurance company.  Markel offers three distinct sources of value.  First and most significantly, the company has a longstanding record of generating underwriting profits in several niche markets in the property/casualty insurance industry.  The insurance business was greatly expanded with the 2013 acquisition of Alterra and now includes a significant reinsurance business.  Second, Markel has a long history of investing shareholders equity and insurance float in a portfolio containing both common stocks and fixed income securities.   Thomas S. Gayner, Markel’s President and Chief Investment Officer, has a long demonstrated ability to run an equity portfolio earning returns in excess of the S&P 500.  Third, over the past decade, Markel has been building its Markel Ventures group of manufacturing and service businesses operating outside the insurance sector.  This is very much in line with Berkshire Hathaway’s business model but is still a relatively small source of value relative to insurance and investments.

Insurance Underwriting

Markel, in its current configuration, must still be evaluated first-and-foremost as a property-casualty insurer.  The effectiveness with which the company conducts its insurance business can easily overwhelm the results of the investing and non-insurance sectors.  The universal rule when evaluating an insurance company is to ascertain whether management has a demonstrated track record of discipline when it comes to setting appropriate rates for coverage and is willing to walk away from customers rather than underwrite policies at prices likely to lead to underwriting losses.  Since nearly all insurance managers will say the right things when it comes to underwriting discipline, one must ignore the rhetoric and look at the results over long periods of time.

The combined ratio of an insurance company measures underwriting performance.  The ratio compares incurred losses, loss adjustment expenses and underwriting, acquisition and insurance expenses to earned premiums.  If the combined ratio is less than 100 percent, the company has an underwriting profit.  If the ratio is over 100 percent, the company has an underwriting loss.  In today’s low interest rate environment, any insurance company that is not at least at break-even (combined ratio of 100) is unlikely to offer shareholders a reasonable return on equity.  The figure below shows Markel’s combined ratio since 1999:

Markel's Combined Ratio

As we can see, Markel has posted satisfactory combined ratios in most years, with the ratio falling under 100 percent in eight of the past ten years.  What this means is that the company is generating float that represents cost free leverage that can be profitably employed in the company’s investment operations.  Furthermore, the company’s underwriting performance has stacked up well historically against the industry as a whole as we can see from the figure below which appears in Markel’s 2014 annual report:

MKLCRvsIndustry

A full evaluation of Markel would need to delve deeper into the insurance operations than we have in this article.  Markel currently divides its insurance business into three segments:  U.S. Insurance, International Insurance, and Reinsurance and the company’s historical financial statements traditionally used different segmentation prior to the Alterra merger.  Furthermore, Markel’s 2013 acquisition of Alterra greatly increased the size of the insurance business and introduced the reinsurance business into the mix.  One cannot necessarily look at Markel’s fifteen year underwriting record and assume that these results will replicate in the future with the current book of business.  However, Markel’s management has taken steps to conservatively reserve for the business inherited from Alterra and initial results have been positive over the past two years.  The important point to take away from this brief overview of Markel’s insurance operations is that current management has a demonstrated track record of generating low or no cost float for deployment in the company’s investment operations.

Investment Portfolio

Markel has an investment portfolio of $18.6 billion (including cash equivalents) while shareholders’ equity stands at $7.9 billion as of March 31.  This substantial investment leverage is primarily made possible due to Markel’s historically cost free float as well as a modest amount of traditional debt.  Markel shareholders effectively have $1,330 of investments working on their behalf even though book value per share is only $564.

Of course, even cheap or cost free leverage can be a double edged sword when it comes to its effect on equity if investment results are poor.  So even if Markel’s insurance managers continue to do a great job generating combined ratios well under 100 percent, shareholders might not benefit from this cheap leverage unless the company’s investment management delivers attractive returns.  As a result, one must examine the historical track record of Markel’s investment operations and formulate an opinion on how well the investments are likely to perform in the future.

Markel’s investment portfolio was comprised of the following asset classes as of March 31, 2015:

Investment Allocation

As of December 31, 2014, the fixed maturity portfolio had a relatively short 4.2 year duration and an average rating of AA.  Due to the Alterra acquisition, Markel inherited a sizable fixed income portfolio. Management has been slowly allocating additional funds to the equity portfolio since the merger although this process has no doubt been hindered by relatively high valuations in the general stock market.  Over time, it is not unreasonable to expect that Markel’s investment allocation will tilt further toward equity securities and away from fixed income investments, particularly if the interest rate environment remains unfavorable.  Nevertheless, Markel will always have to maintain a very significant fixed income portfolio that will probably roughly approximate the level of float generated by the insurance business.

Although Markel’s equity portfolio contained 106 stocks as of March 31, 2015, it is heavily concentrated with the top twelve positions accounting for over fifty percent of the value of the overall portfolio.  Berkshire Hathaway is currently the largest equity position followed by CarMax, Walgreens Boots Alliance, Brookfield Asset Management, and Walt Disney.  Diageo, Marriott, Home Depot, Wal-Mart, and Deere round out the top ten.  For a full listing of Markel’s equity holdings, please refer to Dataroma’s analysis of the portfolio.

Although much analysis could be conducted on each of Markel’s top ten equity investments, for our purposes in this article, we will just examine the end results over the past ten years as measured against the S&P 500 index:

Investment Results

Investors seriously considering Markel might want to go back even further than ten years but the conclusion will be the same:  Markel has a demonstrated record of achieving excellent equity returns relative to the S&P 500 index.  This has been demonstrated through multiple market cycles over a very long period of time.  Tom Gayner is only 53 years old and anyone who has heard him speak about Markel knows that he clearly enjoys his job and is unlikely to leave.  It is unclear whether he has developed an investment team capable of producing outsized equity returns so succession is always a concern but the chances are good that Mr. Gayner will remain in charge of the equity portfolio at Markel for a decade or longer.

As we noted earlier, low cost or cost free float is only valuable in the hands of investment managers with a demonstrated track record of performance.  Markel has a demonstrated ability to generate cost free float and to deploy it intelligently over long periods of time.

Markel Ventures

Berkshire Hathaway shareholders have benefited greatly over the decades due to the fact that Warren Buffett is willing to invest the company’s capital in both wholly owned subsidiaries and in marketable securities depending on conditions prevailing in the market.  At certain times, it has been possible to purchase small pieces of a business (common stock) at prices far below what it would cost to acquire the entire business in a negotiated transaction.  At other times, an entire business might become available at a price that is more attractive than the common stock of comparable businesses.  Mr. Buffett’s approach allows the ultimate flexibility and increases the chances of profitably deploying capital in various market conditions.

Several years ago, Markel created a wholly owned subsidiary called Markel Ventures.  Today Markel owns interests in various industrial and service businesses that operate outside the insurance industry.  Much like Berkshire’s model, these businesses have management teams responsible for day to day management of operations while capital allocation and other strategic decisions are determined collaboratively between subsidiary management and Mr. Gayner.  According to the latest annual report, Markel seeks to “invest in profitable companies, with honest and talented management, that exhibit reinvestment opportunities and capital discipline, at reasonable prices” and the company intends “to own the businesses acquired for a long period of time.”  All of this should sound familiar to Berkshire Hathaway shareholders.

Markel does not consider Markel Ventures to be a reportable segment but the company’s financial reporting has slowly increased the amount of detail provided about this collection of businesses.  A consolidated balance sheet and income statement was provided in the 2014 annual report pertaining to the Ventures business.  The income statement is replicated below:

MKLVenturesIncomestatement

A complete review of Markel Ventures and an assessment of individual business units is beyond the scope of this article, but it would not take long for a reader to review the information provided by Markel in the latest annual report.  It is quite clear that management has big plans for Ventures and that the importance of this sector has increased quite a bit in recent years.  We choose to mostly disregard Ventures when assessing Markel’s current value and view the operations as providing additional upside potential in the future – perhaps significant upside potential.  In other words, it might be best to demand Markel Ventures for “free”, meaning that one could demand sufficient value from the insurance and investment operations to justify the price paid for the stock without giving consideration to the additional value potential of Ventures.

Is Markel Worth $800/share?

Insurance companies are typically evaluated based on the stock price relative to book value.  The fair value of an average insurer with a mediocre underwriting track record and a conventional fixed income portfolio would probably be less than or equal to book value particularly in the current interest rate environment.  So at a superficial level, Markel does not appear to be particularly cheap with the stock price exceeding $800 per share and book value of $564 as of March 31, 2015.  A price-to-book ratio of 1.42 would be quite generous for a typical insurer.  But is Markel typical?

It is quite clear that Markel has a demonstrated ability to produce underwriting profits over long periods of time and to perform more strongly than the typical insurer.  Furthermore, Markel has an investment record that is far better than what one might expect from an insurer restricted to a traditional fixed income portfolio.  This has not been lost on market participants in the past as we can see from the chart below:

Markel Price History

We can see from a visual examination of the chart that the market has almost always assigned a price-to-book ratio in excess of 1.0 to Markel.  The main exceptions were during the depths of the financial crisis and in mid to late 2011 when even Berkshire Hathaway briefly traded near book value.  We can see that the strong price movement in Markel stock over the past several years has been accompanied by strong book value per share growth but the market has slowly been willing to assign a more generous price-to-book ratio especially over the past year.

Does this mean that Markel’s price-to-book ratio is too high?

A longer term view would indicate that the market regularly assigned a more generous price-to-book ratio prior to the financial crisis as illustrated by the following chart:

MKL P/B Ratio

If viewed in this larger context, one may regard the return to a price-to-book ratio in the 1.5 range to be the bottom of Markel’s typical valuation range prior to the financial crisis.  Prior to 2008, Markel typically traded in a P/B range of 1.5 to 2.0 or higher rather than the 1.0 to 1.5 range that has prevailed since the crisis.

Regardless of the price-to-book ratio’s movements over time, what we really care about is whether buying or holding Markel stock at $800 is likely to yield acceptable investment returns over time.  One cannot reasonably make an informed decision on the attractiveness of a stock simply by looking at one easily calculated number.

The following valuation model attempts to look at Markel’s valuation primarily in the context of the power of its investment portfolio to drive up book value per share.  For this exercise, which is by its nature relatively imprecise, we make assumptions regarding the likely returns for Markel’s overall investment portfolio (cash, fixed income, and equities) over the next five years and estimate how these returns will impact book value.  We assume that the insurance business provides a combined ratio of 100 percent (underwriting break-even) over the period and assign no value to Markel Ventures.  Based on these inputs, we attempt to estimate shareholders’ equity five years from now.  A future market capitalization is estimated based on using a range of possible price-to-book ratios that might prevail in five years.  Finally, we use a discount rate to estimate the present value of the market capitalization.  We assume a constant share count to arrive at a current intrinsic value per share.

Markel Valuation Model

Taking the base case as an example, we assume that Markel can compound the investment portfolio at a rate of 5 percent over the next five years and that the terminal price-to-book ratio will be 1.5.  Under those assumptions, we can expect the market capitalization of Markel five years from now to be approximately $18.9 billion.  If we demand a 10 percent annualized rate of return to own Markel shares, we could then pay up to $840 today and achieve that required return.  If we pay the current price of $805, the implied rate of return would be closer to 11 percent.

If one takes the conservative scenario, Markel would only compound the investment portfolio at a 3.5 percent compounded rate and the terminal price-to-book ratio would be 1.25.  Under such conditions, someone demanding a 10 percent annualized rate of return should only pay up to $608 for the shares today.  Another way of looking at it is that someone using these assumptions would have to settle for a 4 percent return if paying $805 for the shares today.

Clearly there are many ways of looking at Markel’s valuation and the model illustrated above is just one example.  However, it does seem like Markel is not particularly overvalued at $800 per share and could be worth substantially more if the market assigns a higher price-to-book ratio and Mr. Gayner can compound the investment portfolio more rapidly than the base case assumes.  Furthermore, if the insurance business operates at an underwriting profit and Markel Ventures begins to provide more material results, there could be additional upside.

On balance, Markel’s stock price exceeding $800 doesn’t appear to be irrationally exuberant.  However, whether the shares offer an attractive proposition for investors today depends on the variables used to estimate the company’s future success as well as the margin of safety the investor demands when making a new commitment.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel Corporation.

 

Platinum Underwriters 2013 Results February 7, 2014

This article provides a brief update to The Rational Walk’s research report on Platinum Underwriters.  More than two years have passed since the report was published in October 2011 which is enough time to evaluate the validity of the investment thesis.  Platinum recently released results for 2013 along with a detailed financial supplement and held a conference call for analysts.  We take a look back at the situation in late 2011, evaluate the latest financial results, and attempt to determine whether Platinum might represent a solid investment opportunity based on its current market price and future prospects.

A Brief Look Back

Market participants are often thought of as being forward looking but it is not uncommon for investors to simply discard investments that have demonstrated temporary weakness in the recent past.  This was the case with Platinum in 2011.  Due to the impact of major catastrophes in 2011, Platinum had posted a net loss of $231 million for the first nine months of the year and an abysmal year-to-date combined ratio of 156 percent.  As a result, Platinum shares traded at approximately two-thirds of fully diluted tangible book value as market participants focused on negative headlines rather than Platinum’s strong long term record spanning nearly a decade.  For full details regarding the company’s financial position at the time, please refer to the research report.

The chart below shows Platinum’s stock price performance from January 2011 up to the current date (click on the image for a larger view).  As we can see, the stock price fell steadily throughout 2011 before bottoming out in the fourth quarter and starting a steady rise where the stock more than doubled over two years.

Platinum Underwriters Stock Chart

We take no credit for the timing of the report which happened to be released near the low for the stock.  There is no way to predict what a stock will do in the short run.  Instead, the investment thesis was based on the market ignoring the company’s long term fundamental strengths which became more clear to the market once better current period results started to emerge in 2012.

Recent Results

Platinum reported net income of $223.3 million and diluted earnings per common share of $7.35 for 2013.  Annual return on equity was 12.9 percent and fully diluted book value per common share was $60.64 as of December 31, 2013.  Over the two year period ending on December 31, 2013, fully diluted book value per share grew at a rate of 13.7 percent.  During the fourth quarter of 2013, Platinum shares traded at near book value most of the time.  Shareholder returns over the two year period was in the neighborhood of 100 percent due to both the increase in book value as well as the market lifting the price-to-book ratio from a one third discount to book to parity.  One can view shareholder returns of consisting of a combination of improved investor sentiment and solid financial results.

A number of charts and exhibits appeared in the 2011 report which serve to quickly illustrate Platinum’s long term track record along with what we believed was temporary weakness in 2011 that was unlikely to recur repeatedly in the future.  One of the most important metrics for an insurance company is the combined ratio.  An insurance company that regularly posts a combined ratio above 100 percent is generating underwriting losses on a normalized basis and must rely entirely on investment income to provide a return to equity holders.  In the current interest rate environment, any insurer that does not have a sustainable combined ratio well below 100 is unlikely to achieve acceptable returns for equity holders.  The exhibit below shows Platinum’s combined ratio by segment from the company’s inception through the end of 2013.

Combined Ratio by Segment

The purple bar for each year shows the total combined ratio for all segments.  We can see that after a very poor 2011, Platinum generated very low combined ratios for 2012 and 2013.  Part of the drop in the combined ratio was due to lower current period catastrophes but Platinum also posted regular “reserve releases” that bolstered results in 2012 and 2013.  Reserve releases occur when management revises prior loss reserve estimates to reflect lower than expected claims based on receiving additional information from primary insurers.  As the exhibit below shows, net favorable development has been a recurring feature of Platinum’s reports for most of its history.

Loss Development

In general, insurance companies attempt to estimate reserves at a level that is sufficient for payment of both known and unknown future claims.  Some management teams are more conservative than others, however, and this conservatism is most evident when one examines loss development trends.  There is some risk that a management team may purposely overstate reserves in good years in order to release reserves in bad years which would constitute a “cookie jar” type of policy but eventually this type of bad practice is likely to be exposed.  In the case of Platinum, it appears that management’s long history of conservative practices is sound and should give investors confidence.

Disciplined Management

One of the charts provided in the 2011 report displayed the trend of declining written premiums since 2005.  Management has been disciplined in terms of rejecting inadequately priced business and this has been evident in a steep decline in written premiums.  An updated chart is displayed below which shows that this trend has continued but might now be stabilizing.

Written Premiums

While written premiums have declined, Platinum has maintained a very strong equity position with written premiums declining to 32 percent of equity from 39 percent at the end of 2011.  Shareholders equity has increased over the two year span despite the fact that management has repurchased a significant number of shares at prices well below book value.  The share count decreased from 35.5 million at the end of 2011 to 28.1 million at the end of 2013.  Every time Platinum purchases its own shares below book value, this results in accretion to book value for continuing shareholders.  Platinum nevertheless appears overcapitalized at $1.75 billion of shareholders equity given management’s statement that only $1.5 billion of equity is needed to support the business (see conference call transcript link provided above).  This points to the possibility of future repurchases at prices below book value.

Conclusion

Platinum Underwriters serves as a good case study regarding opportunities that exist when short term adversity clouds the judgment of market participants and obscures a solid long term track record that is likely to continue.  In Platinum’s case, sticking to the principles that led to its pre-2011 track record allowed management to grow book value per share at a very satisfactory rate in 2012 and 2013.  This growth in book value was then combined with the market’s reassessment of the company’s prospects as “headline” numbers from earnings reports improved and 2011 numbers receded from memory.

Value investing is not a discipline that has any chance of outperforming the overall market under all conditions and time frames.  In fact, poor performance is nearly inevitable in the short run when purchasing securities that other market participants despise.  However, over a two to three year investment time horizon, value investors can usually benefit from the market’s reassessment of a fundamentally sound company.  Platinum is currently trading at approximately 91 percent of book value which reflects some pessimism but not the extreme disdain implied by the prevailing discount in late 2011.  As a result, investor results for Platinum going forward are likely to track progress in the underlying business with the prospect of a small additional gain if shares trade closer to book value.

Disclosure:  No position.

Investors Title Company Approaches Intrinsic Value June 21, 2012

“In the short run, the market is a voting machine but in the long run it is a weighing machine.”

— Benjamin Graham

In this article, we revisit the investment thesis for Investors Title Company which was first profiled on The Rational Walk in November 2010 with an update provided in March 2011.  Investors Title is one of the smaller players in the title insurance industry which provides an essential but little understood product required for nearly all real estate transactions in the United States.

At the time of the initial write-up, we noted that Investors Title appeared to be significantly undervalued but offered no particular assessment regarding when Benjamin Graham’s famous “weighing machine” would close the valuation gap.  In recent weeks, the market has assigned a valuation to the company that appears to be more appropriate, yet no obvious “catalyst” was responsible for the change in valuation.  After a brief detour into the workings of the “weighing machine”, we examine what has transpired at Investors Title over the past year and assess the company’s current valuation.

The Weighing Machine Works … But Not on a Quarterly Schedule

It is easy to dismiss financial markets as hopelessly psychotic given day to day gyrations in prices that often have little to do with changes in the underlying economics of a business.  However, the fact that few investors are able to outperform market indices consistently should lead one to approach market prices with some respect. When an investor decides to take a position in a security, he is implicitly saying that the collective opinion of his fellow market participants, as expressed in the current price, is mistaken. The questions that must be answered include why the market’s assessment is mistaken and what timeframe is being considered by market participants.

Whether the market is “right” or “wrong” very often depends on the timeframe in question.  Most market participants have a short term outlook, despite protestations to the contrary.  Institutional investors may simultaneously agree that a security is deeply undervalued but refuse to purchase shares because there is no obvious “catalyst” that would drive the stock price up during the current quarter.  One only needs to read interviews with “long term” individual investors before and after the recent Facebook initial public offering to observe that while most everyone claims to have a multi-year time horizon, almost everyone wants instant gratification instead.

Value investors who can identify undervalued securities without obvious catalysts and are willing to own shares without knowing precisely when the “weighing machine” will reflect intrinsic value have an important advantage over the vast majority of market participants.

Investors Title’s Texas Expansion 

As we noted in the original write-up in November 2010, Investors Title is one of the smaller players in the title insurance industry and has traditionally focused on markets in the southeastern United States.  In 2009, 44 percent of direct premiums were written in North Carolina where the company was founded in 1973.  North Carolina, South Carolina, Virginia, and Tennessee accounted for 65 percent of direct premiums in 2009 demonstrating that management was not straying too far from its home base.  Notably, the company lacked exposure to markets that suffered the worst of the real estate bust such as Florida, Arizona, Nevada, and California.  As explained in the original write-up, although title insurance is not directly triggered in cases of home prices falling, the discovery of title defects tends to rise in falling real estate markets.

Starting in 2010, Investors Title began an aggressive expansion into the Texas market.  From a standing start with no reported volume in 2009, Texas accounted for 32 percent of direct premiums in 2011 moving North Carolina into second place at 27%.  Total direct premiums increased from $62.2 million in 2009 to $81.6 million in 2011 with Texas accounting for $26.3 million of the 2011 total. Texas has accounted for more than all of the premium growth over the past two years.  Whether this is a positive or negative change remains to be seen but the geographic distribution of business has clearly changed.

Financial Results – 2009 to 2011

The following exhibit displays key data related to Investors Title’s performance over the past three years.  This is not a comprehensive discussion of financial results which can be obtained in the company’s latest 10-K for 2011 and 10-Q for the first quarter of 2012.

  • Revenues.  We can see that title insurance revenues increased significantly in 2011 which was driven by the expansion into Texas as discussed previously.  Total revenues shows a similar pattern. The difference between total revenues and title insurance revenues is accounted for by the combined effect of investment income, realized gains and losses, and other revenues driven from fee, trust, and management services income.
  • Net Income.  Net income rose from $4.8 million in 2009 to $6.4 million in 2010 and $6.9 million in 2011.  Earnings per share advanced at a faster rate due to declining share count driven by repurchases of common stock.  Net income as a percentage of total revenue declined from 8.9 percent in 2010 to 7.6 percent.
  • Agency Retention. One of the most important metrics for a title insurance company is the percentage of premiums retained by agents.  This is particularly important for Investors Title given the increasing percentage of total title insurance revenue attributed to agencies which rose from 65 percent in 2009 to 80 percent in 2011.  We can see that agency retention jumped from 72 percent in 2009 and 2010 to 76 percent in 2011.  According to the company’s filings, this is primarily due to the expansion into Texas which is a market that has higher commission rates.
  • Losses as Percentage of Title Revenue.  Title losses and claims as a percentage of title revenue fell from 14 percent in 2009 to 7 percent in 2010 to 4 percent in 2011.  This is clearly a significant improvement, but the loss ratio rose to 8.3 percent for Q1 2012.  From 2001 to 2011, the average loss ratio was 11.7 percent, so recent results are showing a lower than normal level of losses.  According to the company’s 2011 10-K report, the drop in the loss ratio from 2010 to 2011 was primarily due to favorable development for prior policy years.  Loss estimates are subject to significant error.  At 12/31/2011, 83.6 percent of the $38 million in loss reserves on the balance sheet were incurred but not reported (IBNR), meaning that a large portion of reserves are estimated by management.
  • Book Value per Share.  Total stockholders’ equity increased from $97.3 million at 12/31/2009 to $106.5 million at 12/31/2011 while shares outstanding fell from 2.3 million to 2.1 million due to repurchases.  Tangible book value per share rose from $42.56 at 12/31/2009 to $50.54 at 12/31/2011.  Tangible book value per share advanced further to $51.74 at 3/31/2012.

Stock Price Performance

When one looks at the key data for Investors Title over the past three years, it looks like the company has made steady progress in its operational results and has managed to grow book value per share at a reasonable rate in light of the economic conditions that prevailed during this period.  However, the stock price since the date of our original write-up has been far more volatile as we can see below (click to enlarge):

We are hard pressed to identify reasons for the wild gyrations in price, although someone inclined to do so could probably look for real estate related headlines for the periods where major moves were made and attempt to reconstruct a storyline.  Doing so, however, would be quite pointless as the better explanation seems to be that the stock price of Investors Title only had a vague correlation with business results.  It is true that business results improved along with book value over this timeframe, but the magnitude of the stock price advance was far greater than the increase in book value or intrinsic value.

Intrinsic Value:  Then and Now

In our November 29, 2010 write-up, we noted that Investors Title was trading at a market capitalization of $66.5 million versus tangible book value of $102.5 million as of September 30, 2010.  We also noted that the valuation history of Investors Title suggested that there were relatively few years when the market price of Investors Title common stock did not at least match or exceed the prior year-end book value per share.  Given the fact that Investors Title appeared to be significantly overcapitalized, a large percentage of the intrinsic value is derived from its investment holdings.  The main risk to stated book value is that insurance reserves may be understated, but the company’s long term track record did not indicate a strong likelihood of major reserve problems.  Overall, trading at a price of $29.15 vs. tangible book value of $44.86 per share, buying shares appeared to be equivalent to buying one dollar for only 65 cents.

Since the original write-up, the stock price has advanced from $29.15 to $54.50, or 87 percent, while tangible book value per share has increased from $44.86 to 51.74, or 15.3 percent.  Clearly, the stock price has significantly outperformed the business over the past nineteen months.  With the current stock price at a slight premium to the last reported book value, Investors Title is clearly not the 65 cent dollar it once was.  However, it remains a profitable business with a demonstrated history of growing book value per share over time even through some very difficult economic conditions.  There is no reason to think that Investors Title will be unable to grow book value at mid-to-high single digit rates for many years to come based on its demonstrated earnings power.  However, double digit growth in book value seems somewhat unlikely given the fact that the company has so much of its capital invested in fixed income securities.  Additionally, the risk profile of the business itself has increased due to the expansion into Texas which has suddenly become the company’s largest market.

One of the reasons it is important to document an investment thesis prior to initiating a position is because otherwise one might be tempted to change the rationale for an investment over time without subjecting the change to serious examination.  If an investment was initially purchased based on a large discount to tangible book value, it should be sold when that discount is no longer present unless there is reason to believe that the company can compound book value at rates of return higher than the investor’s hurdle rate over long periods of time.  If Investors Title seemed sure to compound book value at 10 to 15 percent over the next decade, it would probably not make sense to sell merely because the initial discount to book has been eliminated.  However, facing the prospect of relatively modest growth in book value per share going forward, the case for shifting the investment rationale in order to justify holding the shares seems quite weak.

What was the Catalyst?

At the time of the original write-up, there was no catalyst identified that would erase the gap between the stock’s market price and intrinsic value.  In fact, the real estate market was in poor shape and not expected to recover anytime soon.  The real estate market is still in poor shape today and not expected to recover anytime soon.  If we look at the stock chart presented earlier, it is hard to see what catalyst drove the market gyrations.  There seems to be no specific catalyst responsible for moving the shares toward intrinsic value.

Given the choice between an undervalued security with no identifiable catalyst and one that has a very likely catalyst, intelligent investors would pick the latter because it is always preferable to have a sense of how long one will have to wait.  Annualized returns would obviously be far greater if we could buy into undervalued situations shortly before a catalyst magically drives the shares to full value but the investing world doesn’t seem to work that way.  By the time a catalyst is obvious, the undervaluation may have already vanished.  Or there may never be a catalyst and the share price may simply reflect intrinsic value for unidentified reasons.  Value investors who are willing to commit funds to undervalued investments without identifying a specific catalyst have a wider array of possibilities available and an advantage over those who simply must “know” when their investment will turn a profit.

Disclosure:  The author of this article closed out his position in Investors Title between June 6 and June 20, 2012 at prices ranging from $51.80 to $54.50.

Swiss Re Estimates $1.2 Billion Pre-Tax Loss From Japan Disasters March 21, 2011

Based on recent reports, the economic damage caused by the earthquake and tsunami in Japan could range from $122 to $235 billion.  However, only a small percentage of total economic damages are likely to be insured.  Estimates vary, but according to a World Bank study quoted in The Wall Street Journal, only $14 to $33 billion of the losses are likely to be covered by private insurance.

Due to the nature of the disaster, reinsurance firms did not immediately disclose estimates of losses due to the earthquake and tsunami.  However, loss estimates are now beginning to emerge with Swiss Re reporting projected claims costs of $1.2 billion net of retrocession and before taxes.  The company emphasizes that a great deal of uncertainty remains due to the difficult conditions that still exist in the hard hit areas of Japan.

Insurance Coverage Limited to Specific Risks

Swiss Re notes that Japanese government run insurance programs covering earthquake and tsunami risk for residential properties are not reinsured in the international market but coverage for fires following earthquakes are usually protected by reinsurance.  Commercial and industrial coverage is typically reinsured.  All coverage for nuclear facilities excludes damages caused by earthquakes, tsunamis and their aftermath and Swiss Re believes that the unfolding disaster at the Fukushima nuclear plant is “unlikely to result in a significant direct loss for the Property & Casualty insurance industry.”

Swiss Re’s loss estimate is based primarily on modeled estimates rather than an examination of specific losses and the company expects that reconciling modeled losses to the estimates of ceding insurance companies and to original policyholder losses could take several months.

Berkshire’s Quota-Share Exposure:  Approximately $300 million

Berkshire Hathaway has a 20 percent quota-share reinsurance contract with Swiss Re covering “substantially all of Swiss Re’s property/casualty risks incepting from January 1, 2008 and running through December 31, 2012″ according to Berkshire’s 2010 10-K.  Swiss Re may have retrocession agreements with other reinsurers but the company’s 2010 annual report (pdf) lists Berkshire as its “most significant single counterparty”.

If we assume that Swiss Re’s only significant retrocession agreement is with Berkshire, then we could infer that Swiss Re’s pre-tax loss estimate prior to the effect of the agreement was $1.5 billion and that Berkshire’s share is $300 million.  However, this figure is obviously subject to significant revisions in the coming weeks and months as actual damages are reconciled with rough estimates from Swiss Re’s models.

Berkshire is likely to have additional exposure to the disaster through its General Re and Berkshire Hathaway Reinsurance subsidiaries.  The company has yet to provide loss estimates.  Berkshire also owns a 10.5 percent minority stake in Munich Re which is believed to have significant exposure to Japan.  Munich Re has not provided loss estimates.

Disclosure:  Long Berkshire Hathaway.

What Does Buffett’s Valuation of GEICO Imply for Progressive? March 6, 2011

Note to Readers:  On March 1, 2011, The Rational Walk published a comprehensive report, Berkshire Hathaway: In Search of the Buffett Premium, which examines the intrinsic value of Berkshire in great detail.  Order the report for immediate electronic delivery, or download our free 22 page sample (pdf) — there is no registration required for the sample.

Warren Buffett provided an unusual level of insight into his views regarding Berkshire Hathaway’s intrinsic value in his latest letter to shareholders which we discussed in more detail when it was released last week.  While Mr. Buffett gave us his views of Berkshire’s normalized earnings power along with several other guideposts to his thinking on Berkshire’s intrinsic value, he did not present a specific estimate.  However, he came extremely close to doing so in the case of GEICO.  In this article, we will take a look at Mr. Buffett’s comments on GEICO and potential implications for the intrinsic value of Progressive, GEICO’s most fierce competitor.

Examining GEICO’s Economic Goodwill

Mr. Buffett’s letter describes his personal experience with GEICO over the past sixty years as well as the terms of Berkshire’s investments in the company.  In 1996, Berkshire purchased the 50 percent of GEICO that it did not already own for $2.3 billion implying a value of $4.6 billion for 100 percent of GEICO.  At that time, GEICO had tangible net worth of $1.9 billion which means that Berkshire valued GEICO’s goodwill at $2.7 billion.  Berkshire effectively paid 2.4 times tangible book value which was considered a high valuation at the time.

In the letter, Mr. Buffett elaborates on how he thought about the $2.7 billion of goodwill at GEICO in 1996 and how he views GEICO’s goodwill today:

The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company’s low costs, its policyholders were consistently profitable and unusually loyal.

Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO – off to a strong start in 2011 – is the gift that keeps giving.

Although a careful parsing of the statement shows that Mr. Buffett does not explicitly state that GEICO’s economic goodwill is $14 billion, it is strongly implied that using the “97%-of-premium-volume yardstick” is just as appropriate today as it was in 1996 when Berkshire acquired full control of GEICO.  Some analysts may question whether this is the case given that GEICO today has a much higher market share than it had in 1996 and presumably growth prospects from today’s levels might be slower.

Implied Value of GEICO:  $20.5 Billion

We do not have individual balance sheets for all of Berkshire’s insurance subsidiaries but GEICO publishes selected financial information based on statutory accounting rules, which generally presents a more conservative picture of a company’s net worth when compared to GAAP accounting.  According to data on GEICO’s website, policyholders’ surplus was approximately $6.5 billion as of December 31, 2010.  The policyholders’ surplus figure should be free of intangibles at this point (see this report for some information on statutory accounting and goodwill).  Therefore, if GEICO’s goodwill is worth $14 billion, it follows that the company as a whole is worth approximately $20.5 billion based on Mr. Buffett’s valuation methodology.

Implications for Progressive

We have periodically followed Progressive on The Rational Walk mainly because of the fierce competition between GEICO and Progressive but also because the companies are so similar in terms of performance over the years.  If Mr. Buffett loves GEICO, it is quite likely that he also admires Progressive’s performance.  In The Rational Walk’s recent report on Berkshire, In Search of the Buffett Premium, we include an appendix comparing GEICO and Progressive.  The following exhibit is taken from the report:

The similarities between the companies are striking particularly when viewed from the perspective of very consistent underwriting profits over the past decade.  Over the 1999 to 2010 period, GEICO grew premiums earned at a 10.5 percent rate while Progressive grew premiums at a 8.8 percent rate.  The average combined ratio was 93.6 for GEICO and 92.3 for Progressive.  In general, GEICO posted lower expense ratios while Progressive posted lower loss ratios in most years.  In 2010, earned premiums were very similar for GEICO and Progressive and underwriting results were almost identical.

We have not performed a thorough valuation of Progressive, but it does not seem too far of a stretch to consider the implications of Mr. Buffett’s views on GEICO’s intrinsic value on Progressive given the similarities between the two companies.

As of December 31, 2010, Progressive had tangible equity (based on GAAP) of $6,049 million.  If we use the “97%-of-premium-volume yardstick” to estimate Progressive’s economic goodwill, this results in a goodwill estimate of $13,886 million.  The total intrinsic value estimate would be $19.9 billion, or slightly over $30 per share.  Progressive’s market capitalization as of Friday, March 4 was $13.78 billion, or $20.88 per share.

Jumping to Conclusions?

Are we safe in assuming that Mr. Buffett would value Progressive in the same manner as he values GEICO?  Possibly not since he could believe that GEICO has important advantages over Progressive that will result in a higher level of growth going forward.  Past history would suggest that GEICO appears to be able to grow at a somewhat higher rate than Progressive while also maintaining excellent combined ratios.  Perhaps this is due to important competitive advantages emanating from a higher level of goodwill at GEICO compared to Progressive.

However, we can also look at Progressive’s valuation from another perspective.  Using the market value of $13.78 billion, implied economic goodwill assigned by the market is currently $7.73 billion.  As a percentage of last year’s earned premiums, economic goodwill is currently at a “54%-of-premium-volume yardstick” as compared to the “97%-of-premium-volume yardstick” that Mr. Buffett used in 1996 to value GEICO and appeared  to endorse as being equally relevant today.  It would appear that Progressive’s  track record is strong enough to justify a higher valuation if we use Mr. Buffett’s methodology even if Progressive’s position is not quite as strong as GEICO’s.

We should stress that a $19.9 billion valuation for Progressive would be quite aggressive at nearly 3.3 times tangible book value.  In addition, we are not stating that Progressive is worth $19.9 billion at this time, having not performed sufficient due diligence on the company to make such an assertion.  Instead, we are simply making the observation that Warren Buffett’s valuation of GEICO seems to imply that he would regard Progressive as undervalued if he views Progressive and GEICO as having similar economic characteristics.  Of course, he never made any such statement.  But the inference is, at the very least, interesting and warrants further study of Progressive.

Disclosure:  Long Berkshire, No Position in Progressive.