The Long History of Shareholder Activism

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”  — Upton Sinclair

On the commute home from work, a man suddenly has a brilliant flash of insight and comes up with a unique business idea.  Having long ago achieved financial freedom, he is no longer compelled to work for his employer and has sufficient capital to pursue the idea.  A month later, a small office is set up and, before long, there are a dozen employees at work turning the idea into reality.  Through ownership of 100 percent of the equity of the business, there is no conflict between the owner and the manager because he is the same person.  Three years later, a major expansion opportunity requires additional capital.  The owner’s father-in-law, being a successful businessman himself, provides capital (and, in due course, unsolicited advice) in exchange for 40 percent of the equity.  Although the business is still “all in the family”, Thanksgiving dinner becomes a little more awkward that year.

Dear ChairmanSome element of an agency problem exists the moment a business transforms from a pure owner-operator model to one that involves outside shareholders.  Obviously, the degree to which an agency problem exists depends on the individuals involved, the separation between owners and managers, and the amount of equity that management continues to own.  The character of management counts a great deal, but few managers treat non-management owners as true “partners” in the business.  In Dear Chairman:  Boardroom Battles and the Rise of Shareholder Activism, Jeff Gramm provides an entertaining history showing that the agency problem and shareholder activism is nothing new.  The media often portrays shareholder activists as rapacious and amoral individuals with no social conscience.  While this is sometimes true, more often the interests of owners are advanced by activists.  Through eight chapters presenting interesting case studies, the book offers insights into how activism has evolved over nearly a century.  Social mores have changed dramatically but the inherent tension between managers and owners has been a constant.

The case studies range from Benjamin Graham’s campaign against Northern Pipeline in the late 1920s to campaigns by Dan Loeb and Carlo Cannell in recent years, and it is likely that readers will find different chapters more or less compelling based on their interests and period of personal involvement in the stock market.

Benjamin Graham: Activist Pioneer?

For students of Benjamin Graham, reading about his activist campaign against Northern Pipeline shows a side of the father of value investing that has not been widely known previously.  In an exceedingly polite but firm letter, Mr. Graham asserts the right of owners of a company to claim excess capital that is not remotely necessary for the operations of the business.  Northern Pipeline’s management had hoarded excess capital over a long period of time which eventually resulted in an inefficient structure for shareholders who owned an operating business along with a tax-inefficient securities portfolio.  The following quote from the letter is just as applicable today:

“The determination of whether capital not needed in the business is to remain there or to be withdrawn, should be made in the first instance by the owners of the capital rather than by those administering it.”

Not only were Northern Pipeline’s managers behaving in a manner similar to many corporations today, they apparently pioneered one of the annoying tactics management often uses to discourage shareholder involvement.  The annual meeting was held in Oil City, Pennsylvania even though the company’s executive offices were conveniently located in New York City.  The remote location did not stop Benjamin Graham from going to a meeting to make a presentation on how to distribute the excess capital.  However, due to a procedural motion, he was not even permitted to speak at the meeting.  Northern Pipeline’s management also tried to obfuscate the issue by claiming that investors with no operational knowledge of the business were trying to exert operational control when the question was entirely one of capital allocation.  Sound familiar?

Graham’s Activism Influences Buffett

We can be sure that Warren Buffett knew about the Northern Pipeline story when he began investing in Sanborn Map Company three decades later.  As we discussed in a review of Warren Buffett’s Ground Rules, the Sanborn Map situation involved a very similar scenario of an operating company being coupled with a large securities portfolio representing capital that was completely unnecessary for the business with management stubbornly clinging to that capital.  Sanborn Map is also briefly discussed in Dear Chairman.  Mr. Buffett no doubt was inspired by the Northern Pipeline example as he launched his own activist campaign against Sanborn.

One chapter in Dear Chairman stands out as a bit different from the rest.  In the early 1960s, American Express faced a dangerous situation in which much of its economic goodwill could have been eliminated due to the salad oil scandal.  The book provides details regarding the background of the scandal and how management initially reacted to it.  However, Mr. Buffett did not launch an activist campaign against American Express management.  To the contrary, he sent a letter to management supporting its decision to cover the losses of customers even though doing so was not strictly required from a legal perspective.  Other investors were not pleased with American Express absorbing losses that the company was not contractually required to cover but Mr. Buffett understood that the savings in hard cash would be far outweighed by the loss of reputation and associated economic goodwill.

Here we have a wonderful example of a young Warren Buffett explicitly advocating for the reduction of tangible book value of a company in exchange for economic goodwill that was nowhere to be found on the balance sheet but nevertheless a very real asset.  Many investors believe that Warren Buffett shifted from a “pure value” approach to “paying a fair price for a great business” with Berkshire’s acquisition of See’s Candies in 1973 but the salad oil scandal at American Express shows that his appreciation for economic goodwill was already well developed a decade before the See’s purchase.

“And Then What?”

The book does not present shareholder activism in a one-sided manner.  Critics of activism often complain about short term oriented activists motivated by greed rather than the long term health of a business.  At times, misguided activism can destroy tremendous value for shareholders.

In the BKF Capital chapter, we are presented with a case study of failed activism that destroyed an asset management company.  BKF Capital was criticized by the activists for having high expenses that transferred most of the benefits of assets-under-management growth from shareholders to employees.   Asset management companies are notorious for high compensation costs and BKF Capital had higher costs than several firms that the activists claimed were comparable.  Management argued that the comparisons were not valid for a small and rapidly growing firm and that cutting compensation would result in an exodus of talent and destruction of the company.  In the end, that is precisely what happened when the activists got their way.

The activists were not necessarily incorrect in their criticism of BKF Capital.  The Chairman and CEO had made some questionable decisions that suggested nepotism and the compensation levels were certainly high.  The problem is that the activists apparently failed to ask an important question:  “And then what”?  What are the second and third order effects of cutting compensation when it comes to asset growth?  Is the flight of talent a realistic risk that must be taken into account?  It appears that not enough second-level thinking took place.

Losing by Winning

Sometimes in the heat of battle, there can be an excessive focus on “winning” and not enough focus on what happens after the “victory”.  Even Warren Buffett was not immune to making decisions in the midst of a boardroom battle that he would later regret.  On May 6, 1964 Seabury Stanton offered to purchase the Buffett Partnership’s interest in Berkshire Hathaway for $11.375 per share.  Mr. Buffett was not pleased.  He had previously offered to sell its holdings for $11.50 per share and Mr. Stanton had said “Fine, we have a deal.”  In response to insulting tender offer, Mr. Buffett instead began accumulating more Berkshire shares and eventually took control of the company in 1965.

In his 2014 letter to Berkshire Hathaway shareholders, Mr. Buffett referred to his behavior as “a monumentally stupid decision”. Berkshire Hathaway became Mr. Buffett’s main investment vehicle.  In 1967, he entered the insurance business through Berkshire rather than through the partnership (BPL):

If BPL had been the purchaser, my partners and I would have owned 100% of a fine business, destined to form the base for building the company Berkshire has become. Moreover, our growth would not have been impeded for nearly two decades by the unproductive funds imprisoned in the textile operation. Finally, our subsequent acquisitions would have been owned in their entirety by my partners and me rather than being 39%-owned by the legacy shareholders of Berkshire, to whom we had no obligation. Despite these facts staring me in the face, I opted to marry 100% of an excellent business (NICO) to a 61%-owned terrible business (Berkshire Hathaway), a decision that eventually diverted $100 billion or so from BPL partners to a collection of strangers.

Although Berkshire has worked out remarkably well, the outcome would have been far better had Warren Buffett resisted the urge to “win” in his battle with Seabury Stanton.  Any aspiring activist has to be humbled by this story.  Whether the reader aspires to be an activist or simply wants greater insight into activism and the impact on target companies, Dear Chairman contains insights and lessons that are worth careful consideration.

Purchase Dear Chairman:  Boardroom Battles and the Rise of Shareholder Activism from Amazon.com

Book Review: Warren Buffett’s Ground Rules

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” 

— Warren Buffett, letter to partners, October 9, 1967

As Warren Buffett wrote these words to his partners in late 1967, he was writing from the perspective of a 37 year old man who was about to wrap up the eleventh year of his partnership having achieved gross returns of 1606.9%, which represents annualized returns in excess of 29 percent.  For a number of years, Mr. Buffett had been warning his partners that future results would not come close to his past track record.  However, in 1968, the partnership posted its highest ever gross return of 58.8 percent which exceeded the return of the Dow Jones Industrial Average by an amazing 45.6 percent.  Then in May 1969, with assets under management exceeding $100 million ($~650 million in 2016 dollars), Mr. Buffett announced plans to close the partnership and retire.

Warren Buffett's Ground RulesThe idea of closing up shop with an unparalleled thirteen year track record and assets under management growing at a tremendous clip probably seems crazy to most modern-day investment managers.  Although Mr. Buffett did not charge a fixed annual management fee like most other funds, he was entitled to 25 percent of all profits over a six percent hurdle rate.  Even if his performance was destined to fall to 10 percent, on average, he would have generated fees of at least $1 million per year in 1970s dollars.  However, by the late 1960s, he was securely rich and did not want to be “totally occupied with out-pacing an investment rabbit all my life.”  The only way to slow down, in his view, was to stop.  Jeremy Miller’s new book, Warren Buffett’s Ground Rules, does an excellent job of putting the Buffett Partnership letters into context.  Perhaps more significantly, Mr. Miller draws a number of lessons from the letters that are potentially just as actionable for investors today as they were for Mr. Buffett five decades ago.

The Buffett Partnership letters have been available for a number of years and many investors understandably pored over the details chronologically in an attempt to replay the amazing track record and come up with applicable lessons.  However, just as Lawrence Cunningham added significant value putting the Berkshire Hathaway annual letters into context, Mr. Miller’s efforts with the partnership letters have revealed valuable insights that a chronological reading might miss.

For practicing investors today, the most valuable section of the book is Part II where Mr. Miller goes through the three main categories of Buffett Partnership investments:  The Generals, Workouts, and Controls. All three represent fields where modern-day investors can look for bargains with an individual’s area of focus depending mostly on temperament, circle of competence, and assets under management.

The Generals

The Generals were companies that made up a concentrated portfolio of undervalued securities that represented the majority of overall partnership gains.  With only one exception, Mr. Buffett never discussed any of the Generals with his partners or even disclosed the names of the companies.  This strict secrecy might appear eccentric to investors today.  After all, we see famous hedge fund managers on television describing their favorite investments all the time.  Mr. Buffett’s desire for secrecy, even when he was relatively unknown, stemmed from his lack of interest in seeking out fame as well as his desire to continue accumulating shares of his favorite investments at low prices.  There was no incentive for him to reveal his portfolio and invite “coat-tailing”.  According to the book, the partnership would typically have 5-10 percent positions in five or six generals with a number of smaller positions adding another 10-15 percent in aggregate.

How did Warren Buffett go about selecting the Generals?

He was constantly appraising the value of as many stocks as he could find, looking for the ones where he felt he had a reasonable ability to understand the business and come up with and estimate for its worth.  With a prodigious memory and many years of intense study, he built up an expansive memory bank full of these appraisals and opinions on a huge number of  companies.  Then, when Mr. Market offered one at a sufficiently attractive discount to its appraised value, he bought it; he often concentrated heavily in a handful of the most attractive ones.

Imagine for a moment Warren Buffett sitting in his office in the late 1950s with The Wall Street Journal, a Moody’s Manual, a pile of printed annual reports, a notepad, and a pencil.  These were the tools of his trade at the time when he was coming up with these lists of investment candidates.  There was no SEC website, no access to spreadsheets like Microsoft Excel, no way to research companies except to send out for information, and he didn’t even have an HP-12C.  The idea of coming up with a list of hundreds of investment candidates and then keeping up with them and gauging their relative attractiveness is hardly an easy task with modern resources but it is certainly possible for diligent investors.  In the 1950s and 1960s, raw memory, intellect, and work ethic were probably greater competitive advantages than they are today, but the right temperament, which is timeless, is even more critical.

Workouts

Merger arbitrage was a major source of investment ideas and profit for the Buffett Partnership throughout its history.  As Mr. Buffett was wrapping up the partnership in 1969, he lamented that his performance in workouts that year had been “atrocious”.  Indeed, merger arbitrage was a hazardous activity in the 1960s and remains so today, except now there is far more information and efficiency which could make this field more challenging.

For the partnership, the overall experience in workouts was positive due to Mr. Buffett’s skill and insight into which deals to bet on.  When an acquisition is announced, the spread between the price the target company’s stock trades at and the offer price represents potential profit to an investor purchasing the stock.  The degree to which the investor can profit depends on the size of the spread, the amount of leverage used, the amount of time between buying the target’s stock and the transaction closing, and whether the deal actually does close or falls apart.  The situation becomes much more complex when an offer involves the acquiring company’s stock rather than cash.

Despite the risks, workouts represented an attractive field for the partnership both because of the profits they generated and due to the fact that these returns were uncorrelated to the overall stock market.  In most years, workouts made up 30-40 percent of partnership assets.  When the overall level of the stock market was rising, Mr. Buffett would tilt the partnership away from Generals and toward Workouts.  When the stock market was falling, he would allocate more capital toward Generals and less toward Workouts.

In contrast to the secrecy surrounding Generals, Mr. Buffett was more willing to discuss Workouts once they were fully … worked out.  Mr. Miller presents one such case study regarding Texas National Petroleum from the 1963 letter.  In considerable detail, Mr. Buffett describes how he came up with the idea, researched the matter in great detail, and profited from the spread that emerged.  One interesting item to note is that the company’s management was often available to comment on how the process was going.  While perfectly legal, ethical, and appropriate based on the rules in existence at the time, it isn’t clear whether managers today would be willing to discuss the progress of a transaction with an outside shareholder.

Modern-day investors can pursue workouts today but have to use a great deal of caution.  One potential field for consideration might involve looking at deals that involve Berkshire Hathaway.  For example, when Berkshire announced the Precision Castparts acquisition in August 2015, Precision Castparts shares did not trade up to the $235 offer price.  Shares jumped from around $193 on the day before the announcement to slightly over $230 on the day of the announcement.  One could purchase shares at $230 in mid-November and at a little over $231 just days before the acquisition closed in January 2016:

PCP August 2015-January 2016

Obviously buying shares during this period was not entirely risk free.  If the transaction fell through for any reason, shares would probably have fallen back to August levels or perhaps even further given the overall market environment in early 2016.  However, Berkshire is known for never backing out on acquisitions once announced.  The risk seemed quite low.  An investor who added leverage and waited until the transaction was about to close could have earned substantial returns.

Is this field risk free or for the faint of heart?  Not at all, but this was an important category for the Buffett Partnership and worth examining for those who believe that they have a suitable temperament.

Controls

Berkshire Hathaway’s policy is to never pursue hostile acquisitions and the company does not typically seek to influence the managers of investees.  Warren Buffett is not known as an “activist” investor today but that is precisely what he was at times during the 1960s.  The most famous example is Berkshire Hathaway itself where Mr. Buffett built up a stake in the company over several years before assuming control and forcing out management.  Berkshire started out as a General and morphed into a Control.

Although Berkshire Hathaway might be the most famous example of a Control, Mr. Miller’s coverage of the Sanborn Map Company is a classic that modern-day investors might find it easier to relate to.  Sanborn Map made up 35 percent of the partnership in 1959 and concluded successfully in 1960.

Sanborn was a successful publisher of very detailed maps used by insurance companies to assess various risks.  The company was a cash cow and management built up a large securities portfolio over a number of years.  By the late 1950s, the map business was in decline.  The market quotation of Sanborn implied that the map business had negative value, as Mr. Buffett described:

In the tremendously more vigorous climate of 1958 [in comparison to the late 1930s] the same map business was evaluated at a minus $20 [per share] with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.

The size of the investment portfolio had also made managers and directors complacent and there was a lack of urgency in rejuvenating the map business, which Mr. Buffett believed still had positive value.  Mr. Buffett joined the board but found that most of the other directors had nominal holdings of the stock and did not share his urgency.  In late 1958, an opportunity arose when several unhappy large shareholders decided to sell.  However, even in combination with unhappy continuing shareholders, Mr. Buffett lacked an outright majority.  Seeking to avoid a proxy fight, a solution was devised to take out all shareholders who wanted to exit:

About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value.  The map business was left with over $1.25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated.  The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.

In this example, we see an investor who was not yet thirty years old take effective control of a company founded in the late 1800s and devise a solution that not only resulted in significant gains for the partnership but also a positive outcome for continuing shareholders of Sanborn.  So, while Warren Buffett was an “activist” in his early years, the basic elements of fair dealing that he is known for today were already present.

George Risk Industries – A Modern Day Potential Control?

Are there still situations like Sanborn Map?  The situation at George Risk Industries in early 2010 was not identical to Sanborn Map but it “rhymed” in certain ways.  George Risk, founded in 1965, had an operating business but was massively overcapitalized with a large securities portfolio.  The son of the company’s founder served as CEO and had a controlling interest.  With a market capitalization of just over $20 million at the time, the company also traded below net current assets.

Fast forward to 2016 and not much has changed.  The founder’s son passed away and his daughter took over as CEO.  The family still has a majority interest in the company.  The valuation of the company has nearly doubled to around $37 million and shareholders have received meaningful dividends throughout the period.  The company is still massively overcapitalized.  Returns from owning George Risk have not equaled the return from S&P 500 or Berkshire Hathaway.

Would Warren Buffett, if he had been operating with very little capital in 2010, have attempted to purchase shares of this thinly traded stock?  Would he have taken an active role trying to persuade the Risk family to distribute securities to shareholders?  We cannot know the answer to these questions but would note that this field of endeavor is still very much open to small investors who have the appropriate temperament, and perhaps more importantly, a great deal of patience and ability to underperform for a long period of time while waiting for the investment thesis to play out.

Anyone who is interested in George Risk has the luxury of access to the SEC database covering almost 20 years of company history, something an investor operating in the 1950s could only dream about.

Closing the Partnership

As one reads the final chapters of the book, we know how the arc of Mr. Buffett’s life will proceed and view the story from that perspective.  However, in the late 1960s, it really did appear that Mr. Buffett wanted to slow down.  It was clear that he did not want to fully “retire” and intended to take at least an advisory role at Diversified Retailing and Berkshire Hathaway.

Some of you are going to ask, “What do you plan to do?”  I don’t have an answer to that question.  I do know that when I am 60, I should be attempting to achieve different personal goals than those which had priority at age 20.  Therefore, unless I now divorce myself from the activity that has consumed virtually all of my time and energies during the first eighteen years of my adult life, I am unlikely to develop activities that will be appropriate to new circumstances in subsequent years.

It is hard to not observe that Mr. Buffett closed the partnership shortly before reaching 40 years of age.  Was this part of a mid-life crisis?  Those of us on the far side of the big 4 – 0 might relate to the need to make some sort of reassessment upon the realization that we will soon be closer to receiving Social Security than to our college years.  It is obviously true that the environment of the late 1960s, described in detail in the book, was the main factor and Mr. Buffett really did feel like he was out of good ideas that could be implemented within the constructs of a $100 million portfolio.  However, it is interesting to get somewhat of a personal window into what went into the decision at this point in his life.

Regardless of intentions, we know that any “slow down” did not last for long.  As Chairman and CEO of Berkshire Hathaway, Mr. Buffett took the underlying ground rules of his partnership into a corporate form.  As the Berkshire Owner’s Manual makes clear, the corporate form has not erased the partnership culture.

Most value investors are familiar with the history of Berkshire Hathaway and with the broad outlines of the Buffett Partnership as documented in excellent biographies such as The Snowball and The Making of an American Capitalist.
Thanks to Mr. Miller’s efforts, we now have the ability, in a concise and efficient format, to explore Warren Buffett’s early years as a professional investor.  Whether reading the book for actionable approaches to investing or just out of biographical curiosity, it is definitely time well spent.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

A Closer Look at Markel Ventures

Markel Ventures is a wholly owned subsidiary of Markel Corporation focusing on acquiring companies outside the insurance industry.  Starting with the $14 million acquisition of AMF Bakery Systems in 2005, Markel Ventures has grown into an operation that generated over $1 billion in revenue in 2015 which accounted for nearly 20 percent of Markel’s total revenue.  Although the vast majority of Markel Corporation’s value remains tied to its insurance subsidiaries, Markel Ventures has grown to be a more important part of the overall business.

We have covered Markel on a number of occasions in recent months starting with an overview of the company shortly after shares reached $800 in June 2015.  Although the Markel Ventures operation was discussed, the valuation estimate did not explicitly assign any value to the non-insurance subsidiaries, putting forth the following argument:

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.

Shares have recently been climbing toward the $1,000 level which can be partially attributed to the company’s strong insurance results and book value growth in recent quarters.  However, the expansion of the company’s price-to-book ratio implies that market participants are starting to place more value on Markel as a “mini-Berkshire”.  Insisting on valuing Markel based on the insurance operations alone makes the current price appear to be increasingly stretched.  While changing valuation models in response to a run-up in a stock price is potentially hazardous, so is ignoring an important segment of a company and coming to the wrong conclusion regarding whether the shares continue to offer a reasonable value.  It is clearly past due to take a more serious look at the history and current composition of Markel Ventures.

History of Acquisitions

Although Markel Ventures began operations in 2005, the company took a conservative approach in terms of how quickly to build up its portfolio of non-insurance operations.  After the AMF Bakery Systems acquisition in 2005, the company waited until 2008 to add a second business and did not commit significant capital until the economy was in the midst of the severe economic downturn following the financial crisis of 2008.  Markel Ventures was first discussed in the company’s 2009 letter to shareholders.  Management argued that the criteria for acquisitions was essentially the same as the criteria for stock market investments:

Strategically we believe the ongoing development of Markel Ventures will create value for Markel. All of these companies fit our longstanding investment discipline. As is the case in what we seek in our portfolio of publicly traded businesses, these businesses are profitable, with good returns on capital, they are run by management teams with equal measures of talent and integrity, they will use their profits to either grow their existing business or return the cash to Markel and we acquired them at fair prices.

Ventures was expected to provide opportunities for reinvestment of capital within individual units or elsewhere within Markel.  Additionally, management found it attractive to have a source of earnings and cash flow independent from the insurance business which can provide additional flexibility to deploy cash at the holding company level without undue regulatory scrutiny during stock market downturns.

During the early years, Markel provided very limited data regarding the non-insurance subsidiaries.  Although significantly more detail has been provided over the past several years, some estimations were still required when coming up with a picture of the overall acquisition history.  The data in the following exhibit should be considered a good faith estimate rather than a precise accounting of the acquisition history of Markel Ventures (click on the image for full size):

MKL Ventures History

The bakery businesses have been consolidated into the Markel Food Group and links for the websites of the other subsidiaries can be found on Markel’s website.  Many of the businesses are quite interesting to read about but to keep this article to a reasonable length, we will refer the reader to Markel’s website for further information and proceed to a relatively high level look at the overall Markel Ventures operation based on consolidated information found in Markel’s financial statements.

Balance Sheet

Since 2012, Markel has provided a balance sheet for the Markel Ventures operations.  This is obviously useful for any evaluation of the unit’s overall economic performance and it also serves as a check on the imprecise accounting of the Ventures acquisitions presented above.  The following exhibit shows the balance sheet data for Markel Ventures for the past four years:

Ventures Balance Sheets

It is important to note that the balance sheets for Markel Ventures are fully consolidated into the balance sheets of Markel Corporation, with certain intra-company items eliminated in consolidation.  Although Markel Ventures utilizes debt, we should note that at December 31, 2015, $216.9 million of the $322.4 million of debt was due to other subsidiaries of Markel Corporation and eliminated in consolidation.  Markel Corporation has predominantly funded Markel Ventures using equity, thereby redeploying funds that it generated through the insurance operations over the years.

The non-controlling interests on the balance sheet arise from the fact that Markel Ventures often acquires a majority stake in a company that falls short of complete ownership.  In many cases, the remaining shares of the company are acquired subsequent to the initial transaction at prices that vary with the post-acquisition performance of the unit.  We can see that total capital employed of approximately $900 million is roughly in line with our estimate of the cash Markel Ventures has deployed over the past decade.  Earnings of ventures subsidiaries that are retained within the Markel Ventures organization would increase equity over time.  However, the balance sheets we have access to do not provide enough granularity to isolate changes in equity due to earnings retention versus new investment.

Operating Results

Over the past five years, revenue from Markel Ventures operations has increased rapidly due to the number of new acquisitions that have been made.  The company separates Markel Ventures revenue into manufacturing and non-manufacturing segments.  The exhibit below displays income statement data for the past five years:

Markel Ventures Income Statements

At a surface level, these results are not exactly inspiring to look at.  The overall operating margin has been in the mid-single digits over the past couple of years and net income has been modest relative to the investments made in Markel Ventures to date.  However, for a number of reasons, reported net income is not a particularly good measure of how the businesses have performed to date.  The reader should be very skeptical of this claim since specious “adjustments” to earnings have proliferated like wildfire in recent years.  EBITDA, Adjusted EBITDA, and even more creative measures are usually designed to obfuscate rather than enlighten.

Markel management does provide EBITDA information for Markel Ventures with the rationale explained in detail on pages six to eight of  the 2010 letter to shareholders.  Readers are encouraged to review this information and come to their own conclusions regarding the usefulness of EBITDA when it comes to evaluating Markel Ventures.  From our perspective, the primary use of EBITDA is to evaluate the performance of the business relative to capital employed in a manner that is independent of capital structure and tax policy.  The exhibit below shows the EBITDA information reported by Markel over the past seven years:

Markel Ventures EBITDA

The use of EBITDA, although warranted with the caveats explained by Markel’s management, seems a rather crude measure particularly because depreciation is a very real expense that must be taken into account.  Certain Markel Ventures subsidiaries are more capital intensive than others but we can see that depreciation has become a rather meaningful line item.

We prefer to look at Markel Ventures by starting with the net income line item and then making adjustments that seem appropriate in an effort to understand the true economic earnings of the group of businesses.  There are three major adjustments we have made:

  • Diamond Healthcare Goodwill Impairments.  Over the past two years, there have been goodwill impairments taken to write down the value of Diamond Healthcare.  Although these charges indicate that management may have made errors when deciding how much to pay for Diamond to begin with, they are non-cash charges that obscure the current earnings power of the group as a whole.
  • Cottrell Earn-Out Adjustment.  In 2015, there was a significant charge recorded to account for an increase in the expectation of “earn-outs” to be paid to the former owners of Cottrell.  At the time the Cottrell acquisition was made in 2014, a portion of the amount to be paid to the owners was based on the performance of the business in 2014 and 2015 subsequent to the close of the acquisition.  Markel’s management made an estimate of the amount of this “earn-out” based on their expectation of how Cottrell would perform.  It turned out that Cottrell performed better than anticipated.  As a result, the additional amount owed to the former owners was charged as an “expense” in 2015.  This charge is better looked at as an increase in the purchase price of Cottrell and should logically be attributed to a capital account rather than an expense account.
  • Amortization.  Accounting rules require management to amortize intangible assets over a period of time by recording charges against earnings.  In the 2010 letter to shareholders, management argues that this is not a real economic cost because the value of intangibles should actually be increasing over time rather than shrinking, assuming that intelligent acquisitions were being made and properly managed.  This viewpoint has merit but, in the interests of conservatism, we consider 20 percent of amortization charges to be “real” and 80 percent to be “non-economic”.  Warren Buffett has estimated the non-economic percentage of Berkshire Hathaway’s manufacturing, service, and retail amortization charge to be 80 percent.  While the mix of businesses are obviously different, using the 80 percent approach rather than assuming all amortization is non-economic seems like a conservative adjustment to make.

The exhibit below shows our estimate of “economic earnings” for Markel Ventures based on making the adjustments discussed above and accounting for tax effects.  Note that the tax effect line item may be overstated if amortization and/or goodwill impairments are not deductible for income tax purposes.  However, sufficient information does not appear to exist to make this determination so the adjustment is made in the interests of conservatism.

Markel Ventures Economic Earnings

If the estimate of economic earnings is in the ballpark and recent trends continue, it looks like the ventures operations, in aggregate, are earning around 10 percent on equity.  Obviously, this adjusted figure is far different from the return on equity one would calculate based on reported net income.  However, the adjustments seem quite defensible based on the arguments presented above.

Markel recently reported results for the first quarter of 2016.  Markel Ventures EBITDA was $41.1 million, up from $33.6 million in the first quarter of 2015.  Net income to shareholders was $14.1 million, up from $10.5 million.  Management reported that the increases were primarily due to higher earnings at certain manufacturing operations as well as due to the CapTech acquisition in December 2015.

Valuation

The valuation approach presented in June 2015 explicitly did not account for any value associated with the Markel Ventures operations.  As noted earlier, the assumption was that any value that existed in the ventures operation would be an additional “margin of safety” for investors or could be viewed as a bonus.

Although the vast majority of Markel’s intrinsic value still resides in the insurance business, Markel Ventures has been growing to the point where it should be explicitly considered in the valuation process.  There are a number of approaches that could be used to incorporate Markel Ventures.  The methodology we have chosen, which clearly is not the only “valid” approach, is to segment the insurance and ventures operations as if they were two separate companies.  We estimate the value of each unit and then come up with a sum of the parts to arrive at the total valuation for Markel Corporation.

The valuation of the insurance business is essentially identical to the approach presented in June 2015, except that we have deducted equity attributable to the ventures operations from the estimate of insurance equity.  We assume that Markel posts a 100 percent combined ratio over the next five years and deploys its investments at various rates of return.  We then come up with a terminal price-to-book value for the insurance business only to estimate the market’s assessment of the business in five years.  This valuation is then discounted to estimate today’s present value of the insurance subsidiaries.

The Markel Ventures valuation model simply estimates 2016 “economic earnings” and applies an earnings multiple ranging from 16 to 20 to arrive at an estimate of current intrinsic value.  One can debate both the estimate of economic earnings and the multiple selected but a good “reality check” is that the estimated valuation falls within a plausible range given the cash that Markel has invested into these businesses over the past decade.

The exhibit below presents the valuation exercise for Markel Corporation as described above:

Markel Valuation

The overall valuation of Markel Corporation is simply the sum of the parts divided by shares outstanding at March 31, 2016.  Taking the base case estimate, we arrive at a valuation of $909 per share, with $825 per share attributed to insurance operations and $84 per share attributed to Markel Ventures.  Although this baseline estimate is materially higher than what we would estimate if Markel Ventures were totally ignored, it is still substantially below where Markel has traded recently.

Markel has a very strong track record, as we have pointed out in past articles, and the current share price might very well prove to be justified based on future events.  Nevertheless, it is always prudent to estimate the value of a business based on sound principles that are not subject to changes designed to “justify” a recent price advance.  At the same time, valuation methodologies cannot remain so fixed as to fail to respond to material changes in the underlying business. Markel Ventures has clearly reached the point where shareholders must estimate its value in some manner.  The method above is one of many ways to do so.

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