The Rational Walk
Intelligent Investing is not a "Random Walk"

Markel Corporation: Q2 2015 Results August 6, 2015

Markel Corporation released second quarter 2015 results yesterday and held a conference call this morning.  Although second quarter results were favorable for the insurance business, unrealized losses in the investment portfolio caused book value per share to decline slightly to $554.97.  Book value is still up approximately 2 percent for the year. Diluted net income per share for the first half of 2015 more than doubled to $20.21 compared to $8.91 for the first half of 2014.

Markel’s common stock only recently surpassed $800 per share and approached $900 in recent days.  Despite a modest decline today, Markel’s stock is still up over 29 percent in 2015 leaving its price-to-book ratio at levels not seen since before the 2008-09 financial crisis.

Insurance Results

Markel has continued to post very strong results for its core insurance business.  For the first half of 2015, the consolidated combined ratio came in at 90 percent which is down substantially from 98 percent for the first six months of 2014.  The improvement in the first half combined ratio was driven by improvements in all three of the company’s insurance segments.  Markel has continued to demonstrate solid underwriting performance and has been willing to shrink premium volume when justified.  The table below, taken from Markel’s 10-Q report, provides a good summary of the performance of the insurance business for the second quarter and first half:

Markel Insurance Results 1H 2015

It is important to note that Markel has a history of conservatism when it comes to establishing reserves for losses.  To an unusual degree compared to less complex businesses, insurance executives have a great deal of latitude when estimating ultimate losses related to current year events.  This is particularly true in lines of business where losses may not be reported for a long period of time.  It has become a recurring theme of Markel earnings reports to see “favorable development” on prior years’ loss reserves.  While it may seem like focusing on “favorable development” is an exercise in over-analyzing the minutia of an insurer’s internal management, it is indeed of vital importance for the serious investor.  The table below illustrates the  major impact prior years’ development can have on periodic reported results:

Markel Insurance Disclosures 1H 2015

Clearly the magnitude of prior accident year development can have a very large effect on the results being reported for any given period, to the point where development can often be larger in magnitude than the periodic underwriting gain or loss, making it the controlling element in whether underwriting is profitable or not for a given period.  Markel does appear to often over-reserve in current periods only to scale back estimates in later years.  Such conservatism, within reason, is a positive attribute since surprises can also be negative.  Unfavorable development is also often known as “reserve strengthening” in insurance company jargon and typically something investors are not pleased to be surprised with.

Overall, Markel continues to demonstrate a longstanding ability to generate underwriting profits in a conservative manner.

Investing Results

Markel’s history of investing shareholders equity and policyholder float at attractive rates of return has been an integral component leading to strong book value growth.  The table below is a good summary of investing results for the second quarter and first half of 2015:

Markel Investment Results 1H 2015

Although the components of the investing segment that are reflected on Markel’s income statement were roughly comparable to the results posted last year, there were significant unrealized losses in the second quarter of 2015 that negatively impacted comprehensive income and book value per share. In the press release as well as the conference call, management attributed the unrealized losses to an increase in interest rates during the second quarter as well as strength in the U.S. dollar.

A portion of Markel’s fixed income portfolio is invested in securities denominated in foreign currencies with the intent of matching these assets to projected future policyholder liabilities also denominated in foreign currencies.  While a stronger U.S. dollar results in a decline in the reported value of these fixed income securities, the matching liability also declines resulting in minimal net exposure.

The more important factor leading to negative reported results in the quarter is clearly a rise in interest rates but this will eventually have a silver lining as Markel reinvests maturing fixed income securities into new securities with a higher yield.  This will result in net investment income rising in future years.  Markel’s fixed income portfolio duration is relatively low which is a positive attribute during times of rising interest rates.

Markel Ventures

Although Markel still does not recognize Markel Ventures as a reportable segment, disclosure has improved in recent years.  The following table provides a reconciliation of EBITDA, management’s preferred metric, to reported net income:

Markel Ventures 1H 2015

One quirk in quarterly results for Markel Ventures has to do with the Cottrell acquisition which closed in July 2014.  Markel linked a portion of the purchase consideration to Cottrell’s post-acquisition performance through 2015.  Since Cottrell has performed better than anticipated at the time of the acquisition, Markel will have to pay additional “earn out” compensation to the prior owners.  Rather than treating this earn-out compensation as part of the purchase price of Cottrell, accounting regulations force Markel to treat the earn-out as a current period expense.  During the quarter, Markel increased its estimate of the earn-out by $17.6 million.  Management views this payment to Cottrell’s former owners as part of the purchase price of Cottrell while accounting regulations treat it as a current period expense.  It appears pretty clear that Markel’s management makes the more logical case regarding how to view this payment.  As a result, one can view current period results as quite a bit more favorable than reported in the table above.

Conclusion

Markel reported a solid second quarter and first half of 2015 despite a quarter-to-quarter decline in book value per share driven by the effect of rising interest rates on the company’s fixed income portfolio.  The investment case described in June when Markel breached the $800 per share level remains intact.  However, it is important to note that the share price has advanced considerably since June and even more dramatically over the past year.

Markel now trades at approximately 1.59x book value which is close to a high in the post 2008-09 crisis period.  However, while this price-to-book ratio looks high if the post-crisis average is the “new normal”, it should be recognized that it would represent more of a floor for the price-to-book ratio that prevailed from the turn of the century until 2007.  Overall, even at today’s higher price, Markel appears to represent a compelling opportunity to own a high quality insurance business with additional potential upside if Ventures evolves into a smaller version of Berkshire Hathaway’s non-insurance conglomerate over time.  However, it would be unreasonable to expect share price increases in the future to come anywhere close to the pace of the recent advance.

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

Comments Off on Markel Corporation: Q2 2015 Results

When to Sell a Successful Investment July 20, 2015

“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher

“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks

There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value.  In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio.  This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time.  During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk.  Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.

On the other hand, the decision to sell can frequently be agonizing for various reasons.  If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership.  Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment.  Often times, the best approach is to pull the band-aid off quickly and move on.

The more interesting question, and the subject of this article, is when one should sell a successful investment.  This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common.  In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success.  We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum.  This necessitates careful consideration of when a successful investment has run its course.

Motivations for Selling

There are obviously a number of motivations that would lead an investor to sell a successful investment.  Many of the reasons are somewhat beyond the scope of this article.  It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence.  Such needs may be immediate or on the horizon.  Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short.  In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.

Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment.  This is the more interesting scenario for purposes of this article.  When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?

Assess Prospective Returns

Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail.  It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis.  Investors are subject to both good and bad luck.  When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.

Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level.  For example, a month ago, we posted an article on Markel trading above $800 per share for the first time.  Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article.  As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.

The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years.  Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.

Consider Tax Consequences

Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities.  Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future.  However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities.  Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.

All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities.  For example, consider an investor who purchased Markel shares at $400 approximately four years ago.  Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains.  The current effective top Federal income tax rate on long term capital gains is 23.6 percent.  Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities.  In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.

Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346.  At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.

If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment.  At that rate of return, the new investment will be worth $1,234 in five years.  Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government  resulting in net proceeds of $1,123.

(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads.  We have ignored transaction costs for purposes of simplicity.)

The Hurdle May Be High

As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable.  In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off.  Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower.  Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.

It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account.  In such cases, the tax friction disappears, but the other issues remain.  Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities.  It goes without saying that frequent activity on a short term basis is almost always ill advised.  The same is often true in the long run, as Philip Fisher pointed out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel.  Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares.  See also general disclaimer.

Comments Off on When to Sell a Successful Investment

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.

 

Comments Off on Markel Corporation at $800/share

How to Read the Berkshire Hathaway Annual Report February 27, 2015

Berkshire Hathaway Mill - New Bedford, MAThe release of Warren Buffett’s annual letter to shareholders is one of the most important events of the year for value investors.  This year, the significance of the letter is accentuated by the fact that fifty years have passed since Mr. Buffett took control of Berkshire Hathaway. Mr. Buffett is effectively the “founder” of Berkshire in its current form as an investment holding company and conglomerate of operating subsidiaries.

Berkshire Hathaway’s annual report, scheduled to be released tomorrow morning, has long followed a format leading off with a table documenting Berkshire’s annual and cumulative performance followed by Mr. Buffett’s letter to investors and Berkshire’s financial results for the past year.  This year, Mr. Buffett’s letter is expected to focus on his view of Berkshire’s potential evolution over the next fifty years.  In addition, Charlie Munger has written a separate letter to shareholders outlining his view of Berkshire’s next fifty years.  According to recent interviews, there has been no collaboration between Mr. Buffett and Mr. Munger when it comes to presenting their thoughts on Berkshire’s future.

Form Your Own Opinion

From the moment the report is posted online at 8 am eastern time tomorrow, social media and news outlets will be flooded with various opinions regarding the annual letter and Berkshire’s results.  Sometimes one has to wonder how it is possible for anyone to form instant opinions but it is a virtual certainty that at 8:01 am, declarative judgments of the contents of the material will already be prevalent online.  To immunize yourself against this intellectual assault, simply print the annual report on actual paper, turn off your computer, and disconnect from all social media and news until after finishing a review of the report.  Failure to do so will inevitably pollute your own judgment regarding the contents of the report and, even worse, may do so in a subliminal manner as the opinions of others act in subtle ways to alter your own thinking.

First Things First

As a general rule, it is best to review the actual results of a business prior to reading management’s assessment of the results.  In most cases, the reason behind doing so is to avoid being unduly influenced by management teams (or more frequently PR consultants) who are trying to spin results in some way.  With Berkshire Hathaway, we do not have to worry about Mr. Buffett trying to mislead shareholders but if we read his letter prior to reading about Berkshire’s results, we will invariably be influenced by his conclusions anyway.  Since it will be very difficult to read the entire financial report before peeking at Mr. Buffett’s letter, at least resolve to conduct a thirty minute review of Berkshire’s important business segments and overall financials before delving into the letter.

What to Look For in the Letter

Mr. Buffett’s letters typically follow a format where he presents his overview of Berkshire’s recent results and follows up with essays on various topics.  Sometimes the topics are directly relevant to Berkshire’s business units but often they also involve much broader topics.  It is likely that the letter will, to some degree, follow the format of prior years but we can perhaps expect a more lengthy review of how Berkshire’s fifty year record came about since this forms the foundation of what Berkshire is today.  Once that foundation is well understood, we can look to the future and we can expect Mr. Buffett’s views on how Berkshire might evolve over the next fifty years.

There are a number of key topical areas that shareholders should look for:

Management Succession

There is no reason to believe that Mr. Buffett has changed his mind regarding continuing to lead Berkshire Hathaway as long as he is fit to do so and recent television interviews provide no reason to suspect any deterioration in his physical or mental condition.  However, as the recent passing of Berkshire Hathaway Director Donald R. Keough at age 88 reminds us, the health of a man in his eighties can often change for the worse very quickly.  Berkshire’s succession plan may not be needed for another ten or twenty years or it could be needed in the near future.

Mr. Buffett is nearly certain to not name the current frontrunner to be Berkshire’s next CEO but he could very well expand upon his thoughts regarding the necessary qualities and characteristics that will be needed.  At this point, there are a number of Berkshire executives who are often named as potential future CEOs but, as time passes, many of these men are getting into their 60s or 70s.  Mr. Buffett might drop clues regarding the desired duration of his successor’s tenure.  He has previously hinted that the next CEO should have a long tenure and, if this is reinforced, one might tend to believe that the top candidate could be in his 50s rather than in his 60s or 70s.

Capital Allocation

Mr. Buffett’s prior letters have often gone into great detail regarding his views on the role of a CEO as capital allocator.  This will be one of the most important roles for the next CEO in addition to maintaining Berkshire’s unique corporate culture.  A key decision that the next CEO will face will involve whether to return capital to shareholders or to continue Mr. Buffett’s practice of retaining all earnings.

Shareholders who might otherwise agitate for a return of capital have long been content to allow Mr. Buffett to retain all earnings since having a large amount of cash on hand provides him with a great deal of optionality when it comes to future deals.  Given Mr. Buffett’s long demonstrated mastery of the art of capital allocation, having long periods of near-zero returns on a pile of cash is viewed as an acceptable trade-off to preserve the optionality of a major deal that would be facilitated by the cash.  No matter how accomplished Mr. Buffett’s successor will be, shareholders are unlikely to have the same patience.  Some words of wisdom regarding how much flexibility Mr. Buffett’s successor should have in this regard might be useful.

It will be virtually impossible for Mr. Buffett to paint a picture of Berkshire in fifty years without at least implicitly rendering a verdict on Berkshire’s ability to continually deploy cash internally at attractive rates of return.  If Berkshire retains all earnings for the next fifty years and is able to reinvest those earnings into attractive new subsidiaries and investments, the market capitalization of the company would be truly mind boggling.  For example, if Berkshire can compound its market capitalization at 5 percent in real terms over the next five decades, its market capitalization would exceed $4 trillion in current dollars.  At some point, Berkshire will clearly have to return capital to shareholders.  Mr. Buffett might provide clues regarding when that day is likely to arrive.

Organizational Structure

Berkshire has a reporting structure where nearly all of the major subsidiary CEOs report directly to Mr. Buffett.  This is partly due to the history behind many acquisitions and Mr. Buffett’s ability to inspire subsidiary managers to the point where they need hardly any “oversight” at all.  Berkshire’s future CEO, regardless of accomplishment, is not going to be Mr. Buffett’s equal in terms of inherent capabilities or in terms of his ability to inspire unquestioned loyalty from his subordinates.  However, it is critically important for Berkshire to retain a decentralized structure that empowers subsidiary managers.  How should this balance be achieved?  While the exact approach may be one that Berkshire’s next CEO will have to formulate, perhaps some clues will be provided in Mr. Buffett’s letter.

“What Would Warren Do?”

At some point, Berkshire’s next CEO is going to face a crisis or some event that leads shareholders and, perhaps even the Board, to start obsessing over “what Warren would do” under the same circumstances.  While it is very important to take lessons from Mr. Buffett’s life and business track record, nothing could be more harmful for Berkshire’s next CEO than to be a slave to the inferred decisions of a past leader.

Apple’s current CEO, Tim Cook, had the seemingly impossible task of taking over for an ailing Steve Jobs in 2011.  Mr. Jobs was adamant that Mr. Cook should not be haunted by constantly asking “what would Steve do?” but should simply do what he thought was right.  Obviously, it would be foolish for Tim Cook to make decisions without considering the lessons he learned from Steve Jobs, but ultimately he has to make his own decisions.  The same will be true for Mr. Buffett’s successor.  Mr. Buffett might choose to paint a picture of how Berkshire shareholders should think about evaluating the next CEO in this light.

Conclusion

The best approach for reading Berkshire’s annual report, or the annual report of any company, is to make your own judgments and avoid being influenced by others until after you have first reached your own preliminary conclusions.  On Saturday morning, the best approach is to print the report on actual paper and to go off-line to avoid even the temptation of considering the views of others prematurely.  Spend the better part of the day reading the report and considering what Mr. Buffett and Mr. Munger have to say about Berkshire’s future and then, if you choose to, engage in discussions with other Berkshire shareholders or review what the professional pundits have to say.

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

Comments Off on How to Read the Berkshire Hathaway Annual Report

Revisiting Berkshire Hathaway’s Valuation September 18, 2014

Berkshire Hathaway

Berkshire Hathaway HeadquartersOver the past five years, Berkshire Hathaway has been a frequent topic on The Rational Walk easily surpassing the coverage of any other company.  In retrospect, there have been many reasons for this lopsided treatment of one company in a universe of thousands of publicly traded businesses.  What motivated this unusual focus on Berkshire Hathaway?

Perhaps the most important reason is the clear fact that Berkshire Hathaway is a unique company driven by a very uncommon management philosophy which has led to extraordinary results for shareholders. The record of Warren Buffett and Charlie Munger’s management of Berkshire Hathaway over the past fifty years is unique in business history and certain to be examined for decades to come.  Both investors and managers naturally seek to better understand this extreme outcome and the approach that was used to achieve it.

However, another important motivation involved the market’s valuation of Berkshire in the aftermath of the tumultuous events of 2008 and early 2009.  For a number of years, it appeared that the market had permanently reassessed Berkshire’s intrinsic value relative to valuation levels that had prevailed for a long period of time.  In recent weeks, Berkshire’s stock price has reached record highs, but more importantly the valuation of the stock has returned to levels that might have been considered within the bounds of “normalcy” prior to late 2008.  In this article, we revisit Berkshire’s current valuation relative to historical ranges and assess whether a return to normalcy is justified.

Berkshire’s Price-to-Book Ratio

There are a number of approaches that analysts have used to estimate Berkshire Hathaway’s intrinsic value, many of which have been discussed in some detail in past articles as well as in more extensive reports published in 2010 and 2011 (both of which are now available at no cost).

Following Berkshire’s price-to-book ratio is one of the more straightforward approaches and does have some important limitations.  However, it does have the advantage of being easily calculated based on market prices and figures published on a quarterly basis in Berkshire’s SEC filings and there is at least rough correlation between valuations derived from the price-to-book ratio and more sophisticated approaches.  Additionally, it is often cited by market participants and analysts and is therefore a good way of looking at investor sentiment with respect to Berkshire shares.  Perhaps most importantly, price-to-book is the criteria upon which Berkshire’s repurchase plan is based indicating that Warren Buffett regards this metric to be an important, albeit understated, measure of Berkshire’s intrinsic value.

The chart below presents the closing price of Berkshire Hathaway Class A shares for each trading day since December 31, 1999 along with the then-current book value per A share which is published on a quarterly basis.  Additionally, Berkshire’s repurchase threshold, which was introduced in September 2011, is charted since the date of its introduction.  The repurchase threshold was initially set at 110 percent of book value in September 2011 and subsequently raised to 120 percent of book value in December 2012.

Berkshire Hathaway 2000-2014

From this simple chart, we can see that Berkshire has almost always traded at a significant premium to reported book value except on a few occasions.  In early 2000, Berkshire was out of favor as the dot-com bubble reached its peak and briefly traded at only a small premium to book value.  This situation prevailed for only a short time before Warren Buffett indicated an interest in repurchasing Berkshire shares at $45,000, which was 118 percent of book value at the time.  During the depths of the panic in the fourth quarter of 2008, Berkshire briefly approached book value as reported at the end of the third quarter;  however, this was during a time when market participants were not only in a state of panic but also correctly anticipated that depreciation in Berkshire’s large portfolio of marketable securities would lead to a drop in book value.  During the third quarter of 2011, Berkshire shares approached book value which prompted the introduction of Berkshire’s repurchase plan.

The following chart represents the same underlying data but in a form that allows a more clear examination of the price-to-book ratio trend over time.  We simply take the closing price of Berkshire’s Class A shares and divide by the last reported book value figure provided by Berkshire’s annual and quarterly SEC filings.  The dark red line represents Berkshire’s repurchase authorization threshold introduced in September 2011 and revised in December 2012.

Price to Trailing Book Value

From just a brief look at the chart, it is quite apparent that the market’s assessment of Berkshire Hathaway changed six years ago.  For most of the decade up to that point, Berkshire traded in a range between 150 and 200 percent of book value.  Following the financial crisis, Berkshire’s range has been between 100 and 150 percent of book value.  The recent appreciation of Berkshire shares has increased the valuation to 147 percent of book value as of September 17.  This is at the top of the post-financial crisis range, but toward the bottom of the range that prevailed prior to the crisis.

Was the Lower Range Justified in late 2008 and early 2009?

It is important to recognize the fact that Berkshire Hathaway was not alone in the market’s valuation adjustment of “financial” companies following the financial crisis.  The level of perceived risk in financials increased dramatically in the aftermath of September 2008 and for the most part, the market was justified in its reaction at the time given the uncertainty that prevailed.  Mr. Buffett himself has commented extensively regarding the importance of government intervention at the time, and it was not clear whether officials were up to the task required.  Regardless of one’s views on the specifics of the various “bailouts”, it is quite clear that the carnage in the financial sector would have been far worse had there been less intervention at the time.

Despite the rationality of the market’s overall aversion to financials in late 2008, it is important to point out that Berkshire itself was in remarkably good shape compared to other companies.  Furthermore, Berkshire was a conglomerate engaged in diverse business activities even though it was perceived and valued as a financial.  Berkshire was in a position to provide financing to others at a time when lack of liquidity threatened to sink firms that were previously seen as rock solid.  One could argue that the market’s failure to differentiate Berkshire from its perceived peers was irrational on the part of Mr. Market.

On the other hand, investors had a wide array of choices as the market hit its lows in early 2009 and Berkshire Hathaway stock is necessarily evaluated against other alternatives.  In short, looking at the situation in retrospect, it is no surprise that Berkshire shares were roughly cut in half in less than six months even though intrinsic value couldn’t have possibly dropped by that much.  Indeed, Berkshire suffered a drop of less than 15 percent in book value per share over the course of Q4 2008 and Q1 2009 while the share price dropped over 50 percent from September 19, 2008 to its low on March 5, 2009.

Is a Lower Range Still Justified?

While hindsight might appear to justify the market’s initial reassessment of Berkshire’s intrinsic value in late 2008 and early 2009, it is much harder to make the same case as the United States economy began to recover from the financial crisis.  Even long after market participants had overcome the shocks of 2008 and early 2009, Berkshire shares continued to trade at very low price-to-book ratios.  The implication was that Berkshire’s many franchises were not collectively worth much more than the carrying value of the businesses despite the fact that Berkshire had proven itself to be resilient throughout the downturn.

The post-recession years also brought major changes to the composition of Berkshire itself with the most notable example being the acquisition of Burlington Northern Santa Fe in early 2010.  While property-casualty insurance remains Berkshire’s most important business today, the acquisition of BNSF significantly transformed Berkshire’s earnings stream.  If we also consider the acquisition of Lubrizol, additions to the Berkshire Hathaway Energy portfolio, purchasing the minority interests of Marmon, and many “tuck-in” acquisitions, Berkshire has become far more diversified over the past five years.

BNSF is an interesting case in point when looking at Berkshire’s price-to-book ratio.  At the time of the acquisition, Berkshire used a combination of cash and stock to acquire BNSF and the purchase price was allocated to various accounts on Berkshire’s balance sheet and included substantial goodwill.  As we revisited the BNSF acquisition in late 2013, it became clear that if BNSF had remained a stand-alone company, the market’s assessment of its intrinsic value would have dramatically increased from 2010 to 2013.

The following chart shows the stock price performance of Union Pacific, BNSF’s closest comparable company, from the date of Berkshire’s acquisition of BNSF to September 18, 2014 (click for larger image):

Union Pacific Stock ChartClearly, if Berkshire Hathaway had waited until today to acquire BNSF, a much higher purchase price would have been required.  Yet, Berkshire’s book value continues to reflect the acquisition cost of BNSF in February 2010 unadjusted for any subsequent reassessment in the eyes of Mr. Market.  If we were to adjust BNSF’s carrying value on Berkshire’s balance sheet to reflect the same level of appreciation as Union Pacific shares, Berkshire’s book value would increase by over $50 billion, or in excess of $30,000 per A share.  However, none of that hypothetical increase in value is reflected in Berkshire’s reported book value.

Conclusion

The example of BNSF discussed above is illustrative not merely because of the rather extreme nature of the potential valuation discrepancy between its carrying value on Berkshire’s balance sheet and its likely market value.  It also alludes to the fact that many of Berkshire’s other businesses have similarly appreciated over time.  The most extreme examples involve companies like See’s Candies that were purchased decades ago at a cost that is a tiny fraction of today’s true market value.  Over long periods of time, one can expect the difference between fair value and carrying value of wholly owned subsidiaries to rise rather than fall, implying that Berkshire’s price-to-book ratio might be expected to increase over time rather than decline.

This article focuses on Berkshire’s price-to-book ratio rather than utilizing a broader set of tools such as the float based, “two column”, or sum-of-the-parts approaches that have been discussed on this site and elsewhere over the years.  Although the price-to-book ratio has its important limitations, enough evidence exists to believe that Berkshire’s valuation based on this measure should not be appreciably lower than it was prior to the financial crisis.  Furthermore, one could reasonably expect Berkshire’s price-to-book ratio to increase at a slow pace over a period of several years.

It appears that Berkshire’s stock price has finally returned to the lower end of a “range of normalcy” in recent weeks.  While no longer as severely undervalued as it was for most of the past six years, there is no evidence to suggest that Berkshire’s share price has reached irrational levels even though it is at a record high.  Given today’s share price, Berkshire shareholders are likely to achieve returns commensurate with the growth of intrinsic value plus perhaps some additional increase in the market’s assessment of the stock.  Fortunately, Berkshire has prospects for intrinsic value growth that are quite attractive in today’s investment environment.

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

Correction to Article

September 20, 2014

A reader brought up an error in the article related to Burlington Northern Santa Fe.  The article, which remains as originally posted, stated that BNSF remains on Berkshire’s balance sheet at the approximate valuation paid for by Berkshire in February 2010.  While this is technically accurate, the statement ignores the fact that BNSF has remitted dividends to Berkshire on a consistent basis over the years.  BNSF had aggregate net income of $14,012 million from the date of Berkshire’s acquisition through the end of the second quarter of 2014.  During that same period, BNSF paid $14,250 million in cash dividends to Berkshire.  So while BNSF’s book value has remained roughly the same, Berkshire’s overall book value has grown due to cash dividends remitted to the parent company.

5 Comments on Revisiting Berkshire Hathaway’s Valuation