Markel Corporation Reports 2015 Results

Markel Corporation released fourth quarter and full year results for 2015 earlier this week.  Although the annual report will not be released until later this month, there are enough details in the press release to form some initial impressions.  We previously discussed Markel in June 2015 when the share price first exceeded $800.

Markel’s book value per share was $561.23 at the end of last year compared to $543.96 at the end of 2014 which represents an increase of 3 percent.  Book value growth was held back in 2015 primarily due to a decline in the equity and fixed income investment portfolios.  However, over the past five years, book value per share has grown at a more satisfactory compound rate of 11 percent.  Management evaluates the company’s progress based on growth of book value per share on a five year rolling basis.

Insurance Underwriting Results

Over the past ten years, Markel has slowly diversified into a number of non-insurance operations in an attempt to emulate the model that has worked so well for Berkshire Hathaway over the past half century.  However, we still view Markel as primarily a property-casualty insurer.  Insurance underwriting takes center stage when evaluating results.

Markel’s consolidated combined ratio was 89 percent in 2015 compared to 95 percent in 2014 driven by more favorable development and a lower current accident year loss ratio.  The combined ratio is a key metric for any insurance company since it represents the percentage of earned premiums that are consumed by loss and loss adjustment expenses, policy acquisition expenses, and operating expenses.  A combined ratio under 100 percent, when sustained over a long period of time, demonstrates discipline and skill on the part of underwriters.  When underwriting is profitable or break-even, all of the policyholder “float” – that is, premiums collected by Markel in advance of payments made to policyholders, can be invested in fixed income or equity securities at no cost.

As we can see from the press release, the combined ratio of all of Markel’s underwriting segments improved in 2015.

Markel 2015 Underwriting Results

A significant driver of the improvement in 2015 involved “favorable development” which refers to re-estimating ultimate losses for prior years.  A great deal of management discretion is involved in estimating ultimate liabilities for policies where claims may be unknown for several years.  As a result, it makes sense to look at the track record over an extended period of time.  The exhibit below shows Markel’s combined ratio from 1999 to 2015.  Combined Ratio 1999-2015Investors can debate the meaning of “long term” but a large majority would probably consider a track record of this length to be significant.  The combined ratio only slightly exceeded 100 percent for three out of the past fourteen years.  The addition of the Alterra reinsurance business in 2013 did change the composition of Markel’s book of business but initial results appear to be favorable.

Investing Results

Markel’s investment results for 2015 were comprised of net investment income, realized investment gains, and unrealized investment losses.  Net investment income for 2015 was $353.2 million which was down slightly from $363.2 million in 2014. The decline was due to lower bond income primarily driven by unfavorable foreign exchange rates which depressed results for foreign interest income when translated into US Dollars. Realized gains of $106.5 million exceeded the $46 million reported in 2014.  $44.5 million of write-downs for other-than-temporary declines in equity securities were included in 2015 results.  In general, Markel’s investing philosophy is very long term in nature and the timing of sales of investments, and the resulting realized gains and losses, is not particularly meaningful for any given year.  The company posted net unrealized losses of $320.5 million, net of taxes, in 2015 compared to a $661.7 million gain in 2014.  These unrealized losses were due to declines in equity and fixed income securities.  The full annual report and 10-K will be required to further analyze Markel’s investment results for the year.

Markel Ventures

2015 marks the ten year anniversary of Markel Ventures.  Over the past decade, Markel has slowly diversified into a number of unrelated manufacturing and non-manufacturing companies that are either wholly owned or majority owned.  Tom Gayner, Markel’s co-Chief Executive Officer, is responsible for capital allocation and oversight of the Markel Ventures companies with individual company executives responsible for day-to-day operations.  This model is very similar to Berkshire Hathaway’s well proven non-insurance operating philosophy.

Markel Ventures posted $1 billion of revenues in 2015 compared to $838.1 million in 2014.  The increase in revenues was primarily due to the July 2014 acquisition of Cottrell and higher revenues in the manufacturing units as well as certain non-manufacturing operations.  Markel presents some summary information in the press release which is reproduced below:

Markel Ventures

Net income from Markel Ventures rose to $11 million in 2015 from $9.6 million in 2014 while EBITDA rose to $91.3 million from $81.3 million.  Net income and EBITDA were positively impacted by more favorable results in manufacturing operations partially offset by headwinds in the non-manufacturing operations.

The underlying results of the manufacturing operations were significantly better than the headline numbers appear to be.  When Markel acquired Cottrell in 2014, a portion of the purchase consideration was based on Cottrell’s post-acquisition earnings through the end of 2015.  Cottrell posted better than expected results in 2015 which drove a $31.2 million increase in the contingent consideration due to Cottrell’s former owners.  One might assume that additional payments made to Cottrell’s former owners would be considered to be part of the cost of acquiring Cottrell and capitalized but that is not the case.  Instead, this $31.2 million increase in contingent compensation was charged against earnings in 2015 which is a significant non-recurring distortion.

In addition to the Cottrell distortion, Markel’s 2015 non-manufacturing results include a $14.9 million non-cash goodwill impairment charge related to the Diamond Healthcare unit.  According to statements made in the Markel conference call, Diamond Healthcare has no remaining accounting goodwill on the books.  Putting aside the question of whether Diamond Healthcare was a good acquisition in retrospect, with no remaining goodwill on the books similar charges are not possible in the future.

When one considers the Cottrell and Diamond Healthcare distortions, it looks very likely that results for Markel Ventures in 2016 will show significant growth in reported net income and EBITDA.  We did not explicitly account for the value of Markel Ventures in the valuation model presented in June.  It looks like the value of Markel Ventures is going to be too significant to ignore in the future.

The Long View

The case we made for Markel’s long term appeal in June appears to be fully intact.  Fluctuations in equity and fixed income markets make year-to-year progress in book value growth uneven but over the long run the skill and discipline of management becomes evident. The exhibit below shows Markel’s daily share price along with quarterly book and tangible book value along with a chart showing the price-to-book value over time.  We can see the steady progress in book value and note that the valuation on a price-to-book basis does not appear to be overly aggressive.

The Long View

For an insurance company, skill in underwriting is an absolute prerequisite when it comes to creating long term value and, more importantly, avoiding disaster. Certain insurers like Markel and Berkshire Hathaway take the value proposition a couple of steps further by investing policyholder float in equity securities and owning non-insurance subsidiaries.  It will be interesting to see further details of Markel’s progress in the upcoming annual report.

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

Coping With Irrational Markets

One of the requirements for efficient capital markets involves the rapid dissemination of relevant information necessary to make investment decisions.  Superior information can provide a material edge for investors and has traditionally been viewed as a competitive advantage for those who have the necessary skill and work ethic.  The amount of information available to all investors today is greater than ever before but so is the noise — and the noise tends to become overwhelming and have negative implications for investor psychology.  This phenomenon is glaringly obvious so far this year as sentiment has turned decidedly negative.

Howard Marks recently released his latest memo, On the Couch, in which he provides commentary on recent market developments and current investor psychology.  Toward the end of the memo, Mr. Marks outlines his “prescription” for investors which is replicated below:

  • The first essential element in coping with markets’ irrationality is understanding.  The importance of psychology and its influence on markets must be recognized and dealt with.
  • The second key lies in controlling one’s emotions.  An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings.  Thus it is absolutely essential to keep optimism and fear in the appropriate balance.
  • Emotional self-control isn’t enough.  It’s also important to have control over one’s circumstances.  For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings.  Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance.  At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions.
  • And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool.  Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa.

It is likely that the majority of readers of the memo are professional investors who need to be particularly concerned with the third bullet point.  For a professional responsible for managing money on behalf of clients, having the right skill set and emotional temperament is not enough if the emotions of other people can result in fund outflows that force ruinous forced liquidations at just the wrong time.

Fortunately, individual investors have an edge when it comes to dealing with irrational markets.  By not being accountable to others, an individual investor only has to be accountable to himself.  Provided that the individual has made good decisions in the past, market volatility need not be a major concern except when contrarian actions can be taken to benefit from market irrationality.

Individual investors who take a passive approach and purchase low cost index funds are best served by ignoring short term market movements and not even looking at the market value of their portfolio more than once a month.  The perceived level of volatility of a portfolio is much lower if one examines market value once a month or once a quarter rather than daily or hourly.

Of course, many investors view themselves as enterprising investors.  Anyone reading this article is likely to be either a professional investor or an enterprising individual investor.  And who are we kidding?  Such individuals are going to be looking at market quotations on a daily basis at a very minimum.  When even Warren Buffett is known to keep CNBC on during the business day, albeit muted, how realistic is it to think that the rest of us can resist the urge to check quotations relatively often?

It is important to learn to view market gyrations as an opportunity rather than a curse so that we can act as contrarians.  Generally, this means having a certain amount of cash that can be deployed at opportune times.  One approach that can be helpful in down markets is to proactively place good-til-cancelled limit orders at low prices.  This can create a mindset of cheering for market declines rather than advances since those limit orders will get closer to executing as the market plummets.  Obviously, conviction is required to follow through on this approach and one must remain cognizant of intrinsic value changes that are actually warranted and adjust accordingly.

Oaktree has recently started posting videos of Howard Marks introducing the topic of each of his memos.  The introduction to “On the Couch” is available here.  Readers can also subscribe to receive notification of future memos.  Howard Marks is scheduled to be the keynote speaker at the 19th annual CSIMA Conference on January 29.  Mr. Marks previously appeared at the 2011 CSIMA Conference where he made a presentation touching on many similar topics.

Disclosures:  None

Berkshire’s Repurchase Level is not a “Floor”

“You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets.” –Warren Buffett on repurchases, 2011 annual report

After posting a 12.5 percent decline in 2015, Berkshire Hathaway’s common stock entered the new year only modestly above the company’s repurchase threshold of 120 percent of book value.  As a result, many commentators have been speculating on the possibility of repurchases in the near future.  Due to recent market volatility, many investors are seeking “safe havens” in the short run and have noticed that Berkshire has limited downside before reaching the repurchase threshold.  It is not uncommon to see references to a “floor” for Berkshire’s stock price roughly corresponding to 120 percent of book value.  Based on the last reported book value figure of $151,083 as of September 30, 2015, the repurchase threshold currently stands at $181,300 which is slightly more than 8 percent below Berkshire’s closing price on January 6.

The exhibit below displays Berkshire’s Class A share price and book value per share since 2000 along with Berkshire’s “buyback threshold” since Warren Buffett introduced the first such threshold in September 2011.  The threshold was originally set at 110 percent of book value and was subsequently raised to 120 percent of book value in December 2012.  It is unusual for a public company to telegraph its intentions in this manner.  However, Mr. Buffett feels strongly that if the company repurchases stock, departing shareholders should be fully aware of the possibility that the company may be buying and that management views the shares as undervalued.

Berkshire's Price and BV History

Anyone looking at this chart might be forgiven for thinking that the repurchase threshold represents a “floor”.  Indeed, the stock has rarely traded below the prevailing repurchase level since it was first introduced in September 2011.  However, there are a number of reasons to be very cautious when thinking about the repurchase threshold.

Repurchases and Intrinsic Value

The main motivation for Berkshire to repurchase stock has nothing to do with maintaining a short term “floor” in the stock price.  It has everything to do with purchasing shares at a level that is clearly below intrinsic value, conservatively calculated.  Here is what Mr. Buffett had to say in the 2011 annual report regarding the newly introduced repurchase authorization.  (Note that the repurchase threshold was subsequently raised to 120 percent of book value in December 2012):

At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

It appears that many investors are focusing on part of Mr. Buffett’s statement rather than looking at it in full.  He clearly states that Berkshire will only repurchase shares well below intrinsic value and that he will likely repurchase aggressively if that opportunity arises.  However, it is also clear that repurchases will not occur simply to support the stock price and that Berkshire could very well pursue opportunities other than repurchases in particularly weak markets.

A Thought Experiment

We make no attempt to predict stock prices in the short run and have no particular opinion regarding the possibility of a major bear market in the near term.  However, it is worth pondering a scenario where stocks fall sharply in the near term and how that might impact Berkshire’s book value and propensity to repurchase shares.

If the equity markets enter a severe bear market in 2016, perhaps falling 30 to 40 percent, Berkshire’s large holdings in publicly traded securities will almost certainly participate in the decline as well which will have a negative impact on reported book value.  Additionally, Berkshire’s equity derivative investments will also show mark-to-market declines which will negatively impact book value in the short run.  Exerting a pull in the opposite direction, it is almost certain that Berkshire would still report substantial operating earnings which would increase book value.

Where will the dust settle?  It is certainly possible that a declining stock market could result in Berkshire’s book value falling in any given quarter or even in a full year despite the effect of substantial operating earnings.  Such a decline in book value would obviously reduce the repurchase threshold commensurately.  Therefore, even if the repurchase level could be considered a “floor”, that floor could be moving downward in the short run.

However, the situation is even more complex.  If equity markets decline severely, that will present major opportunities for Mr. Buffett to deploy Berkshire’s cash.  Not only will publicly traded equities be cheaper but the market for private businesses would probably soften as well.  If the market decline is also accompanied by real or perceived systemic risks to the overall financial system, as was the case in 2008-2009, Mr. Buffett’s phone will be ringing off the hook with offers for unusual investment opportunities at attractive terms because Berkshire will have cash and the “Buffett stamp of approval” is worth a great deal in crisis conditions.

Faced with a rich set of investment opportunities brought about by a market panic, there is no reason to believe that repurchasing Berkshire shares will be Mr. Buffett’s favored choice under such conditions.  

If Berkshire does indeed trade at or slightly below the threshold in a given quarter and it is revealed that Berkshire did not repurchase shares, or repurchased only a modest amount, all talk of a “floor” will likely disappear.  As Mr. Buffett said in the 2011 annual report, he has no interest in repurchasing shares simply to “support” Berkshire’s stock price.

Repurchase Threshold is a Long Term Buying Signal

Rather than viewing Berkshire’s repurchase threshold as a floor or as a short term buying signal, long term oriented investors should instead regard it as a long term buying signal.  This is not merely because of the fact that Mr. Buffett plainly regards purchases at such a level to be a bargain, but because Berkshire demonstrably provides more intrinsic value at such a price than one must pay in exchange for shares.

We last commented on Berkshire’s valuation in September 2014 when the shares were reaching record highs.  The shares continued to advance up to the end of 2014 and have declined since that time.  There are many methods that can be used to estimate Berkshire’s valuation but buying at a low price-to-book ratio has proven to be a reliable approach in the past.

Through year-end 2014, Berkshire delivered annualized book value growth over the preceding ten years of 10.1 percent.  This was a ten year period that included the tail end of a bull market, the most severe economic downturn since the Great Depression, and the subsequent recovery.  Even if we assume a somewhat lower rate of book value growth over the next decade, such as 9 percent, Berkshire’s book value will likely be close to $350,000 per share by 2026.

A number of valuation methods, such as the two-column approach, confirm that a price-to-book ratio of 150 percent is not unreasonable.  This would imply a stock price of around $525,000 ten years from now representing somewhat more than 10 percent annualized returns if buying at the current stock price.  This is quite attractive for a company with Berkshire’s overall risk profile and there is room for some upside beyond that.  (Note that if Berkshire starts to pay dividends at some point over the decade, which seems more likely than not, total returns would be somewhat lower due to less internal compounding and, for some shareholders, tax consequences).

The lesson is clear:  Use Berkshire’s repurchase threshold as a long term buying signal, not as a short term signal.  The threshold does not represent a short term floor and people buying the stock as a short term safe haven could very well be disappointed.

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