The Problem of Rational Capital Allocation

“In theory there is no difference between theory and practice. In practice there is.” — Yogi Berra

Imagine that you are the founder of a highly successful small chain of restaurants.  After immigrating to the United States from Italy as a teenager, you built up a modest amount of capital working several jobs and living an extremely modest lifestyle.  Finally, you opened a neighborhood Italian restaurant in midtown Manhattan in 1980 at the age of twenty-five.  It was not so much a restaurant as a tiny storefront offering take-out specialties and serving a lunch crowd.  Within a couple of years, lines were forming by 11:00 am and persisted for three hours or more each day.  Loyal patrons said that there was nothing remotely like it in the city.  Over time, you were able to raise prices at a rate moderately exceeding inflation with no noticeable drop off in demand.  This was followed by an expansion into a larger location with seating and, eventually, into a chain of eight nearly identical restaurants in Manhattan.

At the age of sixty, you have amassed a comfortable fortune, held mostly in cash, having elected to retain the vast majority of your historical profits rather than expand more aggressively.  You are happy with the lifestyle and financial security provided by your small restaurant chain and not particularly concerned about optimizing your business strategy any further.

You have achieved the American Dream.

Our example is fictional but chances are most readers could identify at least a few familiar examples of such a business.  The United States is full of highly profitable niche businesses that have created massive economic moats and must enjoy abnormally high returns on equity as a result.  In most cases, the founders of these businesses are tremendously skilled at the operational details that made their business into a success but either do not have the skills or lack the inclination to act as capital allocators.  But this may not be a tragedy.  At a micro level, sometimes optimization isn’t necessary to serve the purposes of a small business owner.

From Horatio Alger to Business School

But what if our fictional protagonist had chosen an alternate path to the American Dream?

Rather than choosing up-from-the-bootstraps entrepreneurship, our young immigrant could have focused on academics, graduated from college, and secured admission to one of the elite business schools.  It is likely that a man capable of extreme success in entrepreneurship would have found a way to graduate from business school with an elite MBA.  In theory, such an education would provide not only the tools to succeed from an operational perspective but also the added capability of being skilled when it comes to capital allocation.  After a couple of decades in the trenches, would it not be reasonable to expect that the same level of skill required to achieve success operationally would also be present when it comes to capital allocation, broadly defined?

In fact, this is a key question that is not asked nearly often enough.  If we assume that the large enterprise in question is a publicly traded company with a broad shareholder constituency, it is no longer remotely acceptable to focus only on operations and neglect capital allocation.  Unlike a small entrepreneur who might be perfectly justified to not focus much attention on capital allocation matters, this issue is of prime importance for the chief executive of any public enterprise.  Despite this importance, many CEOs are shockingly unskilled at capital allocation.  Having risen through the ranks through operational disciplines, capital allocation sometimes seems like a mere afterthought or, even worse, as a tool for obfuscating the true economics of an enterprise.

Oil Majors’ Dividends Survive Crude’s Plunge!

On Monday, November 16, a front page article in the Wall Street Journal documented how the world’s biggest energy companies have “doubled down on their promise to protect dividends, despite a precipitous drop in profits this year, driven by a steep decline in oil prices.”  The shares of large energy companies have long been havens for shareholders interested in receiving a regular stream of dividends, as the reporter notes:

Oil majors have little choice but to pay fat dividends to keep investors.  Most of these companies don’t offer investors compelling growth prospects as they struggle to replace even the millions of barrels of oil pumps every year.  Fat dividends are a crowd-pleasing but potentially risky strategy given concerns about the length of the current price downturn and its impact on cash flow.

The article goes on to describe the long term dividend record of the oil majors.  Many have longstanding records of rising dividends spanning multiple decades.  For example, Exxon has increased its dividend at a 6.4 percent annualized rate over the past 33 years.  CEOs openly admit that the dividend is paramount in their decision making process.  “This is all about making sure we can continue paying dividends to our shareholders,” said Royal Dutch Shell CEO Ben van Beurden.

At first glance, perhaps this attitude makes sense.  After all, a company is owned by its shareholders.  Large energy company shareholders overwhelmingly care about the dividend and the managers they have hired align their own behavior with the wishes of the owners.  So where is the problem?

Ultimately, companies attract the shareholder base they deserve.  If regular, recurring, and rising dividends are the end-all of a company’s existence, that is all well and good as long as the owners understand that they might be acting in a sub-optimal manner in order to generate this result.  Are shareholders looking at the overall capital allocation situation and thinking about how to best allocate free cash flow to maximize the overall intrinsic value of the firm in the long run?  Is a recurring and rising cash payout, made regardless of underlying business conditions, a way to optimize intrinsic value over time?  One gets the sense that these considerations are not openly and explicitly considered.  There is no point in picking on energy companies in particular.  Irrational thinking about capital allocation is pervasive in many other industries as well.

A Clean Slate

At the risk of being excessively theoretical, let us step back and consider what rational capital allocation might look like if one ignores past precedent, the cash dividend preferences of current shareholders, and the bias of current managers.  Even if the theoretical conclusions we draw are not entirely realistic in practice, it should help to consider what is optimal and then consciously depart from the optimal, when needed, in the interests of pragmatism. 

If the future could be foreseen perfectly, the intrinsic value of any firm rests on the free cash flow the business can generate over its remaining life discounted back to present value at an appropriate rate.  Obviously, one cannot actually know the precise timing and magnitude of cash flows even for the next few years let alone the remaining life of a typical business.  However, this is the theoretical place to start.  Once we begin to focus on free cash flow, it also becomes apparent that it is critically important to determine what a firm does with such cash flows.

At a basic level, a firm can use free cash flow for the following purposes:

  • Invest in internal expansion opportunities.  Widen the moat of the existing business through the intelligent allocation of capital as opportunities arise.  Our small restaurant owner chose to modestly expand the size of his chain from a single storefront operation to eight restaurants over thirty-five years.  Larger businesses invest internally as well.  For example, Burlington Northern Santa Fe makes investments in enhanced locomotives, track infrastructure, and technology designed to deepen its competitive advantage.  These investments go beyond the bare minimum capital investments required to simply maintain the characteristics of the existing business.  They are meant to widen the company’s moat.
  • Invest in external expansion or diversification.  A firm can use its free cash flow to acquire another business either within its existing business lines or in entirely different areas.  This is usually done in order to consolidate market share, capture “synergies”, or otherwise make the resulting enterprise more valuable than the sum of each operation standing alone.  More rarely, a conglomerate structure can be pursued in which a business acquires a totally unrelated business.  Of course, Berkshire Hathaway is the prime example of a successful conglomerate that readily comes to mind.  Usually, there must be some special skill present in management that justifies bringing multiple unrelated businesses under one corporate roof.  Chief Executives of conglomerates must be exceptional capital allocators.  Note that an investment program in marketable securities is essentially an external expansion diversification.  A firm is becoming a small fractional owner of businesses unrelated to its core operations.  Again, Berkshire Hathaway is a good example.  Charlie Munger’s Daily Journal Corporation is another example.
  • Pay Down Debt.  A firm can choose to deploy free cash flow toward changing its capital structure by reducing debt.  There are numerous theoretical constructs regarding the “optimal” level of debt that a firm should employ and this goes beyond the scope of our immediate concern regarding capital allocation.  A debt-free balance sheet is certainly a sign of conservatism yet there are legitimate reasons to carry debt even if a firm has abundant free cash flow available to become debt free.  Common reasons include tax efficiency as well as distortions caused by a high tax burden on American firms associated with repatriating cash from overseas operations.
  • Return Capital to Shareholders.  If internal and external investment opportunities are scarce and the level of debt is optimal, a firm may return capital to shareholders in two ways:
    • Cash Dividends.  This is the most common way in which a firm can return capital to shareholders and it is a very simple process.  A dividend is declared and paid out to all shareholders on a per-share basis, and all shareholders are left to address the tax consequences of the dividend for themselves.  Tax consequences can vary widely depending on the shareholder base.  While it is normal for a firm to declare a quarterly dividend and either hold it constant over time or steadily increase it, this is not a pre-requisite for the use of cash dividends.  Although unconventional, some firms choose to declare irregular cash dividends and establish no expectation regarding dividend recurrence over time.
    • Stock Repurchases.  Repurchases used to be quite rare but are now a very common means of returning cash to shareholders.  However, the motivation for many repurchase plans isn’t primarily related to returning cash to shareholders.  Instead, management may wish to “neutralize” dilution due to option issuance or may be seeking to temporarily boost the company’s share price.  There are complicated incentive systems at work that could very well lead to completely non-economic reasons for stock repurchases. The only rational reason to repurchase stock is when shares are available in the market at a price that is demonstrably less than a conservative estimate of a firm’s intrinsic value.  If such a condition does not exist, stock repurchases will destroy value regardless of the motivation behind the repurchase.

The listing above is hardly ground-breaking and forms the key set of principles that executives are supposed to consider when making capital allocation decisions.  Obviously, anyone who has earned an elite MBA, or any MBA for that matter, would be familiar with these core principles.  So why is it that we often see clearly sub-optimal decision making such as recurring cash dividends raised in an annual stair-step manner regardless of underlying business conditions?

Back to the Real World

As Yogi Berra famously noted, there is a big difference between theory and practice when it comes to operating in the real world.  Having the best intentions and following a sound and principled capital allocation process may not always be possible in all settings due to long standing institutional biases and shareholder expectations.  It would be utterly naive to suggest that a new CEO of a long established business engaged in irrational capital allocation practices could change the approach immediately.  Instead, what investors should look for is an overall approach consistent with rationality even if certain aspects may not be strictly defensible.

The first consideration is whether a firm has free cash flow available to deploy.  This is not necessarily a measure that must be taken on an annual basis and can perhaps be viewed in a normalized sense.  For example, a good business with a solid underlying moat may in fact be cyclical and lack ample free cash flow in periods when major investment opportunities exist.  The normal cyclical variances in free cash flow should not rigidly determine whether investment opportunities are exploited.  For a strong firm, it may very well make sense to engineer major acquisitions in times of business weakness by using debt or common stock, if shares are not especially undervalued.  In so doing, the long term intrinsic value of the business could be enhanced.

It is much more questionable, however, to continue paying large and rising cash dividends during times of weak free cash flow.  While certain investor groups may like the idea of steadily rising dividends, very few businesses have underlying economics that make such a dividend policy intelligent.  In the real world, variances in free cash flow will exist and should be taken into account when paying out dividends.  A rigid policy of fixed or rising dividends could actually impede intelligent expansion or acquisition opportunities in difficult economic conditions because, in addition to weak free cash flow, the firm will have to find cash for dividends.

For firms paying dividends, it makes more sense to either establish a variable dividend policy in which the annual payout varies completely based on economic conditions during the year or a very small dividend likely to always be covered by free cash flow plus a variable dividend, or “special dividend” determined based on available free cash flow.  Progressive is a good example of a company with a variable dividend policy.  A policy of special dividends has been popular among offshore oil drilling firms such as Diamond Offshore in recent years.  Such a policy is especially well suited for the highly cyclical oil industry, despite the attitude of the oil majors cited in the Wall Street Journal article.

If a firm chooses to pay a dividend while also repurchasing shares, it is incumbent upon the management to clearly explain why this decision has been made and what drove the proportion of cash return via dividends versus repurchases.  Repurchases should only be made in conditions where the share price is clearly and demonstrably below intrinsic value.  A clear warning sign of irrational capital allocation is a fixed share repurchase authorization that calls for buying a certain amount of stock each year regardless of the share price.  Sometimes firms even openly admit that they are doing this to offset stock option dilution.  However, this is irrational.  The issuance of stock options is a compensation issue, not a capital allocation matter.  Issuing shares to employees and repurchasing shares are two totally distinct transactions, despite the apparent need for some firms to pretend otherwise.

Rational and Practical Capital Allocation

Chief executives should ideally be competent operational managers as well as skilled capital allocators.  These skills are two sides of the same coin when it comes to achieving satisfactory returns on shareholder capital.  If a CEO is not a skilled capital allocator but is excellent operationally, perhaps the capital allocation function can be overseen by an independent director but this is hardly an ideal situation.  The Chief Executive must be the ultimate person accountable for overall returns to shareholders.  Excelling operationally while squandering the resulting wealth on indefensible capital allocation is hardly a good overall record.

Investors should be cognizant of the many historical and cultural reasons behind dividend policies that may not withstand strict scrutiny when it comes to optimizing capital allocation.  In such cases, the focus should be on not compounding past mistakes.  If a firm has a dividend in place, perhaps it is more practical to leave it in place but stop automatically increasing it in a stair-step manner each year regardless of business conditions.  Over time, inflation and real growth of a good business will reduce the economic meaning of a nominally fixed dividend and allow for incrementally better capital allocation without forcing a confrontation with established interests resistant to any change.

It is far less forgivable to tolerate share repurchase programs that lack rational economic merits.  A CEO who tolerates a repurchase of shares at high prices merely to offset stock option dilution or to temporarily boost the price of the stock is unworthy of shareholder trust and does not deserve to retain his or her job.  If a CEO puts in place a repurchase program, it must be clearly defended as accretive to the wealth of existing shareholders.  Any company repurchasing a fixed dollar amount of stock each year is almost certainly failing this test.

Ultimately, capital allocation will drive the real returns of investors over long periods of time.  Investors who ignore this key function and tolerate sloppy thinking and reasoning from their managers are likely to suffer lower returns over time compared to investors who demand a higher standard, even if that standard eliminates the vast majority of investment candidates from consideration.

The Individual Investor’s Edge

“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” — Warren Buffett, 2013 Letter to Berkshire Hathaway shareholders

As Albert Einstein wisely stated, compound interest is the eighth wonder of the world:  He who understands it earns it while he who doesn’t pays it.  The vast majority of individuals who take the initiative to accumulate savings should follow Warren Buffett’s advice on using index funds and dollar cost averaging to achieve satisfactory returns over time.  For those earning at or above the median wage in the United States, it would be very difficult to end up poor if one simply saves ten to fifteen percent of gross income and dollar cost averages into the S&P 500 over several decades.

But what about non-professional individual investors who want to achieve better than average results?  In the short run, the stock market resembles a manic-depressive character who bids up prices one day and sends them down the following day without much of a reason for the change in sentiment.  Benjamin Graham’s “Mr. Market” character perfectly personifies the psychology of financial markets in the short run.

Any individual who pays attention to the markets can observe this insanity and it is seductively easy to draw the logical conclusion:  If the markets are so crazy, why not try to profit from the insanity?

Circle of Competence

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

One of the ironies of financial markets is that while short term action may appear utterly stupid, it is a grave mistake to assume that market participants are individually stupid or that it is somehow easy to outperform market averages by actively trading.  Investors would do well to constantly think about the fact that there is another equally motivated investor on the other side of every trade they are considering.  That investor may resemble Mr. Market’s irrationality at any given time, or he may have superior insights into the security in question.

The existence of superior insight is often referred to having a “circle of competence” encompassing the activities of the business or industry in question.  To claim that an industry falls within one’s circle of competence is not to be taken lightly.  It involves far more than being familiar with a company’s product line or reading about the industry in question in the newspaper.  One must possess expert knowledge of the subject matter to possess superior business insights that other market participants do not also possess.  For most non-professional individual investors, this type of insight is only likely to exist in subject matter related to the investor’s profession.

The problem is that most investors would be ill advised to concentrate their personal investments in their employer or its competitors since there would then be a correlation between the individual’s source of employment income and the performance of his investments.  A general industry downturn could cost the investor his job and, at the worst possible time, result in a severe depreciation in his investment portfolio.  Few individuals, even those with a reasonable emergency fund, would find this correlation of misfortune to be a pleasant experience.

But is it not possible to obtain competence in fields outside one’s area of employment?  It certainly should be with enough intelligence, dedication and effort.  Few individual investors are going to be motivated to spend the time and energy required to truly understand multiple industries, let alone develop special insights that professionals do not have.  It is certainly not impossible for a small percentage of individuals to possess this ability.  However, it would certainly be very difficult for most investors to do so.  On the other hand, it may not be that difficult to obtain a working knowledge of various industries and businesses.  In this case, an individual would possess knowledge that is at least as good as other market participants but perhaps have few, if any, special insights into the industry or business in question. Can such an individual expect to show any meaningful results in exchange for the effort?

Timeframe Arbitrage

The enterprising individual investor has one major advantage that nearly all professional investors lack:  there is absolutely no logical reason to care about short term performance when evaluating investment candidates.  To the extent that commitments to common stocks have a timeframe measured in several years (ideally five to ten years or longer), there is really no reason whatsoever to care about the price movements of the investment over the next week, month, quarter, or year.

The ability to take such a sanguine view of the world is limited to non-existent for the vast majority of professional investors.  Professional investors who are engaged in active management of a portfolio are evaluated based on their performance relative to other active managers as well as benchmark indices.  Professional prestige, career advancement, and compensation hinges on short term performance.  For this reason, many professional investors “closet index” in an attempt to closely replicate the results of a benchmark and deviate from this practice only when they believe that doing so provides an edge in the short run.  The pain of falling far short of a benchmark can be far greater than the pleasure of exceeding it.

It is true that there are many value oriented professional investors who take a longer term perspective.  However, such investors are still not immune to shorter term comparisons.  It is striking how many value oriented hedge fund managers publish quarterly letters to shareholders in which holdings are analyzed based on performance over a meaningless timeframe.  Why is this done?  Clearly investors demand that kind of feedback from managers and it is necessary to comply with this demand in order to retain assets under management.  Even with a long term mindset and the best of intentions, it is hard to see how a value oriented professional investor can make decisions to maximize value in 2020 when he knows that it will be necessary to explain short term price movements a couple of months from now when year-end 2015 results are reported.


Most individual investors are well advised to simply save as much of their income as possible and dollar cost average into one or more low cost index funds over many decades.  Using this approach, one need not make exceptional amounts of money to retire with a greater net worth than the vast majority of Americans.

With success virtually assured using such an investment approach, one must have very good reasons to deviate and embrace active portfolio management.  Still, many enterprising investors will seek to do better either because they wish to accumulate capital at a faster rate or simply because they enjoy the process (the most successful with have both characteristics).  Such investors will need to develop a working understanding of a number of industries and businesses to have a decent prospect of outperforming a benchmark index over time.

But do they require the truly superior insights implied by the circle of competence concept?

Surely having superior insights is something an investor should aspire to achieve since the truly big winners most likely require such insight.  However, achieving insights that put the individual on par with professionals operating in the same industry could be sufficient if the individual investor harnesses his or her major advantage:  timeframe arbitrage.  By doing so, the individual can invest in situations that may appear compelling to a professional in the long run but not in the short run.  The individual will view himself as trading with people who are not stupid but simply have different priorities and goals.

Markel Corporation at $800/share

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.


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:


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:


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.