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Markel Corporation at $800/share June 18, 2015

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

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

Overview

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

Insurance Underwriting

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

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

Markel's Combined Ratio

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

MKLCRvsIndustry

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

Investment Portfolio

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

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

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

Investment Allocation

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

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

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

Investment Results

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

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

Markel Ventures

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

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

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

MKLVenturesIncomestatement

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

Is Markel Worth $800/share?

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

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

Markel Price History

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

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

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

MKL P/B Ratio

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

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

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

Markel Valuation Model

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

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

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

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

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

 

Joy Global: A Misunderstood Cyclical? July 24, 2012

Joy Global is a leading manufacturer of underground and surface mining equipment used in the extraction of coal and other minerals.  The company manufactures essential and highly specialized products such as continuous miners, longwall shearers, and roof supports critical for safety in modern mines.

Such equipment carries high price tags and requires continuous maintenance and support.  In recent years, original equipment has accounted for approximately 40 percent of Joy Global’s sales with the remainder accounted for by aftermarket parts and services.  Based on reading this description, Joy Global should be categorized as a cyclical company that can be expected to do well in times of economic strength and face headwinds during recessionary periods. The market certainly agrees:  At around $50, Joy Global trades at under eight times trailing earnings.

Alexander Roepers, founder and Chief Investment Officer of Atlantic Investment Management recently described his bullish views on Joy Global in the Spring 2012 issue of Graham & Doddsville (pdf).  Graham & Doddsville is a free newsletter published by Columbia Business School students and is well worth reading.  Note that Joy Global was trading at a significantly higher price at the time the Graham & Doddsville article was published.  Mr. Roepers concluded his bullish thesis as follows:

For the bears, Joy’s shares are pricing in peak earnings per share of $7 or $8, so it’s trading at 10x peak earnings. But, in our view, these are not peak earnings. We see Joy’s earnings trending up over time. They had one flat year in earnings in the Great Recession. Caterpillar earnings were down 60%. Sales were down nearly 40% at Caterpillar, while sales at Joy were flat.

Interestingly, Wall Street’s “consensus” estimates for the current fiscal year still reflect healthy earnings growth.  Value Line’s June 8 coverage of the company forecasts earnings of $10.65 by 2015-2017.  Putting aside the questionable accuracy of earnings estimates years into the future, we can see that market participants have not explicitly called for a drop in earnings yet, although the stock price seems to foresee a decline.  Intrigued by Mr. Roepers thoughts on Joy Global and the subsequent decline in the company’s stock price, we decided to take a look at the fundamentals to determine both the upside potential and downside risk.

Coal:  Perception and Reality

To understand Joy Global, it is necessary to step back and look at the high level dynamics driving the coal industry.  Coal is probably the most hated fossil fuel in existence because it is dirty compared to alternative forms of energy, particularly natural gas.  According to the EPA, natural gas fired power generation “produces half as much carbon dioxide, less than a third as much nitrogen oxides, and one percent as much sulfur oxides” compared to coal.

Much to the chagrin of environmentalists, the use of coal has increased significantly over the past few decades both in absolute terms and as a percentage of total primary energy supply according to the International Energy Agency’s 2011 Key World Energy Statistics publication.  The following chart taken from the report shows world total primary energy supply from 1971 to 2009 by fuel type:

In 1973, coal and peat accounted for 24.6 percent of the total versus 27.2 percent of the total in 2009.  As the reader may guess, this trend has been driven by emerging economies.  Use of coal use within the OECD group of richer countries fell from 22.6 percent of the total in 1973 to 20.2 percent in 2009.  The majority of the increase in coal use has been in the poorer parts of the world with China being the most notable example.  The following charts show the breakdown of worldwide energy use by region/country:

According to the IEA, China is the largest producer of coal in the world at 3,162 million tons of production in 2010.  The United States was in second place at 932 million tons with India in third place at 538 million tons.  China’s world leading production is not even sufficient to keep up with demand and the country imported an additional 157 million tons in 2010.  According to Mr. Roepers, 70 percent of China’s electricity is generated from coal.

What About Cheap Natural Gas?

Cheap and abundant natural gas clearly poses a threat to coal fired electricity generation in the United States.  However, as The Economist’s recent survey on natural gas made clear, the supply and demand dynamics that have created low natural gas prices in the United States are not present in most other parts of the world.  Natural gas prices in Asia are far higher than in the United States and the cost of liquefying and shipping natural gas is not only expensive but requires extensive infrastructure to support.  Clearly coal will not be going away anytime soon as a primary energy source in China.   The inexorable rise in energy demand in China could very well slow in an economic recession but the secular trend demonstrates rising demand over time and much of that demand will be fueled by coal for years to come.

Joy Global’s Track Record

Readers are encouraged to review the business summary section of Joy Global’s fiscal 2011 10-K for general background information on the company and its long history.  The company went through a bankruptcy reorganization and emerged from the process in July 2001.  Since that time, the company has posted strong results with revenues rising from $1.15 billion in fiscal 2002 to $4.4 billion in fiscal 2011 (year ended October 28, 2011).  Net income rose from a loss of $28 million in fiscal 2002 to a profit of $610 million in fiscal 2011.  The following exhibit shows the steady margin expansion driving these results:

The company has delivered attractive returns on equity and total capital over the past decade.  As of April 27, 2012, total debt was 41 percent of capital:

Consistently high returns on capital often indicates the presence of an economic moat.  In the case of Joy Global, this may come from the fact that the mining equipment industry is essentially a duopoly with large barriers to entry according to Mr. Roepers:

Joy Global has a strong competitive position with enormous barriers to entry. Two Milwaukee based companies, the other being Caterpillar subsidiary Bucyrus International, control the market – it’s a duopoly.  No one else in the world can make these pieces of equipment. At Joy’s factory, in order to support the stamping equipment used to construct the equipment, JOY has a 200 feet deep concrete foundation beneath their machines. Regulators will not provide approval today for a plant requiring 200 feet of concrete.

During the 2008-2010 economic downturn, Joy Global’s results barely missed a beat with only a modest decline in revenue from fiscal 2009 to fiscal 2010.  Margins were maintaining along with profitability.  Despite having many characteristics of a cyclical company, Joy Global did not post steep revenue declines and ruinous losses when the world economy misfired.

Aftermarket Parts – Stabilizing Factor

There are probably many contributing factors to Joy Global’s robust record even during times of economic slowdown.  One factor is likely to be the company’s revenue mix by product type.  The company’s original equipment products are clearly high dollar purchases for customers and the timing is likely to be somewhat discretionary in nature.  If a mining company is breaking ground on a new mine, it is likely to require new equipment but aging equipment in existing mines can often be coaxed into additional years of service during tough economic times.

Joy Global maintains an extensive network of service and distribution centers capable of rebuilding and servicing equipment and selling replacement parts and other consumable items.  As the installed base of equipment grows, so does the opportunity to service the equipment over time.  Such equipment is very expensive and specialized and customers are probably reluctant to choose a “bargain” priced company to service the equipment.  As a result, Joy Global enjoys a “moat” when it comes to servicing its installed base.  The following chart shows the mix of business between original equipment and aftermarket over the past decade:

The company does not provide operating income and margin data by product type but it is possible that certain aftermarket services and parts could command attractive margins relative to original equipment.  On the other hand, the percentage of Joy Global’s sales attributable to aftermarket equipment has fallen in recent years during a period in which operating margins have been expanding which points to the opposite conclusion.  However, the important point is that orders of new equipment could fall substantially in a recession but aftermarket parts and services probably will not and could potentially behave in a counter-cyclical manner if more customers choose to repair old machines rather than buy new ones.

Regional Results

The Euro-area is a basket case with the “core” countries barely treading water and the periphery firmly mired in recession.  China may be on the brink of a serious slowdown, although few forecasters would predict an actual contraction in GDP.  Meanwhile, the United States plods along with substandard GDP growth and the prospect of the “fiscal cliff” pushing the economy into recession in 2013.  In light of these problems, let’s take a look at Joy Global’s results by region.

The following chart displays the company’s sales by region from 2005 to 2011.  During most of this time frame, the United States accounted for between 45 and 50 percent of total sales.  Europe has hovered at around 7 percent over the past three years with Australia between 14 and 16%.  “Other Foreign” makes up the balance and has risen from 22 percent of total sales in 2005 to 35 percent in 2010 and 31 percent in 2011.  It is likely that China is driving changes in “Other Foreign” revenue.

The following chart displays operating income by region:

We can conclude that the United States is clearly the most important market for Joy Global and that Europe is relatively insignificant in comparison.  Although China is grouped in “Other Foreign”, the Australia region is also impacted by conditions throughout Asia and would be affected by a slowdown in China.  It would be interesting to have a breakdown of original equipment vs. aftermarket by region but this is not available based on the company’s filings.

Cash Flow and Acquisitions

We compiled a record of Joy Global’s cash flow from fiscal 2002 to the first half of fiscal 2012 which ended on April 27, 2012.  During this ten and a half year time frame, the company generated $3.2 billion of net income and $2.8 billion of free cash flow (with free cash flow calculated as operating cash flows less net purchases of property, plant, and equipment).  Over this period, the company also issued nearly $1.3 billion in net debt.  Dividends paid to shareholders accounted for $489 million with share repurchases (net of stock option related issuance) of $835 million.  $2.4 billion was used for acquisitions (net of proceeds from dispositions).

The following chart displays free cash flow and net income over the past decade:

Clearly the trend is in the right direction and most net income converts to free cash flow over time.  The company has devoted the majority of free cash flow along with considerable debt toward acquisitions with the most recent being the acquisitions of LeTourneau and International Mining Machinery (IMM).  LeTourneau produces earth moving equipment and historically manufactured drilling equipment.  Joy Global divested the drilling equipment division shortly after the acquisition.

IMM is a leading designer and manufacturer of underground coal mining equipment in China.  Since the IMM acquisition was completed in early fiscal 2012, the financial results discussed in this article do not reflect IMM’s operations. IMM reported revenues of RMB 1,942 million ($306.3 million) and operating profit of RMB 417 million ($65.8 million) for its fiscal year ended December 31, 2010.  Based on the purchase price allocation for IMM presented in Joy Global’s fiscal Q2 10-Q, the total cost was $1.4 billion.  It remains to be seen whether this cash was allocated wisely but the purchase price certainly doesn’t seem cheap based on IMM’s 2010 results.

Risks

It seems clear that the current valuation of Joy Global is pricing in a significant decline in results.  Although the company has demonstrated resiliency with respect to economic downturns in the past, a severe recession, particularly in the United States, could impact results given the fact that the United States is the company’s most important market.  If an economic collapse, perhaps driven by the 2013 “fiscal cliff” also coincides with a further decline in natural gas prices, the shift from coal to natural gas electricity generation could accelerate.

There are many vocal bears when it comes to the Chinese economy.  If China experiences an actual decline in GDP rather than a slowdown in growth for any extended period of time, Joy Global’s results will definitely be impacted and the performance of newly acquired IMM will suffer as well.  Another major risk involves the potential for China to develop methods to harness advances in fracking to increase the production of domestic natural gas.  Although China may face certain obstacles in tapping its shale resources (see The Economist’s survey referenced earlier), a breakthrough in natural gas production cannot be ruled out.

Although Europe is a small part of Joy Global’s business, the Euro-area seems on the verge of a meltdown (then again, this has been true for a couple of years now).  Sales and operating income in Europe were hit hard in fiscal 2010 and this could easily happen again if the Euro zone falls apart in a disorganized manner.

Debt service has not been an issue for Joy Global in recent years, but it must be noted that significant debt is on the balance sheet due to the acquisitions described previously.  In addition, the company has underfunded pension plans in place that should be treated as long-term debt when valuing Joy Global’s equity.

Summary

The market consensus clearly indicates that Joy Global should be classified as a traditional cyclical company and that its recent results are somewhere approaching “peak earnings”.  Oddly enough, Wall Street’s “consensus” estimates disagree with this assessment and forecast higher earnings for fiscal 2012 and fiscal 2013.

It is almost certainly useless to come up with a macro forecast and probably useless to attempt to forecast Joy Global’s results with precision.  However, a “back of the envelope” valuation could take a rough estimate of the company’s likely fiscal 2012 revenues ($5.4 billion run-rate based on first half results) and apply various operating margins to estimate operating income.  Although operating margins have been above 20 percent recently, if we use a more conservative 17 percent, this would indicate operating income of about $900 million for fiscal 2012.  Using a 8x multiple would lead to an enterprise value of $7.2 billion.  Subtracting net debt of $1.25 billion and pension liability of $245 million leads to an equity valuation of $5.7 billion, or about $54 per share.

This “back of the envelope” exercise seems to indicate that Joy Global is not radically undervalued based on its recent price of around $50 per share.  However, the assumptions used seem quite conservative, especially the 17 percent operating margin.  If we use a 20 percent operating margin and leave all other variables the same, we would arrive at a valuation of about $68 per share, meaningfully higher than the current quote.  It seems likely that if the world doesn’t completely fall apart, Joy Global represents a bargain at its current price.  At the very least, the company is worth keeping on the radar as a potential opportunity in case emotionally driven selling occurs in a market panic.

Disclosure:  No position in Joy Global.

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Note to Readers:

Readers may be interested in The Genius of Warren Buffett, a course offered by The University of Nebraska this fall over three weekends:

The Rational Walk is listing this event as a service to readers who may be interested and receives no compensation for resulting registrations.

Investors Title Company Approaches Intrinsic Value June 21, 2012

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

— Benjamin Graham

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

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

The Weighing Machine Works … But Not on a Quarterly Schedule

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

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

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

Investors Title’s Texas Expansion 

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

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

Financial Results – 2009 to 2011

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

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

Stock Price Performance

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

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

Intrinsic Value:  Then and Now

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

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

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

What was the Catalyst?

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

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

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

Complimentary Berkshire Hathaway Analysis Available Now! June 17, 2011

The Rational Walk is pleased to make our report on Berkshire Hathaway published in February 2010 available to readers free of charge! The analysis was published shortly after the release of Berkshire Hathaway’s 2009 annual report.  Although the analysis is over a year old, the historical background and valuation approach may be useful for readers.

On March 1, 2011, The Rational Walk published “Berkshire Hathaway:  In Search of the Buffett Premium”. The new report represents a major expansion and update to the earlier analysis and includes updated data and valuation models.  Readers who find the 2010 report interesting may want to purchase the more recent report.

The complimentary report appears below in Scribd format.  Readers may also click on the link below to download the report in pdf format.

Click on this link to download the report

Middleburg Financial: The Foundation of Sokol’s “Mini Berkshire”? April 2, 2011

Middleburg Financial, a small bank holding company with a base of operations in the prosperous suburbs of Northern Virginia, has been in the news over the past few days due to David Sokol’s comments on CNBC indicating that he plans to build a “mini-Berkshire” after resigning from Berkshire Hathaway in the wake of revelations regarding his trading in shares of Lubrizol Corporation.

We previously published our thoughts on Mr. Sokol’s actions with respect to Lubrizol including a timeline of events, an account of Mr. Sokol’s statements after his resignation, and apparent inconsistencies between his statements and information appearing in the Lubrizol proxy statement.  We will not rehash these subjects in this article.  Instead, we wish to revisit Mr. Sokol’s investment in Middleburg Financial.

Background

Although various newspapers have covered Mr. Sokol’s investment in Middleburg Financial in recent months, we believe that the Rational Walk’s article published on March 26, 2010 was the first detailed report of the investment.  We followed up on the story in late October 2010 when Mr. Sokol received approval from Middleburg’s Board of Directors to increase his stake from 20 percent to a maximum of 30 percent.

A review of Mr. Sokol’s filings on the SEC website indicate that he has been buying additional shares of Middleburg Financial with a small purchase of 300 shares on March 29 being the most recent transaction.  Mr. Sokol currently owns slightly over 1.4 million shares, or 20.2 percent of the company.  His ownership interest is worth approximately $22.5 million as of April 1, 2011.

Did Sokol Pitch Middleburg to Buffett?

In his recent CNBC appearance, Mr. Sokol made the following comments in response to questions from Becky Quick:

BECKY: So does this, is this a pattern of trading activity like this that has happened with other deals that you’ve brought to Berkshire’s attention?

SOKOL: Ah. No, ’cause the other deals that I’ve brought to Warren, he hasn’t had an interest in. But, you know, Berkshire furnishes us a list of companies that Berkshire has a conflict in —

BECKY: Sorry, just to go back to that. You looked at other companies before, bought a stake in it, mentioned it to Berkshire, Warren wasn’t interested, but you still maintained those stakes in those companies?

SOKOL: Um. Well, only one which is a small bank but it never would have been of interest to Berkshire.

With a market capitalization of $111 million, it seems obvious that Middleburg Financial is far too small for Berkshire to invest in, but it is interesting that Mr. Sokol appears to have mentioned the bank to Mr. Buffett.  It may have been another bank, although it seems more likely than not that Mr. Sokol was referring to Middleburg Financial.  It seems doubtful that Mr. Sokol seriously “pitched” Middleburg Financial to Mr. Buffett and we see no conflict of interest between his ownership of the bank and his position at Berkshire, in stark contrast to his actions with respect to Lubrizol.

A Foundation for Sokol’s “Mini Berkshire”

It seems highly doubtful that Mr. Sokol plans to use Middleburg Financial as a basis for building a “mini Berkshire”.  The bank’s recent financial results have not been particularly strong and there does not seem to be much advantage in using the bank as a basis for acquiring stakes in non-financial companies.  In addition, there are many problematic aspects associated with banks owning non financial companies.

However, this does not mean that Mr. Sokol may not attempt to exert more influence over the operations of Middleburg Financial.  In a recent article in the Washington Business Journal (in which The Rational Walk is quoted), Middleburg’s management stated that Mr. Sokol is a “great source of advice” but is “too busy” to serve on the board.  The bank recently changed its bylaws to allow non-Virginia residents to serve on the Board and presumably Mr. Sokol now has more time on his hands to provide management with more “great advice”.

Bottom Line:  Not a “Mini-Berkshire” But Sokol May Get More Involved

Middleburg Financial’s shares jumped sharply on Thursday, March 31 after Mr. Sokol’s comments on CNBC led to speculation that Middleburg Financial would serve as his base for future business activities.  This seems almost entirely unwarranted.  Investors may wish to examine Middleburg Financial as a potential bet on the recovery of a small bank in a prosperous area of the country but the company is not going to become the next Berkshire Hathaway.

The media frenzy over David Sokol’s potential involvement will probably prompt enterprising reporters to descend on the small town of Middleburg on April 27 for the company’s annual meeting.  Perhaps Mr. Sokol will be there and will make a move to become Chairman or at least to join the board.  Or this could be an entirely wasted exercise and reporters could be left covering the minutiae of a relatively unknown and not particularly cheap regional bank.

If there turns out to not be much of a story at the annual meeting, not all is lost.  Middleburg is located in a spectacular small town country setting, spring is one of the nicest seasons in Virginia, The Red Fox Inn serves a lovely brunch, and Market Salamander has wonderful dessert.  It could be a great boondoggle for reporters, although we warn that typical per-diems may be insufficient to fully enjoy all the town has to offer.

Disclosure:  No position in Middleburg Financial, Long Berkshire Hathaway.