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: Q2 2015 Results

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

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

Insurance Results

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

Markel Insurance Results 1H 2015

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

Markel Insurance Disclosures 1H 2015

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

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

Investing Results

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

Markel Investment Results 1H 2015

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

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

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

Markel Ventures

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

Markel Ventures 1H 2015

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


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

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

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

When to Sell a Successful Investment

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

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

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

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

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

Motivations for Selling

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

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

Assess Prospective Returns

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

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

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

Consider Tax Consequences

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

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

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

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

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

The Hurdle May Be High

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

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

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