Markel Ventures: A Deepish Sort of Dive

As a bona fide scaredy-cat of acquisitions, it's comical that some of my favorite companies are serial acquirers. The longer you've studied Buffett and Munger, the more you're reminded that investment bankers pitching deals is usually bad for business. Avoid the temptation and stick to your knitting. The more deals you do, the more likely you'll overpay or have an integration issue or forget one key variable. If you're really lucky, you get to have your own personal Dexter shoes incident.

So when a company's strategy is predicated on acquiring new companies, I run, sometimes screaming. This is, you see, what scaredy-cats do. There is one exception and this one exception has led to over 30% of my portfolio. This exception is when I really trust management. Because when you know what you're doing, buying companies can create a lot of wealth. See John Malone, Henry Singleton, Warren Buffett (Trades, Portfolio), Bob Iger.

I've gushed about Markel (MKL, Financial) in the past. With their impressive track record, Tom, Richie and Anne – and their forebears – have earned it. A $10,000 investment in 1987 would be worth $1.15 million today. That's a 16.8% return for three decades. Underneath that impressive track record is a long-term focus, that humble contrarian streak and a deep regard for their shareholders. If you're looking for causes of 16.8%, I'd look no further than that list. It was the first stock I ever bought in 2008. I still own the shares.

So after a decade of watching them closely, I really, really, really, really, really, really, really trust Markel's management. About a decade ago, they announced they were moving on to a new phase from the Berkshire Hathaway playbook. No longer would they just purchase stocks. Now, they would also purchase whole companies. I shrugged my shoulders and nodded. That was the obvious next step for Markel. Keep it up, gents.

But as the years have gone by Markel Ventures has been this brilliant idea that has been a bit of an enigma to me. It made perfect logical sense for Markel to move from just buying public equities and to begin buying private companies. It was just the choices they made seemed odd. Most were in the manufacturing space, where capex can destroy the cash an owner gets to put in his or her pocket. The financials seemed to support this. When you read the annual report, it seemed like the returns were middle single digits, not the mid-teens that you expect from Markel.

And I know that the serial acquirer is a dangerous investment. But Tom Gayner (Trades, Portfolio) had earned my trust, so I just let it ride. This year, in the company's 10-K and in investor calls, they raised their hand and said, Markel Ventures is growing up and will be a large driver of the growth of Markel. Pay attention.

So I did a deeper dive and dug through the last decade of annual reports to see what exactly has been going on in Markel Ventures.

Analyzing the serial acquirer is just like analyzing any other company in many respects.

1. What are the moats like?
2. What forces affect supply and demand?
3. What does competition look like?
4. What are the returns on tangible assets?
5. How much runway is there to deploy cash well?

Let's start with moats. As you look at the portfolio of Markel Ventures companies, you see a group of companies that compete in very boring, old-school manufacturing industries: high-speed baking and food processing equipment, industrial dredges, automotive trailers and transportation equipment, and now in 2018, after the acquisition of Costa Farms, ornamental plants. There is also a smattering of real estate, technology consulting and health care companies.

Herein we run into one of the dangers of owning a serial-acquirer quickly turning into a conglomerate. How can you ever become an expert on all these businesses? The truth is, you can't as a non-full time investor. We just can't become an expert, especially looking backwards. There are too many companies, too many industry dynamics, too much nuance. We will always be out of our circle of competence on a number of the companies. Rule No. 1 of really, really, really, really trusting management is our protection to this problem, but it doesn't mean that we can't try to get smarter. Our goal here isn't a complete understanding. We are looking for a theory of the case. What drives demand? Is it possible that a low price company could come in and steal market share? If someone had $50 million, could they dent the business?

Looking at these questions, from this higher level, I see a group of businesses with relatively stable long-term demand. Bread is not going anywhere–no matter how big the Paleo diet gets. For each person in the advanced world that swears off gluten, there are many more in developing nations that will be adding commercial bread to their diet. Ornamental plants. The Egyptians brought these to the modern world 4,000 years ago. That's my kind of long-run demand. Housing is another eternal need. Technology consulting is going to be needed for a long-long time. These products are right in the wheelhouse of classic Berkshire acquisitions–boring. This makes me feel good.

We've dealt with demand. What about that other line on your freshman macroeconomics graph? The bakery unit is likely going to face some issues attached to steel (or some other commodity metal) prices and Costa will run into problems with hurricanes and global warming generally. The input cost of fertilizer could affect margins for Costa.These problems are immaterial through an entire business cycle most likely. Yes, there is the off chance that a massive oil price increase could muck with their business, but guess what, everyone else's business will be mucked up as well.

How about competition? Do any of these companies face certain onslaught from low cost manufacturing in China? My guess is probably not. Industrial baking equipment is likely a pretty low manual labor manufacturing process. Add in the obvious need to service machines and clients and it seems like low-cost labor could hurt, as it always does. But it does not look like Dexter Shoes. Thinking about Costa Farms, I'm less certain about the long-term threat of cheap competition. Ornamental plants are cheap. Seeds are really cheap. Sun...cheap. Water? Pretty damn cheap. The cost on these low price items is really going to be in transportation and the people caring for the plants. Somewhere, there is a Chinese entrepreneur ready to clean Costa Farms clock. But, not so fast. Transportation matters here. 7,288 miles is a long way to keep something delicate alive on its way to market. Dig under the hood of Costa and you see a company that is already in China and has operations in the Dominican Republic as well.

Now, let's talks numbers. I'm in love with Cash Return on Tangible Assets, so let's start there. The results lately have gotten interesting. See below, and I'll explain the two asset levels later.

2012 through 2015 is a big fat, meh. And you're likely wondering why there are two levels of tangible assets. I guess we can take that necessary aside now.

I'm not in love with the fact that on the Markel Ventures Balance Sheet 50% of the assets are considered "Other." I get that 700 million dollars is chump change on a 24 billion dollar balance sheet. On the flip side, those 700 million dollars in Other Assets were responsible for roughly one-third of the Net Income for the entire company.* Because we've got this black box of assets, we have to make some assumptions. I try to use ranges when I'm uncertain and lean towards the worst case scenario. My low assets assumes that half of those assets are real. That is to say that they are needed to keep the businesses running. The other half, I'm going to assume are not tangible at all. Maybe their deferred tax assets or another weird figment of accounting nuance that express something, but not what I care about. But, since that may not actually be the case, I also calculate our return on tangible assets assuming that 100% of those other assets are real and therefore should be used in our calculation. There is another alternative which is all of those assets are intangible. If that was the case, much of what I discuss below is balderdash, the returns on tangible assets would be phenomenal. But we don't know, and since we don't, we assume the worst.

The other key point to note is that Markel does not disclose a cash flow statement for Markel Ventures. That means that it is impossible to know what CapEx looks like for Markel Ventures. I'm giving them the benefit of the doubt and saying that CapEx = Depreciation, but that is far from certain. Markel Ventures has a lot of industrial businesses that may require lots of equipment. On the flipside, maybe you can create industrial baking equipment without minimal Capex. This is a bit like a doctor telling you you're healthy but not getting a blood pressure reading. Your weight and heart rate my look good, but a key figure is missing. I'm hoping Markel will continue to expand disclosure in the future to help its owners understand its business.

Aside over. When we take those three assumptions and look through 2012-2015, we are underwhelmed. Making 5% when the market was making 15% is a pretty bad ROI. And five years isn't ten, but it ain't day trading either. 2016 -2017 is getting better. But, and this is a big but, 2017 had the kicker of the Trump tax cuts. You can look at this two ways. Optimistically, you can say, we get that kick going forward, so enjoy it. Alternatively, you can say that can say that without the 45M kick from those tax cuts, we're back to the 8-12% cash return on tangible assets. And don't get me wrong, these figures are good, but because they come after five years of meh, I'm not jumping up and down yet.

So where does this leave us? What do we think about Markel Ventures? We all have to make our own calls, but, for me, the answer is a big fat I don't know. I just don't. I wish I did. There I things I like. The numbers are fine. But I just don't know. Right now, this goes into kinda too hard, business is probably fine, but I better trust management file. I probably have twenty hours into this and that is as good of conclusion as I can muster. Investing is simple, right?

Writing this post took much longer than I thought it would. Some folks may find this surprising, but when you have a collection of thirty some odd companies, it gets complicated. (Sarcasm intended.) Add some less than ideal financial reporting, and I'm left trying to have a point of view that I have no right to have. I just don't know enough. I can't be an expert on industrial baking and ornamental plants and the dredging industry. I may be one of the few in the world longing for the time to become one, but it just isn't possible. As an investor, I need to wrestle with this. This goes back to what Charlie Munger (Trades, Portfolio) said at this year's annual meeting, "Investing isn't a formula."

I have over 10% of my net worth in Markel stock currently. Markel Ventures is a huge part of the growth story for the next decade and I just don't understand the economics and the moats of all of their businesses. As a general rule of the thumb, this is a very bad combination. But, for now, I am going to continue to make an exception.

Tom and the Markel team have earned a good deal of rope from me. You may be surprised to know that their past performance isn't the primary creator of this rope. As an investor, I'm interested in the root causes, not just the lagging indicators. I believe that Markel's astonishing performance has been the result of brilliant managerial performance driven by their values and the culture they have created at Markel.

When I read the Markel Style every year on the inside cover of their annual report, I nod along. When I read, watch or listen to Tom and the team, I nod along. They are practicing business how I think it should be practiced–for the long term–for the shareholders. They truly care about delivering for their customers. But there is something else, they possess this uncanny ability to be bold and conservative simultaneously. They enter new markets. They buy stocks outside their usual circle of competence. Balancing this dichotomy is their secret sauce. It doesn't mean they are perfect or Markel won't make a mistake. What it means is that Markel is learning. The organization is getting smarter, and then acting on it. This is the reason I want to keep owning Markel in large quantities. This sort of culture builds moats. This sort of culture returns cash. My inability to put a number on the return on tangible assets for Markel Ventures just doesn't matter, for now.

Disclosure: I have over 10% of my family's net worth in Markel. Do your own research. Start here.

* Net income is only part of the economic profit of an insurance company like Markel. You also have to take into account the investment portfolio. I am trying to make a point that the returns on these assets are not immaterial to the business.

A few footnotes and a thank you

I was listening to a podcast yesterday. At the end of the podcast, the host thanked the listeners and explained why creating the podcast was so important to him personally. Why are only podcasts allowed to do that? Why don't blogs? So I'm going to do the podcast thing now and see how it goes.

Thanks to everyone that took the time to get to the bottom of this article. When I started thinking about writing this over a year ago, I was hyper-focused on trying to give something different to my readers. I wanted to provide a different view than most of the investment related blogs out there. I wanted to show my process with its warts and lumps, and really give the reader not only what I thought, but how I go there. I'm hoping with each post I get a bit closer to that goal. I really hope that it lets everyone out there believe that you don't need to be twentysomething quant genius to improve your investing results. You just have to be curious and spend a little time at it. Anyway, thanks for reading and please reach out to me at [email protected] if you have any questions or ideas.

And now my footnotes.

I always love when podcasts put up show notes. It may just be me, but I love connecting the dots between what was discussed and the deeper information out there. So, I thought, why not create some footnotes for my longer blog posts. Here goes:

For more information about Tom Gayner (Trades, Portfolio) and Markel, I highly recommend the work from John Huber that can be found here. There are also great interviews with him that let him explain his worldview directly.

https://moiglobal.com/tom-gayner-interview/

https://www.youtube.com/watch?v=2sG91e1Wh4I

I also think that this podcast Full Disclosure: Capital Gayner is worth listening to as well.

There really is no better way to get a feel for Markel than to read the Markel Style and the annual shareholder letter. If you're a first-time reader, don't get scared of big words like surety and classes of business like "specialty insurance." You can skip them or keep using Google and dictionary.com. Either way, you'll get a feel for their business and their world-view. Here is a link to the 2017 Markel Shareholder Letter. You can find the rest of them here.

About Ryan

Ryan Dolan is a regular guy who got interested in Warren Buffet at business school a decade ago. He launched the Mighty River in 2017 to share investing wisdom, hard-earned mistakes and his general approach to applying Warren and Charlie's values to life. He likes to call it the guide to getting rich slowly. mightyriver.org

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