I haven’t written about Markel (MKL) in a long time. The same goes for my investment activity: I initiated a small position in 2014 but haven’t bought or sold a single share since. But after a difficult 2018 for the company (along with some pressure on the stock price), an update is needed.
For some background, Markel is a holding company. Its primary business is specialty insurance, which means it provides coverage for hard-to-place and unique risks outside of the standard insurance market. For example, it offers coverage to summer camps, lawn care companies, classic car owners, martial arts instructors and vineyards (its business is diversified across over 100 product lines, which limits its exposure to any one area). To compete across these specialty lines, insurers need both cost-effective distribution and unique knowledge of the risks that are being insured.
When you think about it in that light, it makes sense that a leading insurer in a given niche should be able to generate some attractive underwriting results. In addition, underwriters at Markel are highly incentivized to write profitable business (as opposed to growth); for example, none of the underwriters in Markel’s insurance operations receives incentive compensation unless their book of business produces an underwriting profit. As noted in the 2005 shareholder letter, “We want our associates to earn reasonable base salaries and benefits but have the opportunity to earn significant performance incentives based on underwriting profitability … over the past three years, our incentive compensation payments have averaged over 40% of base salaries.”
This combination has led to attractive underwriting results over the long run. A look at Markel’s combined ratio shows it has consistently outperformed the property and casualty (P&C) industry:
Over the past decade, Markel has written at an average combined ratio of roughly 97% -- about four points better than the property and casualty industry as a whole.
On top of strong underwriting results, Markel has generated significant value through its investment portfolio (at the hands of co-CEO Tom Gayner (Trades, Portfolio)). As an example, its equity portfolio outperformed the S&P 500 by roughly 400 basis points per year from 2000 to 2018. The combination of profitable underwriting and outsized investment returns has created meaningful value for Markel's shareholders over the long run (book value per share has more than sextupled since 2000).
In addition to its core insurance business, Markel has acquired a collection of non-insurance businesses over the past 15 years (known as Markel Ventures). These businesses have become increasingly important to the company’s financials over time (with the company spending nearly $1 billion on Ventures acquisitions in the past five years, inclusive of contingent considerations). While it’s still relatively early days for Ventures, it should provide an avenue for long-term growth that pairs well with the firm’s proven investment acumen.
Finally, Markel has recently built a presence in the insurance-linked securities (ILS) market. The company first entered ILS with the 2015 acquisition of investment fund manager CATCo for $206 million (now Markel CATCo Investment Management, or MCIM). It expanded its presence through the purchase of Nephila for $973 million (one of the early entrants in the ILS market and “the preeminent ILS manager in the world” according to management), as well as the $919 million acquisition of State National.
Markel’s ILS business took a turn for the worse in 2018 when it received government inquiries from the Securities and Exchange Commission, the U.S. Department of Justice and the Bermuda Monetary Authority (BMA) into loss reserves at MCIM. This eventually led to a $179 million impairment charge that reduced the carrying value of goodwill and intangibles at the unit to zero as well as the subsequent firing of two senior executives. When special redemption rights were offered to investors in the fund, the vast majority chose to head for the exits. As noted in recent filings, “MCIM’s ability to maintain or raise capital has been adversely impacted.” Finally, Markel also invested $200 million of its own capital in the fund, which has sustained significant losses.
There’s no sugarcoating it: This was a tough two years for the ILS industry broadly and for CATCo specifically. Despite these struggles, management has consistently voiced a belief that ILS could become strategically important for Markel over the long run. Considering its decades of experience in the Insurance business as well as the trust it has, in my view, rightfully earned from investors over the years, I’m inclined to give it the benefit of the doubt. With that comes the belief that if results do not improve over time (i.e. they're wrong on ILS), Markel will alter course accordingly. For what it’s worth, here’s what growth in ILS and alternative capital space has looked like over the past 20 years:
I’ll let management have the last word on this topic:
“We’ve been on a multi-year and multi-acquisition process to build our capabilities in the ILS market … we’ve assembled the largest single entity that participates in the ILS market. We are incredibly optimistic about the future of this business and what it means for Markel … We entered for the next 10 to 20 years, and we're very excited about what that looks like.”
Conclusion
As part of my research, I went back and reread the shareholder letters from the past fifteen years. If you're interested in Markel as a potential investment, I would recommend you do the same.
I walked away from that exercise with the belief that this is a high-quality company with a trustworthy and intelligent management team. It is cultivating a culture focused on long-term value creation. It has preached a consistent message for many years and has delivered strong results. Markel is run by the kind of people that I’d like to partner long-term.
While the pace of book value growth has slowed, that could prove temporary. By my math, intrinsic value growth of roughly 10% per annum is not an unrealistic target. If that proves correct, the current valuation is attractive in a world where long-term U.S. government bonds yield less than 3%.
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