Valuing Markel

In my previous post I valued Berkshire Hathaway using Tom Gayner’s valuation method, which he described in a Value Investor Insight interview from 2012.  So I figured  I might as well put Markel’s numbers into the spreadsheet and see what we get.  Before I get to that here’s a quick summary on Gayner’s valuation method for those who didn’t read the last post.


 

Valuation Method Summary

Gayner breaks down the business valuation into three parts:

  • underwriting profits
  • investment returns
  • non-insurance normalized earnings  

He then applies a range of returns to insurance premiums earned, the investment portfolio and also estimates normalized earnings for the operating businesses.  Finally he takes the sum of all three parts and applies a multiple of 10x, 14x and 18x.  I changed things up a bit, but most of it is self explanatory.


 

Markel’s Investment Returns

I decided to adjust the investment portfolio returns down (vs what I used in the Berkshire model) to a base case of 5% with a low of 3% and high of 7%. Historically Markel has achieved higher investment returns (see below):

  • 5-yr annual return:  7.4% 
  • 10-yr annual return:  6.2% 

I’m being conservative with Markel for a few reasons.

1. Markel has an unusually large fixed income allocation due to the acquisition of Alterra  

When the investment portfolio from Alterra was inherited by Markel the total investment portfolio went from $9.3B in 2012 to $17.6B in 2013.  It almost doubled!  Alterra’s $7.9B investment portfolio consisted mostly of fixed income securities and a hedge fund portfolio that was subsequently liquidated.  This diluted Markel’s equity allocation, which currently sits at roughly 55% of shareholder equity.  Obviously having less invested in equities and more in bonds will lead to lower returns.  Historically Markel’s equity returns have outperformed fixed income returns by a wide margin.

  • 5-yr annual return: Equities, 20.4%   Fixed Income: 4.7%
  • 10-yr annual return: Equities, 13.4%   Fixed Income: 4.6%

2. Markel doesn’t use float to invest in equities like Berkshire 

Markel invests in equities with shareholder equity only; whereas, Berkshire uses both shareholder equity AND float.  Markel’s float is mostly invested in fixed income securities that match Markel’s insurance liability durations.  In a Gurufocus interview from 2011 Gayner explained why Markel does this vs. investing in float like Berkshire:

TG: “Berkshire has a much bigger balance sheet than Markel and a much bigger base of equity compared to its insurance liabilities than we do. As such, they can allocate more of the investment portfolio towards equities. Over time, if we continue to grow and build up our equity capital we should be able to move in the same direction as Berkshire.  Furthermore with a rising interest rate headwind and potentially lower forward returns from stocks I’m lowering expectations for conservatisms sake.”

I thought that last part was very interesting.  I’ve seen Gayner state that his preference is for equities to be 80% of shareholder equity, but I’ve never heard him say they would like to eventually invest the float.  This strikes me as another under appreciated benefit to the upside that could juice returns further as Markel grows in scale.  For now though, returns have and will most likely be lower than Berkshire’s.

3.  Rising interest rates

With such a large fixed income portfolio the obvious drawback is as interest rates rise the existing fixed income values will fall.  And theoretically equity returns should be lower in the future.  This combination would put a drag on investment returns going forward.  On the other hand as rates rise (assuming it continues) Markel’s investment income will rise too. But for the sake of conservatism I’m lowering return expectations.

Markel is being proactive by keeping durations lower than normal and waiting.

From the 2014 Annual Letter:

“We continue to own a portfolio of fixed income securities which mature faster than what we expect from incoming insurance claims. We will continue to maintain this modest override from our normal design until such time as interest rates are higher than current levels. We just don’t think we are being paid appropriately to take the risks of owning long-term bonds so we won’t do it.”

On rates rising over the long term:

“We normally don’t try to predict interest rates but we can use common sense to say that we believed they were too low during the last few years, and now they are trending back to a more normal level. Consequently, we too will trend back towards a more normal bond portfolio over time. This should increase our investment income substantially in the years to come.”

Again, a little off subject, but Gayner and co. are aware of the rate environment and as with insurance underwriting they are being disciplined by waiting for a price that warrants the risk taken.


 

Markel Valuation

Markel’s historical combined ratio is 96%, they had a 95% combined ratio in 2014 and so far in 2015 (through Q3) have an 89% combined ratio.  Due to fairly consistent underwriting profits I kept underwriting returns at 4%, the same as Berkshire’s.  I used 2014 net cash earnings for Markel Ventures opposed to Gayner’s use of EBITDA; and as previously discussed, I lowered investment returns to 5% for the base case.

Screen Shot 2015-12-23 at 8.35.31 PM

 

The base case shows a FV of $1,215 per share with 38% upside from Tuesdays close of $879.85.  Fair value here would imply 2.2x book value, which is at the upper end of Markel’s historical range.  Seems a little rich, but the assumptions aren’t overly ambitious.  If you play around with the assumptions you’ll see (especially when compared to Berkshire) just how much investment return drives the overall intrinsic value for Markel.

At base case $81 EPS Markel trades at:

  • 10.9x comprehensive earnings
  • 14.7% ROE

If we take the base case assumption down to 4% investment returns we get a FV of $1,014 (15.3% upside).  If we take it down to 3% we get a FV of $814 (-7.5% downside).  Of course you can also play with the multiples.  If Markel is only getting 3% returns on investments does it deserve a 15x multiple?  So for me this one is a bit tougher than Berkshire.  The range of outcomes are greater no doubt.


 

A few other thoughts on Markel’s bright future:

1. Markel Ventures growth

I didn’t forecast any growth for Ventures in the model because a) disclosure is minimal and b) it’s still a fairly small part of Markel. EBITDA for 2014 was $95m which comes out to just 8% of the estimated total net profit.  Also, it’s just too hard to forecast (at least for me).  But we can still look at what has happened so far.  Ventures has grown significantly over the years with 30% annual revenue growth since 2005.  Adjusted Ebitda has grown significantly as well.

Screen Shot 2015-12-23 at 9.06.33 PM

(BTW if you’re questioning Gayner’s use of EBITDA I recommend you check out The Brooklyn Investor post I linked to at the bottom)  

Again, this is off a pretty small base and at the moment is still a small part of the business, but I think Ventures could play a large part in Markel’s growth over the next decade.  Gayner said at a recent Markel brunch that if Ventures was outside of Markel they would earn greater than 20% ROIC.  Ventures gives Gayner yet another avenue he can allocate capital to and should provide consistent cash flows.  

2. The Leverage Ratio

The leverage ratio is currently 2.45x, which is at Markel’s low end historically.  If leverage increases to the historical average of 3.5x (or up at all), returns will be magnified.

3.  Increased portfolio mix towards equities

This one ties into the previous bullet.  Gayner has said in the past that their target goal for equities is 80% of shareholder equity (currently at around 55%).  This could be viewed as a nice tailwind for future returns as the investment portfolio mix moves toward equities, but that also depends on your view of the market and Gayner’s ability to beat it.  Additionally, as I quoted earlier, Gayner believes at some point Markel will be able to invest the float in equities a la Berkshire.  Currently Berkshire has about 65% of it’s investment portfolio in equities (rough estimate); whereas Markel has only 23%.  Bottom line, an increase in equity allocation could be a significant tail wind for returns in the future.


 

Conclusion

I do think that Markel’s stock could take a breather and pull back some.  Berkshire did just that in 2015.  It peaked around $150 after a pretty impressive multi-year run up and then receded back down to the $127 range (now ~$131).  If Markel is a large percentage of your portfolio than maybe trimming wouldn’t be a bad idea.  I did this with Berkshire when it was around $150.  I sold 20% of my shares as it was encroaching on 13% of my portfolio, then Berkshire stock dropped down to $127-128 where I bought the shares back.  A rare and lucky “trade” for myself.  This approach allows you to take a little off the table in the short term, but still participate in the long term compounding of a great business.  That said sitting on your hands might be the best bet.

In my original post on Markel I had a FV range of $800 to $1200 using a few different valuation methods.  I’m pretty comfortable saying that at today’s price Markel is at least fairly valued.  I know that opinion is not very popular lately, especially on twitter.  Some people are worried that Markel is getting expensive after the rather quick run up in the last year or two (65% return in 2 yrs).  This strikes me as shortsighted if you believe Markel is truly a great company that can compound overtime.  How many times in Berkshire’s history did people get burned by selling when they thought the stock was slightly overvalued.  Of course Markel is not Berkshire, but I tend to believe the business model is one built to compound overtime in the same vein as Berkshire.  In my opinion there is quite a bit of optionality in Markel’s future.

So that’s my two cents.  I’ll leave you with some interesting quotes from Chuck Akre’s 2011 VII interview:

On rising interest rates

“Just as TD Ameritrade is a coiled spring levered to rising interest rates, so too is Markel when there’s an upturn in the insurance pricing cycle.”

On the Leverage Ratio:

“As part of that model, they constructed a holding company balance sheet which typically had $4 of investments for every $1 of book value, so that when they earned 5% after-tax on their investments, that was magnified four times and the change in book value was 20%. When pricing is soft and the business isn’t growing, that gearing ratio shrinks because they can’t add enough to the investment portfolio to maintain the 4:1 ratio. Today the gearing is more like 2.5:1.”

On valuations:

“So you’re paying around 125% of book. That is hardly expensive for a high-quality, well-run and transparent insurance company that I believe can compound book value at 15% annually. As I mentioned earlier, 200% to 300% of book is not at all out of line for this type of company in a different part of the cycle.”

 


 

Additional Info/Links:

MKL IV Spreadsheet

Markel Corp (MKL): A Conservative Compounder

Valuing Berkshire with Help From Tom Gayner

Value Investor Insight 2012- Tom Gayner

The Brooklyn Investor- Markel Ventures

Tom Gayner Gurufocus Interview 2012

Value Investor Insight 2011- Chuck Akre

Markel (MKL): A Compounding Machine- John Huber

 

Valuing Berkshire with Help From Tom Gayner

I recently came across a post by Greg Speicher from 2011 that described Tom Gayner’s method for valuing Berkshire Hathaway (h/t Value Seeker @Find_Me_Value for the link). The post referenced a 2011 Value Investor Insight interview in which Gayner discusses his valuation method for Berkshire.  It’s really a great interview with a ton of insight from Gayner.  He’s always fairly open with his thinking, but I found this interview particularly informative.  I might have to do another quick post on it.

Anyway, Greg did a great job summing up Gayner’s method by creating a corresponding valuation spreadsheet including Gayner’s assumptions.  I thought it might be interesting to update the spreadsheet and see how Gayner’s valuation method looks today with shares at seemingly cheap levels. (quick note: Greg’s original post was in July 2011; a very good time to buy BRK shares, which were around $75 per B share, 1.1x -1.2x book value and have since produced 12.4% annualized.  The price actually dropped to $65 per B share later that September, producing 15% annualized.)  


 

Gayner’s method for valuing Berkshire:

TG: “I break the business into three parts, insurance, investments and the other operating companies. For the insurance business, which is currently relatively soft but is well-positioned and well-run, I look at the level of insurance premiums running through the business and assume at the low end that it breaks even on an underwriting basis, in the middle range makes 4-5 points of underwriting profit and at the high end makes 8-9 points. For the investment portfolio, I assume it earns from 3% at the low end up to 10-12% at the high end. For the operating businesses, I look at the actual cash flow produced over the past three years and overlay my expectations over the next few years to get a range of possible normalized earnings. On all of that, I apply 10x, 14x and 18x earnings multiples to arrive at a fair-value range for the company overall.”

The TL;DR version:

  • underwriting profits
  • investment returns
  • normalized operating cash flow

Gayner then takes the sum of all three and applies a multiple of 10x, 14x and 18x.

It’s pretty simple.  What’s interesting about this method (to me) is that Gayner’s not just some hedge fund investor valuing a business.  He is essentially valuing his business, which is as close to Berkshire as it gets.


 

Valuation

 

Screen Shot 2015-12-21 at 8.53.04 PM.png

I adjusted the spreadsheet a bit from Greg’s by doing five scenarios instead of three, and used slightly different multiples.  For insurance premiums I used Q3 ttm and assumed a range of zero to 8% underwriting profits with 4% as the base case.  I estimated the investment portfolio at $196.7B, which includes all investments as of Q3: equity portfolio, fixed income, “other”, the Kraft-Heinz investment and $25B cash.  I don’t recall how much cash the PCP deal involves, but you can adjust the cash level as you see fit.  I used Gayner’s range of 3% investment returns on the low end, to 10% on the high end, with a 7% base case.  For operating earnings base case I estimated future growth of 10% annually for three years off of $12.47B ttm, and took the average earnings.  Then I took the total net profit and applied multiples of 10, 14, 15, 16 and 18.

The base case has a FV of $181 per B share or 39.8% upside from Friday’s close of $129.53 per B share  (1.79x book value).  Not to shabby.  Yes, it’s very simplistic but I think this gives a good idea of what possible.  Can Berkshire achieve 4% underwriting profit?  I think so.  7% investment returns?  Probably.  And a 15x multiple  on that is not unreasonable.

At $12.08 EPS Berkshire trades at ($129.53 per B share):

  • 10.7x comprehensive earnings
  • 12% ROE

Conclusion

The main thing I took from Gayner’s method was the visual of just how big the operating businesses are becoming for Berkshire and its intrinsic value.  Growth here should lead to a declining importance of book value multiples, which we sometimes tend to anchor to.  Gayner alluded to this in the Markel 2014 Annual Letter stating that growth in book value CAGR is the best way to measure growth in intrinsic value opposed to using absolute book value multiples.

Anyway, this is just one method of many for valuing Berkshire, but one I’ll probably continue to use if for no other reason than to model various return scenarios from the three segments.

For a good discussion on BRK valuation take a look at Value Seeker’s (@Find_Me_Value) recent tweets.  Some great detail, and interestingly a similar FV despite the very different approach.

I attached the spreadsheet below so you can adjust/play with the assumptions yourself. I’d love to hear what people think about this so feel free to comment.


Additional Info:

Tom Gayner’s approach to valuing Berkshire Hathaway

Value Investor Insight: June 2011

BRK IV Excel Spreadsheet

Morningstar BRK Report

 

 

 

Todd and Ted Portfolio Update (9.30.15)

I updated the T&T portfolio as of Q3.  Let me know if anything is missing or should be added.

Todd & Ted Combined Portfolio (updated as of 9.30.15)
Stock Shares Held Market Value % of Portfolio
DVA 38,565,570 $2,789,448,000 14.97%
T 59,320,756 $1,932,670,000 10.37%
CHTR 10,281,603 $1,808,020,000 9.70%
GM 50,000,000 $1,501,000,000 8.05%
DE 17,052,110 $1,261,857,000 6.77%
PCP 4,200,792 $964,963,000 5.18%
VRSN 12,985,000 $916,222,000 4.92%
SU 30,000,000 $801,600,000 4.30%
BK 20,112,212 $787,393,000 4.23%
V 9,885,160 $688,600,000 3.70%
VZ 15,000,928 $652,691,000 3.50%
AXTA 23,199,474 $587,875,000 3.15%
LMCK 15,386,257 $530,210,000 2.85%
LBTYA 11,957,285 $513,446,000 2.76%
MA 5,229,756 $471,306,000 2.53%
WBC 3,559,189 $373,110,000 2.00%
TMK 6,353,727 $358,350,000 1.92%
LBTYK 7,346,968 $301,373,000 1.62%
LMCA 7,800,000 $278,617,000 1.50%
GE 10,585,502 $266,966,000 1.43%
FOXA 8,951,869 $241,522,000 1.30%
SNY 3,905,875 $185,412,000 0.99%
VRSK 1,563,434 $115,553,000 0.62%
CBI 1,983,190 $78,653,000 0.42%
GHC 107,575 $62,071,000 0.33%
MEG 3,471,309 $48,564,000 0.26%
JNJ 327,100 $30,535,000 0.16%
DNOW 1,825,569 $27,018,000 0.14%
MDLZ 578,000 $24,201,000 0.13%
LILA 517,139 $17,422,000 0.09%
LILAK 367,348 $12,578,000 0.07%
UPS 59,400 $5,862,000 0.03%
LEE 88,863 $185,000 0.00%
Total: $18,635,293,000

Ferrari: Notes from the Form F-1 (RACE)

I recently read the Form F-1 (which you can find here) and thought I would share some of the more interesting parts… at least to me.

A little background first. In October, 10% of Ferrari will be sold to the public via IPO, then the remaining 80% will be spun off to Fiat Chrysler shareholders early next year (the other 10% is owned by Piero Ferrari). Many Fiat shareholders (including myself) bought shares before Fiat and Chrysler merged in large part due to the value of Ferrari. You could of bought Fiat (which at the time owned less than half of Chrysler, Alfa, Maserati and 90% of Ferrari) for less than the value of Ferrari. Having Ferrari as backing put a nice basement on the downside and gave me confidence investing in a small Italian auto manufacturer with a ton of debt. It also helped that CEO Sergio Marchionne was focused on creating shareholder value and understood the value of Fiat’s assets. Anyway, here we are.

Structure post IPO:

Screen Shot 2015-08-20 at 8.58.01 PM

Intro from the F-1:

Screen Shot 2015-08-18 at 9.23.46 PM-2

2014 Financial Summary
Revenue: €2,762
Net Profit: €265
Adj EBITDA: €693
EBIT: €389
Cars Produced: 7,255

Net Revenues by Segment:

Screen Shot 2015-08-18 at 9.32.29 PM

Shipments

One of the most discussed issues regarding Ferrari has been the number of cars produced and whether going above the 7,000 car cap limit is dilutive to the brand. It’s officially the limit is no longer…

“Our strategic business plan reflects a continuation of the low volume strategy, while gradually increasing shipments to approximately 9,000 units per year by 2019.”

Shipments from 2010-2014:

Screen Shot 2015-08-18 at 9.42.34 PM

I’ve seen some argue that increasing production to 9,000 or 10,000 cars would dilute the brand and it’s exclusivity. In the whole world there will only be 9,000 cars sold in 2019…. 9,000! In the world! That’s pretty damn exclusive IMO. A move to 9,000 cars would be a 24% increase over 2014 or a 4.5% annual growth rate through 2019. That’s pretty reasonable. Of course beyond 2019 I’m not sure how they’ll proceed. They also mention that Ferrari’s market share in the luxury performance car market has declined due to the rise of wealthy individuals in conjunction with the static 7,000 car cap limit. They don’t focus on market share or consider it relevant, but it does illustrate how Ferrari could be better aligned with its growing wealthy customer base.

Sergio has mentioned 10,000 cars is possible. He’s also stated that Ferrari should sell one less car than demanded. His argument is essentially that there is a greater growth of wealthy individuals and Ferrari should grow with that demand. He also mentioned that exclusivity can be so extreme that it becomes absurd, referring to the 3+ year waiting lists and 7,000 cap limit.

I agree that maintaining exclusivity of the brand is paramount. One of the biggest mistakes luxury companies make is becoming greedy in the pursuit of short term profits. Inevitably it bites them in the butt by cheapening the brand over time. This happens quite a bit in fashion (Tommy Hilfiger, KORS, Coach). They try to sell more clothes, bags or whatever to more people and all of the sudden everyone and their mom has one of these things. It’s no longer cool or exclusive. Not everyone will own a Ferrari (obviously), but it could become less desirable if it doesn’t maintain ultra-luxury status.

I don’t know how turning Ferrari into a luxury brand opposed to just a luxury car company will affect the long term brand value. Will Ferrari theme parks, clothes, key chains or whatever they think up cheapen the brand? They already have many of these things, but it’s worth keeping an eye on. As far as car production goes IMO, 7,255 to 9,000 cars will not damage exclusivity.

John Elkann, the head of the Agnelli family and CEO of Exor Spa (holding company that controls Fiat), will own a majority voting stake in Ferrari. His prescence gives me comfort in the long term future of Ferrari. I think Elkann will show the same patience he has for Fiat by allowing and encouraging a long term approach that upholds the brands ultra-luxury status.

Formula 1 Racing Team

I have to admit I had no idea how big Formula 1 racing is. In 2014 their were 424 million television viewers, which is the most watched annual sport series in the world.

“More generally, Formula 1 Racing allows us to promote and market our brand and technology to a global audience without resorting to traditional advertising activities, therefore preserving the aura of exclusivity around our brand and limited the marketing costs that we, as a company operating in the luxury space, would otherwise incur.”

Screen Shot 2015-08-20 at 8.53.50 PM

Ferrari takes a share of annual profits from the FOWC (Formula One World Championship Limited), which includes television broadcasting royalties and other commercial activities. 60% of the profits are distributed to the teams based on the ranking of each team. So the first place team gets the most money and last place the least. There is sponsorship money from the likes of Phillip Morris, Shell, Santander and others. Ferrari is also the only team that gets paid a fee for just being a part of the race. All of this money is used to offset the cost of the racing team.

The racing team is kind of a marketing, client schmoozing and R&D department all in one. Many of the racing teams designs, technological advancements and enhancements make their way onto later production models.

Engines

What I found most interesting was the engine segment. Revenues are up 300% since 2011 and went from 3.5% to 11.3% of revenue. This is mostly due to the ramp up of Maserati, which uses engines built by Ferrari. This quarter’s revenues were lower due to a decrease in Maserati sales, but longer term this could be a nice area for growth. It’s a double edge sword that depends on the success of Maserati. Sergio is planning to introduce multiple new models over the next few years including the Levante SUV next year.

“Net revenues generated from engines were €311 million for 2014, an increase of €123 million, or 65.4 percent, from €188 million for 2013. The €123 million increase was mainly attributable to an increase in the volume of engines sold to Maserati, and to a lesser extent, driven by an increase in net revenues generated by the rental of engines to other Formula 1 racing teams.”

Here’s the deal with Maserati:

“Our arrangement with Maserati is currently governed by a framework agreement entered into in December 2014. Pursuant to this agreement, the initial production run of up to 160,000 engines in aggregate through 2020 is expected to increase to up to 275,000 engines in aggregate through 2023 to cater to Maserati’s planned expanded model range and sales. Volumes and pricing are adjusted from time to time to reflect Maserati’s changing requirement.”

“In order to meet our obligations under our agreement with Maserati, we constructed a new production line dedicated to the Maserati V6 engine, which was funded by Maserati.”

I believe Alfa is using Ferrari engines as well, which is not referenced at all in the F-1. I found that kind of curious. Anyway, it could be a huge boon for engine growth since Alfa is being positioned for a bigger/broader market than Maserati. The stated goal of 400k Alfa’s is a ridiculously lofty goal, but for Ferrari’s purposes anything at all will be good for business.

UPDATE: From what I’ve read Ferrari isn’t building Alfa engines.  Alfa is using the term “Ferrari Developed” or “Ferrari Designed”.  Not sure what the hell that means.

What I like about the growth in engine sales is it can ramp up quite a bit, it produces good money for Ferrari and all while having very little impact on the Ferrari brand. I don’t know if the market even realizes that Ferrari makes money by selling and producing engines. Maybe, but I highly doubt they realize their is growth potential here.

Markets by Region

“We divide our regional markets into EMEA, Americas, Greater China and Rest of APAC, representing respectively 45 percent, 34 percent, nine percent and 12 percent of units shipped in 2014. In recent years we have allocated a higher proportion of shipments to the Middle East and Greater China and, to a lesser extent, the Americas and a lower proportion to Europe, reflecting changes in relative demand as part of our strategy to manage waiting lists and maintain product exclusivity.”

Screen Shot 2015-08-19 at 9.26.02 PM

True to the statement above you can see that Middle East and APAC shipments have been growing the most as a % of total cars shipped.

Economic Sensitivity

“During the financial crisis, suffered only a single year of modest (less than 5 percent) decline in shipments in spite of the luxury status of our cars and the discretionary nature of their purchase.”

I was happy to see this quote and it’s quite the accomplishment if true. Still I wish they would give more information on shipments and financials over the last decade, but I didn’t see anything prior to 2010. (If anyone has 10 year financials please let me know!)

Screen Shot 2015-08-19 at 9.28.25 PM

The chart above shows Ferrari shipments vs the luxury performance car index. You can definitely see a dip in 2008-2009, but much better than the index, which includes sport cars with 500hp and a retail price above 150,000 euro (Aston Martin, Bentley, Ferrari, Lamborghini, McLaren, Mercedes Benz, Rolls Royce). The Ferrari data is based on the top 22 countries (approx. 80% of total shipments in 2014).

“While affected by global macroeconomic conditions, the luxury goods market is also impacted by several more specific factors, such as, in recent years, the significant economic growth and wealth creation in certain emerging economies and rising levels of affluence and demand from the emerging middle and upper classes in Asia and a general trend towards urbanization. Particularly following the 2008-2009 downturn, this has led the global luxury goods market to return to perform better than global GDP, as shown in the chart below.”

Screen Shot 2015-08-19 at 9.31.53 PM

Platforms and Production

Just like the big boys Ferrari utilizes common platforms in order to reduce fixed costs by using two architectures that enable both front and mid-rear engines for flexibility.

Screen Shot 2015-08-20 at 9.01.48 PM

Over the last decade the Ferrari facilities have been significantly upgraded. This will allow them to ramp up production without any issues as the cap limit is lifted. It should also help boost margins by spreading production costs across more cars.

“Our facilities can accommodate a meaningful increase in production compared to current output with the increase of weekend shifts or, to address special peaks in demand, temporary employees. Production could be increased even further with the introduction of a second shift on car assembly lines compared to the single shift currently operated.”

I think this is one of the bigger parts of the bull case on Ferrari. As they raise production to 9,000 cars not only will that help the top line, but costs should rise slower leading to better margins going forward.

Limited Edition Cars/ Life Cycle

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“The exclusivity of a particular product offering is also a relevant factor in its profitability. For example, in November 2013, we launched the LaFerrari, our latest limited edition supercar, which was planned for a total production run of only 499 units. In light of the exclusivity of the offering, along with the supercar advanced technological and design content, LaFerrari has a sales price in excess of €1 million, which is much higher than other models in the Ferrari product range. Therefore, our 2014 and 2015 net revenues have benefited significantly from shipments of LaFerrari. We expect to complete the production run of the LaFerrari in early 2016. In general, more exclusive offerings generate higher net revenues and provide better margins than those generated on shipments of range models (which include Sports and GT models, V8 and V12 models and represent the core of our product offering) and special series cars. Similarly, our limited edition cars which we launch from time to time are typically sold at a significantly higher price point than our range models and therefore they benefit our results in the periods in which they are sold.”

I mentioned it earlier, but without more detail I’m not sure how one-off type models will affect revenues due to their lumpiness.

As for the range models:

“Generally, we plan for a four to five year life cycle for our range models. After four to five years, we typically launch a modified or M model based on the same platform but featuring significant aesthetic updates and technological improvements. This is, for example, the case of the California T, launched in 2014, which replaced and updated the earlier California, featuring new sheet-metal, new interior, a revised chassis and a new turbocharged powertrain. Typically, four years after the launch of the M-model, we start production of an entirely new model based on an completely new or overhauled platform. Therefore, the cumulative life cycle of each of our models is approximately eight to nine years, and typically we have launched one new model every year while keeping four or more range models in production at any time. The actual life cycles of our models vary depending on various factors including market response. Special series have different, typically shorter, lifecycles. We usually utilize additional platforms for production of our supercars, such as LaFerrari.”

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With the range models there is actually a nice steady cycle that can last 8 to 9 years with just one refresh. I do have a feeling Sergio is aware of the lumpiness and would push for a smoother more predictable one-off production roll out. But still, not sure how much can be done about this. We’ll just have to be wary of the possibility that current earnings are above average and figure out what the normal earnings power is through a full cycle.

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Pricing

Since 2005 Ferrari has achieved a CAGR in net revenues of 7%. This is with production levels that didn’t increase much due to the 7,000 car cap limit. Without knowing the complete picture I think this gives us an idea into their ability to raise prices and how with expanding the cap limit what growth might be possible.

“We believe our cars performance in terms of value preservation after a period of ownership significantly exceeds that of any other brand in the luxury car segment. High residual value is important to the primary market because clients, when purchasing our cars, take into account the expected resale value of the car in assessing the overall cost of ownership. Furthermore, a higher residual value potentially lowers the cost for the owner to switch to a new model thereby supporting client loyalty and promoting repeat purchases.”

This was fascinating to me. The resale value of Ferrari’s are very high and sometimes higher than the original purchase price. I was aware of that fact, but didn’t think about how it makes customers more likely to be a repeat buyer (after selling the old car). Also, it provides stability in new car pricing.

“We seek to increase over time the average price point of our range models and special series by continually improving performance, technology and other features, and by leveraging the scarcity value resulting from our low volume strategy. Furthermore, the content of the cars we sell can be customized through our interior and exterior personalization program, which can be further enhanced through bespoke specifications. Incremental revenues from personalization are a particularly favorable factor of our pricing and product mix, due to the fact that we generate a margin on each additional option selected by the client.”

Customization offers items such as rare leathers, custom stitching, special paints, special carbon fiber and personalized luggage to match the car interior, which on average add 15% to selling prices.
And of course there are the limited edition supercars (La Ferrari) that can exceed $1 million per car; as well as, very limited edition series and one-off cars that all have higher average price points.

The Ferrari “Brand”/ Licensing

Marchionne has stated that Ferrari is a luxury brand not just a car company. A big part of that branding effort is expanding into other areas outside of actual car making. To achieve this Ferrari is looking to expand retail stores and licensing out the brand for theme parks, accessories, sportswear, toys, video games and who knows what else. You can see the list below. They are also planning on branching out into other luxury goods in adjacent lifestyle categories. Not sure what that means exactly, but I’ll be keeping an eye on whether this truly enhances the brand… or possibly has the opposite effect.

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A significant portion of licensing revenues comes from Ferrari World royalties. At the moment this is the only theme park, but there are plans to open one theme park in each geographical region. I assume this means at least 4 total, maybe more. They mention specifically having one in North America and Asia. There is a deal in place to open a European theme park in Barcelona, in which PortaVentura Entertainment will invest 100 million set for a 2016 opening.

“Net revenues generated from sponsorship, commercial agreements and brand management activities were €17 million for 2014, an increase of €5 million, or 1.2 percent, from €412 million for 2013. The €5 million increase in sponsorship, commercial and brand net revenues was mainly driven by new sponsorship contracts entered into by our Formula 1 racing team during 2014.”

As you can tell from the quote above, they lump F1 sponsorship money with the brand licensing so it’s hard to say what the parks and other accessories are bringing in.

Conclusion

As a Fiat shareholder I’m pretty excited about the Ferrari spin. I don’t know what the market will pay for it, but I’ve seen some pretty aggressive estimations including Sergio’s comment that Ferrari is worth “at least $11 billion”. The ADW Capital link below is even more aggressive. It assumes EBIT margins 3x the current level and 10k cars by 2018. Too aggressive in my opinion. And as we’ve seen in the F-1, they’re targeting 9,000 by 2019. I’ll need to do some more work (and get more information/detail) before I can confidently value Ferrari. If you made me guess I’d say $5 billion is a fairly reasonable number.

What I do know is Ferrari is one of the top brands in the world that will be growing revenues at a better than expected rate (4.5% p.a. alone in shipments not including pricing). From 2005 to 2014 they grew revenues at a 7% CAGR without much of an increase in shipments. They’ll be scaling to a level where R&D costs from F1 and costs for the production models should remain stable or grow slower than revenues allowing margins to expand. Also, we have upside potential from a significant increase in engine sales from both Maserati and Alfa Romeo (possibly not Alfa). Finally there is the expansion into Ferrari “the brand”. I don’t know what to expect from the theme parks and other Ferrari related products, but it’s worth keeping an eye on and if they do it tastefully it could be another boost to the bottom line.

It’ll be interesting to see what happens come October. Anyway, hopefully I added some value to the discussion. Let me know in the comment section if you have any gripes, questions or more information on Ferrari.

Todd & Ted, Concentrated Portfolios and Some Links

I recently tweeted out some of my favorite 13F’s and figured I would make a more expansive post for future reference. I personally like looking over select 13F’s, especially if there are a significant amount of new buys. Some people dismiss it as useless, but I think if you follow great investors that have concentrated portfolios with relatively long term holdings then it can be extremely useful for idea generation. I mean really with dataroma.com and whalewisdom.com it hardly takes anytime to notate new buys, adds, sells of gurus you’re interested in. At worst it’s simply entertaining to see what they’re are up to.

My personal favorites:

Arlington Value Capital (Allan Mecham)
Akre Capital Management (Chuck Akre)
SQ Advisors (Lou Simpson)
Berkshire Hathaway (WEB, Todd and Ted)
Markel Corp (Tom Gayner)

The first three are extremely concentrated and tend to favor great businesses (compounders). They all have had great long term success; although Mecham is relatively new/young he has done very well. I think Mecham and Akre have some great under followed ideas that are interesting for deeper dives.

Lou Simpson is great. As most of us know he was in charge of GEICO’s portfolio for decades under Buffett until he retired. Lot’s of high quality companies. His 10th position is ~5% of the portfolio! Love it. Lots of interesting names… from Liberty Global and VRX to UPS and Wells Fargo.

I’m biased on Berkshire and Markel. I own significant amounts of both, so selfishly I want to see what these guys are buying. Gayner has a great track record of beating the market, but honestly I don’t find many ideas from his 13F (although, maybe I should). He has quite a few holdings that are very small percentages of the portfolio. He calls these his “minor league team”, which i thought was interesting. Basically he’ll buy a business he’s interested in but doesn’t quite understand (like Amazon) and own it for awhile forcing him to pay closer attention. After awhile he’ll either bump them up to the majors or just get rid of the stock if he still doesn’t understand it.

With Berkshire I’m more interested in Todd and Ted’s picks. Buffett’s are so large and rarely change (although when they do change it’s fun to speculate/debate his reasoning, ie. IBM).

After looking at the Berkshire 13F I wanted to see what the portfolio allocations looked like without Buffett’s giant holdings lumped in. So as you can see below I did just that. It’s both Todd and Ted’s picks together. I took out Buffett’s Big 4 (WFC, AXP, IBM, KO), also PG, USB, WMT, GS, MCO, DE, MTB, USG, COST and QSR. There might be others I’m missing or maybe one of these isn’t actually his picks but it should give us a fairly accurate picture.

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Anyway, combined they have ~50% of the portfolio in the top 5 holdings and ~68% in the top 10 with a total of 34 holdings. The DTV/AT&T deal is going through and the recent PCP acquisition will free up quite a bit of cash for the T’s to allocate (I think DTV was a joint pick; PCP a Combs pick). One of the T’s made a new buy in Axalta Coating Systems (AXTA), which I’m not familiar with. Notable due to it being 3% of their portfolio off the bat. I’d be very interested to hear their thoughts on multiple media companies they own, especially the various Malone entities.

Ok enough Berkshire. There are a few newer 13F’s I’ve been following (new to me) that I like quite a bit:

Bares Capital Management (Brian Bares)
Abrams Capital (David Abrams)
Giverny Capital (Francois Rochon)
AltaRock Partners (Mark Massey)

These guys are EXTREMELY concentrated (anywhere from 7 to 25 holdings).
Bares
Bares specializes in Small-cap compounders so I really like to keep a close eye on his holdings for ideas possibly in the early innings. Currently Colfax (CFX) is his largest holding at 19.75% of the portfolio. Ouch.

(Links):
Brian Bares Interview MOI
Interview MOI (video)
Abrams
Abrams is a former Baupost guy. Very concentrated. Has a good mixture of ugly/cheap/hated and great businesses. One thing to keep in mind is like Klarman the equity portfolio is only a portion of the whole fund. Abrams owns some private held companies and debt investments from what I remember.

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(Links):
In Boston, Secretive Hedge-Fund Billionaire Stays in Shadows
Hedge Fund World’s One Man Wealth Machine
AltaRock

AltaRock owns 7 stocks:

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Respect.
(Links):
Hedge Fund AltaRock’s Investing Principles

Giverny
Giverny is run by Francois Rochon. Fully invested at all times, 25 positions and focuses on great businesses.

Top 10 Picks:

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(Links):
Rochon Interview
Rochon Gurufocus Interview

Honorable Mentions:

Pershing Square (Ackman)
Weitz Investment Mgmt (Wally Weitz)
Pabrai Funds/Dalal Street (Mohnish Pabrai)
Aquamarine Capital Mgmt (Guy Spier)
Wedgewood Partners (David Rolfe)
Smead Capital Mgmt (Bill Smead)
Yacktman Asset Mgmt (Don Yachtman)
ValueAct (Jeff Ubben)
MFP Investors (Michael Price)
FPA Crescent (Steven Romick)
FPA Capital (Bob Rodriguez)
Oakmark (Bill Nygren)
Tweedy Browne
Third Avenue (Marty Whitman)

A couple more interesting extremely concentrated funds: (h/t to @bluegrasscap who brought these to my attention and btw is probably my favorite follow on Finance Twitter)
Tesuji Partners
Lavasseur Capital Partners

And finally the most useless 13F for me:
Baupost (Seth Klarman)

I have no clue… Half are Bio names I won’t even try to figure out. He changes positions frequently sometimes, so I can’t gauge his timeframe/convictions. Plus the equity portfolio is just a part of his whole portfolio. Too hard pile. Probably the reason he’s one of the best.

Feel free to suggest any other good funds in the comment section (especially concentrated, long term value funds).

Markel Corp (MKL): A Conservative Compounder

Background

Markel’s been around for close to 90 years, went public in 1986 and has compounded at a 20% annual rate since the IPO. Steve Markel is Vice Chairman along with CIO Tom Gayner and Chairman/CEO Alan Kirshner.

From the 2014 10K:

“We are a diverse financial holding company serving a variety of niche markets. Our principal business markets and underwrites specialty insurance products. We believe that our specialty product focus and niche market strategy enable us to develop expertise and specialized market knowledge. We seek to differentiate ourselves from competitors by our expertise, service, continuity and other value-based considerations. We also own interests in various industrial and service businesses that operate outside of the specialty insurance marketplace. Our financial goals are to earn consistent underwriting and operating profits and superior investment returns to build shareholder value.”

By consistently underwriting profitably MKL essentially gets paid to invest insurance premiums. This is what Warren Buffett refers to as “float”. CIO Tom Gayner uses the float to invest in equities and fixed income. He has handily beaten the market by a significant margin over many decades using a disciplined value based approach.

Quick Investment Thesis

Markel is a compounding machine with multiple ways to allocate capital effectively. They have a long history of underwriting profitably and are consistently below a 100% combined ratio. Tom Gayner has invested premiums at market beating returns and just recently began acquiring wholly owner operating companies, which is yet another avenue for capital allocation. Qualitatively Markel’s management and culture are superb. Management is long term oriented and treats shareholders as partners. Many people call MKL “Baby Berkshire” due to the similar structure and disciplined culture they share.

At todays price we are paying a better than fair price for a conservatively run business that can compound our capital at above average returns with below average risk.

A Great Company and Capital Allocator

Markel makes money basically three ways:

  1. Underwriting Profits by underwriting in a disciplined manner and forgoing writing premiums if the price doesn’t justify the risk
  2. Investment Income by investing the “float” in fixed income and equities
  3. Operating Businesses, called “Markel Ventures”, but this is currently a small portion of Markel’s profits, which I’ll touch on later.

Insurance

Most insurance companies hope to break even on premiums written. They make the bulk of their money by investing the premiums for investment income. This is also the reason why many insurance companies find it hard to turn away less than stellar premiums and end up underwriting money losing insurance deals. Markel refuses to underwrite this way, instead opting to forego premiums and wait for better pricing or look for better places to underwrite/allocate capital.

combined ratio

As we can see in the above graphic Markel has underwritten very well over the last 5 years especially when compared to the industry average (which is above 100%). In their 28-year history Markel has averaged a 96% combined ratio. This means that not only is this float an interest free loan, they are getting paid to hold other peoples money and invest it for their own benefit.

The insurance segment is divided into three segments: U.S. Insurance, International Insurance and Reinsurance. As you can see below U.S. Insurance is the largest segment, but what’s interesting is Markel barely had a presence internationally just 10 years ago.

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I won’t get into too much detail on insurance segments, but Markel (as mentioned in the business description) is unique in that they underwrite specialty insurance that tends to be a niche product with less competition. For instance they famously insured Judy Garlands ruby red slippers from The Wizard of Oz. Other types include:

youth and recreation oriented organizations and camps, child care operators, social service organizations, museums and historic homes, performing arts organizations, senior living facilities and wineries. “

Of course they still insure the typical types of insurance such as property, worker’s comp and professional insurance, but they pursue unique and hard to place risks.

The bottom line is when it comes to insurance Markel values underwriting profits above all else. If a certain insurance market is showing poor pricing they will simply scale back until pricing improves, which usually happens after a significant event or catastrophe. Employees are incentivized and aligned with this goal.

Investments

Tom Gayner is the CIO and chief capital allocator. If we used a Berkshire analogy he would be Warren Buffett, investing the float and shareholders equity in equities and whole businesses. Comparing Gayner to Buffett is borderline sacrilege, but Gayner is no slouch. His investment record is phenomenal having consistently beat the S&P annually for both 10 and 20 year periods. His approach to investing is explained in the annual report:

“As to our equity selection process we continue to use our durable four step process in seeking excellent long-term investments. We look for, one, profitable businesses with good returns on capital and modest leverage; two, management teams with equal measures of talent and integrity; three, businesses with reinvestment opportunities and/or capital discipline, at; four, reasonable valuations.”

Gayner’s investment portfolio embodies the above quote:

gayner.jpg

 

 

 

 

 

 

Gayner’s portfolio is comprised of great businesses that he can hold onto for long periods of time further helping compound capital by deferring taxes on investments.

As you can see below, Gayner’s performance has been quite good:

returns

Recently Markel acquired Alterra, an insurance company that predominantly invested in fixed income. The Alterra acquisition doubled Markel’s insurance business. It also increased the investment portfolio from $9.3 billion to $17.6 billion. You can see this jump in the above graphic from year 2012 to 2013 under the invested assets row. Due to Alterra’s heavy allocation towards fixed income, Markel’s portion of equity investments as a % of shareholders equity dropped to around 50%.

Gayner has stated his long-term goal is to get that number back up to 80% of shareholder’s equity. This is a nice tailwind having Gayner with more money to invest in higher returning securities.

Operating Businesses

Otherwise known as Markel Ventures.

From the 10K:

“Through our wholly-owned subsidiary Markel Ventures, Inc. (Markel Ventures), we own interests in various industrial and service businesses that operate outside of the specialty insurance marketplace. These businesses are viewed by management as separate and distinct from our insurance operations. Local management teams oversee the day-to-day operations of these companies, while strategic decisions are made in conjunction with members of our executive management team, principally our President and Chief Investment Officer.“

In very similar fashion to Berkshire Hathaway, Markel looks for operating businesses that are profitable, have little need for capital reinvestment, run by “honest and talented” management, at reasonable prices in which they can own ideally forever. Markel currently owns 15 companies including: AMF, a designer and manufacturer of bakery equipment; Cottrell, designer and manufacturer of auto transport equipment; and Parkland Ventures, a leading operator of manufactured housing communities.

In 2014 Ventures had $838 million in revenue with $95 million in adjusted EBITDA. Year over year growth in revenues for 2014 was 22% and EBITDA 13.5%. At its current size Ventures is still a small percentage of Markel, but it’s growing. It’s a great place to allocate capital and also a way of diversifying Markel’s business lines.

Capital Allocation Summary

Markel views their ability to allocate capital as a distinct advantage over most other companies. Gayner uses an example of a capital-intensive business such as a car manufacturer, which needs to keep plowing profits back into making cars no matter what the prospects look like for profits. Markel of course has multiple avenues to allocate capital that can help them succeed in any environment.

In the 10K Gayner laid out his thought process on capital allocation for Markel:

  1. Organic growth in existing insurance and Markel Ventures operations
  2. Acquisitions in both insurance and non-insurance
  3. Purchase stocks and fixed income to support insurance operations and earn good returns on capital
  4. Buyback stock when a purchase offers better returns than the previous three options

It’s rare to see such a clear and concise capital allocation process laid out for shareholders, especially one that makes sense.

Management and Culture

As mentioned earlier management is conservative, disciplined, skilled and extremely shareholder friendly. For example, underwriters are incentivized to write profitably and are rewarded on a multi year rolling basis for profits, not growth in premiums like most insurance companies. This is pretty rare. Essentially they are incentivizing staff to turn away unprofitable insurance. Another interesting tidbit is that every Markel employee is a shareholder. They don’t get stock options, only bonuses and discounted shares for purchase.

The culture at Markel is very unique. At the most recent Markel Brunch in Omaha Steve Markel talked about the “Markel style”:

“People who fit with the Markel style value teamwork over individual achievement; have disdain for bureaucratic processes; believe in the primacy of serving shareholders; and prefer a meritocracy to a general sort of egalitarianism.”

Alan Kishner Markel’s CEO:

“It’s OK to make mistakes at Markel, just don’t make the same dumb-ass mistakes.”

They also do a great job of explaining how to measure progress and performance for Markel. Gayner writes in the 10K:

“We measure financial success by our ability to compound growth in book value per share at a high rate of return over a long period of time. To mitigate the short-term volatility, we measure ourselves over a 5 year period. We believe that growth in book value per share is the most comprehensive measure of our success because it includes all underwriting, operating and investing results.”

To sum it up, management is top notch and the culture at Markel is legit. They are conservative, disciplined, long term oriented and are true partners with shareholders. This humble down to earth attitude combined with discipline reminds me of Berkshire and gives me comfort knowing that management can be trusted.

Valuation

I’ll use three methods to get an idea of what Markel is worth:

  1. The Two-Column Method
  2. Book Value Ranges and 5 Yr. Growth Estimates
  3. Comprehensive Earnings/ROE Method

The Two-Column Method

Warren Buffett himself has in the past suggested to shareholders that using the two-column method for valuing Berkshire Hathaway is a rough proxy of it’s true intrinsic value.

Essentially the two-column method values the insurance portion of the business by using investments per share and then adding operating earnings from the non-insurance portion of the business at an appropriate multiple.

Using the two-column method we get an intrinsic value of $1201 implying a 48% upside from todays price.

The left side of the equation is fairly straight forward, but the right side (Ventures) needs a couple assumptions regarding earnings and multiple. I decided to use pretax earnings, which required some adjustments. From net income I added back amortization, the goodwill impairment and income tax expense. This gives a clearer picture of Ventures true earning power. The 10x pretax earnings multiple is what Buffett likes to pay for good businesses and also after taxes is roughly 15x earnings (the long term market average). I believe Ventures owns above average businesses and assigning an average market multiple is fair. However, at current earnings Venture’s intrinsic value is only 3.4% of Markel’s total intrinsic value.

4 (2)

Book Value and Expected Growth

Markel has a long track record of compounding book value at high rates of return; they also have generally traded in a range of 1.5 to 2x book value. It’s a very simplistic method, but if we apply a range of growth rates in book value to the historical norm in book value multiples we can get a good idea of expected returns.

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In the above chart I first used a range of 5-year book value compound growth rates. As you can see below, 5-year BV CAGR over the last decade has ranged from a low of 9% to a high of 18%. That 9% is the lowest 5-year book value CAGR ever at Markel, which includes the financial crisis.

6a

6b.jpg

In the past both Buffett and Gayner have alluded to a range of book value multiples that they thought represented undervalued and/or overvalued. That range is somewhere between 1.5 and 2x book value. Historically Markel has traded at an average BV multiple of 1.75.

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In the bear case I used 9% BV CAGR at a 1.5x BV multiple and a 9.8% annual return. Both of these are on the lowest end of Markel’s historical range.

For the base case I used a 11% BV CAGR at the historical average 1.75x BV multiple. This case resulted in a 15.3% annual return.

For the bull case I felt that 1.75x BV was a more appropriate multiple than 2x BV. I then used a 14% BV CAGR, which resulted in a 18.4% annual return.

The main drawback of this method is the book value multiple can sometimes reflect Mr. Market’s mood. Despite continued success and growth of the underlying business multiples can get much lower. This happened after the financial crisis, where the market brought Markel (and Berkshire!) down to nearly book value. However, this means nothing to long-term shareholders. Over 5-10 years the multiples should reflect the underlying business. Hence why growth in book value since Markel IPOed mirrors the return on investment for shareholders over that same time period.

Comprehensive Earnings/ROE Method

The ROE method is even simpler than the last two. If we assume Markel can compound book value at 12% for the foreseeable future we can call that a 12% ROE. A 12% ROE on $560 in book value per share equals $67.20 in comprehensive earnings. At todays price of $811 that comes out to 12x earnings.

If we use the more conservative 9% ROE from earlier, we get $50.40 in comprehensive earnings. That comes out to 16x earnings.

At 14% ROE we get $78.40 of comprehensive earnings, which is 10x earnings.

Although very simple, I think this gives us a good idea of what were paying for Markel. Even at 16x earnings it’s a fair price for a great company.

Taking the base case of 12% ROE and applying an average market multiple of 15x earnings we get intrinsic value of $1008 per share.

Valuation Summary

Taking into account the above valuation methods I think an appropriate intrinsic value range for Markel is anywhere from $800 to $1200, with an average price target of $1000. At $1000 we are getting a 23% upside for a great business that should continue to compound at double-digit rates for years to come.

Risks

In the most recent Markel Brunch held in Omaha an audience member asked “What is the greatest threat to your business?”. Steve Markel first replied by saying:

“I feel awfully good about our business. It’s a challenge to think of one big danger. Which may be the biggest danger. We don’t want to believe our own bull-s— all the time.”

CFO Anne Waleski mentioned that as CFO she is paid to worry about a major event combined with a market event. I thought this was interesting because to her this is the worst-case scenario and gives us an idea of how they think. Gayner reiterated Markel’s comments by pointing to complacency as a major threat. Some may dismiss these comments as narrow minded, but I think management truly believes most risks are within themselves. The business model of Markel has so many options to grow that one threat is really hard to do significant long-term damage.

Beyond the scope of management’s thoughts some risks that come to mind are interest rate risks, inadequate loss reserves, extended soft markets, increased competition in insurance markets, a large natural disaster, a poor acquisition and inferior investment returns.

What’s great about Markel is they have been through each of the previously mentioned risks. They’ve been through both the 2000 and 2008 market crashes, are currently in a very extended soft insurance market, are currently experiencing increased competition from hedge funds in the reinsurance market, they experienced natural disasters such as Hurricane Katrina and made a poor acquisition in Terra Nova insurance. Despite encountering all these risks they’ve continued to thrive and compound book value over decades. They thrive and continue to learn from their mistakes, this is part of why Markel is such a good business.

Conclusion

If the market were to close for the next decade I can think of no better company to own than Markel. They are extremely conservative, disciplined, with a culture that incentivizes and supports such a demeanor. They think of their shareholder’s as partners and management has significant skin in the game with us.

The business model is superb and underappreciated. Buffett pioneered the use of float and Markel is one of the few to successfully replicate this idea. By underwriting profitably they are getting an interest free loan that pays them to hold the money! Tom Gayner continues to make market beating investment returns and after the Alterra acquisition he has double the money to invest. Moving from 50% of shareholders equity in stocks to 80% (Gayner’s target weight) will be a huge tailwind for Markel.

When valuing Markel Ventures I didn’t build in any assumptions for growth despite the fact that it is growing significantly on its own and more acquisitions are likely. I look at Ventures as a free option for shareholders that could be a very significant driver of value over the next decade.

Markel’s ability to compound and allocate capital, underwrite profitably, leverage float, invest at market beating returns, and buy operating businesses make this a first in class company that at worst were paying a fair price for and at best a cheap price.

 

“We want Markel to be one of the world’s great companies.” – Tom Gayner