Ensuring returns
As it stands, Markel shares are priced to deliver 4% on its investment portfolio and break even on an underwriting basis — in perpetuity. That’s silly. Viewed against management’s record, I doubt that will be the case. The combined Markel-Alterra wrote $4.4 billion worth of premium last year. As a guppy in a large pond, Markel’s pint-sized underwriting footprint and specialty focus play to its advantage, allowing the company to write good business, grow, and maintain its underwriting standards.
Looking ahead, I expect Markel will generate combined ratios in the vicinity of 96%-97% — a 3%-4% pre-tax margin on its insurance operations — with a bit of volatility, courtesy of Alterra’s reinsurance book. I also expect the special sauce that’s fueled Markel’s investment portfolio to keep kicking. I estimate its equity portfolio will deliver 7%-8% annualized returns and its bond portfolio to normalize around 4%-5% as interest rates eventually recover. On this basis, I peg the shares’ worth at $750. Not bad for a sleepy insurer.
What would worry me
Because insurance companies agree to replace a good if damaged, lost, or destroyed, unexpected inflation can hit earnings hard. While that’s a risk, Markel Corporation (NYSE:MKL)’s management contemplated this possibility, and claims to have priced its book accordingly. Another risk derives from interest rates remaining low for a sustained period, in which case insurers earn less on their bond portfolios. Markel shares appear more than priced for this risk, but it bears watching.
In Markel-specific factors, I see two: First is the Alterra deal. Integrating disparate corporate cultures is a hard thing, and reinsurance isn’t a business for those with soft skin. While it appears to have been done at a fair price, and Alterra’s history is solid, I’d reconsider my investment if it turned out an unmitigated flop. Next is the state of equity markets. Because Markel has a large chunk of its net worth tied up in stocks, the state of the markets affects the company’s near and long term. In the long run, I think everything will be OK. Most significant, managing eventual succession for key leaders is essential. Insurance companies and investing organizations are only as capable as those sitting behind the desks.
Last on the list is tax policy. It may seem odd, but it matters — a lot. Markel has substantial unbooked capital gains and derives a substantial portion of its net worth and income from investments. Should rates move higher, that would ding its compounding ability. My valuation gives account to this possibility, but I’d expect the shares to take a near-term hit if it happened.
The bottom line
By my math, this baby Berkshire appears poised to deliver big profits. And today, it comes at the intersection of quality and cheap. I’m not going to let that opportunity pass.
The article Why I’m Buying Markel originally appeared on Fool.com and is written by Michael Olsen, CFA.
Michael Olsen, CFA, owns shares of Berkshire Hathaway and Markel. The Motley Fool recommends American International Group, Berkshire Hathaway, and Markel. The Motley Fool owns shares of American International Group, Berkshire Hathaway, and Markel and has the following options: long January 2014 $25 calls on American International Group
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