More knowledge, biases, issues and open Q’s on MKL.

As within German politics, there are few double whammies, and much more talk than (thoughful) action. Turns out, the likelyhood for a true double or triple whammy in Markel is not that high probably, after reading the letters and giving it more thought …

This is not investment advice. Please read the disclaimer. I might own discussed stock(s) currently or at a later time. I might transact in any securities at any time.

Reading letters (and a warning)

In general, I always wondered somehow when reading on fintwit ir somewhere else, that people read a huge pile of content — be that all letters from a special investor or company, financial statements, reviews, or whatever — if they truly derived any net benefit, and neither do I know if I did derive a net benefit after reading the Markel letters. Why I think that? Well, it is simple.

It is a lot of unstructured data. Thus we (read I) most likely draw pretty much biased conclusions. Some people might have a talent for such stuff and come up with objective views. If I have that talent, I don’t know. But, I wrote that the letters would be a big factor if I invested in Markel (now a small position). The letters would educate me as an investor and build trust over the long-term, enabling — potentially — high after tax returns. So I read the letters and here are my (certainly biased) takeaways. Take this as a warnig (note to myself).

I learned something about the company, the industry, and accounting, then and now when reading the letters. On the downside, I often re-read the exact same stuff.

(what helped me to actually read them? – There is a sequence of events and things don’t get done if people don’t do them, rules from Simply Brilliant)

MKL in the (competitive) insurance industry

Despite being a specialty insurer Markel is operating in a fiercly competitive industry with industry cycles including extended periods with unprofitable underwriting operations (soft markets), sometimes elevated through the entry of hedge funds. Too much supply (capital) results in lower prices (underwriting profitability). Prices and profitability rose after extrordinary events like 9/11, and some hurricanes. MKL’s CR is very volatile over time, and segmental results were even more so. This was supported by high-ish capital markets returns bailing out underwriting losses. One advantage as a specialty insurer, vs mass insurers, say PGR, is that most rate increases are unregulated which might be helpful over extended inflationary periods.

• Will capital leave the insurance industry (ie HF) now that we have interest rates once again?
• Will competition increase, now that higher interest rates can better support underwriting losses?

The letters mention frequently how fiercly competitive the insurance industry is and yet, they sound optimistic for Markel’s future in almost every single letter or year. This seems mostly hope. Despite having a better culture, emplyoees and a longer-term focus with potentially better customer relationships, the industry’s competitive nature will only allow for a certain level of capital returns that are not even known when selling the product. Of course, it could change for the better (noticing my hope?). Ie, Markel’s 2020 initiative referred to as ’10-5-1′ targets for earning 1bn underwriting profits from 10bn of annual premiums (ie 10% underwriting margin) within 5yrs. That would be 2025 (or 2026?).

Markel mentiones various times the importance of its financial model and ROE drivers, ultimately driving BVPS growth: underwriting leverage (NPE/EQ) and investment leverage (total investments/EQ). I wrote about insurance ROE drivers here – not yet knowing the names underwriting and investment leverage. Markel does emphazise financial soundness (trust is at the heart of the insurance business) shown in low debt-to-capital ratios and a (too?) conservative fixed income investment portfolio covering claims, but even then, high leverage ratios did drive ROEs, toghether with higher yields and higher underwriting margins. (below chart does not take into account equity allocated for non-underwriting businesses, but the trend (or problem) is clear I think. Investment yield understates total returns)

Lower interest rates vs early years after IPO are an additional adverse factor resulting in likely lower base returns from investments. Further, the equity investments are less concentrated (so average returns to be expected, even with presumed skill).

Acquisitions in the underwriting business to play a smaller role in future since it is harder to move the needle at MKL’s todays size. Former acquisitions targets were to be had at low-ish prices with bad operations and fundamentals that were fixed over time and integrated. Premiums were reduced drastically to meet MKL standards. Sometimes reaching profitability took longer than atncipated. MKL realized they had to do some centralizing and system updating in todays technology driven world. Indeed there is some evidence of better ERs afterwards (one of the P&C hallmarks).

Despite the goal of always conservative reserving, Markel was underreserved for many years, ie after the asbestos losses.

MKL’s transition (in financial metrics)

Financial goals were changed quickly. The 20% growth target was canceled in 1990 and the 20% ROE target was abolished, or not mentioned anymore soon thereafter. This is partially warranted, since MKL did some big acquisitions funded with stock issues, affecting BVPS. EPS was sometimes mentioned, sometimes not. BVPS was mostly mentioned, though, the period for CAGRs was not always consistent and varied from 1, 5, 10, to 20 years (by pure coincidence in 2005? No! On the one hand MKL is listed for 20yrs now. On the other hands, 5yr and 10yr CAGRs are much below the 20% target).

Very long-term CAGRs are misleading and we should not fool ourselves believing we would (as a base case) earn the same returns that MKL shareholders earned due to high compounded annual groth rates or CAGR of book value per share (BVPS) in the very early years after its IPO. These were fuelled by significantly better ROE drivers (see above) and many acquisitions, partially financed by issuing shares at high P/B ratios. (a negative view is managemnet wanted to reach BVPS goals). I think we cannot entirely rule out that Markel gets acquired.

The transition or diversification from the insurance underwriting business into insurance non-underwriting services warrant a shifting focus on different financial metrics. Over the very long term, BVPS is still a reasonable metric, but, during strong expansion/growth periods of Markel ventures it might understate true value creation. Looking at Markel Venture’s Ebitda has some merit, but I would not take it at face value. The truth is somewhere in between. But as Markel transitioned away from a concentrated equity investment portfolio to a much more diversified one, probably for lacking edge (?), though 5 and 10yrs periods ending in 2021 saw strong equity returns of 18.6 and 17.3%, why should buying whole businesses (ie PE) bring much better results? The answer might be, culture: Business owners preferring a ‘good home’ for their life’s work nad thus making inbound calls. It might! Reviews are not bad.

Conclusions

I like the incentive schemes and details learned, ie about broad based employee ownership.

I like the focus on financial soundness and strong capital position (essential for insurance) but it might be too conservative. I would like higher equity exposure within the investment portfolio, also, since businesses are pretty diversified by now.

In essense, I do not expect much above average returns in this competitive industry, I rather expect slightly above market returns, ie low to mid teens (10-15%), that I can capture rahter stress free … hopefully!

I bought a 3.2% position at 1251 per share at Dec 18th.

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• Altas (2009): thereafter lower expenses / ER ?
• Explosive development of MKL Venture’s Ebitda ?
• Broadly diversified quity portfolio of 100+ positions (video)
• Find my pdf table from reading the letters here.