Intelligent investors should be skeptical when reading about companies that could be the “next Berkshire Hathaway” or executives who resemble a “younger Warren Buffett”. The reality is that very few companies have even a remote chance of replicating Berkshire’s 20.8 percent compound annual gain in per-share market value over past 52 years. Furthermore, companies that meet or exceed that track record in the future will have to adapt to the conditions that prevail during their time. Mr. Buffett’s value investing principles are timeless but the application of those principles will not remain static. The idea that mimicking the style of Berkshire Hathaway’s website or shareholder communications brings one closer to achieving Mr. Buffett’s performance confuses style for substance.

Markel Corporation has been discussed frequently on this website not because the company might be the “next Berkshire Hathaway” but because management has consistently adopted many of Mr. Buffett’s principles in substance while retaining their own unique style of operations. As the management team notes in the company’s recently released 2016 annual report, the long term record has been strong with compound annual growth in book value per share of 19 percent over the thirty years since the company’s initial public offering.

Is Markel the “next Berkshire Hathaway”? We would not presume to know the answer, but should management be able to continue compounding book value at 19 percent over the next 22 years and maintains the current price-to-book ratio and share count, the company’s current $13.5 billion market capitalization would rise to over $600 billion. This is almost certainly far in excess of the results one can reasonably expect but falls into the category of an interesting thought experiment.

Time Frames Guiding Management

One year is not a very long period of time and typically an insufficient time period to measure management’s effectiveness. Yet how many times do we hear managers make excuses for poor decisions by saying that they should not be judged over one year periods … and similar excuses come up every year? A series of short-runs eventually becomes the long-run, so it is interesting to see how Markel’s managers view this reality:

“While we necessarily break down our results in the normal pattern of yearly increments, we don’t think about Markel in annual terms. We think about your company in two distinct yet completely connected time horizons, namely forever and right now. These two time frames guide our actions. We believe that Markel remains unique among most publicly traded companies in emphasizing the forever time horizon as much as we do. That is an immense competitive advantage for us as we continue to navigate into an always uncertain future that continues to change at faster and faster rates.”

Management seems committed to adapting to rapid changes, especially those brought about by technology, and doing so in a timely fashion rather than using the tired excuse of having a “long term outlook” to explain away short term deficiencies. With many companies, it seems like there are always short-term excuses for poor performance that tend to recur every year. However, a moderately long time horizon, such as five years, is obviously made up of a series of five one year periods. In order to produce good long term outcomes, managers have to show up every day with that goal in mind.

Three Engines of Activity

Management characterizes the company as having three “engines of activity”: Insurance, Investments, and Industrials. Markel’s roots as an insurance company account for the first two engines. Insurance underwriting profitability is an essential ingredient for success and provides management with low or no-cost funds to invest in fixed income securities. Markel historically invested shareholders’ equity in common stocks but over the past decade has increasingly directed funds to majority or wholly controlled companies under the umbrella of Markel Ventures, characterized in the letter as “Industrials”.

Insurance

The insurance market is characterized as “brutally competitive” in the letter indicating that pricing pressure is significant and that the market is soft, at least in the niche segments in which Markel typically competes. Nevertheless, total insurance premiums written increased 4 percent to $4.8 billion in 2016 and the combined ratio was 92 percent indicating underwriting profitability:

“Conditions across the insurance market worldwide remained brutally competitive. That is true in every product across the board. Despite the ongoing competitive nature of insurance markets we produced an underwriting profit as demonstrated by the combined ratio of 92%. We’ve been profitable on an underwriting basis in 15 of the 21 years shown on this chart [the letter includes a 21-year summary of financial data] and we hope that provides you with a tangible sense of how much we mean it when we say that we are dedicated to making an underwriting profit. We will continue to exercise discipline, and walk away from insurance risks that in our opinion carry a likelihood of underwriting losses.”

Anyone who follows the insurance industry knows that, without exception, managers talk about achieving underwriting profitability and rejecting poorly priced business even if that means a loss of market share. In reality, most managers fall well short of this objective. We can see Markel’s track graphically in the following exhibit:

The early years on the chart show that no management team is immune from mistakes. Markel had some trouble initially with the acquisition of Terra Nova which impacted 2000 results and 2001 was impacted by adverse development that required an increase in reserves as well as the September 11 terrorist attacks. Since then, results have been much more consistently positive. Although the nature of insurance makes terrible results in some future year nearly inevitable, management has credibility when it comes to underwriting discipline. Credibility is important because sometimes negative results will be surprising as was the case recently with an $85 million reserve increase that will impact Q1 2017.

Investing

Markel traditionally invested policyholder float in fixed income securities with a duration intended to match policyholder liabilities while investing shareholders’ equity in common stocks. In 2016, Markel reported a total return of 4.4 percent from its publicly traded securities portfolio, comprised of a total return of 13.5 percent from equity securities and 2.4 percent from fixed income securities. Here again, management makes a distinction between the short run and long run when it comes to evaluating results:

“We specifically use the term “reported” for the one year number and “earned” for the 5 year term. Those words describe two different, yet related things, and we think it is important to conceptually discuss the nuance meant by using those two different words.”

The term “reported” is the simple arithmetic stating the return Markel achieved on securities during the given year but, in the short run, these results might differ from changes in intrinsic value of the securities. This appears to be the case for both equity and fixed income returns for 2016:

“In our opinion, while the equity portfolio enjoyed a reported return of 13.5% for the year, we believe that the underlying economic performance of the businesses we own in that portfolio was probably slightly less than that reported return. Some individual companies performed meaningfully better than what the change in stock prices would suggest, and some performed less well than you might think at first glance. Additionally, the dispersion of economic performance between individual companies, and one industry as compared to another, seems to be getting wider in our opinion. In aggregate, the overall equity portfolio return of 13.5% remains directionally correct in describing the underlying business performance of our investees, but that number is not precise in describing their aggregate economic progress, and we believe it might be just a touch high.”

Management is more confident that the 15.9 percent annualized five year reported return on the equity portfolio more accurately describes what Markel “earned” in terms of advances in the intrinsic value of the underlying companies. The passage of time tends to eliminate the differences between what is “earned” and what is “reported” – meaning that in the long run, changes in quoted values reflect underlying intrinsic value. This is identical in substance to Benjamin Graham’s analogy of the stock market being a voting machine in the short run but a weighing machine in the long run.

The duration of Markel’s fixed income portfolio has been rising in recent years. Management has stated a goal of keeping a relatively constant duration of between four and five years in the fixed income portfolio in order to match the expected timeframe in which policyholder claims will be paid out. However, in the short run, the longer duration led to the fixed income portfolio falling in quoted value in the fourth quarter of 2016 as interest rates rose. The present value of Markel’s insurance liabilities also fell in theory but were not repriced on the balance sheet:

“The rise in interest rates in 2016 means that our “reported” returns from the fixed income portfolio were lower than our economic returns from owning those securities. U.S. GAAP accounting recognizes that mark to market change of the fixed income portfolio but it doesn’t recognize that the net present value of our insurance liabilities decreased economically by a similar amount. Over five years, these sorts of timing and reporting differences resolve nearly completely, which is why we pay attention to the 5 year number much more than the annual amounts.”

Overall, Markel’s investment results have been very good in recent years as we summarize in the exhibit below (click on the image for a larger view):

Industrials (Markel Ventures)

Many of the comparisons between Markel and Berkshire Hathaway are driven by Markel’s recent entry into non-insurance businesses which has made the company into something of a mini-conglomerate. The history of Markel Ventures makes for interesting reading and shows how management has gone about this transformation since 2005. In addition to diversification, Markel believes that these businesses add resiliency to the overall corporation:

“Markel Ventures continues to grow as a positive factor within your company. This collection of businesses provides a diversified stream of cash flow for Markel that is not tied completely to the economic fates or regulatory forces affecting our insurance operations. As such, these cash flows provide resiliency for the company as a whole and allow us more options to consider when we make capital allocation decisions. Resiliency is a much more important concept than diversification. Diversification is a necessary condition to obtain resiliency, but it is not in and of itself sufficient to achieve that goal. Resiliency means so much more. Our goal is to continue to build resiliency at Markel. Resiliency means that whatever the markets, and technology, and change, throws at us, we’ll be able to rise to those new challenges and circumstances.”

Results at Markel Ventures continue to require additional explanations beyond the raw numbers. This is primarily due to the impact of accounting conventions, specifically the manner in which goodwill is evaluated on an annual basis. When an acquisition is made, the consideration paid to the seller in excess of identifiable assets is recorded as goodwill. The goodwill of each individual business unit is evaluated for impairment each year and written down if needed. However, because this is done at each individual business unit rather than in aggregate, the overall economic goodwill of the Ventures businesses could be rising even as a goodwill write-down is taken at one unit. Management believes that the $18.7 million write-down in 2016 does not reflect fundamental impairment of the goodwill of Ventures as a whole:

“Neither we nor anyone else knows when or if energy prices will rise or to what degree. That said, the carrying value of this cyclical business has been reduced substantially through this particular goodwill charge. This creates an asymmetric financial reporting outcome. The process creates a one way street where only negative events get highlighted and charged off in lumps. Future good news of better earnings, and the implication of a business that is worth more economically, will never show up in the balance sheet. You’ll just see those earnings anonymously comingled with all of the other earnings streams in the income statement.”

Of course, there is nothing to prevent management from highlighting these positive developments in the annual letters when warranted or providing more granularity in financial reporting. Currently, Markel Ventures subsidiaries are presented in a non-granular manner which could partly be due to a desire to conceal information from the competitors of individual subsidiaries but also makes it more difficult for shareholders to evaluate results.

Capital Allocation

Markel restated the principles of capital allocation that were presented a few years ago in the 2013 annual report:

“We will continue to use our capital with the same priorities. As we wrote in the 2013 annual report, “Our first and favorite option is to fund organic growth opportunities within our proven, existing line up of insurance and non-insurance businesses. Our next choice is to buy new businesses. Our third choice is to allocate capital to publicly traded equity and fixed income securities, and our final choice is to repurchase shares of our own stock when it is attractively priced and increases the value of each remaining outstanding share.”

It is interesting that repurchases are listed as the last choice in the list, but perhaps not surprising given that Markel has not historically repurchased a meaningful number of shares. Repurchase activity in recent years seems more related to a desire to keep the share count constant as new shares are issued as part of the company’s stock incentive programs and has not varied much based on Markel’s valuation. As an example, Markel’s stock price traded at only a modest premium to book value for much of 2013 yet repurchases for the year were only $57 million, as compared to $51 million in 2016 when shares traded at a much more significant premium.

Overall, however, management should be evaluated based on progress in intrinsic value per share and Markel has posted good results in recent years with compound growth in book value per share of 11.5 percent over the past five years and 10.2 percent over the past decade. Management has reason to be confident in their ability to compound intrinsic value at satisfactory rates far into the future and shareholders seem willing to allow for retention of capital in order to fund that growth.

Conclusion

The exhibit below shows Markel’s track record from the turn of the century through earlier this month, with the top chart showing the movement of the company’s stock price, book value, and tangible book value per share and the bottom chart showing the company’s price-to-book ratio:

As Markel’s stock price advances to near the psychologically meaningful (but substantively meaningless) $1,000 per share level, it is notable that the price-to-book ratio is only now reaching levels that prevailed before the financial crisis. Markel is still primarily an insurance company, albeit with a growing collection of non-insurance subsidiaries, so price-to-book remains a meaningful but understated measure of intrinsic value.

The bottom line is that we have no way of knowing whether Markel is the “next Berkshire Hathaway” but the track record since the company’s IPO thirty years ago gives us reason to at least watch closely in the coming years. Substance matters much more than style. Markel’s management is very different from Berkshire’s in style but has adopted much of the substance that resulted in Berkshire’s unusual success.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway and Markel Corporation.

Highlights from Markel’s 2016 Annual Letter