Markel 2011 Annual Report

Markel's annual report was released and it's a pretty good read.  For fans of Berkshire Hathaway, this is a company that is following a similar model; insurance company with emphasis on underwriting profits instead of premium growth, investing float unconventionally (more equities than most insurance companies) and is even starting to invest in operating businesses through their Markel Ventures segment.

Anyway, MKL is interesting to look at as it is trading at 1.16x book value (BPS at December 2011 of $352.10/share versus current price of $410.64) which is pretty cheap for a solid company like MKL.

However, as I will mention later, MKL's valuation may not go up much if interest rates don't 'normalize' or if the insurance market doesn't 'harden' and they can't get their float / investment leverage up. 

Anyway, a quick summary is:

• Combined ratio of 102% due to the high number of large catastrophes like the Australia/Thailand floods, earthquake in New Zealand and Japan, tornadeos and hurricane in the U.S. etc...  These catastrophes accounted for 8 points of the combined ratio.  At $105 billion in catastrophe losses for the industry, this was the largest catastrophe loss ever.
• Total tax equivalent investment return was 7%.  Before tax adjustment, the investment portfolio returned 6.5%; the fixed income earned 7.6% (largely due to decreasing interest rates and rising bond prices) and the equity portfolio gained +3.8%.
• Book value per share was $352.10/share, and increase of 8% for the year. Book value increased 9%/year over the past five years.  Book value grew 12.3%/year in the past 10 years and +17%/year in the past 20 years.  The one and five year growth rates are pretty impressive given the huge catastrophes last year, financial crisis and very soft insurance market in recent years.
• MKL says that their equity portfolio is earning double digit returns on an underlying basis, implying that eventually the equity portfolio too will start returning double digits.  

Anyway, here are some pictures from the annual report:



It is impressive that they grew book value 8.9%/year over the past five years despite the financial crisis and the many catastrophes (especially last year).  Book value per share grew last year.

The book value per share growth rates for various time periods, again, is:

5 years:   +8.9%/year
10 years: +12.3%/year
20 years: +16.9%/year

Underwriting performance also continues to do well compared to peers...

Investment results aren't too exciting, but again t he market has been flat recently with a big crash in between.

Anyway, what is the steady state, normalized increase in book value per share we can expect with MKL going forward?  Historical book value growth is very impressive, but with lower investment leverage and much lower interest rates, it's going to be tough to grow book value.

Of course, if the economy really starts to recover, the insurance market hardens (it doesn't stay soft forever) and interest rates start to come up, then MKL can really start growing at a nice pace again.

But let's not bake that into the cake and see what happens if things stay more or less the same.  I will assume a combined ratio of 97% (the five year average is 96%, ten year average is 97%-ish), bond yields of 2.0% and various return levels for the equity portfolio.

And I will use the current investment portfolio allocation mix and unchanged earned premiums. 

So other than underwriting profits and investment returns, there is income from the Markel Ventures operating business portfolio.  As a proxy I will use the other operating income (Other revenues minus other expenses; Markel  Ventures is in here, although I think interest expense is below the operating income line on the income statement so will not match what MKL says is their earnings from this business)

Deducted from that would be interest expense and amortization of intangibles.

Given all of the above, if bonds yielded 6% and stocks returned 10%, the steady state, normalized increase in book value of MKL would be 15.1% pretax and 9.8% after tax.  That's not bad at all, but not that exciting.  This is due to the lower investment leverage lately.

Bonds don't yield 6% anymore, so let's see what happens if the bond portfolio actually only yielded 2%.     With a 2% bond return and 10% equity portfolio return, the pretax ROE would be 8.6% and 5.6% after tax.

With 2% bond return and stocks only returning 7%, the same would be 6.9% pretax ROE and 4.5% after tax ROE.

So this is clearly not that exciting is current conditions persist.

This would be a no-brainer buy if MKL can earn 10% on book even in these conditions, but that's not really the case.

However, we do have to give credit to MKL for the fact that they *have* increased book value at a nice clip in the past five and ten years despite horrible conditions.

So what can I say?  I do like MKL; they seem to be a solid shop run by decent, honest people.  Their historical track record is impressive.  The stock price is very reasonable and in more normal times this can easily trade far above book value.

However my only reservation is that if soft market conditions persist and low interest rates persist for longer than people expect (as in Japan), then MKL's growth in book can slow down a lot over the next few years.

We'll see.