Markel 2014 Annual Report

The Markel (MKL) annual report is up on the website and as usual it's a really good read.   Markel seems to be on fire, doing really well.  They grew BPS +14% in 2014 versus +13.7% for the S&P 500 index (total return) and +8.3% for BRK (BPS).  The equity portfolio also did really well, up +18.6% in a year that a lot of hedge funds and value investors didn't do too well.

Markel is getting more and more invested in the non-insurance business (like BRK).  Adjusted EBITDA for the Markel Ventures segment (the non-insurance business) was $95.1 million in 2014.   They note in the letter to shareholders that back as recently as 2004, MKL's underwriting profit (which is pretty much the same as EBITDA) was $72 million.    So the non-insurance business is bigger now than the insurance business was ten years ago.  Well, there was a big merger (Alterra), but still.

MKL does a great job of describing what they do and how they do it in the letter.   I am not going to get into much detail, but I thought I'd make some comments about MKL in general.

First, just a reminder of how MKL makes decisions on capital allocation.  It's nice when it's written out like this clearly:

Capital Allocation
I just grabbed the first sentence of each paragraph or section that talks about what MKL does with their capital:

• First, we look to support organic growth in our existing insurance and Markel Ventures operations. 
• Second, we can pursue acquisitions in the realm of insurance or non-insurance businesses (that should cover it).
• Thirdly, we acquire publicly traded equity and fixed income securities for the dual purposes of supporting our insurance operations and earning good returns on our capital.
• Our fourth and final choice for capital allocation happens when we believe that the repurchase of our own shares creates better returns than any of the first three choices.

How They Pick Stocks
This is the same thing written every year, but is always good to remember:

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. You'll find this language in every Markel annual report since 1999. We believed in this approach since the beginning. We just started explicitly stating it in the annual report that year. Expect this language to continue in future annual reports.

Long Term Performance
I like looking at things over the long term and it's great when there is consistency and comparability over the years with a company.   MKL is a great company to follow because they have the letter to shareholders going back to 1986 posted on the website, and their annual reports have financial metrics also going back to 1986.

Here is a table of MKL's BPS growth and equity portfolio performance over the years versus the S&P 500 index (total return).  I also put BRK (BPS basis) in the table as a comp.  I actually did this for an earlier MKL post and I just updated it.

At the bottom, I put the 5, 10 and 20 year returns.  And in the spirit of looking at things "through-the-cycle", I also put the respective returns since the two recent peaks, 1999 and 2007.    The MKL equity portfolio return only goes back to 1990 so I don't have a "since 1986" for that.   But I think we have enough data here to be impressed with the performance there.

                           MKL versus the S&P 500 and BRK

							MKL
		S&P 500					equity
	BRK	w/dvd	difference	MKL	vs. S&P	vs. BRK	portfolio	vs S&P 500
1987	19.5%	5.1%	14.4%	36.3%	31.2%	16.8%
1988	20.1%	16.6%	3.5%	97.9%	81.3%	77.8%
1989	44.4%	31.7%	12.7%	26.8%	-4.9%	-17.6%
1990	7.4%	-3.1%	10.5%	-12.1%	-9.0%	-19.5%	-7.0%	-3.9%
1991	39.6%	30.6%	9.0%	51.8%	21.2%	12.2%	26.9%	-3.7%
1992	20.3%	7.5%	12.8%	29.8%	22.3%	9.5%	13.1%	5.6%
1993	14.3%	10.1%	4.2%	37.5%	27.4%	23.2%	28.7%	18.6%
1994	13.9%	1.3%	12.6%	-7.6%	-8.9%	-21.5%	-3.3%	-4.6%
1995	43.1%	37.6%	5.5%	53.1%	15.5%	10.0%	29.7%	-7.9%
1996	31.8%	23.0%	8.8%	24.9%	1.9%	-6.9%	26.9%	3.9%
1997	34.1%	33.4%	0.7%	32.6%	-0.8%	-1.5%	31.4%	-2.0%
1998	48.3%	28.6%	19.7%	18.2%	-10.4%	-30.1%	13.3%	-15.3%
1999	0.5%	21.0%	-20.5%	-10.9%	-31.9%	-11.4%	-10.3%	-31.3%
2000	6.5%	-9.1%	15.6%	49.6%	58.7%	43.1%	26.4%	35.5%
2001	-6.2%	-11.9%	5.7%	7.7%	19.6%	13.9%	16.9%	28.8%
2002	10.0%	-22.1%	32.1%	6.7%	28.8%	-3.3%	-8.8%	13.3%
2003	21.0%	28.7%	-7.7%	19.1%	-9.6%	-1.9%	31.0%	2.3%
2004	10.5%	10.9%	-0.4%	19.8%	8.9%	9.3%	15.2%	4.3%
2005	6.4%	4.9%	1.5%	3.5%	-1.4%	-2.9%	-0.3%	-5.2%
2006	18.4%	15.8%	2.6%	32.0%	16.2%	13.6%	25.9%	10.1%
2007	11.0%	5.5%	5.5%	15.4%	9.9%	4.4%	-0.4%	-5.9%
2008	-9.6%	-37.0%	27.4%	-16.2%	20.8%	-6.6%	-34.0%	3.0%
2009	19.8%	26.5%	-6.7%	27.2%	0.7%	7.4%	25.7%	-0.8%
2010	13.0%	15.1%	-2.1%	15.5%	0.4%	2.5%	20.8%	5.7%
2011	4.6%	2.1%	2.5%	7.9%	5.8%	3.3%	3.8%	1.7%
2012	14.4%	16.0%	-1.6%	14.7%	-1.3%	0.3%	19.6%	3.6%
2013	18.2%	32.4%	-14.2%	18.2%	-14.2%	0.0%	33.3%	0.9%
2014	8.3%	13.7%	-5.4%	14.0%	0.3%	5.7%	18.6%	4.9%
5 year	11.6%	15.5%	-3.9%	14.0%	-1.5%	2.4%	21.6%	6.1%
10 year	10.1%	7.7%	2.4%	12.5%	4.8%	2.3%	12.4%	4.7%
20 year	14.3%	9.9%	4.5%	16.5%	6.6%	2.2%	12.7%	2.9%
Since 1986	16.4%	10.4%	6.0%	19.8%	9.4%	3.4%	12.3%
Since 1999	9.4%	4.2%	5.2%	14.8%	10.6%	5.4%	11.3%	7.1%
Since 2007	9.4%	7.3%	2.1%	10.8%	3.5%	1.4%	10.1%	2.9%

This is a pretty amazing record.  MKL's BPS growth outperforms the S&P 500 index and BRK in every time period except for the five year return (lags the S&P 500 index).   BPS has outpaced both the S&P 500 index and BRK by wide margins since both the 1999 and 2007 peaks.  The equity portfolio also outperformed the S&P 500 index by pretty wide margins in all time periods.  The 700 bps outperformance since the 1999 peak is pretty impressive as is the five year return.  


BPS versus Change in BPS
In recent annual reports, MKL has talked about how BPS has been an important metric when MKL was an insurance company, but that this is less and less the case so BPS won't be as important as in the past.  They want us to focus on the change in BPS instead of the level itself.  This is sort of what Buffett is saying too about BRK's BPS (even though he has a different way of showing intrinsic value).

There are things that change BPS but don't show up in earnings, so they feel the change in BPS over time shows the real earnings power of the company.

So what does that mean for us?  If we take that at face value, then we can just look at the change in BPS over time as earnings and then slap an earnings multiple on it to get a valuation.   It's definitely true that EPS is not very useful in companies like MKL; it's the comprehensive income that matters.  And that is reflected in changes in BPS.

What's MKL Worth?
So then, let's see what MKL is worth if we look at a "normalized" earnings rate and a P/E multiple.  MKL's BPS is around $544/share now.  Last year was a pretty strong year in the stock market and it was very quiet in the insurance world (not a lot of big events) so earnings might be above trend.

But over time, MKL has grown BPS at double digit rates.   The five, ten and twenty year returns were around 14%, 13% and 17%/year.   Maybe the 20 year rate of return is skewed higher by the early years.  So we can use 13%-14%/year.  Let's say 13%.

If, over time, MKL can grow BPS at 13%/year, that implies comprehensive EPS of around $71/share.  If MKL traded at the market P/E, say 17x, that would value MKL at $1,200/share.    The long term P/E of stocks in general has been around 14x (for the past 100 years or so).  Put a 14x multiple on $71/share gives us a fair value of MKL of around $990/share.

MKL is now trading around $780/share.

Here is this idea laid out in a table.  The percentage is the growth in BPS (or comprehensive ROE) over time of MKL and the top row is the P/E ratios.  So to get the fair value of MKL using the various assumptions, just look for the figure in the table.  For example, if MKL has a normalized comprehensive ROE of 13% and trades at a 14x P/E, MKL would trade at $990/share.

Markel Fair Value Given Comprehensive ROE and P/E Ratio

	P/E
%growth	8	10	12	14	16	18	20
8%	348	435	522	609	696	783	870
9%	392	490	588	685	783	881	979
10%	435	544	653	762	870	979	1,088
11%	479	598	718	838	957	1,077	1,197
12%	522	653	783	914	1,044	1,175	1,306
13%	566	707	849	990	1,132	1,273	1,414
14%	609	762	914	1,066	1,219	1,371	1,523
15%	653	816	979	1,142	1,306	1,469	1,632
16%	696	870	1,044	1,219	1,393	1,567	1,741
17%	740	925	1,110	1,295	1,480	1,665	1,850
18%	783	979	1,175	1,371	1,567	1,763	1,958
19%	827	1,034	1,240	1,447	1,654	1,860	2,067
20%	870	1,088	1,306	1,523	1,741	1,958	2,176

Of course, this table can be converted so that the output is not a fair value for MKL, but a fair value P/B multiple.  This way, we can use the table to value other companies (like BRK, Y etc.):


Fair Value P/B Ratio Given Comprehensive ROE and P/E Multiple

	P/E
%growth	8	10	12	14	16	18	20
8%	0.64	0.80	0.96	1.12	1.28	1.44	1.60
9%	0.72	0.90	1.08	1.26	1.44	1.62	1.80
10%	0.80	1.00	1.20	1.40	1.60	1.80	2.00
11%	0.88	1.10	1.32	1.54	1.76	1.98	2.20
12%	0.96	1.20	1.44	1.68	1.92	2.16	2.40
13%	1.04	1.30	1.56	1.82	2.08	2.34	2.60
14%	1.12	1.40	1.68	1.96	2.24	2.52	2.80
15%	1.20	1.50	1.80	2.10	2.40	2.70	3.00
16%	1.28	1.60	1.92	2.24	2.56	2.88	3.20
17%	1.36	1.70	2.04	2.38	2.72	3.06	3.40
18%	1.44	1.80	2.16	2.52	2.88	3.24	3.60
19%	1.52	1.90	2.28	2.66	3.04	3.42	3.80
20%	1.60	2.00	2.40	2.80	3.20	3.60	4.00

So from this table, we see that if we think MKL's normalized earnings level is 13% and trades at a 14x P/E multiple, it should trade at 1.8x BPS.

Of course, this is just one way to look at this.   There is a problem with this sort of analysis if there is too much financial assets on the balance sheet.

For example, if MKL sold everything and then just owned an S&P 500 index fund, then one can argue that the long term return of the stock market is 10% and so the normalized comprehensive ROE of MKL is 10%.  Slap a 14x multiple on that and suddenly, the S&P 500 index fund is worth 1.4x BPS.  (Financial alchemy!).  Well, there are taxes.  And obviously, noone would put a 14x multiple on this entity.

So again, it's just one way to look at things.  We have to be careful not to create alchemic value (that won't be realized).

But otherwise, MKL is an above average company and has a very good long term track record outperforming the market (on an earnings or value creative basis), so at least a market multiple is not unreasonable.  If today's market P/E is too high, then we can at least use the long run market average.

Float Better than Equity
And here's another thought.  Someone posted a comment in my BRK post that float is better than equity.  I don't want to get into that discussion here too much, but it's an old argument.  Basically, since BRK makes money on the float (negative cost of float), it's better than equity.  And float also grows (or at least has grown until recently; going forward, I don't know if we can bake growth into any valuation cake as Buffett seems to be talking down any expectation of float growth and is insisting on at worst, a very slow decine in float).

So if that's the case, float shouldn't be deducted against assets in any valuation.  The two column approach to BRK valuation basically assumes that float is as good as equity since full value is given to investments held per share.

Where am I going with this?  Well, MKL too has a really good long term underwriting record.  So is float as good as equity for them too?

Check out this long term data (from the annual report).  The gray area to the right is stuff I calculated myself for reference.  The other data is directly out of the annual report:

MKL Long Term Performance

	Gross			Port			5-year			Written
	written	Comb	Inv	per	SH		CAGR in	Closing		prems/	Inv	Price /
	prems	ratio	port	share	equity	BPS	BPS	price	P/B	equity	lev	inv/share
1989	44	78%	79	$14.54	60	$11.69	na		0.00	0.73	1.32	0.00
1990	412	81%	411	$77.27	55	$10.27	na	$11.75	1.14	7.49	7.47	0.15
1991	406	106%	436	$81.77	83	$15.59	35%	$22.00	1.41	4.89	5.25	0.27
1992	304	97%	457	$84.64	109	$20.24	34%	$31.25	1.54	2.79	4.19	0.37
1993	313	97%	609	$112.55	151	$27.83	25%	$39.38	1.42	2.07	4.03	0.35
1994	349	97%	622	$115.45	139	$25.71	17%	$41.50	1.61	2.51	4.47	0.36
1995	402	99%	927	$170.95	213	$39.37	31%	$75.50	1.92	1.89	4.35	0.44
1996	414	100%	1142	$209.20	268	$49.16	26%	$85.00	1.73	1.54	4.26	0.41
1997	423	99%	1410	$257.51	357	$65.18	26%	$156.13	2.40	1.18	3.95	0.61
1998	437	98%	1483	$268.49	425	$77.02	23%	$181.00	2.35	1.03	3.49	0.67
1999	595	101%	1625	$290.69	383	$68.59	22%	$155.00	2.26	1.55	4.24	0.53
2000	1,132	114%	3136	$427.79	752	$102.63	21%	$181.00	1.76	1.51	4.17	0.42
2001	1,774	124%	3591	$365.70	1,085	$110.50	18%	$179.65	1.63	1.64	3.31	0.49
2002	2,218	103%	4314	$438.79	1,159	$117.89	13%	$205.50	1.74	1.91	3.72	0.47
2003	2,572	99%	5350	$543.31	1,382	$140.38	13%	$253.51	1.81	1.86	3.87	0.47
2004	2,518	96%	6317	$641.49	1,657	$168.22	20%	$364.00	2.16	1.52	3.81	0.57
2005	2,401	101%	6588	$672.34	1,705	$174.04	11%	$317.05	1.82	1.41	3.86	0.47
2006	2,536	87%	7524	$752.80	2,296	$229.78	16%	$480.10	2.09	1.10	3.28	0.64
2007	2,359	88%	7775	$780.84	2,641	$265.26	18%	$491.10	1.85	0.89	2.94	0.63
2008	2,213	99%	6893	$702.34	2,181	$222.20	10%	$299.00	1.35	1.01	3.16	0.43
2009	1,906	95%	7849	$799.34	2,774	$282.55	11%	$340.00	1.20	0.69	2.83	0.43
2010	1,982	97%	8224	$846.24	3,172	$326.36	13%	$378.13	1.16	0.62	2.59	0.45
2011	2,291	102%	8728	$907.20	3,388	$352.10	9%	$414.67	1.18	0.68	2.58	0.46
2012	2,514	97%	9333	$969.23	3,889	$403.85	9%	$433.42	1.07	0.65	2.40	0.45
2013	3,920	97%	17612	$1,259.26	6,674	$477.16	17%	$580.35	1.22	0.59	2.64	0.46
2014	4,806	95%	18638	$1,334.89	7,595	$543.96	14%	$682.84	1.26	0.63	2.45	0.51

Inv port = Investment portfolio
SH equity = Shareholders' equity
Inv lev = Investment leverage (total investments / shareholders' equity)
Price / inv/share = Stock price divided by investments per share

Combined Ratio
The combined ratio at MKL for various time periods (average) are:

Since 1989:   98.0
5 year:           97.6
10 year:         95.8
20 year:         99.6

The combined ratio has been under 100 in all time periods.  If BRK's float is as good as equity, I would argue that this is also true at MKL.

Investments per share at MKL at the end of 2014 was $1,335.   So, borrowing from BRK's two column valuation idea, we can say that MKL is actually worth, right now, $1,335/share.    This assumes break even underwriting and no value to Markel Ventures, which has almost $100 million in adjusted EBITDA.

If MKL was valued at investments per share, how would you have done over the years?

Increase in Investments per Share
1 year                  +6.0%
5 year                +10.8%
10 year                +7.6%
20 year              +13.0%
Since 1989        +20.0%

This reflects total investment return and change in float.

Going forward, we would have to add the value created by Markel Ventures, which is not reflected at all in this "left column" valuation of MKL.   We will have to add the right column over time as it gets bigger.

As reasonable as all of this sounds, you will notice (far right column in above table) that MKL has never traded at anything close to investments per share.

Conclusion
Anyway, MKL is a great company and is doing really well.  I don't know the correct way to value MKL, but I just looked at some interesting approaches to see what valuations I can come up with given what MKL has said in their annual report(s), on what Buffett has said about BRK etc.

I'm sort of just putting these different things together in a logical way to see what comes out.

It seems reasonable to me that MKL can trade at $1,000/share.   It doesn't seem like too much of a stretch to me.  But will it ever get there?  I have no idea.  I just think it would be OK if it did.

Check out the report, it's definitely worth the time!

Alleghany Annual Report 2014

Alleghany (Y) also just published their annual report for 2014.  As usual, it's a really good read.

A long time ago, Dorothy Boyd said to Jerry McGuire, "You had me at 'hello'".

Well, Alleghany had me with this:

BPS grew +12.7% in 2014 compared to +13.7% for the S&P 500 index.  Y noted that the five year performance for Y of +9.6%/year lagged the S&P 500 index total return of +15.5%/year because the S&P 500 was coming off of a low point and that the index might be overvalued today.

Here is a summary of 1 year, 5 year and 10 year BPS changes for Y compared to the S&P 500 index:

                             Y BPS           S&P (total return)
1 year                    +12.7%          +13.7%
5 year                    +9.6%            +15.5%
10 year                  +8.6%              +7.7%
Since 2007            +7.5%              +7.3%

And since Buffett mentions a "through-the-cycle" performance figure to offset the S&P 500's crisis low point advantage in the five year performance figure, I did the same for Y.  Y narrowly beats the S&P 500 index on that basis.  That's not bad at all, actually, when you see how conservatively they have been managed.

Here is a chart from the annual report:

BPS has done well in the past ten years, but the stock price lagged a little bit, but that is due (as is explained in the annual report) to the fact that Y traded at 1.22x BPS in 2004 and was at 1.0x BPS at the end of 2014.

And then there was an interesting paragraph in the letter that raised my eyebrows.  I know investment managers (including Buffett) have been struggling with beating the S&P 500 index recently.  I notice that even many of the well-known value investors have been underperforming.

But this paragraph was kind of interesting:

The S&P 500 is a challenging benchmark because it is not a static population of companies.  Losers are kicked out of the index, and vibrant, growing companies are added.  It also represents America's leading companies, including a number of companies that dominate their industries.  By contrast, the New York Stock Exchange Composite index is more representative of the average company.  In 2014, the NYSE Composite returned 6.9%, and has returned about 6.9% a year over the past decade. 

Honestly, I've never really looked at the S&P 500 that way, but I suppose it's true.  It isn't a static population of companies.  And yes, it's true that losers are kicked out and then "vibrant, growing companies" are added.  And yes, it also represents "America's leading companies, including a number of companies that dominate their industries."

In some sense, isn't that sort of what you want in a portfolio?  Is this why Buffett so likes to recommend people just buy an S&P 500 index fund?  (And if the S&P 500 is filled with leading, vibrant, dominant companies and the NYSE Composite are just average companies, how about going long the S&P 500 index and shorting the NYSE Composite?!  Long the excellent, short the average!).

McGraw Hill Greatest Fund Manager on the Planet!
So, wait a second.  The S&P 500 index is actively managed (as described above) and everyone has trouble beating them.  Doesn't that make the S&P 500 index committee the best portfolio managers around?  There is more than $1.25 trillion of assets directly tied to the index.  If they are that good and can outperform everyone else, surely they can charge 1.0% management fee.  That's $12.5 billion in management fees right there.  Assuming they can get a 50% operating margin (which should not be a problem with that kind of revenues and a single index committee) that's $6.3 billion in operating income, and then put a 10x multiple on that and it's suddenly a $63 billion business right there inside a $27 billion market cap company!

But, alas, it's not so simple as we'll see in a second.


NYSE Composite
Since the S&P 500 index is an actively managed index of great, vibrant companies, Y suggests looking at the NYSE Composite as "more representative of the average company".

Y's performance certainly looks better against the NYSE Composite; BPS of +12.7% in 2014 versus +6.9% and +8.6%/year over 10 years versus +6.9%/year.

But I don't know if the NYSE Composite is a good benchmark.  First of all, the NYSE Composite includes all common stocks (tracking stocks and REITs too, I think) listed on the NYSE.  That includes a lot of ADR's, which are foreign companies.  If you want to include foreign companies, there are better benchmarks.  The ADRs represent a skewed group of foreign stocks because it would only include companies who have ADRs listed on the NYSE.

Also, choosing companies only listed on the NYSE would skew the population as some of the best managed companies are not traded there (Apple, Google etc...).

A much better benchmark might be the Russell 1000 or Russell 3000.  Maybe the Wilshire 5000.

But let's just look at the Russell 1000 and 3000.  I pulled some total return figures for these indices (and put them next to the S&P 500 index and Y BPS figures):

                        Russell       Russell          S&P               Y
                        1000            3000             500                BPS      
1 year               +13.2%      +12.6%        +13.7%          +12.7%
5 year               +15.6%      +15.6%        +15,5%          + 9.6%
10 year              +8.0%         +7.9%         + 7.7%           +8.6%
Since 2007        +7.5%         +7.5%          +7.3%           +7.5%

Looking at this, it seems like the Russell indices are a lot closer to the S&P 500 index.  This is probably because it includes the many NASDAQ-listed companies.  Also, the NYSE Composite was probably dragged down in recent years due to the lagging foreign ADRs; we know Europe and emerging markets are in the gutter these days.

The Russell indices also add "vibrant, growing companies" and drop losers, but it is done mechanically.  The NYSE also drops losers too (delisting) and they do add companies by lobbying companies to join the NYSE.  So none of these indices are really static populations.

By the way, the Russell 1000 is the top 1000 U.S. companies by market cap and the Russell 3000 is the top 3000 companies.  Since this is market cap (or float) weighted, they will correlate highly as most of the change in the index will be determined by the largest 1000 companies.

As you see, the Russell 1000 tracks the S&P 500 index very closely.  This is obviously why the S&P index committee would never get 1.0% fees on assets tracking the index.

More Detailed ROE
Here's a look at how the ROE breaks down:

Ares Management, L.P. (ARES)
Y bought a stake in ARES back in 2013.  This deal makes sense in that Y needs expertise in managing their fixed income portfolio.  It was mentioned in the letter:

ARES closed at $17.14 at the end of 2014 and had paid two dividends in 2014 totalling $0.42.   Annualizing that, you get around 4.9% dividend yield on the closing price.   And if this is expected to grow, it's not bad at all.

ARES is now at $19.66.  Economic net income per share in 2014 was $1.26/share.   That's a 6.4% earnings yield.  Distributable earnings were $0.92/share, or a yield of 4.7%.   ARES makes most of it's income in fixed income so doesn't have the big ups and downs of private equity.

Anyway, it's an interesting idea.

Insurance Stuff
The insurance businesses have been doing really well, but a lot of that is that there haven't been a lot of events recently.

Here are some interesting comments on the business, though:

This is the sort of conservatism that I like in Y.

And here's an interesting commentary on the insurance business and deflation:

Investments
The equity portfolio at Y didn't do too well; 5.6% vs. 13.7% for the S&P 500 index.  They have a new manager running the portfolio and it's still a little early so I wouldn't give too much weight to a single year performance.  We'll see how it performs over time.

There is a lot of commentary of the current environment; the usual cautious stuff about QE etc.

And then there is an analysis of what's going on in the energy markets.  Here's the conclusion:

I didn't really think about it this way, that the peak was in 2008.   Maybe that is correct and the latest collapse is just a part of the extended bear market in crude oil.   If that is the case, then maybe a turn is a little closer than thinking about the collapse last year as the beginning of something.

They too see sustainable prices in the $70-80/barrel range.

Long Term Performance Target
There was a comment in the outlook section of the letter that made me scratch my head a little bit.  Look:

It says that Y increased BPS at almost 9%/year over the past decade, "at the upper end of our stated objective of 7-10% annual growth over the long-term."

But that makes it sound like their goal was 7-10% growth in BPS since 2004.  I only remember seeing this 7-10% goal recently, so I went back to the old letters to see.

Check this out:

2004 AR:  "Our long-term goal is to increase our stockholders' equity per share at double-digit rates, but only if we can do so without taking excessive risk." 

2005 AR: "Alleghany's principle financial objective is to grow book value per share at double-digit rates without employing excessive amounts of financial leverage or taking undue amounts of operating risk." 

This continued for another year or so, and maybe there was a year where it wasn't mentioned at all, but the next time a goal was mentioned was during the crisis:

2008 AR:  "Alleghany's goal is to compound its book value per share at attractive rates over a long period of time. " 

This was obviously due to the fact that Y wasn't growing BPS at double digit rates at that point.

The first time I noticed the 7-10% goal was in 2011:

2011 AR: "Our goal is to increase book value per share at a rate of growth that exceeds the total return on the S&P 500 over time. We believe that book value per share growth of 7-10% per year will achieve this goal, and that there is a good chance that our current portfolio of insurance, reinsurance, private capital and public equity investments will allow us to achieve these results over time.  Importantly, our business model calls for market-beating book value growth with a low risk profile." 

I may be wrong about this; I just quickly looked through the old annual reports.

It's not a big deal, but I thought it was a little misleading.  It's only because I've been reading the reports for a long time that it made me think, hey, wait a minute.

It's still a decent performance over time and I still like Y.  I do think they are well-managed.  And again, this sort of performance given their conservatism is pretty good (read the letters; some will describe them not as conservative but extremely pessimistic, especially compared to Buffett's letter!).

Conclusion
I always enjoy reading the Y annual report.  I think it's run by great people and like it a lot.  It's a little conservative for my taste, but look, they are beating or at least keeping up with the S&P 500 index without taking a lot of risk.

They are also investing in private businesses, like BRK and MKL.  It's interesting that MKL and Y are both taking a similar approach, breaking out their investments into private businesses; disclosing EBITDA of them etc.

It's definitely an interesting situation at 1.0x BPS.

Berkshire Hathaway Annual Report 2014

So the long awaited annual report came out last weekend.   As usual, I thought it was a great report.  For most Berk-heads, though, it's mostly the usual same old, same old.   There was one big difference, though, this year.  Buffett changed the performance page of the letter to include change in the stock price of Berkshire Hathaway.  This is the way Leucadia reported their performance during the Cumming/Steinberg era; they had a column for both book value per share and stock price.   I wish others like Loews would do it like this too (but using total returns of the S&P 500 index instead of just the price change).

Tracking the stock price can be tricky as a stock can be overvalued or undervalued at any given point in time.  But over long periods of time, as Buffett says, the stock price should track intrinsic value.  Buffett feels that over the 50 years, the stock price has actually tracked intrinsic value better than book value  (because book value overstated intrinsic value back in 1965 and understates it now).

Book value per share grew only +8.3% in 2014 versus a +13.7% total return for the S&P 500 index.  BRK's stock price, though, increased +27% on the year.   As we'll see later, BRK's intrinsic value might have grown something closer to 13%.

This is a snip from the annual report.  The left column is the change in book value per share, the middle column the change in the stock price and the right column is the S&P 500 index total return.

You will see that BRK outperformed the S&P 500 index on a BPS basis only once in the last six years.  On a stock price basis, it outperformed three times in the past six years.  But that's mostly because 2009 was a low point for the S&P 500 index.  BRK's BPS fell a lot less during the crisis.

In last year's letter, he said that things are good as long as BRK's BPS outperforms the S&P 500 index through the cycle.  This was in response to questions with respect to underperforming over a rolling five year period.

Looking at it on a through-the-cycle basis, BRK's BPS growth is still looking good.  Last year he used the 2007 BPS as the previous peak.  From 2007 through 2014, BRK grew BPS at a pace of +9.4%/year versus +7.3%/year for the S&P 500 index (on a total return basis).

By the way, the trailing 5, 10 and 20 year returns based on BPS compared to the S&P 500 index looks like this (annualized):

                     BRK BPS              S&P 500 total return
5 year             +11.6%                 +15.5%
10 year           +10.1%                   +7.7%
20 year           +14.3%                   +9.9%

The five year return still lags, but again, that's largely due to the S&P 500 index coming off of a low point during the crisis.

The main reason Buffett included the stock price on the front page of the annual report is that due to the ever-growing operating businesses (as opposed to the stock portfolio), book value of BRK is increasingly understating intrinsic value.

To direct shareholders to a more accurate measure of intrinsic value, he has been guiding towards looking at the two main components of BRK's value; the investments per share and pretax profits per share of the operating businesses.  

I don't want to get too involved in the valuation of BRK here as that would be another lengthy post (or series of posts); I just wanted to see the difference in BPS and a valuation based on the two-column valuation method.

BPS Growth versus Intrinsic Value Growth
In the 2014 annual report, there is an update of a table he put in a previous one.  It's the investments per share and pretax profit per share of BRK over time.  From 1970-2010, he shows the figures for every 10 years, which is fine.  We don't need too much detail for what I am going to look at.

For the period between 2010 and 2014, I pulled the figures from each annual report as he has included the most recent figures in every report since 2010.

Again, I don't want to get into what the right multiple is to value the operating businesses, but for simplicity I just used 10x pretax earnings.  10x pretax is what Buffett said he would pay for businesses with similar quality/characteristics to what BRK already owns.  And we know he wants to pay a fair price for a wonderful business, and not a wonderful price for a fair business.  So I guess 10x pretax earnings is a fair price (and not a bargain basement price).

In any case, you will see that it won't matter much what multiple I use for this analysis; the direction is what interests me.

Anyway, in the table below, I put the investments per share and pretax profit per share in the two left columns.  This is right out of the annual reports so should be correct.

For the value of operating businesses, I use a multiple of 10x.

For total intrinsic value of BRK (Total IV), I just added investments per share and the value of the operating businesses.

The column after that, "Op biz % total IV" is the value of the operating businesses as a percentage of total IV of BRK.

BPS is just BPS as reported by Buffett, and the following columns in gray are annualized changes in the respective items (S&P is total return).

Intrinsic Value Growth  vs. BPS Growth

BPS is used as a proxy for intrinsic value and it has been a decent one over long time periods.

However, his view is that recently, the operating businesses has become a bigger part of BRK so BPS is an increasingly less accurate indicator of BRK's IV (understates it by a large amount).

So the first thing I did was look at how much the operating businesses are as a percentage of BRK's total IV.

Back in 1970, the figure was 30%.  That makes sense as it started initially as an operating company.  But in 1980 this figure went down to 20% and then in 1990 to 12%.  So back then, investments really determined the value of BRK.  Even in 2000, the figure was 15% or so.  And then in 2010, that has increased to close to 40%.  So yes, BRK is more and more turning into an operating company.

On the right side of the table in gray is the change in BPS and intrinsic value over time.   The top half of the table represents annualized changes over 10 years.  So the 2010 figures show the annualized changes for the period 2000-2010.  You will notice that BPS and intrinsic value tracks each other closely.

And the lower half of the table from 2011 through 2014 are just year-over-year changes.

The interesting thing is that to me, it still looks like it tracks pretty closely.  Between 2010 and 2014, BPS grew at a pace of 11.2%/year but IV grew at 12.7%/year.   I guess 1.5%/year is a pretty big difference in this world.   But as a tracker of value, it seems close to me.

Here is a table that shows the same as the above, but with comparisons versus the S&P 500 index (total return) in bold:

BRK BPS and IV Growth versus the S&P 500 Index (total return) 

It looks like even using the IV growth instead of BPS, BRK underperformed in three of the last four years.  But again, the S&P has been roaring back from financial crisis lows, so this is not representative of any four year period by any means.

Moving the Target
Of course, this will lead to people bickering about how Buffett moved the goal post after the fact.  Well, I don't care about that.  We know how well BRK is doing and we understand why Buffett changed the front page so it doesn't matter what other people say.  Who cares, really.  


All Glass House
And by the way, Buffett was on CNBC the other day, and he really ripped into David Winters of the Wintergreen Fund.   Winters criticized the Coke compensation plan and I wrote about how his analysis was just plain wrong.  Buffett agreed that the plan was too much, but didn't want to endorse the figure Winters was throwing around as being totally wrong and misleading.  And then Winters started getting personal with Buffett, even going so far as selling his BRK stock saying that if he can't stand up for shareholders in the KO situation, how can he trust Buffett to run BRK?

I thought that made no sense whatsoever.

Anyway, Buffett said that Winters criticized Coke, but said that Winters has underperformed in every time period (including since inception) and charges 150 basis points (when you can get into an index fund for 17 bps)  in fees so he is throwing rocks from an "all glass house".   He said you are paying a high price for negative value creation.

Here are Wintergreen's returns from the 2014 annual report:

Total expenses are 1.85% and 1.63% (for Investor class and Institutional Class respectively) which sounds pretty high in this day and age.  If we are looking at 5-7% returns in equities going forward, these expenses are 30% of expected gross returns!

Apparently, you can get airtime any time by criticizing Buffett (the other surefire way is to call for a stock market crash), but I guess one should be careful and think hard about whether you really want Buffett to take a close look at you.

Optimistic as Usual
Back to the report.  As usual, Buffett is very optimistic:

And it occurred to me that BRK keeps doing really well despite it's size even compared to the other Berk-a-likes.  Many of them, to me, seem far too pessimistic and conservative.  And that may have hurt their results over time.

And yes, we are in a raging bull market now so of course optimists will look better than less optimistic people.  Things will surely look different when the cycle turns and things head down.

But Buffett has sort of always been this way and he has been tested in down markets, including in the financial crisis.  His optimism didn't put BRK at risk of permanent impairment in any area.  That's the difference.  Optimistic traders can get killed pretty quickly (due to the leverage they incur).  But if you run a rock-solid, Gibraltar-like operation like BRK, optimism pays.

The key, again, is not to be optimistic and right short term (by forecasting and avoiding downturns by taking protective measures), but to be optimistic long term and solid enough to survive any downturns that will inevitably come in the short term.

Buffett seems to me to like the guy that has his seatbelt fastened and does a smooth 60 or 70 mph down the highway, and traders that get in and out are like people going 120 mph on a highway without their seatbelts fastened thinking that when they see trouble ahead, they'll have plenty of time to put their seatbelts on before impact.  Otherwise they sit at a rest stop waiting for 100% clarity (which never happens anyway).

Investment Advice
And as usual in recent reports, Buffett gives advice on investing.

It's amazing to think that the dollar has declined 87% since 1965.  A lot of the stock market bears have mentioned the declining dollar as a major part of their bear thesis.  I've been hearing that sort of talk since the beginning of my career; the dollar is going to go down so you should own gold, land, houses, land bank stocks, Japanese stocks, Chinese stocks, emerging market stocks, frontier market stocks, any foreign stocks, commodity funds, commodity-linked ETFs etc... on and on...

And yet one of the best investments during that time has been U.S. stocks.

Having been in the business for a long time, I can tell you that yes, a lot of the errors and losses in the financial markets are due to people trying to avoid the perceived risk of the stock market (while trying to earn stock-market-like returns).  So much money is burned by trying to avoid "temporary" mark-downs.

Of course, the financial industry loves this.  There is more options and futures to trade, more swaps, more funds to sell etc.

There was a story recently about some janitor or something that never made more than $17,000/year or some such, who just passed away and donated $40 million.  Every now and then we hear these stories.  None of these people are highly trained geniuses like Buffett.  They just sat on stocks for a long time and didn't fudge with the portfolio.

I don't know if I mentioned this before on this blog, but one day a long time ago, a co-worker whispered to me that he was a millionaire.  And he was a low-level clerk that never made a high salary or bonus.  He never made six digits in any single year (up to that time).  And yet he was a millionaire (and no, he wasn't 80 years old or anything like that).  But he just really underspent and never sold any stock he bought.  Once he bought something, he never sold it.  Of course, this causes some to go to zero.  But so what?  Sometimes you lose less letting some stocks go to zero than buying and selling all the time trying to avoid the occasional zero.

Berkshire - Past, Present and Future
Both Buffett and Munger wrote about BRK's 50 year history.  They are great reads.  I'm not going to write anything about it here; just go and read it yourself.

We always wish Buffett would write a book, but he sort of has. If you look at all of his annual letters (including the partnership years), he has written way more than a book.  And Buffett's review and outlook for BRK is a great addition to the real time "book" he has been writing since the 1950's.

Oh yeah, and I almost forgot.  One thing he said in his 50 year essay on BRK; he did sort of give a valuation hint on BRK:

He says 2x BPS is an unusually high price that might make even BRK a "rash speculation".  So we know that 1x BPS is very cheap.  The middle of that is 1.5x BPS.  BRK is willing to buy stock at 1.2x book, so maybe 1.2x is attractive and 2.0x is 'rash'.  The midpoint of that is 1.6x BPS.

I have been of the school that BRK shouldn't trade at historical average P/B ratio due to it's increasing size and lower prospective returns, but Buffett's argument that BPS is less and less relevant as the operating businesses become a bigger part of BRK is a valid one.  But that's a whole other discussion so maybe for another time.

Conclusion
The annual report is a great read!  Go and read it if you haven't already.  Or go read it again.