History's tales of hyperinflation tell an almost inconceivable story, where a dollar's value withers like a raisin in the sun. Take a present-day example: At this year's beginning, the Argentine government claimed a man could eat on six pesos a day, but the reality was much more stark -- it bought little more than a cup of yogurt.
Fudged government stats play a big part, but there's a brutal truth in this: The Argentine peso's purchasing power was evaporating.
The inverse can apply to exceptional companies. With time's passage and value accrued, a shrewd management team can make a dollar go further. Paradoxically, a company that's more expensive in nominal terms might actually be cheaper.
That why I'm buying shares of Markel (MKL 1.43%) -- specialty-insurer-cum-mini-Berkshire (BRK.B 1.30%) -- for my Real Money Portfolio again. Though shares have ticked up from my original purchase price at 1.2 times book value, Markel shares look cheaper than my first purchase, as imminent catalysts lie in wait: A savvy management team's poised to capitalize on hardening underwriting markets and interest rates turning higher. And yet, the market's still pricing Markel shares as if its best days are past. I don't think that's the case. That's why I'm adding a position equal to 1.5% of my portfolio's capital.
More, and why today?
Predictions, particularly those of the discrete and short-term variety, are more often fruitless than nutritious for successful investments. But whether it's this quarter, next year, or two years out, I think Markel shares are poised to turn higher sooner than not.
Better risks: After years languishing -- five, six, or seven, depending on your source -- insurance rates are finally turning higher, and with a vengeance. The unfortunate confluence of several years of horrible catastrophes and low interest rates draining returns from insurers' bond portfolios has proven a potent cocktail. And markets are responding.
A sampling of several judicious underwriters tells the story: W.R. Berkley (WRB 1.75%) increased prices 6.5% last quarter, Chubb (NYSE: CB) raised prices at a high-single rate in its standard commercial and professional lines, and Markel passed single-digit increases, as did specialty peer HCC Insurance Holdings (NYSE: HCC).
By my math, prices could increase up to 25% still, as many smaller specialty insurers still contend with adverse loss developments from prior years' mistakes and need to strengthen their balance sheets. That would mean good things for Markel.
Fed tapering. Really: As the Fed begins its long-awaited taper, interest rates should slowly but surely turn up, and possibly sooner. Markel's management, understanding this possibility, has positioned its bond portfolio in short duration issues -- and should capitalize as it repositions to higher return issues. On account of the still-tenuous state of many insurers' balance sheets and years-long pricing drought, I'd expect hardening insurance markets to keep on. The result is a near-perfect confluence of [positive] events for savvy insurers.
To give a sense of the consequence: If interest rates were to increase 400 basis points, Markel would net $400 million more pre-tax from its bond portfolio. That alone could increase return on equity four percentage points.
Management doing its thing: The recently acquired Alterra book of business, which offers potential reward and a new flavor of risk, continues to perform well -- a credit to management's due diligence. Likewise, management continues to approach its business mix with a decided ambivalence: pushing for price increases, selectively opting against renewing poor risks, and above all, emphasizing underwriting profits. Odd as it may seem, that's a rare commodity in the insurance world.
And all of this might seem empty were it not for the fact management incentives back the talk. They have every incentive to do shareholders right. As I wrote before, they're compensated on the five-year-rolling average of growth to book value per share. That's good news for shareholders -- because growth in book value means, loosely speaking, Markel's becoming more valuable. More to the point: Vice Chairman Steve Markel owns $150 million worth of stock, and President and Chief Investment Officer Tom Gayner almost $20 million.
So, while some managers will chase the flavor of the day, growth, or some such shiny thing as markets improve -- we can expect Markel's managers to take a disciplined tack. In short, if there's any management team for whom I'm at risk of developing some affection, it's Markel's.
The price of a good thing
You might think all of this sounds good, but the price just can't be right. Wrong. As the market takes a wait-and-see approach to the Alterra deal and a hard market, Markel shares are priced at 1.2 times book value, implying the company will earn just 11%-12% returns on equity in perpetuity. I don't think that's such a high hurdle: By my math, it only needs to break even on its underwriting operations and generate a 5% after-tax return on its investments to clear the bar. The rest is gravy.
And that, dear Fool, tells the story. I'm happy to own more Markel, and I'll sleep well doing it.
