Matching a stable of strong insurance businesses with intelligent investing is one of the key formulas Warren Buffett used to turn Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) into one of the greatest investments of the past half-century. Fortunately for investors who weren't able to ride Buffett's market-crushing train, there are several smaller companies that have embraced Berkshire's formula with great success. One of those is Alleghany (NYSE:Y), a multi-line insurance company whose objective is "to create value through owning and managing operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance." Sound familiar?
Alleghany's market cap of under $7 billion is but a tiny fraction of Berkshire's $280 billion. Yet it's making many of the same early moves that eventually turned Berkshire into the giant conglomerate it is today. That makes it a potentially very compelling investment for those who are looking to find an investment that has a shot at replicating at least some of Buffett's extraordinary success.
My Foolish colleague Paul Chi and I purchased Alleghany for our real-money portfolio last year, and we're already enjoying some nice early gains. After Alleghany's latest results, we're going back for more and intend to purchase shares this week.
A Berkshire-worthy performance
As CEO Weston Hicks put it in Alleghany's first-quarter results, the company is off to a solid start to 2013. An uneventful quarter in terms of catastrophes helped Alleghany's insurance subsidiaries report favorable results, including a combined ratio of 83.1% (a number below 100% means an insurance company was profitable in its insurance underwriting).
Benefiting the results was a full quarter of Transatlantic Holdings' (TransRe) results. Alleghany acquired Transatlantic (from the jaws of Warren Buffett and Berkshire Hathaway in fact) in late 2011, adding a leading global reinsurance franchise to Alleghany's already strong stable of property and casualty insurance companies. Thanks mostly to TransRe, Alleghany's underwrote $1.1 billion in net insurance premiums in the quarter, a 152% jump over last year's first quarter, which only included 25 days of TrasRe operations as an Alleghany subsidiary. Alleghany's underwriting profit hit $181.4 million, up 81% from a year ago.
All signs point to these favorable insurance trends continuing. Hicks mentioned in the press release that the property and casualty insurance market is "gradually improving ." This follows comments he made in his recent annual letter to shareholders that Alleghany's underwriting profitability would likely improve in 2013.
On the investment side, Alleghany managed a total return on its investment portfolio of just 1% in the first quarter. That might not seem all that grand, but you have to remember that the bulk of Alleghany's investment portfolio -- as is the case for most insurance companies -- is composed of fixed-income investments (read: bonds). The fixed income side of Alleghany's portfolio actually dipped slightly in the quarter, down 0.2%. Fortunately, however, Alleghany's equity portfolio was up a solid 11.5%, beating the total return of the S&P 500.
And thanks to Alleghany's insurance model, even small returns can add up to solid gains in the company's book value. According to Hicks, at the end of 2012, Alleghany's investment portfolio was roughly 2.6 times the size of its shareholders' equity. Assuming Alleghany breaks even on its insurance underwriting and holds the line on other expenses, every 1% gain in Alleghany's investment portfolio should translate to nearly a 3% gain in its book value.
In the first quarter, Alleghany's 1% investment gain combined with its underwriting profits to generate a 4.1% increase in Alleghany's per share book value to $394.71.
A bargain price
Right now, Alleghany's stock price trades right around its $394.71 book value, which we view as quite a bargain considering the strength of Alleghany's insurance franchises, its shareholder-minded management team, and its investment pedigree. If Alleghany merely replicates its first-quarter performance over the next three quarters -- not a stretch, especially if Alleghany's energy-concentrated investment portfolio picks up a little steam -- then its book value will climb to around $445 by year-end 2013.
If Alleghany's share price merely tracks its book value per share (we think it deserves to be much higher), then investors are looking at close to a 13% gain over the next seven months. If the market starts to recognize the strength of Alleghany's business and awards it a multiple to its book value, then we're looking at even bigger returns.