Tom Gayner set the tone at the Markel (NYSE:MKL) shareholder brunch on May 4th, extolling the wisdom of Warren Buffett's shareholder letters and noting that as an he read the Oracle's words as an early twenty-something, they "dripped with common sense."
Some 30 years later, Gayner sits as President and CIO of Markel, a self-styled tiny Berkshire Hathaway (NYSE:BRK-B).
Each year, a group of Markel shareholders gather for brunch in a non-descript conference room at the Omaha Hilton, the day after the Berkshire annual meeting. In the three years I've attended, a lot's changed.
In 2012, large breakfast tables accommodated food and laptops, and by my best guess, about 200 people populated the room.
This year, chairs are stacked side-by-side, and if I had to wager, about 400 to 500 people crammed the room.
The Markel breakfast, despite its growing popularity, still retains a certain cult appeal. Most attending are hardcore value acolytes, and the questions are typically hard-hitting. But there's one thing it shares in common with Berkshire: CEO Tom Gayner and Vice Chairman Steve Markel's words, and business sense, drip with common sense.
On underwriting profitably: The insurance industry is a strange animal. For its stated mandate -- insuring consumers against the possibility of a given event -- you'd think it'd be a conservative lot. In fact, its record of underwriting profitability is absolutely abysmal. As Warren Buffett noted in the most recent Berkshire Hathaway shareholder letter, the insurance industry's earned a net loss on its core operations, writing insurance policies. State Farm, the country's largest insurer, has incurred underwriting losses for 9 of the past 12 twelve years. The underwriting cycle -- where insurers chase volume and cut prices when times are good, and subsequently gush losses, prompting markets to firm up, is predictable as weather.
At its heart is another seemingly irrational business maxim, the idea of making it up on volume. Because insurers receive premiums up front, they're free to invest the proceeds. However irrational it seems, most insurers, consciously or not, choose to forego profitability in hopes of earning money back on investments -- making it up on volume. It's proven remarkably self-destructive. As Steve Markel noted, companies sitting atop the insurance food chain have regularly rotated, given a multi-decade view.
Markel is refreshingly unique in this regard.
The company emphasizes profitable underwriting operations, and invests well. For longtime shareholders, this isn't a new development. Steve Markel and Tom Gayner have emphasized it for the better part of a decade. And it's worked to meaningful effect -- book value per share's grown at a 15% clip for 20 years, and generated underwriting losses for only two of the last 10 years. Repetitive as it may be, Gayner and Markel hammered at the same point this year. Again. I never get tired of hearing it.
When competition's fine: Within that vein, Gayner made a subtle distinction on the nature of competition, namely that it can be good. He noted that he likes rational competition, those insurance companies that consistently choose to write business profitably. Why? Because they reinforce an industry dynamic that benefits everyone.
On the state of insurance markets: Steve eloquently noted that, after years of languishing, insurance markets (and premiums) have gotten back to what he dubbed "good" levels -- they're not great, but pockets of irrational competition are emerging. For would-be investors that bears watching, because it may afford an opportunity to invest.
What's Markel worth? A somewhat consistent refrain at the Markel shareholder breakfast pivots around the stock's worth. Gayner and Steve, for their part, think it's between 1.5 and 2 times book value. And for what it's worth, this humble analyst agrees. The midpoint of this bogey roughly correlates with a 6% pre-tax return on Markel's investment portfolio, and a 3% operating margin on its insurance policies -- well in line with Markel's historical performance. Not to be forgotten: Shares don't look particularly expensive at current thresholds, fetching 1.3 times book value.
On the Alterra deal: Just over a year ago, Markel completed a fundamentally transformative deal, acquiring Alterra Corporation, a reinsurer, in a deal that doubled written premium. Size aside, the deal pushed Markel into a riskier corner of the market -- reinsurance. I'll admit, I was concerned. Asked how it was progressing, Gayner replied that the integration is 99% complete, and things are progressing swimmingly -- no surprises, and they're quite pleased with the quality of Alterra's books. Equally significant, Gayner and Mr. Markel emphasized the deal's potential to open as yet untapped growth potential.
And there's more work: Steve emphasized that insurance-related expenses can be reduced three to four percentages points -- no small feat in a business that generates single-digit margins on its core product. Gayner also made sure to note that equity exposure, currently at about 50% of shareholder's equity, should march toward 80%.
For shareholders, that could spell a virtuous, compounding cycle.
The importance of an ownership culture and trust: This is another oft-repeated piece of Markel wisdom that bears more repeating. Buffett's quick to emphasize the importance of buying great businesses, because at some point, an idiot will man the helm. But he's also quick to praise and note the importance of effective leaders. Gayner and Mr. Markel are equally emphatic about people and culture, and for good reason. Motivating, retaining, and incentivizing good behaviors among high-performing employees can raise the bar for entire organizations -- on performance, morale, and many of the fuzzier metrics.
Gayner summed it up well:
"...refer to that as giving people a long leash. People that are high-performers like a lot of autonomy, don't like to be micromanaged. Part of that owes to the idea that people like to be given goals, and work within the culture. Now, occasionally, that'll bite us in the ass. The benefits of that aren't concrete, but it accrues in terms of people working effectively within an organization, and being happier."
And they reinforce the positive feedback loop in one concrete measure: 50% of their bonus, as Gayner made sure to emphasize earlier, is in stock. That creates an ownership culture, and more importantly, incentivizes good behavior.
On investing in banks: I've long avoided bank investments. If all businesses are black boxes, and they are, the extent of the black box effect is magnified in banks, because we just don't know what balance sheet boogey monsters sit within, and most of the biggies are 10 times leveraged. That can make a small mistake mushroom quickly. (Reference Societe Generale rogue trader scandal.)
Gayner, for his part, offered two separate bits: first, he avoids bank investments, because they've not been enormously successful for them. He separately noted that the Markel folks don't like businesses that assume debt in excess of "prudent" thresholds. Put those issues together, and they resemble... banks.
Insurers they respect: It's always smart to ask smart people whom they respect, because that compounds knowledge accrual. And in case you're wondering, when asked about insurance companies they respect the answers were: Progressive (NYSE:PGR), Chubb (NYSE:CB), Travelers (NYSE:TRV), and GEICO. And yeah, I agree.
Red flags in insurers: For better and worse, insurance is a business about risk. Properly managed, the insurance business is beautiful. Squelched and minimized, risks come back to bite -- and sometimes hard. Chief among the things they seek are conservative underwriters. And in case you're wondering, insurers' financial statements tell a thing of two about this effect. Look at what the wonkish types call loss triangles. Did a company reserve for losses in excess of the originally anticipated amount? If so, that might mean its underwriters, or management, are trying to get a little too cute.
And that, dear Fools, should do it. Rest assured, we'll be back next year.