What Are We Reading?

Sirius to make an Investment in Pandora (Link)

Markel Overview (Link)

Merger between HDFC Life and Max fails to materialize (Link)

There are no brave old men in finance (Link)

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Liberty Media — Q4 2015 Shareholding

As I continued to dig into Libery Media (LMCA/K) ownership, I came across a few interesting names that are invested along with John Malone. While it is true that LMCA/K have declined quite a bit since 12/31, we will  only know who else added in Q1 only by April 15th. I knew that Berkshire Hathaway was invested with LMCA/K but I was frankly amazed that it was close to $900M as of 12/31. Looks like one of Warren’s deputies Todd or Ted or both are dabbling with Malone’s entities. You can find our previous thoughts on Liberty Media Corporation here

Datasource: Dataroma.com

LMCA Portfolio Manager % of portfolio Shares Value as on 12/31/2015
Markel Corp 0.5 426,000 $                         16,720,500.00
Berkshire Hathaway 0.23 7,800,000 $                       306,150,000.00
 
% of portfolio Shares Value as on 12/31/2015
LMCK Weitz Value 5.75 1,150,000 $                         43,792,000.00
Century Management Advisors 2.35 39,650 $                           1,509,872.00
Markel Corp 0.54 522,000 $                         19,877,760.00
Berkshire Hathaway 0.44 15,386,257 $                       585,908,666.56

What are we reading?

Markel Q2 Results Discussion (RationalWalk)

Notes from the AGM — Bajaj Auto Ltd (Ankur Jain)

Cost of capital — Opportunity cost (Hurricane Capital)

Old Post — Alice Schroeder on Reddit (Reddit)

Buffett on Banks (Fundoo Professor)

What Geico’s acquisition costs and other associated costs taught me about business economics, management quality and valuation (Fundoo Professor)

Greenlight Re and Third Point Re

We had written about the structural advantages of re-insurers before here. We ran through some numbers and here is what we found.

Both Greenlight Re and Third Point Re are structured similarly with Greenlight Capital and Third Point LLC running the investment books. Both follow 2% management fee and 20% incentive agreements with high watermark. Currently unearned premium is around 50% of equity (actually close to 40% of equity) for both the insurers. We have assumed cost of float as 2% for both the insurers. We tried to model the returns to the shareholders under various circumstances of underlying returns from the hedge funds. The shareholder equity varying as a function of float net of the cost of float.

Underlying Equity  $100.00
Float Leverage  $ 50.00
Total Assets  $150.00 102%
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $105.00 $102.90 $102.90 -31.4% 1.0% -48.1%
-20% $120.00 $117.60 $117.60 -21.6% 1.0% -33.4%
-10% $135.00 $132.30 $132.30 -11.8% 1.0% -18.7%
0% $150.00 $147.00 $147.00 -2.0% 1.0% -4.0%
5% $157.50 $154.35 $153.48 2.3% 1.0% 2.5%
10% $165.00 $161.70 $159.36 6.2% 1.0% 8.4%
20% $180.00 $176.40 $171.12 14.1% 1.0% 20.1%
30% $195.00 $191.10 $182.88 21.9% 1.0% 31.9%

Over a period of time, if one assumes that the insurers grow their float to get a structure where they have $100 of float for $100 of equity (which is still conservative as reinsurers typically write 5X of capital) However, given the general risky nature of where the float is invested, 1X is a more proper allocation for this strategy.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 102%
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $140.00 $137.20 $137.20 -31.4% 2.0% -64.8%
-20% $160.00 $156.80 $156.80 -21.6% 2.0% -45.2%
-10% $180.00 $176.40 $176.40 -11.8% 2.0% -25.6%
0% $200.00 $196.00 $196.00 -2.0% 2.0% -6.0%
5% $210.00 $205.80 $204.64 2.3% 2.0% 2.6%
10% $220.00 $215.60 $212.48 6.2% 2.0% 10.5%
20% $240.00 $235.20 $228.16 14.1% 2.0% 26.2%
30% $260.00 $254.80 $243.84 21.9% 2.0% 41.8%

One thing is very evident here, if the re-insurers are not prudent and conservative, it will wipe out equity fast as float functions exactly how leverage does. Companies like Berkshire own whole companies where earnings are less volatile compared to stock market instruments and they also own a lot of fixed income instruments. Third point returned -32.6% in 2008 and Greenilght Capital returned -22.6% in 2008. The above table clearly shows what would happen if another such year were to occur for these two insurers whose investment books are managed by the insurers. As the investments are starkly different from other insurers, it might be worthwhile to consider the volatility of the instruments.

How would Berkshire or Markel look with a similar capital structure? Remember, they do not charge 2% and 20%. However, they have taxes to drag them down and both of them have great historical performance to their back on running a reinsurer and its investment books. Markel lost 16% of their book value in 2008 which is remarkable considering that they were leveraged 2.2:1 on their float largely thanks for their fixed income instruments which was up 0.2% and equities were down 34%. Berkshire was down (9.6)% in 2008 thanks again to the fortress balance sheet and the fixed income securities that Berkshire owns.

If Markel or Berkshire had a similar structure, this is how they would look.

Underlying Equity $100.00
Float Leverage $50.00
Total Assets $150.00 100% 35% Full Tax
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Before Tax Net Underlying Returns of Shareholder Equity After Tax
-30% $105.00 $105.00 $105.00 -30.0% 0.0% -45% -45%
-20% $120.00 $120.00 $120.00 -20.0% 0.0% -30% -30%
-10% $135.00 $135.00 $135.00 -10.0% 0.0% -15% -15%
0% $150.00 $150.00 $150.00 0.0% 0.0% 0% 0%
5% $157.50 $157.50 $157.50 5.0% 0.0% 8% 5%
10% $165.00 $165.00 $165.00 10.0% 0.0% 15% 10%
20% $180.00 $180.00 $180.00 20.0% 0.0% 30% 20%
30% $195.00 $195.00 $195.00 30.0% 0.0% 45% 29%

With $100 of Float to $100 of equity

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $140.00 $140.00 $140.00 -30.0% 0.0% -60% -60%
-20% $160.00 $160.00 $160.00 -20.0% 0.0% -40% -40%
-10% $180.00 $180.00 $180.00 -10.0% 0.0% -20% -20%
0% $200.00 $200.00 $200.00 0.0% 0.0% 0% 0%
5% $210.00 $210.00 $210.00 5.0% 0.0% 10% 7%
10% $220.00 $220.00 $220.00 10.0% 0.0% 20% 13%
20% $240.00 $240.00 $240.00 20.0% 0.0% 40% 26%
30% $260.00 $260.00 $260.00 30.0% 0.0% 60% 39%

Markel at the end of 2014 had $145 of float to $100 of equities. Remember the fixed income securities and why Markel will not be very volatile and probably the returns will not exceed 10% on assets invested.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $171.50 $171.50 $171.50 -30.0% 0.0% -74% -74%
-20% $196.00 $196.00 $196.00 -20.0% 0.0% -49% -49%
-10% $220.50 $220.50 $220.50 -10.0% 0.0% -25% -25%
0% $245.00 $245.00 $245.00 0.0% 0.0% 0% 0%
5% $257.25 $257.25 $257.25 5.0% 0.0% 12% 8%
10% $269.50 $269.50 $269.50 10.0% 0.0% 25% 16%
20% $294.00 $294.00 $294.00 20.0% 0.0% 49% 32%
30% $318.50 $318.50 $318.50 30.0% 0.0% 74% 48%

When one takes a closer look at the economics of the business models, it looks like third point and Greenlight re have managed to replicate a capital structure that replicates similar economics to Berkshire or Markel while getting much much better deals for themselves in the process instead of the taxman.

However,  things get interesting further. Greenlight Re is trading at 0.87 book and Third Point Re at 1.07 times book. Berkshire is trading at 1.46 book and Markel at 1.64 times book.

Underlying Equity  $ 100.00
Float Leverage  $ 50.00
Total Assets  $ 150.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $150 Invested Net Underlying Returns of Shareholder Equity P/B =1 P/B =1
-30% $105.00 -48.1% -41.8% -51.5%
-20% $120.00 -33.4% -29.1% -35.7%
-10% $135.00 -18.7% -16.3% -20.0%
0% $150.00 -4.0% -3.5% -4.3%
5% $157.50 2.5% 2.9% 2.3%
10% $165.00 8.4% 9.6% 7.8%
20% $180.00 20.1% 23.1% 18.8%
30% $195.00 31.9% 36.6% 29.8%

If the re-insurers grow the book to have float to 1X of capital.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity
P/B =1
P/B =1
-30% $140.00 -64.8% -56.4% -69.3%
-20% $160.00 -45.2% -39.3% -48.4%
-10% $180.00 -25.6% -22.3% -27.4%
0% $200.00 -6.0% -5.2% -6.4%
5% $210.00 2.6% 3.0% 2.5%
10% $220.00 10.5% 12.0% 9.8%
20% $240.00 26.2% 30.1% 24.4%
30% $260.00 41.8% 48.1% 39.1%

A good comparison would be Markel today. I have just included what Berkshire would do with a similar capital structure.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 35% Full Tax Berkshire MKL
1.46 1.64
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
P/B =1
P/B =1
-30% $171.50 -74% -74% -81.8% -83.8%
-20% $196.00 -49% -49% -65.1% -68.9%
-10% $220.50 -25% -25% -48.3% -54.0%
0% $245.00 0% 0% 0.0% 0.0%
5% $257.25 12% 8% 5.5% 4.9%
10% $269.50 25% 16% 10.9% 9.7%
20% $294.00 49% 32% 21.8% 19.4%
30% $318.50 74% 48% 32.7% 29.1%

Clearly given the valuation difference between Third Point, Greenlight Re’s with the Markel’s of the world, the risk-reward points clearly towards the former.

However, one must be very mindful on how the volatility is handled within the books. Markel and Berkshire have their fixed securities helping them manage well through a downturn. Will Greenlight and Third Point be able to replicate with their long / short strategies and event driven value investing?

Will the shareholders want the comfort of the Berkshire balance sheet at expensive valuations and a size that kills performance or the risk / reward of the newer re-insurers with seasoned hedge fund managers like David Einhorn and Daniel Loeb who have been lackluster of late and are still new to the re-insurance business. Or is there a place for both categories in one’s portfolio?

Disclosure: Own BRK.B, MKL; Evaluating GLRE and TPRE

Markel 2014 Year End Letter

Markel Corp. is arguably one of the world’s leading insurance operator. It has one of the best track records in the insurance business with a very conservative management, accounting practices and a business model that is evolving to the size the Markel is growing to. We purchased Markel on the days after the acquisition of Alterra, when for a brief few days, the shares traded at book value. Since then, we have been sitting on it.

As seen below, Markel has had a stupendous year, with both book value and the 5-year CAGR both doing pretty well. The 5 year book value CAGR is a good indicator for long term value creation for balance sheet driven companies. By and large, the letter is all good news.

Results

There is one painful section of the letter that I had a tough time comprehending — Markel Ventures. Markel has been on the tested path of Berkshire Hathaway, to own operating companies as an alternative capital allocation vehicle to investments. By and large, it has been fairly successful. Compared to ten years ago, the revenue has growth from $60M to $800+M. However, it was the discussion about EBITDA that caught my attention. Markel Ventures is measured based on adjusted EBITDA. EBITDA as a metric is bad enough but the metric goes even further and excludes goodwill impairment charges. The letter then goes through a painful section on how the goodwill impairment charges could have been avoided if the business had been lumped under a bigger business. I think since the entity was not bought as part of a bigger company, the goodwill must be evaluated at the entity level balance sheet. When one pause and thinks about it, it does not put Markel’s management in very good light. It will very important to keep track of Markel Ventures as it becomes a bigger piece of Markel. More disclosure in Markel ventures would be a welcome change in the future.

EBITDA

Impairment1

Beyond that, the letter provided a good insight into the state of affairs at Markel. With Alterra being more conservatively reserved than before, the integration happening well, the insurance business performing robustly and the investment business roaring, Markel’s management no doubt deserves the trust of shareholders. The record that they have generated speaks volumes for the way the management runs the business. This is one no brainer compounding machine over the long run if bought at the right prices. At March 20th closing price of $778.5 and book value of 1.4, good performance is fairly baked in the price. It is no longer the bargain it was post the Alterra acquisition but definitely one worth holding in the books if one already has it.

Disclosure: Own shares of Markel.