Tom Gayner and Steve Markel on Value Investing

The following are my notes from a talk that Tom Gayner and Steve Markel gave on November 20, 2008 at Value Investing Conference at the University of Virginia, Darden School of Business. The talk was entitled “A Casual Talk with Two Guys from Richmond.” Steve Markel is the Vice Chairman of the Markel Corporation, an underwriter of specialty insurance. Tom Gayner is Executive Vice President and Chief Investment Officer of Markel and a highly respected value investor.

Markel is in the business of underwriting specialty insurance at a profit and investing the money the insurance business generates with a long-term orientation.

They believe that their long-term success owes itself to consistent discipline.

Markel insures items that are hard to insure. They typically don’t get involved until those seeking insurance have been turned down by others.

The high level of volatility in the markets in recent times is a sign of a shortened time horizon by many of its participants. There is a growing disconnect between the activities of investment managers and the underlying businesses they own.

Markel’s largest source of investment funds is loss reserves. This is typically invested in fixed income of various durations to provide funds to meet insurance claims.

The second biggest source of funds is shareholders equity which can be invested with an infinite time horizon. Some portion of shareholder equity is invested conservatively in fixed income to provide a margin of safety with regard to insurance claims obligations.

Markel’s first filter for equity investments is that a company be a good business with high returns on invested capital. Although this may seems obvious, Gayner has seen it violated many times. This means a good return on total assets employed, as opposed to a high return on equity through the use of excessive debt.

Making money over time means that you are providing something of value that people are willing to pay for. Gayner won’t invest unless there is a track record of profit.

Markel’s goal is to compound book value per share at a high rate over a long period of time. Since its IPO, Markel has compounded book value at a rate of approximately 20%. This is a result of their business model: underwriting insurance claims profitably and reinvesting the funds with a long-term value orientation.

Their concentration on specialty insurance, where they can get an edge and their unwillingness to write insurance that is not expected to be profitable is key to their success. They use minimal leverage.

Business in general and insurance in particular will be lumpy by its very nature because of the uncertainty of short-term events. Markel measures performance in rolling five-year periods to maintain a long-term perspective.

The second test for equity investments is to insure that the managers of a prospective investment have both talent and integrity. One without the other is useless for investment purposes. These are tough to measure but you can look at a management’s track record as a gauge.

They do not want to provide moral hazards when underwriting insurance. They want their interests and those of the insured party to be closely aligned. For example, they would not insure a $100,000 horse for $1,000,000. They feel that this principle is important in investing and was violated in the recent market debacle. How many executives had nothing to lose when they levered up their companies by a factor of 30 or 40?

The third filter in evaluating an investment is to look at the reinvestment dynamics of the business. Ideally, a business earns a high return on a capital and can reinvest over the long-term at as good or better rate of return. That makes a compounding machine that builds wealth over time. Berkshire Hathaway is the best example of this. The next best thing is a business which generates a high return on capital but does not have a good opportunity to reinvest its funds at a high (or even good) rate of return. The worst thing that a business such as this could do is squander capital in investments that promise a poor rate of return and that destroy value. The worst kind of business is one that generates poor returns on capital and needs more of it all the time. An example of this is the airline business.

The fourth screen for equity investments is price. Markel defines a fair price as one that allows an outside shareholder to earn the same type of return that the business itself earns. If you pay too much, the underlying business may prosper nicely but you will not be rewarded for the investment.

Historically, Markel has traded between 1.5 and 2 times book value. They don’t focus on where the stock trades, which they can’t control, but on building shareholder value over time.

They don’t focus on macro economic factors because they believe that they don’t think they are consistently predictable. They focus on what they can control.

Disclosure: The author owns shares of Markel.

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