Smart Money Masters — April 2017 Issue

Betting on the Next Berkshire Hathaway

I t was a strong first month for your Smart Money Masters portfolio.

Your very first recommendation, Navigator Holdings Ltd. (NVGS), soared 25.11% since Feb. 10. On March 1, Navigator announced a profit of 14 cents, versus expectations of 4 cents per share, and the stock rocketed 27.27% the following day.

This is the kind of price action you can expect from this Wilbur Ross-driven turnaround play. First, there is a surprise earnings announcement on the upside. Second, a few months of consolidation ensues before the next round of betterthan-expected news drives the stock further upward.

Berkshire Hathaway (BRK-B) continued its relentless rise upward and closed the month with an impressive 7.08% gain. The irony is that Warren Buffett campaigned actively against President Donald Trump before the U.S. presidential election. Meanwhile, the Trump rally has seen Berkshire Hathaway’s share price explode 18.87% since Nov. 8. This increase has put billions of dollars into both Buffett’s and Berkshire shareholders’ pockets.

And there may be more to come. Investment bank Barclays estimates that if the U.S. corporate tax rate is cut to 20% from 35%, Berkshire Hathaway’s book value will get a boost of $27 billion — a 10% increase. That’s more good news for Buffett and for you as a Berkshire shareholder.

Bill Ackman’s massive bet on Restaurant Brands International (QSR) is also paying off. The stock closed the month 6.21% higher after reporting better-than-expected earnings. QSR also announced the acquisition of another brand, Popeyes Louisiana Kitchen, into its fast food portfolio. The controlling shareholder, Brazilian private equity firm 3G Capital, is driving these kinds of acquisitions, as it gobbles up more assets to restructure.

The other 3G Capital controlled company in your Smart Money Masters portfolio, Kraft Heinz (KHC), also eked out a 1.26% gain. This increase came despite Kraft Heinz’s failed $143 billion bid for Anglo-Dutch rival Unilever.

The ‘Baby Berkshire’ Beating Buffett

This month’s Smart Money Masters recommendation — Markel Corporation (MKL) — bears such a close resemblance to Warren Buffett’s Berkshire Hathaway (BRK-B) that analysts have dubbed it the “Baby Berkshire.”

The nickname “Baby Berkshire” is apt.

With a market capitalization of just $13.74 billion, Markel is just 2% the size of Berkshire Hathaway’s $432 billion.

Warren Buffett often has said the biggest enemy of Berkshire Hathaway’s future market-beating returns is its size. He conceded that Berkshire’s unwieldy size is also likely to impair its investment returns in the years ahead.

Markel offers the best of both worlds.

On the one hand, Markel has a Buffett-inspired investment strategy, with time-tested results.

On the other, Markel has a relatively small, $4.15 billion investment portfolio, which increases its chances of generating market-beating investment returns.

Most importantly, Markel has a 30-year track record that confirms it can replicate and even surpass Buffett’s investment track record at Berkshire.

Investment Philosophy

Tom Gayner, Markel’s Co-Chief Executive Officer, has run its investment portfolio since he joined the company in 1990.

Gayner is a very public disciple of Warren Buffett.

As a value investor, Gayner approaches investing with the rigor of the accountant he once was. A stock represents a share of a real-world business. The value of that business is the present value of the future cash flows.

Gayner also operates with a Benjamin Graham–like margin of safety. Like Buffett, he stresses the importance of working within his circle of competence.

In short, his philosophy sounds a lot like the “Oracle of Omaha” himself.

In picking stocks, Gayner applies a simple but rigorous four-point filtering process.

Specifically, Gayner looks for:

1. Profitable companies that produce high returns on capital

2. Management that is both talented and honest

3. Businesses that have sizable reinvestment opportunities (compounding machines)

4. A fair price

Markel’s $4.15 billion stock portfolio is less concentrated than Berkshire’s. Still, his top 10 holdings account for 44.42% of his overall portfolio.

Meet the Manager

From Accountant to a Buffett Beating Investment Manager

Thomas Gayner began his career in accounting at PricewaterhouseCoopers as a Certified Public Accountant after graduating from the University of Virginia in 1983.

Gayner got bored quickly and became a stockbroker and small-cap stock analyst. His job was to identify value among smaller regional companies that had huge growth potential over the long term. One of the companies Gayner covered as an analyst was Markel. He befriended thenMarkel CEO Steve Markel, and today is Markel’s Co-Chief Executive Officer.

As a value investor and acolyte of Warren Buffett, Gayner makes the annual pilgrimage to Omaha each year to Berkshire Hathaway’s annual meeting. Markel even holds an annual brunch after the Berkshire meeting where management updates Berkshire investors on the “Baby Berkshire’s” own progress.

As a former accountant, Gaynor is acutely aware of taxes’ impact on investing. Markel is a full corporate taxpayer at the 35% tax rate. So if a stock has a dollar’s worth of gains, and Markel sells it to buy something else, only $0.65 is left to invest in the second idea.

That makes Gayner very selective. As a result, Markel has very little turnover. Gayner prefers to buy a stock at $20 that he expects to rise 10 or 15 fold over long periods of time.

Gayner has been mentioned in the past as a possible candidate to succeed Buffett at Berkshire as its chief investment officer. “It would be arrogant of me even to comment on such a possibility.” Gayner once told Barron’s. “He’s the master, and we are all his students.”

Gayner’s portfolio is also robust. It fell 34% in the market collapse of 2008 but held up better than the S&P 500’s 37% loss.

Gayner prides himself on being conscientious. As he puts it: “I think as hard as I can about what I would do if this was my own money and even if it was all the money I ever will have.”

As it turns out, Gayner conveniently has married this conscientiousness with a solid dose of self-interest. Gayner holds 34,192 shares of Markel stock, worth more than $33.6 million. But it is good to know that Gayner has a lot of skin in the game.

How Markel is a Mini-Berkshire Hathaway

Founded in 1930, Markel is a specialty insurance holding company. Both Markel’s underwriting and investment strategy are modeled explicitly on Berkshire Hathaway. Markel even holds a shareholder brunch in a conference room at the Omaha, Nebraska, Hilton hotel each year — on the day after Berkshire Hathaway’s annual meeting.

Over the years, Markel has established a reputation as one of the leading players in specialty insurance markets. The company has insured everything from classic cars, boats and event cancellations to children’s summer camps, vacant properties and new medical devices. Markel insured the red slippers Judy Garland wore in the Wizard of Oz. No other company has insured show horses for more than 50 years.

Markel’s size, expertise and capacity to insure unusual risks have given Markel both pricing power and a sustainable advantage over its competitors.

Insurance premiums have grown by an average of 18% per year over the past two decades.

Over the last 10 years, Markel has averaged a “combined ratio” of just under 96%. As long as that number is under 100%, Markel is taking in more money in premiums than it is paying out in claims. Such efficiency makes Markel a rare bird among insurance companies.

The Insurance Industry’s ‘Unfair Advantage’

Analysts have long pointed out that insurance companies have an unfair advantage in investing.

This advantage comes from the insurance industry’s infamous “float,” which is a feature that many investors have a hard time getting their head around.

The insurance business differs from every other type of business.

On the one hand, selling property-casualty insurance is tough. Competition is fierce. Insurance products are essentially identical. Meanwhile, the industry’s record of assessing risks — that is, its ability to earn money on policies sold — is terrible.

State Farm, the largest insurer in the United States, has lost money on insurance policies for nine of the past 12 years.

On the other hand, insurance is the only business in the world where people throw money at a business “for free.” In every other business, companies have to provide some good or service. Even banks have to pay out depositors.

Insurance companies then take the premiums paid by policyholders — the “float” or the money that belongs to policyholders from premiums reserved for future claims — and invest them into a range of financial assets.

Insurance companies also enjoy huge tax advantages. That’s because they don’t pay taxes on the premiums you pay them because they haven’t yet “earned” any of that money.

So unlike most companies that have to pay taxes on revenue and profits before investing, insurance companies get to invest all of the money they receive first.

Think of the “float” as a large tax-free loan that bears no interest and rarely has to be paid back.

How Markel Invests its ‘Float’

Much like Berkshire, Markel’s core specialty insurance business is profitable and generates a significant float. Markel then invests this for the benefit of shareholders.

Few insurance companies invest a significant percentage of their portfolio in stocks. Most industry players invest in cash equivalents to ensure they can always pay claims.

Markel invests a much larger portion of its float into stocks. This strategy results in higher returns for the investment portfolio over time — although at the price of higher volatility. Here, Markel’s philosophy again echoes that of Berkshire Hathaway. Markel invests its shareholder equity with a long-term view, believing that stocks of quality companies at fair prices will outperform bonds over long periods of time.

As a bonus, Markel manages its $4.15 billion stock portfolio for less than 0.01% in annual expenses. That’s about one-70th the cost of the average U.S. stock mutual fund.

How Tom Gayner is Beating Warren Buffett

One of the best-kept secrets in investing is that Markel has outperformed Berkshire Hathaway since the late 1990s.

Under Gayner’s stewardship, Markel’s share price has increased an average of 11.33% per year over the last 15 years, 7.36% per year over the last decade, and 19.28% per year over the previous five years.

Since 1990, Markel shares have risen from $21.75 to $984 for an average annual return of 15.1%.

Low turnover, long holding times and paying very little taxes on capital gains is behind much of Markel’s Buffett-beating gains.

Ironically, Gayner’s biggest position is Berkshire Hathaway. Today, it makes up approximately 12.3% of Markel’s stock portfolio. It also is a position Markel has held for over 25 years.

Gayner has held Markel’s other large positions, CarMax (KMX) (7.62% of the portfolio), Brookfield Asset Management (BAM) (4.1%), Walt Disney (DIS) (4.14%) and Marriott International (MAR) (2.98%), for at least 15 years each.

As Gayner puts it: “If you stumble on something that really compounds in value for decades, it can make all the difference. The things you were right about become more and more important as time goes by, while the things you were wrong about become less and less important.”

Outstanding Performance at a Fair Price

News of Markel’s investment success gradually has been seeping out to investors.

Markel’s current Price to Book (P/B) ratio today stands at 1.62. That’s below Markel’s long-term, 30-year average P/B Ratio of 1.73.

My back-of-the-envelope calculation shows that if Markel traded at its historic average valuation, it would be trading at $1051 — and not at its current price of $984 per share.

That’s not a massive discount.

At the same time, if you buy Markel, you own a consistently profitable insurance company, with one of the world’s top investors at the helm, as well as a shareholder-friendly long-term management.

And you get all of this at a fair price.

So buy Markel Corporation (MKL) today, and place your stop at $800. I’ve given this stock a low-risk rating of 2.

Sincerely,

Nicholas A. Vardy