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Broad Run 3Q17 Letter – Long Markel & Exit of World Fuel Services

Broad Run Investment Management 3Q17 Letter, October 20, 2017

  • Returned 5.0% net of fees during 3Q17 compared to 4.6% for Russell 3000
  • YTD, returned 13.5% net of fees vs. 13.9% for Russell 3000

Markel

  • Followed Markel closely since the late 1990s and owned it as a large position since 2009
  • Property and casualty insurance company managed with a very purposeful strategy to compound long-term value per share on an after-tax basis
  • Insurance companies can be thought of as having two lines of business: insurance underwriting and investing
    • Insurance underwriting involves making contractual commitments to customers to pay insurance claims of uncertain magnitude in the future, in exchange for fixed premium payments today
    • Since there is a lag between when premium payments are collected, and when loss payments are made, capital or “float” accumulates and is available for the insurance company to invest for its own benefit
  • In general, insurance is a lousy business; regulated and capital intensive with low customer switching costs and few barriers to entry. As a result, over the last 30 years, industry as a whole has produced ROE of 8%
  • Allure of investable float, combined with the estimation required to set insurance pricing is a tough mixture that leads to aggressive competition and dismal economic returns
    • However, Markel takes a very different approach from most in its industry which has enabled it to generate attractive growth and returns

Insurance Underwriting

  • In insurance underwriting, Markel mostly focuses on niche and specialty segments of the insurance market, rather than the much larger but more commoditized standard commercial and personal lines categories
    • Provides coverage for more than 100 unique risk categories including engine, antique cars, bars and taverns, and summer camps, among others
    • Requires specialized knowledge to price these policies accurately and often unique distribution to reach the customer resulting in reduced competition and more opportunity for profitable business
  • Markel has worked diligently to establish and maintain a culture of underwriting discipline. Insurance markets are cyclical so employees on the front lines making decisions need to write business when pricing is sufficient, and curtail writing business when it is not. Much like the stock market, most of the time it is not obvious if pricing is good or bad, it takes experience and judgment to make the right decisions
  • To incent right behavior, Markel compensates underwriters based on actual performance of their book of business over time, rather than on short-term production volumes like many other insurers do
  • Combination of Markel’s selective market focus and disciplined underwriting culture have made the company a top-tier insurance underwriter

Investing

  • Relative to other insurers, Markel makes substantially higher allocation to equities and lower allocation to fixed income; target equity allocation is 50-80%, many times higher than its peers
    • This approach has been quite successful, with equities outperforming fixed income over time, and Markel’s public equity portfolio outperforming the overall equity market by about 2.5% annualized over the last 27 years
  • Since 2005, company has broadened its equities activity to include buying private businesses
  • There are advantages to Markel in owning private businesses rather than public equities, including elimination of double taxation of dividends, and control/oversight of the investee’s capital allocation
  • Markel’s private equity investment results have been good, and as an asset class now compose 1/5th of its overall equity portfolio
  • We like that buying private businesses provides an additional capital allocation option to management, and suspect that its importance will continue to grow over time

Growth & Valuation

  • Believe that the annual change in book value per share is a good proxy for its annual change in intrinsic value. Over the last 20 years, Markel’s book value per share compounded at 13% annualized
  • Believe that the same forces that drove Markel’s growth in the past are present today
  • If Markel can continue to generate superior underwriting results, produce solid investment returns, and make opportunistic acquisitions, we believe book value per share can compound at a low-teens rate over the next decade
  • If Markel can increase book value per share 13% per year on average, at its current 1.6x book value multiple, it is the equivalent to trading at a 12-13x multiple of owner earnings. We believe Markel remains an underappreciated compounder

World Fuel Services (INT) – SOLD

  • First purchased World Fuel Services in 2011, attracted to the company by its leadership in marine and aviation fuel distribution, its high ROIC business model, and its long-tenured and successful management team
    • Was also benefitting from fuel producers outsourcing fuel marketing to 3rd party distributors/brokers, so believed that it was well positioned for profitable growth through continuation of this trend
  • Largest and among the most credit worthy of the independent fuel distributors
  • During the great recession and for several years afterward, its superior access to credit enabled World Fuel to finance favorable payment terms for customers when competitors could not
  • As credit has become more widely available and oil prices have declined, World Fuel’s advantage diminished, and margin compression followed. Also, at lower oil prices, company’s very profitable add-on services, such as fuel price hedging, are less utilized by clients, further pressuring margin
  • World Fuel has responded by undertaking a major acquisition push in the aviation and land fuel distribution markets. These acquisitions have offset the margin compression on its legacy business enabling the company to hold overall profits relatively flat
  • However, acquisitions are not a historical competency of the company, and the results from this recent effort are not good; more than $1.3Bn has been deployed in these deals at what we estimate is a mid-single digit ROIC
  • We have been negatively surprised by the profitability of the legacy business at World Fuel, and the evidence suggests the company is not creating value through its acquisition program
  • Exited the position at a low-teens multiple of estimated 2018 cash earnings, a fair price in our opinion, for a business that does not have a recent record of financial success, nor a credible plan to create economic value going forward

Image Source: Broad Run Investment Management

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