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Wednesday, August 14, 2013 - 13:00

Is This 'Forever' Stock The Next Berkshire?

Wednesday, August 14, 2013 - 1:00pm

Hidden inflation is an insidious devourer of profit. Forget what the Consumer Price Index is telling us -- higher costs don't always get passed on to the consumer. Sometimes quality is reduced instead.

Whether it's the bag of potato chips that's half-filled with air, the controversy of "pink slime," or the shrinking amounts of cake mix in packages that used to hold more -- whether we admit it or not, the inflation we've been worried about is already here.

It's the kind of environment where we see "Forever Stocks" shine. These are companies that have businesses built to last through bear markets, rising interest rates and, yes, inflation.

This "Forever Stock" has an operating margin of 44%, which gives it plenty of wiggle room to withstand economic hardships. Expected earnings growth is 11.8%, and its business model has started to turn the heads of some of the biggest players on Wall Street. The company has been referred to as a "Baby Berkshire" since it's an insurer with a large investment arm similar to Berkshire Hathaway (NYSE: BRK).

But why buy the baby version instead of Warren Buffett's eponymous brain child? As Buffett explains: "Our future rates of gain will fall far short of those achieved in the past. Berkshire's capital base is now simply too large to allow us to earn truly outsized returns." Berkshire is too big to generate the enormous returns it did when it was smaller and more agile.

The "Forever Stock" I'm talking about is insurer Markel (NYSE: MKL). Markel specializes in insuring niche markets such as summer camps, antique motorcycles, auto races and amusement parks. It faces little competition in these markets, which gives Markel the ability to adjust rates as economic conditions change without losing its client base.

The specialty insurance company recently reported mixed results on second-quarter earnings, mainly due to its $3.3 billion buyout of competitor Alterra. But that should hardly be taken as bad news. The acquisition increased Markel's book value by 12% to $452 per share, giving the stock a very attractive 1.17 price-to-book (P/B) ratio. Compare that with Berkshire's 1.45, and we start to see how Markel is the better value.

The size difference between the two companies reveals why Markel has the ability to invest in ways Berkshire cannot. Markel's market cap is just over $5 billion, less than 2% of the massive Berkshire.

Merkel's total operating revenues have increased 30% from last year, to $1.9 billion. This is attributed to a 27% gain in insurance operations as well as a 64% profit from Markel Ventures, the company's non-insurance businesses. Perhaps the most significant number is the change in cash and cash equivalents, up from $863 million last December to $1.7 billion as of June, which gives it even more flexibility in difficult economic environments.

While Markel is still more of an insurance company than Berkshire, it has been seeing tremendous success with the business investments that make up Markel Ventures. A number of diverse companies are held in this segment such as AMF Bakery Systems, a designer and manufacturer of high-speed bakery equipment, and Diamond Healthcare, a leader in behavioral health services.

And it's not just private equity that's driving returns, but investments in Buffett-approved companies like Coca-Cola (NYSE: KO), Costco (Nasdaq: COST), American Express (NYSE: AXP) and a large stake in Berkshire Hathaway itself. All in all, Markel is a triple threat that has staying power and the maneuverability to snag attractive companies that the cumbersome Berkshire can't.

A telling sign that Wall Street is a believer in the company can be found by looking at institutional transactions. In the last quarter, 592,550 shares were purchased representing 6.7% of shares outstanding. Management has slowly been adding to its holdings as well and currently owns 14% of Markel's total market cap.

Risks to Consider: Markel is a property and casualty insurance company and has the standard risks of higher than expected losses on claims as well as being subject to interest-rate risk and market risk from its investment operations.

Action to Take --> Markel is a value buy based on its current P/B ratio of 1.17. Expected earnings growth of 11.8% gives us a price target of around $575 within the next 12 months.

P.S. -- Buffett has said his preferred investment horizon is "forever" -- and after six months and $1.3 million in research expense, we've uncovered the absolute best group of Forever Stocks. To learn more about these stocks -- including some of their names and ticker symbols -- click here.

Daniel Cross does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.