Two Insurance Investors Beat the Market

Although 2008 wasn't much of a year to shout about with stocks hitting the skids and putting a dent in almost all investment portfolios, we found a couple of insurance companies that look like they beat the market, by a little anyway. Both  Alleghany  and  Markel (MKL) began 2008 with an equity investment portfolio that, if left unchanged, would have beaten the S&P 500 by 6 and 4 percentage points, respectively, through Feb. 12, 2009. We would have liked to be able to give the overall performance of each portfolio for the entire year, but because of operational issues such as claims, capital ratios, and shifts in the allocation between equities and fixed income, it is impossible for us to arrive at a number.

Because we respect the stock-picking prowess of these companies, we have taken a close look into their fourth-quarter holdings and the changes in their equity portfolios. At Morningstar, we are always searching through the top picks of investors like Alleghany and Markel to unearth new ideas endorsed by respected professionals. A word of caution, though: Because of the delay in filing the reports, known as 13-Fs, we cannot know if the portfolios of today are the same as they were at the end of the fourth quarter. But at least we can see which new companies showed up in the portfolio and any major changes that were made.

 Alleghany  
The most noteworthy event in the fourth quarter was Alleghany's increased allocation in the energy sector, which was facilitated by the sale of its investment in Darwin Professional Underwriters, previously 25% of the equity portfolio. Alleghany purchased 1 million shares of  Occidental Petroleum (OXY), raising its energy sector allocation to 47% at the end of 2008. Occidental is a narrow-moat stock that has bordered on 5-star status since last July, and Morningstar analyst Allen Good likes the stock because of its leadership in enhanced oil-recovery techniques to tap older oil and gas assets.

Overall, energy wasn't very good to Alleghany in the fourth quarter as the average price per share of those stocks owned at the beginning of the quarter dropped 36%, far greater than the 20% decline in the S&P 500 over the three-month period. But Alleghany is a long-term holder and its past successes suggest that a one-quarter evaluation is a bit short-sighted. We think the average current share price to our fair value estimate for all stocks in the energy sector is 67%, leaving lots of room for share appreciation.

Another major equity portfolio change at Alleghany was the sale of about 20% of its holdings in  Burlington Northern Santa Fe Corporation . Alleghany has been a longtime holder of Burlington stock and tends to sell whenever it becomes too large a portion of the equity portfolio. Even so, Burlington ended the quarter comprising 36% of the stock portfolio, the highest in over a year. Despite Alleghany's concentration issues, it's hard not to like Burlington. Analyst Keith Schoonmaker notes that Burlington has an attractive freight mix rich in coal, grain, and intermodal container traffic. The rail continues to improve operating metrics like train velocity, terminal dwell time, and train length. Burlington also produces prodigious free cash flow, exceeding 7% of annual revenue. What's more,  Berkshire (BRK.B) owns 22% of the railroad--and Berkshire certainly isn't bad company to keep.

Finally, we note that Alleghany trimmed it holdings in health care; the major transaction was the sale of 1 million shares of  Pfizer (PFE). However, Alleghany did hold on to its 275,000 shares of  Wyeth , which has recently risen on a takeover offer from Pfizer. Genius or lucky, either way it turned out to be a great call.

 Markel  (MKL)
Unlike Alleghany, Markel's sector allocation in its equity portfolio has remained fairly constant over the past year with financial services occupying the largest position at around 45%. Financial services hasn't been a great place to be in over the past year but Markel's largest positions are in Berkshire (both (BRK.A) and (BRK.B)) and  Fairfax Holdings (FFH), the three of which comprise 25% of the entire stock holdings. We think Berkshire is a wide-moat, deep 5-star stock that any long-term investor would be wise to own. Senior analyst Bill Bergman notes that Berkshire's own investment portfolio has taken a hit or two with the deterioration we've seen in the equity markets, but its continuing financial strength has enabled the firm to pursue attractive capital allocation opportunities in investments as well as in reinsurance.

Within financial services, Markel increased its position in  Brookfield Asset Management (BAM) from 2.2 million shares at the end of the third quarter to 3.1 million shares. Analyst Todd Lukasik believes that the fair value of Brookfield's hard assets likely exceeds its recent share price, but the firm's occasionally complex investment structures and financial contracts increase the uncertainty around our fair value estimate.

 Disney  (DIS) was another company in which Markel increased its stake, more than doubling its ownership to almost 1.5 million shares. The wide-moat media giant owns a collection of valuable media assets that are currently on sale at an attractive price, according to analyst Larry Witt.

Markel sold its position in  Marsh & McLennan (MMC). MMC is a wide-moat, 5-star pick, in our view: The company turned in an impressive performance in 2008 in light of the weak economy and softening insurance markets, and its valuation remains attractive relative to most of the other publicly traded brokerage firms, according to Bill Bergman.

In the third quarter,  Fidelity National Financial (FNF) was the best-performing stock in Markel's equity portfolio. The stock gained 21% in the quarter, benefiting from its timely and deep-value acquisition of three title insurance companies from now-bankrupt competitor LandAmerica. Fidelity has cut costs and staff in an attempt to weather the real estate storm and we think its dominance of the title insurance market with almost 50% market share could pay off in the long term, if it can survive a rapidly depreciating market.

Unfortunately, Markel had a number of stocks that severely underperformed in the fourth quarter. Of its largest holdings,  Forest City , was the worst on a percentage basis, diving 78% in the quarter. Other notables were  Bank of America (BAC) (-60%),  CarMax (KMX) (-44%),  White Mountains (WTM) (-43%), and  General Electric (GE) (-37%).

Looking forward, however, we think Markel's equity portfolio is poised to outperform the market. Four of Markel's top five holdings, representing 36% of the market value of its portfolio at year-end, garner wide-moat ratings. And 61% of the entire stock holdings were invested in wide-moat stocks. (In 2008, stocks rated wide moat by Morningstar analysts beat the field by a landslide as recently explained in an article written by analyst Warren Miller.)