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The 10-Ks are out and the merger was approved earlier this week by both Markel and Alterra shareholders. So the deal appears almost certain to go through and the implied discount for buying ALTE shares has all but disappeared.

I went through my Markel valuation model both as a stand-alone and with the ALTE merger incorporated (pro forma) and it looks like the merger adds about $50 to my intrinsic value estimate for Markel. This is primarily because the investment portfolio (including cash) grows from $9.3 billion to $16.6 billion and I expect the portfolio to be invested in a manner reflecting Markel's historical allocation rather than keeping Alterra's nearly 100% fixed income allocation.

Currently, Markel has about 29% of total investments (including cash) allocated to equity securities. The combined pro-forma figures drop the equity allocation to 15.7%. To get back to 29%, Markel will have to shift approximately $2.3 billion from fixed income into equities. This will probably not happen immediately but over the course of several quarters.

The valuation model I use is relatively simple. I assume various after tax rates of return on the investment portfolio for the next five years and add the cumulative returns to today's estimated shareholders' equity. I then subtract estimated after-tax debt service costs. Assuming a 100 combined ratio and giving no credit to Markel Ventures, this figure is my estimate for shareholders equity in five years. I then discount this figure at 10% to arrive at a present value, then divide by the pro-forma shares outstanding.

My baseline estimate is for 4.5% after-tax returns from the investment portfolio. I estimate combined shareholders equity of approximately $6.1 billion based on 12/31/12 data and adjusted for changes in the value of Markel's equity portfolio since 12/31/12. Total invested assets (pro forma based on 12/31/12 data less $10/share cash to be paid to ALTE shareholders) is about $16.7 billion. A $16.7 billion portfolio should grow to $20.8 billion at 4.5% over five years which would add $4.1 billion to shareholders equity. I subtract $400 million for after tax debt service costs. Total estimated shareholders equity in five years is: $6.1 billion + $4.1 billion - $0.4 billion = $9.8 billion.

I use a baseline P/B multiple of 1.5 against the $9.8 billion resulting in expected market cap of $14.7 billion in five years. Discounting at 10%, I come up with present value of $9.1 billion. I estimate that there will be 13.8 million shares outstanding after the merger which gets me to intrinsic value per share of ~$660. Based on today's price of $480, that implies 38% upside.

Looking at it another way, Markel is a 73 cent dollar at today's quote. Additionally, even if Markel traded at $660 today, I would expect it to return about 10% annually over five years based on my assumptions leading to a share price of $1,000-$1,100 in five years. From today's price, that's comfortably above a 15% annualized rate of return.

There would be additional upside from Markel Ventures but I don't want to go through the trouble of even estimating it at this point. The obvious risks include bad underwriting, poor investment performance, etc.
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