It's been about one month since the Naked Portfolio was conceived. As promised, here is the report for the month of August 2005. Below is a comparison of the portfolio's performance compared to the S & P 500 Index.

Yes, disappointing month indeed. The portfolio is trailing the S & P 500 by 0.18%. There are two holdings in the portfolio. Berkshire Hathaway (NYSE: BRKb) is the largest holding; making up 90% of the portfolio. Markel Corp (NYSE: MKL) makes up the remaining 10%.

The portfolio started with $3,000 found-in-the-bush money which I used to purchase one Berkshire Class B share. With the aim to make this portfolio as "real" as possible for average people, like me, who doesn't have a lot to invest, I assumed a deposit of $500/month to my brokerage account. So with the first month of $500 saved, I purchased one share of Markel.

Berkshire Hathaway
I don't think 0.18% after one month is bad considering how the market is reacting or perhaps just beginning to react towards the effects from Hurricane Katrina. Berkshire is and will be affected by the losses caused by Katrina. Berkshire's subsidiary General-Re is the third largest reinsurer in the world. They provide insurance to insurers including Markel. Ah, do you see the connection between the two holdings now? :)

Buying Berkshire is almost a no-brainer to me. The holding company run by two of the most successful investors — Warren Buffett and Charlie Munger — has been growing its book value at an average of 21.9% annually, handily beating S & P 500's 10.4% a year (with dividend reinvested). If you hate picking stocks on your own and are considering mutual funds or index funds to invest your money, don't. You are probably better off buying Berkshire. You get the same benefits of money being managed by professionals except these professionals consistently beat the market and they charge no fees (well, maybe $7 if you buy them through Scottrade).

Due to recent fears of the effect of Katrina on reinsurers, Berkshire's shares have dropped a little: about 1%. However, the trailing twelve months have seen the stock falling 3.6% compared to S & P 500's rise of 7.7%. With cash per share of $1,063.73, you are essentially paying $1692.27 for a Class B share for $157.88 EPS which translates to a "real" P/E of 10.7. Estimating the growth rate for the next 5 years is the tough part. Zacks estimates an 11% growth per year. So assuming that, Berkshire has a PEG ratio of 0.97. A stock with a PEG ratio of less than 1 is a buy-watch. Unfortunately, as per my assumption of funds available for investment, I don't have enough to purchase another share of Berkshire at this time.

Markel Corp
I believe Markel is undervalued. Markel is an insurer and reinsurer (through Markel Re). So it is likely that Katrina may have some effect on Markel. Surprisingly, the stock has risen 1.51% since my purchase. Markel is still a bargain at the current price.

Before Markel announced its 2005 second quarter results on August 2, the stock was trading at around $330/share. After the earnings release, the share dropped 7% as a result of lower premium volume even though the earnings rose. I think the market was overreacting.

To understand Markel, you need to understand the specialty insurance business — the niche market that Markel operates in. Specialty insurance provides coverage for risks that most insurance companies either don't understand or can't stomach. For instance, Markel provides insurance for summer camps where all kinds of risks exist; ranging from fire, snakebites, allergy attacks, drowning to sexual harrassment lawsuits. Because there is so much risk involved and so little competition, Markel gets to charge high premiums. The result from specializing in these niche markets allow Markel to improve its book value 30% a year since 1991 while reducing its workforce. That's efficiency at its best. The stock has risen more than 1,000% since 1991. Now, this is what Peter Lynch would call a 10-bagger.

So how does focusing in specialty experience the decrease in premium volume in the latest quarter? Profit margin is very important especially in the cut-throat insurance industry where providers compete mainly in price. When a niche market becomes too saturated with competitors, the profit margin drops. If the profit margin drops to a point where it doesn't make sense to continue operating in that market it's time to move on to a new niche market. And that's exactly what Markel did in 1990s and continue doing now. Of course, the question now becomes how easy is it to find new niche markets? Because Markel operates in specialty insurance, the answer is pretty easy. Quick, list all the insurance coverage you know: auto, home, health, and life. Well, may be you know a handful more. But my point is for those other things in life that no one can think of that needs insurance, Markel will be perhaps the only one who will. Like to jump off planes in your free time, call Markel. Like to swim with sharks, call Markel. Like to eat fugu, call Markel. Oh, in case you do like to eat fugu, make sure you eat at one of the 17 restaurants certified by FDA to serve fugu.

I also love Markel because of its management. Markel was founded by Sam Markel in the 1930s. Today Markel is still managed by the Markel family. Alan Kirshner, CEO of Markel is a Markel by marriage. He has been with Markel for about 45 years. Tony Markel, 38, runs the underwriting arm of Markel. Steve Markel, 31, runs the investment arm of Markel. Together, the trio turned Markel into a $3.2 billion company and growing. Interestingly, while management returned good results their compensations are still below industry average.

Finally, Markel recently announced a share repurchase program for up to $200 million. There are two possible reasons a company repurchase its shares: 1) to temporarily improve its share price 2) management thinks the stock is undervalued. I doubt Markel announced the share repurchase due to reason #1 because if they did it didn't affect the stock price much. Another little piece of good news is Markel is ranked #75 on Forbes 100 Best Mid-Cap Stocks.

Conculsion
So I summarized what I think about both holdings in the Naked Portfolio. I will continue to hold for now. As a matter of fact, I'm considering buying another share of Markel with the $500 infusion for the month of September 2005.

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