Avoiding losses is Fairholme Fund's key to prospering.
Bruce Berkowitz, manager of the $190 million Fairholme Fund, thinks that when it comes to investing, scoring big gains takes a back seat to avoiding losses. "We're always killing ideas by talking about what can go wrong and how we could lose money," says Berkowitz, 46, of himself and co-managers Larry Pitkowsky, 40, and Keith Trauner, 47. "We configure the portfolio toward companies that will do well in difficult environments."
The Short Hills, N.J.-based principals of Fairholme Capital Management, which manages some $1.2 billion in assets, give ample breathing room to the small basket of securities that survive their scrutiny. The fund holds no more than 25 positions, which can include stock of companies of any size as well as senior debt or convertible bonds. And the managers are not afraid to let what they consider their premiere picks make their mark. The fund's two largest positions, Berkshire Hathaway and Leucadia National, a holding company with operations in telecommunications, financial services and other industries, recently accounted for about 30% of fund assets. A little over a year ago, almost half of the fund's assets was invested in those stocks, both of which some analysts would classify as mutual fund alternatives because they are holding companies with diversified portfolios.
Both Berkshire Hathaway and Leucadia have been in the fund since its inception nearly five years ago. Because the managers will only trim or eliminate a holding if its valuation becomes excessive or a company's financial health deteriorates, this mid-cap blend offering has a low 13% annual turnover rate.
To find stocks with plenty of downside protection, Berkowitz and his co-managers believe in following the cash, sticking with great owner-managers and swooping in on bad news. The first two components of their strategy usually apply to stocks of companies with a solid financial underpinning and strong leadership that they believe are selling below what they are worth.
"I grew up working at a corner grocery store, and the only thing that mattered was how much cash was left in the register after the bills were paid," says Berkowitz of his attraction to strong cash flow. "The same principal applies to companies." He also demands a healthy balance sheet and above-average return on capital, as well as a stock price that reflects a discount to Fairholme's calculation of a company's intrinsic value. "When great owner-managers are combined with a high free-cash flow and the right price, investment performance should be exceptional," he says.
To spice up returns, the trio will sometimes scavenge at the outskirts of the market by buying stocks of what they consider mediocre businesses that are selling at a large discount to intrinsic value. Frequently, these are businesses whose stock prices have been driven down by negative publicity or unique one-time problems. In these situations, there must be a catalyst for change that will narrow the gap between the market price and their fair-value estimates. Occasionally, they will invest in distressed or defaulted bonds of brutally clobbered or bankrupt companies. These holdings are generally senior securities with a priority claim on the company's capital structure, a feature they believe provides an added safety net. In 2002, for example, the fund acquired senior bonds of WilTel (formerly Williams Communications), a troubled telecommunications company that had filed for Chapter 11 bankruptcy. Because of the precarious nature of the company's finances, the bonds were selling at about ten cents on the dollar. After the reorganization, WilTel senior bondholders eventually became its new shareholders. Leucadia bought out those shareholders in a tender offer, a move that allowed the fund to realize a 70% return on its original bond investment. "With reorganization, today's senior bondholders are tomorrow's equity holders," says Berkowitz of the reasoning behind the distressed-bond-play strategy.
Although the fund has no beleaguered-bond plays in its portfolio at the moment, Berkowitz remains confident in his ability to find new disasters with a silver lining. "Right now, we don't see anything exciting," he notes in a viewpoint that helps explain why the fund has nearly 20% of its assets in cash and Treasury bills. "But things can change quickly. We're always looking for stress points in the market." Currently, the trio is keeping an eye on banks and other financial service providers whose Achilles heel is rising interest rates. "As interest rates go up, organizations with complex hedging strategies, and those that profit from spreads between the cost of lending and borrowing, become vulnerable," he says.
Betting On Insurance
When Fairholme Capital launched the fund in December 1999, many viewed the beaten-down insurance stocks that dominated its portfolio as badly out of favor and susceptible to further declines. At the time, stocks of companies in the property-casualty industry languished as investors focused on Internet plays and other technology issues.
Berkowitz, who had left Salomon Smith Barney as a managing director two years earlier to start Fairholme Capital, says a number of disgruntled clients left the fledgling advisory firm to get their tech-stock fix elsewhere. "We couldn't go there because those companies were burning cash rather than accumulating it," he recalls. "At the same time, insurers were being hit by a combination of premium underpricing and low interest rates."
The tide began to turn in mid-2000, when the tech boom turned into a bust and insurers began raising premiums and improving their cash flow. Thanks largely to the robust performance of its insurance holdings that year, the fund returned 46.5%, beating the S&P 500 Index by more than 55%. It clobbered the index again the following year by 18% points, with a total return of 6.2%. Although Fairholme slipped 1.6% in 2002, it still managed to beat the index by 20.5%. So far this year, the fund remains well ahead of the index.
The only year the fund did not outperform the index was 2003, when its 24% total return fell below the S&P's 28% surge. Because the managers take a very concentrated approach in terms of the number of stocks and industries they invest in. "the fund's performance is likely to deviate from the broader market averages," notes Morningstar analyst Dan McNeela. He adds that while high-quality picks have kept it out of trouble, its large stake in insurance stocks "makes it dependent on improving fundamentals of that industry."