Can Bruce Berkowitz Bounce Back?
Just how badly has Bruce Berkowitz stumbled? Year to date through July 18, his once storied Fairholme Fund (symbol FAIRX) lost 13.7%. That trails Standard & Poor's 500-stock index by an astounding 18.6 percentage points and is stinky enough to place the fund next-to-last among large-company value funds, reports Morningstar. Over the past 12 months, Fairholme gained 4.4%, lagging the S&P 500 by 20.6 points.
According to fund tracker Lipper, investors have yanked $2.8 billion this year out of Fairholme, which now holds less than $15 billion. To make matters worse, the Securities & Exchange Commission has launched an investigation into St. Joe Co. (JOE), a Fairholme holding at which Berkowitz had himself installed as chairman.
Every fund, no matter how good, goes through spells when it looks absolutely terrible. The devilishly tricky part for you, the investor, is to determine whether the manager -- in this case Berkowitz -- has really lost his touch, or whether he has just hit one of those inevitable rotten patches. Is this the time to sell Fairholme or to invest more in it?
Berkowitz’s long-term record is certainly cause for confidence. It’s every bit as good as his short-term record is bad. Even with this year’s dreadful performance, Fairholme returned an annualized 9.7% over the past ten years through July 18-- an average of 6.9 percentage points per year better than the S&P 500 and good enough to put it in the top 1% among its peers. What’s more, not including 2011, the fund has beaten the S&P in every calendar year save one since its inception, at the end of 1999.
You could say that Berkowitz was overdue to fall flat on his face. Now the question is, can he get up?
The problem -- and the potential opportunity -- for Fairholme investors is Berkowitz’s huge weighting in many of the nation’s most controversial financial giants. At last report, the fund had almost three-fourths of its stock holdings in financials (accounting for about 54% of total assets) and another 11% in real estate.
Fairholme’s biggest positions include insurance giant American International Group (AIG), Bank of America (BAC), Morgan Stanley (MS), Goldman Sachs (GS) and Citigroup (C). Each of those stocks is at least 5% of the fund. Berkowitz has slashed the fund’s cash position to 7% -- the lowest level I can recall.
Berkowitz sees nothing unusual in what he’s doing -- and there’s no question that his success was built on big sector bets. “This is how we make our money,” he says. “We go into stressed areas where perceptions don’t match reality, and we’re usually early. And we buy more, and eventually we’re usually right.”
Berkowitz, 53, recalls the savings-and-loan crisis of the late 1980s and early 1990s. He feels as if he’s watching the same movie again. “This happens to banking every ten or 20 years, and in less severe forms probably every five years.”
By “this,” Berkowitz means the credit cycle. It begins when bankers and other financial-service firms tire of just making boring loans. So they look for more-profitable, albeit riskier, opportunities. When these turn out well, they grow more hair on their chests and progressively take ever-greater risks. Then it all blows up -- in 2008-09, with numerous financial firms failing, the developed world falling into a deep recession, and angry taxpayers left footing the bill.
Recapitalized by Uncle Sam, the bankers start all over again. But just now, early in the new credit cycle, even some bankers are a bit chastened. Berkowitz argues that banks are only making the safest loans and investments, and that their balance sheets look more pristine than they have at any time since the savings-and-loan blow-up.
Berkowitz marvels at the cheapness of the shares of these financial behemoths. They sell at big discounts to book value (assets minus liabilities) and tangible book value (book value excluding intangible items, such as goodwill), the measurements most commonly used to value financial stocks.
Why are they so cheap? Much of it relates to investor psychology. Explains Berkowitz: “A lot of people lost a lot of money in banks. And a lot of people want to blame the banks for everything bad that has happened to them. The psychology has gone to the extreme point of pessimism on these stocks. This is when you make your money.” He adds: “I can’t come up with a strategy for how the banks do badly from here.”
Berkowitz brushes aside talk of a Japan-style “lost decade” in the U.S. He says the economy is improving, and the worst loans are already off banks’ balance sheets. But if the economy fails to emerge soon from the softness it began to experience in the spring, the banks will continue to suffer, as more old loans turn sour.
I wish Berkowitz were invested in another sector. I don’t think I’ll ever again trust financial companies. Their books are impenetrable. Ultimately, you have to take a bank’s balance sheet on trust. Or not.
But Berkowitz is a brilliant investor -- one of the best of this generation. Co-manager Charles Fernandez seems to be playing a bigger role in running Fairholme, which makes me worry less about Berkowitz making his decisions in isolation. Berkowitz has also hired a couple of analysts. Confidence is essential in a great manager, but hubris can be his undoing.
Last November, I questioned whether it made sense to stick with Fairholme’s wager on financial-services stocks (see VALUE ADDED: Fairholme Fund’s Big Bet On Financial Stocks). (Editor’s Note: Kiplinger’s Personal Finance removed Fairholme Fund from the Kiplinger 25 in the May 2011 issue; see Our Favorite No-Load Funds of 2011.) If you’ve stayed in the fund this long, you shouldn’t sell now. For those on the sidelines, it might be time to start creeping back in. But until the economy shows more signs of health, I doubt the fund will prosper. Over the long term, though, I would not bet against Berkowitz.
Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.