Value Added


Fairholme Fund's Big Bet on Financial Stocks

Steven Goldberg

Bruce Berkowitz is a brilliant fund manager, but his current portfolio makes me nervous.



At 52, Bruce Berkowitz is at the top of his game. Over the past ten years through November 15, Fairholme Fund (symbol FAIRX), which he manages, returned an annualized 11.7%, putting it in the top 1% of large-company value funds, according to Morningstar. Over that period, the fund beat Standard & Poor’s 500-stock index by an average of 11 percentage points per year.

Berkowitz makes big bets. He has invested large chunks of the fund’s money in a handful of stocks, often in just a few industries. He’s ridden those stocks higher for years, sold them, and switched into another small cluster of stocks that subsequently performed just as well or even better. And Berkowitz isn’t afraid to hold cash, which reduces risk and comes in handy when stocks go on sale. Currently, the fund holds about 25% of assets in cash and 10% in bonds.

At present, Berkowitz is making a huge bet on financial stocks, with 74% of the fund's stock investments in that iffy sector. This is a classic Berkowitz move. If he's right, Fairholme, member of the Kiplinger 25, will shine and its shareholders will be handsomely rewarded.

But success begets its own problems. In particular, Berkowitz keeps piling more onto his plate. Assets in Fairholme, which launched in 1999, have swollen to more than $17 billion. Berkowitz also has about $400 million in a new fund, Fairholme Focused Income (FOCIX), that invests mainly in bonds. In January, he'll launch a third fund, Fairholme Allocation, which will invest in both stocks and bonds.

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Fairholme's growth makes it far more difficult for Berkowitz to exit concentrated positions should he commit a blunder. Exhibit A is American International Group (AIG), the troubled insurer. At 7% of assets, it's Fairholme's largest holding. Fairholme owns 30% of AIG’s common stock. If Berkowitz is wrong on the stock and he decides to unload it, it will be impossible for him to sell without depressing its price.

Fairholme also owns 5%-plus positions in several of the big Wall Street banks: Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS) and Bank of America (BAC), which owns Merrill Lynch. Berkowitz would be able to sell these positions more easily, but his ownership of so many of the poster children of the 2008 financial meltdown makes me queasy.

Berkowitz, naturally, defends his strategy. "Right now, financials are the sweet spot of the market," he says. "These firms have been under the microscope for two years. You can see all the ugly stuff. When you"re shrinking, every crack shows. The government hired law firms and accounting firms and accumulated a massive amount of detailed information on these firms. You can’t hide after what they’ve been through."

Berkowitz didn’t rush into these stocks just because their share prices collapsed: “We waited until we knew the companies were going to survive. We saw the injections of capital into these companies and a significant slowing of their problems.”

Then Berkowitz did what he always does when he focuses on any industry: He hired top talent on a consulting basis to probe still deeper. His hired guns this time were former government officials. When the banks and other financial firms accepted money from the federal government, Berkowitz says, they had to agree to extensive reporting requirements. That information is in plain sight on government Web sites. The outcome of his extensive research: “The financials have rock-solid balance sheets.”

Berkowitz will likely turn out to be right on the banks -- and on AIG, another big recipient of government-rescue money.

He may be right, too, on St. Joe Corp. (JOE). Fairholme owns 30% of the outstanding shares of the Florida land-development company. St. Joe, the largest private landowner in Florida, has become a fascinating story. David Einhorn, who runs Greenlight Capital, a hedge fund, has sold short St. Joe shares (a bet that the stock’s price will fall), and recently made public a 139-slide presentation suggesting that many of St. Joe’s properties were worth far less than the value ascribed to them on the company’s balance sheet.

Berkowitz says Einhorn is putting the worst light possible on St. Joe: “There’s good, bad and ugly in all situations, and Einhorn was 139 pages of bad and ugly.” Berkowitz likens St. Joe’s ongoing development of the Florida panhandle to what is now Fort Lauderdale, as well as Hilton Head, in South Carolina.

Berkowitz is one of the smartest money managers I know. But I detect some worrisome signs. First, his management firm is essentially a one-man band. Co-manager Charles Fernandez sticks largely to operational matters. Berkowitz’s former co-managers have left the firm. I think all investors do better if they have someone with whom to review ideas. Such deliberations can prevent a lot of mistakes.

Although Fairholme’s concentrated approach isn’t new, its focus on the most dangerous sector of the 2008 implosion is. Financials may well be healthier and safer now than before they went into their near-death spiral. The credit cycle tends to work that way.

But I think Berkowitz understates the risks he’s taking. If the U.S. slips into recession again (admittedly an unlikely scenario), all bets are off for financials.

In any event, I’d be surprised if financials delivered superior returns over the next few years. The history of booms and busts argues strongly otherwise. After the technology boom and bust of the 1990s, tech stocks languished for years. Ditto for energy stocks after the boom and bust they went through in the late 1970s.

In short, Berkowitz is taking a big risk for what may be only a modest profit. I’m not sure anymore whether it makes sense to hang on for the ride.

Steven T. Goldberg (bio) is an investment adviser.



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