Sell Energy, Buy Health

Bruce Berkowitz is shaking up his portfolio dramatically. The manager of top-performing Fairholme fund (symbol FAIRX) has drastically cut the fund's stake in commodities and correspondingly raised its weighting in downtrodden health-care stocks.

At the end of last year, Fairholme held 21% of its assets in oil-and-gas producers. Now the allocation is just 7% -- and all of that is in one stock, Canadian Natural Resources Ltd. (CNQ).

Berkowitz isn't making predictions about the price of oil. Oil stocks are trading, he notes, as if prices will decline to $70 or $80 a barrel. "But since oil-and-gas stocks have gone up three and four times, it's time to lighten the load," he says. Most important: "We're selling what is cheap to buy what is cheaper."

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What's cheaper, in Berkowitz's view, is the health-care sector -- in particular, drug stocks and managed-care companies. Pharmaceutical stocks, market darlings in the 1990s, have performed poorly for most of this decade, primarily because of patent expirations and the failure of drug companies to create new blockbusters. Managed-care stocks have been hurt by fears that state and federal health-care reforms will cripple their businesses.

Pharma now totals 18% of Fairholme's assets. Never one to make small bets when he's highly confident, Berkowitz scooped up 49 million shares of Pfizer (PFE), making it more than 10% of his $8.7-billion fund. He predicts that Pfizer will become "the merchant bank of pharma," buying up, marketing for and going into joint ventures with biotech firms that discover new drugs. Pfizer also has hundreds of promising drugs in its pipeline and plans to become a major player in generics.

Berkowitz also bought Forest Labs (FRX) and generic-drug firm Mylan (MYL), investing 4% of the fund's assets in each.

No stock exemplifies the slow torture of Big Pharma better than Pfizer, the industry's largest company. It crested at $50 in 1999 and closed August 12 at $19.72. Brokerage analysts estimate on average that Pfizer will earn $2.37 per share this year, giving it a price-earnings ratio of just 8. Meanwhile, the stock yields 6.5%. It's hard to argue that Pfizer isn't a bargain.

Another 8% of the fund is in two managed-health-care firms -- WellPoint (WLP) and WellCare (WLC). As Berkowitz sees it, the U.S. government will need these companies to help run any health-care system the nation might have. I think he's right.

Berkowitz's moves, disclosed in his report for the six-month period that ended May 31, look well timed. Over the past three months through August 12, energy stocks have fallen 7%, while health-care stocks have risen 5%.

I think Berkowitz, 50, and his team run one of the nation's best funds. Start with returns. From the fund's inception at the end of 1999 through July 31, Fairholme has earned an annualized 15%. During the same period, Standard & Poor's 500-stock index returned virtually nothing (0.6% annualized, to be precise). Year-to-date through August 11, the fund gained 0.5%, compared with a loss of 10% for the S&P 500.

As the fund has grown, Berkowitz and his seven full-time analysts have spent more money contracting with outside analysts and other professionals who specialize in the sectors and the companies that the Fairholme team is investigating.

The fund's intensive research efforts usually lead it to own just 20 or so stocks-and to take positions in excess of 10% in those Berkowitz likes the best. That can be risky -- just ask Oakmark Select's Bill Nygren (see Where Oakmark's Nygren Went Wrong. But so far, Berkowitz hasn't made any huge mistakes.

Fairholme has delivered top-notch returns while holding a lot of cash-at present 14% of assets. "Cash allows you to buy in very stressful times," Berkowitz says. Of course, cash also has helped performance during down markets; it will hurt in up markets.

Berkowitz's recent flurry of activity is unusual; he holds stocks four or five years, on average. But the past six months were an exception. In addition to swapping energy for pharma, Berkowitz trimmed the fund's stake in Berkshire Hathaway (BRK.B) from 20% to 11%. He cited concerns about the company's ability to grow, given its mammoth size and speculation about the eventual successor for 77-year-old Warren Buffett.

See what Berkowitz has to say about Sears, one of the fund's major holdings.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.