CONSUELO MACK: This week on WealthTrack, a Great Investor who has taken a plunge investing in battered financial stocks. In a rare interview, Fairholme Fund’s Bruce Berkowitz, Morningstar’s Fund Manager of the Decade discusses why he sees treasure where others see a trap. Fairholme Fund’s Bruce Berkowitz is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. One of the hallmarks of the Great Investors who have appeared on WealthTrack has been their willingness to go against the crowd, to invest in places others shun. That strategy puts them into uncomfortable, unpopular and frequently unprofitable positions for periods of time, some extended, some not.
This week’s Great Investor guest is no exception. As a matter of fact, he exemplifies the hazards and what he hopes will once again be the vindication of contrarian investing. He is Bruce Berkowitz, founder and chief investment officer of Fairholme Capital Management, whose tag line is “Ignore the crowd.” He manages three mutual funds, including his flagship Fairholme Fund whose outstanding long term track record earned him Morningstar’s first Domestic Equity Fund Manager of the Decade award in 2010. At the end of the last decade, the value fund had delivered average annualized returns of 13.2%, putting it in the top one percent of Morningstar’s large blend category- outdistancing the S&P 500 by 13 percentage points a year and expanding to nearly $20 billion dollars in assets.
Fast forward to today and the fund’s ten year track record is still beating the market, albeit by a much smaller margin, and is in the top one percent of its category, but its dropped to eight percent annualized returns and it is trailing the overall market in the last three and one year periods; plus its assets are now approaching half of what they were.
What’s changed? Over the last couple of years Berkowitz, who has always run a very concentrated stock portfolio, has loaded up on financials- to the tune of more than 75% of the portfolio. The group skyrocketed off the market bottom in 2009, but has been by far the worst performing sector year to date. Among Fairholme’s largest positions are battered names such as American International Group, Bank of America, Citigroup, and yes, the more lightly bruised Berkshire Hathaway, a long time holding.
I began the interview by asking Berkowitz why with all of the legal, regulatory, economic, and market uncertainties surrounding financials he was sticking with them.
BRUCE BERKOWITZ: The negatives are all uncertainty about the future. And what I try and do is focus on the facts of today. So, when you look at the income statements, they’re making huge cash flows, a lot of it being paid for the foolishness of 2007 and 2008, which eventually will burn off and those huge cash flows will show. If you look at the balance sheets of the company, they have– banks, for example, they have the strongest balance sheets that they’ve had probably in a history of their histories. If you look at reserving, it’s stronger than at any time. If you look at the trends, the trends are turning favorable. If you understand the nature of loans and the average life of five to seven years, and your troubles in 2007, 2008, you’ve already had a good– you’ve had a three, four year look at how the loans progressed. You know how they’re going to turn out. Credit cards, other types of loans are much shorter. They’ve already burnt through all that. The case of Bank of America, they have five different businesses, four of which are quite profitable, but there’s this one business, residential mortgages, which are still giving a lot of trouble, and they just took a $20 billion hit in one quarter as their estimate of what all the costs are going to be, including non-cash cost, you know, reduction of goodwill and other intangibles. And people believe that that can keep going like that. It can’t. It’s like insurance reserving. When we change your estimate, you change the number in one quarter for all the past and all your beliefs about the future.
So there’s a lot of fear in the marketplace right now, which I take as a positive because the financials are priced for failure, and that’s how you want to buy them, to be priced for failure, because the pessimism is intense and the market price reflects the pessimism, and then you could pair the market price to what you believe the company will earn in a more normal environment, and let’s say you take that with the funds. I take every one of our companies, and I look through; I take the earnings of the companies and I translate that into what it’s going to be in earnings per share of the Fairholme Fund. And I think that the companies have an earnings power of $4 per share for the Fairholme Fund, and the Fairholme Fund is $27 or whatever it may be per share, and I think, well, what’s that earnings? And what does that mean? And if I’m right, eventually, price follows true earnings, and hopefully, the mania that we’re in right now and the intense madness of the crowd will allow me, allow the fund to buy more, allow me to buy more, to take advantage of a cheaper price, the same way, you know, your favorite food group is on sale at the grocery store. It shouldn’t be much different than that.
CONSUELO MACK: But when you talk about the mania that is surrounding the financial stocks right now, have you ever seen the kind of mania, madness, craziness in any group that you’ve been so focused on before, in your experience as a money manager?
BRUCE BERKOWITZ: In my career, every day is reminiscent of the early ‘90s, with the financial institutions of that time. Wells Fargo was supposed to go bankrupt and there were a couple of investors, I believe that they were Buffett busters. They thought Buffett was going to lose his shirt on Wells Fargo, and I looked at Wells Fargo and I saw that even their bad assets were earning an income, which is the case with banks today. And how can bad be earning an income? So it was an overreaction. You know, our brains are wired for overreaction and momentum, and follow the crowd. So, Fairholme, our tagline is, “Ignore the crowd.” And another one of our lines is, you know, “Count what matters.” So we count the cash.
So when I see companies selling for below liquidation value, for below the cash that they own, that they had in their own bank and in other banks, and I look at the reserves and the strengths and the trends, I keep trying to pick away at them and kill them and chomp them, and what if the recession keeps going, and what if there’s a double dip? And what if house prices continue to go down? And what if they don’t know what they’re doing and they haven’t reserved properly? I mean you ask all those questions and the answer is,