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Bruce Berkowitz “Sears Intrinsic Value is the $64 Question”

Bruce Berkowitz "Sears Intrinsic Value is the $64 Question"

Interview with Bruce Berkowitz, released today by Fairholme Funds. First the fund holdings, which have two things in common; most were down in 11, and most are financials.

TOP HOLDINGS BY ISSUER * * * as of 11/30/2011

%of Total Net Assets

American International Group, Inc. 26.2%

AIA Group Ltd.  11.4%

Sears Holdings Corp.  10.7%

Berkshire Hathaway, Inc. 9.3%

CIT Group Inc. 6.9%

Bank of America Corp. 5.5%

General Growth Properties, Inc.  4.2%

The St. Joe Co. 4.0%

China Pacific Insurance (Group) Co., Ltd. 3.8%

Leucadia National Corp. 3.6%

Total 85.6%

Now for the interview with Bruce

EDITED FOR CLARITY AND ACCURACY
Fred: Bruce, it’s great that we can do this today, because we’ve had a really
tremendous response to asking our shareholders for questions. So we’ve taken
all the questions and put them in the order of how often they were asked, and if
it’s okay with you, I’ll just get right into it.
Bruce:  Great, if you’ve got questions, hopefully, we’ll have answers.
Fred: Okay. The most asked question was about Sears. People want to know what is the intrinsic value of Sears?
Bruce: That seems to be the $64 question, and it’s hard for most to get a hold of it because of the different components. Everyone knows there’s real estate, that they’re a brand, and there’s an online component. A lot of people don’t realize that there’s a service business with 12 million visits to homes every year, a warranty business on the products. Of course there’s Sears Canada – mostly owned by Sears now. But the real interesting issue which people have to get their hands around is the long leases that Sears and Kmart have. You have to ask yourself the question, when does the long lease equal in value what
ownership is. So when you take into account the very long leases and just the nature of what it is to be an anchor in a mall, how you become an anchor and the terms and conditions of becoming an anchor in a mall, there’s tremendous value. Quite alot of work to get there, but when you add up all the values, including the long leases and the importance of anchors in malls, plus the brands, whether it’s Lands’ End online or the Sears websites that are doing reasonably well, you come up with a pretty big number. The number is multiples of what we think the current stock price is, but we’ll let everybody on the outside figure out what the exact range is.

Fred: Given all those asset values, people also wanted to know whether you view this
like a Berkshire Hathaway type of company?
Bruce: A lot of similarities. Warren Buffett, hedge fund manager, starts to invest
heavily in a textile mill, Berkshire Hathaway. Over time, decides to call it a
day as a fund manager, stays focused on Berkshire Hathaway. Tries to turn
around the company, the entire company for the benefit of the employees.
Eventually comes to the conclusion it can’t happen, fixes what he can. Sells
what he can’t fix and moves on with insurance and becomes a conglomerate
holding company, and the Berkshire that we know today.
If you take a look at Eddie Lampert in Sears from Kmart, so then the merger
with Sears, then trying to fix the entire system. Recently announcing that it all
can’t be fixed, so that which can’t be fixed will be sold. He’s going to
rationalize it, and you can take a look at the cash flows. Whether it’s his
partnerships, the company’s recent purchase of more Sears, there’s a pretty
good analogy between the two. So can Sears become Eddie Lampert’s
Berkshire Hathaway? Well, so far it looks that way. We’ll see.
Fred:  Believe it or not, the second most asked question was about last year.
Everybody knows that 2011 was a really tough year, and they want to know in
retrospect, would you have done anything differently if you knew what you
know now?
Bruce: In retrospect and in hindsight, yes, I’d do a lot differently. I’d go all to cash and I would have really slowed down the selling of the healthcare companies and the buying of the financials. With hindsight, of course I would do that. You know, we bought the healthcare companies when everyone thought they were going bankrupt because of Obamacare, and we knew that wouldn’t be the case and we did reasonably well. But we sold too soon, because the financials became cheaper and because of the market’s belief that President Obama was going to destroy the financial system. But the financials that we bought were cheap and they became much cheaper. Of course we buy cheap, and we bought more of those stocks cheaper. So yes, with hindsight, of course we’d do a lot. We’d be perfect. But given the events and given the fact that the business trends of every company that we purchased, that’s all the financials that we purchased during that period have all turned positive since the time at which they’d been purchased. So it’s going the way we expect it to go. It all looks great. The rest of the investment world has to start to be convinced that these are valuable franchises that are going to make money once they clear up the sort of one-time fixable problems they had from sort of the irrational exuberance of home ownership.
Fred: Sort of the follow-up to that, which they didn’t ask, but I’ll ask you is, are you happy with the whole portfolio the way it is now? Is this the portfolio that you want to take forward for the next couple of years?
Bruce: This is it. This is the kind of portfolio composition, business type that I had in the early ’90s where I had my greatest performance, companies like Wells Fargo and others. It’s what I know best. It’s the industry that we’re in. I mean, these companies, especially the financial services companies, are just dead center in what I believe to be my circle of competence. I’ve seen this act
before. I’ve seen the play before. I’ve seen the cycle of financials. That’s the
one thing good about old age, you’ve seen it before and you know how it plays
out. History may not be exact, but it does rhyme. I’m excited. I never thought
I’d have another opportunity to really take advantage of the financial cycle.
And we’re going to do it, and hopefully this will be the year it shows.
Fred: AIG is our largest holding in the Fairholme Fund, and people wanted to know what the investment thesis is specifically on AIG. The backup question to that was why would you want to own a company that the government owns 77% of?
Bruce: We’ll go with the latter question first. Why the government ownership is such a concern to long-term investors I don’t know. To me it would be a positive. If you’re truly a long-term investor, and you like to buy cheap and cheapen your value base, then the worst that could happen is you get to buy more at a cheaper price. That’s the situation that we’re in, and that’s the reason why we bought more at a cheaper price, because of this fear. Going back, AIG, starting in this business, was the champion of the insurance business. A global
enterprise, showing America how you can compete on a worldwide basis. Then you had it trading at five, six times book value, and then you have this tragedy that happens to the company, one step after another. It was Eliot Spitzer and then the recession and then the loss of management and the credit default swap issues. Then the taking of tremendous chunks of value from the company in order to repay the banks. And then the government taking its pound of flesh. A tragedy. line today is two core franchises are intact, Chartis and SunAmerica. The company has a tangible book value of $45 a share, going probably to $55 with the realization of tax-deferred assets, a few other areas. Earnings power of four dollars a share. So we’re buying a company that was started in 1919 by C.V. Starr, at half of book value, that still has a significant franchise. And that’s where we are. It’s not more difficult than that, and it’s a very common model that we’re using for many of our companies. A company, a fixable problem. Fixable problem is covering up all that’s good at the company. When the problem is fixed in total, and you see the normal cash flows of the business in a more normal environment, then it will be obvious to everyone the earnings power and the balance sheet strength of the company, and many of our other companies.
Fred: In the financials, in the banks and in the finance companies, going back to 2008 when you hadn’t invested in them, you actually said you couldn’t know what
they owe, or what they owned, and it was difficult to know who owned them.
But things have changed. Could you specify how that’s happened?
Bruce: Well 2008 was really the beginning. It became obvious to everyone the
significant problems from the real estate markets. We saw it, and Fairholme
was always very financial services-oriented, and we got out of all the financials
and started to watch what was going on. So we waited and waited for the
companies to be recapitalized and restructured. Once they were recapitalized
and restructured, and a couple of years went by, you can get an idea about the
aging of the loans and contracts. Of course, investing is all about what you pay,
what you give versus what you get. The prices just came down tremendously.
So it got to the point where enough time went by where we believed we understood the loans, or we had an idea of a range of expectation and an
understanding of the continued earnings power of the company. Plus they were recapitalized by the government. So sterling balance sheet, continued earnings power. A quantifiable range of what it would take to fix the problems, mostly caused in 2006/2007 mortgages. With time you begin to know it. It’s no different with insurance reserves and other areas. So you have today, a company with a book value of $20, a tangible book value of $12, $13. Earnings power of four dollars a share. And with a stock price seven, seven-and-a-half, wherever it may be.
Fred: Bank of America?
Bruce: Bank of America…it doesn’t get any better when it comes to value investing. Investors tremendously overweight what recently happened to them, because of the pain and suffering that investors went through with the banks, and forget all of history, underweight all of history. Now banks, financials have cycles. We’ve just been through one, we’re finishing one, and we’re about to begin a new cycle for financial services.
Fred: One of the little soap operas in this cycle for us is that two of our portfolio companies are suing each other. Bank of America and MBIA. So some of the shareholders want to know your view of who’s going to win.
Bruce: In fact, there are three; Bank of America, MBIA, and AIG. AIG’s also suing Bank of America over issues. It all gets to representations and warranties, who promised what and what type of promise, what type of warranty. But the reason why we’re on all sides of the fence is enough time has developed where you can see the reserves that the banks have, you can see the receivables that MBIA has, you’ve seen the development of the court cases over a couple of years. Enough time’s gone by where Bank of America will end up owing MBIA some money, and most likely it’s already been reserved for. Even if it isn’t totally reserved for, Bank of America has such a significant cash flow coming in, pre-tax, pre-provisioning of $30 billion, $40 billion, even higher in a more normal environment, it’s not an issue.
Whereas it’s going to be a very big win for MBIA, it will be a significant amount of money for MBIA. This will allow them the capital that they’re going to need to start new business again, especially after they get rid of another issue, which is what they call the transformation, in terms of the banks suing MBIA over the way they’ve changed their legal entities. So that has to get done, everybody has to settle up. You know, there’s a lot of blame to go around for everyone. Banks have the blame, our government had blame, Freddie, Fannie, ACORN, people who actually signed loans and took the loans had a little bit of personal responsibility in there. The concept of home ownership went to an illogical extreme. It went from home ownership is a good idea to everyone should own a home. And that’s what’s led to the disaster, because greed kicked in and so on.
So that’s going to be cleaned up, it’s going to be taken care of. Everyone’s
going to be able to move on and get past this fixable problem. Then MBIA is
going to absolutely be known for being the one guarantee agency that kept its
word. Because unlike rating agencies, MBIA put their money where their
mouth is. So if they guaranteed an issue, then they guarantee the buyers of that
issue that they will take care of the timely payments of interest and principal.
And they have. They’ve spent $5 billion, $6 billion of their money paying
holders of asset-backed bonds without taking into account whether or not they
illegally or erroneously purchased those bonds from the issuer. So they’re
going to fight it out with the issuers as to whether or not they’re owed money,
but they’ve kept their word to the holders of the bonds. When they start to do
new business, people are going to remember that.
Fred: They were there.
Bruce: They were there, and they paid out, unlike the rating agencies which, you know, the ratings went down, but that was it. So it’s been a long process,
there’s probably another year to go.
Fred: That’s a complete answer, but it presupposes that MBIA net, in their suits with Bank of America, is going to win money. That’s our operating assumption?
Bruce: Right. If you take a look at the reserves that Bank of America has for those types of lawsuits, if you look at Bank of America’s settlements with other
monolines and you look at what others have done in the industry to settle, it’s
clearly that money’s going to be passed from Bank of America to MBIA on a net basis.
Fred: But you could have a settlement and have both stocks go up, because it’s good for both?
Bruce: You should, because Wall Street hates uncertainty. What isn’t going to be a big hit for Bank of America, could be a huge one for MBIA. So it clears the
path at Bank of America to move forward, allows MBIA to move forward, and
it takes away a lot of uncertainty. It’s going to be a win for both.
Fred: Moving away from the portfolio, there are a bunch of questions that were Fairholme focused. The first one has to do with turnover in personnel and
people want to know why, and they want to know is that good for the
company?
Bruce: I think it is good for the company. People change, companies change.
Sometimes the needs of the company and the needs of the individual no longer
mesh. The environment changes. Our investment focus changes. At one point
in time we’ll need an expertise in one area, and maybe three years later, we will
not need that expertise. There’s a limited amount of dollars, so we always want
to make sure we have the best people for the best task at-hand. In the end, for
people that have been at Fairholme, I think Fairholme has been better for them
being here. We’re better for having new people come in, too, and that is the
process. It seems to be okay at brokerage firms, at hedge funds, at other places,
but for a mutual fund, there’s this concept that everybody has to stay forever; it just doesn’t make sense to me.
You know, our shareholders deserve the very best people for the current
environment. And that’s what we do, and hopefully our performance shows
that.
Fred: Everyone’s also aware that we had redemptions last year, and they’re focused on knowing did the redemptions hurt our performance?
Bruce: We’re long-term investors, so let’s take this to an illogical extreme. Everyone leaves, I’m the last one left as a shareholder. And I end up with positions that are cheap, with billions of dollars of tax-deferred assets, and a great future. What I am trying to say is that for the long-term shareholder, the amount of redemptions should not matter. Could it potentially cause a lowering of price on a short-term basis? Yes. Do I think it has negatively affected short-term performance? No. I mean, there’s a reason why we had $3 billion of cash that everyone was complaining about, and we utilized that cash for redemptions. We’ve had to take other actions, but we have a more focused portfolio, because of that. So it has been to the long-term good of those of our shareholders who are still here. I still have to prove it, but the next couple of years we’ll know.
Fred: Well, your extreme example is a good segue to another question that came up several times. People want to know if you still have most of your liquid net worth in the funds, and were you buying last year?
Bruce: Yes and yes. All of my family’s liquid net worth is still in the funds and I
pretty much bought every month of the year. So the answer is yes. I mean,
that’s what we do. We buy at X and we go to half X…
Fred: You’re going to buy more.
Bruce: …not to buy more makes no sense.
Fred: Could you review the rationale for the three funds, because people still want to get that clear in their minds.
Bruce: The reason for three funds, well, let’s back up. We had the  Fairholme Fund and it grew and grew and grew. Then we went through the difficult period of 2008 where we had great relative performance, but there were shareholders
who wanted an income-oriented fund. They said I don’t want to leave Fairholme, I don’t want to go somewhere else; why don’t you have an incomeoriented fund? So we created the Focused Income Fund for those shareholders. In fact, it was a good idea because during that difficult period when the credit markets froze up, there were some great fixed-income investments which may not necessarily have been perfect for the Fairholme Fund, but were outstanding for an income fund.
So we created as soon as possible, the next year, the Focused Income Fund.
Then a year later, shareholders were saying, you know, you’ve gotten so big,
you really can’t take advantage of small quantity ideas anymore. It would be
nice if there was a fund to take care of the small quantity ideas that really can
make a big difference to the Fairholme Fund. That’s why we created the
Allocation Fund. That it would be small and we could really make a difference
with small quantity ideas.
So if you look today at the three funds, you will see that we use different parts
of the capital structure, and maybe even derivatives on the capital structure, for each of the funds.
In the case of Bank of America, we’ll have the common equity in the Fairholme Fund where we have warrants on Bank of America in the Allocation
Fund, because it’s a small quantity idea. We would never be able to accumulate enough of it for the Fairholme Fund. We wouldn’t have the liquidity. But for
the Allocation Fund, it makes a lot of sense. Then if you take a look at Sears,
Sears has some great bon ds that are very high-yielding. We’ll use Sears bonds
in the Focused Income Fund, where we’ll have Sears stock in the Fairholme
Fund. Or MBIA, believed to be a great investment, any fund can only have ten
percent of MBIA’s stock or of an issue of MBIA. So that in the case of the
Fairholme Fund, it could never be a very big position, but it could be a very big
position in the Allocation Fund. The bonds of MBIA we have used in the
Focused Income Fund. So we do the work anyway, on a company, up and
down the credit structure, from the bonds, right down to the preferred common equity. We try to utilize it where we can.
Fred: Use it appropriately?
Bruce: If it’s a small quantity idea, it could really make a very big difference for the
Allocation Fund. That’s the reason for the three funds. Every time shareholders have a reasonable suggestion, we’ve tried to act on that suggestion.
Fred: The last question from shareholders is about your time. They want to knowhow do you spend your time, and has that changed much?
Bruce: My time is basically 80-20. Eighty percent on research, ideas, trying to destroy ideas, trying to come up with new ideas. Timely review of existing
investments. And 20 percent on management and other activities. You know,
a few years ago I was on two or three boards. But now I’m on the board of St.
Joe, and people think that the chairmanship of St. Joe is taking up all of my
time. That’s not true. It’s taken up time, it’s been a very valuable experience in
the same way my first directorship on a NYSE company was a very valuable
experience, which I believe will help the funds in terms of what is gained.
At St. Joe, we went in as a shareholder because we wanted to make a
difference. I promised that we would make a difference and then I would be
gone. So today, we have a new board, a new management team. The bleeding
has stopped at St. Joe, the balance sheet has been stabilized. The company is
now in a position where they have the wherewithal to weather whatever the
real estate environment is in the next few years, and to patiently wait for
opportunity. And it’s great. So it’s been unbelievably educational, it’s been
interesting. I think that we’ve done well for the St. Joe shareholders and for
Fairholme shareholders. And when I’m asked, I’ll leave.
Fred: What else can you tell us?
Bruce: Twenty-eleven was a difficult year. It just didn’t make sense. Fundamental values of our companies were improving, but the stock prices were being pummeled. Based upon correlated events, whether it was Europe or just the pain of the past, or very low interest rates. This tells me you have to have a long-term orientation. You can’t follow the crowd, or as we say, you have to ignore the crowd. Just because you’re right doesn’t mean you’re going to be immediately right. The value investor suffers from being a bit early. I mean, we shall see. So all in all, it tells me that given the stress of 2011, I think we have the shareholders who understand what we do. I believe there were those who did not understand what we do, those who chased performance, short-term performance.
Fred: Long gone?
Bruce: They’re long gone. So we have the core shareholder base, with a core group of ideas that keep us in good stead, I think, for the next few years. If it’s anything like a replay of the ’90s that we witnessed, it should be quite good.
Fred: Thanks, Bruce.

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