Bruce Berkowitz’s Fairholme Fund commentary for the first half year ended June 30, 2015.
To the Shareholders and the Directors of The Fairholme Fund:
The Fairholme Fund (the “Fund” or “FAIRX”) decreased 0.91% versus a 1.23% gain for the S&P 500 Index (the “S&P 500”) for the six-month period that ended June 30, 2015. The following table compares the Fund’s unaudited performance (after expenses) with that of the S&P 500, with dividends and distributions reinvested, for various periods ending June 30, 2015.
At June 30, 2015, the value of a $10,000 investment in the Fund at its inception was worth $53,107 (calculated by assuming reinvestment of distributions into additional Fund shares) compared to $18,952 for the S&P 500. Of the $53,107, the value of distributions reinvested was $18,347.
The potential advantages of the Fund’s long-term focused investment approach are most evident when evaluating performance over any consecutive 5-year period since the inception of FAIRX. The Fund has achieved 123 positive 5-year return periods and only 4 negative 5-year return periods, compared with 100 positive 5-year return periods and 27 negative 5-year return periods for the S&P 500. The Fund’s average rolling 5-year return was 70.70% versus 35.09% for the S&P 500. The Fund has outperformed the S&P 500 in 96 of 127 5-year periods, calculated after each month’s end. The Fund’s worst 5-year-period return was (6.89)% versus (29.05)% for the S&P 500. In its best 5-year period, the Fund’s return was 185.26% versus the S&P 500’s best return of 181.57%.
Bruce Berkowitz’s Fairholme Fund – Portfolio Review
AIG is our biggest winner (common and warrants comprise 29.6% of the Fund portfolio), as our remaining stake has almost tripled from the Fund’s average purchase price. Book value grew 12% year-over-year, and the company’s equity-to-assets now exceeds 20%. Fewer adverse developments from past business, reduced operating expenses, and common stock buybacks should allow the opportunity for double-digit growth to continue toward and potentially surpass book value per share.
The same should be true for Bank of America (20.6% of the Fund portfolio), which today has over $250 billion in shareholder’s equity – more than any other company in any industry in the United States. A focus on growing revenues while reducing operating costs (particularly litigation-related expenses) should result in rising profitability. With a Tier 1 capital ratio well above stringent regulatory requirements and “global excess liquidity sources” that would sustain operations for 40 months, Bank of America has regained the financial strength to support much higher earnings, yet its stock price also remains below book value.
The market price of Sears Holdings (7.1% of the Fund portfolio) reflects intense skepticism about the company’s net assets and ability to transform its operating business. Since the Fund initiated its investment, Sears has distributed $31.85 to its shareholders via spin-offs and other corporate actions. Most recently, Sears sold 235 properties, plus joint venture interests in 31 additional properties, for $3.1 billion in cash proceeds. While the market is still digesting the facts associated with this recent separation transaction, our updated sum-of-the-parts valuation exceeds $125 per share fully diluted, net of debt. We expect the company’s focus on “profitability instead of revenues” to result in operational efficiencies, expense reductions, and gross margin improvement.
Recently, one CNBC television personality highlighted the real estate assets of Macy’s and Ethan Allen and challenged his own “pedestrian” focus on retail sales performance: “Instead of looking at the earnings per share and the estimates . . . [look] at the more valuable real estate underneath . . . Never going to look at [them] the same way . . . !” It remains unclear why he and others are not willing to apply that same logic to Sears.
The Fund’s latest investment is Seritage Growth Properties (1.4% of the Fund portfolio), a newly formed real estate investment trust that purchased the 266 properties from Sears and began trading this month. Seritage and its joint venture partners – GGP, Macerich, and Simon Property Group – intend to reconfigure or redevelop a substantial portion of the properties acquired in order to generate additional operating income and diversify the tenant mix. A recent analyst report noted that “the demographic profile of the [Seritage] owned portfolio is surprisingly good, with 10-mile density and incomes of 692k and $77k, respectively, slightly better than the mall REIT portfolio averages of 680k and $77k.” We are bullish also based upon our independent assessment of real estate values, recent transaction data, and expected dividend increases as the company repositions properties to command higher rents from new tenants.
The St. Joe Company (6.7% of the Fund portfolio) recently announced that it received final approval from state and local agencies for its 110,000-acre Bay-Walton Sector Plan, with 170,000 residential units and more than 22 million square feet of retail, commercial, and industrial development. We believe that the company’s nearly $700 million in cash will enable it to implement the Sector Plan over time and simultaneously allocate the excess capital.
Bruce Berkowitz’s Fairholme Fund – Ownership of Fannie Mae and Freddie Mac preferred stock
Today, shareholders of The Fairholme Fund collectively own $3.4 billion liquidation value of Fannie Mae and Freddie Mac preferred stock. That means each shareholder effectively owns approximately $25,000 (on average) of two of the most profitable franchises in America.
Yet for reasons that are not entirely understood, some in government apparently want their friends in the mortgage-industrial complex to take for free what you, the shareholders of these companies, paid for with cash. So we continue to search for the truth:
- Why did federal regulators design a financial support program for Fannie and Freddie on the basis of academic estimates of future performance rather than tried and true statutory accounting and claims-paying ability (which is the standard for all regulated mortgage insurers)?
- Why did federal regulators require Fannie and Freddie, while in conservatorship, to purchase $40 billion per month in underperforming junk bonds from competitors?
- Why did federal regulators force Fannie and Freddie, while in conservatorship, to participate in Treasury’s Home Affordable Modification Program (HAMP) and Home Affordable Refinance Program (HARP), which resulted in more than $46 billion of losses that the companies would not have otherwise incurred?
- Why did mortgage-backed securities issued by Fannie and Freddie perform dramatically better than private label securities issued by big banks throughout the financial crisis?
- Why did federal regulators settle litigation cases initiated by Fannie and Freddie against major financial institutions for significantly less than what other similarly situated plaintiffs recovered?
- Why did federal regulators seize more than $18 billion in litigation proceeds recovered by Fannie and Freddie to date?
- Why did federal regulators order Fannie and Freddie to delist their securities from the New York Stock Exchange in 2010?
- Why did federal regulators prohibit Fannie Mae from selling $3 billion of Low Income Housing Tax Credits to third-party investors?
- Why were Fannie and Freddie, while in conservatorship, forced to divert billions of dollars in guaranty fees to Treasury to offset the cost of a payroll tax cut?
- Why did FHFA, as conservator, force Fannie and Freddie to gift all of their capital and all future earnings