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.
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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, they survive. What investors are not focusing on is the inherent earnings power of the institutions. Bank of America, today, in this environment, makes $36 billion a year of pretax, pre-provision, so $36 billion before they have to pay taxes, which they won’t be paying for many years because of the last few years, and before they allocate money to bad loans, reserves, for whatever. So that’s $36 billion a year to add to any problems or issues. I talk to guys who get divorced, they feel like half their money is gone. I say it’s just a delay of game.
CONSUELO MACK: I’m sure they take that advice with a grain of salt. But let me ask you, because the last time I talked to you about your investments in financials, over a year ago, you said that the biggest risk to your position, and you just mentioned it, would be the correlation risk, and that they all don’t do well because of, let’s say, a double dip in the U.S. Now, we have people like Martin Feldstein saying that we’re going into a recession. We have the Chairman of a major bank in Germany saying basically that the European debt crisis essentially represents the equivalent of a Lehman Brothers. How do you assess the correlation risk now?
BRUCE BERKOWITZ: In really tough times, everything’s correlated except for cash, one. Two, everyone’s already assumed that we’re back in a recession. The price reflects it. I mean, literally the banks can shut their doors, stop doing business, run off the business that they have, and make more money than the stock price. So, and that can happen in a recession. And if you think about the human nature, after you– banks made so many bad loans in 2007, 2008; the loans that they’ve made in 2009, 2010, this year, it’s unbelievable. Everyone complains on how tough it is to get a loan because they’ve gone from no documentation to unbelievable documentation. But it’s the nature. And if you stop growing, the financial institution stops growing, the cash comes piling in the front door. So these fears about not having enough capital, aren’t able to– not have the reserves to pay for the past, they’re just, they’re unfounded. And even if times stretch out and get worse, the earnings power, a fundamental earnings power of the institutions, which will allow them to more than just survive.
CONSUELO MACK: There’s been a change in your portfolio mix, again, since I talked to you over a year ago. And one of the biggest changes is that in your asset mix, a year ago you had a sixth of the Fairholme Fund was in cash equivalents. Now it’s down to under two percent.
BRUCE BERKOWITZ: It’s not two percent, but it’s single digits.
CONSUELO MACK: It’s single digits.
BRUCE BERKOWITZ: Yeah, mid-single digits.
CONSUELO MACK: But you also had, I guess, about a sixth was in fixed income securities as well. So, at that time you told me, you know, we have billions of dollars in cash in the Fairholme Fund, ready to take advantage of whatever further stresses may come our way. So what happened to all of that cash, number one, in the last year?
BRUCE BERKOWITZ: Well, we’ve used it for further investments in AIG, and others. And we used it for redemptions.
CONSUELO MACK: You’ve always talked about cash as being your financial valium.
BRUCE BERKOWITZ: Right.
CONSUELO MACK: And that it gives you the kind of flexibility. So you have less financial valium now.
BRUCE BERKOWITZ: Correct. But at some point in a business cycle, one has to get greedy. And the time to get greedy is when everybody’s running for the hills with fear, that usually is a great time to get the greed going. And we’ve become greedy- less cash, more concentrated investments, bigger percentage of investments. Because my definition of skill is knowing when you’re lucky and taking advantage of that luck, and we’re very lucky right now. We have financial institutions that are so cheap I would not, I did not think I would see again in my lifetime, since the early 1990s. They have stronger balance sheets than they’ve ever had.
CONSUELO MACK: When you see stocks that you hold, the Bank of Americas, the Citigroups, the Goldman Sachs, whatever, AIGs that are down, you know, 30, 40%, you know, and I’m just talking about year to date. That, to you, is an opportunity to get greedy. It’s not a reason to flee, sell–
BRUCE BERKOWITZ: Yes, right. No, you don’t want to be in denial so you take out your checklist of the 500 aspects you look at with a company and try and understand, you know, you go through it all again and then you try and understand why the market is behaving the way it is, trying to find out where the differences are between perception and reality. You go through it all again, so you don’t want to go into denial, so you want to recheck all of your work. But at that point, if you can’t kill it, you have to have the courage of your conviction. That’s what you’re getting paid for. This is the time when I really earn my money.
CONSUELO MACK: But one of the things that you told me a year ago, and this is a quote, you know, the worst situation is if you’re backed into a corner and you can’t get out of it, whether for illiquidity reasons, shareholders may need money, we’re talking about redemptions; if you have an investment that is usual, you’re a little early and you are early in the financial stocks, I think …
BRUCE BERKOWITZ: A little early, that’s kind of you.
CONSUELO MACK: And you don’t have the money to buy more or you don’t have the flexibility, that’s a nightmare scenario. Great investors never run out of cash. We always want to have a lot of cash. So, you know, how close are you to your nightmare scenario? That’s my question.
BRUCE BERKOWITZ: About five percent from the nightmare scenario of not having the cash for redemptions. But you change. You look at your positions, you want to be in liquid positions, that high trading, where if you need it to cut some of your positions, you would have the liquidity to do it. And it changes. There are correlations between the size of the portfolio, the value portfolio and the cash you need, and where you believe you are in the cycle. If you think you’re bouncing around the bottom, and you’ve already paid the price for having courage of your convictions, then I don’t think we need to have the cash around that we do and–
CONSUELO MACK: So do you think that we are bouncing around the bottom and that you have paid the price, essentially, for the courage of your convictions? And it takes a lot of courage.
BRUCE BERKOWITZ: Well, if I’m wrong, I don’t deserve to be in business, in this business, because everything I look at tells me that the financial companies that we’ve invested in are extremely cheap, below their book values, below their tangible book values, below their liquidation values. The trends are getting better. The balance sheets are strong. I don’t know what more investors want. There’s a fear of the future, but I don’t understand the math that’s being applied to the forecast of the future. I’ve never been that good at the future, but I do know that that fear is reflected in what you’re paying for a share of Bank of America or Citigroup or whatever.
CONSUELO MACK: So let me ask you about some of your major holdings, because in a letter dated February of 2000, that you recently resent to clients, you said, “Concentrated investing implies less risk of permanent loss as long as you maintain superior knowledge about the companies you own.” So, among the most controversial positions that you own, Bank of America, for instance, which has been very much in the news, what don’t the naysayers understand about Bank of America that you and Warren Buffett do?
BRUCE BERKOWITZ: I think the naysayers just don’t believe what Bank of America is saying. They believe that Bank of America is fibbing about the numbers, about the trends, about the strategy, about the model, about their ability to– I don’t know. It’s asking me to analyze something which doesn’t exist, which is very tough, and that can take on a whole life of its own. But the good news about that is that’s what gives you a price of around $7 a share for a company that could potentially earn $3 a share. Now, there aren’t many times in life you can buy a storied franchise that touches one out of every two people in the United States at two and a half times what you expect their earnings are going to be in a more normal time. Now, I don’t know how it gets better than that.
CONSUELO MACK: So let’s talk about AIG.
BRUCE BERKOWITZ: I mean AIG was roughly treated, where the government took 87%. They didn’t take 87% of other financial institutions.
CONSUELO MACK: And they still own …
BRUCE BERKOWITZ: And owns 77% and they’ll make money and their cost– they’re a little underwater, but AIG’s tangible book value, and if you want to think about tangible book as a liquidation value, especially with an insurance company, it’s less than 50 cents on the dollar, so you’re picking up dollar bills for less than 50 cents. Storied franchise- I mean AIG still has a great name around the world and people may be disgusted with it to some extent. Investors have lost money. But with a one for 20 reverse split, you know, in the old days AIG hit over $100 a share and the equivalent today, it’s trading about $1.25. So it’s 98% plus down. Yes, they’ve had to sell some bits and pieces, but the balance sheet is stronger. The two businesses that caused the issues were relatively small part of the company. They’re closed out.
CONSUELO MACK: And so your sense of AIG’s position today is what?
BRUCE BERKOWITZ: I think it’s much stronger leadership with Bob Benmosche, new leadership at Chartis, a much stronger balance sheet, huge assets, great tangible book value, great equity, huge deferred tax asset, which isn’t even on their books. I mean like Citigroup, this is the case with Bank of America, AIG will not be paying taxes for many years given the previous losses. So, nope, past shareholders have paid the price. They’ll never recover from where they bought stock; new management, company has paid the prices. So there is a 70% overhang and a lot of investors won’t go near the stock until that overhang disappears, waiting for the government to get out, thinking that the government will make a very bad deal. But, you know, you take that to an illogical extreme. Does that mean you wouldn’t buy the stock at 20 or ten? Five? A dollar? You still wait for the government to get out? So at some point, not knowing exactly how the government is going to get out and what’s going to happen to those shares, I have to look at the balance sheet of the company, the earnings power of the company, what I believe the company is capable of earning or growing, and what they’re doing and what they’re selling and put it all together- the good, the bad, the ugly- and then look at the price where the company is trading and make a decision as to whether or not this institution can be permanently killed, which the case is no, and whether or not at that price, there’s a sufficient margin of safety to not loose any money and hopefully make a reasonable return for shareholders.
CONSUELO MACK: One Investment for long-term diversified portfolio that all of us should own some of?
BRUCE BERKOWITZ: It has to be Bank of America.
CONSUELO MACK: It does?
BRUCE BERKOWITZ: Everybody can read all about it in the newspapers everyday on TV. You can read every known conceivable negative known to mankind and press all around the world and blogs and whatever you want to read, the most extreme negatives. But you have to balance the positives, as we have discussed. And if I’m right, Bank of America has a $20 book value. In the next ten years I could see them easily doubling their book to $40 and paying out a very nice dividend yield, so you would eventually have, in my opinion, a double-digit dividend yield, fabulous appreciation in a bank that will be considered an extremely safe investment.
CONSUELO MACK: So Bruce, one other question: last time you were on WealthTrack, again- after winning Morningstar’s Fund Manger of the Decade Award, I might add- I’m going to quote you. You told me that: “What worries me is knowing that it is usually a person’s last investment idea that kills them. As you get bigger you put more into your investments and that last idea, which may be bad, will end up losing more than you’ve made over a decade. That is why, if you look at the fund today, to me…” this was over a year ago …
BRUCE BERKOWITZ: Right.
CONSUELO MACK: “…it looks more conservatively positioned than it’s ever been. We’re two thirds invested in equities today, not a kamikaze strategy.” You are no longer two thirds invested in equities. You’ve got a much higher percentage of equities, a much smaller percentage of cash. So, I mean is this not a kamikaze strategy? I mean what, if the financials fail, or if this strategy does not work out, haven’t you really bet it all, bet the ranch?
BRUCE BERKOWITZ: I think you have to– it’s a question on how you position the argument. If the financials fail, the United States’ financial system has failed, and capitalism as we know it has failed, and we have a lot of bigger issues, and I don’t see that happening. We’re not a leveraged institution. We still have cash. We’re not dependent upon anyone for money. Our biggest risk in terms of that cash would be if shareholders can continue to leave, take money out. If they do, we have significant positions that can be trimmed down on a pro-rata basis so that the remaining shareholders do not get affected. And it’s just a question of time, and we want to try and position the portfolio so the longer it takes, the more the remaining shareholders will prosper.
CONSUELO MACK: And the remaining shareholders include the Berkowitz family, because you are invested heavily in your funds.
BRUCE BERKOWITZ: Right. You can’t be 100 percent positive about anything. That’s– to have a fanatical belief would be a mistake. So, by having all the family money into these positions, it’s a safety check. No one wants to throw out 30 years of hard work, so why would you possibly want to risk that which you may need for that which you don’t need? So it’s a safety check and puts me squarely in the shoes of shareholders, and it allows me to feel the joy and pain of our shareholders. And it’s been six months. In February I was a hero, now I’m a bum. So, we’ll see six months from now. Revenge should be sweet.
CONSUELO MACK: I’m sure you can hardly wait for that revenge.
BRUCE BERKOWITZ: Then I’ll be upset that I didn’t buy more at such low prices and how could I have been so stupid?
CONSUELO MACK: So Bruce Berkowitz, Fairholme Fund, who continues to ignore the crowd, for better or for worse short term at any rate, and hopefully, long term it will turn out to be for the better. Thanks very much for joining us.
BRUCE BERKOWITZ: Thank you.
CONSUELO MACK: The motto, “ignore the crowd” isn’t just for professional value investors like Bruce Berkowitz. It also applies to individual investors in mutual funds, which leads me to this week’s Action Point. It is: stay with your favorite mutual funds during down periods. Third generation value fund investor Chris Davis of the Davis Funds sent me this graphic. It shows that underperformance is inevitable, even from top performing managers. During the last decade, 94% of the top quarter of large cap equity fund managers have fallen into the bottom half of their peers at least once during the decade for a three year period; 63% hit the bottom quarter for three years; and 30% the bottom ten percent. As we have said many times on WealthTrack, there is a reason individual investors consistently underperform the mutual funds they invest in. They buy high, when performance is great, and sell low, when performance is poor.
Next week, we’re going to bring you a rare interview with a Financial Thought Leader and one of Wall Street’s top ranked strategists- Francois Trahan will explain why he believes the old economic models are broken and why safety is the best strategy for investors for the rest of the year.
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