Bruce Berkowitz’s Fairholme Focused Income Fund commentary for the first half year ended June 30, 2015.
To the Shareholders and Directors of The Fairholme Focused Income Fund:
The Fairholme Focused Income Fund (the “Fund” or “FOCIX”) increased 5.05%, versus a decrease of 0.10% for the Barclays Capital U.S. Aggregate Bond Index (the “Barclays Bond Index”), for the six-month period that ended June 30, 2015. Since inception, the Fund increased 53.05% versus 24.18% for the Barclays Bond Index. The following table compares the Fund’s unaudited performance (after expenses) with that of the Barclays Bond Index, with dividends and distributions reinvested, for various periods ending June 30, 2015.
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At June 30, 2015, the value of a $10.00 investment in the Fairholme Focused Income Fund at its inception was worth $15.30 (calculated by assuming reinvestment of distributions into additional Fund shares) compared to $12.42 for the Barclays Bond Index. FOCIX returned 2.2 times more than the Barclays Bond Index on a $10.00 investment since inception. Of the $15.30, the share price (net asset value per share) was $10.72 and the value of distributions reinvested was $4.58. This difference, more than anything, demonstrates how the Fund has outperformed the market (as represented by the Barclays Bond Index) over the period shown.
Fairholme Focused Income Fund performance driven by Sears Holdings
The Fairholme Focused Income Fund’s positive performance in the first half of 2015 was largely driven by price appreciation in our largest position – Sears Holdings Corporation 6.625% senior secured notes. At June 30, 2015, giving effect to the exercise of all rights for Seritage Growth Properties, the Fund is composed of securities from 11 issuers (82.3%) along with U.S. Treasury Bills and money market funds (16.7%). We believe that the Fund’s barbell strategy – high-yielding securities of companies that we understand well coupled with a sizable cash buffer – continues to prove its mettle. We estimate that an instantaneous 100 basis point increase in interest rates may reduce the fair market value of the portfolio securities by 3.3% (approximately 8 months of interest). This includes the Fairholme Focused Income Fund’s recent acquisition of Seritage Growth Properties common stock, a long duration investment that benefits from economic growth and inflation – two factors that may drive interest yields higher over time. The duration of the portfolio’s fixed income and preferred securities, excluding Seritage common, is just 2.3%, less than half the entire portfolio’s yield-to-maturity of 5.2%. Either way, we believe the portfolio is well positioned for a higher interest rate environment, particularly when considering factors such as the current shape of the bond yield curve and a risk-free rate hovering around zero.
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Sears Holdings (30.0% of the Fund portfolio) continued to demonstrate its financial flexibility in 2015 by completing a separation transaction of 235 properties, plus joint venture interests in 31 additional properties, for $3.1 billion in cash proceeds. The company’s bonds rose on the news, as unsubstantiated fears of a liquidity crisis subsided and fixed income analysts upgraded the notes to “Market Weight.” Seritage Growth Properties (4.3% of the Fund portfolio), a newly formed real estate investment trust that began trading this month, purchased the 266 properties and disclosed its intention to reconfigure or redevelop a substantial portion of the locations in order to generate additional operating income. We believe that as Seritage recaptures and repurposes the excess Sears and Kmart real estate and recycles the below-market rents into new rents, the company will deliver an above-average long-term return including dividend growth.
Imperial Metals Corporation 7.0% senior unsecured notes due 2019 (22.5% of the Fund portfolio) have benefited from positive developments over the last few months. The company recently received a final permit to operate its tailings storage facility at the flagship Red Chris Mine – another important milestone. We observed the mill running at capacity during our site visit in May, and expect Imperial to focus attention on increasing recovery rates and improving profitability. In addition, the company received a permit earlier this month to partially recommence operations at Mount Polley, which should help the company generate additional cash flow.
For seven years, Fannie Mae and Freddie Mac (5.3% and 5.2% of the Fund portfolio, respectively) have been held against their will in a perpetual conservatorship that has dramatically exceeded its mandate and, perversely, only serves to harm their safety and soundness. Every three months the proverbial cash register at each of these mortgage insurers is looted by a repeat offender – the United States Treasury – unlawfully claiming entitlement to all of Fannie and Freddie’s profits in perpetuity while disclaiming any allegations that it has effected the largest nationalization in American history. One need not be a legal scholar to recognize that this illicit scheme is antithetical to the basic notion of a C-O-N-S-E-R-V-A-T-O-R-S-H-I-P. While the progress that litigants are making before the third branch of government is not being reflected in recent prices of Fannie and Freddie preferred securities, we remain cognizant of Mr. Market’s propensity for sudden mood swings.
Chesapeake Energy preferred stock (1.6% of the Fund portfolio) has underperformed this year due to lower commodity prices and a leveraged balance sheet. We believe that management will navigate through the current operating environment, which may allow incremental purchases bearing double-digit interest yields for the Fund.
Two floating-rate perpetual preferred stocks were replaced with intermediate-term corporate bonds issued by HRG Group and Jefferies Financial (0.8% and 2.3% of the Fund portfolio, respectively). We believe that both have adequate asset coverage and carry current yields exceeding 7.5%.
Most recently, the Fairholme Focused Income Fund acquired HomeFed Corporation 6.50% senior unsecured notes due 2018 (4.6% of the Fund portfolio) through a private placement offering. HomeFed invests and develops residential and commercial real estate properties across the country. We have followed the company’s evolution for years, including its acquisition of Leucadia’s real estate properties in 2014. Given HomeFed’s strong balance sheet and valuable underlying assets, we believe these limited duration notes sporting a yield-to-maturity of 6.9% have solid potential.
The Fairholme Focused Income Fund reopened to new investors in March 2015, and we intend to continue scanning the horizon for opportunities to selectively deploy capital.
Bruce R. Berkowitz
Chief Investment Officer
Fairholme Capital Management
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