Value Investing

Berkowitz: On Fannie Mae “I expect further gains from any Trump Administration-led initiative”

From Bruce Berkowitz’ 2017 letter to investors

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Dear Shareholders and Directors of Fairholme Funds, Inc.:
This past year did not go as planned for Fairholme Funds shareholders. Although markets reached new highs in 2017, there was not much to celebrate as the securities of Sears Holdings Corporation (“Sears”) and Sears Canada wrecked the Funds’ performance. Sears realized billionsof dollars from asset sales, as we predicted, but I did not foresee the operating losses that have significantly reduced values. Getting the asset values largely correct, but missing the company’s inability to stop retailing losses, has been hugely frustrating and fatiguing for me to watch. Today Sears is a much diminished position and nowhere as relevant to our financial position.

Our history since inception demonstrates that holding tight amid disappointing performance often pays. This has been the case for as long as I have run Fairholme Capital Management (“Fairholme”). On numerous occasions, long periods have elapsed before prices have matched our estimates, and I will discuss below some of the driving forces that can make this happen again. Before elaborating, I’d like you to know that Fairholme-related entities own 8.2% of The Fairholme Fund, 20.1% of The Income Fund, and 43.7% of The Allocation Fund. My family is the largest shareholder in each. I eat my own cooking and I feel the same recent disappointments as you, but I also want to share my strong belief in future outperformance. One final point: You may have already seen that effective January 1, 2018, Fairholme has voluntarily waived its annual management fees to 80 basis points.1 We have done this in recognition of the elevated levels of cash and cash equivalents currently held in the Funds’ portfolios as we await attractively priced investment opportunities.

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Fannie Mae and Freddie Mac:
Fannie and Freddie have helped tens of millions of Americans secure affordable, predictable mortgages to help achieve the dream of financial independence while operating under the conservatorship of the Federal Housing Finance Agency (“FHFA”). Since 2012, Fannie and Freddie have shipped the entirety of their profits—$275 billion and counting—to the U.S. Treasury. You’ve heard this all before. The point is, with hundreds of billions in profits flowing to the federal government, there is no doubt about Fannie and Freddie’s earnings power or their ability to serve the public and survive. That is why reform is coming. In a letter to the Senate this month, FHFA Director Mel Watt re-emphasized that “ongoing conservatorship is not sustainable and needs to end.” He believes Fannie and Freddie should be public utilities with regulated rates of return. We agree. Treasury Secretary Steve Mnuchin tells us 2018 is the year for Fannie and Freddie reform. “We need to fix Fannie and Freddie,” Mnuchin said in September. “[…] we’re going to fix [them] and when we fix [them] we want to make sure we never put the taxpayers at risk.” We also agree Fannie and Freddie must be returned to their private owners. So far, the Funds have realized $140 million of gains from Fannie and Freddie investments over the past four years. I would expect further gains from any Trump Administration-led initiative.

 

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And

After eight long years of cover-ups, bald-faced lies, and judicial obstruction, the government has finally released thousands of documents demonstrating that the Obama Administration created false pretenses to unlawfully siphon tens of billions of corporate cash from Fannie Mae and Freddie Mac. These documents clearly demonstrate that senior government officials knew the GSEs were on the verge of sustained profitability and took actions to usurp all of those profits. Indeed, the documents reveal that these officials lied to the public and perjured themselves in federal courts. The so-called “Net Worth Sweep” was unnecessary to prevent a “downward spiral.” Put simply, we now have unambiguous evidence that the Obama varsity team knew what their statutory authorities were, willfully exceeded those authorities to steal billions of dollars from investors, and subsequently engaged in a cover-up to hide their wrongdoing.

When you follow the cash, it’s easy to see that Fannie and Freddie have generated hundreds of billions in profits, taxes, and consumer savings.
Each held tens of billions of tangible value and maintained tens of billions in earnings power – even at the worst point of The Great Recession.

Each had the wherewithal to pay all bills and pursue its stated mission of providing liquidity when all others cannot.

Federal agencies continue to defend contrived accounting gimmicks by arguing that they followed the law and, notwithstanding, they are above it. As more and more documents are released, the Department of Justice will see that the actions undertaken by former officials undermine their defenses and long-established laws. Fannie and Freddie can safely return to their role of insuring the uniquely American housing finance system against catastrophic risk with private capital. There is a proven blueprint to succeed, and we hope to successfully resolve this matter before reaching the Supreme Court of the United States.
After all, capital markets are based on the sanctity of contracts – the original buyers’ and sellers’ expectations and rights travel with a contract no matter who holds it. When this saga ends, we expect contracts to be honored and substantial value for all stakeholders.

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Sears, et al.
From the ashes of failed retailers often come great real estate companies. Malls and shopping centers are not in permanent decline. Sears spin-off, Seritage Growth Properties, has re-tenanted over three million square feet at more than three times old rents since 2015, and demand continues to grow. Investors may disagree on the exact path forward for Sears, but the company owns many valuable assets and there is huge value in optimizing all of them. In the first half of the year, Sears sold the Craftsman name for a net present value of $900 million. Real estate sales added another $400 million. Sears remains extremely competitive in all aspects of hardline retail. Company vendors are estimated to earn $5 billion annually from relationships with Sears. There is no reason why Sears cannot share in this success and monetize assets through innovative partnering.
Sears continues to accelerate the pace of its operational restructurings, and is heading toward $1.25 billion in annualized cost savings. The news that Amazon is now offering Kenmore appliances with Sears’ white-glove delivery, warranty, and installation services greatly improves the competitive landscape for both. In addition, “Shop Your Way” already has millions of members enjoying a simple, easy, and personalized shopping experience. If you want to learn more about the Shop Your Way program, visit the following link: www.shopyourway.com/fairholme/getmore.

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Seritage Growth Properties:
Seritage is a simple redevelopment story clouded by a complex tenant relationship with Sears. Seritage owns 40 million square feet of retail space and surrounding parking lots; Sears occupies 75% of its retail space. When Sears closes stores at Seritage locations, the real estate is re-rented at market rates three times higher to tenants such as Whole Foods and Nordstrom Rack. Proportionally higher cash distributions to owners then follow. I believe this opportunity to recapture valuable real estate is why Warren Buffett personally became one of the largest shareholders of Seritage.

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