Bruce Berkowitz Fairholme: Sears, a complex sum-of-parts story

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Bruce Berkowitz Fairholme Capital Management, L.L.C. annual report for the year ended December 31, 2014.

Also see Bruce Berkowitz 2014 Letter To Investors: Fannie, Freddie, BAC, AIG

“(E)ven the intelligent investor is likely to need considerable willpower to keep from following the crowd.” – Benjamin Graham

To the Shareholders and Directors of The Fairholme Allocation Fund:

The Fairholme Allocation Fund (the “Fund” or “FAAFX”) decreased 9.03% versus an increase of 5.97% for the Barclays Capital U.S.

Aggregate Bond Index (the “Barclays Bond Index”) and an increase of 13.69% for the S&P 500 Index (the “S&P 500”), respectively, in 2014. The following table compares the Fund’s unaudited performance (after expenses) with that of the Barclays Bond Index and S&P 500, with dividends and distributions reinvested, for the period that ended December 31, 2014.

Bruce Berkowitz Fairholme: Fannie Mae, Freddie Mac and Imperial Metals responsible for unimpressive 2014 performance

After completing its fourth year, the Fund maintains its lead over the Barclays Bond Index but still trails the S&P 500 since inception. At December 31, 2014, the value of a $10.00 investment in the Fund at its inception was worth $12.47 (calculated by assuming reinvestment of distributions into additional Fund shares) compared to $11.67 and $17.83 for the Barclays Bond Index and the S&P 500, respectively. Despite the Fund’s unimpressive 2014 performance – largely due to second half declines at Fannie Mae, Freddie Mac, and Imperial Metals – our optimism regarding the portfolio’s long-term potential has not dissipated. We believe that the Fund is well positioned to generate positive returns going forward. Such conviction is partially evidenced by the fact that Fairholme Capital Management employees and affiliates (who collectively own over 30% of FAAFX) meaningfully increased their stakes in the Fund during 2014. These contributions, along with those of other existing shareholders, helped the Fund conclude 2014 with assets at a year-end all-time high of $365 million. At December 31, 2014, the Fund is composed of securities from thirteen issuers (76.3%) along with U.S. Treasury Bills and money market funds (23.7%).

Over the course of the year, the Fund took advantage of periodic fluctuations in the price of Sears Holdings (17.6%) to buy more of its common stock. Additionally, the Fund acquired senior unsecured 8% notes due 2019 (5.0%) and warrants expiring in 2019 (2.7%) through participation in the company’s Q4 2014 rights offering as well as opportunistic open market purchases. These newly issued notes yield an attractive 10.6% to maturity, and have rationally rallied to a higher price. Each Sears warrant can be used to purchase one share of common stock at an exercise price of $28.41. The warrants will adjust favorably for any future corporate actions and distributions, and the exercise price is payable either in cash or by surrendering the 8% notes (valued at par) at the holder’s discretion.

Bruce Berkowitz Fairholme: Sears, a complex sum-of-parts story

For years, Sears has remained a complex sum-of-parts story largely misunderstood by traditional retail analysts and business reporters alike. Legions of armchair observers have been fixated on the notion that “Sears, in its present form, is not where America wants to shop.”1 Such readily available conventional wisdom may provide easy fodder for commentators, but those who rely upon this “wisdom” when investing should heed Thomas Edison’s dictum: “There is no expedient to which a man will not resort to avoid the labor of thinking.” Few have the inclination to dig very deep, let alone the willingness to devote a full time analyst – supported by three additional researchers and a small army of third-party consultants with expertise in topics such as advertising and marketing, defined benefit plans, distribution and logistics, real estate valuation and redevelopment, and reinsurance – to cover a single company day in and day out.

Sears’ management has acknowledged that recent performance must improve, and the pace of transformation from a traditional storebased retailer to a membership company offering an integrated retail platform appears to have accelerated. Chairman Lampert has made clear that he will not sit by and burn the furniture; indeed, recent corporate actions (including tax efficient distributions of Lands’ End and Sears Canada) have already created significant shareholder value. Notably, at one point during 2014, the market cap of newly independent Lands’ End almost rivaled the market cap of its former parent Sears Holdings. As part of its ongoing asset reconfiguration, the company recently announced that it is “actively exploring means to monetize a portion of our owned real estate portfolio (potentially in the range of 200 to 300 stores), through a sale-leaseback transaction, with the selected stores to be sold to a newly-formed REIT.” Given our longstanding focus on the company’s vast real estate portfolio (including site visits to over 100 locations in 2014 alone), we believe that any such transaction would be accretive for long-term shareholders.

Bruce Berkowitz Fairholme: Stakes increased in Fannie Mae and Freddie Mac

As with Sears, the Fund’s investments in Fannie Mae (4.5%) and Freddie Mac (5.3%) are not well suited for those lacking patience or courage of conviction. When an adverse ruling by a federal district court judge in late September caused significant price declines in both the preferred and common stock, we used the opportunity to increase the Fund’s existing stake. Despite beltway rhetoric to the contrary, the United States Treasury has already recouped $36 billion more than it disbursed to Fannie and Freddie during the crisis, rendering this our nation’s most successful equity investment ever. In fact, Treasury’s current profit from Fannie and Freddie is almost three times more than it made from all of its other financial rescue programs combined. After such a feat, Treasury’s insistence on prohibiting Fannie and Freddie from prudently rebuilding capital by sweeping all of the companies’ net income to its coffers every quarter would make even Gordon Gekko blush.

By preventing Fannie and Freddie from accumulating any cushion against potential future losses, Treasury is obstructing FHFA’s ability to perform its duties as safety and soundness regulator of both companies. Treasury’s actions are also directly impeding the statutory obligations of the Federal Housing Finance Agency (“FHFA”), as conservator, to “preserve and conserve [their] assets and property.” The status quo of perpetual conservatorship is untenable. Given the dim prospects for comprehensive housing finance reform legislation in the foreseeable future, we believe that FHFA will ultimately heed the pragmatic advice offered by Senate Banking Chairman Tim Johnson on November 19 at a congressional hearing and “engage the Treasury Department in talks to end the conservatorship.” If this Administration fails to do so, it will bear responsibility for having increased taxpayer risk with respect to the companies while impairing the ability of lowerand middle-income Americans to afford a home – perhaps permanently.

The Fund increased its position in Imperial Metals (5.7%) after the company suffered an unexpected breach at the Mount Polley tailings pond in August, halting operations at that site and temporarily delaying the launch of its massive Red Chris mine. Management has responded admirably under stressful conditions, and an October visit by the Fairholme Research team confirmed that they are prepared to re-commence normal operations. We look forward to the ribbon cutting ceremony for their flagship copper/gold project at Red Chris in the near future.

The Fund’s portfolio of double-ratchet TARP warrants continues to perform well, with Bank of America (10.8%), Wells Fargo (7.4%), JPMorgan (4.1%), AIG (3.4%), and Lincoln National (2.5%) all gaining over the course of the year. The prospect of meaningful capital distributions gives these unique warrants plenty more room to run. The healing process is now entering a new phase, as the companies have begun to responsibly flex their financial muscles, taking advantage of improved economic fundamentals to generate substantial value for their shareholders.

The Fund’s cash position remains above its historical average of 17.5%, leaving us well equipped to capitalize on select market opportunities in the months ahead.

Respectfully submitted,

Bruce R. Berkowitz

Managing Member

Fairholme Capital Management

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