Bruce Berkowitz has said that his deep value and contrarian investing style will not guarantee short-term results, but he promises his shareholders will be rewarded for their patience over the long term. Last week, he explained why some of his positions – especially those in the financial services sector – are among the best opportunities in the market.
Berkowitz was named Morningstar’s US Fund Manager of the Decade for the period 2000-2010, as his flagship Fairholme Fund outperformed virtually all of its peers. This year has been a different story, though, as his fund has lost 7.76%, a disappointing mirror of the 7.70% gain the market as a whole has experienced.
In a keynote presentation at Morningstar’s Investment Conference on Thursday, moderated by Don Phillips, Berkowitz defended his holdings in firms such as AIG, Bank of America and MBIA, and he responded to a number of now-common criticisms of Fairholme. Berkowitz moved to put skeptics at ease over Fairholme’s unorthodox structure and business model, and he denied charges that the firm’s rapid growth has made it too large to maintain its culture and investment style.
“Ignore the crowd”
Fairholme has always sought to “ignore the crowd,” Berkowitz stressed. Indeed, that is his firm’s tag line, and he described how he has organized his firm in a unique and distinctive manner.
Berkowitz said he relies on a small internal staff and hires consultants for industry analysis to minimize the deleterious effects of groupthink at the company, and in doing so ultimately saves shareholders money. Instead of relying on in-house “experts,” whose expertise can become irrelevant at any time, Fairholme’s heavy use of consultants eliminates the need to retraining periodically useless employees. This hire-as-needed strategy also gives the firm flexibility to seek out the top minds for whatever problem Fairholme needs clarified.
The small size of Fairholme’s staff is not without precedent in the financial industry, Berkowitz further noted. In fact, it is very common among hedge funds, and even Warren Buffet operates in Omaha with a minimal set of permanent personnel. In Berkowitz’s estimation, Fairholme is wisely ignoring the popular wisdom of the modern mutual fund industry in order to follow a more sensible path, one already trod by respected financial leaders.
Fairholme continues to break the mold for large mutual fund companies in other ways, investing much more boldly than most large funds tend to. Protesting the charge that Fairholme has gotten complacent since its successes in the old days, Berkowitz pointed to the Allocation Fund (FAAFX) that Fairholme recently established in order to retain its freedom to act on ideas that require smaller investments.
Berkowitz sees Fairholme’s larger scale as a positive development. Scale gives investment companies a degree of influence that is often necessary to properly manage their assets, he said. Without the power of scale, according to Berkowitz, Fairholme would have been incapable of taking an active role in its investment in AIG (although he noted the jury is still out on the value of that move). Furthermore, scale helps to minimize the relative costs of labor, such as legal fees, Berkowitz said.
Fairholme learned early on to protect itself against groupthink. Berkowitz established his value-oriented fund at the height of the tech bubble in the ’90s, and he subsequently refused to enter into the speculative frenzy that emerged. Berkowitz estimated that this position lost him a third of his customers, but he was well situated when the bubble popped.
Contrarianism is key to Berkowitz’s investment strategy. Popular thought quickly devolves into hype and hysteria, sometimes causing the overvaluation of companies like those Berkowitz managed to avoid during the tech craze, sometimes causing similar undervaluation. Berkowitz firmly believes that today’s financial services industry has been hit by the latter effect.
Strong fundamentals in the financial services industry
While some may hold that large financials are too convoluted and opaque to properly analyze for investment, Berkowitz said that the time and capital he has committed to researching these large institutions justifies his confidence in their quality. Once again, he believes that a proper analysis of these complex organizations in their fine details contradicts the pessimistic common view of them. The public, Berkowitz said, is shy on financials because of the personal traumas many of us endured during the financial crisis.
Bank of America is one such “Evil Empire” (as he put it) that Berkowitz thinks is less guilty than popular wisdom holds. In his address, he cited Bank of America’s early response to the mortgage crisis, calling the company “ahead of the curve in reform.” He pointed out that the national attitude towards homeownership was at least as responsible for the crisis as the banks were.
Berkowitz said that unfair appraisal of banks has characterized investors as well, and he sees a great opportunity to step in. As an example, Berkowitz pointed to the fact that Goldman Sachs is now trading below tangible book value. That’s still “expensive compared to some of our other positions,” he said.
The points against bank stocks, namely their complexity and the lost value of their real estate loans, have been overly emphasized to the point where important mitigating factors are being ignored, Berkowitz argued. Not only is Bank of America generating $4.50 to $5.00 per share in cash before provisions and taxes, but the company will have no need to pay taxes at all for years to come, thanks to its massive losses during the financial crisis. Berkowitz noted that it would take only a 1% return on assets to generate a return on tangible equity of at least 15% for a $12 stock. “If you could buy that for half of book value, what else do you have to do in this life?”
Other unorthodox investments
Mutual funds cannot invest directly in real estate, and Berkowitz has instead taken a large stake in St. Joe Company, a real estate developer in Florida with substantial holdings in its Panhandle, where Berkowitz sees an undervalued market. With the state investing billions of dollars into the area, including constructing a new international airport, Berkowitz sees a potential for development comparable to Boca Raton or Fort Lauderdale.
He optimistically noted that Fairholme Funds has not yet even fully taken stock of all the assets it has acquired there, including potential mining and extraction opportunities, as well as the obvious agricultural play. He then mentioned that the potential for agriculture could make real estate a better hedge on inflation than gold.
Berkowitz also defended a number of recent acquisitions including AIA (an insurance company poised to make strong plays in China) and MBIA.. He predicted growth in Chinese life insurance given the expansion of China’s middle class, and he sees potential for AIA to lend to the China Pacific Insurance Group to fill the growing market. Fairholme’s stake in AIG uniquely positioned it to acquire AIA and make that move, Berkowitz said.
While Fairholme’s stake in MBIA may seem schizophrenic given the latter’s legal dispute with Bank of America, Berkowitz thinks this a false problem. A win for MBIA, as he sees it, will mean little to Bank of America and a great deal to MBIA. The lawsuit’s unequal impact on the two parties, as well as the high likelihood of MBIA’s eventual triumph, has moved him to take a stake on both sides of the argument.
Conclusion
Fairholme’s commitment to unorthodoxy has a history of results, but recent performance has been troubling. While admitting that he has “an extreme case of premature accumulation of financial services companies,” Berkowitz thinks that in the long term his investments will play out in Fairholme’s favor. The bottom line for Berkowitz is that fundamental analysis shows these companies to be undervalued.
In the end, only time will tell if Fairholme’s consistently contrary positions will continue to add value. If one is to judge by recent performance, the future looks bleak for Fairholme. Fortunately for Berkowitz, recent past performance is an infamously inaccurate predictor over long time horizons, and there is still time for his analysis to bear fruit.
Maybe Berkowitz will be able to prove us all wrong a few more times.
Read more articles by Sam Parl
