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Liquidity Risk Increases at Fairholme

Following dismal performance and billions in investor outflows over the past several years, this fund faces serious liquidity risks. 

Kevin McDevitt, 10/03/2016

On pace for its third consecutive bottom-decile calendar-year finish and after nearly $5 billion in three-year net outflows, Fairholme faces serious liquidity risks. These risks and poor results lead to a cut in the fund's Morningstar Analyst Rating to Neutral.

The fund has endured outflows in every month since March 2011, a total of nearly $15.7 billion. Since then, manager Bruce Berkowitz raised cash mostly by selling liquid stocks like American International Group Inc AIG, Bank of America BAC, and Berkshire Hathaway BRK.A.

But such stocks are gone. The largest holding as of May 2016 was St. Joe JOE at 13.8% of assets. Fairholme owns 31% of the shares. Morningstar estimates it would take more than 100 days to sell that position without affecting the share price. Plus, Berkowitz is the chairman, further complicating matters. The days-trading estimates for the fund's next-largest positions, Fannie Mae and Freddie Mac preferreds (combined 21.4% of assets), are also greater than 100 days. Sears Holdings SHLD (where Berkowitz is on the board) shares would take more than 20 days.

Berkowitz has compensated by increasing liquidity elsewhere. Cash was 27.5% of assets in May (or about $800 million). The fund also had 17.9% of assets in short-duration, high-yield bonds like Chesapeake Energy CHK.

But this may not be sufficient should outflows continue. Year-to-date net outflows through August 2016 were about $650 million and $1.5 billion during the trailing 12 months. At a $70 million monthly run rate, the fund's cash would be exhausted in less than 12 months. The fund's short-duration, high-yield bonds could perhaps be sold, but these bonds might not be reliable sources of liquidity during a period of market stress.

Fannie/Freddie, Sears, and St. Joe could still bear fruit, but the fund's predicament shows the danger of owning them in a daily liquidity vehicle. Its liquidity risks could be exacerbated if Berkowitz needed to sell securities into a falling market to meet redemptions. This fund was always more aggressive than most peers, but its risks have taken on a greater urgency.

Process Pillar: Positive | Kevin McDevitt, CFA 09/15/2016
Manager Bruce Berkowitz embraces complexity, especially within the devilishly complicated financials sector, and concentration. Neither of these is for the fainthearted. But with just 10 stocks in the portfolio, concentration creates an incentive for him to spend extra time understanding a company as compared with a manager with more-dispersed assets.

Berkowitz makes big bets on deeply out-of-favor stocks whose unpopularity may owe in part to their opacity. That was the case with financials such as Bank of America and AIG in 2011 and 2012, because their balance-sheet-related risks were hard to quantify, and more recently with Fannie Mae and Freddie Mac. Berkowitz's comfort with such financials is a distinguishing trait, but he generally sticks to his circle of competence. He has tended to avoid technology, for example. He is also more than willing to work in an activist role if need be, as he's currently doing with Fannie and Freddie and did with St. Joe in the past.

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