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Fairholme's Girth Doesn't Have to Spell Doom

This fund will eventually stumble, but the culprit won't necessary be its size.

Michael Breen, 12/21/2010

Fairholme has gathered $4.1 billion in net inflows so far in 2010, more than any other domestic-equity fund and an amount equal to 41% of its total assets under management just 11 months back. Managed by Morningstar's Domestic Equity Fund Manager of the Decade, Bruce Berkowitz, the fund now has $17 billion in assets, and is the 19th-largest actively managed domestic-stock fund.

That's a lot of scratch to put to work, and it's got some longtime Fairholme shareholders nervous. Many have contacted me to say they worry that Berkowitz will drown in a sea of cash and will have to ditch the flexible, eclectic approach he's used to build the fund's stellar record. That's a valid concern. Plenty of funds have raked in hot money during long winning streaks only to disappoint for a stretch thereafter. They've then had to manage big outflows that hamper their ability to execute their strategy. Bill Miller's Legg Mason Capital Management Value LMVTX is a famous example of this, but far from the only one.

Big Is Not Always Bad
But it doesn't have to end in tears when assets pour into a fund. I looked at the 40 actively managed domestic-equity funds with more than $10 billion in assets and was surprised to see a steady group of performers showing few signs of losing a step. About 70% are beating their category average over the past three years and 82% are besting it over the past five. So, a bulging asset base is a big hurdle, but one that can be cleared.

Berkowitz Not Yet Handcuffed
The most common way for massive inflows to derail a fund is by forcing the manager to alter his approach. The good news for Fairholme shareholders is that, in this case, the influx of assets hasn't forced Berkowitz to change his stripes.

The fund's cash stake is now 24% of assets, but that's nothing new. From day one Berkowitz has kept a pile of dry powder on hand. In fact, about a fourth of the fund's assets were in cash its first three years--a time when it had less than $50 million under management. The only time the portfolio's cash hoard dipped below double digits was in late 2008, when Berkowitz was among a tiny group of investors loading up on bargains at the tail end of the bear market. The cash cushion would also provide plenty of wiggle room if the fund is ever hit with mass redemptions.

The portfolio hasn't become bloated, either. Many fast-growing funds boost the number of names they hold to spread their new cash around, diluting their best picks. But Fairholme continues to own 20-25 stocks. The percent of assets in its top 10 holdings is a tad lower than its historic range but that's a function of it owning 6% stakes in two separate tranches of General Growth Properties GGP debt. Combine these, and the portfolio is as concentrated as ever.PAGEBREAK

And Berkowitz hasn't had to change the type of firms he buys. Many managers who once profited by finding lesser-known small or mid-sized stocks are forced up the market-cap ladder as assets climb, fundamentally altering their strategy. But at $16.4 billion, Fairholme's average market cap matches its 2002 level and is in line with its historic range. The fund's sector weightings are also in flashback mode. Berkowitz has stashed 74% of his equity assets in financials, in line with the oversized bet on that sector he made from 2000-04.

Fairholme's size has even created some opportunities lately. In 2010, Fairholme committed $2.7 billion to partner with Bill Ackman's Pershing Square Capital and Brookfield Asset Management BAM in a deal to successfully recapitalize General Growth Properties. Without Fairholme's bulk, the deal--already starting to benefit Fairholme's shareholders--probably wouldn't have closed.

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