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The Secret of Fairholme's Success

Berkowitz gets creative.

Michael Breen, 09/07/2010

Few mutual funds look or behave like Fairholme FAIRX. That's by design. Manager Bruce Berkowitz knows that to beat the pack, you need to break from it, and he acts accordingly.

Berkowitz's process is the inverse of most managers'. He focuses on what could go wrong, not right, with potential investments. Only after determining that going bust isn't possible does Berkowitz look for a firm's positives. Even then he anchors on the here and now, shunning the projections and big assumptions about the future that are needed for the discounted cash-flow analysis many rivals use. The phrase "positive catalyst" is never uttered at Fairholme. Berkowitz simply looks for firms with loads of cash on their balance sheets and double-digit free cash-flow yields where the coupon appears to be rising or stable. Like Warren Buffett, Berkowitz prefers to be approximately right, rather than precisely wrong.

Off the Beaten Path
Berkowitz and Charlie Fernandez are the only investment professionals at the firm. Berkowitz says having dedicated industry specialists leads to skewed results, as those operating in one space often fall prey to relativism, perhaps advocating for the best option in a horrible group that should be avoided altogether. Instead, Fairholme hires an array of outside experts who not only provide raw data but also try to poke holes in Berkowitz's analysis on specific stocks and bonds. Berkowitz rarely meets with management, preferring a deep dive on the data to see if they've delivered on past promises.

A few years back, Berkowitz broadened the fund's charter, giving him flexibility to invest in a wide range of securities. This shop has one main fund that can hold nearly anything, not the dozens of funds that can hold only one type of investment. Berkowitz says he chose this route after watching several prominent investors he admired devolve into corporate keepers of their family's broad and growing fund lineups, taking them away from what they did best--investing.PAGEBREAK

Lots of Rope
Berkowitz makes the most of his flexibility. The portfolio has two thirds of its assets in equities, with the remainder split between cash and a mix of short-term fixed-income securities that includes floating-rate loans, commercial paper, high-yield corporates, and convertible bonds--hardly a typical mix for a large-blend fund.

A recent deal highlights Berkowitz's adaptability. The fund owns more than $1.5 billion of convertible debt and floating-rate loans from mall operator General Growth Properties GGP. Fairholme has partnered with real estate firm Brookfield Properties BPO and hedge fund Pershing Square to provide a $3.9 billion financing plan and capital backstop to help the struggling REIT emerge from bankruptcy. If General Growth continues shoring itself up, the fund's convertible bonds will pay off in spades. It's the sort of creative and advantageous deal Warren Buffett regularly does, but few mutual funds would dream of making.

The fund made a similar bet with CIT Group CIT. Fairholme bought a mix of equity, senior debt, and floating-rate loans after the small-business lender's bankruptcy. In the process, CIT shed liabilities, got new management, and has returned to profitability.

This isn't the first time Berkowitz has used this playbook. In late 2008, Fairholme did a recapitalization deal with auto lender AmeriCredit ACF, exchanging its debt for a pile of new common shares. AmeriCredit got credit relief in its time of need. Fairholme gained control of a quarter of the firm's shares at a rock-bottom price and created a self-fulfilling situation. Once it was clear that AmeriCredit had shored up its liquidity, the market bid up its shares fivefold.

Against the Grain
Berkowitz is dodging the herd elsewhere. Save for Berkshire Hathaway BRK.A, he wouldn't touch banks or insurers in 2007 because of a lack of clarity on their liabilities. That was a big reason the fund lost less than nearly all its rivals when financials went off the rails in 2008's downdraft. But now the fund has half its assets in financials. In addition to Berkshire Hathaway, AmeriCredit, and CIT Group, the fund now holds Citigroup C, Bank of America BAC, American International AIG, Regions Financial RF, and Goldman Sachs GS--a recent buy. Berkowitz says government scrutiny and Treasury audits have better illuminated the landscape, giving him a comfort level in the firms' balance sheets.

Berkowitz's case for Goldman Sachs typifies his approach. He bought the stock right after the SEC charged Goldman with trading improprieties. Not many managers joined him. But Berkowitz saw little merit to the SEC's case, saying Goldman was following standard operating procedures for investment bankers. And at any rate, he says the stock tumbled by a much greater amount than any lasting damage to its operations. The firm continues to generate strong returns, and downside is limited at his entry price, according to Berkowitz. The stock trades at a forward P/E of just 7.4.

What Could Go Wrong?
The fund runs big issue-specific risks, but Berkowitz's skill as a security analyst has kept that risk from biting investors.

A couple of other factors keep things on an even keel. First, Berkowitz loves cash. The fund nearly always has 20% of its assets in cash, so Berkowitz can quickly take advantage of unexpected opportunities without liquidating existing holdings. And the big cash hoards on the balance sheets of most holdings, including Berkshire Hathaway, WellCare Health Plans WCG, and Sears SHLD, have a stabilizing effect as well. As Berkowitz is fond of saying, "Cash is worth an awful lot of money when others don't have it."

Berkowitz has a good record of averaging down in stocks. He did so in 2008 and early 2009 when Sears' shares dropped by two thirds. He backed up the truck near the stock's lowest point ever, citing the firm's solid balance sheet and nearly 25% free cash-flow yield. Sears shares have since tripled, but the firm still generates a double-digit free cash-flow yield.

An area of small concern is the fund's structure as a 1940 Act mutual fund. Berkowitz is increasingly doing hedge-fund-type deals, such as the recent General Growth Properties transaction, that require patience and can be illiquid. If a rough patch leads to redemptions, Berkowitz might lose some ability to do the creative deals that are becoming his hallmark. It's a minor quibble, and it would take a landslide of redemptions to eat into the fund's gargantuan cash reserves, but it's worth monitoring.

Conclusion
Only time separates luck from skill, and this fund's risk/reward profile since its 1999 inception is no fluke. Even so, Berkowitz will stub his toe at some point. It is matter of when, not if. But expect him to remain adept at carving his own path over time.

A version of this article appeared in Morningstar FundInvestor.

Michael Breen is a senior mutual fund analyst with Morningstar.

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