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Taking Stock of Fairholme

During a brutal year, here are some points to keep in mind.

Kevin McDevitt, CFA, 11/17/2011

Much has been written and said about Fairholme's FAIRX epic fall in 2011. It's not without cause; the fund has dropped more than 27% this year and trails the S&P 500 Index by nearly 29 percentage points. Rattled shareholders have left the fund in droves. Investors have pulled an estimated $6.5 billion from the fund over the past eight months--which, along with market depreciation, has cut assets by more than 50% since its $20 billion February peak. Along the way, many have questioned manager Bruce Berkowitz's so-far disastrous move into financials stocks, which he built throughout 2010. More recently, critics point to former comanager Charlie Fernandez's Oct. 17 departure and the embarrassing Barron's expose that followed as evidence of further chaos.

While there are plenty of legitimate concerns about Fairholme, in some cases the public-opinion pendulum has swung too far to the other side. After being hailed as a genius just last year, some now wonder whether Berkowitz was ever that good in the first place. Other critics accuse Berkowitz of changing his approach, believing that he had not previously made such a large investment in financials. With judgments flying fast and furious, now may be a good time to take stock, reviewing how the fund got here and what may lie ahead.

To address two common worries upfront, Fernandez's departure shouldn't be a major disruption for the fund, although personnel turnover overall is a concern. The latest Fairholme analysis addresses these issues in more detail. And although he remains chairman at St. Joe JOE, Berkowitz's involvement should be diminished since the company named a new CEO in October.

Financials: Only the Names Have Changed
When it comes to financials, this isn't Fairholme’s first rodeo. In fact, they were there at the beginning. In August 2000, the fund had 82% of its equity portfolio in financials--not that far off the August 2011 portfolio's 87% weighting. Berkowitz even increased that stake to 93% of the equity portfolio in December 2002 before wisely scaling it back over the following six years. Indeed, his love of financials predates the fund itself. Berkowitz put a third of his net worth in Wells Fargo WFC in the early 1990s in the wake of the S&L crisis. (Here's a link to a 1992 interview in which Berkowitz lays out his thesis.)

Wells Fargo aside, the fund's focus, then and now, has been on insurance companies. Although current holdings such as real estate company St. Joe and Bank of America BAC get much of the media attention, they claim just 10% of assets. Majority government-owned American International Group AIG dominates the portfolio. Including warrants, AIG, along with AIA (its former subsidiary), accounts for about a third of the equity portfolio. Overall, about half the equity portfolio is in insurance stocks. Again, this is not new. The insurance stake was even greater at times in the early 2000s; in those first few years, Berkshire Hathaway BRK.B and White Mountains Insurance WTM together often claimed more than a third of the portfolio.

But Bank of America is not the blue-chip that is Wells Fargo, which has long been considered one of the best-managed U.S. banks; nor is AIG on par with Berkshire Hathaway in terms of quality. (To be sure, Berkshire Hathaway is still in the portfolio, but it claims only about 8% of assets versus the 23% AIG stake.) AIG is not as diversified or as financially strong as Berkshire Hathaway. Insurance companies generally avoided the worst of the credit crisis, but AIG is an obvious exception. It's healthier today, but it still has balance sheet and strategic operational issues that seem to crop up every quarter.

Thus, compared with the early 2000s, the fund's picks have been more aggressive this time around. That has been the market's verdict so far this year. For the year to date, both AIG's and Bank of America's shares have dropped more than 50% through Nov. 11, while Berkshire and Wells have fallen just 3.9% and 15.7% respectively.

The circumstances today are far different, too. The fund's first foray into financials occurred in the wake of a tech bubble, not a financial crisis. The bursting of that bubble left banks and insurance companies relatively unscathed compared with the beating tech stocks absorbed. While the insurance industry faced shocks of its own, particularly the Sept. 11 terrorist attacks, investor apathy was the prevailing theme. Warren Buffett and Berkshire Hathaway had been written off after missing the tech boom and trailing the S&P 500 Index by 20.5 percentage points in 1999. When the fund loaded up on Berkshire in 2000, the stock was out of favor, but hardly distressed.

Kevin McDevitt is an Editorial Director with Morningstar.
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