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GoodHaven Realizes Its Vision

The firm is stepping out of Fairholme’s shadow, thanks to a big-time investor.

Kevin McDevitt, 01/31/2012

Life is rarely easy for startups, whether the business is managing money or creating the next social-networking app. Besides coming up with a compelling product or service, attracting capital is often the most difficult task. Fairholme FAIRX alums Larry Pitkowsky and Keith Trauner addressed that issue soon after they formed GoodHaven Capital Management, the advisor to GoodHaven GOODX, near the end of 2010.

But Pitkowsky and Trauner faced the additional challenge of distinguishing themselves from one of the most iconic managers of the past decade, Fairholme’s Bruce Berkowitz.

Launching a new firm is easier for some mutual fund companies than for others. The founders of Marsico, Causeway, Wintergreen, and DoubleLine all had track records at other shops before striking out on their own. That made it far easier to attract investor interest. DoubleLine, for example, has already collected about $14.6 billion in new money since April 2010, thanks to both manager Jeffrey Gundlach’s stellar 16-year career at TCW Total Return Bond TGLMX and to excellent short-term performance from flagship DoubleLine Total Return DBLTX.

Without a public record of their own, Pitkowsky and Trauner largely started from scratch. They certainly contributed to Fairholme’s success from its 1999 inception through October 2010 as analysts, comanagers, and, finally, as consultants. During that time, the fund had the large-value category’s best return, 13.6% annualized versus 3.6% for the category median.

Pitkowsky and Trauner say that they formed GoodHaven because they wanted the flexibility to invest anywhere, which Fairholme had enjoyed before assets swelled in 2009 and 2010. But there’s likely more to it than that.

Although Pitkowsky, Trauner, and Berkowitz won’t discuss the circumstances, disruptions to Fairholme’s investment team probably played a role in their departures, too. As related in an October article in Barron’s, a former Fairholme analyst claims that Berkowitz made Charlie Fernandez head of the investment team shortly after he joined the firm in late 2007, even though Fernandez did not have any prior investment management experience. Fernandez was then named a comanager on the fund in January 2008, with Pitkowsky and Trauner then removed as comanagers later that year. (Fernandez left Fairholme in October.) That experience could only fuel the duo’s desire to prove themselves on their own.

Fairholme’s performance hit a wall after Pitkowsky and Trauner cut their ties in late 2010, but it’s difficult to determine precisely how much they contributed to the fund’s prior success or how much their departure hurt. Pitkowsky, Trauner, and Berkowitz are reluctant to talk about who was responsible for what.

Trauner has said that in 2000 he recommended Barrick Gold ABX, a stock that has nearly tripled since then. But it was never more than a small position in the portfolio.

Looking for an Angel
With such unanswered questions in the air, Pitkowsky and Trauner knew that it might be a slog attracting assets, especially considering investors’ aversion to U.S. equity funds in recent years. Pitkowsky and Trauner tried to sidestep the need for a big marketing push by pursuing a lead investor instead. They approached Tom Gayner, who is the CIO at highly respected insurance company Markel MKL, as well as chairman of the Davis Funds, about making an investment in their firm, as well as becoming the firm’s first separate-account client.

Beyond providing capital, Markel’s investment would be a powerful endorsement for an unproven management team. That’s because Gayner is a highly accomplished investor in his own right. Under his leadership, Markel’s equity portfolio gained 7.6% annualized over the 10 years through Dec. 31, 2010, versus a return of just 2.7% for the S&P 500 Index. A Warren Buffett disciple, Gayner built this record by sticking to blue-chip companies such as Buffett’s own Berkshire Hathaway BRK.B, as well as insurer Fairfax Financial FRFHF and spirits maker Diageo DEO.

Pitkowsky, Trauner, and Gayner’s relationship stretches to Fairholme’s early days, as Markel was one of the fund’s first investments in 2000. Based on their long association, Gayner was eager to invest with them. His high comfort level came from having watched how the duo went about their business for more than 10 years. “There’s no substitute for knowing someone for an extended period of time,” Gayner says. Plus, he had seen enough to be assured of their competence. “I had talked with them about investment ideas, and I could tell by the types of questions they were asking that they knew what they were doing,” Gayner says.

Markel invested in the firm in late 2010. This capital infusion gave GoodHaven breathing room from day one. It also helped the firm limit the fund’s expense ratio to a reasonable 1.1%. The firm’s minimal infrastructure helps keep costs in check, too. There is only one junior analyst on the investment team (although more may be added in the future), and the back-office operations are outsourced to US Bank.

More in Common Than Similar Sounding Names
A lean approach to infrastructure is one of several traits GoodHaven shares with Fairholme. Treating shareholders well is another. While the duo would like to grow the firm’s asset base, they would rather do so through capital appreciation than through massive inflows. Size shouldn’t be a problem anytime soon, though, as the fund’s assets are currently a modest $91 million. Importantly, they have already committed to closing the fund once firmwide assets reach $3 billion to $5 billion. Pitkowsky and Trauner want to maintain the flexibility to make meaningful investments in small-cap companies, which are about a third of the equity portfolio. Their go-anywhere value philosophy depends on having the freedom to invest in companies of any size, across the capital structure.

Pitkowsky and Trauner took a tangible step in aligning their interests with shareholders’ when they each invested $1 million in the fund. This partnership mentality showed in the fund’s first semiannual report, too, which included a fairly thorough discussion of their investment philosophy as well as the thesis behind several holdings.

The fund is run in a similarly aggressive fashion to Fairholme. In fact, there are a number of carryover stocks from Pitkowsky and Trauner’s days at Fairholme. Six of the fund’s 18 holdings are past or present Fairholme positions, including Berkshire Hathaway, Sears Holdings SHLD, White Mountains Insurance WTM, Barrick Gold, Jefferies Group JEF, and Mohawk Industries MHK.

Pitkowsky and Trauner also embrace deeply out-of-favor companies. They are happy to invest in companies that are cheap because they are going through operational challenges (“fallen angels”), such as Sears. The duo also likes so-called orphans such as top holding Spectrum Brands SPB. Few Wall Street analysts picked up coverage of the consumer goods company after it pulled out of bankruptcy in 2009. Trauner and Pitkowsky believe that it will pay off a large chunk of its high-cost debt over the next year, creating substantial free cash flow.

But even when bought at reasonable prices, these stocks can be highly volatile. Poor results at Sears’ rapidly deteriorating retail stores, for example, have pounded its share price. Although Jefferies’ shares have recovered recently, its exposure to European sovereign debt has been a cloud over the company. Finally, after enduring management upheaval, Hewlett-Packard HPQ shares have dropped by more than a third since March as it struggled to transition away from its lowmargin PC business.

GoodHaven’s large stores of cash and bonds help alleviate these risks to some extent. Its combined cash/bond stake was 36% of assets at the end of August, but Pitkowsky and Trauner say it will likely be closer to the 15%–25% range that Fairholme maintained for years. The fund’s current large cushion reflects Pitkowsky and Trauner’s conviction in only buying stocks with a solid margin of safety. While they will be willing to hold on as prices appreciate, they are adamant about not overpaying for stocks.

Going Their Own Way
Although there are similarities, the fund isn’t a carbon copy of Fairholme. One notable difference is its smaller exposure to financials. To be sure, the fund did have 26.6% of its August equity portfolio in financials versus 18.1% for the large-value category average. But this is far below Fairholme’s 91% financials stake.

Plus, GoodHaven’s positions are not nearly as concentrated; Berkshire Hathaway is the biggest holding at 4.6% of assets. Meanwhile, Fairholme has close to 22% of its assets in insurer American International Group AIG alone. Neither does GoodHaven hold any banks, which, along with AIG, were the greatest sources of Fairholme’s terrible 2011 performance. Although Pitkowsky and Trauner are not against owning a bank, they’re reluctant to do so since the Financial Accounting Standards Board eased mark-to-market accounting rules on illiquid mortgage assets in April 2009. This ruling made it difficult to determine a bank’s true tangible book value. Plus, higher capital requirements and declining net interest margins could prevent banks from earning decent returns on their capital.

That’s not to say that the fund’s financials holdings don’t have issues of their own. For example, Walter Investment Management WAC leveraged its balance sheet to acquire Green Tree Financial’s subprime-mortgageservicing business this past March. The company is now working to reduce its debt load, but its balance sheet could be at risk in the meantime. Money manager Federated Investors FII has a stronger balance sheet but about three fourths of its assets under management reside in low-yielding money market funds. Federated has offered fee waivers since yields are below the cost of operating these funds, hurting profitability. It may be a while before profitability improves, too, given the Fed’s commitment to keep rates close to zero through mid-2013.

A second major difference with Fairholme is GoodHaven’s affection for technology companies. Although it briefly held a position in Cisco CSCO last summer, Fairholme generally avoids tech. Berkowitz considers that sector beyond his circle of competence. On the other hand, Trauner’s experience as a programmer early in his career gives him more comfort in this space.

In addition to Hewlett-Packard, the fund owns stakes in both Google GOOG and Microsoft MSFT. Although Microsoft is sometimes dismissed as a dinosaur, Pitkowsky and Trauner believe that its business has in many ways grown stronger since the early-2000s’ tech bust. Trauner argues that the Office franchise’s resilience in the face of competition from free, open-source software and other threats demonstrates its underlying strength.

Their Chance to Show the World
For Pitkowsky and Trauner, the task is now to show that they were more than just along for the ride at Fairholme. Although the fund has been around only since April, it hasn’t stumbled in a difficult equity environment. Its returns for the year were roughly flat versus a 7.7% loss for its average peer. Much of this superior showing, though, owes to the fund’s big cash and bond stake. GoodHaven’s journey is still just beginning. But it will have to get used to being measured not only against its benchmark but also against its former partner.

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