Investing Specialists

Time to Bail on Fairholme Fund--Or Stand Pat?

Christine Benz

Fairholme Fund (FAIRX), one of the best-performing mutual funds of the past decade, has fallen hard in 2011. Owing in large part to losses in its financials holdings, the fund has shed more than a fourth of its value so far this year and places in the lower reaches of the large-value category for 2011 to date.

Yet more news rocked Fairholme fund-watchers' worlds on Tuesday, when the firm announced that comanager Charlie Fernandez had left the firm. (Analyst Kevin McDevitt has since posted an analysis that discusses Fernandez's departure as well as the arrival of two additional investment professionals at the firm.)

Given the recent headlines as well as the fund's popularity among many Morningstar.com readers, I decided to take the pulse of our Discuss forum participants on this now-controversial fund. Have investors been adding to Fairholme at this juncture, dumping it, or simply standing pat? And what factors have motivated their decisions?

A thought-provoking thread ensued, illustrating the conundrum that owners of truly active funds face when their managers struggle. While a healthy contingent of readers believes that the risk profile of the fund has changed due to manager Bruce Berkowitz's heavy emphasis on the financials sector, other posters argued that selling out now is short-sighted: If they liked Berkowitz when his charge was flying high, they should like him even more when his holdings could be on sale.

To read the complete thread or chime in with your own thoughts on Fairholme's fortunes, click click here.

'Too Much on His Plate'
At least a few posters noted that Fernandez's departure gives them trepidation about the fund's future.

Lanibay is one such investor, writing, "I just sold my shares on the news that Fernandez departed. I have deep respect for Bruce; however, there is no in-house contrarian voice that could tell Bruce that he may be wrong. Financials will eventually have their days in the sun, but I am selling on principle, in the view that I am no longer comfortable with a solo skipper, however brilliant."

BillGun's concern is that Berkowitz could have "too much on his plate." He noted, "In my opinion, he was already stretched too far after taking on double duties, 'joining' the board of directors of St. Joe Co. (JOE) (probably an ill-advised move on his part...). Perhaps his abundance of good press overly inflated his better judgment [regarding] assessing his personal capacity, abilities, and infallibility. The loss of Mr. Fernandez only makes matters worse, and may prove devastating."

Glasshalffull, too, grew concerned when Berkowitz stepped into the St. Joe fray. "I dumped all of my FAIRX earlier this year when it became apparent Berkowitz had more interest in using the fund's money to pursue his personal interests with St. Joe. (I prefer a fund manager for my fund--not a corporate raider, ego-centric power seeker, whatever.) Haven't regretted that move one day since."

JillBill, while standing pat with shares of Fairholme Fund, concurred that Berkowitz could be doing too much at once: "I agree with other posters that Bruce may be overextended. Honestly, I am uncomfortable when a manager becomes a star and attracts so much attention."

Fmulder agreed that too much hype can be a negative, especially when it's perpetuated by the fund company itself. "I think whenever a company and/or mutual fund does a full-page ad in The Wall Street Journal touting their performance, it is an indicator to sell."

Fairholme's size--certainly much less of a concern now than it once was because of the fund's massive redemptions recently--is on dclemons' mind. "The problem with Fairholme is that it was allowed to get too large. The large cash position told me [Bruce Berkowitz] was having a hard time deploying capital. I just knew that was going to be a problem eventually. I too sold early on in the year because of the over weighting of financials."

'75% of FAIRX Is in Financials? Gasp.'
A much larger group of users is concerned that the risk profile of the portfolio has changed: As Berkowitz has upped the ante within the financials sector, he has cast the fund's lot with an industry that many think could take a while to recover, if it does at all.

FMulder wrote, "I have sold approx 60% of my Fairholme holdings early August. I have great respect for Bruce Berkowitz. However, the fund is now like a financial sector fund, which does not meet my IRA asset allocation. Sorry, FAIRX has become more risky for my taste."

AdirondackJack, too, is worried that the fund's current bet could go even further awry: "I sold my entire position about five months ago because I didn't think that Berkowitz was considering all possible outcomes when he bet so heavily on financials. With the headwinds that face the global economy, you have to be cautious, and I felt that he was not."

Broadview agrees: "I sold Fairholme back in March this year after seeing increasing investments in AIG (AIG), St. Joe, and other financials that really are not likely to recover their former glories. You would have to make the assumption that Berkowitz knows something that is not appreciated by the market or, as I have, decide that he is making a sector bet hoping for the best. I think that as an investor, one has to look at what information is available and not go with past results."

Peterg summed up the views of the financials stocks naysayers with this post: "75% of FAIRX is in financials? Gasp. Accounting shams, massive write-downs, toxic debt, excessive risk taking and the list goes on for big banks. These things make banks nearly impossible to put valuations on. It seems like Bruce is doing more speculating and less investing. I applaud him for his conviction and his huge bet may reward shareholders eventually, but I'll search for alpha elsewhere."

Mesmer thinks that financials face political risks as well. "Millions of people in this country are fed up with the large banks, and in my opinion…there is tremendous political risk for these companies."

Rathgar pointed out that redemptions from the fund could force Berkowitz to unload some of the very holdings that have brought it the most pain recently: "Berkowitz is now forced to sell beaten-down financials to raise funds to pay departing shareholders. He bought these stocks for 50 cents on the dollar and is selling for 25 cents on the dollar."

Lsernoff, who sold out of Fairholme in mid-2010, is also concerned that ongoing redemptions could change the character of the fund. "I feared redemptions were forcing Berkowitz off of his game of hoarding cash and waiting for opportunities."

A few posters noted that Fairholme's current positioning gives them bad flashbacks to their experiences with Oakmark Select (OAKLX), which suffered big losses during the financial crisis due to a giant position in Washington Mutual.

Newyearsjohnny is one such investor, writing, "[P]erformance this year reminds me of Oakmark Select… That fund had a tremendous run and then held on to a position in Washington Mutual while it sank into the sunset. I waited too long to sell that fund and paid the price. I sold half of my position in Fairholme at the beginning of the year because it had gotten to be too big a percentage of my portfolio. Sold the rest several months ago when I became convinced that Berkowitz has his heels dug in too deeply on financials while the market was convinced they were still overpriced."

Rajenkins told of writing Oakmark manager Bill Nygren to question him on his big WaMu position. "Surprisingly he responded, and with assurances that he had great confidence in WM's management. Not convinced, I sold out of Oakmark Select before the WM failure. The lesson I learned is that I must use my own judgment, regardless on the reputation of the fund manager."

Poster Mattwright, meanwhile, argues that those drawing parallels between Oakmark Select's bet on WaMu and Fairholme's position in financials are missing the big picture. "On a short-term basis, [getting out of Oakmark Select in time to dodge the WaMu debacle] might have been a good move, but why not take a whole minute to actually look at the fund's total performance over time? 2007 was terrible, but [Oakmark Select] has been a significant winner since then. Even in 2008 when WaMu blew up, the fund outperformed the S&P 500."

'Mr. Market Offering Us a Bargain'
Yet even as some investors see landmines ahead for financials stocks--or at the very least extreme uncertainty--others think the sector looks cheap.

Elmo4star is one such contrarian: "[I'm h]olding the shares based on the fact that the banks are in much better shape than in 2008, and will recover. Bruce may be early, but I doubt he is wrong."

Tangoluna argues that Berkowitz is doing what he has always done: finding value in unloved names. "P/E for Bank of America (BAC) = 5.6, AIG = 7.6. Sounds like value stocks to me. Whether they're good investments or not only time will tell. I'm encouraged that Warren Buffett bought into Bank of America."

BallThree, while adding to Fairholme Focused Income (FOCIX) and Allocation (FAAFX) rather than the flagship Fairholme Fund wrote, "I think Berkowitz, as Morningstar's manager of the decade, knows what he's doing. I think he bought these bank stocks cheap, and their having gotten cheaper is just Ben Graham's nutty friend, Mr. Market, offering us a bargain."

Brentf is also looking to Fairholme Fund as a way to play an extremely unloved sector. "I bought [the fund] after it had plunged. Then it took another 15% drop just to remind me I wasn't so smart at all. I was looking for a way to get exposure to a select group of financials but with some diversification so [I'm] going to hold Fairholme for that purpose."

Other posters, however, believe that a financial sector fund is a more straightforward way to make a contrarian bet on this unloved sector.
Macunix, like several other readers, argued for swapping Fairholme for a financials ETF. "Make no mistake, right now FAIRX = [ Financial Select Sector SPDR] (XLF). And, since [Bruce Berkowitz] thinks the financials are a great bargain now, it seems that this condition will hold until they have had a substantial recovery. So, if you have a loss on any FAIRX shares but want to hang in with the financials, I don't see what's not to like about selling, putting the $ in XLF, and buying FAIRX back later."

Javajoe also likes a financials sector ETF because it's not apt to get buffeted around by redemptions or managerial issues. [Fairholme is s]till highly correlated to financials.... If you like financials as a contrarian play, why not go into [Financial Select Sector SPDR] and insulate yourself from the manager and redemption risk?"

'Holding On and Hoping That Inspiration Will Strike'
Although few posters said they were adding new money to Fairholme, a large number of posters said they're standing pat with their Fairholme Fund holdings, confident in Berkowitz and the fund's prospects of a rebound.

Emeless wrote, "I am holding on and hoping that inspiration will strike within six months. I am giving him the chance to apply the experience of ten years of success in order to get out of this deep hole."

scaulfield also believes that Berkowitz has what it takes to turn the ship around. "[I'm] hanging on.... [It's] hard to believe that Mr. B's brains have suddenly turned to mush. Either it really is a random walk or there are some folks who can beat the market. If such folks really do exist, I'd have to believe that Mr. B's one of them."

JBP57, while hinting that you may need to have a long time horizon to experience a resurgence in Fairholme's fortunes, wrote, "Our family is long-lived so I'm hanging on to our shares, which are in Roth IRAs. At some point in the future, the current economic storm will abate, Bruce will right the good ship Fairholme, and at that point we will think about making an exit or not."

Markb, meanwhile, is learning to make peace with the fund despite what will likely be a more volatile profile going forward. "I see two issues: has Berkowitz lost his 'smarts'? I doubt it. And, has the fund character changed? It seems so. When I bought it in '06, big chunks were in Berkshire and cash, with the above-mentioned emphasis on not losing investor capital. So for me, I'm learning to live with the new volatility and holding pat for now."

Reflections on Active Funds
Some posters rightly pointed out that Fairholme's recent travails are far from an isolated incident, as periodic performance weakness has marked the careers of some exceptionally successful fund managers.

Lanibay summed it up: ALL value managers worth their salt will underperform for periods of time... [Mutual Series'] Mike Price, [former Oakmark manager] Bob Sanborn, Bill Nygren, [ Oakmark International's (OAKIX)] David Herro, [ Yacktman Fund's (YACKX) Donald] Yacktman, managers of the Longleaf Partners Fund (LLPFX), Dodge & Cox managers."

Rossinator concurred: "The market doesn't seem to like being beaten for extended periods of time...Bill Miller, Bruce Berkowitz and less dramatic examples...sooner or later it (Mr. Market) extracts his revenge!"

Palmreader is losing faith in active management: "I sold all of my shares earlier in the year, preserving several years' worth of gains and avoiding a further 20% decline in value. I thought I'd learned my lesson in 2008 but I'm a slow learner I guess: Active managers, no matter how assiduous or talented, eventually make bets that turn out to be wrong, if not downright misguided. Bruce seems to be genuinely concerned for the interests of his shareholders (witness his all-inclusive telephone conferences when returns hit a rough patch), but the ideal of the iconoclastic, outperforming money manager who consistently beats the market over long periods of time is a figment of our collective imagination. All of the money I redeemed and reinvested went into index funds."

For Kenster1, the broader lesson is to periodically scale back on hot-performing funds, thereby reducing the impact of the inevitable blowup. [I]nvestors gotta know that for stock funds, whether it be Oakmark Select, Dodge & Cox International Stock (DODFX), FAIRX or even a Midcap Index or whatever--you gotta take profits off the table (rebalance) when it does well."

RogerD, meanwhile, argued that investors in stocks must have a sufficiently long time horizon to stomach their bouts of weak returns. "Eight months seems like an extremely short time horizon to use in judging Mr. Berkowitz's performance. It could take two or three years for his investment thesis to play out and that should be well within an acceptable time frame for stock investors."



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Christine Benz has a position in the following securities mentioned above: LLPFX OAKLX. Find out about Morningstar's editorial policies.