Another Downgrade for Fairholme

The following is our latest Fund Analyst Report for Fairholme Fund FAIRX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Fairholme's Morningstar Analyst Rating is cut to Negative from Neutral after more staff departures and ongoing liquidity issues.

This fund's advisor has once again failed to retain senior staff. The firm's director of research, Dan Schmerin, left in December 2017. (Two analysts also left the firm in 2017's second half.) Schmerin joined the firm in 2011 and replaced industry veteran Fred Fraenkel as head of research after Fraenkel had been in the role for less than two years. (Fraenkel subsequently left the firm altogether in September 2015.) Schmerin's departure will potentially leave a hole given his background in distressed securities, a status with which bond holdings from both Sears and Imperial Metals are potentially flirting.

Schmerin's departure came amid poor performance and outflows. The fund is off to a bad start again in 2018 and is already down 7.9% through February, trailing the Russell 1000 Value Index by nearly 6.8 percentage points. Its positions in Fannie Mae and Freddie Mac preferred shares, as well as in Sears and Imperial Metals securities, have continued to struggle. As a result, outflows continue and the fund's asset base shrinks further. Total assets were $1.6 billion at the end of February 2018, down nearly $1 billion in 12 months.

Outflows and declining assets continue to exacerbate the fund's liquidity issues. Despite selling some shares in 2017, top holding St. Joe grew to 24.4% of assets as of Jan. 26, 2018, up from 19.8% as of May 2017. Meanwhile, the bulk of the remaining portfolio is in low-quality securities, with Sears continuing to sell assets and close stores, Imperial Metals on shaky financial ground, and the U.S. Supreme Court recently deciding not to hear parts of Fannie and Freddie lawsuits brought by Fairholme and others.

Manager Bruce Berkowitz has at least maintained a cash cushion, which was 25.9% of assets as of Jan. 26, or about $440 million. But if outflows continue, he will be forced to continue selling securities that are liquidity-constrained. This fund's options may continue to narrow.

Process Pillar: Negative | Kevin McDevitt, CFA 03/01/2018 Manager Bruce Berkowitz embraces complexity, especially within the devilishly complicated financials sector, and concentration. Neither of these is for the fainthearted, but it can lead to long-term success, albeit with massive volatility. Currently, though, Berkowitz is embracing extreme concentration in positions--namely St. Joe and Fannie Mae and Freddie Mac preferreds--that don't offer robust liquidity. This creates an inherent mismatch when such concentration resides in an open-end mutual fund with daily liquidity and subject to redemptions. For this reason, the fund's Process Pillar is cut to Negative.

Berkowitz's comfort with such financials is a distinguishing trait, but he generally sticks to his circle of competence. He has tended to tread lightly in technology, for example. He is also more than willing to work in an activist role if need be, as he's currently doing with Fannie and Freddie and did with St. Joe in the past.

He focuses more on business analysis than valuation work. In his view, thoroughly understanding a business supplants the need for elaborate models. He supplements his efforts by hiring outside experts to help him understand technical issues or to poke holes in his thesis. He then assigns a multiple to a company's normalized cash flow. He is also willing to let cash build and invest throughout the capital structure, often owning short-term, high-yield bonds.

About $7 billion in outflows during the past five years has forced manager Bruce Berkowitz to sell his most-liquid stocks in order to raise cash and meet redemptions. From 2011 to 2015, Berkowitz raised cash mostly by selling liquid stocks like AIG, Bank of America, and Berkshire Hathaway.

But stocks like those are gone from the portfolio and the biggest remaining positions are far less liquid. The largest holding as of Jan. 26, 2018 was St. Joe at 24.4% of assets, up from 18.0% just eight months earlier. Fairholme owns 34.3% of the shares. Morningstar estimates that it would take the fund 75 trading days to sell the position without affecting the share price. Plus, Berkowitz is the chairman, further complicating matters. The fund held another 23.2% in Fannie Mae and Freddie Mac preferred shares as of Jan. 26, 2018. Berkowitz has been trimming this position, which was a combined 33.8% of assets as of May 2017.

Berkowitz has compensated by continually selling securities to raise cash. Cash was 25.9% of assets--or about $440 million--as of Jan. 26, 2018. The fund also had 15.7% of assets in short- to intermediate-term corporate--mostly high-yield--bonds as of November 2017. It only had about 31% of assets in common equity shares. Nevertheless, the risks inherent in the portfolio's holdings are more akin to equities than fixed income.

Performance Pillar: Negative | Kevin McDevitt, CFA 03/01/2018 This fund's record since inception remains strong, but bottom-decile returns in three of the past four calendar years have severely tarnished its results. The fund's five-year 4% annualized gain through February 2018 trailed the Russell 1000 Value Index by an astonishing 8 percentage points. Over the trailing 15 years, its 8.9% annualized return trailed the index by 1 percentage point. These poor results and the fund's embattled portfolio amid outflows lead to a downgrade in the Performance Pillar to Negative from Neutral.

Nevertheless, the fund gained 9.5% annualized from its late 1999 inception through February 2018, beating the index by 2.6 percentage points. But this is cold comfort to many current investors as most of those gains were earned in the years prior to 2011.

Because of the fund's highly concentrated and eclectic portfolio, calendar-year results are often feast or famine in relative terms. It has finished in the large-value Morningstar Category's top or bottom decile in nine of the past 10 calendar years. Its behavior also tends to be loosely tied to the broader market. It doesn't closely resemble any of the major indexes and has an R-squared (a measure of correlation) of just 55 relative to the Russell 1000 Value Index since its inception.

This fund has fallen on hard times, but it could still rebound. But its extreme concentration and volatility make it unsuitable for the vast majority of investors.

People Pillar: Neutral | Kevin McDevitt, CFA 03/01/2018 This fund's advisor has once again failed to retain senior team members. Fairholme Capital Management's director of research Dan Schmerin left the firm in December 2017. (Two analysts, Grant Stark and Roger Puerto, also left the firm in 2017's second half.)

Schmerin joined the firm in 2011 and replaced industry veteran Fred Fraenkel as head of research after Fraenkel had been in the role for less than two years. (Fraenkel subsequently left the firm altogether in September 2015.) Schmerin's departure will potentially leave a hole, given his background in distressed securities, a status with which bond holdings from both Sears and Imperial Metals are currently flirting.

This continues Fairholme’s history of failing to retain senior staff. The firm once lost four comanagers in a four-year stretch. That may owe to Bruce Berkowitz's relentless pace as well as his reliance on his own work and that of hired outside experts. But for whatever reason, none of his senior analysts or comanagers have stuck around for very long.

More broadly, although Berkowitz has been successful in years past, his judgment in recent years must be called into question. In particular, he has put the fund at risk by investing in securities with somewhat constrained liquidity within an open-end mutual fund. This combination of factors justifies a downgrade in the fund's People rating to Neutral.

Parent Pillar: Positive | Kevin McDevitt, CFA 09/27/2017 Bruce Berkowitz founded Fairholme Capital Management in 1997 and launched flagship fund Fairholme in 1999. In 2010, it introduced two more funds, Fairholme Focused Income FOCIX and Fairholme Allocation FAAFX, and in 2013 it launched a partnership to invest in private companies. While the newer strategies place additional demands on Berkowitz, who is the clear investment beacon at the firm, he maintains just one investment philosophy for them all. Berkowitz prioritizes shareholder communications with thorough letters and periodic Q&A sessions with shareholders. Berkowitz and the firm's employees have more than $200 million invested in the firm's three funds (down from $500 million several years ago). He has also closed funds when inflows have outpaced investment opportunities to preserve the integrity of the investment process. This investment centrality and transparency, alignment with fundholders, and capacity management earn the firm a Positive Parent rating.

However, Berkowitz has struggled to retain senior investment personnel, and key-manager risk is an issue. On the regulatory front, in June 2011 the SEC named Fairholme in a private investigation tied to its position in The St. Joe Company. (Berkowitz is also St. Joe's chairman.) St. Joe and the SEC settled the matter in October 2015. St. Joe, without admitting or denying any factual allegations, consented to the SEC's issuance of an administrative order.

Price Pillar: Neutral | Kevin McDevitt, CFA 03/01/2018 This fund's management fee was lowered to 0.80% from 1.00% as of Jan. 1, 2018. As a result, the fund's Morningstar Fee Level moved to Average. Its 0.83% prospectus expense ratio is 6 basis points below the large-cap no-load peer median. As a result, the fund's Price Pillar is raised to Neutral.