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By Don Phillips | 06-09-2011 12:00 PM

Berkowitz: Ignoring the Crowd Is Painful, But It Works

In Part 1 of a Morningstar Conference interview with Don Phillips, the Fairholme manager discusses the fund's contrarian philosophy, operations, and size.

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Don Phillips: I know that a lot of you were super-excited about this conversation we're having at lunch. People keep coming up to me saying, "I can't wait to hear from Bruce."

This is going to be wonderful. It's an exciting time to talk about the fund. As you know, the Fairholme Fund has been widely praised. Morningstar analysts have been very fond of it. Bruce has been a winner of our Manager of the Year Award. He's also the only winner to-date of the Morningstar Equity Fund Manager of the Decade.

He's had an absolutely terrific record, and now he's had a six-month period where the performance has been ... less than terrific.

We didn't even rehearse that, and that's a great time to talk about this. I was talking with Hedda Nadler, who many of you may know works with Bruce on the PR side, just about how important it is that when performance is out of favor, that's when you want to be talking about things. And those organizations that go into radio silence when times are tough, they make it much harder for [advisors] to do [their] job, because ... how do you explain to the client why the performance hasn't been as strong or should we stay the course.

And so those are some of the things that what we'll talk about today.

Bruce, let me start just at the beginning. You launched a value-oriented mutual fund at the peak of the tech bubble. What were you thinking? Why then and why a mutual fund? Why not a hedge fund route?

Bruce Berkowitz: The original reason for mutual fund. Forgive my voice. I am having an extreme case of premature accumulation in financial services companies.

The mutual fund, I wanted the transparency, wanted my shareholders to be protected, I wanted a public record. That's why I did it.

Why a value fund? It's the only thing that I know. It had nothing to do with the tech bubble at the time. It was an interesting time, and it reminds me very much of a time like today. We are in 2000 after having a very successful 15 odd years in various firms, and I started Fairholme. When the tech bubble got going, about one-third of all of my clients just left. They just said, "you know, you are doing okay, but this tech stuff is great. You got to get into it."

I said, "I'm not going to do it. You are going to lose money." And even my smartest clients said, "Oh, you got to do it! Everybody else is! Come on!" 

So, we stayed value-based. It was painful. It ended up working out OK. We are going through a painful period right now, and a year from now we'll see.

Phillips: You've got to have one of the most brilliant tag lines for your firm. I love it, and in three words, I think it sums up so much with just: "Ignore the Crowd."

Clearly, you knew a lot about how asset management firms were organized and managed. You've done yours in a completely different way. Can you talk a little bit about how you've structured your research team and how you go about doing business, because it's not the typical model?

Berkowitz: Well, "Ignore the Crowd" is just based upon how when everybody is happy about a company, the price reflects it. When people can't stand a company, the price reflects that pessimism. It's also about group-think. When I worked for Wall Street firms, there will be 12 people around the table debating this, that. Should we do it? Shouldn't we? Usually the person with the least amount of knowledge had the most powerful say in the matter, and it just didn't make any sense.

Phillips: The tyranny of the articulate.

Berkowitz: Yes. So, at the end of the day, investing is about one person has to take the responsibility of pulling the trigger, and group-think always dummies down to the lowest common denominator, and so, you ignore the crowd. It's still painful, but it's worked.

Phillips: You also ... use a lot of outside consultants ... for various specific tasks where you need additional information. How does that work?

Berkowitz: What we've tried to do is rather than develop people from business school--have gone there, have been, done that. If we're interested in a new area, a few years ago, it was health care. So, we found people, consultants in the health-care business for 30 years that could be had for less than the price of a graduate from Harvard Business School, and to try and help pick apart our ideas as to Obamacare, will the health-care companies remain, and everyone thought we were crazy investing in UnitedHealth and WellPoint and all those companies ... because they were all going to disappear.

We asked the experts in Washington--we hired a few--"Well, how is this all going to play out?" And we realized the government just doesn't have that many people to run all of these businesses. So, they picked at our ideas, they couldn't kill them, and that's how we use the outside consultants.

But instead of having full-time employees, we'd rather dedicate the money to experts in the certain industries and sectors that we're involved in, and throw the money that way to get the very best people for the amount of time we need. Then they know, we know that when it's over, it's over.

When you build up a big firm of analysts, it's very difficult. You get to know the analysts, you get to know the family, friends, and they are part of the family. But what happens if the sector that person is expert in, you're no longer interested in for the next two or three decades? What do you do with the person? You retrain, and you end up hurting the shareholders because at the end of the day, it's all about the shareholders. You got to put yourself in the shoes of the shareholders. It can't be about your family. It can't be about your employees and associates. It has to be about the shareholders.

So, nimble, quick, turn on a dime, stay focused. Now, this works for people outside of the mutual fund business, whether it's a hedge fund or Warren Buffett with 12.3 people in Omaha, or other companies. But for some reason ... you don't look at it in a positive way in the mutual fund business, which makes no sense to me.

Phillips: One thing that always comes up with Fairholme is that it's had its explosive growth in size, and I would assume one thing that this model allows you to [do is] scale up, much more rapidly as opposed to hiring all the people internally. But could you just talk more broadly about the difference in the size of the fund? What can you do today that you couldn't do in the past, and then are there some activities that perhaps you could do with a smaller fund that today you can't do with the main fund but perhaps would do with the Allocation Fund?

Berkowitz: Sure, I'd be happy to. A valid criticism of the Fairholme Fund as we grew in size was that we would not be able to truly take advantage of small-quantity ideas that is because of regulation or liquidity or whatever, we could never get enough because we're so focused. We could never get the kind of position that we would want, and that's the reason why, at the beginning of this year, we created the Allocation Fund. So, for those people who thought that if we found small-quantity ideas, we take advantage of it, we would put it there, so we do.

So, that was one reason. During the tough times of 2008, some people wanted to take some chips off the table. They wanted a place to park their cash. We found some very interesting fixed-income investments, but they weren't good enough for the Fairholme Fund; that's why we created the Focused Income Fund, to have an income orientation. That's the reason.

So we basically listen to our shareholders. If we got a weak link at Fairholme, we'll try and create another fund, and that's reason for the adoption of the other two funds.

Phillips: How about with the main fund. I mean as Buffett has gotten bigger, he's used his additional scale to shareholders' advantage. Are there things you can do now with the Fairholme Fund that you couldn't do as a smaller fund.

Berkowitz: Scale has helped us so far. There'll be a time when it doesn't, but so far it has helped us. We would never have been able to commit $2.7 billion to GGP on the restructuring and before that buy $2 billion of busted debt. If we didn't have the size we would never--now, the results are not in yet--but we would never have been able to be a big player in AIG or the U.S. Treasury. We'll see if that was a good idea or not. It gives us the size to be able to matter. You need that kind of critical size, especially in private transactions, that are so labor-intensive, and with the Fairholme Fund we're charging a flat 1%, no frontload, backload, ... nothing else. So we need to scale, when you're going to pay ... those legal balances and so on.

So scale has helped. Clearly one day it won't. And I hope we'll figure it out before our shareholders figure it out that we should close down or maybe even give money back. The way I believe we'll have an early warning system on that, is that I take every penny of my family's money and put it into the funds, such that if I do something stupid with the funds, I'll get hurt much more being a shareholder than I will in the fees I get from the funds, and I'm hoping that that creates a level playing field both on a conscious and at a subconscious level, so that we don't do anything stupid. Of course after about 30 years, I can't imagine looking at the mirror after making some kind of bonehead maneuver.

Phillips: I've watched a lot of funds over the years and typically, you seek funds that have a lot of character; they are willing to be bold and different--they'll do that when they are smaller. But as they get bigger, they tend to look more and more like the market, because their incentives are just to hold on to the assets that they have. You haven't taken that tack. You are still willing to run a very bold and distinct fund, which would seem to me to be putting shareholders interest over the management company's interest.

Berkowitz: It's quite humorous in that people are starting to say that we lost our edge ... because we weren't focused enough like we were in the old days, and we're too big.

So here we are today focused as we were right in the middle of my circle of competence in financial services companies. It's like it's déjà vu all over again, with financial services from the late '80s, the early '90s. One thing great about getting older besides losing your voice is that you've been around long enough to see a few styles come in and out. Maybe you've seen the play before. Every five or 10 years, the financial services companies get themselves into a pickle. Every five or 10 years, you have to be bailed out. It just seems to be the nature of capitalism, and it's one of the side effects of capitalism. So, here I am. I ran for my dangerous health-care companies and put all the money into financial services. Little did I know that my dangerous health-care companies would become defensive plays in this time.

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