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By Christine Benz | 08-12-2011 01:27 PM

Fairholme Doubles Down on Financials

As Bruce Berkowitz intensifies his bet on the financials sector, risk-averse investors may want to steer clear, say Morningstar's Ryan Leggio and Kevin McDevitt.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Although, it was one of the best-performing funds of the past decade, Fairholme Fund has recently hit the skids dropping more than 20% in the past month alone. Here to discuss what's been going on at Fairholme Fund as well as Fairholme Focused Income are Ryan Leggio. Ryan is a fund analyst for Morningstar and on the phone with me is Kevin McDevitt. He is editorial director at Morningstar. Ryan and Kevin thanks so much of being here.

Ryan Leggio: Thanks for having us Christine.

Benz: So, let's get right into the bulk of the call. I know that you talked about Bank of America. That's been a highly controversial and also painful position for Fairholme Fund, what did Bruce Berkowitz have to say about that position and is he still confident in having such a large position in the bank?

Leggio: Well, Christine, he had a conference call earlier this week with Bank of America CEO Brian Moynihan, where Bruce asked him a lot of questions. There have been a lot of concerns about the bank. In recent weeks, its stock price has kind of been under pressure. Talking with him earlier today, Bruce really is still confident in the bank's management and the bank's prospect going forward.

Benz: So Kevin, he is leaving the position size relatively large, it sounds like he's not inclined to trim back in Fairholme Fund?

Kevin McDevitt: Not trimming by choice at least, I don't think. I think as Ryan said his conviction remains very high in Bank of America as well as the other financial positions in particular Citigroup, MBIA, and AIG. As Ryan alluded to, he still feels like Bank of America is doing quite well. He feels like the company is in great shape financially. It is adding to its tangible book value, it is making money, and it's adding to the reserves. So, from Bruce's perspective, I don't think conviction is really waivered at all in Bank of America in particular as well as his other positions.

Benz: So another thing I want to talk about with you Kevin is the issue of cash in the fund. We saw the portfolio that came out at the end of May actually had a very small cash stake down, quite a bit from where it was earlier this year. Is it still running with a pretty concentrated portfolio and little cash at this point?

McDevitt: Well, the equity portfolio is still very concentrated, and it has probably become more so. But he did say that he has built up cash significantly since the end of May, and obviously with the massive outflows out of the fund--in fact we've had $4 billion or so leave the fund through the end of July--I think he now sees that he needs to maintain a fairly healthy cash cushion at this point, especially what's been happening in the market recently so far in August. But that said, the flip side of that is even though I think cash levels have gone up quite a bit, the equity portfolio itself though has become more concentrated as he has had to sell existing positions that were going to build up cash. So, again on the one hand you have a bit more of cash buffer there, but that equity portfolio has become more concentrated, too.

Benz: Kevin, I think an important question is whether at some point if the fund does continue to see outflows and we've been seeing some of the information that you get about inflows and outflows that it has been one of the hardest-hit funds in terms of redemptions, at some point will those redemptions begin to impede performance or impede the way that he is running the fund?

McDevitt: Well, from his perspective, I think in a way he would certainly prefer to not have redemptions, but I think he is comfortable with how he is managing the portfolio. I think for existing shareholders and perspective shareholders, though, there is a lot to think about and in particular it's what I mentioned before, it's a fact that as redemptions continue, the portfolio itself will become just more and more concentrated. So, the potential risk in the portfolio at least in some respects will continue to increase. How that will shake out in terms of performance is somewhat of a separate issue only in a sense that we don't know yet how these bets are going to work out. They could all work out very well. But, again, as the portfolio does become more concentrated, that is a potential risk for existing and potential shareholders.

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