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By Don Phillips | 06-09-2011 12:00 PM

Berkowitz on His Conviction in Financials and St. Joe

In Part 2 of a Morningstar Conference interview with Don Phillips, the Fairholme manager makes his case for Bank of America, Goldman Sachs, as well as Sears Holding and the controversial Florida real estate company.

This video is an exclusive benefit of your Morningstar.com Premium Membership.

Phillips: Well, we had a panel yesterday evening with some terrific value investors who were quite wary about financials. A direct quote was: "Large financials with heavy leverage and black box balance sheets are just too hard to analyze."

In a sense, you've become almost the contrarian's contrarian here--where even the traditional value managers are shying away from this area, you've dove in in a very big way. What's the reason to have this kind of conviction in financials?

Berkowitz: That is the big question, sane or insane with our financials exposure. And I quote, a year ago, year and half ago, I did say it's hard to know what the financials own, what the financials owe, and before the government came in, it was hard to know who owned the financial companies.

But with enough time, and with enough capital infusion, I was feeling comfortable. Whether you are looking at an insurance company with reserves or you're looking at a bank with loans, you have to look at every vintage, every year, of the loans, and you have to understand that whether it's a commercial loan or a residential loan, whether it's floating, whether it's fixed--these loans have average lives.

So for example, the difficult loans were 2007-2008. Today, ... probably less than 40% of 2007 loans still exist. That vintage of 2007 is burning through, and the rules, the banking laws are pretty strict as to when you've got to write it off, when you got to call it a day, when you've got to repossess. And 2008, it's probably less than 50%. So you've gone beyond the halfway point; enough time has gone by from 2007-2008 to see how those loans are developing.

Meanwhile, you have banks with balance sheets that have never looked better in terms of the equity, the heft that they have in the balance sheet, and the pre-tax, pre-provision income that's flowing into the institutions, and that size of that cash inflow will be more than enough to take care of remaining problems.

Phillips: I was talking to an advisor earlier in this conference, and he said, I've been a Fairholme shareholder for a long time; my clients are very pleased, and I understand the philosophy: You have to have a willingness to go into stressed areas, but my goodness, does Bruce have to be in all of them? Could we tick through a few of these names, maybe starting with AIG and …

Berkowitz: ... Citigroup, Bank of America. "Bank of America single-handedly caused the problems in the real estate world," I don't think so, but they're being blamed for it right now. Again, investing is all about what you give versus what you get. So, you got to take a look at the price of these companies versus what's there and understand the perverse psychology that exists in the situation.

Today, people are just wildly pessimistic about Bank of America. Why? Well, they hate it. I lost my job because of them, I lost my house because of them. And people don't go back to the point where we started out with a great idea: Everybody should own a home. Then it got further, and then something happened: People started to forget that it's important that you should be able to pay for that home.

So then you had Freddie loosening standards, Fannie Mae loosening standards, you had advocacy groups like ACORN picketing banks for not lending fast enough, more aggressive enough. You had the government telling everybody, "Lend, lend, lend! The best thing in the world is to own a home." Well, it isn't if you can't afford it; it becomes a ball in the chain.

So, we've had all these little incremental moves, so now Bank of America becomes patriotic and buys Countrywide and now Brian Moynihan and his team have being kicked everyday for being the evil empire, when in fact Bank of America was the first to lower late charges, the first to step up. They're ahead of the curve in reform. They have an extra 30,000 people right now working through the problems. They are doing everything in their power.

So the negative is the real estate. It's ... working through all the bad residential real estate, the reps and warranties issues about the securitizations, and you have to understand that. Then on the other side you have to understand Merrill Lynch, Bank of America, NationsBank, Fleet, MBNA--there are dozens of institutions that are now Bank of America.

With Bank of America, you then have to go to the math, and the math is that $4.50 to $5 a share of cash is going into the company before provisions and before taxes. Taxes forget; they have about $100 billion of losses they have to make up. So they are not going to be taxed for quite a long time. So $4.50, $5--so you take out the provisioning in a more normalized provisioning, and the company should make at least $2 a share. I won't tell you what I really think they could make, but just at least $2 a share. Can that be so bad for a $12 stock? Can they go out of business with the kind of equity they have now? No. "The government is going to kill them. The government is going to take away all their profits just like the way the government was going to take away all the profits from the health-care companies two years ago." You know what? They don't have to be egregious. If they just make a 1% return on assets, which would translate into a 10% return on equity, which would probably translate into a 15%-plus return on tangible equity, and if you could buy that at half of book value, what else do you have to do in this life? And that's where we are today, but obviously so far I'm wrong.

Phillips: Another name you own and mentioned earlier in this conference: Goldman Sachs. I believe the manager said, "they're always on the front page and it's never good." What's it like living with a holding like that, and what's the rationale for it?

Berkowitz: Every day, evil empire banging, banging...

Phillips: Now it's Libya right?

Berkowitz: Libya... [Pause] They're smart guys [at Goldman]. They've got a great franchise. They've been of tremendous help to us in Asia. I like the people. I personally think they're ethical, decent guys, and I like working with them with what we do with them, and how many times you see Goldman Sachs around tangible book value, and that's where we are, and that's kind of expensive compared to my other positions.

Phillips: How about Sears? That's another name that's a controversial one.

Berkowitz: The way I think Sears works out after three years of really nothing so far is that one day, Eddie Lampert will own one share, and Fairholme Capital Management will own one share for our shareholders, and that's it, and we'll split the pie.

... It wasn't that long ago in my mind when Apple was about to fail and Microsoft had to come to bail them out. Today, the great retailer Sears, Kmart are considered bombs. It's all over; they could never do anything in retailing. If that happens, then the pessimism will push the stock down, and you will continue to buy the shares back. He has bought back $6 billion of shares already since the merger, and I don't think the company is worth more than about $7.5 billion today. So, give it five, six more years, we'll be down to 2 shares, I'll have one, he'll have one, and we'll see what happens with the property and the brand names and the insurance and the warranty business and everything else.

Phillips: One name that we'd be remiss not to talk about, because everyone talks about it with you these days, is St. Joe and the role that you played there. Could you maybe back up for the audience and explain?

Berkowitz: St. Joe is very simple. I grew up very poor in a one bedroom apartment, and I always wanted a backyard. So, I figure 600,000 acres was a pretty good start.

St. Joe, the Panhandle Florida, is a beautiful place. Some of the most beautiful beaches I've seen in the world. And you can't describe them; you just have to see them. It's the last place open in Florida where people will eventually be able to live and work.

Now, whether St. Joe becomes a melting ice cube, which is just stop the bleeding, wait for the real estate market to pick up. We have a quarter of a billion dollars in cash, no pension liabilities, less than a 100 employees now, everything is in great shape. A fortune has been put into the land. The State of Florida has put in billions and billions of dollars into the land, highways, byways, brand new international airport. But that's all worth nothing until something good happens. So, there is the debate--and whether St. Joe builds the next Tampa, St. Pete, Panama City.

The problem with St. Joe real estate, and one way people look at it is, it's the use of discounted cash flow models, because after a certain period of time, say 10 years, every present value goes to zero, and if you use the same kind of thinking that's being used on St. Joe, you would never have done Fort Lauderdale, you would never have done Boca, you would never have done Hilton Head, and every other great place.

So the vision is that St. Joe becomes a great place to live and work with this new airport, with 20 flights a day, 20 in, 20 out. And we'll see what happens. But we've stopped the bleeding. ... We still need a little bit more time to understand everything that we own, including what's under the ground and what's over the ground. Story is, last year some guy was interested in buying some timber. So we don't just sell him the trees; we sell him the trees and the land, and then we find out, he was really interested in aggregates. So we had a huge supply of aggregates for building materials; we didn't even know it.

So, now, today, we're going back. We're looking at all 600,000 acres--that's 900 square miles. It's almost, roughly, I don't know, two thirds the size of the state of Rhode Island. I mean just our airport project alone is bigger than Orlando; it's bigger than the Island of Manhattan. So there's huge scale, but this time needs to be done. So it's a small position. Good can come from the position. Its long-term, Fairholme, as a mutual fund company cannot directly invest in real estate. St. Joe can directly invest in real estate, and Fairholme can directly invest in St. Joe. We'll see how that turns out.

Phillips: I'd like to open this up to questions from the audience. So if we could ask our wranglers to go out, and if you've got a question, try to flag down one of these people in the red Morningstar shirts. But before we do that, I'd like to ask you a follow-up on this.

You're both in a world where you're the chairman of St. Joe and then investing in the fund, or investing in the company through this. You've taken on a lot of headaches that a typical fund manager would not do. Could you talk a bit about that situation?

Berkowitz: Some people play golf, some people watch TV, they go to the movies. They are social. They have friends. I became the chairman of St. Joe.

Phillips: How's that going over at home?

Berkowitz: I have a great wife. In fact we had our anniversary yesterday--32 years, not bad.

Phillips: Congratulations.

Berkowitz: Thank you.

It's tough, there can always be conflicts between being president of Fairholme Fund, chairman of St. Joe, but people are worried about inflation. Land is great. You can't grow food on gold. You can grow a lot of stuff on St. Joe's land, but I have a vision for Joe. For example, in Asia, hundreds--billions of U.S. dollars are owned in Asian countries sitting probably in our U.S. Treasury earning nothing. So maybe they will like to bring a few of those dollars down to St. Joe and build something.

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