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What's Going on at Fairholme Fund?

Christine Benz

Christine Benz: Hi. I am Christine Benz for

After a nearly unbroken string of topnotch performance, Fairholme Fund has recently hit a rough patch with bottom decile year-to-date and trailing one-year returns.

Here to discuss what's going on at Fairholme Fund is Kevin McDevitt, he is editorial director for Morningstar, and he also the analyst on Fairholme Fund.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, I know we are always the first to say don't focus on short-term performance, but a rough patch like this, especially for a fund that has had such a string of superb returns, is a little eye-popping. I know our users are concerned about what's going on there, and we've seen some redemptions from the fund. So, I am hoping you can provide some color on what have been the big drawbacks for Fairholme from a performance standpoint?

McDevitt: Sure. I think, the first thing to point out, though is, it's really amazing that this hasn't happened sooner. They haven't had a period of underperformance like this at any other time, except for 2002 perhaps or 2003--a period of this type of underperformance for the fund, [which has had] as you mentioned just a long string of top decile performances.

In terms of what's hurting the fund this year, it's really the financial positions. The fund has about 90% of its equity exposures in financials, and that's really been the hardest hit sector so far year-to-date.

Benz: Right, and AIG in particular, the top holding there, has really sunk after having been quite good for the fund in the past. AIG has really dragged it down recently.

McDevitt: Yes. Absolutely. AIG had a great rebound in 2010, and this year it's really been held back by the fact that, investors know the government--again the government is a 92% stakeholder or shareholder in AIG--and they're planning on selling that position sometime this year, and that's really put damper on the stock. Again investor know those shares will be coming to market, so it's a huge liquidity event, and that's I think really been hurting the shares.

Benz: Right, and also it sounds like the shares will fetch a much lower price than perhaps people had originally thought they might?

McDevitt: Yes, and certainly less than what Berkowitz expected, and he admits that. I think, his line right now is, he feels like he has been too early to get into financials. I think he still has very strong conviction in those stocks. But I think he does feel like he was early, with AIG in particular.

Benz: Okay. So 90% financial, should that affect how someone's thinking about the fund? Should it not occupy a core-type slot in a portfolio? Is it better off as kind of an aggressive kicker? How should someone think about that?

McDevitt: That's the real question, and hopefully a 90% position in financials is getting people's attention, because I think that's where the focus should be, on Berkowitz's strategy, and what's in the portfolio versus past performance--because again, I think, past performance gives kind of an unrealistic picture of what could happen going forward. He has been so good, so consistently, that in some ways that, I think, could be deceiving.

In terms of what role the fund should play in a portfolio, I think the only way this should be a core holding is if you really understand Berkowitz, understand his strategy, and understand that it's going to underperform for potentially long stretches, for long periods of time.

I think this fund will continue to do well over the long term. I think Berkowitz is a fantastic manager, but anyone who deviates this much from the benchmark, this much from the index, is going to have long periods of underperformance.

I think, again, it will pay off in the long-term, but as a shareholder, you have to share that conviction, you have to have that same conviction of what he is doing. If you don't, then the fund is either not appropriate for you or should occupy just a very small part of your portfolio.

Benz: I thought it was interesting in your recent Analyst Report you said, if you are one of the people who is leaving Fairholme right now because you are spooked by this, maybe you are better off leaving because this isn't the right fund for you.

McDevitt: ...And this actually has not been that bad. ... You can say the fund is underperforming--it certainly has--but in absolute terms, it hasn't been that bad.

Benz: Something like 7% down year-to-date.

McDevitt: Right. In the scheme of things, compared to a year like 2008, this has not been that bad. So in a sense, this is your chance to get out, if this is enough to make you nervous, this is a great time, I think, to sell the fund, because it's probably not a good fit for you.

Benz: Right. So Kevin, I want to talk about the redemptions, because sometimes when you hear that a fund has been seeing sizable redemptions, as Fairholme has recently, you wonder, "Well, is this going to affect how the manager is running the fund? Is he going to have to hold more liquid names than he otherwise might? Let's talk about that and whether people should be concerned about that?

McDevitt: I think, in his case, in this fund's case, in Fairholme's case, it's far better positioned and prepared for redemptions than most other funds. Berkowitz has about 25% of the portfolio in cash, and even though they've already had redemptions of about $1.3 billion so far this year, he still has plenty of cash on hand to meet potentially future redemptions.

So, I think the cash is there and also the good thing from an investment standpoint is, I don't think he will be in a position where he ever has to sell a position or sell shares in a company because he needs to meet redemptions. That's the worst-case scenario, especially for a value investor. So I think he is insulated from that.

Benz: Right, and he likes to keep that cash cushion because he wants to be opportunistic. It sounds like he could still see significant redemptions and then some, but still have some money to deploy into selected opportunities.

McDevitt: Absolutely. I think, it's really there for both reason, I think, it is there to meet redemptions, but ... we met with him in March, and he mentioned then that ... there would be another buying opportunity in two to three years. So, I think he wants to have some dry powder on hand for that eventuality.

Benz: Right. Well, thank you, Kevin, so much for sharing your insights into this fund. I know, our users will very much appreciate hearing your perspective.

McDevitt: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for