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Fairholme Doubles Down on Financials

Christine Benz

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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Benz: So, Kevin, I wanted to discuss the suitability of the fund in investors' portfolios, given its level of concentration, given the big bet on banks, some of which have been troubled. Would you say that it's only appropriate for a certain type of investor at this particular point?

McDevitt: Yeah. I would think that at this point, I think the fund really is only appropriate for really very risk-tolerant investors as just a starting point, but I think even if you are someone who has a very high risk tolerance, you wouldn't want to have this be a core position in your portfolio at this point. I think it's a position that it could potentially be one that's a satellite holding kind of in the periphery of your portfolio.

But given the concentration, I think it's really the vast minority of shareholders who will be comfortable with the fund's level of volatility and the concentration in its portfolio. I think it's important that investors be honest with themselves too when making that assessment. I think it's easy sometimes still to look at the fund's long-term performance which is still, Christine, as you mentioned very good, it's excellent. But investors should focus more I think now on the risks in that portfolio and ask where could it go from here.

Again, this is not at all to say how the fund itself will perform. It's very possible these positions could all work out over time, but you really got to have a very strong stomach to be able to hang in there through the inevitable volatility.

Benz: Right. Ryan, I want to shift gears a little bit. I know in your call with Berkowitz, you also discussed the Focused Income portfolio. What's going on there? Are they some of the same issues that we're seeing in the big fund?

Leggio: A little bit, but not to the same extent certainly. A big issue I've been watching in that fund is the growing equity stake in the fund. So, by way of background, a little over a year ago last May the fund had 0% of assets in equities. In February of this year it had close to 20%, and with the recent filing as of May of this year, it has a little over 25%. In talking with Bruce, it sounds like because of the very low yields in a lot of bond sectors right now and the opportunities he is finding in the equity space, he is comfortable having a 20%-30% range for equities in the fund for the foreseeable future.

Now, most of these companies that he owns, such as Verizon and a lot of the pharmaceutical companies, are paying pretty hefty dividend yields, and they have strong balance sheets. Our equity analysts think they're either fairly valued or undervalued; so that's not the issue. It really is just that the fund went from having 0% exposure in equities to now 20%-25% exposure in equities.

Benz: So what's the complexion of the bulk of the portfolio; what's in there?

Leggio: So, the bulk of the portfolio then is in corporate credit really in names that he follows in the Fairholme Fund. So he has Sears bonds in the fund; he has MBIA bonds in the fund, a big holding in Fairholme and Fairholme Allocation. He has a new position in a big bank in the fund, and these are all corporate bonds with maturities say in the three- to eight-year range that are yielding anywhere from 6% to upward of 10% in some instances.

Benz: So what does performance look like on Focused Income so far?

Leggio: Well, as you can expect because the equity stake has increased, and we just now got the May portfolio now, with the recent sell-off, the fund has taken a pretty big hit. It's about flat for the year so far, and again that's really because of the equity stake. And it's also because of two new positions in the fund, Citigroup and Bank of America, that he has in the Focused Income Fund and that's common equity. Those aren't preferreds or corporate bonds, and certainly those two names have taken a hit over the last couple of weeks.

Benz: So it sounds like Ryan, you think that the fund's role in one's portfolio has also changed a little bit as that equity stake has grown? Let's talk about your thoughts there?

Leggio: Absolutely, Christine. I think initially when we first saw the fund, it had a lot of commercial paper, almost entirely in bonds. We were thinking a shorter time horizon for the funds, such as one, two, or three years. I think now that it's looking more like a conservative-allocation fund. The risks have certainly changed, and investors' time horizon needs to increase because it can take a while for some these equity names to work out. So maybe, along the lines of closer to three or even five years or even greater rather than that shorter timeframe when the fund owned mostly commercial paper and short-term corporate bonds. So certainly the role in the portfolio has changed I think.

Benz: So let's touch briefly on that allocation fund. We haven't talked about it. It's a fairly new offering. I think we've just recently begun to see what that will look like. Any thought on what's going on there, and how one might think about that particular fund right now?

Leggio: Sure. So, I think it's really taking Berkowitz's views to the next level and in terms of the concentration of Fairholme, it really makes Fairholme look meek. It has two positions as of the recent May filing that are 25% of asset to roughly each, and that is MBIA common equity and AIG common equity. So it really just expresses the best ideas for Bruce and kind of where I think he is seeing the best opportunities.

Benz: So it sounds like all the things that we've been saying about risk tolerance, for the other two funds you might want to take an upper notch and have an even higher stomach for risk, if you're looking at that one?

Leggio: Absolutely.

Benz: Well, Ryan, Kevin, thank you both for sharing your insights into what's going on at these funds. I know they are very high-profile among Morningstar.com users, so people would really be happy to get some new information. Thank you.

Leggio: Thanks for having us.

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