We're Wary of the Recent Interest in Fairholme Fund

A version of this article originally appeared in Morningstar FundInvestor.

Our review of  Fairholme Fund's (FAIRX) portfolio and conversations with manager Bruce Berkowitz give us confidence in the fund. In fact, Fairholme is the largest single holding in my portfolio. But given the recent beatings that other concentrated, "star" managers such as Bill Miller at  Legg Mason Value Trust (LMVTX) and Bill Nygren at  Oakmark Select (OAKLX) have taken, I wanted to highlight some of the similarities and differences of risk that Fairholme contains, especially for investors not familiar with it.

I worry that investors now expect Berkowitz to whip the S&P 500 Index every year. Many investors have likely put Fairholme on the top of their "new buy" list recently, as the fund is having another great year of relative performance due to a timely move out of energy. Investors sadly began to take notice of this fund in 2005--coincidently the last year of Miller's "streak" of calendar-year wins versus the S&P 500 Index--as fund assets grew from $264 million to $1.5 billion that year. We've seen investors quickly get disenchanted with Miller's and other focused funds even though a bad year is a certainty with a focused fund. To be sure, Miller by now has strung together a number of bad years, but we saw redemptions start quickly there and at other funds that should be held for 10 to 30 years. Meanwhile, assets have continued to flood into Fairholme in recent years--the fund sported a $7.8 billion asset base as of October 31.

The publicity of Miller's winning streak certainly stoked his fund's popularity, but a calendar year is an arbitrary endpoint for analyzing fund returns. Mutual funds don't have business cycles or busy seasons like industrial firms and clothing retailers. I went back and analyzed his fund's rolling 12-month returns from 2000 through 2005, which covers the inception of Fairholme through the end of Miller's calendar-year streak. The result? Miller beat the index in 42 of 61 periods. That's certainly a great batting average (something the Cubs and Sox could have used this year in the playoffs, but I digress) but it shows that Miller has been far from perfect versus the index. Fairholme, interestingly, beat the index in 56 periods, yet saw its calendar-year winning streak broken in 2003 when its 24% gain trailed the index's nearly 29% rally. Perhaps even more telling, though, are the cumulative total returns over the period from 2000 to 2005--Fairholme posted a 170% gain, while Legg Mason Value Trust's cumulative rise was 15.6%.

Still, the funds share similar inherent risks within their portfolios. Like Miller, Berkowitz manages a compact portfolio. In reality, the portfolio is even more concentrated--64% of assets are stashed in the fund's top 10 holdings, and each of the bottom seven holdings as of Aug. 31, 2008, makes up less than 1% of assets. Concentration isn't inherently bad, but as seen with Value Trust's recent performance, a handful of missteps can sink a concentrated fund. In addition, fund flows can impact a manager's strategy. Miller has had to sell stocks to meet redemptions, and a change in sentiment for Fairholme could force Berkowitz to do the same. Fairholme is in a better position to handle such an event, though, as the fund typically has 10% to 20% of assets in cash. Berkowitz believes the key is finding management teams that are serial winners with whom the fund can partner for the long haul. If he can't find them, he'll gladly park cash on the sidelines. So, while Berkowitz is riding a hot streak right now thanks to sidestepping financial disasters and making a timely move out of energy, investors should still expect the fund to lag during strong, momentum-led rallies such as in 2003. Some of his holdings will require many years and a lot of patience to pay off. We hope, but can't be sure, that the latest batch of shareholders will stick out the inevitable years in which the fund lags.

In the end, this fund remains one of the best, but using it wisely and understanding what it does--and doesn't do--will be the key to reaping its full rewards.