Why Fairholme Moved into Health Care

Michael Breen: Greetings. This is Mike Breen from Morningstar, coming to you from the 2009 Morningstar Investment Conference. We have collected a lot of the best money managers in the business here, and I am fortunate to have one with me here right now, Bruce Berkowitz of the Fairholme Fund. How are you Bruce?

Bruce Berkowitz: Great, Mike.

Michael: You were on a panel earlier and were getting a little grilling about some general themes in your portfolio, so I thought we would talk about some of those.

But as a backdrop, it was very interesting when we spoke last fall. You were a little bit philosophical saying it was almost like the best of times and the worst of times. The fund was down, the market was horrible, but you are finding incredible deals, 20% free cash flow yields on companies, and that led you to a few sectors. So maybe you can give us a little background on how you ended up and where the portfolio is today.

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Bruce: Well we made a big move in health and defense, knowing that we were going to head into a tough time, a recessionary time, and looking back and seeing that the companies maintained their free cash flows.

What really brought us to the area was just the stress in the industry. With the democrats coming in, everyone knew that these companies were going to take it on the chin, or at least verbally take it on the chin, and there stock prices just dropped off a cliff.

So when we compared sort of what we were paying to what we were getting, ...and understanding that healthcare and the health and safety of our families does not go down much.

So we looked at the cash flow trends and we knew that the defense budget was going up, healthcare budget was going up. With all the demographics and what is going on in the world, we went to that sector. And of course we were wrong to the extent that when times get really tough everything is correlated and everything goes down.

But so far we are right on the cash flows, and these companies make good money and they are essential. I mean, the healthcare companies and drug companies, they are the health system of the United States.

The defense companies, they pretty much are the defense system of the United States. They are still quite cheap and probably are at free cash flow multiples that aren't really often seen, so we are comfortable.

Michael: So a lot of headline risks, but not in your mind a lot of business risks.

Bruce: There are always going to be a lot of headline risks because of the nature of the businesses and how the population needs ever increasing amounts of healthcare. We all want to live to 100. We all want to tap dance everyday until we hit 100.

Michael: Speak for yourself. [laughs]

Bruce: There are unintended consequences of having a longer and healthier life than previous generations. It costs a lot of money. And that last year of your life is awfully expensive.

So there is no real villain. We can look to cut the friction, the system. There is fraud in the system; that can be done. Eventually, maybe if you are a couple of hundred pounds overweight you have to be told you have got to lose some weight before you get some new hips and new knees, or Americans may have to start to exercise again; that will save us a lot of money.

But overall, the healthcare companies, like the defense companies, they don't have excessive margins. They are fair, 4% or 5%, they are fair margins, so there is no gouging that is taking place.

But what has happened is since there prices have so dramatically dropped, it is a very good free cash flow yield compared to price. But the business model is tight. They are working hard to try and reduce costs. They are being pounded in the press everyday.

But my answer is, if we don't use the existing companies, who are we going to use?

Michael: OK. We have discussed managed care companies, so that might be a perfect of example of that where really the government can speak all they want about changing things, but they can't really displace those firms because they are doing the entire system.

Bruce: These are the same firms that are doing all the work for the government in Medicare, Medicaid. When the government needs to figure out what companies should charge for a certain procedure of medicine they make go to a division of United Health to find the answer to that.

So sometimes when they are talking about, "We can do it cheaper against company A, " they are really talking about the same company that is doing both sides for them. And you are getting into differences in the quality of treatment or what you are receiving.

Michael: And as you said earlier today, the government is good at cutting checks. That is the main thing they can do, and these firms still need to be around to kind of implement the services.

Bruce: Right. I think it has been shown that when it is left to the government and they just send out checks that the cost increases rise, and that using a healthcare company, health insurer, has allowed them to somewhat slow the growth down.

But there is going to be more to do and everyone is going to have to do their part. But this country is all about being able to earn a reasonable return on investment, not excessive.

And these companies have a scale and they don't have that much investment intensity. And to a large extent, besides the government, they have been their own worst enemies in their very poor capital allocation decisions of the past few years when they were buying competitors at very high rates and they were buying their own stock back at multiples of where their stock is trading today.

So today can't be a mistake if they can terry, and the cash flows are still coming in, so we shall see.

Michael: OK. Great. Thank you very much for your time.

Bruce: It is good seeing you.

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