Six Financial Stocks One Ultimate Stock-Picker Is Buying

By Vishnu Lekraj | Stock Analyst

As you may recall from previous articles, we firmly believe that portfolio managers send signals about how they feel about a particular stock by the amount of money they're willing to commit to it at any given time. This is why we focus on not only the holdings of our Ultimate Stock-Pickers, but also on their purchases and sales. We generally assess the relative attractiveness of an individual security by how many funds are currently holding it, the percentage that each stock makes up of each manager's portfolio, and whether or not our Ultimate Stock-Pickers have been adding to or subtracting from their positions. However, we also like to look at new money purchases and outright sales, which we feel offer additional insight into the thinking of our top managers about their holdings.

Aside from the individual holdings of our top managers, we also pay attention to the sector allocations being made by our Ultimate Stock-Pickers, both in the aggregate and on a case by case basis, as they tend to provide us with an indication of where our top managers have placed their biggest bets relative to both the broader market (as represented by the S&P 500 Index (SPX)) and their peers. We hinted at some of this in our last article, when we noted that five of the six best performing fund managers among our Ultimate Stock-Pickers over the last year--a list that included  Yacktman (YACKX),  Fairholme (FAIRX),  Columbia Value & Restructuring ,  Dodge & Cox Stock (DODGX),  Hartford Capital Appreciation (ITHAX), and  Oak Value --had made only slight adjustments to their sector allocations. This isn't too surprising, given that most managers avoid tinkering too much with their portfolios when things are going right.

Berkowitz Makes a Big Bet on Financials
That's what makes the significant changes Bruce Berkowitz has made to the stock portfolio at Fairholme over the last couple of quarters all that more interesting. Throughout most of 2009, Fairholme's largest sector holding was in health care, which made up as much as 40% of the fund's stock portfolio during the first half of last year, with  Pfizer (PFE) alone making up a full one fifth of its stock holdings. Berkowitz (who is not only Fairholme's managing director but also its largest individual shareholder) started bulking up on health care about the same time that the housing and credit markets started to falter, waiting until the second quarter of 2008 to initiate his stake in Pfizer. While traditionally a more defensive sector, Berkowitz believed that his health care holdings were undervalued, and that they would provide excellent returns over the long run. This didn't stop them, though, from participating in last year's significant market rally, although their returns were muted somewhat by concerns over the Obama administration's drive to push health care reform through Congress.

However, sometime during the third quarter of last year, Berkowitz shifted gears and started unloading Pfizer. His rationale behind the sale was that, with the markets operating in a more normal environment (albeit one that could still have aftershocks connected to the collapse of the financial markets nearly two years ago), the fund needed to shift focus to offense rather than defense. While not pointing directly at Pfizer, Berkowitz noted that he was bothered by the recurrence of nonrecurring expenses in the pharmaceutical industry, as well as the impact that lower tax rates in some of the industry's overseas operations can have on cash flows and taxation should a firm chose to repatriate those earnings (as Pfizer did as part of its purchase of Wyeth last year).

Six Financial Services Stocks Fairholme is Buying

Stock Price and Morningstar Rating data as of 05-14-10 unless otherwise noted. Fund holdings as of 02-28-10.

By the end of February 2010, Fairholme had sold off the majority of its stake in health care by divesting its holdings in Pfizer,  Forest Laboratories , and  WellPoint (WLP). As such, the fund went from having 44% of its portfolio invested in health care at the end of February 2009 to less than 10% this year. At the same time, Berkowitz increased the fund's exposure to financial services to more than 50% of total stock holdings from just 13% in the year ago period. In the most recent quarter, the fund added new positions in  Bank of America (BAC),  Regions Financial (RF), and CIT Group . Fairholme also added to what was already a fairly significant holding in  Citigroup (C). The buying didn't stop there, though, as Berkowitz reinforced his financial services outperformance thesis with large purchases of  American International Group (AIG) and  Goldman Sachs (GS) over the last couple of months. Committing more than half of his fund to financial services, Berkowitz seems to be signaling that the worst is over for the industry. Given the regulatory concerns, tumultuous operating environment, and headline risks that financial firms still face, Berkowitz's belief in the undervalued nature of the industry may seem shaky. But on closer examination, we believe the fund manager has a few not so obvious reasons for making such a big bet.

The Pig Continues to Move Down the Python
In a speech Berkowitz gave at the 2010 Value Investing Congress earlier this month, he reiterated some of the comments he made to one of our fund analysts back in February when he was asked how he got comfortable enough with Citigroup to make a significant new money purchase in the stock during the latter half of 2009. In his view, the financial services industry is like a python and the bad debt moving through the system is a pig that the python has swallowed whole. When the python first swallows the pig there is a huge lump in its body that prevents it from moving as freely as it normally would. At this point, Berkowitz believes that most of the bad debt has been identified and that it is in the process of being purged from the balance sheets of many financial institutions. In essence, the pig is now moving down the python, meaning that it will only be a matter of time before the snake is able to start moving freely again. As long as the pig continues to move down the python things should improve for financial firms. This dynamic was seen in the latest round of earnings from the sector, with both Citigroup and Bank of America reporting an easing of loan losses and delinquencies, and a dramatic improvement in earnings.

Financials Have Become Less Risky
We also believe that Berkowitz sees little downside in owning certain financial institutions, as the federal government has shown a willingness to backstop cataclysmic losses. This effectively creates an artificial floor, where the equity positions of Fairholme's holdings have limited downside, and potentially unlimited upside. In particular, Citigroup and Bank of America received a large chunk of the federal government's support for the industry, and are now producing positive results. Assuming a steadily improving economy, these results should only increase and push the equity value of both firms upward, with the government backstop providing investors some downside protection. While recognizing that the current political climate is fervently against a repeat of the "too big to fail" bailouts that happened in 2008 should the financial services industry collapse again, we think that the federal government will have a completely different attitude when it is actually staring into the abyss.

Although the situation is slightly different with AIG, Berkowitz believes that the nearly two years the firm has been under government control has cleansed the company, and left it solidly positioned to recover. In his view, "the firm retains a valuable franchise, is resuscitating its cash flows, and has done a good job walling off its risks." While it is still too early to get a feel for how Berkowitz's investment in AIG will affect the weightings of the fund, as Fairholme isn't due to file its semi-annual report (for the six months ended May 2010) until July of this year, a recently filed 13G form with the SEC revealed that Fairholme Capital Management owned more than 25.4 million shares of AIG's common stock, of which 23.3 million shares are owned by The Fairholme Fund. At a closing price of $37.92 this past Friday, the position would be worth $925 million, making it one of the largest positions in the fund.

Limitations to Government Interference
In the case of Goldman Sachs, Berkowitz believes that the government's investigation will go nowhere. In his view, the firm did not violate any rules or break any laws, and that as a market maker, the investment bank didn't do anything its peers weren't doing. He feels that Goldman's brand and reputation are still intact, with the majority of the firm's operations being of very high quality and ethical standards. Details about the size, type and timing of the investment in Goldman remain scarce, though, with Berkowitz merely acknowledging at the Value Investing Congress that he had taken a new position in the firm.

While it would be difficult to argue with Berkowitz's success as a portfolio manager, having recently been designated Morningstar's Domestic-Stock Manager of the Year and Domestic-Stock Manager of the Decade, not to mention the fact that he continues to trounce the market in 2010, we differ slightly with Berkowitz on Goldman. In our view, the anger and scapegoating emanating from Washington has hit a fever pitch, and we believe that government would like nothing better than to make an example of at least one major Wall Street player, with Goldman's success and reputation making it a prime target for the Feds. If the government does not relent, it could potentially damage the firm's reputation and ability to conduct business as it has in the past. That said, the standard the government has to meet in order to prove any illegality on Goldman's part is extremely high, leaving reputational risk as our main concern. Berkowitz clearly feels that Goldman's proven business savvy will ultimately prevail, and clients will still seek its skill set for future deals.

Government Providing Clean Financials?
We also have issues with Berkowitz's belief that the sector has essentially been scrubbed, with the U.S. government and many of its financial regulators having already gone through every liability and asset on the books of the largest financial firms. As we see it, knowing all of the inner workings of a complex financial institution like Citigroup or AIG is a nearly impossible task. From plain vanilla consumer banking to highly complex proprietary trading, a major financial conglomerate has a plethora of levers and widgets to understand. The term "black-box" has been thrown around to describe these firms, and Berkowitz is relying on the federal government's ability to shine a light on these black boxes. While it was probably a smart move on Berkowitz's part to wait until the government was confident enough that the firms he was making significant bets on could survive and operate efficiently longer term, and the industry was actually started to report improved results, his reliance on the government's ability to competently audit and know the inner workings of these black boxes could prove to be a dubious strategy.

Disclosure: Vishnu Lekraj does not own shares in any of the securities mentioned above.