Taking Stock of Fairholme

Much has been written and said about  Fairholme's (FAIRX) epic fall in 2011. It's not without cause; the fund has dropped more than 27% this year and trails the S&P 500 Index by nearly 29 percentage points. Rattled shareholders have left the fund in droves. Investors have pulled an estimated $6.5 billion from the fund over the past eight months--which, along with market depreciation, has cut assets by more than 50% since its $20 billion February peak. Along the way, many have questioned manager Bruce Berkowitz's so-far disastrous move into financials stocks, which he built throughout 2010. More recently, critics point to former comanager Charlie Fernandez's Oct. 17 departure and the embarrassing Barron's expose that followed as evidence of further chaos.

While there are plenty of legitimate concerns about Fairholme, in some cases the public-opinion pendulum has swung too far to the other side. After being hailed as a genius just last year, some now wonder whether Berkowitz was ever that good in the first place. Other critics accuse Berkowitz of changing his approach, believing that he had not previously made such a large investment in financials. With judgments flying fast and furious, now may be a good time to take stock, reviewing how the fund got here and what may lie ahead.

To address two common worries upfront, Fernandez's departure shouldn't be a major disruption for the fund, although personnel turnover overall is a concern. The latest Fairholme analysis addresses these issues in more detail. And although he remains chairman at  St. Joe (JOE), Berkowitz's involvement should be diminished since the company named a new CEO in October.

Financials: Only the Names Have Changed 
When it comes to financials, this isn't Fairholme’s first rodeo. In fact, they were there at the beginning. In August 2000, the fund had 82% of its equity portfolio in financials--not that far off the August 2011 portfolio's 87% weighting. Berkowitz even increased that stake to 93% of the equity portfolio in December 2002 before wisely scaling it back over the following six years. Indeed, his love of financials predates the fund itself. Berkowitz put a third of his net worth in  Wells Fargo (WFC) in the early 1990s in the wake of the S&L crisis. (Here's a link to a 1992 interview in which Berkowitz lays out his thesis.) 

Wells Fargo aside, the fund's focus, then and now, has been on insurance companies. Although current holdings such as real estate company St. Joe and   Bank of America (BAC) get much of the media attention, they claim just 10% of assets. Majority government-owned  American International Group (AIG) dominates the portfolio. Including warrants, AIG, along with AIA (its former subsidiary), accounts for about a third of the equity portfolio. Overall, about half the equity portfolio is in insurance stocks. Again, this is not new. The insurance stake was even greater at times in the early 2000s; in those first few years,  Berkshire Hathaway (BRK.B) and  White Mountains Insurance (WTM) together often claimed more than a third of the portfolio.  

But Bank of America is not the blue-chip that is Wells Fargo, which has long been considered one of the best-managed U.S. banks; nor is AIG on par with Berkshire Hathaway in terms of quality. (To be sure, Berkshire Hathaway is still in the portfolio, but it claims only about 8% of assets versus the 23% AIG stake.) AIG is not as diversified or as financially strong as Berkshire Hathaway. Insurance companies generally avoided the worst of the credit crisis, but AIG is an obvious exception. It's healthier today, but it still has balance sheet and strategic operational issues that seem to crop up every quarter. 

Thus, compared with the early 2000s, the fund's picks have been more aggressive this time around. That has been the market's verdict so far this year. For the year to date, both AIG's and Bank of America's shares have dropped more than 50% through Nov. 11, while Berkshire and Wells have fallen just 3.9% and 15.7% respectively.

The circumstances today are far different, too. The fund's first foray into financials occurred in the wake of a tech bubble, not a financial crisis. The bursting of that bubble left banks and insurance companies relatively unscathed compared with the beating tech stocks absorbed. While the insurance industry faced shocks of its own, particularly the Sept. 11 terrorist attacks, investor apathy was the prevailing theme. Warren Buffett and Berkshire Hathaway had been written off after missing the tech boom and trailing the S&P 500 Index by 20.5 percentage points in 1999. When the fund loaded up on Berkshire in 2000, the stock was out of favor, but hardly distressed.

S&L Redux? 
But rather than the tech bust, Berkowitz contends that the current environment is reminiscent of the early 1990s' savings-and-loan hangover. After the S&L crisis, banks reeled from the collapse in commercial real estate values. Bank stocks sold at single-digit P/E ratios as they struggled to work through bad loans amid weak economic growth. (Sound familiar?) Buffett famously built a position in Wells Fargo when it was trading at just 5 times earnings. Berkowitz also invested heavily in the stock, just as many commentators predicted the demise of Wells and many other banks. Buffett and Berkowitz were vindicated in spades as the shares soared in the decade's second half.

Yet this crisis has arguably been worse with potentially longer-term ramifications. Berkowitz has predicated these investments on the belief that this is a cyclical downturn (albeit a particularly nasty one), but others believe that something more structural is at work. For one, this crisis leveled the housing market, which is much larger than the commercial real estate market. Currently, there is about 5 times as much residential mortgage debt as commercial.

Second, the S&L crisis was more regional while this has been global, and it has ravaged the entire financial system. At its core, it is a debt rather than a liquidity crisis, and overleveraged individuals and governments in the developed world face years of austerity and deleveraging. This combination, coupled with a depressed housing market, could curtail loan demand for years to come.

Third, in the 1990s, banks generated lofty returns on equity partly by leveraging up their balance sheets. Given the tougher capital requirements coming down the pike, this is unlikely to be repeated. Thanks to low yields, the profit outlook for banks also looks weak relative to the early 1990s. In late 1992, Wells Fargo's net interest margin, which is the difference between its cost of funds and the rate at which it loans money, was about 5.7% and growing. Bank of America's most recent net interest margin was just 2.3%, and it's unlikely to improve any time soon given the Fed's pledge to keep rates close to zero until at least mid-2013. Meanwhile, low rates also make it difficult for insurance companies to make money on their float.

Banks generally have far stronger balance sheets than they did before the crisis began four years ago, but risks remain. As Morningstar bank analyst Jim Sinegal has pointed out, in the early 1990s, before securitization really got going, Wells Fargo had to worry only about the loans on its balance sheet. Today Bank of America must also worry about the $2 trillion in mortgages that it and acquisition Countrywide Financial originated from 2004 to 2008. It, along with fellow top-10 holding  Citigroup (C), still have considerable derivatives exposure as well.

This Stuff Looks Cheap 
Berkowitz acknowledges that issues remain, and that he got into financials too early. But going forward, his conviction in these holdings hasn't wavered. If anything, he believes that Bank of America, Citigroup, and AIG represent even better values at their current, historically low-price multiples. All three companies trade at half-book value or less. And while the operating environment may remain challenging for several more years, this is potentially priced into the stocks. Currently, the fund's holdings that are covered by Morningstar's equity analysts have an average price/fair value of just 0.68 versus an average 0.89 price/fair value across the coverage universe. This could give the fund a decent margin of safety.

It may need it, as the fund has been operating with a smaller cash cushion than usual this year. Ongoing redemptions are partly to blame, as the fund had only about 6% of assets in cash and bonds at the end of August. Historically, the fund rarely had more than 80% of its assets in equities. Berkowitz had long held ample cash as a way to take advantage of attractive buying opportunities. That stake had also helped dampen volatility to some extent.

These days, Berkowitz has had to keep selling positions, such as  Goldman Sachs (GS) and  Morgan Stanley (MS) this past summer, to stay ahead of outflows. Until outflows slow significantly, it will be difficult for Berkowitz to rebuild the reserve to past levels without compromising his investment process. His conviction is such that he would rather keep cash below average rather than sell large chunks of his favorite positions.

Where Do We Go From Here? 
As investors decide what action to take, there are several points worth considering. First, as bad as this year has been, the fund's long-term record remains excellent. Its 10-year annualized return through October has still beaten the S&P 500 Index by nearly 5 percentage points. Rough years such as this one can be worth enduring for long-run gains.

Second, when it comes to deeply contrarian strategies such as this one, short-term losses can sow the seeds of long-term gains. Buffett has often said that he would gladly trade a large short-term loss when underwriting insurance policies for the likelihood of long-term gains. Given that Berkowitz plans on sticking with his positions, that possibility exists here. Keep in mind, though, that the road ahead could be a long one. After Berkowitz bought Wells in the early 1990s, it still took four to five years before the stock really took off.

Finally, Berkowitz can still claim expertise in financials. This is the same guy who bought Wells Fargo in the early 1990s when many thought it was going out of business, and he is also the same person who dramatically scaled back on financials before the last credit crisis. By 2007, the fund had hardly any financials exposure outside of Berkshire Hathaway. As a result, it held up far better than most large-value peers during the 2008 bear market.

Conclusion 
This fund set up unrealistic expectations for itself by beating the S&P 500 Index in nine of its first 10 years. This is not the fund for those looking for year-to-year consistency. But for those who can handle its extreme volatility, there could still be a pay off down the road.