Liquidity Risk Increases at Fairholme

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On pace for its third consecutive bottom-decile calendar-year finish and after nearly $5 billion in three-year net outflows, Fairholme faces serious liquidity risks. These risks and poor results lead to a cut in the fund's Morningstar Analyst Rating to Neutral.

The fund has endured outflows in every month since March 2011, a total of nearly $15.7 billion. Since then, manager Bruce Berkowitz raised cash mostly by selling liquid stocks like

But such stocks are gone. The largest holding as of May 2016 was St. Joe JOE at 13.8% of assets. Fairholme owns 31% of the shares. Morningstar estimates it would take more than 100 days to sell that position without affecting the share price. Plus, Berkowitz is the chairman, further complicating matters. The days-trading estimates for the fund's next-largest positions, Fannie Mae and Freddie Mac preferreds (combined 21.4% of assets), are also greater than 100 days. Sears Holdings SHLD (where Berkowitz is on the board) shares would take more than 20 days.

Berkowitz has compensated by increasing liquidity elsewhere. Cash was 27.5% of assets in May (or about $800 million). The fund also had 17.9% of assets in short-duration, high-yield bonds like

But this may not be sufficient should outflows continue. Year-to-date net outflows through August 2016 were about $650 million and $1.5 billion during the trailing 12 months. At a $70 million monthly run rate, the fund's cash would be exhausted in less than 12 months. The fund's short-duration, high-yield bonds could perhaps be sold, but these bonds might not be reliable sources of liquidity during a period of market stress.

Fannie/Freddie, Sears, and St. Joe could still bear fruit, but the fund's predicament shows the danger of owning them in a daily liquidity vehicle. Its liquidity risks could be exacerbated if Berkowitz needed to sell securities into a falling market to meet redemptions. This fund was always more aggressive than most peers, but its risks have taken on a greater urgency.

Process Pillar: Positive | Kevin McDevitt, CFA 09/15/2016 Manager Bruce Berkowitz embraces complexity, especially within the devilishly complicated financials sector, and concentration. Neither of these is for the fainthearted. But with just 10 stocks in the portfolio, concentration creates an incentive for him to spend extra time understanding a company as compared with a manager with more-dispersed assets.

Berkowitz makes big bets on deeply out-of-favor stocks whose unpopularity may owe in part to their opacity. That was the case with financials such as Bank of America and AIG in 2011 and 2012, because their balance-sheet-related risks were hard to quantify, and more recently with Fannie Mae and Freddie Mac. Berkowitz's comfort with such financials is a distinguishing trait, but he generally sticks to his circle of competence. He has tended to avoid technology, for example. He is also more than willing to work in an activist role if need be, as he's currently doing with Fannie and Freddie and did with St. Joe in the past.

He focuses more on business analysis than valuation work. In his view, thoroughly understanding a business supplants the need for elaborate models. He supplements by hiring outside experts to help him understand technical issues or to poke holes in his thesis. He then assigns a multiple to a company's normalized cash flow. He is also willing to let cash build and invest throughout the capital structure, often owning short-term, high-yield bonds.

Nearly $5 billion in outflows during the past five years have forced manager Bruce Berkowitz to sell his most-liquid stocks in order to raise cash and meet redemptions. From 2011 to 2015, Berkowitz raised cash mostly by selling liquid stocks like AIG, Bank of America, and Berkshire Hathaway.

But stocks like those are gone from the portfolio and the biggest remaining positions are far less liquid. The largest holding as of May 2016 was St. Joe at 13.8% of assets. Fairholme owns 31% of the shares. Morningstar estimates that it would take the fund more than 100 days to sell the position without affecting the share price. Plus, Berkowitz is the chairman, further complicating matters. The days-trading estimates for the fund's next largest positions, Fannie Mae and Freddie Mac preferred shares, would also be greater than 100 days. Sears Holdings (where Berkowitz is on the board) shares would take more than 20 days.

Berkowitz has compensated by making the rest of the portfolio more liquid. Cash was 27.5% of assets in May (or about $800 million). The fund also had 17.9% of assets in short-duration, high-yield bonds like Chesapeake Energy.

Plus, it's possible that the Sears, St. Joe, and Fannie/Freddie positions could still work out. The combined 21.4% stake in Fannie and Freddie is the most speculative in the portfolio, but Berkowitz says he expects some sort of resolution with the government in the next 12 months.

Performance Pillar: Neutral | Kevin McDevitt, CFA 09/15/2016 This fund's record since inception remains strong, but bottom-decile returns in four of the past six calendar years (including so far in 2016) have severely tarnished its more-recent results. The fund's five-year 7.2% annualized gain through August 2016 trails the Russell 1000 Value Index by an astonishing 7 percentage points. During the trailing 10 years the fund lags the index by 1.1 percentage points annualized. Its Performance rating is being cut to Neutral.

Nevertheless, the fund has gained 10% annualized from its late 1999 inception through August 2016, beating the index by 3.7 percentage points. But this is cold comfort to many current investors as most of those gains were earned in the years before 2011.

Because of the fund's highly concentrated and eclectic portfolio, calendar-year results are often feast or famine in relative terms. It’s on pace to finish in the category’s top or bottom decile for the ninth time in 10 calendar years. Its behavior also tends to be loosely tied to the broader market. It doesn't closely resemble any of the major indexes and has an R-squared (a measure of correlation) of only 61 relative to the Russell 1000 Value Index since its inception.

This fund has fallen on hard times, but it could certainly rebound. But its extreme portfolio and volatility make it suitable only as a satellite holding; and even then, only for the most thick-skinned investors.

People Pillar: Positive | Kevin McDevitt, CFA 09/15/2016 Manager Bruce Berkowitz always has done things his own way, which is reflected in this fund's contrarian approach. He didn't take the usual path of rising through the analyst ranks or working under an established investor but rather taught himself using value investor Ben Graham's principles as his guide. Being self-taught helped make him one of the more independent-minded managers around. He began his career with Merrill Lynch in 1983 before managing client accounts at Lehman Brothers and Salomon Smith Barney. He founded Fairholme in 1997.

Berkowitz is the fund's sole manager and driving force, but he doesn't work alone. Head of research Dan Schmerin oversees a team of four analysts, most of whom have been hired in the past three to four years. Schmerin, who worked with distressed securities at the U.S. Treasury, was hired as an analyst in 2011. Berkowitz also relies heavily on the work of hired outside experts, one of the keys to the fund's long-term success. That combination, along with the firm's internal team, earns the fund a Positive People rating.

But Berkowitz has struggled to maintain the team's continuity as the firm has failed to retain senior staff. Former head of research Fred Fraenkel left the firm in September 2015, having been hired in September 2012. The firm had additional turnover in the past, having once lost four comanagers in a four-year stretch.

Parent Pillar: Positive | Kevin McDevitt, CFA 08/25/2016 Bruce Berkowitz, the sole owner of Fairholme Capital Management, has aligned his financial interests with fundholders'. Berkowitz and the firm's employees have about $500 million invested in the firm's three funds, and he does not have an outside investment account. He has also closed the funds when inflows have outpaced investment opportunities.

With only four strategies, Fairholme is an investment-driven firm. It introduced two funds in 2010,

The firm's mutual funds are overseen by a board that's led by Berkowitz; five of the seven directors are independent. The board could do more to push for lower fund expenses. All but one of the independent trustees own positions in the funds.

On the regulatory front, the SEC named Fairholme in a private investigation in June 2011 tied to its position in St. Joe Corporation. The filing cites the firm's compliance with reporting obligations under Section 13(d) of the Exchange Act. Berkowitz, who is the St. Joe chairman, believes their Section 13(d) filings have been timely and appropriate. St. Joe and the SEC settled the matter in October 2015. St. Joe, without admitting or denying any factual allegations, consented to the SEC's issuance of an administrative order.

Price Pillar: Negative | Kevin McDevitt, CFA 09/15/2016 This fund’s 1.03% expense ratio is 13 basis points greater than the median for no-load, large-value offerings. Its Morningstar Fee Level is Above Average. For this reason, the fund receives a Negative Price rating.