On Wednesday night, Bruce Berkowitz of the Fairholme Fund (FAIRX) gave a presentation entitled "Beat the Pack by Breaking from it" to the New York City chapter of the American Association of Individual Investors (AAII). Below are my notes on Berkowitz's presentation, the questions and answers that followed, plus a quick look at the hedging costs of stocks that were mentioned during the event.
Bruce Berkowitz on his investment method
- Most of what I learned about investing I learned before I went to college. “Count the money” – count the money that comes in a business, and count the money that goes out – what you’re left with is the profit.
- Cash is important because that’s the only thing my family can spend.
- I became a book maker one summer in college – learned a lot of reverse psychology.
- All about cash. All about counting cash. You run out of cash, you’re dead.
- Not just any kind of cash – cash an owner can keep after all the bills are paid, including the costs of maintaining the franchise.
- What’s the ‘normal’ amount of cash (in a normal year)?
- How can I kill it? What’s the worst that can happen?
- Compare my calculations to the price of the stock (what I pay today versus future cash flows)
- Is there a margin of safety (to account for miscalculations, etc.).
- Concentrated portfolio – why buy your 50th favorite idea?
- Volatility doesn’t equal risk. Risk is the chance of a permanent loss of capital.
- Have patience, because it’s impossible to time it right. (I’ve tried everything – chicken bones, technical analysis). I always seem to suffer from premature accumulation – I buy too soon, and keep buying.
- I try to think of all the ways I can think of to commit financial suicide, and try not to do those things.
An example: Bank of America
- Bank of America Corporation (BAC) single handedly caused the housing crisis (from my reading of the papers). We seem to have forgotten how the housing crisis started – government policy. It’s great to own a home (*if you can afford it!). Freddie (FMCC.OB), Fannie (FNMA.OB), ACORN.
- Banking is a cyclical industry – every 5-10 years the banks blow up. Many have lost their reputation by getting into banks to early.
- Positives: Bank of America Corporation is part of the US financial system. The US financial system does not work without Bank of America, Goldman Sachs Group, Inc (GS), JP Morgan Chase & Co. (JPM), Morgan Stanley (MS), Wells Fargo & Co. (WFC), and a few others. To a large extent, the Treasury Department works through these firms (there aren't that many people working in the Treasury Department's buildings in Washington). Nothing works without the financial system.
- I like Brian Moynihan, (BofA) CEO. It will take two more years probably to straighten out mortgage situation. Being more consumer friendly.
- It’s an important company, but it’s hated. I don’t understand why it’s hated – it’s making money, about $1 per share. It has 30k people working on the mortgage issue (remediation, foreclosure, etc.). Still digesting the issues of the crash. But this will come to an end. Most loans have an average life of between 5-7 years. 2007 loans – they only have 48% of those loans left. They burn off. As every month goes by, those problems get taken care of.
- Numbers: before taxes & reserving for bad loans 45-50 billion per year ($4.5-$5 per share). It’s going to be a long time before it pays taxes. Tangible book value (the “real assets” – after you get rid of the goodwill, etc.). $13.21 per share.
- ROA 1-2% isn’t unusual to see in banking.
- Today reminiscent of early '90s (had a big position in WFC back then). I made about 7x on the stock. History repeats itself (though not exactly in the same way).
- The banks have to succeed.
- Uncertainty should diminish over the next 12 months.
- Buy something that’s hated, newspapers telling you you’re wrong.
- When you’re early, you look wrong.
- In a more normal period, it will earn $2+ per share.
- Balance sheet is great, reserves are unbelievable. Then it'll be able to give you every penny of the cash earnings (as dividends or buybacks).
- We were in the healthcare companies when everyone thought we were crazy, because of Obamacare – guess what? Nothing changed. Nothing’s going to radically change with the financial system either.
- Everybody is so focused on the liabilities of financials – time to focus on the assets.
Berkowitz summarizing his investment method
- Count the cash.
- Figure out how much it will earn in a normal year.
- Try to kill it.
- Think about the different ways management can screw you (excessive comp, accounting tricks).
- Compare the market price with all that.
- Margin of safety? Go for it, buy ten or twenty stocks like it.
Questions and Answers with Berkowitz
Q: Why are you down so far this year?
A: If you think you can invest in a fund that outperforms over the long term, and get a steady, monthly, positive return, Bernie Madoff.
Q: How can you have an edge using public information? Isn't all that information already priced in [i.e., isn't the market efficient]?
A: All public info doesn’t get discounted, because not everyone takes the time to dig into publicly available info from original sources; we do, and that’s our information edge. The market isn’t that efficient.
Q: How can you analyize Leucadia National Corporation (LUK)? They shed their skin every year -- it's like a different company every year.
A: It’s a blind trust. You have to have faith in the managers. We do.
Q: Why did you become chairman of St. Joe Co. (JOE)?
A: I grew up in an apartment and never had a backyard, so I thought 600k acres would be a lot of fun. It's a small position, a work in progress. Serious answer: because a brand new, international airport opened up last May. The airport is doing better than expected. We need some more time, to understand what we have.
Q: What motivated you to enter the portfolio management business?
A: Money. I didn't grow up with a lot of it, and I wanted to do better than my parents.
Q & A with Charles Fernandez, President, Fairholme Capital Management
[Charles Fernandez happened to be sitting next to me, and was kind enough to answer a couple of my questions after the event]
Q: In his short presentation on St. Joe Co. (JOE), David Einhorn wrote that if valued JOE's remaining real estate at the average sales price of the last ~500k acres it sold, the company is worth $7-$10 per share. You obviously think the company is worth more than that. Why?
A: JOE's remaining land isn't comparable to the last ~500k shares it sold; that was less valuable land.
Q: Fairholme's investment in JOE seems to be a deviation from Bruce Berkowitz's investment method -- "we need more time to understand what we have" suggests that he didn't do as thorough and quantitative an analysis on JOE as on other investments.
A: We invested in JOE because we felt that our margin of safety was large enough to accommodate the current uncertainty. The company has no debt, plenty of cash on hand, and we've been cutting its expenses.
Hedging costs of the stocks discussed above
The table below shows the costs, as of Wednesday's close, of hedging the stocks discussed above against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about what optimal puts mean in this context, and why I've used 20% as a decline threshold.
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.
Hedging costs as of Wednesday's close
The data in the table below is as of Wednesday's close. I've added SPDR S&P 500 (SPY) for comparison purposes. Note that with the 18.45% spike in the VIX Wednesday, these hedging costs are higher than they were on Tuesday.
Cost of Protection (as % of position value)
Bank of America Corporation
|(GS)||Goldman Sachs Group Inc.||3.23%***|
|(JPM)||JPMorgan Chase & Co.||2.14%**|
Wells Fargo & Co.
|(LUK)||Leucadia National Corporation||3.92%**|
|(JOE)||St. Joe Co.||13.1%**|
SPDR S&P 500
**Based on optimal puts expiring in December, 2011
***Based on optimal puts expiring in January, 2012
Disclosure: I am long puts on JOE.