The behavior of many investors is (while predictable) still sometimes hard to understand. A case in point is what is going on at the Fairholme Fund managed by Bruce Berkowitz.
Long Term Outperformance Berkowitz is a highly respected value manager with an enviable track record at the Fairholme Fund. Consider the following numbers for the period ended March 31, 2011: Fairholme Fund Annualized Rate of Return Since Inception on Dec 29, 1999, is 13.90% Fairholme Fund Annualized Rate of Return for the past 10 years is 11.43% S&P 500 (SPY) Annualized Rate of Return for the past 10 years is 3.5% Fairholme Fund Annualized Rate of Return for the past 5 years is 8.11% S&P 500 Annualized Rate of Return for the past 10 years is 2.75% Over any medium- to long-term time period Berkowitz and Fairholme haven’t just beaten the market, they have beaten it by an exceptionally wide margin. Not surprisingly Fairholme Fund ranks #1 over the past 10 years according to Lipper amongst the 106 multi-cap value funds that Lipper has tracked over that time period. See Fairholme’s performance info (pdf). And as you might expect these exceptional performance numbers have attracted a lot of investors to the Fairholme Fund as assets under management as of March 31, 2011, were $19.27 billion. Short Term Underperformance 2011 however, has not been kind to Berkowitz or Fairholme. According to Morningstar, through July 5, 2011, the Fairholme Fund was down 8.97%, underperforming the S&P 500 by 16.39% and ranking in the 99 percentile for its peer group. And many Fairholme investors have seen enough with the fund having a massive $2.5 billion in redemptions over just the past three months alone. In my opinion watching Fairholme investors pull billions of dollars from the fund because of a few months of underperformance is a fantastic reminder of why it is possible to outperform the stock market. I find it encouraging to see that so much of the investing base that we as investors compete against on a daily basis is incapable of handling a single six-month period of volatility. Realistically, what is more likely? That an investor like Berkowitz who has a 20 year public track record of making intelligent investing decision after intelligent investing decision has suddenly lost the ability to invest? Or that the stock market is disagreeing with him in the short run and that over time this experienced investor will do pretty well with recent investments? I think the answer is obvious and that instead of redeeming investments from the Fairholme Fund investors should be adding to them. Make Your Own Fairholme By Buying the Same Investments Retail investors do have a great advantage over fund managers like Berkowitz. Retail investors don’t have to manage their money around the timing of cash inflows and outflows like a fund manager. So while Berkowitz suffers through a short-term period of underperformance he also has to release cash back to redeeming shareholders, which means he can’t buy more of what is cheap and may even have to sell undervalued securities. So if you believe in Berkowitz the best way to take advantage of the current prices of his favorite securities may be to buy them directly yourself. And because Berkowitz runs a concentrated portfolio it isn’t terribly difficult to effectively mimic the Fairholme Fund. At the end of February Fairholme’s largest positions were as follows: AIG (AIG) – 8.7% Sears (SHLD) – 6.0% Bank of America (BAC) – 5.5% Berkshire Hathaway (BRK.A) – 5.2% Morgan Stanley (MS) – 5.2% Goldman Sachs (GS) – 5.0% Citigroup (C) – 4.9% Brookfield Asset Management (BAM) – 4.7% Regions Financial Corp (RF) – 4.5% AIA Group Limited (HK listed) – 4.4% Total Invested of Fairholme in these ten holdings – 54.1%
Heavily Overweight Financials
The group of companies mentioned above is obviously heavily weighted toward the financial industry and I view that as a good thing. Berkowitz first really came to the attention of the value investing public through his success investing in financials after the last banking crisis in the early 1990s. And that is why I think investors might consider piggybacking on the work of Berkowitz at this time. You get to follow Berkowitz, who is not only an investor with an outstanding long term track record, but also an investor who is right in the middle of his circle of competence when it comes to investing in financial companies. You get to buy these financial companies at not only attractive prices and but prices that are lower than when Berkowitz first identified them as being attractive. In other words if there is one industry you want to be following Berkowitz into it is the financial industry. He knew to avoid the financial industry pre-crisis and I bet he knows now is the time to get back in. Fairholme held a call with investors (pdf) and Berkowitz made the following comments, which summarize why I think an investor should give serious consideration to many of his larger holdings:
“Here are my thoughts on the Fairholme Funds recent performance: horrible, that's the summary in hindsight and it may be expected over the short term.
We've always stated in our reports that short-term performance should not be over emphasized. It’s the long term that counts. This is not the first time we've underperformed; it won't be the last time and I don't think it's reality to outperform every month, quarter or year.
So it's been lousy for months, we've been losing, we're way underperforming, and it may stay lousy for more time. In hindsight we swapped from health insurers and defense to financials too early.
We're in the financials with the belief that they are essential to the well-being of the economy. That they, in the aggregate, are huge chunks of the U.S. financial system. We had similar arguments with respect to health care when many thought the health care industry was dead. We argued at the time that our companies were the health care system in the same way we argue today that our banks and brokers are the U.S. financial system.
Financials remain hated today and blamed for our country's economic troubles. They do deserve part of the blame but we all had a share in the process we're going through. But bottom line, in a perverse way, is that we need to fail short-term to outperform long-term.
We need to buy low and buy lower and buy lower. Even when the crowd yells you're wrong. This is how we've achieved our performance over the past decade and this is how we will achieve our performance in the next couple of decades.
Today's environment is very reminiscent of the 1990s, when the market bust, Wells Fargo was going bust and the banking system was crushed. We bought and we bought … and the process lasted for quite a bit of time and then we went on to make five to seven times our money. I think we'll do quite well in the future now. I don't know if we'll make five to seven times our money. I doubt it, but we are setting up for a good run.
Today the trends are quite positive. Balance sheets are strong and getting stronger. Banks have burned through over half of their difficult loans of 2007 and 2008 while writing great loans in 2009 and 2010. Today our banks, brokers are profitable and safe but still there's great uncertainty about legislation, lawsuits, regulations and future profitability.
Wall Street hates uncertainty; uncertainty creates a cheap price. Over 2011 this uncertainty will greatly diminish, the noise will reduce. Graham and Dodd quoted on the first page of Security Analysis, 'Many shall be restored that now are fallen and many shall fall that now are in honor.'”
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.