Assessing Bruce Berkowitz's Concentrated Bet ON AIG

| About: American International (AIG)

Summary

In 2011 Bruce Berkowitz of the Fairholme Fund put 18% of his portfolio into AIG. Investors should have been paying attention as it subsequently tripled.

His portfolio today is still quite concentrated with over 50% of the fund in just six holdings.

Of interest is his return to the oil and gas sector and in particular Canadian Natural Resources which is a company he knows well.

Our approach to investing is a little bit different. We are only interested in looking at stocks that have found a way into the portfolio of at least one world class investor.

We view doing this as a significant layer of risk reduction for us. The very best investors in the world make very few mistakes. Their research is intensive and they rarely let real dogs into their portfolio.

By limiting ourselves only to stocks that have made it through the due diligence process of one of these investing greats our chances of making a mistake is greatly reduced.

And then there is the potential for finding great stock picks. It doesn't take a rocket scientist to know that great investors tend to pick great stocks.

Bruce Berkowitz of the Fairholme Fund is one of those great investors that we follow. His annual report to investors was just released (link below) and we thought it would be a perfect time to take a look at his current portfolio.

The top ten holdings in his portfolio today look like this:

AIG is still his largest holding, but it has been reduced immensely since is swelled to make up nearly 40% of the fund at one point. That extreme weighting was due to Berkowitz making a very concentrated bet and seeing it pay off in a big way. We will discuss his success with AIG a little later.

Today Berkowitz still has the Fairholme fund fairly concentrated with 52% of the fund in just six holdings.

The sector weightings of the fund is now comprised of the following:

Note that Berkowitz is holding nearly a quarter of the fund assets in cash. That would signify that he doesn't think the market is extremely attractive.

One sector that he does seem to think attractive is oil and gas. It has been years since Berkowitz owned any oil and gas companies. Over the course of the second half of 2015 he has added a company that he is very familiar with back into his portfolio.

The company is Canadian Natural Resources (NYSE:CNQ) and Berkowitz had a major position in the stock nearly a decade ago. He did extremely well with Canadian Natural during that go-round as he unloaded the position as the price of oil shot up to $150 in 2008.

Why has Berkowitz bought back into Canadian Natural? There are at least two very clear reasons.

The first is that he believes that oil prices are going to go higher. He said as much in his annual report (see earlier link).

According to Berkowitz the shale oil supply boom has led to an oil and gas price collapse. That has led to energy companies now selling for huge discounts from historic values, and related service businesses are trading at record lows as well.

When the Fairholme Fund last purchased large amounts of securities in the energy sector, Berkowitz believed that no one thought that the world would function if oil exceeded $40 per barrel. He had a contrarian view that supply and demand forces would push oil higher.

Now (according to Berkowitz), experts believe a price of $10 is possible and $50 per barrel a long way off. He again disagrees. He believes that prices cannot stay below marginal costs when demand grows and supply depletes - at least, not for too long.

Believing that oil is going higher is reason #1 for Berkowitz owning Canadian Natural. Reason number two is that he loves the Canadian Natural Resources management team.

In his previous go-round owning Canadian Natural he referred to CEO Murray Edwards as being a brilliant capital allocator. He went as far as calling him the "Warren Buffett" of the oil patch.

The implication for investors is that if you are looking for a way to play an oil rebound (presuming you believe in one) then Canadian Natural with the stamp of approval from Berkowitz is one great option.

Why Did More Investors Not Pay Attention To Berkowitz In 2011?

In late 2011 a big fat pitch was served up to any investor who was paying attention. Berkowitz had just put 18% of his fund into a single stock.

Do you know how often a manager with the reputation of Berkowitz puts that much of his fund into a single stock?

Never.

Investors should have considered why he would do that?

Consider the risks he was taking by putting that much into one stock. If that investment performs poorly his returns aren't going to just suffer, his investors are going to pull their money out of his fund.

As a fund manager putting 18% of your fund into a single stock and having that stock tank wouldn't just result in egg on your face. It would ruin your business. You wouldn't have a fund left to manage. Your career would be over.

There is one reason that the best fund manager on the planet would put 18% of his fund into one stock. He was certain that there was virtually no risk of losing money and that there was big time upside in the stock.

He was right.

Anyone who was watching could have piggybacked on his idea. Given his track record piggybacking on his idea should have been an appealing opportunity.

Most fund managers don't even beat the market. Clearly, Berkowitz isn't most fund managers. Berkowitz has successfully invested in many different sectors, but his real specialty has always been financials.

Perhaps that is why in the years leading up to the collapse of the housing bubble Berkowitz had no money allocated to the financial sector. He knew to steer clear of financials at the peak of a cycle.

At the bottom of the cycle is another matter entirely.

After the bust, Berkowitz swooped in. In 2011 when Berkowitz put 18% of his fund into just one financial stock. The stock was the then much maligned American International Group (NYSE:AIG). A company that had been front and center in the financial crisis having sold billions of dollars of credit default swaps on rotten U.S. mortgage backed securities.

In total, AIG had required a $182 billion bailout from the U.S. Government to avoid an implosion which would have caused a disaster for the global financial system.

By 2011, AIG was a different company. It had been given a complete makeover. Its balance sheet wasn't clean, it was spotless. So many government agencies had audited AIG's books by 2011 that it was safe to say that no financial company had ever had a balance sheet that was more reliable.

The risk from AIG's balance sheet had been scrubbed away.

Berkowitz pounded the table on AIG for anyone who was willing to listen. In 2011 Berkowitz hosted a conference call for investors and explained exactly why he owned so much of the company.

1. He believed the core AIG business could earn $6 per share which should be worth at least 10 times earnings or $60 (three times the then share price).

2. The Government had been selling shares of AIG that it received during the bailout which was temporarily depressing the stock price (the Government didn't care about valuation it just wanted taxpayer money back).

3. Investors continued to associate AIG with the housing crisis and didn't bother to notice the pristine shape the company was now in (mainstream investors always flock to and from sectors at exactly the wrong time).

Berkowitz recognized AIG in 2011 as the opportunity of a lifetime. He was an expert and knew the company. On top of that he brought in the best financial consultants that money can buy to challenge his findings.

They verified his belief.

Berkowitz put 18% of his fund into AIG and sat back and let time take care of the rest. The stock rose steadily over the next several years to ultimately reach his valuation target of $60 in early 2015.

That is why we pay attention to these great investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.