Top 11 Financial Stocks Owned by Fairholme Fund

by: Hedgephone

Over the past year, I have argued that commodity price inflation and the vertical stock market uptrend is at least partly the result of deficit spending and money printing, and that both of these phenomena have changed the investment landscape going forward. Eventually, the Fed will run out of bullets. The Fed has tripled the size of its balance sheet since the start of the financial crisis, and this so called "monetization" of debt has caused a boom for equity prices.

However, If interest rates rise and the Fed runs out of options for bailing out future problems in financial markets, we may well see a crash of severe magnitude for many assets, including many overvalued high flying consumer stocks. Commodities will likely rise over time as supply and demand shortages and money supply expansion will boost prices for commodities in general.

With that said, the valuations and politics heavily favor the bulls, such as Bruce Berkowitz, in the financial sector. Over the course of this article I will try to show why I believe that many good investment opportunities exist in Fairholme's top ten financial stock picks relative to the overall stock, bond, and commodity markets. I will also try to show how the use of options as a tool for hedging risk can add a bit of a safety net for investors who are cautiously optimistic on the banking and insurance sectors, as these businesses are too complicated to fully understand for most investment professionals, let alone the individual independent long term investor.

The Federal Reserve Banking System is a private company whose stock is owned by its member banking institutions. This corporation is owned by twelve member bank stockholders who receive a yearly dividend payment. The Fed controls the issuance of currency and also the liquidity in the banking system and capital markets through open market operations and through the control of interest rates. To many U.S. citizens, including myself, there appear to be several conflicts of interest between the Fed and the U.S. Taxpayer, but in this article I will not discuss the politics of such a system as much as highlighting this conflict as a positive for investors looking to add exposure in the financial sector.

Rising interest rates, which are being predicted by a number of gurus including Nassim Taleb, Bill Gross, Jim Rogers, and many others are largely a tailwind for the banking business even though the economy could suffer from tightening credit and from a further slowdown in housing. While the mortgage mess is still a huge problem for the banking sector, most of the risk has been transferred to the U.S. Taxpayer (ie, you and me) and off of the balance sheets of the major financial corporations. Thus, a rise in interest rates could actually boost margins for banking institutions while hurting economic activity for the rest of the world. While it is true that higher inflation is bad for lenders, the modern investment banks have found ways to hedge their risks and I believe that the risk of rising yields outweighs the risk of rising prices.

One thing is clear -- the U.S. loves its big banks and cares little for the smaller players in finance. It is with this view, I believe, that Fairholme looks at large cap financials as a bargain at current prices -- we already know that the government wants these companies to grow and expand and that the taxpayers are being leveraged as a backstop in case anything goes wrong for these mega-companies. This affinity for investment banks is a positive for the following ten stocks.

For those living in caves, Fairholme was recently voted Morningstar's Fund Manager of the decade and has absolutely clobbered the S&P 500 over the past ten years, despite all of the efficient market indexing pundits that claim that markets cannot be beaten. Here are eleven top Financial stocks which are owned by Fairholme currently and should be followed given such tailwinds:

AIG -- American International Group is starting to look dirt cheap to this humble investment pro on a price to book value and price to cash flow basis. It is nice to know that I am not alone in my view as FAIRX has a 10% weighting in the name. AIG has grown book value to over $85 billion today from around $55 billion in 2008 while sporting a market cap of just $65 billion. Morningstar lists AIG's forward P/E ratio at 10X and the stock makes up nearly 10% of Fairholme's flagship mutual fund run by Bruce Berkowitz, arguably the king of Value Investing in today's market.

AIG covered calls are an interesting approach, as the May $35 calls can be sold against the stock for around 3.5% in monthly yield while allowing for meaningful appreciation in stock price over that period of time. Investors may also consider selling the January 2012 $35 put options instead of buying the stock directly for $5.2, although they will not be able to participate in the dividend yield. Personally, I think a "buy and hold", or a hedged position versus a short in the Russell 2000 makes a lot of sense given the margin of safety at AIG.

BRK.B, BRK.A -- Berkshire Hathaway is always a good investment it appears, however, the main concern here is an individual investor's holding period. The longer you own Berkshire, the more money you will make over time. Holding the stock for a short period of time is not as wise, however, as the company does fluctuate with the ups and downs of the overall markets. Berkshire is the best run company in the world, and the shares are down a bit recently which puts the valuation at just 15X trailing earnings and at an EV/EBITDA multiple of only 9X.

Berkshire's price to book value of 1.27X should be viewed as a gift as the company has managed to grow book value per share at a truly incredible 20% or so per annum rate over the past 30 plus years. Investors looking to play BRK-B options should consider buying the January 2012 $60 call options and selling the June $85 call options as a hedge.

GS -- Goldman Sachs' stock has suffered recently from three consecutive quarters of negative earnings growth. The company, however, is the biggest and the best in the investment banking and trading business and has one of the top prime brokerage and managed account businesses in the world. GS is a 5% position for Fairholme, so the shares are likely substantially undervalued on earnings and cash flows. The stock trades for a small premium to a growing book value and their core businesses are not drying up any time soon.

BAC -- Bank of America is another 5% position for Fairholme, and Berkowitz likely owns the name due to the stock's small discount to book value and its cheap valuation on forward earnings of just 7.2X 2011 EPS. The "fraudclosure" headwinds are likely fairly short term in nature and it seems unlikely that the federal government will let BAC or any other member banks fail at this point.

C -- Citigroup is one of the toughest companies to value because it is the largest trader in off balance sheet derivative contracts in the world. Citi falls into the "too hard to value" category for me and has for years ever since I read a book by Aswath Damodaran on mortgage derivatives and realized that these contracts are incredibly hard to value let alone understand. The company is cheap, however, trading at around tangible book and for 12.7X trailing earnings and 8.7X forward earnings. Citigroup is another company that will likely not go under while trading for a discount to future cash flows.

JPM -- JPMorgan reported earnings that rose by 67% on a YOY quarterly basis and the shares are another large position for FAIRX. JPM is a well managed company, with the best leadership team out of all of the Fed member banks discussed in this article. Jamie Dimon is a one of the few investment banking leaders whose integrity is unquestionable, although in this case, such a statement is akin to calling a used car salesman "honest" after the bailouts unfortunately stripped the investment banking profession of a substantial amount of respect. Maybe it's a good thing they are well paid after all.

AIA Group (OTC:AAIGY) -- AIA is a Chinese insurance company, which is a large position for Fairholme, and writes business in the growing Chinese life insurance industry. Life insurance is a brand new concept for many emerging market economies and the growth rates for such a product can be expected to climb at a fast pace over the next decade.

MS -- Morgan Stanley looks cheap at 10X trailing earnings and 8.6X forward earnings at a price to book value of just .85X. MS is actually much more highly leveraged than it was pre-crisis and even though the company could be through the worst of the mortgage mess that brought the shares to around $10 in the summer of 2008, the shares are not for the faint of heart and the risks are still quite pertinent.

CIT -- CIT is interesting at .9X book value and 15X earnings, as the leverage ratio for the company has dropped significantly over the past three years. In fact, CIT has gone from having a book value of around $7.5 billion with liabilities of around $72 billion to a book value of around $8.5 billion with liabilities of only $42 billion since 2008, making this a financial stock to watch out of FAIRX's big financial holdings this year.

RF -- Regions Financial is a bit too highly leveraged for my tastes at 10X leverage, but the shares are reasonable at 1X tangible book and 12X forward earnings. Berkowitz clearly feels these leveraged companies can rebound, so the stock may be a good value if the company can right the ship in the coming years.

GE -- GE is a controversial stock and although many investors blame Jeff Immelt for the demise of the stock price, shares do look reasonable to the value investor at a certain price. In the crash of 2008 I was luckily able to sell the Leap GE $10 put options for around $1.30 per contract. I will be looking for a similar "trade" if GE sells off significantly in the future. Shares look a bit rich to me at 18.7X earnings, but the forward multiple of 12.2X looks fairly attractive.

So there you have it, Fairholme's well researched top ideas in the financial space (or at least their top financial names at the end of 2010) and my "quick and dirty" back of the envelope analysis of them. My favorites are AIG and Berkshire for both valuation and business quality reasons, respectively. Remember that stocks have had a tremendous run, so investors looking to add these names right now may want to wait for a sell off in the overall markets or to hedge these names with short positions in other financial stocks. An analysis of potential shorts in the financial space will be made in an upcoming article. Happy Investing.

Disclosure: I am long GS, BRK.B, AIG, C, BAC.

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