For most of the past decade, Fairholme Fund (FAIRX) soared, outpacing nearly all its competitors by a wide margin. Assets poured into the fund, and portfolio manager Bruce Berkowitz was named manager of the decade by Morningstar. But this year the hot manager has turned cold. During the first five months of 2011, the fund lost 7.8 percent, lagging the S&P 500 by 15 percentage points and trailing 99 percent of its peers in Morningstar’s large value category. Nervous Fairholme shareholders have been fleeing. In April, the fund suffered $1 billion in outflows.
Some shareholders fear that the fund suffers from bloat, a familiar problem afflicting successful managers. All too often a small fund delivers big returns and attracts a flood of assets. Then returns suffer because the manager can no longer trade nimbly. Often a hot manager alters strategy as his assets grow. Instead of focusing on a few of his best ideas, the manager begins diluting his portfolio, buying less attractive choices in order to sop up cash. The manager may steer away from small stocks altogether because tiny positions have no meaningful impact on the portfolio.
Bloat could pose a special problem for Fairholme because the fund has grown so rapidly. Assets increased from $49 million in 2002 to $18.8 billion in 2010. Berkowitz acknowledged the concern when he spoke last week at the Morningstar Investment Conference in Chicago. He said that bloat could become a problem some day, but the fund has not suffered yet.
Berkowitz said that Fairholme has not become unwieldy because the fund takes outsized positions in a few unloved holdings. With this approach, a large portfolio can be an advantage, as Warren Buffett has famously demonstrated. Buffett employs his clout to negotiate favorable terms when he buys stocks or bonds. Berkowitz also uses his size to enjoy increased leverage. “Scale has helped us so far,” he said.
In one of Fairholme’s biggest successes, the fund used its bulk to gain a large position in General Growth Properties (NYSE: GGP), a mall REIT that went into bankruptcy. After winning a takeover battle, Berkowitz led a group of investors that bought the REIT’s stock and bonds at big discounts. General Growth recently emerged from bankruptcy, and Fairholme sold most of the positions at huge gains.
To implement his strategy, Berkowitz employs only a skeleton staff. While most big funds hire squads of analysts and portfolio managers, Fairholme relies on outside consultants who provide temporary assistance. As President Obama’s health legislation moved through Congress, Berkowitz recruited veteran consultants to research the impact of the new law. “We found consultants with 30 years experience who could be hired for less than the price of a graduate of Harvard Business School,” he said.
As the health legislation progressed, shares of managed-care companies sank, since investors feared that the businesses could become obsolete. But Fairholme’s consultants argued that the government simply didn’t have enough employees to take over the jobs of the managed-care companies. Convinced that the market had overreacted, Berkowitz began buying health shares—and scored big gains when the stocks rebounded. “Everyone thought we were crazy to invest in Unitedhealth (NYSE: UNH) and WellPoint (NYSE: WLP) because all those companies were going to disappear,” he said.
These days Berkowitz is focusing on financial companies that have been pummeled repeatedly by negative headlines. The list of holdings includes American International Group (NYSE: AIG), Bank of America (NYSE: BAC), and Citigroup (NYSE: C). With investors worried about troubled housing markets and debt problems in Europe, the stocks have sagged lately and hurt Fairholme’s returns. Berkowitz said that he is not worried by his recent setback. He said that the banks will recover soon—just as they have in earlier cycles. “Every five or ten years, financial services companies get themselves into a pickle,” he said. “They have to be bailed out. That seems to be the nature of capitalism.”
Berkowitz said that many of the problems plaguing the financial companies center around loans that were made in 2007 and 2008. But most loans of that vintage have been removed from the books as the debt was paid off or written down. That has helped banks to strengthen their balance sheets. “The cash that is flowing in will be more than enough to take care of the problems,” he said.
Fairholme’s most notable holding may be The St. Joe Company (NYSE: JOE), which owns 900 square miles in Florida near the Gulf of Mexico. The company has been developing housing and beachfront communities. When the Florida real estate markets collapsed, St. Joe reported sizable losses. Berkowitz bought 27 percent of the shares and fought to change the board. Recently he installed himself as chairman. Berkowitz argued that the company had been poorly managed. But now development is moving forward, he said. Over the next decade, the value of the land will skyrocket as developers build a series of beautiful communities. Already the state is building roads, and a new airport opened recently. “St. Joe will become a great place to live and work,” he said.
Fairholme’s position is controversial. Short sellers have piled into St. Joe, betting that Berkowitz is wrong about the demand for Florida land. But the shorts should not be too quick to discount the views of the Fairholme manager. Over the past decade, Berkowitz has taken many positions that appeared risky—if not foolish—and most often he has walked away with big profits.
