Bruce Berkowitz Semi-Annual 2011 Letter to Investors
The Fairholme Fund lost 9.42% during the first six months of 2011 while the S&P 500 Index (“S&P 500”) gained 6.02%. Since inception, the Fairholme Fund increased by 301.18%, which compares favorably to the S&P 500’s gain of 11.34%. A $1 million investment in the Fairholme Fund when it started on December 29, 1999 would be worth $4,011,839 at June 30, 2011 compared to $1,113,381 for a like investment in the S&P 500. The Income Fund earned 3.49% during the first six months of 2011 while the Barclays Capital U.S. Aggregate Bond Index (“Barclays Bond Index”) earned 2.72%. Since inception, the Income Fund increased by 15.04%, which compares favorably to the Barclays Bond Index gain of 9.44%. The Allocation Fund declined 9.30% in its first six months of life in comparison to the aforementioned benchmarks.
The Fairholme Fund's outperformance over the past decade was based on seeking undervalued securities of companies perceived to be in extremis. Our inclination remains to run from the popular and embrace the hated where prices tend to reflect such mistrust. Often, we are ahead of the crowd, too early, and appear wrong for a time. However, performance awards over the years show that we eventually get it right by seeing beyond temporary conditions and by avoiding diversification that leads to mediocrity. Our history is to buy in bulk during blowout sales with the knowledge that market price volatility only measures short-term perception of long-term risk.
When prices fall off the proverbial cliff investors run fearing that the market is omnipotent. But, such plummets do not always mean death and destruction. This was the case in the early 1990's, when studied banks and financial guarantors stabilized around five times normal earnings before their rise to all-time highs.
Today, we believe to be at a similar tipping point for financials with enormous cash flows and diminishing restructuring expenses for the illogical extremes of 2006/2007. Their pre-provision, pre-tax earnings power is compellin A not unreasonable 1% return on Citi's assets or 10% return on equity would yield $6 per share. A 1% ROA or 10% ROE for BofA (BAC) would yield over $2 per share.
AIG (AIG) common stock is similarly cheap, due mostly to market pressures caused by the U.S. Treasury's desire to sell its 77% ownership. When a recovering icon trades at half of our understanding of intrinsic value for a reason that has nothing to do with its prospects, we swing big.
Tremendous opportunities also exist in all parts of MBIA's (MBI) capital structure based on CEO Jay Brown's past turnaround successes, the resumption of new business, run-off earnings, and expected litigation proceeds.
Common to all the aforementioned survivors of the Great Recession are misunderstood net operating losses that will shelter hundreds of billions of future profits from taxes over the years to come.
Holdings in predominant life insurers AIA and China Pacific Insurance Company are the result of 30 years studying successful underwriters and the insurance needs of the middle class. Mark Tucker at AIA and Chairman Gao at CPIC maintain strong balance sheets, know their risks, insist on profitable underwriting, and have a tsunami of demand at their backs in Asia.
St. Joe (JOE) deserves mention given its attention by the press. While our active role at JOE is a first for Fairholme and unusual for mutual funds, our past clearly shows that we ignore what the crowd believes proper and decide for ourselves what is in the best interest of shareholders. We simply view JOE as an investment manager with permanent capital and understand how such companies are capable of above-average returns and how they can complement our other portfolio holdings. The same is true of Sears (SHLD).
U.S. consumer credit ratings are the highest in 4 years, consumer loan delinquencies are down significantly from the peak, and family debt payments as a percent of income are the lowest since 1994. Confidence is growing, albeit in fits and starts, and real estate activities appear to be on the rise. Halfway around the world are tides of capitalism maybe not seen in the U.S. since after World War II. All in all, the trends are positive for our companies and their customers.
Charlie Fernandez and I continue to believe that the U.S. business cycle has not been repealed and that, in the words of Yogi Berra, "it's déjà vu all over again."
Below is a comparison of the Funds' unaudited performance (after expenses) with that of the S&P 500 (before expenses) and the Barclays Bond Index (before expenses), all with dividends and distributions reinvested, for the period ending June 30, 2011.
At May 31, 2011, the Fairholme Fund's Expense Ratio is 1.02%. In the Funds' current prospectus dated March 30, 2011, the Fairholme Fund's Expense Ratio is 1.01%, which includes acquired fund fees of 0.01%. Acquired fund fees and expenses are those expenses incurred indirectly by the Fairholme Fund as a result of investing in securities of one or more investment companies.
At May 31, 2011, the Income Fund's Gross Expense Ratio is 1.00% and the Net Expense Ratio is 0.60%. In the Funds' current Prospectus dated March 30, 2011, the Income Fund's Gross Expense Ratio is 1.02% and Net Expense Ratio is 0.77%. The Manager has contractually agreed to waive a portion of its management fees and/or pay the Income Fund's expenses (excluding taxes, interest, brokerage commissions, acquired fund fees and expenses, expenses incurred in connection with any merger or reorganization and extraordinary expenses such as litigation) in order to limit the net expenses of the Income Fund to 0.75% of the Income Fund's daily average net assets. The fee waiver/expense limitation shall remain in effect until the effective date of the Income Fund's prospectus incorporating the Income Fund's audited financial statements for the Income Fund's fiscal year ending 2011.
At May 31, 2011, the Allocation Fund's Gross Expense Ratio is 1.00% and the Net Expense Ratio is 0.75%. In the Funds' current Prospectus dated March 30, 2011, the Allocation Fund's Gross Expense Ratio is 1.00% and Net Expense Ratio is 0.75%. The Manager has contractually agreed to waive a portion of its management fees and/or pay the Allocation Fund's expenses (excluding taxes, interest, brokerage commissions, acquired fund fees and expenses, expenses incurred in connection with any merger or reorganization and extraordinary expenses such as litigation) in order to limit the net expenses of the Allocation Fund to 0.75% of the Allocation Fund's daily average net assets. The fee waiver/expense limitation shall remain in effect until the effective date of the Allocation Fund's prospectus incorporating the Allocation Fund's audited financial statements for the Allocation Fund's fiscal year ending 2011.
Thank you for your trust,
Bruce R. Berkowitz
Managing Member, Fairholme Capital Management