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Bruce Berkowitz Semi-Annual 2011 Letter to Investors

September 02, 2011 | About:
Holly LaFon

Holly LaFon

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To the Shareholders and Directors of Fairholme Funds:

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


Rating: 4.0/5 (10 votes)

Comments

OV#91
OV#91 - 2 years ago
A lot has recently been written about Berkowitz's "demise". However, the man is an investment genius for a reason, so I wouldn't write him off based on 6 poor months. It is obviously true, that to have returns such as his, one has to ignore the crowd and underperform in the short term. The ugly does not become pretty overnight.

I don't understand how the US economy can recover and grow at a respectable rate without having the banks power the growth. All financing, from corporate to real estate, must flow through BAC, WFC, JPM, C etc...

The banks are essential to a prosperous economy. If BAC were to go under, the shockwaves that it would send throughout the economy would be astounding. It wouldn't matter if you own APPL or JNJ, your holdings would be crushed.

Banks are very cheap, and unless you think BAC or C will actually go under, they are a good long-term buy.
batbeer2
Batbeer2 premium member - 2 years ago
If BAC were to go under, the shockwaves that it would send throughout the economy would be astounding. It wouldn't matter if you own APPL or JNJ, your holdings would be crushed.

True.

Then again, the fact that BAC will be around in one form or other doesn't mean your shares will be valuable. AIG is still around but some shareholders lost a fair bit of money.
ranjitsudan
Ranjitsudan premium member - 2 years ago
This is not 2008! as warren buffet said.

Also remember most of the jombie loans BAC wrote during 2007 have cleared out. BAC have strong balance sheet with high liquidity. I can't imagine things getting worst then 2008, so BAC going burst is out question.

BAC problem is meeting with basel III capital requirement, which BAC propose to meet by selling non core assets and internal capital generation.

I think most of the pessimism/bad news is priced in the stock price.(you never know where's the bottom with high frequency trading now days so dollar averaging could be nice strategy in this instance)
Sivaram
Sivaram - 2 years ago


OV#91: "The banks are essential to a prosperous economy. If BAC were to go under, the shockwaves that it would send throughout the economy would be astounding. It wouldn't matter if you own APPL or JNJ, your holdings would be crushed."

As BatBeer points out, the company may survive but that doesn't mean the shareholders won't be wiped out.

Also, I don't know much about the American banks and their quality of their balance sheet but there is always the possibility of 'too big to save.' I don't think BAC is too big to save but if a few banks end up with huge losses (say from derivatives), I can actually see the government not saving them because they are too big for them. For instance, if you look at how the EC, ECB, and IMF are having problems saving Greece (admittedly this is a government rather than a bank) you can see how too big to save might crop up. Greece is a tiny portion of the ECB and probably costs less than 10% of the potential net worth of the ECB. Yet, they are having serious problems throwing a few hundread billion towards them.

Anyway, my opinion isn't about BAC or any specific investment; I'm just arguing against the strategy to invest based on 'it shouldn't be allowed to fail.'
fcharlie
Fcharlie - 2 years ago
Ranjitsudan says:[url=http://www.gurufocus.com/../ic/space.php?uid=37512][/url]

BAC problem is meeting with basel III capital requirement, which BAC propose to meet by selling non core assets and internal capital generation.I don't think meeting basel III is the problem, I think the perception that they won't meet it without issuing common equity is the problem. On Wall Street, perception and reality are the same over the short term. Berkowitz is probably going to look brilliant in a few years, right now, he looks like a fool.

ranjitsudan
Ranjitsudan premium member - 2 years ago
Even I thought so but since buffet deal, I'm getting bit nervous. The deal is not in BAC shareholder favor, why the hell will you dilute shareholder equity, pay 6% per annum dividend on 5B; when you are confident that you have enough capital to continue your business and meet basel III requirement. One could feel its not that rosy for them.

Berkowitz didn't time the market well, hence looks like a fool... I mean we all knew Europe headline risk would effect banking stocks. He was way too aggressive in his purchase. He got it wrong with AIG purchase as well, now with BAC, C.
cm1750
Cm1750 premium member - 2 years ago
Berkowitz: "A 1% ROA or 10% ROE for BofA (BAC) would yield over $2 per share."

Using these very rough numbers would imply a normalized fair value of $20/share assuming 1.0x BV is fair for a 10% ROE.

What I am concerned about is that Bruce made such a huge bet on financials when BAC only had 33% upside in early 2011 when the shares were $15/share. I don't mind being early but only if the projected IRR compensates for it.

If one was a patient investor and thought it might take 3 years to reach this $20 value, one would demand a 3-year IRR of 30% given the uncertainty of the loan book, economy, regulation etc. That implies a buy price of about $9.

It looks like Buffett was smarter and more patient as he waited and also got much better protection via the preferred stock with massive upside with warrants. Even if Warren is wrong about the common stock upside, he still makes a nice 6% with tax benefits (BRK as a company does not pay full tax on corp dividends). That is why Buffett is the Oracle.

shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
A Berkshire lieutenant bought BAC common shares at a high price before the banking crisis. Late in 2010 Berkshire dumped their common shares of BAC after they climbed in the recovery of 2009-2010. Berkshire suffered a large percentage loss on the investment. Now Buffett has bought preferreds. Clearly he likes the generous terms and lower risk of the preferreds, but don't forget he dumped BAC common stock only a year ago when the recovery was gaining steam.

Bottom line: People buying BAC common stock are clearly gambling. Holders of the common stock are making a much riskier bet than Buffett without getting anything extra in return. BAC has diluted its shareholders hugely in the last five years--and they'll likely do it again.

Buffett has generally been a mediocre stock picker in recent years. He's also a poor picker of Presidential candidates. His public relations skills are as good as ever, though.

When housing finally bottoms (another 10% drop in price or more), you'll have a better idea of how many holes BAC needs to fill in its balance sheet.

Arpan
Arpan - 2 years ago


A Berkshire lieutenant bought BAC common shares at a high price before the banking crisis. Late in 2010 Berkshire dumped their common shares of BAC after they climbed in the recovery of 2009-2010. Berkshire suffered a large percentage loss on the investment. Now Buffett has bought preferreds. Clearly he likes the generous terms and lower risk of the preferreds, but don't forget he dumped BAC common stock only a year ago when the recovery was gaining steam.

Bottom line: People buying BAC common stock are clearly gambling. Holders of the common stock are making a much riskier bet than Buffett without getting anything extra in return. BAC has diluted its shareholders hugely in the last five years--and they'll likely do it again.

Buffett has generally been a mediocre stock picker in recent years. He's also a poor picker of Presidential candidates. His public relations skills are as good as ever, though.

When housing finally bottoms (another 10% drop in price or more), you'll have a better idea of how many holes BAC needs to fill in its balance sheet.


His dumping of BAC common stock had only to do with Lou Simpson retiring. His entire portfolio was liquidated. We can't infer his views on the company based on him dumping the stock.

I agree that holders of the common are making a much riskier bet than Buffett, who has the best deal. A near guaranteed 6% return and all the upside of buying the stock at $7.14, without actually buying it. Not only does it have no downside risk, but he also doesn't have to lay out any capital for 10 years in order to capture that gain.

Poor picker of Presidential candidates? He supported Obama during the 2008 election. How is that poor.

Mediocre stock picker over recent years? How recent is recent? Five years should be the proper time period to measure stock picking. I don't have the data in front of me, but I'm very sure that Berkshire's portfolio has beaten the S&P over the last 5 years.
jonmonsea
Jonmonsea premium member - 2 years ago
I think the structure of the Buffett deal is telling, esp. in comparison to the GS and GE deals. Even at the time, Buffett said that he was not sure that both or even either of the warrants would be in the money at the time of exercise, vis-a-vis GS and GE. And he demanded 10% when treasuries yielded little, and the economy was "in cardiac arrest." In the BAC deal, Buffett has made no comments on the warrants, but clearly the upside he sees in the deal is in making a black box bet on the US (and to some degree, world) economy via BAC, with its massive consumer deposit base. His exercise price is meant to compensate for potential equity dilution and opportunity cost issues in the medium term (hence 10 years), but his 6% demand shows a marked comfort with BAC as a credit risk (and also, likely, a reckognition that 10% prefereds get redeemed very fast when dealing with good credits and miniscule treasury yields). Thus, Buffett protects BRK shareholders by making it more likely they will receive 6% on their money for a fair bit of time (BAC perpet. prefereds yield like 8.8% in the market), even if BAC does a capital raise that dilutes the warrants' value. This is a sweetheart deal that shows a man who insists on never losing money as priority number 1, but it does not mean that Buffett disagrees with Berkowitz that $2 a share in earnings as current float is unrealistic in normal environment. Only that Berkowitz bet big and early, and that he is telling the truth that he is agnostic on the economy and markets in his investments. Holders of FAIRX have suffered from opportunity costs associated with being all-in, unless they are wiling to send in more capital, which over ten years, Berkowitz's stated horizon for AIG, at least, seems very likely to beat that S&P, if not microcap Net Nets or Magic Formula strategies. There is massive volatility involved at FAIRX, but we must also be clear that BRK takes up like 7+ percent of his portfolio. Even a large share issuance at BAC at $5 per share should not make FAIRX lag the S&P over ten years. I only wish Berkowitz had maintained higher cash levels, but we need a lot more time to judge his investments. FAIRX is now a very powerful investment vehicle, more so than a month ago.
ranjitsudan
Ranjitsudan premium member - 2 years ago
Looking at Buffet previous investments, I don't think he is thinking of any capital loss on this at all. He doen't think BofA will go burst. If he has slighest of doubt on losing his capital, he would have let this deal go or as he says he doesn't need to swing.

My point on this thought process is that BAC stock has been beaten up badly, it's good entry point gives margin for safety, common stock doesn't yield anything so let's go for preferred shares, see if things can work out well and it worked for him. Deal gives him both yield and capital growth on common stock. Not bad in current low yield environment.

From BAC point of view, their shareholder are net loser with share dilution. If they need capital to meet basel III requirement, they could have gone to market and raised 5B by issuing common. At least they would have saved 3B on dividend payment to buffet. As a BofA shareholder, I just don't understand this deal . Intially, I thought they are not in hurry in raising capital as it needs to be done over 2-3 years which they will generate enough capital internally but this deal indicates things are not as rosy as management describe. This makes me nervous, waiting for Q3 result!
Koheleth
Koheleth - 2 years ago


I remember Warren telling U of Florida MBA students (it's on YouTube) that he has sometimes made mistakes buying preferreds of companies because it was an "attractive security" but from an otherwise unattractive business "I would have not have bought the equity in". Very telling. At that time he was mainly referring to US Air, I believe, but he added that he would probably do it again in the future, primarily when he has a lot of cash around and he's looking for somewhere to put it.

I'm not saying I know what Warren thinks of BofA, but this is what he has said of similar deals in past.
mbfenner
Mbfenner - 2 years ago
A few weeks ago on Bloomberg(Charlie Rose) Warren said he believed the banking industry was fine. I guess if the industry were fine BAC wouldn't be giving him this deal. He also said this was not 2008. True, but this could be worse with a global slowdown, possible inflation and continued unemployment, not to mention the European contagion which may prove to worsen. And now we know that the U.S. Government is suing the banks for misrepresenting the solidity of their mortgage-backed securities. I, for one, firmly believe the banking industry is NOT fine.

shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
His dumping of BAC common stock had only to do with Lou Simpson retiring. His entire portfolio was liquidated. We can't infer his views on the company based on him dumping the stock.



I agree that holders of the common are making a much riskier bet than Buffett, who has the best deal. A near guaranteed 6% return and all the upside of buying the stock at $7.14, without actually buying it. Not only does it have no downside risk, but he also doesn't have to lay out any capital for 10 years in order to capture that gain.

Poor picker of Presidential candidates? He supported Obama during the 2008 election. How is that poor.


Mediocre stock picker over recent years? How recent is recent? Five years should be the proper time period to measure stock picking. I don't have the data in front of me, but I'm very sure that Berkshire's portfolio has beaten the S&P over the last 5 years.
Are you suggesting Buffett was forced to sell the Simpson stock picks? This sounds rather dubious. Simpson's Geico division was part of Berkshire, as were his stock picks. I can't imagine Buffett dumping shares bought by a manager of a unit at Berkshire if he thought the shares had substantial upside.

Buffett supports Obama, in spite of the awful job he has done as President. If it weren't for the terrible president "W" Bush before him, Obama would be overwhelmingly seen as the worst President since Carter.

Buffett overpaid hugely for COP. In recent years, he has bought large amounts of WFC, JNJ, WMT, USB, and other weaklings....The "halo effect" makes you want to believe that he's beating the market. Nothing stands out in recent years as a great stock pick. The reality is far less flattering. He even wrote in one of his annual reports that Simpson was doing better as a stock picker than he was.

There is downside risk to BAC. If the teaparty and libertarian factions of the Republicans dominate future elections, BAC has a good chance of not being bailed out next time. Rather a preplanned bankruptcy and orderly asset liquidation might be in their future (and the preferred shareholders might get zilch in this event).

Perhaps this is why Buffett is more vigorously helping out Obama this election cycle. He knows Obama will be a good boy and keep Buffett's precious banking investments hooked up to the intravenous drip when the second (nastier) phase of the current Recession/Depression kicks into gear.

Bank America should be broken up, sold off, and re-engineered with new managers. They had enough taxpayer funded handouts.

Arpan
Arpan - 2 years ago
Are you suggesting Buffett was forced to sell the Simpson stock picks? This sounds rather dubious. Simpson's Geico division was part of Berkshire, as were his stock picks. I can't imagine Buffett dumping shares bought by a manager of a unit at Berkshire if he thought the shares had substantial upside.

No, he wasn't forced. He is the Chairman and CEO, he can do whatever he wants. Why would he have to hold the stocks just because Lou Simpson bought them? Simpson held those stocks because he researched them and he liked them. Every investor is different. If Buffett never researched them/followed them/etc. why would he hold these stocks simply because a previous money manager bought them? Furthermore, those positions were small compared to Buffett's standards, and it would have been inefficient for him to hold onto small positions. He dumped everything, including Sanofi-Aventis, which Buffett himself owns in Berkshire's main portfolio (and in his personal portfolio). So as you can see, it has nothing to do with his views on the stock.

Buffett overpaid hugely for COP. In recent years, he has bought large amounts of WFC,J, WMT, USB, and other weaklings....The "halo effect" makes you want to believe that he's beating the market. Nothing stands out in recent years as a great stock pick. The reality is far less flattering. He even wrote in one of his annual reports that Simpson was doing better as a stock picker than he was.

Yes, nothing stands out as a great pick. But the market itself hasn't been great either. In fact it has been poor. COP was a bad stock pick, but that was it. Buffett's major positions such as KO, WFC, JNJ, WMT, PG have done better than the market over the last 5 years. He did write that Simpson was a better picker. But so what? Are you saying that Simpson was a better picker, hence Buffett has done poorly? I don't get that logic.

Buffett supports Obama, in spite of the awful job he has done as President. If it weren't for the terrible president "W" Bush before him, Obama would be overwhelmingly seen as the worst President since Carter.

This is pretty subjective, so there is no point in debating it. If you think Obama is not a good President, then you think Buffett is a bad Presidential supporter. If you think Obama is good, you think Buffett is good at picking a good President.

ranjitsudan
Ranjitsudan premium member - 2 years ago
Perhaps this is why Buffett is more vigorously helping out Obama this election cycle. He knows Obama will be a good boy and keep Buffett's precious banking investments hooked up to the intravenous drip when the second (nastier) phase of the current Recession/Depression kicks into gear.

This is bit farout.. no investor will get intangled in so many if's-and-but's leave only buffet. I think he is more of a number guy - he must have run through number of scenario considering loan losses and share dilution.

Anyhow i alway consider berkshire has better understanding of the economy given they have 70-80 odd business in different sectors; not to forget "Railroad" which provides good understanding on ecomony esp demand side of things. I remember him mentioning Railroad to be the best indicator of economy during 2008-09 financial crisis. [i][/i]I would suggest you all to have a look www.aar.org. Things doesn't look that bad when you look at RailRoad number. However, this should be read in conjunction with other economic indicators.

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