WealthTrack Interview Transcript with Bruce Berkowitz

CONSUELO MACK: This week on WealthTrack, a Great Investor who has taken a plunge investing in battered financial stocks. In a rare interview, Fairholme Fund’s Bruce Berkowitz, Morningstar’s Fund Manager of the Decade discusses why he sees treasure where others see a trap. Fairholme Fund’s Bruce Berkowitz is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. One of the hallmarks of the Great Investors who have appeared on WealthTrack has been their willingness to go against the crowd, to invest in places others shun. That strategy puts them into uncomfortable, unpopular and frequently unprofitable positions for periods of time, some extended, some not.


This week’s Great Investor guest is no exception. As a matter of fact, he exemplifies the hazards and what he hopes will once again be the vindication of contrarian investing. He is Bruce Berkowitz, founder and chief investment officer of Fairholme Capital Management, whose tag line is “Ignore the crowd.” He manages three mutual funds, including his flagship Fairholme Fund whose outstanding long term track record earned him Morningstar’s first Domestic Equity Fund Manager of the Decade award in 2010. At the end of the last decade, the value fund had delivered average annualized returns of 13.2%, putting it in the top one percent of Morningstar’s large blend category- outdistancing the S&P 500 by 13 percentage points a year and expanding to nearly $20 billion dollars in assets.


Fast forward to today and the fund’s ten year track record is still beating the market, albeit by a much smaller margin, and is in the top one percent of its category, but its dropped to eight percent annualized returns and it is trailing the overall market in the last three and one year periods; plus its assets are now approaching half of what they were.


What’s changed? Over the last couple of years Berkowitz, who has always run a very concentrated stock portfolio, has loaded up on financials- to the tune of more than 75% of the portfolio. The group skyrocketed off the market bottom in 2009, but has been by far the worst performing sector year to date. Among Fairholme’s largest positions are battered names such as American International Group, Bank of America, Citigroup, and yes, the more lightly bruised Berkshire Hathaway, a long time holding.

I began the interview by asking Berkowitz why with all of the legal, regulatory, economic, and market uncertainties surrounding financials he was sticking with them.


BRUCE BERKOWITZ: The negatives are all uncertainty about the future. And what I try and do is focus on the facts of today. So, when you look at the income statements, they’re making huge cash flows, a lot of it being paid for the foolishness of 2007 and 2008, which eventually will burn off and those huge cash flows will show. If you look at the balance sheets of the company, they have-- banks, for example, they have the strongest balance sheets that they’ve had probably in a history of their histories. If you look at reserving, it’s stronger than at any time. If you look at the trends, the trends are turning favorable. If you understand the nature of loans and the average life of five to seven years, and your troubles in 2007, 2008, you’ve already had a good-- you’ve had a three, four year look at how the loans progressed. You know how they’re going to turn out. Credit cards, other types of loans are much shorter. They’ve already burnt through all that. The case of Bank of America, they have five different businesses, four of which are quite profitable, but there’s this one business, residential mortgages, which are still giving a lot of trouble, and they just took a $20 billion hit in one quarter as their estimate of what all the costs are going to be, including non-cash cost, you know, reduction of goodwill and other intangibles. And people believe that that can keep going like that. It can’t. It’s like insurance reserving. When we change your estimate, you change the number in one quarter for all the past and all your beliefs about the future.


So there’s a lot of fear in the marketplace right now, which I take as a positive because the financials are priced for failure, and that’s how you want to buy them, to be priced for failure, because the pessimism is intense and the market price reflects the pessimism, and then you could pair the market price to what you believe the company will earn in a more normal environment, and let’s say you take that with the funds. I take every one of our companies, and I look through; I take the earnings of the companies and I translate that into what it’s going to be in earnings per share of the Fairholme Fund. And I think that the companies have an earnings power of $4 per share for the Fairholme Fund, and the Fairholme Fund is $27 or whatever it may be per share, and I think, well, what’s that earnings? And what does that mean? And if I’m right, eventually, price follows true earnings, and hopefully, the mania that we’re in right now and the intense madness of the crowd will allow me, allow the fund to buy more, allow me to buy more, to take advantage of a cheaper price, the same way, you know, your favorite food group is on sale at the grocery store. It shouldn’t be much different than that.


CONSUELO MACK: But when you talk about the mania that is surrounding the financial stocks right now, have you ever seen the kind of mania, madness, craziness in any group that you’ve been so focused on before, in your experience as a money manager?


BRUCE BERKOWITZ: In my career, every day is reminiscent of the early ‘90s, with the financial institutions of that time. Wells Fargo was supposed to go bankrupt and there were a couple of investors, I believe that they were Buffett busters. They thought Buffett was going to lose his shirt on Wells Fargo, and I looked at Wells Fargo and I saw that even their bad assets were earning an income, which is the case with banks today. And how can bad be earning an income? So it was an overreaction. You know, our brains are wired for overreaction and momentum, and follow the crowd. So, Fairholme, our tagline is, “Ignore the crowd.” And another one of our lines is, you know, “Count what matters.” So we count the cash.


So when I see companies selling for below liquidation value, for below the cash that they own, that they had in their own bank and in other banks, and I look at the reserves and the strengths and the trends, I keep trying to pick away at them and kill them and chomp them, and what if the recession keeps going, and what if there’s a double dip? And what if house prices continue to go down? And what if they don’t know what they’re doing and they haven’t reserved properly? I mean you ask all those questions and the answer is, they survive. What investors are not focusing on is the inherent earnings power of the institutions. Bank of America, today, in this environment, makes $36 billion a year of pretax, pre-provision, so $36 billion before they have to pay taxes, which they won’t be paying for many years because of the last few years, and before they allocate money to bad loans, reserves, for whatever. So that’s $36 billion a year to add to any problems or issues. I talk to guys who get divorced, they feel like half their money is gone. I say it’s just a delay of game.


CONSUELO MACK: I’m sure they take that advice with a grain of salt. But let me ask you, because the last time I talked to you about your investments in financials, over a year ago, you said that the biggest risk to your position, and you just mentioned it, would be the correlation risk, and that they all don’t do well because of, let’s say, a double dip in the U.S. Now, we have people like Martin Feldstein saying that we’re going into a recession. We have the Chairman of a major bank in Germany saying basically that the European debt crisis essentially represents the equivalent of a Lehman Brothers. How do you assess the correlation risk now?


BRUCE BERKOWITZ: In really tough times, everything’s correlated except for cash, one. Two, everyone’s already assumed that we’re back in a recession. The price reflects it. I mean, literally the banks can shut their doors, stop doing business, run off the business that they have, and make more money than the stock price. So, and that can happen in a recession. And if you think about the human nature, after you-- banks made so many bad loans in 2007, 2008; the loans that they’ve made in 2009, 2010, this year, it’s unbelievable. Everyone complains on how tough it is to get a loan because they’ve gone from no documentation to unbelievable documentation. But it’s the nature. And if you stop growing, the financial institution stops growing, the cash comes piling in the front door. So these fears about not having enough capital, aren’t able to-- not have the reserves to pay for the past, they’re just, they’re unfounded. And even if times stretch out and get worse, the earnings power, a fundamental earnings power of the institutions, which will allow them to more than just survive.


CONSUELO MACK: There’s been a change in your portfolio mix, again, since I talked to you over a year ago. And one of the biggest changes is that in your asset mix, a year ago you had a sixth of the Fairholme Fund was in cash equivalents. Now it’s down to under two percent.


BRUCE BERKOWITZ: It’s not two percent, but it’s single digits.


CONSUELO MACK: It’s single digits.


BRUCE BERKOWITZ: Yeah, mid-single digits.


CONSUELO MACK: But you also had, I guess, about a sixth was in fixed income securities as well. So, at that time you told me, you know, we have billions of dollars in cash in the Fairholme Fund, ready to take advantage of whatever further stresses may come our way. So what happened to all of that cash, number one, in the last year?


BRUCE BERKOWITZ: Well, we’ve used it for further investments in AIG, and others. And we used it for redemptions.


CONSUELO MACK: You’ve always talked about cash as being your financial valium.


BRUCE BERKOWITZ: Right.


CONSUELO MACK: And that it gives you the kind of flexibility. So you have less financial valium now.


BRUCE BERKOWITZ: Correct. But at some point in a business cycle, one has to get greedy. And the time to get greedy is when everybody’s running for the hills with fear, that usually is a great time to get the greed going. And we’ve become greedy- less cash, more concentrated investments, bigger percentage of investments. Because my definition of skill is knowing when you’re lucky and taking advantage of that luck, and we’re very lucky right now. We have financial institutions that are so cheap I would not, I did not think I would see again in my lifetime, since the early 1990s. They have stronger balance sheets than they’ve ever had.


CONSUELO MACK: When you see stocks that you hold, the Bank of Americas, the Citigroups, the Goldman Sachs, whatever, AIGs that are down, you know, 30, 40%, you know, and I’m just talking about year to date. That, to you, is an opportunity to get greedy. It’s not a reason to flee, sell--


BRUCE BERKOWITZ: Yes, right. No, you don’t want to be in denial so you take out your checklist of the 500 aspects you look at with a company and try and understand, you know, you go through it all again and then you try and understand why the market is behaving the way it is, trying to find out where the differences are between perception and reality. You go through it all again, so you don’t want to go into denial, so you want to recheck all of your work. But at that point, if you can’t kill it, you have to have the courage of your conviction. That’s what you’re getting paid for. This is the time when I really earn my money.


CONSUELO MACK: But one of the things that you told me a year ago, and this is a quote, you know, the worst situation is if you’re backed into a corner and you can’t get out of it, whether for illiquidity reasons, shareholders may need money, we’re talking about redemptions; if you have an investment that is usual, you’re a little early and you are early in the financial stocks, I think …


The entire interview is here.