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Bruce Berkowitz: From Free Cash Flow to Distressed Financials Investor

Note: This article is not a criticism of Bruce Berkowitz, merely noting the massive change in his investment philosophy and portfolio allocation. Anyone who reads the article carefully should come to the same conclusion.

Bruce Berkowitz has earned the award for the best equity fund manager of the decade from Morningstar, and rightly so. Berkowitz’s Fairholme beat the market every year since its inception, except 2003. For the past decade, Fairholme has had an annual return of approximately 12.9%. Despite his consistent performance in the market, his investment philosophy is something which has lacked consistency in the past few years.

On a quick side note: There has been too much talk about the battle over St. Joe between Berkowitz and David Einhorn. St. Joe is a small holding; companies like AIG, BAC and Citi are much more important to Fairholme shareholders; St. Joe has merely been a big distraction.

When talking about his investments, Bruce Berkowitz almost always mentions the importance of free cash flow (FCF) to determine the expected return on investment. However, his latest investments, most of which belong to the financial sector, contradict his stance on FCF.

Bruce Berkowitz’s historic portfolio from dataroma:

1321058555.jpg

The shift from stocks which generate tons of FCF to financial companies which offer hopes of future free cash flow started to occur mostly in the second half of the second quarter of 2010, and has continued to today. I noticed the changing trend of Berkowitz’s investment style, and penned an article on Aug. 3, 2010, titled “Bruce Berkowitz: Where Is the Free Cash Flow?

If we follow his investment philosophy which kept in perspective the FCF of the company, most of the attractive investments belong to sectors such as pharmaceuticals, defense and consumer goods. However, Bruce Berkowitz has been selling companies belonging to the sector despite their high price-to-FCF ratio for financials. We can take as illustrations Pfizer Inc. (PFE), Forest Laboratories Inc. (FRX) and WellPoint Inc. (WLP). Instead, as of now he has been stocking up on financial companies such as Citigroup (C), Back of America (BAC), American International Group (AIG), Mbia Inc. (MBI), Jefferies Group Inc. (JEF) and CIT Group (CIT). All these have a comparatively lower P/FCF than the companies he has been selling off since last year.

If we analyze his current portfolio as of June, it is evident that he is extremely bullish about the financial sector. His current equity portfolio is 90.7% made up of companies belonging to the financial sector. His top 10 holdings include 8 companies which belong to that sector.

According to Google Finance, approximately 97% of Fairholme is invested in equities, leaving approximately 3% in cash. If I remember correctly, Berkowitz used to hold close to 20-25% of his portfolio in cash.

Sector

(Click for Industries)
Trend
Financials point2.gif2011-06-30 gold.gif 90.7%

2011-03-31 green.gif 80.6%

2010-12-31 brown.gif 72.5%

2010-09-30 aqua.gif 80.3%

2010-06-30 red.gif 70.1%

2010-03-31 purple.gif 57.8%

2009-12-31 grey.gif 44.9%

2009-09-30 orange.gif 31.1%
Health Care point2.gif Consumer Services point2.gif2011-06-30 gold.gifndustrials point2.gif2011-06-30 gold.gif 0%

2011-03-31 green.gif 3.1%

2010-12-31 brown.gif 5%

2010-09-30 aqua.gif 6.9%

2010-06-30 red.gif 5.4%

2010-03-31 purple.gif 6.6%

2009-12-31 grey.gif 11.9%

2009-09-30 orange.gif 10.5%


These include:

American International Group (AIG) – makes up 23.42% of Berkowitz’s equity portfolio and has the largest position in the company.

Citigroup (C) – makes up 8.5% of his portfolio and he has the second largest position in the company.

Bank of America Corp. (BAC) – makes up 8.45% of his portfolio. Berkowitz believes BAC will outperform JPMorgan, as the company is making all the right moves.

The remaining four are Brookfield Asset Management (BAM), CIT Group (CIT), Goldman Sachs Group (GS), Regions Financial Corp (RF) and Berkshire Hathaway (BRK.B).

If we compare his current portfolio to that of the past five years, the change in his investment strategy has clearly changed. Berkowitz is clearly relying on the fact that these companies will be able to generate large amounts of FCF in the future. It is not surprising that he is bullish about the companies in the financial sector, like Bank of America and Citigroup, as a lot of other famous investors are as well, such as John Paulson, Bill Ackman and Warren Buffett. Nonetheless, the reason for the change in the investment strategy of Bruce Berkowitz over the past few years is likely because he sees future FCF and the market overreacting by dumping financials across the board.

I will make three points: AIG is a company which is way outside my circle of competence. I believe Warren Buffett read the entire K in one night during the financial crisis in '08, and declined to invest because he did not understand the K. I would guess at least 90% (if not more) of retail and institutional investors who are long or short AIG did not even read the most recent 10-K, which is 399 pages. Another 9% probably did but do not understand it.

I do believe that Bruce Berkowitz is a genius investor and has a better understanding of AIG than almost any other person in the world. Even though Berkowitz had little money invested in financial companies (excluding Berkshire Hathaway) until recently, he has some great calls in the past with financials.

In Joel Greenblatt’s famous book "You Can Be a Stock Market Genius," he mentioned a young analyst who recommended investing in LEAPs for Wells Fargo (WFC), when the company’s future was uncertain. The investment turned out to be spectacular, and Wells Fargo is now one of the largest banks in the country. That young analyst was Bruce Berkowitz.

In a recent interview with Consuelo Mack, Bruce Berkowitz compared the current situation to Wells Fargo in the early 1990s. However, this is unarguably the worst recession since the Great Depression. While American banks are in much better shape than three years ago, there are still huge issues, lawsuits, weak housing, ripple effects from European banks, etc. It is hard to compare the current situation to anything besides the 1930s. Additionally, Berkowitz’s largest holding, AIG, is majority controlled by the U.S. government. AIG’s future might have less to do with future company performance than petty politics.

Finally, a word on Bruce Berkowitz’s overall portfolio allocation. Even if he is right that financials will make a huge turnaround due to his fund structure, he is not being a careful steward of capital. His cash allocation is dangerously low, and as a recent article on GuruFocus mentioned Berkowitz Sold Portion of St. Joe Due to Redemptions. Even if Berkowitz is 100% right, a mutual fund structure is not the correct fund structure to invest the majority of a portfolio in financials and keep little cash for redemptions. To make the point more clear, if Bruce Berkowitz thinks BAC is worth $24 a share and it is currently trading at $6 a share, he might be 100% but could have to sell at $6, due to shareholder redemptions.

Berkowitz would be much better off with a private equity or hedge fund structure, where there can be large lock up periods on investments. With mutual funds, investors can withdraw any day the market is open. Berkowitz’s current portfolio would be much better fitting in a hedge fund structure.

In conclusion, three things seem certain:

Bruce Berkowitz is allocating shareholders’ money in a very dangerous manner.

Even if he is right, he might still lose money due to redemptions.

Berkowitz’s bet will make him the next Bill Miller or Seth Klarman.

Only time will tell if he will be remembered as the former or later.

Disclosure: Long PFE, WFC, and HUM

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 3.0/5 (42 votes)

Comments

jameshou
Jameshou premium member - 3 years ago


Agree 100% with this article!
chrisgeody
Chrisgeody - 3 years ago


the redemption of Joe was from a separate account not the mutual funds.
jameshou
Jameshou premium member - 3 years ago


In addition to my point earlier, and again in agreement with the author, I am concerned that Bruce may have gone against his fundamental principles this time. If / when Greece and other PIIGS countries start to default, it will create a liquidity crisis large enough to through any valuation analysis of financial institutions out of the window, irrespective of how thorough the analysis is, because financial institutions are inherently leveraged, which makes their equity base subject to the magnified effect of asset value on their balance sheets. When the market perceives a financial instituion or a group of interconnected financial institution as as being undercapitalised, then the valuation and expected return of such instituion(s) may become a binary outcome, the equity holders risk being significantly diluted or wiped out in a recapitalisation process implemented in the worst capital market environment. Therefore the value of a financial institution is so dependent on exogenous factors such as liquidity, government policies, leverage cycle etc., it makes the valuation exercise almost redundant in this environment. Therefore, I fail to see how Bruce could understand precisely what the value of BAC is, because the "value" is dependent on so many moving parts. He may very well come out a winner in this huge bet, but from risk management perspective he has not been prudent enough to his investors.

The value of financial insitutions, in particular highly leveraged ones, is an illusive concept. A bet on an illusive value is speculation. A huge bet using investors money on an illusive value is very irresponsible.

Any different views would be very welcomed.
dealraker
Dealraker - 3 years ago
I disagree 100%. This is exactly the way Berkowitz has always invested. I have followed him and was an initial investor in his fund. I sold nearly all of it about a year ago. I disagreed with his view.

But his style has not changed whatsoever.

Why are you criticizing him (you are by the way)? Because his stock prices are down that's why.

When you don't know your ass from a hole in the ground you let stock prices jerk you around like you have a ring in your nose. I personally couldn't handle the heat so I got out of the his game.

Lower stock prices today still don't mean he is in the end wrong. He may still beat the market with this bag of garbage he seems to own today.

jonmonsea
Jonmonsea premium member - 3 years ago
During the Mack interview, Berkowitz stated that any redemptions in FAIRX/FAAFX would be conducted on a pro-rata basis. If this is true, why would shareholder redemptions cause him to have to sell out the positions of remaining shareholders? Is this a typical mutual fund structure?
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
Has the competitive landscape really changed significantly for any of his holdings? Seems to me that they mostly recapitalized, and now simply sit and await market confidence to be restored.

While, I would worry about any legacy issues still sitting buried in their balance sheets I doubt anyone wants to see another major financial institutional failure so, worst case, some sort of workout would be instituted on the first sign of trouble. So while lightning can strike twice I'd guess that unexpected liquidity crises are far rarer events. i.e. the world is driving by their rear view mirrors.
chrisgeody
Chrisgeody - 3 years ago
there is a general lack of understanding on how banks work and their current value. once in a lifetime opportunity. 1/2 of tangible book. 2x normalized earnings. strong reserves. great leadership. its only a matter of time.
supratik
Supratik - 3 years ago
IIRC Buffett did not reject investing in AIG because he did not understand the 10K. His offer was that he would buy all of AIG that was not exposed to the CDOs and leave all that toxic stuff to the government or to other institutions.

As for Berkowitz, I think he is looking at the small picture ie. the books of these financials which looks satisfying to him, and then he is looking at the big picture that these financials are critical to the global economic structure, especially now that they are even more too-big-to-fail than before. He sees these banks as multibaggers so all he wants to do is sit tight and wait.

I don't think he is changing his style at all, and he says that himself in each interview.
ramands123
Ramands123 - 3 years ago
Remember he has not bought "a" bank, he has in essence bought entire Financial System of America. When you buy the entire system at a significant discount to a already depressed book value, chances of huge upside with limited downside are very high.

Remember if entire Financial system of America is going down then so is every other stock in the world.

Chances are very high that this might be his best bet ever and he may very well topple John Paulson and David Tepper as the greatest beneficiary of financial crises.

Shareholders who cannot take short term fluctuations to his fund should not be investing with him at first place. After all that's what his slogan is "Ignore the crowd"

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
Regarding the EU/CMO, the question that isn't asked by the fear mongers is, upon a Greek default what percentage of payments would fall into arrears? A liquidity crisis need not develop, they could resolve their problem overnight if they had the will to do so.
Cowboy77
Cowboy77 - 3 years ago
Isn't the real question just exactly how much are some of the US institutions still exposed to Europe through derivatives? And how much would a collapse in Europe affect our banks?
mevsemt
Mevsemt - 3 years ago
Changing styles? Really? Check out http://www.fairholmefunds.com/pdf/oid1992.pdf and http://www.fairholmefunds.com/pdf/2000FairholmeLetter.pdf

I'd say if you only look back 5 to 8 years it would appear like his style has changed, but if you look over the span of his career you'd probably come to a different conclusion...

mevsemt.blogspot.com
noblepaladin
Noblepaladin - 3 years ago
The common way of thinking right now seems to be "The banks are insolvent until proven otherwise". And of course, it is hard to show that a bank is not insolvent unless it is one of the much higher quality banks like US Bancorp. However, I think this way of thinking is wrong. This isn't the first banking crisis we have ever had. Also, the government knows that they only had one shot at bailing out the banks, there will never be public support for another bailout. Would the government let them get out of the TARP if they are not healthy enough? Many people seem to believe that the Banks got a huge bailout and they are still insolvent. I think they got a huge bailout and now they are healthy again. Getting large sums of cash tends to do that. It might be "wrong". The banks dying might be "justice". But with investing, we are in the business of "what is the highest probability of being the truth?".

All the measurable ratios and numbers imply that the banks are doing okay. Bank of America has some mortgage putback risk, but I think they will be okay even with some pretty bad assumptions. Note that the mortgage can only be putback if it defaults. Just because they have $600 billion of mortgages sold, it doesn't mean that they will get a $600 billion loss. Most of them are performing. And if they are nonperforming, Bank of America is not liable if the guy lost his job and can't pay (if he never had a job and Bank of America misled investors, then they are liable). And even if mortgages don't perform, there is still some recovery in foreclosure. That number suddenly goes down to tens of billions, which can be paid off in one or two years of earnings. It's like the BP situation where the risk of $20-40B knocks down the market cap by $100B.

Of course, with financials, a lot of it has to do with faith in management. People say that the banks have bad management, but that may not be true. Note that Bank of America had one of the best operations, probably just as good as WFC. Their only problem was Ken Lewis brought Countrywide (and later Merrill, but Merrill wasn't that bad, they are making money with it now). But their standard loan business have always been run well. If I just delete the opinions in my mind that were created by the financial crisis (i.e. "Banks are evil, the end of the world is coming"), the banks look like great investments.
sjzhao2003
Sjzhao2003 - 3 years ago
I agree with Noblepaladin that BAC had a very good operation up until the countrywide acquisition. Their average ROA was only a touch below that of WFC and very consistent over time. Also, their deposit franchise is amazing: largest deposit, one of the largest branch network, significant opportunities for cross selling, and their cost of deposit is .33 (second only to WFC at .28 among the largest banks) is much lower than JPM or C. So basically they have a very sound operation. Now their capital position has improved dramatically, but the shares are selling below the cash on their book. Patient shareholders will realize significant gains from here--the market just needs some time to see the real value of BAC. Overall, these banks (not just BAC) are very cheap, weighed down by very negative sentiments which are often not founded on reality.

I don't agree with the original post, though, that Berkowitz has changed his investment style. He has been very consistent over time: buying assets at prices much cheaper than their value. That was the story for healthcare and energy names a few years earlier, and the same with financials now. Also, FCF is only one of the valuation tools available for value investors, and by no means the only tool. Many investors (e.g., Warrent Buffett) clearly prefers ROA for banks.
Rommel Acosta
Rommel Acosta - 3 years ago
This post was pretty helpful, especially because it provoked this discussion. Thanks to all who posted.
jameshou
Jameshou premium member - 3 years ago


Seems every has a valid point. I just want to point out that a liquidity crisis in Europe caused by a Greece default will cause significant write down for all European banks. A contagion may very well impact the US banks. Bruce has exposed his investors to significant systematic risk, irrespective of the value of AIG and BAC. Being fully invested when the crisis is just unfolding leaves him with no room to maneuver and no free cash to take advantage of a downturn. This is irresponsible on his part.
Cowboy77
Cowboy77 - 3 years ago


Seems every has a valid point. I just want to point out that a liquidity crisis in Europe caused by a Greece default will cause significant write down for all European banks. A contagion may very well impact the US banks. Bruce has exposed his investors to significant systematic risk, irrespective of the value of AIG and BAC. Being fully invested when the crisis is just unfolding leaves him with no room to maneuver and no free cash to take advantage of a downturn. This is irresponsible on his part.I agree that this is an "ALL IN" gamble. Grande huevos to say the least.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
I just don't see why Greece is such a big issue. "A significant write down for all European banks."? This is little old Greece we're talking about right?

I think either they will "default" while still continuing to make select payments under threat of major future impairments or people will just get bored with the story and with being scared while economies slowly recover and multiple measures work off any 'criticalness' in the Greek debt situation. Debt can be repackaged, Greece can be kicked out of the EU or whatever... it's not a big deal to me.

Default might be inevitable and in the near future but I think once it happens and various defensive measures set alight, the default will be brushed off and is already more than adequately priced into the market. In fact I'd bet that a significant portion of the market decline to date has more to do with fears of a China slowdown than with the PIGS.
superguru
Superguru - 3 years ago
I agree with AlbertaSunwapta. I am more worried China than I am about Greece. And China going down is going to impact Australia, Canada and Brazil and ....
Rommel Acosta
Rommel Acosta - 3 years ago
China really is the bigger problem, and it doesn't seem like it's the consensus view (yet) that it will slow down more suddenly than expected. Bloomberg had this article today where investors still expect a hard landing (5% GDP growth) in 2016. That seems way too far out to me. Land auctions are starting to fail with regularity; once you see property prices drop 20-30% you can kiss this whole "shift into consumption" economy thesis goodbye. So Superguru is quite right, the resource economies will likely get hit hard.
jameshou
Jameshou premium member - 3 years ago
I agree with the risk in China. However you have to recognise that China is in much better fiscal position than the PIIGS countries. Greece has $500 billion government bond outstanding. A default would not be a small issue. In comparison the Ruassian and Argentina defaults were much smaller (less than 1/10 of Greece's debt). This is also significantly larger than Lehman's balance sheet when it defaulted. Don't forget Italy's debt is 5 times of Greece. Add Spain on top of that, you have a real disaster.

Going back to Bruce, can he really foresee how these events will pan out? Because the outcome of an European debt structuring will impact the intrinsic value of many banks. Can he entrust the capital of his investors to so many constantly moving external factors, such as the decision of German, Greek and other European leaders? Maybe he believes there is already large margin of safety... I admit I cannot foresee how these events will play out.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
China is in a better fiscal position than the PIGS?

I don't know - after these once-in-a-lifetime (or two) booms, a lot of fiscal, financial and societal insanity reveals itself upon a slowdown.
superguru
Superguru - 3 years ago
JameShou - If US could not muster the courage to let any company other than Lehman go down, do you think US and Europe would let Italy and Spain go down?

Rommel Acosta
Rommel Acosta - 3 years ago
@Jameshou

I'm not quite sure China is in a better fiscal position than the PIIGS. You probably looked at official debt figures and those are very understated.

I think most people will be very surprised by the actual amount of leverage in that system before this is all over. Bad loan figures for the banks will skyrocket, in the magnitude of 30% above. If property prices decline significantly, it will be worse.

jhodges72
Jhodges72 - 2 years ago
"Note: This article is not a criticism of Bruce Berkowitz, merely noting the massive change in his investment philosophy and portfolio allocation. Anyone who reads the article carefully should come to the same conclusion."

And what if some of us don't come to the same conclusion? I fail to see how the article "proved" that Bruce's investing style has changed. The only thing the article may have "proven" is that the author of this article possibly doesn't see the value opportunity of the businesses Bruce has decided to invest in. That certainly doesn'tmean that value doesn't exist in those particular investments. Furthermore, Bruce has stated - as well as Warren Buffett and other professionals - that a business is worth the present value of its future cash flow's. However, I don't recal Bruce ever saying, similarily as Warren, that all businesses must meet that criteria. If that were true, Walter Schloss and Benjamin Graham would have never experienced the degree of success they both have as Graham & Schloss weren't advocates of Cash Flow valuations; hence the term "cigar butt"; many of which having negative cash flow.

Therefore, it is quite possible that Graham himself wouldn't agree with your perspective of Bruce.
Brentadams
Brentadams - 2 years ago
You criticize Berkowitz for selling stocks with high P/FCF ratios buying stocks with a low P/FCF ratios. Am I missing something here?

I thought it was best to buy stocks with low price to everything ratios: low P/E ratios, low P/sales ratios low P/book value etc.

Why is Berkowitz doing a bad thing by buying stocks with low P/FCF ratios?

superguru
Superguru - 2 years ago
"I thought it was best to buy stocks with low price to everything ratios: low P/E ratios, low P/sales ratios low P/book value etc."

Only exception, that I read, is that cyclical should bought when P/E ratio is high. I have never bought a high P/E cyclical myself afaik.

ilovesummer
Ilovesummer premium member - 2 years ago


Good article except it doesn't look at the big picture and ask why did he go from FCF to

financial sector?

IMO at the time he used FCF because it was the safest and best way to look at the market.

Currently, the financials have been hammered and FCF assumes absolutely no recovery in financials.

It was noted he used LEAPS and was right about WFC before. I think he see's the same opportunity and is taking it.

History repeating itself . Following the money.

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