Bruce Berkowitz's 2011 Shareholder Letter
What a horrible year for performance! Market prices plunged in many of our Funds’ core holdings in spite of strengthening book values with huge reserving for legacy issues. Using the positions held in The Fairholme Fund, weighted for the Fund’s composition at the end of 2010 and 2011, the line graph on the next page illustrates this divergence in market prices to book values in the last two calendar years using the most recent, publicly available information for 2011 book values.* The Net Asset Values are as of December 31, 2010 and December 31, 2011. If the yearly change in The Fairholme Fund’s NAV reflects investor perceptions of future performance and if changes in underlying book values of portfolio companies approximate current economics, then markets in 2011 expected disaster in the midst of strength. Improving book value levels and ratios show companies recovering from tough times, prepared for uncertainty, and capable of profits without excess leverage. The Fund’s performance last year makes little sense in light of such positive trends and we can only hypothesize from public comments that investors did not fathom our financials’ assets. There appears little understanding of how loan and insurance contracts age and run-off, bad begets good over time, and how U.S. Generally Accepted Accounting Principles (GAAP) create undue quarterly volatility in book values.
In more-normal times, we expect portfolio companies to generate 10% returns on book values, which would lead to much higher common stock returns with discounts to those book values. However, current events always reverberate much louder than the financial histories of past cycles; positive results and actions are now needed to swing market sentiment and prices toward more balanced views and values. AIG’s $1B common stock buy-back, Buffett’s transaction with Bank of America, CIT’s rapid debt refinancing, and MBIA CEO Jay Brown’s repeated stock purchases all point to improving fundamentals – the process has started.
AIG common stock and warrants are by far the largest issuer holding of The Fairholme Fund and the company is worthy of a Dickens novel. Started in Singapore by U.S. citizen C.V. Starr in the 1930’s, built into a shining example of how America can compete and win around the world by an imperial M.R. Greenberg, torn apart by a ruthlessAG Spitzer, and now rising from the ashes of a great tragedy. The company’s book value of $45 per share is heading to $55 in the near future and yearly earnings power of $4 per share will further propel shareholder value. Yet, AIG’s market price plummeted to less than half of book value due to what we can only surmise as a belief that the United States Treasury will sell its 77% ownership stake below the Department’s $29 cost. Why this is negative for long-term investors we do not know. Sears remains a large position in all of our funds, notwithstanding announcements in late December of falling sales and margins, rising expenses, and write-downs. Investors fled with this New Year’s greeting before Chairman Lampert purchased over $150 million of common for his personal account. For many reasons, including management, we continue to believe the assets of this iconic brand to be a multiple of values implied by its current stock market price and continue to see the beginning of a new Berkshire Hathaway.
Bank of America was our worst laggard – even with results showing $20 per share of book value, $5 per share of reserves for bad debt and legal issues, and yearly pre-provision, pre-tax cash flows growing to $4 per share. Shareholders can find our analysis at fairholmefunds.com. If only BofA could buy back its stock at current prices that are near one-third of book value…
Besides cash levels, other main differences among The Fairholme Funds are in the holdings of small-quantity ideas in The Allocation Fund due to capitalization and income-generating ideas in The Income Fund due to mandates.
The Allocation Fund currently owns near its legal limit of an outstanding issue of BofA warrants rather than its common stock. Each warrant gives the right, but not the obligation, to purchase one share of common at $13.30 until January 16, 2019. The strike is quite high relative to current prices, but it lowers in price and the ratio of shares to warrants increases when dividends are paid, and with certain other events. The Allocation Fund also owns warrants on AIG, J.P. Morgan Chase, and Wells Fargo with similar “double-ratchet” features.
MBIAcommon stock is The Allocation Fund’s largest position. Recent legal settlements paid and reserves taken by defendants are convincing skeptics of the company’s ability to more than just survive. Following GAAP, the company reports a book value of about $12 per share. Following Statutory Accounting Principles (SAP) utilized by insurance regulators, book adjusts to $16. Assuming an orderly run-off, the company calculates an adjusted book value of $35. Each method has its strengths and weaknesses and does not include a value for new business.
High-yielding MBIA bonds are the largest issuer-based position while Emigrant Savings Bancorp and Regions Financial remain large positions in The Income Fund. The Fund’s current yield is 9.5%, yield to maturity is 11.7%, and average duration is 4 years.* Not too shabby.
In 2011, The Fairholme Fund lost 32.42% versus a gain of 2.11% for the S&P 500 Index (“S&P 500”). Since inception on December 29, 1999 and through December 31, 2011, The Fairholme Fund earned 199.31% versus a 7.23% gain for the S&P 500. A $1 million investment in The Fairholme Fund when it started on December 29, 1999 was worth $2,993,000 at December 31, 2011 compared to $1,072,000 for a like investment in the S&P 500. In 2011, The Income Fund lost 0.72% versus a gain of 7.84% for the Barclays Capital U.S. Aggregate Bond Index (“Barclays Bond Index”). Since inception on December 31, 2009 and through December 31, 2011, The Income Fund increased by 10.36% versus an increase of 14.89% in the Barclays Bond Index. The Allocation Fund lost 14.00% in its first year of life while the Barclays Bond Index and S&P 500 earned 7.84% and 2.11%, respectively. The charts below compare the Funds’ unaudited performance (after expenses) with that of the S&P 500 and the Barclays Bond Index, both with dividends and distributions reinvested, for the period ending December 31, 2011.
At November 30, 2011, The Fairholme Fund’s Expense Ratio is 1.01%. 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 Fund as a result of investments in shares of one or more investment companies, including, but not limited to, money market funds.
At November 30, 2011, The Income Fund’s Gross Expense Ratio is 1.00%, and the Net Expense Ratio is 0.67%. In the Funds’ current Prospectus dated March 30, 2011, The Income Fund’s Gross Expense Ratio is 1.02% and the 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 expenses of The Income Fund to 0.75% of The Income 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 November 30, 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 the 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 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.
In great years, we asked shareholders not to be swayed by short-term performance. The same is true in a bad year. One circling of the Sun is too short a time to differentiate between good and lucky. Thus, we remain optimistic given our performance since inception and a belief that while history does not exactly repeat, it does rhyme. Unemployment is coming down and elections are near. Our favorite economist,Warren Buffett, is bullish on America. Year-end reports show continuing, positive trends. Our companies are strong and cheap. Shareholders have kept their courage and conviction under stress. Fairholme has kept its word to focus on value-based, long-term investments. We will stay the course.
Thank you for your continued trust,
Bruce R. Berkowitz
Managing Member, Fairholme Capital Management LLC