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Fairholme’s 2011 Results Show the Risk of Concentrated Positions in Hard to Value Businesses

February 03, 2012 | About:
The performance of the Fairholme Fund (FAIRX) and manager Bruce Berkowitz and his comments in his annual letter have been the subject of numerous commentaries. The fund lost 32.42% in 2011.

The commentary seems to fall in to one of two camps. His staunch supporters, including many “value investing guys”, rush to defend Morningstar’s Fund Manager of the Decade and believe his big bets on financials will eventually be vindicated. The other group seems to portray him as an idiot whose contrarian streak got him in trouble and led to a permanent loss of his investor’s capital.

My critique goes a bit deeper. I have no idea whether he will ultimately be vindicated on his bets or not and I don’t particularly fault him for a bit of underperformance (even if it is severe). Everyone makes bad bets and underperforms, it happens to all fund managers. Instead my issue lies with the investment process that led him to make the large, concentrated bets on financials in the first place.

I have no qualms with concentration per se. After all, it has worked out spectacularly well for some investors.

Tom Russo runs a concentrated portfolio with almost 37% of the portfolio in his top four holdings: Nestle, Philip Morris International, Berkshire Hathaway, and Heineken Holdings. Berkshire Hathaway itself runs a concentrated portfolio with 74% of the portfolio in only five stocks: Coca Cola, IBM, Wells Fargo, American Express, and Proctor & Gamble.

For reference the Fairholme Fund has 70% of its portfolio in only six holdings: AIG, AIA Group, Sears Holdings, Berkshire Hathaway, CIT Group, and Bank of America. The allocation is even more concentrated and includes even more financials like MBIA, Emigrant Bancorp, Wells Fargo, and JPMorgan among others.

Russo and Buffett run concentrated portfolio but they have large holdings in simple, easy to understand businesses. You can be fairly certain nothing evil lurks on the balance sheet of Nestle, Coke, or Philip Morris (regulatory risk aside). In addition those companies operate in sectors that are well known for their historic records of high profitability. You could pick tobacco companies by throwing darts and make out pretty well.

Financial firms are a different animal altogether. First of all the financial sector is not known for its historic track record of profitability. Instead it is known for a boom and bust cycle that makes investing in financials for the long term a dangerous proposition. On top of that, rather than choosing small, easy, and simple to evaluate banks Berkowitz piled in to some of the most confusing businesses in the financial sector. Bank of America is a behemoth of cobbled together parts.

I question whether anyone, including regulators and even the management themselves, truly knows the value of everything on BAC’s books. What is even more alarming is I’m not sure Berkowitz went through BAC himself (if that is even humanly possible). I have seen numerous interviews where he states his thesis for BAC and his justification that all is fine on the balance sheet was that federal regulators have been through the books during the crisis and are continuing to monitor the bank so things must be OK (perhaps given the short nature of my interview segments he didn’t have time to elaborate on work FAIRX did themselves?).

I would question the wisdom of relying on third party verification especially in light of the fact that these were the same regulatory bodies that looked the other way during the buildup of the crisis. How much “regulating” versus rubber stamping and “sweeping under the rug” they are doing is something I have serious questions about. The policy of most federal regulators was much more akin to Sgt. Schultz’s approach to guarding the prisoners at Stalag 13, “I see NOTHING! I know NOTHING!” than it was to actual regulation.

Concentration is fine when it is in simple, easy to understand businesses that operate in attractive sectors of the economy. When you start concentrating a portfolio in the financial equivalent of your high school or college cafeterias “mystery meat” bad things are much more likely to happen.

About the author:

Ben Strubel
President and Portfolio Manager of Strubel Investment Management, LLC a value oriented, independent, fee-only Registered Investment Advisor (RIA) based in Lancaster, PA.

Visit Ben Strubel's Website


Rating: 3.1/5 (28 votes)

Comments

brianbook
Brianbook premium member - 2 years ago
Excellent analysis, but in fairness to Berkowitz, he claims that the financial industry is within his "circle of competence".
JoeDaWealthManager
JoeDaWealthManager premium member - 2 years ago
His biggest mistake was not the concentration risk, but the risk being too narrow in financials, too. Since his mentor Warren Buffett often says in the short term, a stocks movement is more a voting machine, when the masses headed to the exits, he suffered redemption risk and was selling his plums because of the high illiquidity of these positions.
ramands123
Ramands123 - 2 years ago
Not to defend him but its worthwhile to read artical on Wells Fargo in 1990's when he defended Wells in oustanding investor's digest.

He is concentrated but he is also diverefied within Financials. His bet is on entire Financial System and not a bank.

His resoaning is right, book of US financial system is at depressed levels and he is buying at a significant discount to already depressed book. Bad loans have an average life which for most part have run-off. Books are lot cleaner. Gone are concentrated extotic deribatives, CDO's , CDS, complex edges. Try reading AIG financials now Vs 2007.

If they get one push in the stock prices, all they have to do is one stock offering and capital ratio's are all set.

He is not the only one try looking at Q3 of Mohnish Pabrai, Francis Chou , Wilbur Ross. All super investors
Alex Garcia
Alex Garcia premium member - 2 years ago
"The other group seems to portray him as an idiot whose contrarian streak got him in trouble and led to a permanent loss of his investor’s capital. "

He hasn't sold off the positions entirely (only the redemptions) so technically they are unrealized losses, but regardless it is going to take some time for the positions to break even.

-Alexg

http://www.valueinvestinghq.com
superguru
Superguru - 2 years ago
"He is not the only one try looking at Q3 of Mohnish Pabrai, Francis Chou , Wilbur Ross."

Except that Mohnish and Francis appeared to have bought financials at much more attractive valuations than Bruce did.

ramands123
Ramands123 - 2 years ago
Not correct Francis Chou bought almost at the same valuation as Bruce did.

Ironically both were Mornigstar's manager of the decade.

Mohnish i think got better valuation. I have a feeling he waited for Warren Buffett to make the first move.

I think he bought all - BAC, GS and Wells Fargo based on Warren or Charlie Munger's remarks..

But that's beside's the point. They all bought similar securities at big Margin of Safety
graemew
Graemew - 2 years ago
I agree completely with your assessment Ben. And the way I would sum it up is by the old saying ''success breeds failure''. Often a run of success can lead to overconfidence and hence the highly concentrated portolio of financials, which rather than hitting the ball out of the park, resulted in a significant loss of capital....whether this will rectify itself remains to be seen.
Downwardog
Downwardog - 2 years ago


Bruce was the manager of the last decade, not this decade. The team that helped him earn track record have left the building. Was he brilliant or fooled by randomness? My guess is the latter. As a risk manager he is plain awful and that is undeniable.
souderd
Souderd - 2 years ago
Not to beat a dead horse, but I agree with the first 3 comments tremendously. As Brianbook said in the first comment, Berkowtiz claims to have an understanding of the financials and has proven they are in his circle of competence. This has already been proven with his 1992 investment in Wells Fargo when that bank was very unpopular to the broad market. (see this article: http://www.gurufocus.com/news/144856/bruce-berkowitz--1992-interview-with-oid-when-he-was-neck-deep-in-troubled-wells-fargo-sound-familiar)

I personally do not doubt his investment process. Which includes his ability to analyze the banks financial statements, his due dilligence of the companies hes invested in ( read the transcript to the Bank of America Q&A conference call Berkowitz had with BAC Execs and also check out the case studies the fund company has on fairholmefunds.com) or the underlying conviction in the value he sees in his concentrated picks. The main factor he got wrong was his timing.

Sure, the financial sector is "scary" and to the general public very unpopular due to the banking crisis in 2008-2009 and with a loomning international debt crisis we are staring straight in the face. Not to mention investors are very put off by the aftermath of the toxic assets and looming lawsuits over the banks financial statements. All and all financials are very UNPOPULAR.

But, going by Fairholme's motto "Ignore the crowd" and the value investing philosophy of Ben Grahm that the market is a short-term voting contest and long-term weighing machine, I think that he saw the entire financial sector as a great opportunity. He reinforced his conviction that he believes banks and bank assets will one day be back to normal levels in an interview in the fall of 2011 with Conseula Mack, "If the financials fail, the United States’ financial system has failed, and capitalism as we know it has failed, and we have a lot of bigger issues, and I don’t see that happening." This quote may be self-serving but the entire interview is along the same lines.

Putting whether you are a critic or a believer of Berkowitz aside, there is always some inherent risk in having a highly concentrated portfolio, whether you understand the company or not. I agree with your arguement that one should invest in what one understands, but to say that business must be in an attractive sector misses the boat. The unattractiveness of the financial sector is leading to the conviction of Berkowitz's concentrated holdings and where the percieved value is. One man's "mystery meat", is another man's filet.

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