Bruce Berkowitz's Second-Quarter Letter
Financial disasters start with great investment ideas taken to illogical extremes. For example, what has been more beneficial to family wealth than home ownership? Yet, we recently witnessed a near collapse caused by residential real estate.
Great investment ideas start with disasters. Liquidity disappears. Assets are marked to mayhem. Intangibles are written off. Companies with fixable problems become unusually cheap and again profitable. Yet, they remain hated for past sins and sell for less than assets minus liabilities, reported as book value. They have little, if any, investment risk.
This is when we focus on buying. This is also when we look dead wrong and have periods of underperformance. This is also how The Fairholme Fund has outperformed the S&P 500 Index in ten of the past twelve years. In 1988, Warren Buffett wrote "…our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." Twenty years later, the 2008 collapse of financial markets was caused by companies ill-prepared for a national decline in home prices, the freezing of credit, and knock-on effects. Today, they stand at polar opposites.
The Fairholme Fund (FAIRX)
The Fund gained 24.7% versus 9.5% for the S&P 500 Index in the first six months of this year. A $10 investment in the Fund at its inception has grown to $37.33 (assuming reinvestment of distributions) compared to $11.74 for the S&P 500 Index. Cash and equivalents stand at $1.25 billion (17% of the Fund). The following chart compares The Fairholme Fund's unaudited performance (after expenses) with that of the S&P 500 with dividends and distributions reinvested, for the period ending June 30, 2012.
Our best idea remains AIG (AIG) common (35% of the Fund) with a reported book value of $57 per share. There are few occasions when systemically important franchises sell for half of book value and are profitable. This is one of those times. AIG warrants held by the Fund (another 3% of the Fund) provide the right to 21+ million shares at $45, or maybe more shares at lower strike prices for the next 34 quarters if dividends above $0.675 per trailing 12-month period are paid.
Bank of America (BAC) is the Fund's next largest financial holding (9% of the Fund) affected by the great housing price collapse. The company's reported book value is over $20 per share. We believe that America's bank is returning to its retail roots (think of Wells Fargo) with a $1 trillion deposit franchise and that bank profits will skyrocket as legacy real estate loans burn-off.
Sears Holdings (SHLD) (11% of the Fund) is one of the largest corporate real estate organizations in the world, with a portfolio of retail locations that is second to none. Generally Accepted Accounting Principles ("GAAP") mandate valuing their real estate at the lower of cost or market. GAAP would force the Dutch settlers to value Manhattan today at the 1626 purchase price of $23.70. The company's reported book value of $43 understates real values. Warrants received by the Fund from General Growth Properties (GGP) (7% of the Fund) during its reorganization provide the Fund the right to "cash-in" the difference between GGP's market price and the current strike price of $9.52 on now 45 million shares. For the next 22 quarters, distributions by GGP will further reduce this strike price and increase the number of shares.
The Fairholme Focused Income Fund (FOCIX)
The Fund seeks, among other things, current income. The Fund gained 6.5% versus a gain of 2.4% for the Barclays Capital U.S. Aggregate Bond Index ("Barclays Bond Index") in this latest six month period. In its first 30 months, the Fund gained 17.5% versus 17.6% for the Barclays Bond Index.
MBIA senior, unsecured bonds maturing between 2022 and 2028 represent the Fund's largest holding (29% of the Fund). These bonds have an average current yield of 10.1% and yield to maturity of 11.4% per annum. MBIA surplus notes of 2033 (another 12% of the Fund) are the most junior of MBIA bonds held by the Fund and have a current yield of 25.9% and yield to maturity of 22.4%.
Sears Holdings' 6.625% of 2018 and Emigrant Savings Bank's 6.25% of 2014 (each 21% of the Fund) have respective yields to maturity of 8.9% and 10.6%. They compare quite favorably to equivalent U.S. Treasuries. Cash and equivalents are at $30 million (12% of the Fund).
The Fairholme Allocation Fund (FAAFX)
The Fund seeks long-term total return. We have typically sought investments for the Fund that are too small to make a big impact on a larger fund. The Fund gained 11.3% while the Barclays Bond Index and S&P 500 earned 2.4% and 9.5%, respectively, in the past six months. In its first 18 months, the Fund is down 4.3% versus a gain of almost 10.4% for the Barclays Bond Index and 11.8% for the S&P 500. Cash and equivalents are at $11 million (4% of the Fund).
MBIA common (32% of the Fund compared to 3% of FAIRX has a reported book value of $10 per share. GAAP mandates no value attributed to unearned premiums and mark-to-market reversals estimated to be worth $20 per share. Since 2008, the company has paid $35 per share on faulty real estate-backed bonds. Management expects to receive at least half back of the $35 from the issuers of the bonds and to restart the municipal bond insurance business with the cash proceeds.
AIG common (18% of the Fund) is our second largest idea for the Fund given valuations and liquidity. Long-dated warrants on AIG, Bank of America, Wells Fargo, J.P. Morgan, and Hartford Financial held by the Fund (in total 16% of the Fund) are unique in that strike prices decline and conversion share amounts increase with dividends paid above threshold levels. The following table summarizes each warrant's current strike price and conversion ratio, expiration date, and quarterly dividend threshold. Estimated returns are attractive, if as assumed below, underlying common share prices meet book values growing at 10% per annum and exercised shares can be sold at such prices.
Liquidity and Concentration of the Funds
Fund share redemptions have forced the Funds to raise liquidity. Rather than selling across the board, we have learned not to sell our best ideas. Again, Mr. Buffett: "The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel…"
Bruce R. Berkowitz
Fairholme Capital Management
As reflected in its current prospectus dated March 29, 2012, The Fairholme Fund's Expense Ratio is 1.02%, which includes acquired fund fees of 0.02%. 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.
This Portfolio Manager's Report is not part of the Fairholme Funds Semi-Annual Report. The Semi-Annual Report contains a Management Discussion and Analysis section covering the period ended May 31, 2012. Opinions of the Portfolio Manager are intended as such. Unless otherwise specified, any references in this Portfolio Manager's Report to a portfolio holding of a Fund is at the latest public filing of Fairholme Funds, Inc. with respect to such holdings at the time of publication. Portfolio holdings are subject to change at any time and are subject to risk. There can be no guarantee that undervalued securities will appreciate as anticipated.
Expense ratios for the Funds stated in the current Prospectus dated March 29, 2012 may differ from the actual expenses incurred by the Funds for the period covered by the Fairholme Funds Semi-Annual Report.
The S&P 500 Index is a widely recognized, unmanaged index of 500 of the largest companies in the United States as measured by market capitalization. The Barclays Capital U.S. Aggregate Bond Index is an unmanaged market-weighted index comprised of investment grade corporate bonds (rated BBB or better), mortgages, and U.S. Treasury and government agency issues with at least one year to maturity. Investors cannot invest directly in an index.
Investors should consider the investment objectives, risks, and charges and expenses of a Fund carefully before investing. The Fund's prospectus contains this and other information about the Fund. To obtain a copy of the Fund's prospectus, please visit www.fairholmefunds.com or call 1-866-202-2263. Please read the prospectus carefully before investing.