The peaks and valleys that define the chart of the Fairholme Fund (Trades, Portfolio)’s performance jutted to a new summit in 2016, proclaiming to investors that a mere $10 laid in the hands of Bruce Berkowitz (Trades, Portfolio) in 2000 would be worth $62.21 today. Far below, at base camp, investors entrusting the same amount to the comparatively plodding and oxygen-starved S&P 500, after clocking another year in its hike, get $20.84 back.
Such was the year of fresh wind not just for Berkowitz, but another popular value fund, Mason Hawkins' (Trades, Portfolio) Longleaf Partners. Most of their returns are owed to stock picking. A generally verdant environment for underpriced equities offered a dose of help, too, as U.S. large cap equity value funds raised the average bar to 15.1% in returns, as measured by Morningstar, year to date. Fairholme topped it with a 26.7% return and Longleaf with 21.62%. Their performance placed them among the best 10 large-cap stock funds of 2016, according to Kiplinger.Ă‚
Longleaf’s year of bounty followed its decision to hang on to stocks as they became more and more discounted from portfolio managers’ estimates of intrinsic value. In a bleak 2015, the Partners Fund fell 18.8%, starkly lagging the 1.4% gain for the S&P. Ahead of the new year, the portfolio had a price-to-value ratio in the upper 60%s, and managers Mason Hawkins (Trades, Portfolio) and Staley Cates did not sell its three biggest detractors as prices declined to less than 40% of their targets.
The depressed pricing situation caused the fund to anticipate a strong rebound. In addition, three of its four largest holdings were already doing well, contributing the most to returns of all their stocks, and the fund believed they still had room to meet price estimates as well as create more value.
Longleaf proved mostly correct in its expectation of further gains for its top four: FedEx Corp. (FDX, Financial), CK Hutchison Holdings (HKG:0001, Financial), Level 3 Communications (LVLT, Financial) and Alphabet (GOOGL, Financial). Each, except for CK Hutchison, down 15.8%, saw its price continue to rise in 2016. As of the third quarter, the fund retained the same group.
A mergers and acquisitions theme that ran through Longleaf’s portfolio companies contributed significantly to gains. Slow growth and low capital costs paved the way for FedEx’s $4.8 billion acquisition of the fourth-largest global parcel operator, TNT Express, and CK Hutchinson’s $24 billion merger with VimpelCom’s Italian assets, creating the largest telecommunications company in Italy. Various other portfolio companies sold off assets, improving their balance sheets.
The acquisition by the fund’s largest holding, FedEx, of TNT Express raised its earnings and flagging margins, and the company announced an increase in 2017 guidance. But the buy also grew its debt to a decade high of almost $14 billion, bringing its debt-equity ratio to 1.01. Despite price appreciation and a price-book ratio near a 10-year high, the benefits of the merger caused Longleaf to raise its estimated value and declare it undervalued.
As the year progressed and the bull market raged on, Longleaf became a degree more conservative. With little on the market fitting its criteria, the fund purchased few new assets and sold off those reaching pricing estimates, raising the cash position to 25%. Viewing a less sanguine market as a possibility by the end of the third quarter, managers had prepared with a set of high-quality, financially strong businesses priced around 70% of their estimated value.
Just below Longleaf Partners’ third-place listing for large-company stock funds in 2016, Fairholme Fund (Trades, Portfolio), led by Bruce Berkowitz (Trades, Portfolio), came in eighth.
Most of Berkowitz’s windfall came in the form of a second-half resurgence of his long-held positions in a variety of classes of Fannie Mae shares, which he bought on the notion that the government’s post-bailout confiscation of the mortgage lender’s profits and denial of dividends to shareholders would all be settled in court. A share that traded for less than a dollar in January had jumped to $5 by December. Freddie Mac, another bailed-out mortgage lender under government conservatorship, traced its counterpart’s path to a high of $4.84.
Greater investor optimism on the entities started with the November presidential election of Donald Trump. Many investors, like Bill Ackman (Trades, Portfolio), believe Trump’s pro-business stance will make him friendlier toward a deal with their shareholders than Barack Obama’s administration and return them to private ownership. Ackman, at a New York Times conference in November, said he had spoken privately with Trump about Fannie and Freddie and planned to again. Ackman predicted investors would see a resolution within 12 months of the new administration.
Together the two positions make up about 21% of the Fairholme Fund (Trades, Portfolio) portfolio as its second and fourth-largest positions. Otherwise, his 12 portfolio holdings made little progress during the year. Sears companies continued to stumble. Sears Holdings (SHLD, Financial), whose board Berkowitz joined earlier in the year, and Sears Canada (TSX:SCC), which make up roughly 15% of the portfolio, both fell by more than half in price. Lands’ End (LE, Financial) and Sears Hometown and Outlet Stores Inc. (SHOS, Financial) also declined by more than a third.
Berkowitz is banking not only on common stocks but on a move of 24.4% of the Fairholme Fund (Trades, Portfolio)’s assets into bonds. The investor, who famously purchased crashing banks of the 2007 financial crisis, took advantage of plunging commodity prices to purchase corporate bonds, whose yields rival equity returns. He expected to continue the trend toward more current income, he said in a mid-year letter. Some of the bonds he bought include those of Sears Holdings, Chesapeake Energy Corp. (CHK, Financial) and Atwood Oceanics (ATW, Financial).
Like Longleaf, Berkowitz has prepared for potential market dial backs – he had 18% of the Fairholme Fund (Trades, Portfolio) in cash as of Aug. 31. “As opportunities emerge in new sectors and securities, our Funds have the necessary liquidity,” his mid-year letter said.
See the Fairholme Fund (Trades, Portfolio) portfolio here.
