July 31, 2017
Fairholme Shareholders and Directors:
Fairholme has established a track record of successful value investing. Over the past 17 years, our flagship Fairholme Fund (Trades, Portfolio) has outperformed the S&P 500 index with a 425.37% cumulative return after all Fund expenses compared to a 132.36% return for a benchmark S&P index.
We have achieved this success by using a distinctive talent for patient value investing – selecting contrarian stakes and then deploying significant funds with conviction. We have consistently sought out attractive opportunities that meet our strict value-oriented criteria. While the world does change, and we always try to consider the reasons for change, the Funds’ investment philosophy remains constant. However, the very strategies that have rewarded us for decades appear misguided. I will explain in this letter why it seems this way and why I still believe the same investment style will generate future successes.
Fannie Mae and Freddie Mac
After eight long years of cover-ups, bald-faced lies, and judicial obstruction, the government has finally released thousands of documents demonstrating that the Obama Administration created false pretenses to unlawfully siphon tens of billions of corporate cash from Fannie Mae (FNMA, Financial) and Freddie Mac. These documents clearly demonstrate that senior government officials knew the GSEs were on the verge of sustained profitability and took actions to usurp all of those profits. Indeed, the documents reveal that these officials lied to the public and perjured themselves in federal courts. The so-called “Net Worth Sweep” was unnecessary to prevent a “downward spiral.” Put simply, we now have unambiguous evidence that the Obama varsity team knew what their statutory authorities were, willfully exceeded those authorities to steal billions of dollars from investors, and subsequently engaged in a cover-up to hide their wrongdoing.
When you follow the cash, it’s easy to see that Fannie and Freddie have generated hundreds of billions in profits, taxes, and consumer savings. Each held tens of billions of tangible value and maintained tens of billions in earnings power – even at the worst point of The Great Recession. Each had the wherewithal to pay all bills and pursue its stated mission of providing liquidity when all others cannot.
Federal agencies continue to defend contrived accounting gimmicks by arguing that they followed the law and, notwithstanding, they are above it. As more and more documents are released, the Department of Justice will see that the actions undertaken by former officials undermine their defenses and long-established laws. Fannie and Freddie can safely return to their role of insuring the uniquely American housing finance system against catastrophic risk with private capital. There is a proven blueprint to succeed, and we hope to successfully resolve this matter before reaching the Supreme Court of the United States.
After all, capital markets are based on the sanctity of contracts – the original buyers’ and sellers’ expectations and rights travel with a contract no matter who holds it. When this saga ends, we expect contracts to be honored and substantial value for all stakeholders.
Sears, et al.
From the ashes of failed retailers often come great real estate companies. Malls and shopping centers are not in permanent decline. Sears (SHLD, Financial) spin-off, Seritage Growth Properties, has re-tenanted over three million square feet at more than three times old rents since 2015, and demand continues to grow. Investors may disagree on the exact path forward for Sears, but the company owns many valuable assets and there is huge value in optimizing all of them. In the first half of the year, Sears sold the Craftsman name for a net present value of $900 million. Real estate sales added another $400 million. Sears remains extremely competitive in all aspects of hardline retail. Company vendors are estimated to earn $5 billion annually from relationships with Sears. There is no reason why Sears cannot share in this success and monetize assets through innovative partnering.
Sears continues to accelerate the pace of its operational restructurings, and is heading toward $1.25 billion in annualized cost savings. The news that Amazon is now offering Kenmore appliances with Sears’ white-glove delivery, warranty, and installation services greatly improves the competitive landscape for both. In addition, “Shop Your Way” already has millions of members enjoying a simple, easy, and personalized shopping experience. If you want to learn more about the Shop Your Way program, visit the following link: www.shopyourway.com/fairholme/ getmore.
St. Joe
St. Joe (JOE, Financial) owns 120,000 contiguous acres with entitlements to build homes and grow jobs for generations to come – at near zero land costs. CEO Jorge Gonzalez and team are making investments that will add value to this land with projects generating recurring revenue. It is my belief that GKN Aerospace may be just the first of many high-tech companies that will move to Northwest Florida. Great jobs build strong communities with top-notch education and healthcare.
If you are considering any type of corporate relocation or expansion, please call Jorge at (850) 544-3177 to find out why one of the largest global aerospace companies chose St. Joe to build their first facility in Florida.
Imperial Metals and Others
Imperial (TSX:III, Financial) has yet to achieve planned costs and recoveries for the next 100 years at its Red Chris property. More cash and time is needed to “get it right” at what we know to be a world-class copper and gold deposit.
Intelsat and Atwood Oceanics are leaders in satellite communications and offshore drilling, respectively. The Funds were able to purchase relatively senior bonds of each at steep discounts to redemption values because of industry overcapacity. Both companies subsequently announced industry consolidating mergers. The Funds cashed out for significant income and realized capital gains.
Sears Canada (TSX:SCC, Financial) (not to be confused with Sears) self-inflicted a court-led restructuring that will guarantee tens of millions of unnecessary professional costs. We are studying ways to recover what appears lost.
Summary
The Income Fund has proved that outstanding performance can be achieved with debt obligations, preferred stock, and real estate investment trust certificates that are generally less volatile with greater cash distributions and shorter payback periods than common stock. The strategies for all the Funds have been heading in this direction.
Overall, the Funds’ net assets stand at $2.6 billion. I, along with Fairholme employees and Fairholme-related entities, own about $221 million of the total. Each Fund holds 20% or more of net assets in cash and investment-grade cash equivalents, and each Fund generates at least enough income to cover Fund expenses. There is light at the end of what appears, at times, to be a never-ending tunnel.
Thank you for your trust and patience.
Respectfully submitted,
Bruce R. Berkowitz
Chief Investment Officer
