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Jacob Wolinsky
Articles  | Author's Website |

Bruce Berkowitz: Where is the free Cash Flow?

August 03, 2010 | About:

I must make a disclaimerabout this article that it is in no way a criticism of Bruce Berkowitz. Berkowitz has proven himself to be an excellent money manager, with a spectaculor record over the past ten years. He certainly deserved Morningstar’s award for equity fund manager of the decade. What I do wonder is why his investment philosophy has changed so much over the past year or so. That is the basis for this article.

"At Fairholme, we treat common stock as the most junior bond in a company's capital structure, where the true earnings, the free cash flow of a company, are akin to a coupon without a maturity date. We get really excited when we can find more senior and secure bonds that yield better than average equity-like returns. We then compare market prices to our estimates of free cash flows, to determinean expected return on investment. Price matters, and buying right is half the battle. Getting a reasonable estimate of expected free cash flow is the other half." Quote from Bruce Berkowitz

This is not the only quote where Berkowitz mentions FCF, Berkowitz almost always mentions FCF when he speaks about stocks that he likes. For the past few years these stocks consisted of many pharmaceutical, defense, and consumer goods companies.

Below is a list of stocks Berkowitz has been selling, along with their P/FCF:

PFE: 9.1

FRX: 8.7

WLP: 3.7

ACF: 3.1

Bruce Berkowitz has been stocking up on financial stocks lately. Financials now represent over 60% of his portfolio. Some of the companies Berkowitz has been buying lately include; MBIA, BAC, AIG, Regions Financial, and CitiGroup.

Let us look at the price over free cash flow of each:

MBIA: -0.9

BAC: 1.5

AIG: 0.2

RFF: 2.4

C: -12.8

MBIA, and Citi are both FCF negative. Regions Financial, AIG, and Bank of America are all P/FCF positive. However, this is only recent phenomenon. Until recently, these companies were losing tremendous amounts of money. AIG lost $100 billion in 2008. However, stocks like WellPoint and Forest labs have experienced much more stable earnings (and FCF) over the past several years, than the financial stocks Berkowitz has been buying. The FCF of the companies he is buying are much more unstable then the companies he is selling. Why not go with Wellpoint at 3.7 P/FCF over Citi at -12.8 FCF?

It seems that Berkowitz has had a large change in strategy over the past few months. Maybe he is relying on the fact that these companies will in the future generate large amounts of FCF, however they are far different than the companies Berkowitz has purchased in the past. If anyone has an answer including Berkowitz himself I would be curious to know.

Disclosure: long WLP, and FRX for one of my clients.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website

Rating: 3.2/5 (31 votes)


Clm10 - 7 years ago    Report SPAM
AIG lost $100 billion in 2008?

Then let's all celebrate that this is not 2008!

Investing is all about what you give for what you get. (Now who says that often in interviews...hmmm?)

The motto of Bruce's fund is Ignore the Crowd™

His style has not changed. He is modeling future free cash flows vs. estimated loan defaults.

His model shows him that the cash flows will begin to overwhelm the losses shortly (before Wall Street traders jack up the share prices).

He is getting in before others so his investors will benefit.

Remember...he has the Wells Fargo experience after the S&L crisis as a guide (look it up).

His track record buys him credibility. Stick with Fairholme.
Halis - 7 years ago    Report SPAM
Free cash flow is not really a good way to value a bank or an insurance company, in my opinion. I would look at a combination of earnings and book value. For a bank, I would look at how much in deposits it has and their cost, against what it earns on those deposits.

For Citigroup and AIG, he is clearly betting that their average return will be higher than what they have experienced in the past few years. Perhaps not as high as what they were experiencing before the Great Recession. But even a reasonably average figure should provide a large margin of safety for either stock.

They are both global brands and I see them recovering in the years to come.

Disclosure: Long C and AIG
Cowboy77 - 7 years ago    Report SPAM
This is a really bold call by Berkowitz. He's my largest holding and I must admit that this gives me pause but I'm sticking with him. He pulls this off and his reputation will be even larger than it is already.
Freehling - 7 years ago    Report SPAM
It seems to me that Bruce, despite being a fundamental value investor who analyzes companies one by one, looks a lot at macroeconomic factors. He bet big on defensive stocks -- healthcare and defense contractors -- during the economic collapse. Now he's forecasting an economic turnaround and stating that financials usually lead the way out of a recession. It's almost like he's betting less on one specific company and betting more on an economic turnaround in which the financial companies hit the worse during the collapse will generate the best returns as the economy improves. Also at this point the financial survivors almost have an implicit "Too Big To Fail" guarantee from the government so perhaps he sees limited downside risk. I too am sticking with BB and Fairholme.
Yswolinsky - 7 years ago    Report SPAM
freeling good analysis, and maybe he is more of a contrarian who goes with whatever is beaten down that sounds like what you are saying.

I just take one issue with the too big to fail argument. Too big to fail does not mean shareholders will be rewarded, it just means the firms wont go under. That happened with AIG and the GSEs. I doubt a big bank like Citi the Gov would seize and wipe out shareholders since it would create tremendous market uncertainty, but who knows for sure?


Yswolinsky - 7 years ago    Report SPAM
Cowboy I agree FCF is not a good way to look at financial institutions. I am just stating that I am bewildered by his sudden pilling up on financial institutions. I trust Berkowitz knows what he is doing, not that he needs my approval. But one has to recognize this is an entirely different Fairholme, than the Fairholme of a year ago.

Adib Motiwala
Adib Motiwala - 7 years ago    Report SPAM
Would be good to post the P/Tangible book and P/B for the financials to round off the discussion.


Superguru - 7 years ago    Report SPAM
Peter Lynch, I believe, bought heavily in last S&L crises and that was a big part of his success.

thing I like so far about Bruce is that he does not get married to a stock, sector and/or philosophy. If he sees better opportunity somewhere else he sells what he thinks will give lower returns and buys what is better. Good example is PFE. very bullish for a while and suddenly out of it.

Also He waited till it was clear to him that downside is limited before buying the financials. Even though it meant he did not buy them anywhere near the bottom.

If something is cheap and safe why not buy it.

It seems He has taken concentrated sector bets before too with Health care and Energy.

If you look at another past high flier, Whitman's TAVFX, it has concentrated bet on region and sector (Honkong and real estate) and seems even riskier (may be because of my lack of knowledge of the companies Whitman has invested in).

Mrd premium member - 7 years ago

All of these stocks fit another quote he frequently says "The problems may be like a pig in a python"

Meaning that at the moment the snake can't move, but will eventually digest the meal, and be able to hunt again. All of these stocks, simply need time to solve their ills, all will for the reasons that were mentioned above, the markets can't replace them, and over time from present and new business and asset sales, they will recover from their problems, and be worth much more.
Dr_evil - 7 years ago    Report SPAM

The simple answer may be that Bruce is using his best estimate of "normal" free cash flow, which is probably not the same as last year.
Yswolinsky - 7 years ago    Report SPAM
I think maybe I should have wrote the article differently. My main point is that Bruce seems to have completely shifted his investment style. His motto can still be "ignore the crowd", but I do not think he is relying on companies with strong past cash flows, and is shifting into companies that are more cyclical, and which might not offer a margin of safety. However, publicly he has never stated any change in his investment strategy despite the radical change.
Yswolinsky - 7 years ago    Report SPAM
Super one top value investor that I interviewed (off the record) called Whitman's in Hong Kong a four letter word. He thinks that the investments offer no margin of safety, and are highly speculative.

Only time will tell if he is right.
Sivaram - 7 years ago    Report SPAM

Y SWOLINKSY: "Super one top value investor that I interviewed (off the record) called Whitman's in Hong Kong a four letter word. He thinks that the investments offer no margin of safety, and are highly speculative."

When I was following Whitman closely, I didn't like his Asian real estate bets either. I think he is right from a value investing point of view but all those assets are extremely vulnerable to a real estate bust in China. But like all classic value investors, Whitman doesn't pay much attention to what may or may not happen in macroeconomics.

As for Berkowitz, I'm not too familiar with him but it's definitely a bold call. A lot of those financials are profitting off taxpayer and central bank assistance and it's unlikely the same support will be extended if there is another crisis so to speak.
Rgosalia - 7 years ago    Report SPAM
Since we are on the topic of Mr. Whitman's investments in Asia, I would like to comment on it.

Third Avenue's Q2 2010 letter to shareholders covers in detail their analysis of the investments in the Hong Kong real estate companies. I highly recommend that you read this letter carefully before signing off Third Avenue's investments as speculative. (I know you don't Jacob or Sivaram - the 'you' doesn't refer to anybody specific)

Mr. Martin has often said 'safe and cheap' investing pays little to no attention to market risk. So far, Mr. Market has not been very kind to Third Avenue's Hong Kong investments. But, if an investor is not willing to live with her portfolio being marked down by 50%, she should not be in investing. In the near-term, there is the market risk that these securities may significantly decline in value. However, as a value investor, it is more important to recognize the underlying business of these securities, and invest only if there is possibility of permanent loss of capital is limited

I believe that Third Avenue has done its research on the underlying business and the managers running these businesses. Based on their research, they think that these investments meet the 'safe and cheap' criteria. So, in that sense, they are not speculating but investing, as per Graham's definition of investing. It may turn out that their investments go sour (because of permanent degradation in business) but only time (as Jacob said), not Mr. Market's daily quotation, will tell if their investment is flawed or not. As a shareholder of Third Avenue, I simply ignore the daily quotations, and spend time reading their letters instead. I applaud Third Avenue for communicating to its shareholders their thesis on these investments. There are very few value shops that can match the quality of communication from Third Avenue.

I have summarized below their comments on one of their larger holdings, but I strongly recommend reading the letter instead.

"Henderson Land Development's major investment properties are in Hong Kong and are 97% leased. It has a very strong financial position with a debt-to-equity ratio of 16.1%. Besides, Henderson Land has an ownership stake in other non-real estate interests. Hong Kong and China Gas make up 46% of Henderson's market cap. The company is run by a very capable team led by Chairman Lee Shau-Kee who owns more than 50% of the company and recently increased his stakes. Henderson is about 12% of Third Avenue's asset. As per the Third Avenue team, it is trading at 25% discount to NAV."

About the comment by a famous value investor, I will quote Ben Graham: "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

Having said the above, if you know of reasons to believe that there will be permanent loss of capital in these specific securities, I encourage you to use that as a counter-argument to Third Avenue's investments in these securities. This could include a certain macro view that you believe may materialize and somehow cause significant damage to the long-term value of these specific securities. The reason I point this out is because I speculate that the situation for these securities could be very similar to what may happen (has happened) in the US. We may go through a major commercial real estate burst (and went through/going through a major recession), but in my opinion, there will be very limited (has not been any) damage to Brookfield Properties' long-term value. If you have reasons to believe otherwise for these Third Avenue Hong Kong securities or for Brookfield, it will make a very valuable post (at minimum to all Third Avenue or BPO/BAM shareholders).

Disclosure: The author is a shareholder of TAVFX and BAM


Q2 2010, Letter to Shareholders, Third Avenue Management.

Vuasu - 7 years ago    Report SPAM
In the crisis of '90s, Buffett also initiated a position with 5 million shares in WFC in 1990, PE was down to 3.7, bought at book value of $58 at PE of 5, down from $84. He paid 289 millions. He continued buying shares in '92 at prices from 66 to 69/sh. By 12/97, his 6.7 million shares were valued at 2.27 billions....

Bruce also did well with WFC during this crisis.
Jaumepared - 7 years ago    Report SPAM
Inflate Inflate Inflate. The Fed and Government keep inflating. The money has to go somewhere. Fix your mark to market problems, put problem assets to the government and you have a recovery which includes significant FCF. If he´s wrong, deflation will blow us all away. But thanks for the thoughtful and insightful comments.

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