One of the best ways to avoid making big mistakes as an investor is to review others' mistakes. Every investor makes mistakes, it's just part of the process, but we can swing the odds in our favor by avoiding repeating the mistakes others have made.
Looking back at Wall Street's history, there are plenty of case studies we can review to give us insight into the things that have and have not worked.
From hero to zero
Bruce Berkowitz (Trades, Portfolio) was one of the greatest fund managers of the 2000s. His investment fund, Fairholme Fund (Trades, Portfolio), was founded on Dec. 29, 1999 and returned 343% to the end of 2010 vs. 5% for S&P 500. That was a return of 14.5% p.a. vs. the index's 0.5% p.a.
Thanks to this track record, Berkowitz was named as the 2009 Domestic-Stock Fund Manager of the Year as well as the Domestic-Stock Fund Manager of the Decade (2000-2009) by Morningstar.
However, in the decade after winning these accolades, Berkowitz's performance began to stagnate. A series of bad investments meant that the fund manager's returns dropped from a mid-teens per annum rate to a mid-single-digit rate for the next decade.
But that changed again in 2020. Fairholme returned over 50% in 2020 thanks to one large investment. The three-year return is now 20% annualized, and the 15-year return is 8% annualized.
Looking back at Fairholme's positions, it's clear what the manager did wrong. For most of the 2010s, Fairholme held large positions in struggling businesses. The two largest were AIG (AIG, Financial) and Sears. Berkowitz owned a large chunk of Sears right up to its bankruptcy, believing there was still value in the distressed group's real estate. Between 2010 and the third quarter of 2018, the fund had between 10% and 25% of assets in this one security.
As Sears' fortunes dwindled, so did those of Fairholme. From a high of nearly $15 billion in the second quarter of 2011, the firm's equity portfolio reached a low of around $350 million in the third quarter of 2018, when Sears finally closed for the last time.
But this wasn't the only misstep. The firm also held a large position in AIG. At one point in 2013, AIG accounted for around 60% of the total equity portfolio. The insurance group's performance has been far better than that of Sears over the past decade, although that's not saying much. The stock underperformed the S&P 500 by around 12% per annum during the past decade, though at least shareholders weren't wiped out.
Since the beginning of 2016, the largest holding in Fairholme's portfolio has been the Californian land bank St. Joe Co. (JOE, Financial). Rising from 25% of the portfolio to the current 90%, this is the one large position that has worked out incredibly well for Berkowitz. In the past year, the stock's value is up 136%.
A high conviction position
St. Joe shows the power of having a high conviction position in a portfolio. As Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have noted repeatedly, an investor only needs one or two incredibly successful positions to do well. Berkowitz had a track record of doing just that before his performance started to slide.
He used the same playbook in the following decade, and eventually, it worked. The challenge the hedge fund manager faced, and it is a challenge all investors will face at some point, is when to cut a losing position.
Both Sears and AIG could have worked out as successfully as St. Joe, but they didn't. In hindsight, Berkowitz should have cut his losses, but he always believed they were both worth more than the market value.
What we can learn from this is the need to be critical and continually re-evaluate our positions. Berkowitz might have quit earlier with Sears and AIG if he'd been more critical of the businesses and how they were run.
Disclosure: The author owns no share mentioned.
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