Bruce Berkowitz: From Free Cash Flow to Distressed Financials Investor

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Sep 25, 2011
Note: This article is not a criticism of Bruce Berkowitz, merely noting the massive change in his investment philosophy and portfolio allocation. Anyone who reads the article carefully should come to the same conclusion.

Bruce Berkowitz has earned the award for the best equity fund manager of the decade from Morningstar, and rightly so. Berkowitz’s Fairholme beat the market every year since its inception, except 2003. For the past decade, Fairholme has had an annual return of approximately 12.9%. Despite his consistent performance in the market, his investment philosophy is something which has lacked consistency in the past few years.

On a quick side note: There has been too much talk about the battle over St. Joe between Berkowitz and David Einhorn. St. Joe is a small holding; companies like AIG, BAC and Citi are much more important to Fairholme shareholders; St. Joe has merely been a big distraction.

When talking about his investments, Bruce Berkowitz almost always mentions the importance of free cash flow (FCF) to determine the expected return on investment. However, his latest investments, most of which belong to the financial sector, contradict his stance on FCF.

Bruce Berkowitz’s historic portfolio from dataroma:


The shift from stocks which generate tons of FCF to financial companies which offer hopes of future free cash flow started to occur mostly in the second half of the second quarter of 2010, and has continued to today. I noticed the changing trend of Berkowitz’s investment style, and penned an article on Aug. 3, 2010, titled “Bruce Berkowitz: Where Is the Free Cash Flow?”

If we follow his investment philosophy which kept in perspective the FCF of the company, most of the attractive investments belong to sectors such as pharmaceuticals, defense and consumer goods. However, Bruce Berkowitz has been selling companies belonging to the sector despite their high price-to-FCF ratio for financials. We can take as illustrations Pfizer Inc. (PFE), Forest Laboratories Inc. (FRX) and WellPoint Inc. (WLP). Instead, as of now he has been stocking up on financial companies such as Citigroup (C, Financial), Back of America (BAC, Financial), American International Group (AIG, Financial), Mbia Inc. (MBI), Jefferies Group Inc. (JEF) and CIT Group (CIT, Financial). All these have a comparatively lower P/FCF than the companies he has been selling off since last year.

If we analyze his current portfolio as of June, it is evident that he is extremely bullish about the financial sector. His current equity portfolio is 90.7% made up of companies belonging to the financial sector. His top 10 holdings include 8 companies which belong to that sector.

According to Google Finance, approximately 97% of Fairholme is invested in equities, leaving approximately 3% in cash. If I remember correctly, Berkowitz used to hold close to 20-25% of his portfolio in cash.


(Click for Industries)
Financials point2.gif2011-06-30 gold.gif 90.7%

2011-03-31 green.gif 80.6%

2010-12-31 brown.gif 72.5%

2010-09-30 aqua.gif 80.3%

2010-06-30 red.gif 70.1%

2010-03-31 purple.gif 57.8%

2009-12-31 grey.gif 44.9%

2009-09-30 orange.gif 31.1%
Health Care point2.gifConsumer Services point2.gif2011-06-30 gold.gifndustrials point2.gif2011-06-30 gold.gif 0%

2011-03-31 green.gif 3.1%

2010-12-31 brown.gif 5%

2010-09-30 aqua.gif 6.9%

2010-06-30 red.gif 5.4%

2010-03-31 purple.gif 6.6%

2009-12-31 grey.gif 11.9%

2009-09-30 orange.gif 10.5%

These include:

American International Group (AIG) – makes up 23.42% of Berkowitz’s equity portfolio and has the largest position in the company.

Citigroup (C) – makes up 8.5% of his portfolio and he has the second largest position in the company.

Bank of America Corp. (BAC) – makes up 8.45% of his portfolio. Berkowitz believes BAC will outperform JPMorgan, as the company is making all the right moves.

The remaining four are Brookfield Asset Management (BAM), CIT Group (CIT), Goldman Sachs Group (GS), Regions Financial Corp (RF, Financial) and Berkshire Hathaway (BRK.B, Financial).

If we compare his current portfolio to that of the past five years, the change in his investment strategy has clearly changed. Berkowitz is clearly relying on the fact that these companies will be able to generate large amounts of FCF in the future. It is not surprising that he is bullish about the companies in the financial sector, like Bank of America and Citigroup, as a lot of other famous investors are as well, such as John Paulson, Bill Ackman and Warren Buffett. Nonetheless, the reason for the change in the investment strategy of Bruce Berkowitz over the past few years is likely because he sees future FCF and the market overreacting by dumping financials across the board.

I will make three points: AIG is a company which is way outside my circle of competence. I believe Warren Buffett read the entire K in one night during the financial crisis in '08, and declined to invest because he did not understand the K. I would guess at least 90% (if not more) of retail and institutional investors who are long or short AIG did not even read the most recent 10-K, which is 399 pages. Another 9% probably did but do not understand it.

I do believe that Bruce Berkowitz is a genius investor and has a better understanding of AIG than almost any other person in the world. Even though Berkowitz had little money invested in financial companies (excluding Berkshire Hathaway) until recently, he has some great calls in the past with financials.

In Joel Greenblatt’s famous book "You Can Be a Stock Market Genius," he mentioned a young analyst who recommended investing in LEAPs for Wells Fargo (WFC, Financial), when the company’s future was uncertain. The investment turned out to be spectacular, and Wells Fargo is now one of the largest banks in the country. That young analyst was Bruce Berkowitz.

In a recent interview with Consuelo Mack, Bruce Berkowitz compared the current situation to Wells Fargo in the early 1990s. However, this is unarguably the worst recession since the Great Depression. While American banks are in much better shape than three years ago, there are still huge issues, lawsuits, weak housing, ripple effects from European banks, etc. It is hard to compare the current situation to anything besides the 1930s. Additionally, Berkowitz’s largest holding, AIG, is majority controlled by the U.S. government. AIG’s future might have less to do with future company performance than petty politics.

Finally, a word on Bruce Berkowitz’s overall portfolio allocation. Even if he is right that financials will make a huge turnaround due to his fund structure, he is not being a careful steward of capital. His cash allocation is dangerously low, and as a recent article on GuruFocus mentioned Berkowitz Sold Portion of St. Joe Due to Redemptions. Even if Berkowitz is 100% right, a mutual fund structure is not the correct fund structure to invest the majority of a portfolio in financials and keep little cash for redemptions. To make the point more clear, if Bruce Berkowitz thinks BAC is worth $24 a share and it is currently trading at $6 a share, he might be 100% but could have to sell at $6, due to shareholder redemptions.

Berkowitz would be much better off with a private equity or hedge fund structure, where there can be large lock up periods on investments. With mutual funds, investors can withdraw any day the market is open. Berkowitz’s current portfolio would be much better fitting in a hedge fund structure.

In conclusion, three things seem certain:

Bruce Berkowitz is allocating shareholders’ money in a very dangerous manner.

Even if he is right, he might still lose money due to redemptions.

Berkowitz’s bet will make him the next Bill Miller or Seth Klarman.

Only time will tell if he will be remembered as the former or later.

Disclosure: Long PFE, WFC, and HUM