Bruce Berkowitz, manager of Fairholme Fund, started his fund 8 years ago. Over the past 8 years his fund has appreciated by 17.40% per annum compared to a gain of 1.71% per annum for the S&P 500 Index. With this article we like to review how Bruce Berkowitz achieved this outstanding result.
This is the return of Fairholme Fund relative to the S&P500. We can see that he has beaten the index by wide margins. He has only one down year, down a minimum of 1.58% in 2002, when the index was down more than 20%. In 2007, when many value investors suffered, he was up by 12.37%, handily beat the 5.5% gained by S&P500. If you invested $10,000 in The Fairholme Fund at fund’s inception, it has grown to $36,117 while $10,000 invested in the S&P 500 Index has grown to $11,455.
Year
2000
2001
2002
2003
2004
2005
2006
2007
Return
46.54%
6.18%
-1.58%
23.96%
24.93%
13.74%
16.71%
12.35%
S&P500
-9.1%
-11.9%
-22.1%
28.7%
10.9%
4.9%
15.8%
5.5%
Bruce Berkowitz achieved good returns well before he started his own shop. Even Joel Greenblatt borrowed his ideas to profit. In his book “You can be a stock market genius”, page 221 - 223, Joel Greenblatt wrote:
“In December 1992, I read an interview conducted by OID with an investment manager at Lehman Brothers who was previously unknown to me, Bruce Berkowitz. The fact that I had no idea who he was didn’t matter. The logic and clarity of the investment case he made for Wells Fargo stock was overwhelming on its own. At that time, Wells Fargo, a large California-based bank, was trading at around $77 per share. California was in the middle of the worst real estate recession since the 1930s. Wells Fargo had by far the largest concentration of commercial real estate loans on its balance sheet equal to only $48 per share (its stock price was approximately $47 per share). Wells Fargo, on the other hand, had commercial real estate loans totaling about $249 per share (as compared to a stock price of about $77), Further, Wells had taken a loss provision (reserves that anticipate future loan losses) of $27 per share the previous year, wiping out almost all of its earnings. In just the first nine months of 1992, Wells had provisioned for an additional $18 per share of losses. Many investors questioned whether Wells Fargo would survive the real estate downturn."
"Berkowitz’s investment case was fairly simple. If you excluded the loss provisions, Wells (adjusting for cash earnings and one-time expenses) was already earning nearly $36 per share before taxes. Of the real estate environment ever recovered to a more normalized level, loan-loss provisions, based on past experience, would probably fall to approximately $6 per share on an annualized basis. This would translate to normalized pretax earnings of $30 per share, or $18 per share in earnings on an after-tax basis (assuming a 40-percent tax rate). At a price of nine or ten times earnings, Wells Fargo could be trading at $160 to $180 per share (versus its then current price of $77). The question wasn’t how Wells Fargo could increase its earnings power to reach $18 per share in after-tax earnings. Wells was already earnings that earning that kind of money – but for the effect of the extraordinary loan-loss provisions. According to Berkowitz, the real question was: What was the right way to look at the loan-loss provisions and how bad were they?"
So what kind of companies does Bruce Berkowitz invests in? He wrote in his 2000 annual shareholder letter. He and his team “focus on creating long-term ownership of companies that have durable competitive positions, predictable cash earnings, high returns on capital, and owner oriented managers – at attractive valuations.”
How did Bruce Berkowitz achieve this? We have studied his shareholder letters, interviews and articles about him. This is what we found out.
Concentrate the bets on the best ideas
Bruce Berkowitz concentrates his investments in a relatively small number of companies. He thinks that the more diversified the portfolio, the more likely the performance will be average.
“If you can buy more of your best idea, why put [the money] into your 10th-best idea or your 20th-best idea? If we're confident in what we do, then that's the way we should do it. The only reason not to is a fear of being wrong. The more positions you have, the more average you are.” He said in interviews with Barron’s.
In his Fairholme fund, Berkowitz has more than 50% of the asset in the top five holdings (excluding cash). His top two holdings, Berkshire Hathaway (BRK-A) (BRK-B), and Canadian Natural Resources (CNQ, Financial) are in more than 33% of the fund.
“We try and know what you can know. We try and only buy a few companies which we believe have been built to last in all environments. We recognize that you only need a few good ideas in a lifetime to be fabulously wealthy....” He wrote in his shareholder letter.
Focus on Free Cash Flow
“Cash is all you can spend,” said Bruce Berkowitz. He does not care much about earning per share, he cares cash earnings. He defines free cash flow as the cash a company would generate annually from operations after all cash outlays necessary to maintain the business in its current condition.
His definition of free cash flow is close to what Joel Greenblatt defines in his book “The little book that beats the market”. Company earning is the cash it brings in minus the cash it spends to maintain current operations.
“Because it makes the most sense to me,” said Bruce Berkowitz in an interview with BusinessWeek. “My first job was at a little corner grocery store, and it seemed pretty simple. Cash goes into the register; cash comes out of the register to pay for supplies, payroll and taxes -- enough to maintain the business at a steady state. What was left over was the owner's earnings, or free cash flow. That was really what the business made.”
Invest with Capable Owner Oriented Managers
All of Bruce Berkowitz’s holdings have the management team that he likes. He wrote:
“So we try to position ourselves with companies that are capable of reacting to whatever environment comes their way, because in the good times companies take care of themselves. It's only in the bad times when you want to find companies that actually plant the seeds of greatness. There is Berkshire Hathaway there has been Leucadia National [LUK], a holding company with a lot of different businesses, and similar companies. They are always playing defense, because you never know when something bad will happen.”
"The Fund continues to own a stable of terrific businesses with some of the most competent and honorable business jockeys in the world. Warren Buffett (BRK-A, BRK-B), Murray Edwards (CNQ), Ian Cumming and Joe Steinberg (LUK, Financial), Charlie Ergen (DISH, Financial), Eddie Lampert (SHLD, Financial), and Jeff Lorberbaum (MHK, Financial) are among the cream of the crop. They are risk-averse business people who intuitively understand that profits are lumpy and conditions not always favorable. No matter the environment, these wonderful owner/managers should be able to find ways to make money for the Fund’s shareholders."
"The winners (in business) are usually run by battle-hardened owner/managers who know that the seeds of greatness are planted during the worst of times and reaped after the storms pass. To the victor belong the spoils…"
Buying on One-time event:
“Volatility is more of an opportunity. There's nothing better than a one-time event that allows you to buy a reasonable company at a great price. So we are looking at the chance -- in terms of risk -- of a permanent loss, based upon our own security research.”
His recent purchase of WellCare Health Plans Inc (WCG) is an example of one-time event. In Oct. 2007 FBI agents raided the headquarter of WCG, and its stocks plunged from $120 to $30s. He started to buy as he recognized that the company continues to grow and continues to get enrollment in more and more counties in the U.S. “And there are certain indicators you can't ignore, among them how WellCare has been building up cash. Also, the independent directors acted quickly and wisely.”
As a matter of fact, we reported his Nov. 2007 purchase of WCG in the Real Time Picks section of Premium Features. Since then, the stock has appreciated by about 40%. If you are not a Premium Member, we invite you for a 7-day Free Trial.
Borrow Ideas from the Best
Bruce Berkowitz is not shy with borrowing ideas from the best. He wrote in the 2002 annual shareholder letter: “On the new investment front, please note WilTel. In recent years, the company spent roughly $8 billion laying optic fibers with all the trimmings just in time to file Chapter 11 in April of 2002. Our interest was piqued when Leucadia National agreed to purchase 44% of the company as part of an overall plan of reorganization. After review of WilTel’s plan of reorganization, the Fund purchased busted senior bonds that have since converted into equity of this newly reorganized company.”
The idea worked well. He wrote in 2003 letter: “Leucadia National has now become the Fund’s second largest holding by acquiring our shares of WilTel Communications in exchange for Leucadia shares at about a 50% premium to our cost. Effectively, we acquired a chunk of Leucadia at around book value — truly a bargain price."
Bruce Berkowitz is a fan of Leucadia management. "Relatively unknown, Ian Cumming and Joe Steinberg have compounded Leucadia’s book value per share at over 20% per annum since they took control of the company in 1978." He wrote in 2002.
Interestingly, Bruce Berkowitz also bought AmeriCredit (ACF, Financial) as Leucadia becomes the largest shareholder of the company, owning 30% of total shares. Is this also a borrowed idea?
Willing to Hold cash:
Bruce Berkowitz is willing to hold cash. He fund always holds about 20% of cash. Holding cash may hurt the overall performance if the market goes up, but he is willing to hold cash because he believes that a certain amount of liquidity in the Fund’s portfolio is desirable to take advantage of new investment opportunities. “No. 1, we don't have to sell that which is cheap [in order to] to buy that which is cheaper, especially companies that we have gotten to know and love. And No. 2, where there are special situations, we can act quickly.” He wrote.
Perform and They Will Come
Bruce Berkowitz does not have marketing team in his firm. He believes in "perform and they will come."
Sure, in 8 years, his asset under management grows to more than $8 billion. His Fairholme Fund has grows its asset from year 2000’s $10 million to more than $7 billion.
On Berkshire Hathaway: In the past, the market has made some mistakes in valuing this company. But in general, right now the market is within an intrinsic value range of anywhere from $125,000 to $175,000 per A share.
On Sears Holding: Look at Lampert's overall performance. He has done a good job with retail holdings in the past, and he understands Sears' assets. We've looked at a lot of the tax assessments and location maps on many of their properties, which have a lot of value and provide downside protection. We're in the middle of a very difficult environment, so Sears is being priced for a very, very difficult outcome. Meanwhile, it's making money, and has significant assets, so I'm not concerned. We've had a position since September.
On Canadian Natural Resources (CNQ): Energy continues to be a substantial component of the Fund with Canadian Natural Resources the second largest Fund investment. Notwithstanding the province of Alberta’s proposed royalty increases, the company has a unique ability to materially increase production without acquisition in today’s high price/high cost environment. Canadian Natural remains undervalued in a world where most reserves are subject to significant political risk and long term-demand threatens to outrun supply.
On EchoStar (DISH): EchoStar’s stock price has recently declined with snowballing residential real estate delinquencies and foreclosures on the theory that homeowners behind on mortgage payments are less likely to pay their satellite-TV bill. Notwithstanding such concerns, the company continues to increase offerings, subscribers, and free cash flow. Recently, the company separated the DISH pay-TV network (ticker: DISH) from its technology company (ticker: SATS) to highlight under-appreciated assets, accelerate growth, and ease capital transactions.
On Leucadia National (LUK): Leucadia National knocked the ball out of the park last year with its investment in Australian, iron-ore miner Fortescue. Although Leucadia does not seem inexpensive, its roster of lottery tickets, liquidity, and history of success in difficult times allow us the luxury of patience.
This is the return of Fairholme Fund relative to the S&P500. We can see that he has beaten the index by wide margins. He has only one down year, down a minimum of 1.58% in 2002, when the index was down more than 20%. In 2007, when many value investors suffered, he was up by 12.37%, handily beat the 5.5% gained by S&P500. If you invested $10,000 in The Fairholme Fund at fund’s inception, it has grown to $36,117 while $10,000 invested in the S&P 500 Index has grown to $11,455.
Year
2000
2001
2002
2003
2004
2005
2006
2007
Return
46.54%
6.18%
-1.58%
23.96%
24.93%
13.74%
16.71%
12.35%
S&P500
-9.1%
-11.9%
-22.1%
28.7%
10.9%
4.9%
15.8%
5.5%
Bruce Berkowitz achieved good returns well before he started his own shop. Even Joel Greenblatt borrowed his ideas to profit. In his book “You can be a stock market genius”, page 221 - 223, Joel Greenblatt wrote:
“In December 1992, I read an interview conducted by OID with an investment manager at Lehman Brothers who was previously unknown to me, Bruce Berkowitz. The fact that I had no idea who he was didn’t matter. The logic and clarity of the investment case he made for Wells Fargo stock was overwhelming on its own. At that time, Wells Fargo, a large California-based bank, was trading at around $77 per share. California was in the middle of the worst real estate recession since the 1930s. Wells Fargo had by far the largest concentration of commercial real estate loans on its balance sheet equal to only $48 per share (its stock price was approximately $47 per share). Wells Fargo, on the other hand, had commercial real estate loans totaling about $249 per share (as compared to a stock price of about $77), Further, Wells had taken a loss provision (reserves that anticipate future loan losses) of $27 per share the previous year, wiping out almost all of its earnings. In just the first nine months of 1992, Wells had provisioned for an additional $18 per share of losses. Many investors questioned whether Wells Fargo would survive the real estate downturn."
"Berkowitz’s investment case was fairly simple. If you excluded the loss provisions, Wells (adjusting for cash earnings and one-time expenses) was already earning nearly $36 per share before taxes. Of the real estate environment ever recovered to a more normalized level, loan-loss provisions, based on past experience, would probably fall to approximately $6 per share on an annualized basis. This would translate to normalized pretax earnings of $30 per share, or $18 per share in earnings on an after-tax basis (assuming a 40-percent tax rate). At a price of nine or ten times earnings, Wells Fargo could be trading at $160 to $180 per share (versus its then current price of $77). The question wasn’t how Wells Fargo could increase its earnings power to reach $18 per share in after-tax earnings. Wells was already earnings that earning that kind of money – but for the effect of the extraordinary loan-loss provisions. According to Berkowitz, the real question was: What was the right way to look at the loan-loss provisions and how bad were they?"
So what kind of companies does Bruce Berkowitz invests in? He wrote in his 2000 annual shareholder letter. He and his team “focus on creating long-term ownership of companies that have durable competitive positions, predictable cash earnings, high returns on capital, and owner oriented managers – at attractive valuations.”
How did Bruce Berkowitz achieve this? We have studied his shareholder letters, interviews and articles about him. This is what we found out.
Concentrate the bets on the best ideas
Bruce Berkowitz concentrates his investments in a relatively small number of companies. He thinks that the more diversified the portfolio, the more likely the performance will be average.
“If you can buy more of your best idea, why put [the money] into your 10th-best idea or your 20th-best idea? If we're confident in what we do, then that's the way we should do it. The only reason not to is a fear of being wrong. The more positions you have, the more average you are.” He said in interviews with Barron’s.
In his Fairholme fund, Berkowitz has more than 50% of the asset in the top five holdings (excluding cash). His top two holdings, Berkshire Hathaway (BRK-A) (BRK-B), and Canadian Natural Resources (CNQ, Financial) are in more than 33% of the fund.
“We try and know what you can know. We try and only buy a few companies which we believe have been built to last in all environments. We recognize that you only need a few good ideas in a lifetime to be fabulously wealthy....” He wrote in his shareholder letter.
Focus on Free Cash Flow
“Cash is all you can spend,” said Bruce Berkowitz. He does not care much about earning per share, he cares cash earnings. He defines free cash flow as the cash a company would generate annually from operations after all cash outlays necessary to maintain the business in its current condition.
His definition of free cash flow is close to what Joel Greenblatt defines in his book “The little book that beats the market”. Company earning is the cash it brings in minus the cash it spends to maintain current operations.
“Because it makes the most sense to me,” said Bruce Berkowitz in an interview with BusinessWeek. “My first job was at a little corner grocery store, and it seemed pretty simple. Cash goes into the register; cash comes out of the register to pay for supplies, payroll and taxes -- enough to maintain the business at a steady state. What was left over was the owner's earnings, or free cash flow. That was really what the business made.”
Invest with Capable Owner Oriented Managers
All of Bruce Berkowitz’s holdings have the management team that he likes. He wrote:
“So we try to position ourselves with companies that are capable of reacting to whatever environment comes their way, because in the good times companies take care of themselves. It's only in the bad times when you want to find companies that actually plant the seeds of greatness. There is Berkshire Hathaway there has been Leucadia National [LUK], a holding company with a lot of different businesses, and similar companies. They are always playing defense, because you never know when something bad will happen.”
"The Fund continues to own a stable of terrific businesses with some of the most competent and honorable business jockeys in the world. Warren Buffett (BRK-A, BRK-B), Murray Edwards (CNQ), Ian Cumming and Joe Steinberg (LUK, Financial), Charlie Ergen (DISH, Financial), Eddie Lampert (SHLD, Financial), and Jeff Lorberbaum (MHK, Financial) are among the cream of the crop. They are risk-averse business people who intuitively understand that profits are lumpy and conditions not always favorable. No matter the environment, these wonderful owner/managers should be able to find ways to make money for the Fund’s shareholders."
"The winners (in business) are usually run by battle-hardened owner/managers who know that the seeds of greatness are planted during the worst of times and reaped after the storms pass. To the victor belong the spoils…"
Buying on One-time event:
“Volatility is more of an opportunity. There's nothing better than a one-time event that allows you to buy a reasonable company at a great price. So we are looking at the chance -- in terms of risk -- of a permanent loss, based upon our own security research.”
His recent purchase of WellCare Health Plans Inc (WCG) is an example of one-time event. In Oct. 2007 FBI agents raided the headquarter of WCG, and its stocks plunged from $120 to $30s. He started to buy as he recognized that the company continues to grow and continues to get enrollment in more and more counties in the U.S. “And there are certain indicators you can't ignore, among them how WellCare has been building up cash. Also, the independent directors acted quickly and wisely.”
As a matter of fact, we reported his Nov. 2007 purchase of WCG in the Real Time Picks section of Premium Features. Since then, the stock has appreciated by about 40%. If you are not a Premium Member, we invite you for a 7-day Free Trial.
Borrow Ideas from the Best
Bruce Berkowitz is not shy with borrowing ideas from the best. He wrote in the 2002 annual shareholder letter: “On the new investment front, please note WilTel. In recent years, the company spent roughly $8 billion laying optic fibers with all the trimmings just in time to file Chapter 11 in April of 2002. Our interest was piqued when Leucadia National agreed to purchase 44% of the company as part of an overall plan of reorganization. After review of WilTel’s plan of reorganization, the Fund purchased busted senior bonds that have since converted into equity of this newly reorganized company.”
The idea worked well. He wrote in 2003 letter: “Leucadia National has now become the Fund’s second largest holding by acquiring our shares of WilTel Communications in exchange for Leucadia shares at about a 50% premium to our cost. Effectively, we acquired a chunk of Leucadia at around book value — truly a bargain price."
Bruce Berkowitz is a fan of Leucadia management. "Relatively unknown, Ian Cumming and Joe Steinberg have compounded Leucadia’s book value per share at over 20% per annum since they took control of the company in 1978." He wrote in 2002.
Interestingly, Bruce Berkowitz also bought AmeriCredit (ACF, Financial) as Leucadia becomes the largest shareholder of the company, owning 30% of total shares. Is this also a borrowed idea?
Willing to Hold cash:
Bruce Berkowitz is willing to hold cash. He fund always holds about 20% of cash. Holding cash may hurt the overall performance if the market goes up, but he is willing to hold cash because he believes that a certain amount of liquidity in the Fund’s portfolio is desirable to take advantage of new investment opportunities. “No. 1, we don't have to sell that which is cheap [in order to] to buy that which is cheaper, especially companies that we have gotten to know and love. And No. 2, where there are special situations, we can act quickly.” He wrote.
Perform and They Will Come
Bruce Berkowitz does not have marketing team in his firm. He believes in "perform and they will come."
Sure, in 8 years, his asset under management grows to more than $8 billion. His Fairholme Fund has grows its asset from year 2000’s $10 million to more than $7 billion.
On Berkshire Hathaway: In the past, the market has made some mistakes in valuing this company. But in general, right now the market is within an intrinsic value range of anywhere from $125,000 to $175,000 per A share.
On Sears Holding: Look at Lampert's overall performance. He has done a good job with retail holdings in the past, and he understands Sears' assets. We've looked at a lot of the tax assessments and location maps on many of their properties, which have a lot of value and provide downside protection. We're in the middle of a very difficult environment, so Sears is being priced for a very, very difficult outcome. Meanwhile, it's making money, and has significant assets, so I'm not concerned. We've had a position since September.
On Canadian Natural Resources (CNQ): Energy continues to be a substantial component of the Fund with Canadian Natural Resources the second largest Fund investment. Notwithstanding the province of Alberta’s proposed royalty increases, the company has a unique ability to materially increase production without acquisition in today’s high price/high cost environment. Canadian Natural remains undervalued in a world where most reserves are subject to significant political risk and long term-demand threatens to outrun supply.
On EchoStar (DISH): EchoStar’s stock price has recently declined with snowballing residential real estate delinquencies and foreclosures on the theory that homeowners behind on mortgage payments are less likely to pay their satellite-TV bill. Notwithstanding such concerns, the company continues to increase offerings, subscribers, and free cash flow. Recently, the company separated the DISH pay-TV network (ticker: DISH) from its technology company (ticker: SATS) to highlight under-appreciated assets, accelerate growth, and ease capital transactions.
On Leucadia National (LUK): Leucadia National knocked the ball out of the park last year with its investment in Australian, iron-ore miner Fortescue. Although Leucadia does not seem inexpensive, its roster of lottery tickets, liquidity, and history of success in difficult times allow us the luxury of patience.
