January 29, 2018
Dear Shareholders and Directors of Fairholme Fund (Trades, Portfolio)s, Inc.:
This past year did not go as planned for Fairholme Fund (Trades, Portfolio)s shareholders. Although markets reached new highs in 2017, there was not much to celebrate as the securities of Sears Holdings Corporation (“Sears”) and Sears Canada wrecked the Funds’ performance. Sears realized billions of dollars from asset sales, as we predicted, but I did not foresee the operating losses that have significantly reduced values. Getting the asset values largely correct, but missing the company’s inability to stop retailing losses, has been hugely frustrating and fatiguing for me to watch. Today Sears is a much diminished position and nowhere as relevant to our financial position.
Our history since inception demonstrates that holding tight amid disappointing performance often pays. This has been the case for as long as I have run Fairholme Capital Management (“Fairholme”). On numerous occasions, long periods have elapsed before prices have matched our estimates, and I will discuss below some of the driving forces that can make this happen again. Before elaborating, I’d like you to know that Fairholme-related entities own 8.2% of The Fairholme Fund (Trades, Portfolio), 20.1% of The Income Fund, and 43.7% of The Allocation Fund. My family is the largest shareholder in each. I eat my own cooking and I feel the same recent disappointments as you, but I also want to share my strong belief in future outperformance. One final point: You may have already seen that effective January 1, 2018, Fairholme has voluntarily waived its annual management fees to 80 basis points.1 We have done this in recognition of the elevated levels of cash and cash equivalents currently held in the Funds’ portfolios as we await attractively priced investment opportunities.
The Fairholme Fund (Trades, Portfolio) seeks to achieve long-term capital growth. From inception on December 29, 1999, to 2017 year-end, FAIRX returned 10.04% per annum after reinvesting dividends and realized capital gain distributions totaling $4.4 billion. At January 26, 2018, FAIRX net assets stand at $1.7 billion. 25.9% of assets are held in cash and cash equivalents, 23.2% in the preferred stock of Fannie Mae (“Fannie”) and Freddie Mac (“Freddie”), 24.4% in the common stock of The St. Joe Company (“St. Joe”), 8.8% in the debt and common stock of Imperial Metals Corporation (“Imperial”), 5.2% in the common stock of Seritage Growth Properties (“Seritage”), and 5.4% in Sears’ debt and equities. FAIRX also has nearly $710 million of tax-loss attributes to shelter future gains from taxes.
The Income Fund seeks current income first and capital gains second. FOCIX’s total return from inception on December 31, 2009, to year-end 2017 is 8.27% per annum with the reinvestment of distributions. At January 26, 2018, FOCIX net assets stand at $271 million and comprise senior debt (both secured and unsecured), preferred stock, income-paying common shares, and investment-grade commercial paper.
Credit risks are mitigated by issuers’ expected cash flows and diversification. High current yields and relatively short maturities mitigate interest rate risks. Also at January 26, 37.6% of net assets are held in investment grade commercial paper yielding 2% and turning over in a few weeks. FOCIX’s current yield is 5.0% and duration (the time it takes to recover invested capital) is eight months. The largest single issuer, Imperial, is 8.7% of the portfolio. Fannie and Freddie preferred stock together compose 9.4%, Seritage common stock comprises 8.6%, while Sears debt is 6.3% of The Income Fund.
The Allocation Fund seeks total return across smaller quantity ideas. From December 31, 2010, to year-end 2017, The Allocation Fund returned a disappointing 2.01% per annum with reinvestment of distributions. As of January 26, 2018, FAAFX net assets are $109 million with cash and cash equivalents at 30.3% of assets. The Allocation Fund’s largest holdings are Fannie and Freddie preferred stock, which comprise 24.5% of the portfolio, while 15.7% of the portfolio is in Seritage common stock, 6.9% is in St. Joe, 4.8% is in Imperial common, 4.4% is in International Wire Group, and 3.2% is in Sears common and warrants.
Fannie Mae and Freddie Mac:
Fannie (FNMA, Financial) and Freddie have helped tens of millions of Americans secure affordable, predictable mortgages to help achieve the dream of financial independence while operating under the conservatorship of the Federal Housing Finance Agency (“FHFA”). Since 2012, Fannie and Freddie have shipped the entirety of their profits—$275 billion and counting—to the U.S. Treasury. You’ve heard this all before. The point is, with hundreds of billions in profits flowing to the federal government, there is no doubt about Fannie and Freddie’s earnings power or their ability to serve the public and survive. That is why reform is coming. In a letter to the Senate this month, FHFA Director Mel Watt re-emphasized that “ongoing conservatorship is not sustainable and needs to end.” He believes Fannie and Freddie should be public utilities with regulated rates of return. We agree. Treasury Secretary Steve Mnuchin tells us 2018 is the year for Fannie and Freddie reform. “We need to fix Fannie and Freddie,” Mnuchin said in September. “[…] we’re going to fix [them] and when we fix [them] we want to make sure we never put the taxpayers at risk.” We also agree Fannie and Freddie must be returned to their private owners. So far, the Funds have realized $140 million of gains from Fannie and Freddie investments over the past four years. I would expect further gains from any Trump Administration-led initiative.
Seritage Growth Properties:
Seritage (SRG, Financial) is a simple redevelopment story clouded by a complex tenant relationship with Sears. Seritage owns 40 million square feet of retail space and surrounding parking lots; Sears occupies 75% of its retail space. When Sears closes stores at Seritage locations, the real estate is re-rented at market rates three times higher to tenants such as Whole Foods and Nordstrom Rack. Proportionally higher cash distributions to owners then follow. I believe this opportunity to recapture valuable real estate is why Warren Buffett (Trades, Portfolio) personally became one of the largest shareholders of Seritage.
Imperial Metals Corporation:
Imperial (TSX:III, Financial) owns the Red Chris mine, which holds a mother lode of copper and gold in British Columbia, Canada. Copper is essential to the transmission of electrons. Gold has been a store of value since the beginning of time. Industry demand for copper is increasing, but mine supply growth is slowing. Demand for electric vehicles, updated electric grids and smart infrastructure will cause further imbalances without new supplies. There is renewed merger and acquisition activity in the sector, as it has become cheaper and quicker to buy assets rather than dig for them. The price of copper has moved back above $3.00. Together, these trends will boost Imperial’s cash flows and valuation.
The St. Joe Company:
St. Joe (JOE, Financial) is building a vibrant economic region and sustainable corporate profits with its communities across coastal Walton and Bay counties in Northwest Florida. The company is doing it the right way, with little debt, low fixed expenses, low-cost land, and $300 million of cash for the inevitable surprises of real estate development. Entitled to develop 178,000 homes and 22 million square feet of commercial space over 122,000 acres, St. Joe has a bright future, something its CEO Jorge Gonzalez and I –as the Chairman of both Fairholme and St. Joe – agree on.
There are big forces working in our favor. While Florida enjoys the country’s second fastest growing population, Northwest Florida’s Emerald Coast, where St. Joe owns its land, is growing twice as fast. The area has a new international airport and miles of sandy coast. Tyndall Air Force Base, which is spending $250 million and creating 1,600 new jobs, is but one example of the area’s rapid economic expansion.2 Aviation companies are looking to be nearby, and local campuses for Florida State University and Gulf Coast State College are expanding their engineering programs to meet expected demand. Passenger counts at Northwest Florida Beaches International Airport have nearly tripled to 910,000 since 2010. Planes are at least 80% full. A fourth national carrier will soon offer new direct flights to major cities. Recently, $1.5 billion was committed to boost the regional economy, using settlement funds from the BP oil spill. Even more appealing to prospective re-locators after the recent federal tax changes is Florida’s zero state income tax. St. Joe’s outlook is promising.
I know the last few years have been hard. Still, the Fairholme Fund (Trades, Portfolio)’s and The Income Fund’s respective after-fee performance since inception remain top-tier, as shown in exhibits following my letter. Based on our holdings, I strongly believe portfolios will return to the outperformance you richly deserve for your patience. I am reminded of Horace’s quote from Ars Poetica found on the first page of every edition of Benjamin Graham’s Security Analysis: “Many shall be restored that are now fallen, and many shall fall that are now in honor.”
Thank you for staying the course.
Respectfully submitted,
Bruce R. Berkowitz
Chief Investment Officer
P.S. I urge everyone to watch Wormwood, The Post, and American Made. These new Hollywood releases explore U.S. government cover-ups, making me realize that our fight for Fannie and Freddie is simply a repeat of history.
