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A fund that beats Buffett at his own game
Fairholme fund uses investing strategies proven by Warren Buffett and the Sequoia Fund's William Ruane. And Fairholme outperforms those masters.
By Timothy Middleton
Warren Buffett, William Ruane and Bruce Berkowitz are fabulous investors.
Bruce who?
Buffett is the world's foremost investor. Ruane is renowned in investing circles as the founder of the Sequoia Fund (SEQUX), which has long been closed to new investors. Each has had a long and illustrious career, and both were employees and pupils of Benjamin Graham, the 20th century's most influential investor.
Berkowitz is in his 40s and only knows Graham because his book, "The Intelligent Investor," guides Berkowitz's investing as thoroughly as it does Buffett and Ruane. For five and a half years, he has run a mutual fund called Fairholme (FAIRX), and, in that time, he has beaten the two more famous Graham disciples like two old carpets.
Since Fairholme was launched on Dec. 29, 1999, the S&P 500 index ($INX) has gone down an average of 1.3% a year. Berkshire has gone up 8.5% a year, Sequoia 9.2%. Fairholme, meanwhile, has surged 19% a year.
Morningstar analyst Dan McNeela loves the fund and ranks it among his "Analyst Picks" of top portfolios. "We've been writing about the fund for three years now," he said in a recent write-up, "but we didnt make it a pick until we were entirely comfortable with the team and its investment process."
Jeff Cedarholm, an investment adviser in Gadsden, Ala., owns the fund personally and in client accounts as well. He says the fund's deep-value, research-intensive style and its concentration in 25 or fewer names makes it capable of delivering sustained above-market returns with below-market risk.
Value investing has been in vogue on Wall Street throughout Fairholme's young life, and, as I've noted recently, it is likely that the growth style will assert itself soon. But that's a short-term, one- to three-year view. Over the next decade, value is likely to prevail, and Fairholme is on a short list of funds that could rank among such value titans as Sequoia, Clipper (CFIMX), Mutual Shares (TESIX) and Third Avenue Value (TAVFX).
Berkshire: An expensive bargain
Buffett runs Berkshire Hathaway (BRK.A, news, msgs), a property and casualty insurer that is actually a gigantic investment pool fed by insurance premiums. Ruane has 35% of his assets in the company; Berkowitz has 15%.
How could the world's most expensive stock -- Berkshire's A shares trade a bit under $85,000 each -- be of interest to a value manager? Because Buffett is sitting on a mountain of cash that, once invested in highly profitable businesses, will send the stock higher still.
"They've got $40 billion to $60 billion in cash, and when you move that from cash, making 2% to 10%, that alone could make a difference of $20,000 to $30,000 in the shares," Berkowitz says.
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While the market has lost 12% of its value since Fairholme was launched, the fund has shot up 150% by buying excellent companies at reasonable prices, as well as a few poor ones at fire-sale prices. It was early to the boom in property-casualty insurance and early to the energy rally.
"Our primary goal has been to try and find great owner-managers and buy companies and stay with them for very long periods of time," says Berkowitz. Portfolio turnover is extremely low, with less than 20% of the fund's holdings changing each year, on average.
The fund focuses on only a few names because, says co-manager Larry Pitkowsky, "We're much more comfortable trying to know a lot about a few things than knowing a little about a lot of things."
The fund currently owns only 17 names, and one of them was in the process of being sold as of the fund's most recent portfolio report.
Fairholme's style is to examine a stock as if it was a bond and its cash flow was its coupon, or yield. Cash flow, which excludes depreciation and amortization, is often referred to as "owners' earnings," and Fairholme sees itself as an owner. So, it wants a return on its investment of at least 10% a year. That translates into an average price the fund is willing to pay for cash flow that is only half the prevailing market average.
Currently the fund has one-third of its invested assets in the financial-services sector. This is traditionally the preferred group for value investors because earnings are lumpy and the stocks are often cheap. It is threatened by higher interest rates, but Fairholme is concentrated in insurance and real estate, which benefit from higher rates.
'Less than spectacular' -- but profitable
Fairholme also invests in what the market calls "special situations," such as bankruptcies and turnarounds. When MCI (MCIP, news, msgs), formerly WorldCom, was in bankruptcy, the fund bought bonds that equate to a price of $16 for post-bankruptcy shares. Verizon is slated to take over MCI for $26.
"We'd rather be with geniuses who have most of their net worth in the company -- that's our preferred model," says Berkowitz. "But absent that, we've come to appreciate over time buying the less-than-spectacular company at a cheap price."
Fairholme was drawn to make MCI the fund's top position when it discovered the company had a hoard of cash on hand greater than the value of the enterprise itself. The reason: Despite its problems, MCI operates in a virtual duopoly with AT&T in supplying comprehensive voice and data communications to giant customers. One is the federal government.
"When it comes to the government and government agencies, they need two companies to bid on all their work," says Berkowitz. When there are only two, both are assured a big share of the market.
Telecom is the fund's second biggest stake, with 30% of invested assets.
Fairholme also has about 12% of assets in energy companies. Two favorites are Canadian Natural Resources (CNQ, news, msgs) and Penn West Petroleum (PWPIF, news, msgs). In a July 1 letter to shareholders, the fund's managers wrote: "Even though they operate in commodity markets, each has owner/managers that have built businesses capable of generating cash in almost all environments. Todays energy demand has apparently surpassed the finite supply of cheap oil and gas. In hindsight, we should have owned more of these gushers."
Rule No. 1: Don't lose money
The rap on funds that own very few stocks is that they are likely to give investors a bumpier ride than more-diversified funds.
In reality, however, Fairholme has a standard deviation, or volatility level, about one-third less than the market. And the advantage of highly targeted investments is that successful bets can have a big impact on performance. Fairholme has a Sharpe ratio of 1.58, three times that of the market. This is a measure of investment gains above what you would expect based on a fund's risk profile. It's analogous to winning $3.16 on every $2 bet at the track.
The fund has a number of other attractive qualities. Expenses are capped at 1%, about one-third less than the average equity fund. Managers and directors are among the largest investors in the fund, so they take their own medicine. As much as they want to make money, they want more not to lose it -- the fund's only calendar-year loss was 1.6% in 2002, when Standard & Poor's 500 plunged more than 23%.
"Rule No. 1 here is not to lose any money," says Pitkowsky. Berkowitz adds: "We assume that our investors in the fund have given us all of their money and that that money does matter."
Currently the fund has 25% of its assets as cash. "We don't see the stock market as cheap," says Berkowitz. "We like the idea of being ready for whatever may come our way. Interestingly, our biggest positions also have very large cash investments."
Another desirable trait of Fairholme is shareholder advocacy. Like the managers of Mutual Series funds, based down the street from Fairholme in Short Hills, N.J., Fairholme's managers are quick to defend their investments publicly. They helped push up MCI's takeover price.
Berkowitz lives in Short Hills, as I do, but there is no Fairholme Street in this little village; the name comes from Berkowitz's address in London, where he once lived.
The market's rally in the last month is making all of us equity investors look like geniuses. But real investment genius is rare, and investing alongside geniuses has always struck me as a superior way to go.
I recently earmarked some idle investment dollars for Berkshire Hathaway B (BRK.B, news, msgs) because I share Berkowitz's view that it's undervalued. But Fairholme looks awfully attractive, too. It is unlikely to sustain almost 20% annual returns forever, but it sure does look likely to beat most of the other stuff I own.
At the time of publication, Timothy Middleton owned or controlled the following securities mentioned in this article: Berkshire Hathaway.
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