One story that has been interesting to follow over the past year is that of Fairholme Fund's underperformance relative to peers and the market. Bank of America has become the talking point for his underperformance, although there are plenty others. It seems to bear a strong resemblance to the typical narrative trajectory of a successful mutual fund sowing the seeds of its own destruction. It has been relatively obscure for many years, only to really burst through to the limelight in 2010 when he was named one of the top mutual fund managers for the decade. The crowd in its infinite wisdom, naturally, decided that Fairholme was the fund to invest in in the aftermath of its out performance. Lo and behold, under performance followed. Is it the inflows? Is it his activist chairman role at St. Joe's? Has he lost his touch?
I find all these arguments unconvincing because his fund has shifted into financials since Morningstar cast the curse of the commentator. The sector has underperformed the market in addition to funds avoiding exposure to the sector, creating the double whammy of underperfoming the market and peers. I think this argument/perspective trumps the other arguments. All the hot money that flowed in in the aftermath of his successful long term record is probably the exact same money that is flowing out afterwards.
1) inflows - I understand the premise from which this explanation flows, but if you look at Fairholme's historical record, the fund has never really generated alpha by investing in tiny obscure companies, so inflows haven't been a drag on actionable ideas. In this case, I'm suspicious of the "size matters" argument, because it's really what you do with the size of your funds. I went through some older 13-F filings to verify this (I use the total value of securities in the filing in the following calculations as a proxy for the portfolio, which ignores what is usually a big cash position and more recently foreign listed stocks - I'm just looking to be vaguely correct and my argument is basically that Fairholme is not wont of investment opportunities as a result of inflows).
In May 2002 (13F), the fund had $550m in stocks - this figure precluded Fairholme from investing with a concentrated value strategy in small companies since mutual funds offer daily liquidity. His largest positions were Berkshire, Household Financial (since bought by HSBC), Leucadia, Markel, Mercury General, and White Mountains, which comprised 91% of the stock portfolio and all had a large finance bent - Berkshire alone was 40%. These weren't tiny names. Six positions were 91% of the stocks the fund owned.
By March 2007 (13F), the US stock portfolio was at $4.9bn, or 9x the size in a matter of 5 years due to inflows. His top 6 holdings - Berkshire, Canadian Natural Resources, Leucadia, Penn West, Mohawk Industries, and Echostar - accounted for 74% of his portfolio. I don't want to obsess over the data point of a decline from 91% in 6 names to 74% as a sign that he had a hard time coping with the inflows, because it really just results of arbitrarily using the top 6 stocks when one would traditionally use the top 10 stocks as that is the point from which diversification doesn't reduce portfolio risk. This is still a heavily concentrated portfolio by any standards.
Jumping to March 2011 (13F), the fund held $14.4bn in US listed securities, with the top 6 positions - AIG, Sears, Bank of America, Citigroup, Berkshire, Morgan Stanley - accounting for 53% of the portfolio, and the top 10 names accounting for 76% - Goldman, Regions, CIT, and Leucadia additionally. I've only been using the top 6, because in 2002, Fairholme really only had 6 significant US listed stocks in the portfolio. A highly concentrated portfolio has been consistent trait over the years, now as much as ever. If anything, the flows are hurting (future) results because the threat is forcing a traditionally high cash position to be used on redemptions rather than opportunism.
2) St. Joe - I'm not sure I understand the argument that this is a distraction, which is based more on the outcome than the process. Fairholme has had hands on roles before in companies. Fairholme was involved in the GGP bankruptcy and some private placement of AmeriCredit financing in what I would call an activist manner. Maybe not in the traditional sense, but Berkowitz couldn't just be chilling in Miami to do all this. From what I've read, Berkowitz's partner, Charlie Fernandez, is an investor with an operational background. In the most 3/31/11 conference call, Berkowitz mentions how Fernandez has been instrumental in many of these activist aspects - financing, lawyers, regulators, and corporate execs. Fairholme never adopted the stance that they wanted to run the company, but stock selection is a similar skill to picking managers to run a business in which you own a stake. While poor performance has correlated with the St. Joe's activist position, it falls well short of causation. One thing that critics haven't mentioned is Fairholme's purchase of AIA and China Pacific Insurance, but Berkowitz mentions in the linked conference call as a potential criticism of style drift and spreading themselves thin.
3) process and outcome - Along the lines of what I mentioned in 1) the fund hasn't really changed its approach. I think it is interesting to compare the Berkowitz thesis on WFC in 1992 to his thesis on BAC in 2011 which is not word for word, but the same process. I think an interesting corollary is the case of Bill Miller, who instead of a long term record of outperformance, had beaten the S&P 500 for 15 years in a row (his Legg Mason coworker, Michael Mauboussin published an interesting paper on untangling luck and skill a while back that I think is more flatteringly applicable in Fairholme's situation). I tried to do some research into what exactly his process was, but it is not nearly as hard and fast as Berkowitz's 2 criteria of tons of cash flow and hard to kill. The top 10 holdings of Legg Mason's Value Equity fund are less than 30% of the portfolio in names that are large and liquid enough to take up 70% of the portfolio if they had the conviction.
My take on the entire situation is that it's probably a mistake to consider Fairholme just another mutual fund. It's like calling GE an industrial firm. It's worth examining because Fairholme has a good long term track record because its managed by people with their money in the funds and a clearly articulated approach by a genetic contrarian. I agree with him along the same lines as to why its a good time to invest in financials right now, banks specifically. On a related note, a newer blog Valuable Behavior, has a series on how to analyze bank stocks that is topical and better written than any type of informative missives I've attempted.
Actually, I think it's worth noting that a big change to his process did occur when he hired Charlie Fernandez and parted ways with his former co-PMs Keith Trauner and Larry Pitkoswsky in 2008--they stayed on as consulting analysts until late last year. Bruce wanted to go in a direction that focused more on private deals (like the GGP negotiations you mentioned), which like you said is Charlie's expertise.
ReplyDeleteI certainly agree with you that he's a dyed-in-the-wool contrarian, and I also don't think his recent (horrendous) performance is any indication that he's finished. I think the St. Joe's battle was a distraction in the sense that a lot of energy was sepnt on it for what is ultimately a meaningless (3%) position relative to the overall portfolio.
I also agree with his general thesis on financials and in particular his bank holdings. He could very well be proven right over the next year or two.
My main concerns are as follows:
1) Manager of the Decade honors and a huge inflow of AUM will undoubtedly go to his head. Not that I know him well, but I'd be concerned that he could now have a god complex that he's unbeatable that lead to riskier bets/more activism.
2)Even though they didn't make the headlines like Berkowitz, Keith Trauner and Larry Pitkowsky had a hand in the fund's performance basically from the beginning. (I'm now looking into GoodHaven Fund).