Why the Buffett-inspired Fairholme Fund just ditched Berkshire Hathaway.
By Michael Breen | 04-27-09 | 04:30 PM
It's not often you give one of your idols his walking papers. But that's what happened in late 2008 when Bruce Berkowitz of Fairholme eliminated his stake--once as high as 20% of assets--in Berkshire Hathaway (BRK.B) (see Page 9 of Fairholme's Feb. 11 conference call).
Berkowitz doesn't think Buffett is washed up. Far from it. But he's taking the Oracle of Omaha at his word. Buffett himself says Berkshire's size makes it unlikely the firm will return better than a percentage point or so more than the S&P 500 going forward. Berkowitz thinks Fairholme can do better.
That's not hubris. Berkowitz says he's not smarter than Buffett--just smaller. And that gives him a wider range of opportunities in a target-rich environment than Berkshire has due to its girth. The same goes for most Buffett-inspired funds.
Like Buffett, Berkowitz takes what the market gives. Some investors have tried to piggy-back on Buffett's moves by piling into the common stock of General Electric after Berkshire bought high-yielding preferred shares and debt in special deals with the firms. The stocks may work out well, but they carry risk. There's a reason Buffett didn't load up on the equity. He could get equity-like returns with lower risk by going higher in the capital structure.
Berkowitz has followed suit. Take Fairholme's recent deal with AmeriCredit (ACF), a provider of subprime auto loans. Fairholme owns equity and several tranches of debt in AmeriCredit and recently did a direct transaction with the firm, exchanging senior notes for common shares on favorable terms. Fairholme now owns a 20% stake in AmeriCredit, creating a mutually advantageous situation. AmeriCredit gets much needed breathing room in the form of liquidity from a patient partner, while Fairholme receives a seat on the firm's board of directors, enhancing its knowledge and control of the situation.
Berkowitz has bought debt elsewhere. Fairholme now has about 10% of assets in high-yielding, senior fixed-income positions in United Rentals (URI), and Sears Roebuck Acceptance. These stakes overlap with equity positions in the same firms. In addition to these bonds paying more than 15% per annum, Berkowitz thinks they provide protection against possible low-ball takeovers of any of the firms.
Buffett waits for fat pitches before swinging and Berkowitz has just remade his portfolio to take advantage of what he thinks are compelling bargains. He's backed up the truck on health care, aerospace, and defense stocks. Fairholm now has more than half its assets in those areas, up from nothing a few years ago. Pfizer (PFE) are all top-10 holdings. They're about 40% cheaper than the overall market but don't look like value traps to Berkowitz. He says all generate tons of cash, continue to grow, and have manageable debt levels.
A secret of Buffett's success has been to buy firms outright and then leave proven managers in place and alone. Likewise, a big part of Fairholme's success has come from identifying and investing in top capital allocators while remaining a silent partner. The fund has long held Leucadia National (LUK), a holding company run by Ian Cumming and Joe Steinberg. Leucadia has compounded capital at a high rate over the years. It has interests ranging from copper mines to wineries to an early-stage biotech firm, among others. Berkowitz and his team know Leucadia's underlying holdings well and think they're cheap. But Leucadia has ownership restrictions that prevent anyone from owning more than 5% of its shares, and Fairholme is at that level. So, Berkowitz has invested directly in a couple of what he thinks are the more attractive firms from the Leucadia stable.
The fund now has a small stake in Fortescue Metals, an Australian iron ore firm whose shares have tumbled alongside ore prices. But Fortescue is a low-cost producer and has a geographic advantage over many rivals due to its proximity to China, a top ore consumer. And AmeriCredit is another Leucadia holding that overlaps with Fairholme.
Fairholme also has a big bet on Eddie Lampert's Sears Holdings (SHLD). It hasn't delivered, but Berkowitz remains confident. He sees parallels with Berkshire in the early days when the focus was on its struggling textile operations. Buffett eventually repurposed capital to better use, and Berkowitz sees the same at Sears. He says the firm trades at just a fraction of its liquidation value.
Do as I Say…
Fairholme shows you can follow the spirit of Buffett's moves without blindly aping them. Buffett made his name early by taking bold, concentrated bets, often in small firms. Now that Berkshire is a behemoth, he can't do that. Individuals and most funds don't face such a burden. Buffett is a smarter investor than us. But we're nimble and have a plentitude of opportunities to work with. So review your options and wait for that fat pitch. You may still end up in Berkshire Hathaway. But you may find a better opportunity among one of the many Buffett-inspired funds mentioned here.
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