September 26, 2014

This show is a WealthTrack exclusive interview with Bruce Berkowitz of The Fairholme Fund. Launched at the height of the tech bubble in late 1999, The Fairholme Fund has been the top performer in Morningstar’s Large Value category since inception, delivering 13% annualized returns and beating its nearest competitor by a margin of 2.4% points a year. Berkowitz believes in “ignoring the crowd”. He’ll explain why nearly 80% of his portfolio is in four financial stocks shunned by most investors.

This week on WealthTrack, a Great Investor who dives to extreme depths to find value. The Fairholme Fund’s Bruce Berkowitz explains his investments in companies that other investors abandoned at the bottom. A rare interview with Fairholme Fund’s Bruce Berkowtiz is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. This week we have a rare interview with a great investor who has generated a fair amount of controversy, admiration, fear and envy among the investment community because of his deep value and concentrated investment approach. He is the Fairholme Fund’s Bruce Berkowitz. At the peak of his flagship fund’s popularity in 2011 it had over 20 billion dollars in assets. By 2012 those assets had plummetted by 70% to $7 billion.

The reason? A 32% drop in the fund’s value in 2011 due to his early and large investments in financial stocks and massive shareholder redemptions because of them.

True to form Berkowitz has stuck to his guns, upped the ante in financial stocks and made a ton of money with two back to back 36% gains in 2012 and 2013.

His largest holding is insurer AIG, which makes up about half of the fund’s portfolio, his second largest is Bank of America at 14.5%. Next are the two so called government sponsored entities, GSE’s known as Fannie Mae and Freddie Mac which he started purchasing over the last year. Combined they add up to 15% of the portfolio.

Today the Fairholme Fund’s assets stand at over $8 billion, mostly due to spectacular gains in AIG, which is still shunned by many on Wall Street.

Now his most controversial holdings are Fannie Mae and Freddie Mac which underwrite nearly 90% of the U.S. residential mortgage market and are 80% owned by the U.S. government since being placed into conservatorship by the government in 2008.

At the time the U.S. Treasury invested nearly $190 billion dollars in them. Since then Fannie and Freddie have returned that and more, a total of almost $219 billion to the government. It’s been a great investment for U.S. taxpayers, but the private shareholders including the Fairholme Fund, activist investors such as Carl Icahn and Bill Ackman haven’t seen a penny of profits. As a result they are suing the government to uphold their rights as shareholders. Even consumer advocate Ralph Nader has joined their side.

I have been interviewing Berkowitz on WealthTrack since 2007. In the past year his family foundation, the Fairholme Foundation, which supports educational and cultural causes has become a supporter of public television and specifically WealthTrack. He has always generated a great deal of interest.

When Morningstar initiated its fund manager of the decade award in 2010, he was the first winner in the Domestic Equity category. He also was the Domestic Stock Fund Manager of the Year winner in 2009. The Fairholme Fund, which he launched at the height of the tech bubble in late 1999 has been the top performer in its large value category since inception, delivering 13% annualized returns & beating its nearest competitor by a margin of 2.4% points a year. It has an excellent market and category beating 10 year track record as well, although it has lagged during the last 5 years. I began the interview by asking him why, with all the battered down sectors available to him after the financial crisis he was once again drawn to financial stocks.

BRUCE BERKOWITZ: It’s investment process. It’s you’re comparing what you pay, what you give to what you get and the price you pay. So you want a cheap price with a big margin of safety, but then of course you have to understand what you’re getting, and the financials, that’s my industry. That’s my company within that industry. It’s my experience, so the financials are within my circle of competence, and because the ones that we bought are so essential to the country, hence, their significant SIFI status that they have and the G-SIFI status. I mean, Bank of America is part of the banking system. AIG is part of the financial system of the country. The country doesn’t work with those institutions. The mortgage business doesn’t work without Fannie and Freddie, so they’re essential businesses that really have no substitutes in terms of if they disappeared tomorrow, there would be real problems, and there’s no one of size or scale that could take over exactly what they do. So once you’ve determined that this is a franchise, a moat, important institutions that help the country and help people, and then once you’ve determined that, the price is very cheap as if you could buy them, and even if they stopped doing business and they just ran off their existing business, you would make a lot of money. You didn’t even have to think about the future. You just had to count the cash. Then all you had to do is say, how can they die? And once you determine that they could not die based upon their capitalization …we went into all these institutions after they were recapitalized and restructured through the TARP program and so on, and they were better capitalized than any time in history, and they were making money again, and they were priced for total failure. It became obviously that these were good investments.

CONSUELO MACK: This is very similar to how you approach the investment process. I remember you telling me many times is that you try to figure out if you can kill it. Well, AIG, for instance, your now largest holding was almost killed, and it had to be bailed out by the government. So when you started buying it in 2010, did you feel that there was no chance that it was going to fail?

BRUCE BERKOWITZ: They were already bailed out, so the capitalization was there. The reason for their stress wasn’t their core businesses. It was because of two very small businesses in terms of lending and credit default swaps, not the core life insurance or the core property and casualty insurance and all of that, and the problems were created during the problems with Eliot Spitzer and Hank Greenberg.

CONSUELO MACK: Hank Greenberg.

BRUCE BERKOWITZ: Then there was the company was lacking of a leader, and then the recession came, and it was just an amalgamation of horrors that led to their potential demise, but once it was recapitalized and once good leadership came in, it was obvious that the main franchises were intact, and you could count the money. You could see where the assets and the liabilities are.

CONSUELO MACK: You had a meeting with the Treasury in, I don’t know, was it 2010 or around there?

BRUCE BERKOWITZ: Yes. Summer of 2010.

CONSUELO MACK: And they said, “Why are you interested in AIG?”

BRUCE BERKOWITZ: And I basically, what I just told you is exactly what I told the treasury. It’s a great franchise. You need it. It’s systemically important, and it’s extremely cheap, and yeah. Of course, the next question was, “Well, why are you the only one?” I said, “I have no idea”.

CONSUELO MACK: So here we are. It’s almost half of your total portfolio in The Fairholme Fund, and you have made a ton of money on it. I mean, you sold over a third of your position that you’ve had, and I don’t know. You’ve made a couple billion dollars realized and unrealized gains. So you have been in situations like this before where you’ve had, I mean, over half or almost half of your portfolio in a specific security. Is this unusual for you?

BRUCE BERKOWITZ: It’s unusual because of the performance to have almost half of the fund at a given time, but as we sell, the price goes up. The values go up. It’s a high-class problem, and eventually we have to lower the concentration which we do slowly and carefully, and AIG’s quite a liquid stock, so it’s not an issue.

CONSUELO MACK: What is the end game for you with AIG?

BRUCE BERKOWITZ: The end game is pretty simple. We bought AIG so cheaply that…and today it’s…

CONSUELO MACK: Like $27 around was your cost basis.

BRUCE BERKOWITZ: Yes, and today its tangible book value which I believe to be a rough proxy of a run-off value. If you just close the doors, run off the portfolio and stop doing business and just how much would you end up in today’s dollars is 75. So there’s not really even much to think about until you see the company get to its book value, and when people start to realize that they have sort of risen from the ashes and they start to get a normal market multiple, it’s $100. So it’s painful to have to sell shares at the current prices, and that’s my biggest stress as opposed to…

CONSUELO MACK: Is having to because it’s so big a part of the portfolio?

BRUCE BERKOWITZ: Yes, being it’s quite a large position for an equity mutual fund. So we have to at some point start to pare the position back, but that’s success. If you do well and it gets too big, it’s okay. I can live with this.

CONSUELO MACK: Bruce, Bank of America. You had a choice of numerous banks that you could have purchased in 2010 when you started buying Bank of America, one of them for instance, Wells Gargo which was a previous holding several years before this and was a very profitable one for you. It’s gone up 110 percent, Wells Fargo has since 2010. Bank of America has only gone up like 10 percent.

BRUCE BERKOWITZ: The reason for buying Bank of America over Wells Fargo is that, one, that the price was much cheaper, the price to buy versus what you were getting and, two, it was clear to me that Bank of America over time would become a Wells Fargo, but it had such a cloud over it about its litigation, about its purchase basically of countrywide financial. So Bank of America comes during a tough time and takes over Countrywide, does a service for the country and for the economy and, of course, from that came tens upon tens of billions of dollars of legal settlements and fines.

CONSUELO MACK: Right. I mean, $70 billion. Who would have thunk that it was? It’s like an ATM basically for the government and litigators.

BRUCE BERKOWITZ: Not me. I knew it would be a lot, but I didn’t think it would be that, but I knew that Bank of America was capable of earning 20, 30 billion dollars a year. So it wasn’t an issue of will this kill Bank of America. It was an issue of how long is it going to take Bank of America to resolve these issues and then allow the markets to see what a high quality institution Bank of America is.

CONSUELO MACK: So you’re seeing that. You’re actually seeing what…

BRUCE BERKOWITZ: We’ve been seeing it since the day we bought the company in 2010. It started already.

CONSUELO MACK: Even though it hurt you in 2011.

BRUCE BERKOWITZ: Well, you know. Oh, dramatically it hurt us in 2011.

CONSUELO MACK: Dramatic, yeah.

BRUCE BERKOWITZ: That’s the problem being a value investor. You look wrong until people agree with you, so the business could be right. The business could be making money, everything. If you were the 100 percent owner of the business, you could be jumping up and down for joy as to how well it’s doing. It’s turned the corner. Everything is, the fundamentals are good, but if the markets don’t agree with you and they’re worried about a double-dip recession or they don’t see what you’re seeing, and the stock keeps going down, well, you look wrong until people agree with you, and they see it for themselves.

CONSUELO MACK: I mean, you’ve made several hundred million dollars in realized and unrealized gains. You’ve sold a very small percentage of the position. So what’s your end game with Bank of America?

BRUCE BERKOWITZ: Well, again you don’t have to be too fancy about this. I mean, Bank of America still sells for dramatically below its book value, dramatically below a run-off value, a liquidation value. We’re getting the future for free, and we still get a discount on what’s on the books, so it’s still quite cheap while the markets overall might be average or fairly valued. Now we need a little time to let everyone see what they look like, what the companies look like in good times.

CONSUELO MACK: Perhaps currently your most controversial holdings are Fannie Mae and Freddie Mac, and they effectively were nationalized by the government in 2008, and you got involved, started getting involved in 2012. Why get involved in two incredible, huge entities that are 80 percent controlled by the government and in fact that the government’s getting all of the profits and dividends from?

BRUCE BERKOWITZ: Well, Fannie and Freddie may be the two most important institutions in the United States. Fannie and Freddie are the home mortgage market. There is no 30-year fixed mortgage at a very low interest rate without Fannie and Freddie. They are the mortgage market, and there are no other companies to be the mortgage market. They have a very special role in our economy in that they’re government sponsored. They’re owned by shareholders such as Fairholme, but they were government sponsored enterprises, and of course the government has every right in the world to change the future sponsorship of these enterprises, but as owner of preferred stock, I have a contractual agreement with these companies based upon contracts done decades ago and so on. So we understand that in the end you can’t change past agreements. You can change the future. We are the owners. The companies are fabulously profitable now. They’re probably the two top reasons for deficit reduction in the United States. As minority holder and others, we own less than 20 percent of the company. So I believe we’re entitled to the profits, and we’re discussing. So Fannie and Freddie remind me very much of AIG where we discussed the issue with AIG, and eventually we resolved the issues, and the government sold its stake in AIG and made a tremendous amount of money for taxpayers, and that’s exactly the way Fannie Mae and Freddie Mac …

CONSUELO MACK: Do you think that’s the way it’s going to work out in fact? I mean, obviously you’re involved with two lawsuits against the government over some would say confiscatory policy, the government towards Fannie Mae and Freddie Mac, and to uphold your shareholder rights, and with Bill Ackman and with Carl Icahn and others.

BRUCE BERKOWITZ: Well, we have to protect the ownership rights of our 200,000 plus shareholders who are taxpayers. I mean, they own it, so we have to protect that and protect legal agreements, contractual law and so on, but it’s my expectation that Fannie and Freddie are just a much bigger sized AIG. I mean, before Fannie and Freddie, AIG was the largest restructuring in the history of the United States, and I’m proud that we had something to do with that, and we helped, and it was a win-win for everyone. I mean, Fannie and Freddie, clearly there’s a win for the country. There’s a win for taxpayers. There’s a win for homeowners. There’s a win for investors. There’s a winning solution for every constituency in Fannie Mae and Freddie Mac. In fact, they absolutely did their job. Their job is to stand up during times of stress, and when everyone else is running for the hills, to keep the mortgage market going, and you lose money at that time, and their job is that … shareholders to lose money at that time, and that in good times to make up that money.

CONSUELO MACK: No one’s disputing the critical role they play in the U.S. economy and the mortgage market, but what is a reach is why you as a money manager who wants to make money for your shareholders would get involved in such a messy situation and now involved in lawsuits, and in two entities that they’re very political, that the government controls. So why take that chance?

BRUCE BERKOWITZ: That question was asked of me of Bank of America. People thought it was going bust. AIG when people thought AIG was going bust, and now that question is asked of Fannie and Freddie, because it’s somewhat different because they’re under conservatorship. But the answer is the same. They cannot disappear. They’re absolutely needed. People have tried to figure out a substitute plan which they have every right to. There is no substitute.

CONSUELO MACK: And as a shareholder, you think that you will eventually benefit from the incredible profitability that these two entities now are exhibiting.

BRUCE BERKOWITZ: Absolutely. They did their job exactly as they were supposed to. They have repaid the American taxpayer plus giving tens of billions of interest, and there’s more to come.

CONSUELO MACK: And now it’s up to the courts essentially to decide whether or not you and other minority shareholders have rights.

BRUCE BERKOWITZ: Our issue with the courts is about the past. It’s about property ownership, the right to own property, confiscation, a deal is a deal, contractual law, what it means to be a shareholder and what rights you have as a shareholder. I mean, we understand that in time of crisis such as in 2008 in the fog of financial war, that a lot of decisions have to be made and made quickly, and you have to sort of give people the benefit of the doubt, but we’re talking about an action that took place in 2012, an amendment to an agreement, a change of an agreement that was made.

CONSUELO MACK: That the government did. Exactly.

BRUCE BERKOWITZ: When the sun was shining and the companies were making money, they unilaterally changed the deal.

CONSUELO MACK: Right. The government decided that they were going to get all the profits and the dividends and no one else would.

BRUCE BERKOWITZ: It’s understandable. No one’s perfect, so a lot of good decisions were made during the time of the financial crisis, but we happen to disagree with what happened in 2012, and the nice thing is we’re talking about very profitable companies that are being of tremendous help to the country, and everyone wins. So eventually we’ll get to everyone wins, and we’ll move on.

CONSUELO MACK: One of the big issues with the Fairholme Fund is that at the peak of your popularity you had over 20 billion invested in the Fairholme Fund, and then it dropped to seven billion within a year. Because of these big bets that you take, is that people quite honestly get scared and they don’t like it when stock prices go down. So you do run a mutual fund. It does have shareholders other than the family, and I know your family is completely invested in the Fairholme Funds as a whole, so how do you kind of rationalize taking these big bets, knowing that you’re going to lose shareholders?

BRUCE BERKOWITZ: Well, the focused process is based upon my circle of competency and what I feel most comfortable with. I mean, my decision to have AIG rather than six different insurance companies or to have Bank of America rather than six different banks is based upon a belief that they were the cheapest relative to their intrinsic value, and I believe after studying them for decades I had an understanding of the institutions. I also have been told that we’re one part of a strategy that people use, but basically when you look at it and if you read our prospectus and what we say from the first day the Fairholme Fund opened is that we’re a focused investor, and we want to pick the very best investments, the top investments. We don’t want to buy number 10 in our list if we can buy more of number one. What I think we’ve done is absolutely have kept to our word as to how we were going to behave, and we showed that we stuck to our guns during extremely stressful times, and it’s proving to be correct and profitable, but the story isn’t finished yet. We’ll know in a few more years whether or not this was the correct strategy. I mean, we’re starting to come back very nicely, but our companies are still quite cheap, but every day people are figuring it out more and more, and we’re getting there. We’ll get there. If it was easy, everyone would do it.

CONSUELO MACK: You have been a consistent deep value investor, and you’ve scared the daylights out of some people. I’m sure your family as well at certain times, but somehow it has always come out right in the end. One last question. One investment for a long-term diversified portfolio which you do not run. You run a long-term portfolio but not a diversified portfolio.

BRUCE BERKOWITZ: Maybe one day I’ll have to run one.

CONSUELO MACK: So what would it be? What you have us own?

BRUCE BERKOWITZ: Clearly one investment that should not keep anyone up at night and to me a no-brainer would be AIG today given that the disconnect between its liquidation value and its current stock price and given that they’re back on track and over the next few years you should see steadily improving earnings from operating efficiencies and correct reserving and new leadership who seems to be doing a very good job. So we focus on the down side. We count the money. I can’t tell you how well AIG is going to do beyond what we think a reasonable fair value is between 75 and 100, but from 55 to there isn’t so bad.

CONSUELO MACK: Bruce, thank you so much for being with us on WealthTrack. We really appreciate this rare television appearance.

BRUCE BERKOWITZ: My pleasure. Thanks.

CONSUELO MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point steals the Fairholme Fund’s slogan which is “Ignore the Crowd.” How would that advice play out in today’s environment?

One is to look at out of favor funds. The Fairholme Fund being a prime example. This first Morningstar Fund Manager of the Decade award winner, has earned Morningstar’s second highest silver medal designation in its large value category, but is now given only a two star rating out of five.

What’s the disconnect? Morningstar refers to the fund’s “horrific loss” in 2011 and its “security risk,” the kind of concentrated deep value bets that the fund has always made.

Is this a core holding for most of us? Probably not. Does it deserve consideration as an ancillary holding for adventurous investors looking for diversification in their stock portfolios? It probably does. Speaking of contrarian views, next week we will talk to top rated economist and Financial Thought Leader, Nancy Lazar, one of Cornerstone Macro’s founding partners who says the U.S. has resumed its position as the primary driver of global growth and that china is falling behind with all sorts of positive ramifications for America.

To see more of our interview with great investor Bruce Berkowtiz to our website’s EXTRA section.

Have a great weekend and make the week ahead a profitable and a productive one.

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