10 Questions for Bruce Berkowitz, Fairholme
The Fairholme Fund is a big believer in concentrating its assets: The fund holds 15 stocks and the No. 1 holding, Warren Buffett's Berkshire Hathaway (BRK.A), constitutes 25% of the portfolio. "Broad diversification," the firm explains on its website, "is a hedge against not understanding what you own."
The unusual $58 million mid-cap offering invites further explanation, beyond just the huge Berkshire stake and the scant number of holdings. The fund has been an outstanding performer since its late 1999 inception, shedding a mere 1.6% in 2002 and averaging a 14% annual return over the past three years, putting the fund in the top 2% of its category, according to Morningstar.
For this week's 10 Questions, I discussed the fund and its philosophy with co-managers Bruce Berkowitz and Larry Pitkowsky, as well as the fund's analyst, Keith Trauner -- three men who have nearly 60 years combined professional investing experience.
Berkowitz, a former Smith Barney managing director, founded Fairholme Capital Management in 1997, a $700 million-in-assets firm that primarily manages individual accounts with a $500,000 minimum investment. He launched the fund because he wanted "to put a public face on Fairholme," he said.The fund roared out of the gate in 2000 thanks to contrary bets on Berkshire and other property-casualty insurers, just as tech stocks were about to go bust. Berkowitz and Pitkowsky still are big believers in that sector, but they also have warmed to a few surprising picks, including a small stake in Gateway and, very recently, WilTel Communications, which at 8.54% of the fund's assets is the second-largest holding. Over the following 10 Questions, they explain their fund, their picks and why they believe that buying and holding the right companies is the only way to go.
1. First off, how was the Berkshire meeting earlier this month?Bruce Berkowitz: Keith represented us this year. Keith Trauner: It was pretty optimistic, I thought. For the markets or for Berkshire Hathaway? Keith Trauner: No, just for Berkshire. (Laughs.) Bruce Berkowitz: For Berkshire specifically, but also more generally it was an upbeat assessment of the property-casualty industry.
2. What's the general investment philosophy of the Fairholme fund?Bruce Berkowitz: The goal of the fund is long-term growth of capital without taking lots of risk. That's it in a nice easy sentence. We are significant shareholders of the fund. Most of us have our entire family net worth tied up in the fund and Fairholme Capital Management. One of our major goals is for all of us to become personally wealthy from the investments we make. One of our investing tenets is: If it's going to be good enough for our clients, it better be good enough for us.
3. What led you to take the enormous stake in Berkshire Hathaway? Does it stem from your espousal of a Buffett/Graham & Dodd philosophy, or did it simply look like the best investment when the fund came out of the gate in late 1999?Bruce Berkowitz: Well, both. We definitely think the Graham & Dodd concept of value is correct. Keith Trauner: There had been some Berkshire stock in the firm before the fund was introduced. Then we bought a lot at the end of 1999-early 2000, when property casualty was in the toilet just as technology was reaching its peak. Berkshire got down below $45,000 a share. [The stock currently trades at about $73,000.] Through that period, we were aggressively adding stock. That coincided with some of our other investments in the property-casualty industry. We saw some signs that the 10-year bear market in industry prices was starting to end.
4. How do you feel about the industry presently? It's had quite a nice run the past three years.Bruce Berkowitz: The property-casualty industry had a horrendous pricing environment in the late 1990s. Then, you had the events of Sept. 11 and the European floods. You had a huge mispricing. In order for the industry to survive, there had to be a period of significant profitability. Furthermore, you have the very low interest-rate structure in the U.S. The property-casualty companies have to do well now. It's either do well or go out of business. We have entered a period of reasonable profitability, especially for those companies who didn't make the classic mistakes on makes in insurance. Keith Trauner: It's even more than profitability; the companies have been divided into two camps: the haves and the have-nots. The haves are the guys who had the capital and didn't step too much into the mess, either in the investing or the underwriting side. They have the ability to grow rather nicely here. Some of the guys who got in heavily on the investment side, they can't grow because they don't have the capital. Bruce Berkowitz: Much of the property-casualty industry is an oddsmaking process. The odds now make sense to write property casualty. After a very long period, you are now getting paid a reasonable amount of money in premiums to write the risks. How long the period lasts we don't know. This good period should last for a number of years. It needs to last a number of years to replenish the coffers of the industry.
5. One stock that often turns up in the portfolios of Buffett devotees is Markel, the specialty insurer for health clubs, bars and the like. It's the fund's fifth-largest holding. What do you like about that particular company?Bruce Berkowitz: First of all, one of the consistent criteria among all of our companies is: We must like the people. We want to see owner-managers. We want to see guys running companies who have a significant amount of their family net worth in the company. We want to see an equal playing field -- that is, when we as equal silent owners do well, they do well. We want the people running it to have a high degree of honesty and integrity. Part of that means people who tell us the good news as well as the bad news. Markel fits that. The guys are good; they know what they're doing; they have most of the family net worth where their mouth is. They treat shareholders as owners. They tell us what they would want to know if our roles were reversed. And they have a very good paper trail. They have all the elements you want from a property-casualty company, or any financial-services firm that is leveraged. It's near-impossible to tell when things start going sour, so you are quite dependent on the guys running the place. Larry Pitowsky: And we were fortunate enough to buy it at a cheap price. It fits in with the spring-of-2000 purchasing we made, when we were looking at property-casualty when everybody else was going crazy over technology. Bruce Berkowitz: And we know Markel well. We took about 10 years getting to know them.
6. That raises a good question. How do you go about stock research and selection? How long does the process take, how far down the management chain do you go?Larry Pitowsky: We don't use anyone else's research. We go as deep as we can to get to know the company, the people who run the company, the suppliers, the customers and competitors. We try to understand the key competencies the company has. Bruce Berkowitz: In the case of Berkshire Hathaway, I don't think I'm exaggerating to say that in the aggregate that we have 30 years of experience studying Berkshire. I don't think I'm being extreme to say that we think about the company on a daily basis. Larry Pitowsky: There's one wonderful thing about that kind of research. Theoretically, investment knowledge is cumulative. Once you understand a company very well, you don't want to let go of that knowledge easily for something you understand one-quarter as well. Bruce Berkowitz: It's kind of like marriage. (Laughs.) After a decade or two, you can look at your spouse and understand within a second what's going on. Where[as] going to another investment is like a first blind date.
7. What would compel you to divorce a stock, so to speak? What's your sell discipline? I know the optimal Buffett-esque holding period is forever.Bruce Berkowitz: We take into account taxes, given that we are the largest owners of what we do. We are looking at the after-tax events. Something has to get pretty out of whack for us to reconsider our investments. Or, something really fundamental in our reasoning for buying the stock must have changed. When we sell, we think we failed. We're not traders -- we're not typically looking for a buy, a pop and a sell. We don't enjoy that. If we're going to spend a good part of our lives studying a company, there's something depressing about selling it after all that time and effort. We'd rather have a nice long run. There's nothing better than buying a stock for a long period of time and seeing eventual dividends of 20%-30% on a cost basis or thinking about buying something 15 years ago and it's gone up 20, 30 times in value. That's what it's all about, that's the magic of capitalism. Keith Trauner: One quick follow-up. You can't do that with the average company or worse. It has to be something that has characteristics that are more attractive than most.
8. So, we've discussed your philosophy. Would you share with us some holdings where you put that philosophy to work?Bruce Berkowitz: Berkshire's the obvious, but there are some less-obvious ones that we have tremendous respect for and the rationale is the same. No. 2 on the list would be Leucadia National (LUK). Here's a company that's had a track record as good as Berkshire Hathaway. It has a market cap that's a fraction of Berkshire -- a little over $2 billion. It's extremely well-suited for this environment. Leucadia and Berkshire are our vultures. (Laughs.) For our clients who do not have the time or [want to make] the effort to go into distressed securities, Leucadia is a wonderful way to participate in one of the best. [President] Joe Steinberg and [Chairman] Ian Cumming are two of the best. We've followed them for nearly 20 years. And we very much like what they're doing right now with Wiltel Communications. Keith Trauner: These guys -- Leucadia and Berkshire -- are just genetically built for tough times. They are built for taking advantage of when markets, the economy and anything you can think of is weak. Bruce Berkowitz: This brings up a good point. What we're trying to do with the Fairholme fund is to show people that we can be trusted with their entire net worth. What we focus on is trying to [find] companies that do well in good times but can do very well in bad times. Companies like Berkshire and Leucadia, while there may be "risk" during difficult, negative periods, what you will find is that that is when they sow the seeds of huge profitability. I just started to read a book on Thomas Watson Sr. of IBM. He enjoyed difficult times because he knew that most of the world suffered during those times. And if you held back and kept a large pile of cash when times are good, the bad times are when you get the bargains. Money becomes worth something again. (Laughs.) Whether it's Berkshire, Leucadia, Alleghany (Y) -- they have solid balance sheets and can take advantage of difficult environments. Larry Pitowsky: Don't forget, we continue to be risk-averse people by nature. The companies we're putting in the portfolio are also risk-averse organizations. They're also looking to compound their shareholders' worth, but they're not looking to get themselves into a situation where a crummy environment causes a big problem. Quite the contrary, a crummy environment can help them compound money even faster.
9. The companies we discussed naturally fit the DNA of your fund. I'd like to talk about a few others that might raise some eyebrows. Let's start with Gateway. What led you to this company?Larry Pitowsky: Gateway (GTW) has a reasonable pile of cash. It has somebody running the show [Ted Waitt] who has some aptitude. Bruce Berkowitz: It's a tough game. Ted is an owner-manager, he has his money where his mouth is. A while back, he went away, hired management. The stock got pounded. We came in after the stock got pounded with a small position, when the stock was around cash per share. The results aren't out yet whether he can turnaround Gateway. But what we do like is that he's not bleeding. But, you know, Gateway is a 1% position in our fund, vs. a 25% position for Berkshire Hathaway. We started looking at Gateway as a possible turnaround. But the results are not in yet. Keith Trauner: Every substantial position we own is a company where we say, "Would we feel comfortable having 100% of our net worth in this company?" That's an answer for any sizable position -- Berkshire, Leucadia -- is yes.
10. Why are you shying away from technology?Bruce Berkowitz: We just made our first big technology investment: WilTel Communications. It's a big position. This is something brand new for the fund. We try to be careful because we've developed a circle of competency in financial services. But when some industries go through what we consider to be the equivalent of a 1930s Depression, we start to look. I'll let Keith explain. Keith Trauner: We don't start out with any knee-jerk aversion to a particular sector. We're willing to look at anything we can understand, run by people we like, and where the price is cheap. We first became aware of WilTel when Leucadia National announced that it had a potential deal to help invest money to take WilTel out of bankruptcy. We started to work on the company. Very, very late in the bankruptcy process, we started to buy defaulted bonds. They had already entered bankruptcy, the bonds were paying about 12 cents on the dollar for a company that had spent the equivalent of $8 billion or more on what in our opinion could be the best next-generation, wholesale network in the country. There were a couple of interesting advantages that they had. They had some very unique long-term customer agreements. For example, they are the preferred provider for SBC Communications (SBC). In effect, they have all of SBC's voice and data business outside of their local areas for the next 17 years. Larry Pitowsky: We had been looking in telecom for well over a year, but it took that long to finally find something we really liked. Bruce Berkowitz: There are others we were examining too, whether it's WorldCom or another company. But the fact that Leucadia is a 47%-owner and manager of WilTel at higher prices than we paid makes us feel very confident. We anticipate that the telecommunications business will be no different than what happened with every other technological innovation: railroad, electricity, television -- we are going through a replay. Things got overheated and a lot of companies disappeared, but we are entering a stage where there will be some survivors who do quite well.
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