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What Ails Fairholme?

Part of Magellan's problem is surely that the large size makes trading difficult. Consider that the fund now has $19.3 billion in assets. A large holding is Toll Brothers (TOL), a homebuilder that accounts for 1.3% of the fund's assets. Now suppose that the Magellan portfolio manager wants to double his position in the homebuilder. To do that, he must spend $207 million to buy 12.8 million shares. But Toll Brothers only has 168 million shares outstanding, and 2.8 million trade each day on average. So the Magellan manager will not be able to make his trade right away. Instead, he'll have to spend weeks slowly accumulating shares. And as he places bids with brokers, the fund's purchases will put upward pressure on share prices. The manager may start buying at $16 and complete the position only when the price has climbed to $18. In contrast, a small fund could take a position in a day.

Like Magellan, Fairholme must make its trades gradually. But Fairholme has a big advantage because it only holds a few positions and often does little trading. While Magellan owns 229 stocks, Fairholme only owns 22. Top holdings include American International Group (AIG), Bank of America (BAC) and Morgan Stanley (MS) . Berkowitz aims to buy unloved stocks and then hold for years. At the moment he is lagging because financial stocks are out of favor--not because his fund has high trading costs. Berkowitz claims that Fairholme's large size actually provides an advantage. Because the fund buys in bulk, it can sometimes negotiate special deals and influence the managements of the portfolio holdings.

Despite the poor recent performance, Fairholme continues to maintain a stellar long-term record. During the past 10 years, the fund has returned 8% annually and outdone 99% of its competitors.

Among the biggest funds is American Funds Growth Fund of America, which has $151 billion in assets. For years, advisors warned that the fund had gotten too big. Undoubtedly the bulk has slowed trading, but the fund has still maintained a strong long-term record. During the past ten years, Growth Fund of America has returned 3.2% annually and outperformed 79% of competitors in the large growth category.

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