Monday, May 23, 2011

Fairholme's Bruce Berkowitz Is Beating Hedge Fund Managers At Their Own Game

Bruce_BerkowitzEvery once in a while, there’s a saga on Wall Street that captures everyone’s attention. The fight over Florida real estate development company St. Joe Co. earlier this year was that kind of saga. On one side was Bruce Berkowitz, founder of Miami-based mutual fund manager Fairholme Capital Management, St. Joe’s largest shareholder, with a nearly 30 percent stake, who believed that the company’s future would be bright once the real estate market recovered and poor management was out of the way. On the other was David Einhorn of Greenlight Capital, a New York–based hedge fund manager who had presciently shorted Lehman Brothers Holdings before it collapsed and was equally outspoken in betting against St. Joe.
In the fall and winter, the two publicly battled under the glare of the media spotlight. Fortune magazine dubbed Berkowitz “the megamind of Miami,” while the Atlantic, not known for its business coverage, sent a writer to the Florida Panhandle to track down a development at the heart of the Berkowitz-Einhorn showdown. In March, in a battle so short you might have missed it if you blinked, Berkowitz and Fairholme won control of St. Joe, gaining four seats on its board of directors and forcing the departure of its CEO. The mutual fund manager had beaten the hedge fund manager at the game.
St. Joe may not seem like a major prize in the big scheme of things, with a market value of just $2.4 billion, but Berkowitz and Charles Fernandez, his No. 2 at Fairholme for the past three and a half years, saw a huge opportunity. Not only did they think that the company’s real estate operations could be worth a lot more in the future, they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett’s Berkshire Hathaway.
“We’re trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders,” Berkowitz says.
Given the financial uncertainty of the postcrash world, where pockets of opportunity may be found in all kinds of places, flexibility is essential. Hedge fund managers like Einhorn have long known this. But Berkowitz has learned it too, growing Fairholme to more than $20 billion in assets since founding the firm nearly a dozen years ago.
In many ways, Berkowitz (who along with Fernandez and other insiders has some $300 million invested in Fairholme) is a traditional value investor who plows through piles of paperwork and reams of financial data to find unappreciated companies. Like Buffett, he follows the principles of Benjamin Graham, the legendary value investor who focused on a company’s assets and ability to generate cash. But his strategy stands apart, marked by extremely concentrated holdings and a willingness to go where others fear to tread, and then to wait, often doubling down as stocks fall in the short term.
Fairholme is the largest investor in American International Group, after the U.S. government. The reviled insurer represents 7.5 percent of  Fairholme Fund’s portfolio, which is loaded up with financials and other loathed sectors. Additional big holdings include Bank of America Corp., CIT Group, Citigroup, Goldman Sachs Group, Morgan Stanley and Regions Financial Corp. Consumer names are sparse, and the one that is there is the retailer almost no one wants: Sears Holdings Corp. “I’m a premature accumulator,” Berkowitz says, laughing. To counter any risk that the portfolio might crater, and to take advantage of opportunities fast, Berkowitz keeps massive amounts of cash on hand — 23 percent of  Fairholme’s assets as of March 31.
“Bruce is very bright, very hardworking, and he marches to his own drummer,” says hedge fund billionaire Leon Cooperman, who has known Berkowitz for more than a decade. “He’s a guy whose investing views I respect.”
“He comes from a very modest background, and he loves to invest,” adds Michael van Biema, a former Columbia Business School professor who now runs Van Biema Value Partners, a New York–based fund-of-hedge-funds firm that invests with small, deep-value-oriented managers. “To us, the single most important characteristic for a manager is this absolute passion for investing.”
The returns of Berkowitz’s strategy have been terrific. Since the Fairholme Fund launched in December 1999, it has beaten the market every year except one; from inception through the end of last year, the fund had an annualized return of 14.47 percent, versus just 0.45 percent for the Standard & Poor’s 500 index. By comparison, Hedge Fund Research’s HFRI fund-weighted composite index returned 6.75 percent annualized over that period. An investor who’d put $1 million in Fairholme at the start would have ended 2010 with $4.4 million. That success earned Berkowitz the title of “domestic stock fund manager of the decade” last year from fund tracker Morningstar.
But the financial world has changed since Berkowitz started investing two decades ago, and he and Fernandez expect that many of the best opportunities going forward won’t involve domestic stocks — the mainstay of  Fairholme over the past decade — but will exist in various corporate restructuring efforts as companies around the globe unwind their debts and shore up their balance sheets. At the same time, Fairholme faces the constraints of its own success: Its ballooning asset size means that bets will need to be ever larger and that investments in smaller companies won’t make a meaningful enough contribution to returns. For the first four months of this year, the Fairholme Fund lagged the S&P 500 — down 2.7 percent versus the index’s 8.4 percent rise — a rare period in which it has not only underperformed but lost money for investors.
“It’s sheer fantasy to think that someone could go up consistently every month for years upon years,” Berkowitz says. “It is just insane to think that a four-month period is anything.”
Operating in Miami, where the firm is based, and nearby Coral Gables, where Berkowitz, 52, and Fernandez, 48, live next door to each other, Fairholme isn’t caught up in the Wall Street vortex. Berkowitz and Fernandez rarely go to the office, preferring to catch up over long predawn walks (Black­Berries in hand) and then work from their oceanfront homes or their favorite Italian restaurant. The firm comprises just 28 people, mostly in administration and compliance. There’s no army of salespeople pitching the fund to
401(k)s, where its presence is de minimis, nor are there lots of researchers and junior portfolio managers on staff. Instead, research is largely outsourced to consultants as needed. The setup is reminiscent of that of    Warren Buffett and his right-hand man, Charles Munger, operating Berkshire Hathaway from the middle of nowhere in Omaha, Nebraska.
“I think Bruce has modeled himself to a great degree after Warren Buffett, and it is an enormous competitive advantage,” says William Ackman, founder of New York–based hedge fund firm Pershing Square Capital Management, who worked with Fairholme and Canada’s Brookfield Asset Management to bring real estate developer General Growth Properties out of bankruptcy last year. Berkowitz’s word, like Buffett’s, can be counted on, a rarity in the fast-moving world of finance, Ackman notes. “If you are not partnered with the right people, they can take advantage of the changes to retrade the deal,” he says. With Berkowitz and Fernandez, “every time there was a twist or turn, they were willing to work with us and the company.”
As the world’s businesses recover from the financial crisis and get their balance sheets back in order, Berkowitz and Fernandez hope to find more opportunities like General Growth. In that case, they bought the company’s debt and then agreed to invest $2.7 billion in the restructuring during a 45-minute meeting with Ackman and the folks at Brookfield. They’re moving further afield, traveling to Asia to check out the business landscape there, while focusing on St. Joe at home. Fernandez, a restructuring expert who has worked with a number of companies affiliated with Miami billionaire Phillip Frost, brings an operator’s mind-set to Fairholme.
The bottom line, however, remains the same: As with other more-traditional value managers, Berkowitz and Fernandez focus on the downside, seeking a large margin of safety in case things go wrong, even as they seek out new opportunities. “You don’t play Russian roulette,” Berkowitz explains. “Sometimes people invest based on probabilities. But what good is probability theory once you blow your brains out? You can’t play again once you’re dead. I don’t want to invest in a company where death is an option.”
BRUCE BERKOWITZ, LIKE SOME of the best investors on Wall Street, didn’t seem destined to become a money manager. He grew up in Chelsea, Massachusetts, a formerly industrial town just outside Boston that had slid into economic decline, and was the first in his family to go to college. His father ran a corner grocery store and was a part-time bookie; young Bruce learned the odds when he had to take over the operation for a few months after his dad had a heart attack.
Berkowitz recalls making his first investment, circa 1973, as a teenager, in a whole life insurance policy from Mutual of New York. Unlike term insurance, which pays out only upon death, whole life insurance is partly an investment in which the cash value accumulates over time tax-free. “Why I did it, I don’t know; it was less money to spend on cigarettes,” Berkowitz says. “I like to see that little table on page 72. It’s like a zero-coupon bond; the discounting is huge. It was the equivalent of going to Filene’s Basement and getting a discount.”
After earning a BA in economics from the University of Massachusetts Amherst in 1980, Berkowitz went to work for the Strategic Planning Institute, a consulting firm, and moved with his wife, Tracey, to England. Bored, he started trading stocks in his spare time. In 1983, at the age of 25, he joined Merrill Lynch & Co.’s London brokerage office, where, thanks to charm and long hours, he became the top fixed-income salesman. By 1987, Berkowitz had a core of 200 wealthy clients, and Lehman Brothers recruited him to start a new office for high-net-worth investors in London. He returned to the U.S. in 1989 and four years later moved from Lehman to Smith Barney Investment Advisors.
From the beginning, Berkowitz’s investing style was clear: He liked to make bets on just a few companies, and he was savvy about financial stocks, which many value investors shun for their complexity. At one point in 1994, he owned shares in just two companies: Berkshire Hathaway and Fireman’s Fund Insurance Co. Nearly a decade earlier he’d learned of Berkshire from Jack Byrne — Fireman’s legendary chief executive, who had previously run Geico and brought it back from the brink with an investment from Buffett — and Berkowitz bought the stock as a baby gift for his first child 25 years ago.
“Jack would always be talking about Warren Buffett,” says Berkowitz. “Berkshire Hathaway is an outstanding model.”
By the late 1990s, however, Berkowitz was chafing under the constraints of working for a big Wall Street firm and itching to go out on his own. In 1999 he recruited two men who would join him at Fairholme: Keith Trauner, a longtime value manager, and Larry Pitkowsky, a PaineWebber broker who’d been managing money on the side. Berkowitz established Fairholme, named after the street he’d lived on in London, in December 1999.
The new firm set up shop in tony Short Hills, New Jersey, operating out of the same building where value investor Michael Price ran the Mutual Series funds. “We all sat in a little room together for a long time,” says Trauner, 53, who had originally met Berkowitz at a shareholder meeting of financial holding company Leucadia National Corp., in which they were both invested. At first, as with most start-up mutual funds, no one paid much attention to Fairholme. “The mutual fund idea was just to throw spaghetti against the wall and see if it stuck,” Berkowitz says.
In its first semiannual report to shareholders, on May 31, 2000, Fairholme, with just $6.2 million in assets, reported that more than 50 percent of the portfolio was in property/­casualty insurers. “These companies fall within our circle of competence and were bought at multi-year lows,” according to that report. Or as Berkowitz, who has sat on the boards of directors of various insurers over the years, says, “I’m addicted to buying life insurance.”
In an early distressed investment, which may be typical of things to come, Fairholme began accumulating the debt of     WorldCom on the cheap after the telecommunications company — as reviled then as AIG is now — filed for bankruptcy in July 2002. That eventually became a hefty position in the shares of MCI, which itself was sold to Verizon Communications in January 2006. “Bruce makes bets where other people don’t see it,” says Cooperman, chairman of New York–based Omega Advisors, which was also heavily invested in MCI stock at the time. “He does his own homework.”
In 2006, Berkowitz relocated Fairholme to Miami, where there’s sunny weather, no income tax and very little Wall Street chatter. Trauner moved to Florida too, while Pitkowsky stayed in suburban New Jersey, but by 2008 they had both left the firm. (Trauner and Pitkowsky recently launched their own money management operation, GoodHaven Capital Management, with backing from Markel Corp., a large insurance company.)
That same year, Berkowitz bailed from financial stocks. He sold positions in Countrywide Financial Corp. and Freddie Mac because their balance sheets had become overleveraged and lending had gone wild. As Fairholme noted in its 2007 annual report to shareholders, well before the financial collapse: “Worldwide, financial institutions may ultimately write off hundreds of billions and are being forced to raise equity to survive — if they can. Almost certainly, there will be high-profile restructurings and continued stress.”
Instead, Berkowitz tilted Fairholme’s portfolio first toward energy stocks and then to drugmakers and defense companies. To help make sense of the defense industry, an area that Fairholme has not typically favored, Berkowitz hired a panel of former generals and admirals to study procurement. “We said, ‘Tell us why we’re being idiots,’ ” he recalls. The process of testing every potential investment against all that might go wrong has been critical to Fairholme’s success.
Fernandez, who is married to a cousin of Berkowitz’s, joined Fairholme as president in January 2008. A 1985 graduate of Florida International University, Fernandez had worked with Frost, a dermatologist-turned-entrepreneur, on a number of companies, including Continucare Corp., IVAX Corp. (which was sold to Teva Pharmaceutical Industries) and Big City Radio, where he’d become chief executive after the enterprise acquired his Frost-backed company, Hispanic Internet Holdings.
“I was an operator; I’m here to fix something, not grow it,” says Fernandez, describing his relationship with Berkowitz. “Our skill sets are similar but different, and that’s key to making us work as a team. When you come to the same conclusions from two different directions, it’s a check and redundancy.”
Around the time that Berkowitz moved Fairholme to Florida, he amended the prospectus for the Fairholme Fund to eliminate rules that restricted investments in non-U.S. securities and “special situations” to no more than 25 percent of the portfolio and to get rid of wording that the fund’s assets would normally be invested 75 percent in U.S. common stocks. “Such changes,” Fairholme told shareholders in 2006, “may help the Fund better achieve its objectives under certain potential economic and market conditions.” (Fairholme’s investing mentality may be similar to Berkshire Hathaway’s, but Berkowitz’s annual reports lack the chattiness of Buffett’s.)
As the firm grew, Berkowitz began appearing regularly on business news programs and in the press. Although Fairholme counts a number of large institutional accounts, the vast majority of its more than 500,000 shareholders and clients are individuals. “Up until about five years ago, I don’t think we had one institutional account,” Berkowitz says. “It was basically moms and pops, some just built up to large-sized owners over 20 years.”
Unlike bigger firms, with their array of salespeople and lower-cost share classes for institutional investors, Fairholme offers the same share class — no-load, with a 1 percent management fee — to all comers. Unusual for funds of its size and track record, Fairholme Fund is barely visible in the $3 trillion 401(k) market: Just 146 companies, including Nike and Xerox Corp., offered it in their lineups, for a total of some $138 million in assets, according to the most recently available data from 401(k) tracking firm BrightScope.
Edward Kuresman, a principal and portfolio manager at Madison Wealth Management, a Cincinnati-based advisory firm with $300 million under management, started putting money with Fairholme in 2009. He needed to replace a deep-value equity manager whose fund manager had left, and went to Miami to check out Fairholme. “We’d certainly heard of Bruce Berko­witz and Fairholme,” says Kuresman, who now has $8 million invested in Fairholme. “His performance was outstanding, he’d started to make headlines, and I was curious. We wanted something different from your typical large-cap value manager.”
When the markets collapsed in 2008, Berkowitz saw a massive opportunity to return to the sector that had long been his mainstay. He sat up at night reading congressional testimony and filings from the government’s Troubled Asset Relief Program, and listening to company conference calls over and over again on high-end headphones. In November 2009, Fairholme started buying financials with Citigroup, taking comfort in the government’s bailout of the then-struggling bank. Its total stake is now worth about $900 million.
In the first quarter of this year, Citi reported net income of $3 billion, a 32 percent decline from the same period in 2010; though losses on troubled loans fell, so did profits in its trading and investment banking businesses. Berkowitz argues that the results show how far along Citigroup has come in fixing its balance sheet and that it’s unrealistic to expect growth so quickly. “A year ago they were an institution that people didn’t know would make it,” he says. “They are profitable now and building their balance sheet and increasing tangible book value and making loans. Their bad loans are declining. Everything is going the right way. I don’t understand where the negatives are.”
Other financial investments followed — AIG, Bank of America, CIT, Goldman Sachs, Morgan Stanley, Regions Financial — until Berkowitz had shifted about half of the firm’s growing assets into financials, a giant bet on Wall Street and the future of the system. In many cases, Fairholme is the largest or second-largest investor in the stock, holding hugely outsize positions. “There are plenty of people out there who think we’re crazy for being in banks and brokers and AIG,” Berkowitz says.
In early 2010, Fairholme began buying AIG bonds, stock and preferred shares. The conventional wisdom at the time was that AIG would never repay the government the $180 billion in bailout money it had received. Institutional investors shunned it. Berkowitz, who had loved AIG since his earliest days of investing, felt there was still good value in its core operations. Whereas others saw the failure of the derivatives unit and the subsequent bailout, he saw an insurance business that had remained large and strong throughout that disaster. “There’s been an intense focus on the liability side of the balance sheet,” Berkowitz says. “It’s time to look at the asset side.”
Although financials have made Berko­witz and Fairholme’s investors rich over the years, they have not done well in 2011. Through April, Bank of America was down 7.9 percent, Citigroup was off 3 percent, Goldman Sachs had fallen 10 percent, and AIG had dropped a whopping 46 percent (though the last number is misleading because the share price fell significantly after AIG issued warrants to nongovernmental shareholders). Still, Berkowitz is undeterred.
“We’re only in the third inning,” he says. “The last time I was heavily involved with the banks, it was a five- to ten-year period. And I’m always early, which in a way is a good thing because if you were right on day one, you’d have a much smaller position.”
If he’s right, the size of the bet on financials will make it a huge win for investors, but there are risks to Berkowitz’s focused strategy and to Fairholme’s ballooning asset base. Money has poured in since Morningstar named Berkowitz manager of the decade in January 2010. In the 12 months through February of this year, investors put $4.6 billion in new money into the flagship Fairholme Fund, according to Morningstar.
Managing massive inflows is difficult, says Ken Kam, founder and CEO of Market­ocracy, a Los Altos, California–based research and investment firm that identifies some of the best investors in the world and builds model funds based on their portfolios. During the 1990s, Kam was co–portfolio manager of Firsthand Funds’ Technology Value Fund, which experienced a flood of money during the tech-stock bubble. “Berkowitz has a broader mandate than we did, but he still has the same problem,” Kam explains. “He’s got to make pretty big changes, and on the whole they have to be right.”
Fairholme has launched two new funds over the past 18 months that have already garnered more than $700 million in assets: Fairholme Focused Income, which buys bonds, and Fairholme Allocation, which focuses on smaller companies. Some Fairholme investors worry that Berko­witz may be stretched too thin. In March, after years of inflows, investors pulled out $300 million, according to Morningstar. Among them was Barry Ritholtz, CEO of online quantitative research firm FusionIQ and a popular blogger at the Big Picture. In early April he posted on his blog that he’d ditched Fairholme from one of his portfolios, but not because of concerns about its size: “[The fight over St. Joe] appears to have been a distraction to Berkowitz, and Fairholme Funds performance has suffered. So we fired him.”
the ST. JOE CO. ONCE DEFINED Flor ida. Assembled with early land purchases by Alfred duPont, St. Joe began in 1936 as a paper company in the Florida Panhandle, at a time when pine trees were plentiful and logging was big business. By the late 1990s, however, the company was focused on its real estate — and on developing vast tracts of beautiful but not easily accessible land that had been acquired on the cheap by duPont’s brother-in-law, Edward Ball. Its fortunes rose and fell with Florida real estate. “St. Joe is nothing less than the history of real estate in the United States,” Berkowitz says.
The Florida Panhandle is one of those areas with beautiful beaches that seem always to be on the verge of happening, but it never really took off. In 1997, St. Joe brought in a former Walt Disney Co. development executive, Peter Rummell, as CEO to turn St. Joe into a real estate powerhouse. Under Rummell’s leadership the company sold off old divisions, developed beachfront communities and laid the groundwork for an airport to serve the region. Between 1998 and 2005, St. Joe’s annual net income jumped from $29 million to $127 million. But by 2008, the year Rummell left and was replaced by Britt Greene, the real estate downturn had hit Florida hard. Sales of St. Joe’s high-end vacation homes had slumped, and the company was making money by selling off parcels of rural land. In 2009, St. Joe lost $130 million. Its shares, which had traded as high as $85 in July 2005, fell below $15 in March 2009.
Fairholme started buying St. Joe shares in 2007 at a price of $32.33 and has since accumulated 29 percent of the company, a stake worth more than $600 million. Berko­witz knew about the Panhandle because of his earlier investments in Leucadia, which had developed Rosemary Beach, and he knew what a big deal St. Joe was in the region. Its scale, in geographic terms, is huge: The company holds some 574,000 acres of land, including beachfront property, and has built or is in the process of developing 31,000 residential lots.
Fairholme’s logic is relatively simple: St. Joe’s fortunes will rise again when real estate does; the land was purchased cheaply, paying them to wait; the new airport, on land donated by the company, will spur development in the Panhandle; and new company management will help. With Northwest Florida Beaches International Airport opened last May, the region should be able to develop not just as a vacation spot but as a commercial hub, Berkowitz contends. “All you need now is for the economy to get going,” he says. “Once you stop the bleeding, time becomes our friend rather than our enemy.”
Hedge fund manager David Einhorn has been very public in his derision of St. Joe. In a 139-slide presentation at the Value Investing Congress in New York last fall, Einhorn set out the reasons he believed that St. Joe, which was then trading at about $25 a share, was worth just $7 to $10. Einhorn showed spectacular photos of Hilton Head Island, Nantucket and Napa Valley — to which St. Joe CEO Rummell had compared the area — followed by images of the undeveloped beaches and run-down streets of Port St. Joe and Windmark Beach, Florida, to much laughter from the crowd. As developments have stalled, Einhorn argued, the company should be valuing its large real estate holdings as rural timberland.
“The problem is that the company is stuck,” said Einhorn, who declined to be interviewed for this story. “If they were to do the best thing for shareholders, which I’m sure shareholders wouldn’t appreciate, they would just sell it right now to someone who would operate it on a low-cost basis as a rural timber company.”
Investors rushed to sell: St. Joe’s shares fell 10 percent, to $22.16, by the end of the day in heavy trading. Afterward, Berkowitz — who snapped up an additional 135,600 shares that day — thanked Einhorn. “I want to send him a box of chocolates,” he told Reuters at the time.
Fairholme moved quickly from there. In January, Berkowitz and Fernandez joined the St. Joe board. Six weeks later, on Valentine’s Day, they resigned, saying they would not stand for reelection until a majority of directors were “committed to shareholder value, pay for performance and effective corporate governance.” On February 16, in a letter to St. Joe shareholders that was included in a securities filing, Fairholme said it had retained executive search firm Spencer Stuart to begin a director search to fill a seven- or nine-member board, whose slate would include Berkowitz, Fernandez, former Florida governor Charlie Crist and Carnival Corp. chief operating officer Howard Frank. “While a written consent will be the simplest way to change the board, it may become appropriate to hold a special meeting of shareholders,” Fairholme wrote. “Of course, Joe’s current directors can immediately step down and appoint our slate in order to save us all much time and expense.”
In a shockingly fast denouement, Fairholme and St. Joe reached a compromise agreement. On February 28, CEO Greene and three other directors resigned (other managers would follow), and Fairholme’s team gained control of the board. Three other directors, including then-chairman Hugh Durden, who would become interim chief executive, remained. The new chairman and vice chairman, as of March 4: Berkowitz and Fernandez, respectively.
On March 3 the company reported its delayed year-end results: a loss of $36 million, an improvement over the previous year’s $130 million in red ink. Sheila McGrath, an analyst at Keefe, Bruyette & Woods in New York, noted that the fourth quarter had a meaningful pickup in residential activity and lauded the company’s focus on commercial real estate opportunities. Later that month, St. Joe appointed a new chief operating officer, Park Brady, former chief executive of vacation-rental company ResortQuest International. By the end of April, shares had recovered to $26.
McGrath now has a price target of $33, below her calculation of $41 in net asset value for the real estate. “For investors to focus beyond that discount valuation, St. Joe needs to mitigate the cash burn,” she says. “While they did cut expenses, it wasn’t enough given the severity and duration of the economic downturn. There is more of a sense of urgency now, and more focus on recurring revenues.”
Berkowitz’s bet is that once the real estate market recovers, St. Joe’s business will rebound, helped by new management, and that the risks of waiting are low because the company has more than $200 million in cash. At the same time, he hopes to bring more economic development to northwest Florida, which has been largely reliant on tourism and the military — perhaps even turning the area around the airport into a new “international city,” in which manufacturers could get tax breaks for setting up in an economic zone. “If it’s six months, a year or 18 months, it doesn’t matter,” Berkowitz says. “Normally at Fairholme, we don’t talk about how much we’re going to make but about how much we might lose. Given our position in St. Joe, I don’t see how we can hurt ourselves.”
But Berkowitz and Fernandez’s vision for St. Joe is much bigger than that. As an asset manager in its own right, St. Joe, which has owned everything from railroads to banks, would give Fairholme a way to play corporate restructurings and do private investments that would not be permitted directly under securities laws regulating mutual funds. Because Fairholme is set up as a mutual fund rather than a hedge fund, it faces restrictions on owning real estate or other illiquid assets — a potential disadvantage for a mutual fund going up against hedge funds as restructurings become more important. But if St. Joe owned it, they could. “We could own a company whose shares are liquid that owns illiquid assets,” Berkowitz says.
Like a mini–Berkshire Hathaway?
“It could be,” Berkowitz says. “That’s an interesting way of describing it. Except the shareholders of Fairholme will benefit, as opposed to Charlie and myself directly. We’ll benefit through our participation in the fund.”
Although St. Joe currently represents less than 3 percent of Fairholme’s assets, Berkowitz hopes to make it a more significant holding. “Our game plan will be to make it a bigger part of the portfolio,” he says. “We’re not wasting our time or our shareholders’ or partners’ time. I hope one day St. Joe is our largest position.”
St. Joe, however, is just one piece of the Fairholme strategy. Berkowitz and Fernandez have been looking east: Over the past year they have flown to Asia four times, using Goldman Sachs to get introductions to sovereign wealth funds and business luminaries in China, Hong Kong, Indonesia, Singapore and South Korea.
For many years, Asia has lured growth investors with its promise of a huge and increasing middle class. Value investors, however, have until recently been less interested, as betting on this growth often meant paying up for it. Now even Buffett is traveling to Asia in search of new investment opportunities. Berkowitz dubs his latest thinking “the bridge” — meaning the connection between the U.S. and Asia — and he’s looking for ways to capitalize on it.
He started with what he knew: insurance. When AIG spun off AIA Group, its Asian life insurance unit, last fall in a highly anticipated and oversubscribed initial public offering on the Hong Kong Stock Exchange, Fairholme put in an order for $1 billion worth of stock. It’s unusual for a value manager to invest in an IPO, but the business was one that Berkowitz understood well. AIA had been considered one of the crown jewels of AIG, and it was being spun off to raise money to repay the U.S. government. Berkowitz jumped at the chance to get in on life insurance in Asia, a way to play the emerging middle class. “You can’t ignore what’s going on in Asia,” he says. “The market is so underserved.”
One thing led to another. When Carlyle Group sold its shares in China Pacific Insurance (Group) Co. late last year, Fairholme bought $700 million worth. “I have studied insurance companies for 30 years, and this one is right up there with Berkshire Hathaway,” Berkowitz says. China Pacific Insurance chairman Gao Guofu — whom Berkowitz and Fernandez had first met at a dinner in Hong Kong — flew from Shanghai to Miami with a team of 15 executives to give them a full presentation.
Berkowitz expects that other Asian investments will follow, though he’s mum on what or when. “There’s a lot of money in Asia, and a lot of clout there,” says Kevin McDevitt, who follows Fairholme for Morningstar, which gives it its highest five-star rating. “I think he just wants access to the information flow that comes from Asia and to be more tied in there.”
The fund’s $4 billion cash hoard gives Berkowitz and Fernandez the ability to invest quickly in any situation — as Buffett has long been able to do — whether in Asia or in overleveraged companies closer to home. “Cash is valuable when other people don’t have it, and it makes the phone ring,” Fernandez says.
At the same time, the cash buffers Fairholme against a liquidity crisis should it stumble and find itself with a large number of investors simultaneously rushing for the exits. Many managers didn’t have such a safety net in the financial crisis and were forced to sell positions at a loss to cover redemptions. “We were very lucky in 2008,” Berkowitz says. “But if something bad happens in the world and people need money, we have to be prepared to give them liquidity.”
For a value manager, especially for one as concentrated as Berkowitz, there are going to be good years and bad. There are few investors who can consistently beat the market, no matter what the strategy. But academic research shows that focused portfolios may outperform — and that’s the arena where Berkowitz wants to play. “Charlie Munger once said, ‘You don’t need too many ideas to do well,’ ” he notes. “It can’t be more complex than that. There’s only two of us.”

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Lunch is for wimps
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