Bruce Berkowitz of the Fairholme fund
Corrected on 03/03/08: An earlier version of this article incorrectly reported that the Fairholme fund was launched in 1997. While its parent company was founded in 1997, the fund was launched in 1999.
As manager of the $6.8 billion Fairholme fund, which he launched in 1999, Bruce Berkowitz is on the hunt for undervalued companies with strong managers and plenty of free cash. Rather than building a traditional, diversified portfolio, Miami-based Fairholme—named after a street Berkowitz once lived on—concentrates its resources on a limited number of positions, a strategy that has led to impressive returns. Fairholme boasts annualized returns of more than 20 percent over the past five years and has returned nearly 2 percent so far in 2008—despite the nasty market.
Berkowitz recently spoke with U.S. News about why diversification is overrated, how volatility is opportunity, and whether Sears Holdings can be the next Berkshire Hathaway. Excerpts:
What kind of fund is Fairholme?
It's a focused fund, nondiversified. That means when we find something we like, we buy a lot. Our top positions plus the cash—and we've averaged about 20 percent cash since we started—is between two thirds and three quarters of the fund.
How does this investment approach differ from others?
In business school, you're taught that diversification is very important. But really, when you think about it, diversification has to do more with ignorance. If you are highly confident in your top five positions, why should you put more in your 10th position if you could put more in your best idea? Secondly, business schools teach that risk is volatility. We think volatility is opportunity. For example, if you follow the business school formula, when something goes down 50 percent in price, it's considered riskier. Personally, I would say it's considered safer—you're paying half.
What opportunities has the recent market upheaval created?
The current turmoil is affecting, of course, the home builders, the suppliers to the home builders, the roofers, the wallboarders, the carpeting companies—and now it's affecting the purveyors of entertainment in one's home, from cable to satellite. So it's reverberating out.
What moves have you made to capitalize on this turmoil?
For example, a company like [satellite television provider] EchoStar Communications (now known as Dish Network). In the last couple of years, there was a perception that the satellite distributors of entertainment wouldn't be able to compete with the cable companies because the cable companies were offering the triple play—you've got the entertainment, you've got the fast cable broadband, you've got the telephone, all on one bill. But that was never true. People want the best service possible, and it doesn't all have to be on one bill. So EchoStar got down to a very low price.
But the company is run by a great guy who owns 50 percent of the company and against the odds built up 12½ million subscribers. And the company was at that point where it was starting to generate significant amounts of free cash, and it was being given away on the basis that there is no way they are going to be able to compete in the future. Now, it's come back down again, the idea being that if so many people are so stressed with their homes—facing the possibility that they are eventually going to be kicked out of their homes—well, obviously, how can they pay their satellite TV bill? [As such, Fairholme recently added to its position in the company.]
Why haven't you jumped into the foundering banking sector?
Our attention naturally goes to stressed areas, and we try and understand it. Now, today you have the banks and the insurers—very stressed. The problem, though, is we can't figure it out. We don't know the true assets and liabilities of these companies. I think some of the companies don't even know. I have a real problem getting hurt on an investment, and my only answer would be, "Well, it was impossible to know, so I had to guess."
What's another position you took amid turmoil?
We've taken a very large position in an HMO called WellCare Health Plans. WellCare is an HMO that provides managed-care services to the government, through Medicare and Medicaid, with 2.5 million members. In the last quarter of last year, its shares were trading between $100 and $120 per share. But then, 200 FBI agents raided the company [as part of an investigation into potential fraud]. So look at the fact sets. First of all, when you look at the history of unknown problems of health companies, they don't get shut down. Two things happen. One, top management is forced to leave; specific culprits pay the price. And two, the companies pay a fine. We knew that the company was going to live. We also knew that the company was vital; healthcare costs are out of control.
And then on top of that, the company had significant free cash flow, gets very high quality marks in service, and is still growing, still taking members. So here you go again, out of the doghouse. It's a company that is still growing, good quality, needed—essential to the health system of the United States—and that's it. And we went in, and we bought.
I see you have a big stake in Canadian Natural. What do you like about the company?
We love their people, we love their plan, and we love their assets. They have enough assets to triple their production over the next 15 years without having to buy another asset. This company is about to start up a project in the tar sands of Canada, and it has huge amounts of reserves in land and in places that are friendly to us: Canada. We're not talking about Antarctica or the deep, cold North Sea. We're not drilling down 5 miles. And you don't have to deal with people you wouldn't normally want to deal with. And basically, our thesis is that we are coming to the end of cheap oil. We have plenty of energy, but it's no longer cheap. And so it's going to require higher prices. So that was our thesis that we've had on Canadian Natural for a bunch of time, and it's worked out quite well.
One of your largest holdings, Sears, has seen its stock price fall by about half over the past year. Do you think Chairman Edward Lampert can turn things around?
I think that he's going to do it. And it's very reminiscent of what happened with Warren Buffett and Berkshire Hathaway in the early days. If you play back the tape, Warren Buffett bought into Berkshire Hathaway, a textile mill, and he took many years to try and turn it around. He had deep respect for the employees; he really gave it his best shot. And then when he realized it wouldn't work, he then started to redeploy the assets and the free cash that was coming out of this industry that was destined to die. And that's how Berkshire Hathaway started.
Sears is the same situation. Sears has a great real-estate portfolio, and people are behaving as if it can only be used as retail space. And they have brands; some of them are quite good. The company has over $50 billion of revenue and is making money, and people are acting as if it's a company that's bleeding to death. People aren't looking at it in the right way. They are measuring it based as a retailer, and they are measuring it based on short-term net income profitability. But there are many more dimensions to Sears. Real estate can have a higher and best use. Today's anchor to a mall can be tomorrow's multipurpose, multiuse building where you can have office buildings, retail, and residential spaces.
Of course, the best thing that could happen would be that he turns around Sears and Kmart and it's a grand-slam home run. The worst thing that happens is he gives it his best shot and starts to find higher and better uses for all of the assets, from land to trademarks to online. If you can see three or four different ways where you can make an awful lot of money with a guy who has a record of making an awful lot of money, it's not such a bad thing.
