Berkowitz Sticks to Time Tested Principles

Published on September 30, 2009

In a conference call this afternoon, Bruce Berkowitz answered a number of shareholder questions regarding The Fairholme Fund, the state of the overall stock market, and prospects for health care reform.  Mr. Berkowitz’s record at The Fairholme Fund since its inception on December 29, 1999 has been nothing short of extraordinary.  Based on the fund’s semi-annual report dated June 30, 2009, annualized performance since inception has been a gain of over 12% annualized compared to a loss of over 3% annualized for the S&P 500.

This article documents some of the notes that I took during the call and are not necessarily direct quotations.  This is not a comprehensive transcript of the event, but focused on areas that I found particularly interesting.  A replay of the conference call should be available on The Fairholme Fund’s website in the near future.

Disclaimer:  I took notes quickly and while I believe the content of this post to be accurate, it is possible that some errors were made.

Update:  Fairholme Funds has posted a transcript of the September 30, Conference call.  Click on this link for the transcript (PDF).

Due Diligence Process

Here are some of Mr. Berkowitz’s comments in response to a shareholder question regarding how he goes about performing due diligence on prospective investments:

  • Review all securities in the capital structure of a company rather than just the common stock.  Common stock should be viewed as the most junior “bond” in a company’s capital structure.  The free cash flow generated by the business is akin to a coupon without a maturity date.  Count the cash after all bills, interest on senior securities, and maintenance capital expenditures.  The free cash flow can then be compared to market prices to come up with free cash flow yields.
  • Fairholme reviews SEC reports, company conference calls, presentations, and other sources when researching an investment.  It is important to focus on every business element that requires management to exercise judgment.  Examine the accounting carefully and pay particular attention to pensions, health care liabilities, regulatory, and tax issues.  Management is “guilty until proven innocent” if there are inconsistencies between the balance sheet, income statement, and cash flow statements.  Be particularly wary of “kitchen sink” charges that could enter into the picture.
  • Examine whether a business model can exist without leverage.  Avoid having to rely on the “kindness of strangers” whenever possible.  Examine where the security being analyzed lies within the overall capital structure.
  • Examine whether managers are true owners rather than just option holders.  This test can be applied by determining whether an executive has actually purchased shares in the open market rather than only through option grants.  It is hard to make a good investment with bad people.  Examine their capital allocation decisions over time.
  • Try to “kill the investment idea”.  If you cannot kill the idea, then it should be compared to other investment candidates that have gone through the same research process as well as existing portfolio companies.  Fairholme focuses on fewer investments than most others in order to have superior understanding of the businesses.  They try to avoid growing their circle of competence too quickly if the risk is losing money.
  • Fairholme uses industry experts and consultants as part of the research process in order to contain costs by avoiding the need to retain such experts on payroll on a full time basis.

Health Care Reform

Many of The Fairholme Fund’s investments are concentrated within the health care sector.  A number of shareholders submitted questions asking about the impact of health care reform on the portfolio holdings.  Mr. Berkowitz turned this part of the call over to Charlie Fernandez.

  • The fund’s analysts and managers are following developments in health care reform on a daily basis.  The mission of the various reform proposals is to expand health coverage for 20 to 25 million Americans and will result in modifying insurance rules and changing rules for Medicare payments.  Mr. Fernandez expects that a bill will pass this year and should cost around $900 billion.  He noted that most reforms do not begin until 2013 and that the plans under discussion include ten years of revenues to pay for seven years of the program.
  • Medicaid expansion will result in opportunities for insurers while the key hospital groups and the pharmaceutical industry have already cut deals with President Obama.  Mr. Fernandez noted that hospitals will have lower bad debt expenses under the reform proposals and that part of the benefit will flow to pharmaceutical firms which typically have claw back agreements with hospitals related to bad debt expenses.  He expects that a 5% increase in revenues for pharmaceutical companies could result from lower bad debt expense for hospitals.
  • Pfizer is The Fairholme Fund’s largest holding and a number of shareholders submitted questions or concerns regarding the investment.  Mr. Fernandez believes that the Wyeth merger will close in Q4 and probably prior to Thanksgiving.  $6 billion in cost reductions are expected within 18 months.  Within one year of the merger, no product will represent more than 10% of profits, a statistic similar to Johnson & Johnson.  Pfizer is also expanding its presence in generics.  The company has growth from 13th to 8th place in the United States in generic drugs.  Fairholme believes that double digit free cash flow yields will accrue to buyers of Pfizer common stock at current market prices.

Other Comments

  • Inflation. Mr. Berkowitz believes that the best way to protect against inflation is to find companies with large and growing free cash flows which are either paid out or reinvested in the business at satisfactory rates of return.  Also, tangible assets will become more valuable if inflation accelerates which is one of the reasons behind the fund’s investment in St. Joe, a large real estate development company in Florida.
  • Sears Holdings. Mr. Berkowitz does not appear to be concerned with the factors discussed in a recent bearish article on Sears that appeared in Barrons.  He still believes that the value of the sum of the parts of Sears is worth more than the current stock price.  If Sears Chairman Eddie Lampert can turn around Sears and K Mart, the shares would be worth considerably more, but this is not central to the thesis.  If Sears Holdings stock price declines, more repurchases of shares are likely and this will benefit shareholders.  If the stock price goes up, shareholders also win.
  • Any Interest In Emerging Markets? Mr. Berkowitz believes that it is hard enough when you’re the home team and he doesn’t want to play “an away game” where he doesn’t know the rules.  There is plenty to do here in the United States.
  • Thoughts on Berkshire and Leucadia. Although a great deal of information is available on these investments, both can be considered “blind trusts”, but being an investor for decades makes it sort of like marriage.  Mr. Berkowitz fully respects the managers of both companies.  He previously sold shares of Berkshire due to the company’s size, age of management, and Warren Buffett’s statement that Berkshire cannot be expected to beat the S&P 500 by large margins.  However, now that Mr. Buffett has put a significant amount of cash to work at higher returns, Fairholme bought back some shares at the “excellent prices” offered earlier in the year.

Value investors would be wise to pay close attention to The Fairholme Fund’s holdings as well as future statements by Mr. Berkowitz.  While SEC filings are available for The Fairholme Fund’s holdings, makes it easy to monitor Mr. Berkowitz’s moves along with the activities of many other super-investors.  Investors should always do their own work on any idea, regardless of who is buying a stock.  However, there is no shame in using super-investors as idea sources and coat-tailing when it makes sense to do so.

Disclosure:  The author does not own shares of The Fairholme Fund or any of the other companies discussed in this post with the exception of Berkshire Hathaway.

Berkowitz Sticks to Time Tested Principles