The portfolio managers at the Fairholme Fund don't rattle easily. Good thing, since on a recent morning they were greeted not just with the news that their second-largest position, MCI (MCI), was to be acquired by Verizon Communications (VZ) at what they consider a "disappointing" price but also with SBC Communications' (SBC) announcement that it planned to pull a big chunk of business from a subsidiary of Leucadia National (LUK), a diversified holding company in which Fairholme also has a big stake. MCI and Leucadia make up 30% of the fund.
Highly concentrated positions are a hallmark of the $300 million Fairholme Fund, which holds 17 stocks and recently celebrated its five-year anniversary. The strategy has been successful so far: The value-oriented no-load fund has racked up an 18.9% annualized return since its Dec. 29, 1999, inception, blowing away the -2.3% annualized return of the Standard & Poor's 500-stock index over that period. Its worst year was 2003, when it lost 1.6%. Naturally, Fairholme's ratings are top drawer. BusinessWeek rates it A, the top grade for risk-adjusted returns, when compared with all other equity funds and with funds in the all-cap category.
If Fairholme's telecom holdings are volatile, the No. 1 holding is a rock: Warren Buffett's Berkshire Hathaway (BRK) accounts for almost 19% of the fund and was one of the first stocks the fund bought. Managers Bruce Berkowitz and Larry Pitkowsky, along with analyst Keith Trauner, are fans of Buffett and stress the importance of managements of high integrity that treat shareholders as partners and own a good chunk of company stock. Like Buffett, Fairholme's managers follow the principles of legendary value investor Benjamin Graham, keying in on a company's assets and cash-generating ability.
Their intense analysis of cash flow played a big part in Fairholme's purchase of defaulted WorldCom debt in the summer of 2003, which evolved into Fairholme's MCI equity stake. "We knew from the cash they generated during the most difficult of times -- bankruptcy, scandal, being in the doghouse with the government -- that it could survive," says Berkowitz.
The firm also acquired a telecom stake by buying the defaulted debt of WilTel Communications Group in 2002. In 2003, Leucadia, already a large Fairholme holding and a major holder of WilTel debt, acquired all of WilTel. The recent news that SBC plans to end its long-term alliance with WilTel sent Leucadia stock down 6.3% in three days. Fund co-manager Pitkowsky maintains that predictions of WilTel's demise are too pessimistic and that if SBC ends its contract there will be "a reasonable settlement."
Fairholme's bottom-fishing during the telecom bust has left the fund with a large exposure to a now-hot sector. "They're going to places where sometimes current prospects look pretty miserable," notes Morningstar analyst Dan McNeela, an admirer of the fund. In the fund's first year, Berkowitz passed on the dot-com craze. And what exciting field did he choose to buy into instead? Property and casualty insurance. His unwillingness to jump into tech led $100 million to leave the fund's parent, Fairholme Capital, but holdings such as Berkshire Hathaway, Mercury General (MCY), and White Mountains Insurance Group (WTM) gave the fund a 46.5% gain for 2000. Berkowitz continued to buy P&C insurers after September 11. The fund's holdings have largely escaped the recent insurance-industry scandals.
Berkowitz' ties to the insurance industry run deep. Last year, White Mountains Insurance invited him to join its board. Yes, says Berkowitz, that presents a conflict, since he's restricted as to when he can buy or sell the stock. But he says the exposure he gets to top minds in the industry benefits his shareholders. Closer to home, he can brainstorm with a savvy investor by walking down the hall of his Short Hills (N.J.) office building -- to the offices of the Mutual Series funds and his buddy, David Winters, a top-notch investor in distressed securities.
Energy is another key sector, and the managers have unearthed opportunities in Canada. "We found a few companies that generate huge amounts of cash and are run by good people," says Berkowitz. Fairholme bought Penn West Petroleum and Canadian Oil Sands Trust at depressed prices, before the market recognized their potential.
Besides getting a good deal when they invest, the Fairholme managers try to give shareholders good value for their money. The fund's expense ratio is 1%; the peer-group average is 1.43%. Berkowitz says the fund could attract more money if it paid distribution fees to brokers, but it won't, because that would increase costs for shareholders.
Fairholme trades infrequently, preferring a long-term relationship with its holdings, but the managers are not passive. They've been vocal in the battle for MCI, arguing that the bids are too low. "We'll strive to ensure that any acquirer pays a fair price," says Berkowitz. By working hard for his shareholders, he hopes they will stick around for the long term, too.
By Suzanne Woolley