Monday, October 7, 2013

The Well Worn Path Where Success Spawns Disappointment: Fairholme Fund

The Well Worn Path Where Success Spawns Disappointment: Fairholme Fund

Bruce Berkowitz has generated an enviable track record as the portfolio manager for the Fairholme Fund, which he started in 1999.  Like other successful managers before him, Mr. Berkowitz has invested in a small group of stocks while generating relatively low turnover.  In other words, he makes big bets and tends to stick with them.    About 10 years ago, Fairholme began to garner attention as assets jumped from $235 million to $1.4 billion between 2004 and 2005. The cash kept flowing in until the fund reached $16.8 billion in 2010.  When Mr. Berkowitz stumbled in 2011, fund holders redeemed in droves, and Fairholme’s assets dropped to $8 billion.  The fund’s performance and assets have come back in the last two years.
Deal Economics (2009)
Mr. Berkowitz’s story seems to be a recurring pattern in money management.  John Rogers of Ariel Capital, Tom Marsico at Janus and then his own firm, and Bill Miller at Legg Mason quickly come to mind as managers who soared and swooned on a wave of mutual fund money.   Their early successes attracted huge fund flows, which inevitably hit a rough patch, and investors departed en masse.

Having rebounded, Mr. Berkowitz is now launching a hedge fund, which Mr. Berkowitz told The Wall Street Journal, “would have the ability to make investments that I could not make in the mutual fund, or larger investments that would not be possible.[1]  It’s hard to see how Mr. Berkowitz could make even larger investments than those found in the mutual fund.  89% of the portfolio is represented by the top 10 holdings,[2] and 75% of the portfolio is invested in the financial sector.

The hedge fund has an interesting fee structure.  Mr. Berkowitz won’t charge a management fee.  However, the profit sharing or carried interest will vary depending on how long investors opt to lock up their money.  Those investors willing to lock up their money for five years would share 15% of the profits with Mr. Berkowitz, while those opting for a three-year or one-year lock up would share 20% and 25% of the profits with him.  This is a sensible strategy from Mr. Berkowitz’s point of view.  His business is already generating ample revenue from the 1% fee he charges for the mutual fund (over $80 million based on current assets), so he doesn’t need any money to cover his research expenses.  And to the extent he holds securities in the hedge fund for more than a year, his percentage of the profits would generate capital gains instead of ordinary income.  If he can raise a billion or so in hedge fund assets, it’s a big win for Mr. Berkowitz. 

As an active management skeptic, I wouldn’t be inclined to invest with Mr. Berkowitz in any event.  However, there are two aspects of Mr. Berkowitz’s business that raise particular concern for me.  First, it appears that Mr. Berkowitz will be pursuing very similar strategies for the mutual fund and the hedge fund.  He says that when a stock could be held in either portfolio, it will be randomly assigned to the mutual fund or the hedge fund, according to the article in the WSJ.  If I’m hiring a money manager, I don’t want ideas to wind up in my portfolio by chance.  I’d like to know that a manager’s best ideas are being selected on my behalf.

Second, Mr. Berkowitz has become increasingly active in the companies he owns in his portfolios.  Obviously, there’s nothing wrong with shareholder activism.  However, Mr. Berkowitz has gone as far as becoming the chairman of the board of St Joe Company, a troubled real estate developer and landowner in Florida.    In my view, Mr. Berkowitz runs the real risk of having conflicting duties between his roles as portfolio manager for the mutual fund and chairman of St Joe.   As chairman of St Joe, he has to weigh the interests of a varied group of stakeholders, not just the shareholders.  As a portfolio manager, his primary duty is to his investors.   While St Joe only represents 6% of Fairholme’s holdings[3], Fairholme owns 27% of the St. Joe’s stock[4].  As a mutual fund investor, I’m not sure I’d want a portfolio manager, no matter how savvy, navigating these tricky waters.

Clearly, Mr. Berkowitz has become fabulously rich from picking stocks, and he’s intent on getting richer yet.  However as his wealth and ego grow, his investors ought to grow ever more cautious.

[3] Ibid at page 5

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