The following is excerpted from the July issue of the No-Load Fund Analyst newsletter published by The Litman Gregory Cos.
Manager Bruce Berkowitz hasn't made many changes to the Fair-holme Fund in the past year.
The fund continues to be heavily concentrated in several large positions, including American International Group Inc. (AIG) and Sears Holdings Corp. (SHLD), which accounted for 38% and 11% of the fund, respectively, as of June 30. Bank of America Corp. (BAC) and General Growth Properties Inc. (GGP) accounted for another 9% and 7%, respectively.
Most of these stocks suffered severe declines last year, causing the fund to underperform the market and its peers significantly. But those same companies also have caused the fund's significant outperformance so far this year.
Through August, the Fairholme Fund gained 30.1%, versus 13.5% for the S&P 500.
We recently spoke with Mr. Berkowitz to get an update on the fund's large bets on certain financial companies and real estate. The real estate bet covers multiple holdings, including General Growth Properties Inc., Sears and The St. Joe Co. (JOE).
Referring generally to the broad portfolio, Mr. Berkowitz said: “We've had two years of improving businesses, with most companies im-proving book values.”
Despite the fund's impressive performance this year, he thinks that the holdings are still selling at very attractive discounts to their respective liquidation values — and he is “waiting right now for others to agree.”
Although Mr. Berkowitz said that his companies' share prices had a horrible year in 2011, “if you look at the fundamental business statistics of our companies, they improved dramatically.”
STILL A MONEY MAKER
AIG, the fund's largest holding, is a good example. Last year, AIG was a major detractor from the fund's performance as the stock declined nearly 60%.
However, for this year through August, this stock gained nearly 50%.
Despite the massive stock price volatility, the company's tangible book value had grown more than 30% year-over-year as of June 30, and Mr. Berkowitz noted that all of AIG's businesses are making money.
He believes that AIG's management has done a good job running the company, allocating capital, understanding where it can improve and which businesses can be cut out.
Mr. Berkowitz thinks that AIG is “just scratching the surface” of what it can do to improve profits and reduce expenses.
As he puts it, management at AIG is “making the right moves.”
Mr. Berkowitz estimates that AIG will generate $5 or $6 a share in cash on a forward basis and that an additional $15 billion to $20 billion more in assets could be sold. The stock is trading in the low to mid-30s, which is about half of book value, so a large portion of the proceeds from asset sales could be used to buy back stock at 50 cents on the dollar.
With continued reasonable capital allocation, Mr. Berkowitz sees AIG as potentially having a book value in excess of $70 a share next year.
Given the current buyback process, he said, “AIG could be done with the government by the end of the first quarter of next year, which is three years ahead of schedule.”
Mr. Berkowitz thinks that investors won't return to the stock until the Treasury's remaining ownership is close to zero, at which point he thinks that the stock price should appreciate and converge with book value. (Last month, the Treasury Department sold $2.7 billion of AIG shares, cutting its stake to about 16 percent.)
This doesn't include any expectation of the stock's returning to a mid-single-digit multiple of book value, a level at which the company has traded at in the past.
As for figuring out whether investors will return to the company after the government is completely out or before that, Mr. Berkowitz said: “I don't know. I've never been good at that ... All I know is that we've got something that's worth over $60 today, and it's going to be worth over $70 sometime next year, in my opinion, and I can't see how price doesn't eventually meet book value.”
We also discussed the fund's large real estate bet, including Mr. Berkowitz's meaningful stake in Sears. He owns about 15% of the company's outstanding shares and is the second-largest shareholder behind Sears chairman Eddie Lampert, who owns 65% of the company's shares.
This year, the stock was up nearly 90% through August after declining 57% last year. Through the properties it owns, Sears is one of the largest corporate real estate organizations in the world, with more than 250 million square feet of retail space.
Although Mr. Berkowitz has always thought that there is a decent chance that Mr. Lampert will be able to turn around the struggling retailer, the fund manager continues to emphasize his analysis of the liquidation value of the company — the value if the retailer was shuttered and the assets were sold off.
“Any way you slice and dice it, the real estate is worth multiples of the stock price,” Mr. Berkowitz said.
Recent real estate transactions in which the company liquidated some of its stores for a significant profit support his numbers, he said.
“Whoever heard of that?” Mr. Berkowitz asked. “Liquidating stores for a significant profit?”
Sears has more than $20 billion in assets on its balance sheet, but according to Mr. Berkowitz, the fair values of those assets aren't reflected, due to generally accepted accounting principles.
In other words, he thinks that Sears' real estate portfolio is being significantly understated because accounting rules require that real estate be carried on the books at the lower of cost or market value.100 MILLION KENMORES
To illustrate the flaw of the approach, Mr. Berkowitz said, “If the Dutch still owned Manhattan, GAAP would mandate the $27 or $28 price to value the entire island.”
Even though he thinks that Sears' real estate is worth multiples of the stock price, he also thinks that the inventory is worth the price of the stock.
Mr. Berkowitz said that there is still value in the brands owned by Sears. “There are 100 million households that have a Kenmore appliance,” he noted.
Sears also has the largest home delivery and appliance repair service, conducting somewhere between 8 million and 10 million home visits per year.
The company also owns Craftsman, DieHard, Kmart, Lands End and Sears Canada, in addition to Sears auto centers and others.
The underlying value of these brands and their inventory is Mr. Berkowitz's “margin of safety,” though he noted that Mr. Lampert is making a dramatic effort to turn around the retail operations.
In just the past few quarters, Mr. Lampert has brought in new management from other companies.
“The last quarter, [the company] shocked everyone and made money,” Mr. Berkowitz said.
“[Mr. Lampert] is going to try to make a go of it, and if he doesn't make a go of it, he's going to slowly sell the real estate. So I just don't see how we lose there,” Mr. Berkowitz said.
Another holding in the fund that was a topic of discussion was St. Joe. Mr. Berkowitz is chairman of the company and plays an activist role. He remains its largest shareholder, owning almost 30%. Year-to-date, St. Joe's stock is up about 30%.
Mr. Berkowitz said that St. Joe's most recent quarterly report speaks for itself.
The company's balance sheet has been shored up, with real estate assets being marked down to reflect management's flexibility to make decisions about whether and how to develop some of the properties.
Mr. Berkowitz also said that the company's cost structure has been reduced to a minimal sustainable level.
As the property market continues to improve, particularly in Florida, where the company's properties are located, St. Joe has options, he said.
For example, Mr. Berkowitz said that the company has lots of land that could be developed to meet the demands of aging baby boomers, who may find Florida appealing for climate and tax reasons.
With the company's now-strong balance sheet, he said that the firm can maintain its much-lower cost structure without having to sell assets at distressed prices. That allows the new management team and board to be patient and “smart” about executing on development plans.
