How Fairholme Is Breaking Wall Street’s Rules

By Brett Arends (WSJ)

How is Bruce Berkowitz making your mutual fund managers look bad? Easy. By doing all the things they say can’t be done. Most fund companies say you can’t time the market. He has. They say you shouldn’t hold lots of cash in an equity fund. He does. They say you mustn’t put too much money into a few stocks. He does that, too.

No doubt the time will come when Mr. Berkowitz, too, trips up. But so far, in its first decade, his Fairholme Fund has put most of Wall Street to shame. Fairholme has made an average annual return of about 13%, says Lipper, inc.. That’s turned an initial investment of $10,000 into about $35,000. It’s the top fund of the past decade. Over the same period, the Standard & Poor’s 500 Index has lost money. So far this year, Fairholme is up another 10%. The S&P 500: About 2%.

And the word is out. Fairholme is this year’s fastest-selling domestic equity fund, says Morningstar. Financial Research Corp., which tracks the industry, estimates investors have poured about $3 billion into the fund so far this year, raising its total assets to nearly $15 billion. The rest of Wall Street? Over the same period, U.S. investors have actually yanked billions from other stock funds.

They’ve given up on Wall Street as usual.

It is a double irony that Mr. Berkowitz happened to launch Fairholme in 1999, near the peak of the big 1990s bubble. That was the high water mark of two myths: That stocks ‘always outperform,’ and that you can’t possibly beat the market, so you should stop trying and just give in to index funds. The decade since has buried both of those myths. And Mr. Berkowitz, and his investors, have been dancing on their graves.

How has he done it? Morningstar analyst Mike Breen explains that Mr. Berkowitz–like another famous contrarian investor, Warren Buffett–likes to take big bets on a few names he feels strongly about. He puts those names through tough stress tests–”he tries to kill the company,” as Mr. Breen puts it–before buying. (Mr. Berkowitz could not be reached for comment.) Unlike Mr. Buffett, he’s willing to switch around a lot. With remarkable timing, he jumped out of energy stocks near the peak two years ago, hunkered down in defensives for much of the crash, and bought financials last year. “He’s reinvented the portfolio three or four times,” says Mr. Breen.

It’s tempting to say Mr. Berkowitz has been very lucky. The timing of some of his market moves has certainly suggested a charmed life. After all, with many investors trying to outperform, inevitably some must succeed. Fred Schwed, in the Wall Street classic “Where Are The Customers’ Yachts,” notes that if you held a big coin-flipping contest someone would emerge as the victor–at which point they would doubtless be hailed for their coin-flipping genius.

But it’s not just luck. A recent study (“Best Ideas”) by Randolph Cohen at the Harvard Business School, Christopher Polk at the London School of Economics, and Bernhard Silli at Goldman Sachs, found evidence that backs up Mr. Berkowitz’s strategy of taking bigger bets on fewer names–and goes very much against the conventional wisdom pushed by the fund companies (and their marketing departments). In a nutshell: Good fund managers can indeed pick the right stocks. Their highest conviction “best ideas” stocks, often their top holdings, have a good chance of outperforming.

The problem is that the fund industry makes managers pack out the rest of their portfolio with rubbish, so their funds look like everyone else’s and can be marketed more easily.

Right now Fairholme’s portfolio looks all wrong–at least according to the conventional wisdom. Mr. Berkowitz has nearly two-thirds of the money in just 10 stocks. Most of those are names that sound incredibly “high risk” to mainstream investors. Many are battered financials. The top names include AIG, Citigroup, Bank of America, bond insurer MBIA, bankrupt mall-owner General Growth Properties, and Florida real estate stock The St. Joe Co. And he holds 15% of the fund in cash.

Whether he’s proven right or wrong on these bets, obviously, remains to be seen. The stocks may well seem highly risky. But Mr. Berkowitz bought them by going against the crowd. And clearly he believes he got them so cheaply that the likely gains outweigh any likely losses. In several cases, he’s enjoyed an extra bonus. Some of these stocks, such as Citigroup, had been aggressively sold short by speculators who were betting they would fall further. When Mr. Berkowitz and his fund began buying, that pushed the price up–and doubtless subjected some speculators to a squeeze. If those speculators were then forced to buy back stock to cover their bets, that would have driven the stock up even further. A double win.

The results are hard to quantify. But even if that has helped Fairholme recently it’s not a sustainable game. Where does this leave investors? Is Mr. Berkowitz the promised savior? Or is he taking crazy risks with your money? The answer is: Maybe neither. Mr. Berkowitz is an excellent investor, but he has not discovered the Holy Grail. None exists. He will probably make a blunder at some point. Human beings have that tendency. In a concentrated portfolio that will have a big effect. Investors found this out the hard way in the case of the last “super investors” who were thought to walk on water–such as Ken Heebner (at CGM Focus), Bill Nygren (at Oakmark) and Bill Miller (at Legg Mason Value). Each had a terrific run of outperformance, and then fell flat on his face. Investors who had rushed into the fund during the good times, thinking they had found the only fund they ever needed, then dumped it again.

Bottom line? Anyone investing in Fairholme needs to understand what they own. Be prepared for the possibility of a roller coaster. Fairholme is a good fund to own, but only as one part of a portfolio. Nobody has all the answers.