Bruce Berkowitz isn’t the kind of manager whose moves make headlines, but they’ve paid off remarkably well for his investors.
Berkowitz, who has headed Fairholme Capital Management since the company was founded in 1999, entered the past decade buying stocks, like Jefferies Group, while the rest of the world was reveling in dot-com wealth. But after ten years, and only a few million dollar investment, Fairholme has grown to an $11.2 billion fund.
“The bottom line is he has been an exceptional stock picker,” said Karen Dolan, the director of mutual fund analysis at Morningstar [MORN].
Berkowitz’s strategy is simple. He looks for companies with strong cash flow at low prices, setting him apart from the standard “price to earnings” approach. It also makes him a contrarian investor, but only by default.
“We want to buy a company where we think we’re getting double digit cash flow yields,” said Berkowitz, Morningstar’s Domestic-Stock Fund Manager of the Decade. “If we’re right we’ll do quite well, and if we’re wrong hopefully we bought with enough margin safety where we won’t get hurt.”
Cash flows, as Berkowitz sees it, are the end result, the final product. “Companies need cash to run and survive, and with that they have a choice to pay out a dividend, profitably grow their business, or make an acquisition.”
His strategy may be simple, but its execution is difficult. Berkowitz does it with a lot of cash on his part, skirting the leveraged purchased, which has enabled him to avoid volatility-related problems. “It gives us liquidity and flexibility that hasn’t hurt our performance yet,” Berkowitz said.
He quipped that during an economic crisis cash is like Xanax. “People that have it are calm, and people who don’t, have to sell to get that calm, and that brings about the bargains.”
His average cash position through the last decade was 18.3%, while his position as of August 31 was 22.4%, far more than in most funds. “It’s an absolute cushion he’s looking for, but his picks have been strong enough to where the cash hasn’t held him back,” Dolan said.
Looking back at the decade it’s easy to see why Berkowitz made his investment decisions. However, it’s not so easy to have the strength of character and tenacity to say one thing while the rest of Wall Street is saying something else. Berkowitz isn’t just extra confident though. “He knows as much, if not more, about his companies than its own insiders,” Dolan said.
“It’s much easier to come up with a scenario on how to make a lot of money, but it’s better to look at how an investment is going to be bad,” Berkowitz said. “We spend most of our time quantifying the downside. When you’ve worked everyday of your life for the last 30 years, there’s a lot of pressure on you not to lose. It’s easier to handle a bunch of people out there making more money or doing better than you do than it is to lose your 30 years of hard work.”
Berkowitz is also emphatic about the support he receives from Fairholme’s investors, of which he is the largest.
“One of the reasons for our success is we have great shareholders,” Berkowitz said.
This isn’t an empty remark from a fund manager. Over the past few years, a lot of good fund managers have lost capital due to shareholders leaving them, while Fairholme has been able to hold on to theirs.
“It’s important to attract the right shareholders for the fund,” Berkowitz said, that’s why the fund charges a 2% penalty if an investors pulls out after the first two months in order to dissuade traders and market timers.
Over the past decade Fairholme earned a 13.2% 10-year annualized total return through Dec. 31, 2009, according to Morningstar, beating the S&P 500 by 14 percentage points. The trick now is to maintain those strong numbers with a larger fund, and Fairholme’s strategy will have to shift as smaller companies becoming increasingly less effective.
Berkowitz said that the fund’s size has helped in may ways, at least in a difficult market environment when there’s plenty to do, but that will change when things start going well again. “That’s when we’re going to have to start thinking about shutting down the fund,” he said, “if I don’t realize first that the fund is too big, I promise you I’ll hear it from our shareholders.”
Looking forward Berkowitz expects “more of the same” in the next ten years. “There’s an inability to predict the future, but you can expect bouts of fear and greed, probably at least one low frequency, high severity event—natural or manmade, and lots of high frequency, low severity bumps in the road,” Berkorwitz said.
Berkowitz added that an investor can approach the future in two ways. He can try to predict it or time it, or he can react and price it, which gets into his investment process. “We tend to look at stressed sectors, industries, markets and from there see if there’s anything interesting,” he said. “When everyone is optimistic about something, you pay a price for that optimism.”