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Excerpts
from “Bruce Berkowitz Stays in the Sunshine”
By Joshua Lipton, August 14, 2008
» | Bruce Berkowitz must be disappointed that
the current Olympic Games program doesn’t include professional
money management in the competition. If it did, the veteran
stock picker’s neck would be weighted down with gold right now.
Berkowitz is the CEO of Fairholme Capital Management in
Miami, which oversees about $9 billion,
most of it in the value-oriented no-load Fairholme Fund
(FAIRX), of which Berkowitz himself is lead
manager.
Question: This has been an obviously volatile,
frustrating market for investors. How do you see the
market behaving for the rest of 2008 and into 2009?
Berkowitz: There are two ways you can
invest: You can try to predict or you can react. We react.
We
look for stressed situations and buy if appropriate.
I hope that the market stays weak and tough and that it
doesn’t go up much. In the last eight years the
market has done nothing, and we are up 300%. This is our
kind of environment.
Some companies have been destroyed, such as Sears, which
is a big position of ours. It is a huge
opportunity. It is so cheap. Everyone thinks that Sears
will be worthless; meanwhile, the store
generates $50 billion in revenue, significant free cash
flow and has tremendous assets. So the fear, or
the prediction of the death of the consumer, has allowed
us to react and buy a retailer like this one.
Question: What is your strategy for the
fund? If I was to build a stock screen like Bruce Berkowitz,
what would it look like?
Berkowitz: We start with the basics: The
only thing you can spend is cash. We want companies that generate significant cash in most times. That is how we
start. We don’t care much about what they
make, but we have to understand it. The balance sheet has
to be strong; we want to make sure there are
no tricks in the accounting. Then we try to kill the company.
We think of all the ways the company can
die, whether it’s stupid management or overleveraged
balance sheets. If we can’t figure out a way to
kill the company, and its generating good cash even in
difficult times, then you have the beginning of a
good investment.
Question: So strong cash flows, solid
assets and experienced, talented managers? Warren Buffett
must
be proud.
Berkowitz: Right, he learned from Benjamin Graham. And
others have learned from him. It’s a simple
formula and it works.
Note: Many of Mr. Berkowitz’s recent purchases are
in health care. Mr. Berkowitz is an expert in
numerous aspects of this industry, including its long-term
projected growth, how different changes that
may be imposed by the government will affect different
stocks, and which stocks will most benefit by
future changes in our health care delivery system, etc.
His breadth of knowledge is impressive, and he
is currently purchasing the stock of dominant companies
in this sector – at very low prices.
The article
then went on to discuss two new stock picks, as well as
his view of the financial stocks:
Question: The fund has added significant investments in
housing-related industries. Let’s talk about
some of your holdings in this space… You like Mohawk
Industries, which manufactures flooring
products.
Berkowitz: It’s run by a great guy.
(The CEO is Jeff Lorberbaum.) They are well diversified
between
hardwood floors, tiles, carpets. They have made a good
push in Europe. What is amazing is that, for a
difficult period of time, Mohawk is still generating a
tremendous amount of free cash. So, you have a
great manager that knows how to react when times get tough.
He will come out of this with a great
balance sheet, still making money during this entire period,
and will be stronger and better than ever.
Question: The stock is down 20% in the
past year. One worry here is that customers will move to cheaper, lower quality products.
Berkowitz: Does it concern me? Yes. Does
it make sense that people will do that? Yes. Business is
not
a smooth process. It’s bumpy. You have to expect
these periods. The price of the stock, in my opinion,
already reflects that. You know, the greatest company in
the world at too high a price is nothing more
than a speculation. Another company, whose prospects are
looking a bit negative for the next year or
two, at the right price, is a great investment.
Question: You’ve avoided most banks and brokers.
Not much interest in bottom fishing here?
Berkowitz: Well, we didn’t know
how to. It is impossible to know what they own and who
they owed.
Let me give you an example: a collateralized debt obligation
squared. In order to understand that one
security, you would have to read hundreds of thousands
of pages of documents to get at the underlying
assets. These products that have been made are so complex,
they are impossible to understand. I almost
think they were done so you could not understand them.
Then, when you are doing swaps and
derivatives with counter-parties, you don’t know
who you are dealing with anymore. Maybe you think
you are dealing with the best. But you don’t know
who the best has been dealing with in terms of their
counter party risk.
Note: I began to study these types of (mostly mortgage-backed)
securities three to four years ago.
Hedge funds and the major banks and brokerage firms were
using them to, theoretically, control risk
while increasing returns. And they were doing them in astoundingly
large amounts.
Over three years
ago Warren Buffett was asked what he thought of this activity,
and he said, “I don’t really understand
all these instruments, but it will end badly.” These
securitized debt obligations got so complicated and
popular that nobody knew what they really had. Before essentially
going out of business, it was
reported that Bear Stearns had 750,000 of these contracts!
It is important to note that both Mr. Buffett
and Mr. Berkowitz not only first saw these huge problems
coming to our financial institutions three
years before the problems manifested, but they also knew
precisely how and where the huge holes in
these institutions were being created through their mismanagement
of risk. Of course, Warren Buffett
is the greatest expert in the world on catastrophic risk
control, and he is the most knowledgeable bank
investor in the country. Put those two together, and it’s
not surprising he knew what was coming.
I am a little surprised that I also saw the problems coming
from these collateralized debt obligations– a
few weeks before I heard Warren Buffett talking about them!
But I would have been shocked had
Bruce Berkowitz not seen them coming. Both he and Mr. Buffett
share the same exact discipline, and
Mr. Berkowitz may be the most skilled of anyone using this
discipline today.
Question: But you do like AmeriCredit,
a specialty finance company that provides credit to buyers
of
new and used autos.
Berkowitz: They got caught up in the shutting
down of the securitization market, which is a tough
business. At the end of the day, if you are dependent on
securitizations and nobody can securitize for
you anymore, it can be a death blow. But with AmeriCredit,
they did it the right way. They give loans
to people that need cars to get to work. They do the loans
based upon the income of the person, not the
collateral value of the car. They do their own work as
to whether or not the person can afford the car.
They don’t want to sell the car to someone who can’t
afford it, unlike a dealer that just wants to sell the
car, get the commission and thank you very much. So they
do the work and management is smart.
They are still making a few pennies and have good cash
coming in the door. They will be a survivor.
So good management, good strategy, the class act in the
industry and the stock has been crushed. We
started buying.
Final Note: This is a perfect description
of the type of company our discipline says to buy. Due
to
circumstances beyond their control, i.e. the near-collapse
of our secondary credit markets, companies
in the lending business are going out of business left
and right. But we have one company,
AmeriCredit, that didn’t make the mistakes the rest
of the industry made. They made their
underwriting decisions based on an individual analysis
of each person’s ability to repay their loans.
Thus, they have had few losses, thereby managing to continue
to make at least a little profit, even as
large numbers of their competitors struggle or go out of
business. And their price is now very, very
low, as the investing public has decided that anything
related to lending is worthless. What do you
think will happen when the credit markets are restored
to any semblance of normality again, and they
have access to dramatically more money? With much of their
competition weakened or gone,
AmeriCredit will be able to generate large profits and
substantial growth in market share.
Talk about making lemonade out of lemons! That’s
essentially what Bruce Berkowitz does. He looks
at troubled industries. The focus is upon sectors that
are basically certain to grow going forward. When
a sector with excellent long-term growth prospects experiences
serious difficulties, he purchases stock
in the right companies when their prices are depressed.
But these companies are continuing to make
money, even while their industry is depressed. When their
industry turns around, their profits will soar.
Last Question: What does Fairholme mean?
Berkowitz: …And I was hoping, when we started, that
it would be the “fair home” for people’s
money that I know that they work very hard for. The key
to us is that we try to ignore the crowd– that’s our tag line. We don’t
pay a lot of attention to what everybody else is doing.
When you ignore
the crowd and go to the places that others won’t,
that is when you have a chance of getting a good
price relative to what you’re buying.
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