3 Undervalued Picks from Bruce Berkowitz
Laura is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Bruce Berkowitz’s Fairholme Fund has an outstanding investment record, but a poor performance in 2011 placed him in the bottom 99% of funds. 2012 has been very strong for Berkowitz as the fund went almost directly to the top 1% as Fairholme’s top financial holdings rebounded sharply. This shows that things change very quickly in the stock market and it is important to have patience and confidence in your research as Fairholme did. While I employ a strict stop-loss rule that prevents me from the kind of volatile movements Fairholme experienced in 2011, there are other fundamental oriented investors that have no problem watching 30/40% volatility in their portfolios. Berkowitz expressed many times that the fund suffered from premature accumulation, but he always want to be sure that when he invests there is a big margin of safety.
Let’s review Fairholme's current holdings:
AIG: Hedge Funds are Buying!
Fairholme's biggest position is AIG (NYSE: AIG), representing 43.6% of the fund portfolio. Top hedge fund managers David Tepper (Appaloosa), Steve Mandel (Lone Pine), Seth Klarman (Baupost), Murray Stahl (Horizon) and Julian Robertson (among many others) have been investing in AIG at prices between $30-$36.
Fairholme best idea remains AIG since 2010, when Berkowitz initiated this concentrated position. AIG trades with a reported book value of $57 per share. Berkowitz expressed in many interviews that there are few occasions when systemically important franchises sell for half of book value and are still profitable. The opportunity is unique for fundamental oriented equity investors, that is why several prominent hedge funds have been accumulating this stock.
AIG is a large insurance company operating in both property and casualty (Chartis) and life (SunAmerica). AIG is a poster child of the financial crisis but has made remarkable progress under the leadership of CEO Robert Benmosche. The government loans have been completely repaid and the balance sheet has been strengthened. Value Investor Bill Nygren expressed in his letter to investors that two years ago, it was almost impossible to estimate the value of AIG’s equity. The analysis involved guessing at proceeds from sales of businesses and valuing large, opaque, leveraged loan portfolios. But today the analysis is the same as it would be for any insurer focusing on future earnings outlook, reserves and capital invested.
Benmosche has done a very good job at rebuilding reserves which have been boosted to a level that is consistent with other high-quality insurers. Capital is reinvested primarily in share repurchases, which is a signal that management is committed to improve future EPS.
I think that the big picture investment thesis with AIG is that the stock is priced as if its future looks like its past. Top value managers seem to expect the current discount to other insurers will diminish as the memory of the financial crisis fades. For example, Chartis went through a hard period of writing unprofitable business just to grow revenues. That has stopped, and I believe that for the past several years Chartis has focused on only writing profitable business even if growth suffers.
In a recent report, Deutsche Bank raised AIG target to $47 from $41 as the stock continues to hold attractive upside without significantly more risk than other insurers. Deutsche Bank believes that bearish investors are focused too heavily on the low ROE and low EPS at AIG, ignoring the significant value to be unlocked by cash-generating assets that don't produce GAAP after-tax income.
Argus Research also projects incremental improvement in ROE over the next few quarters, which will help close the gap between AIG and its industry peers. Argus remarks that AIG's main businesses have stabilized, but are not yet operating at optimal or even industry-average levels, giving an opportunity to grow the business at a faster-than-average pace in a relatively constructive industry environment.
In the last earnings report, AIG showed good profitability metrics. The company reported Q4 (Dec) operating earnings of $0.20 per share, excluding non-recurring items, $0.27 better than the Capital IQ Consensus Estimate of ($0.07) while net premiums earned fell 3.9% year/year to $8.61 billion vs the $8.71 billion consensus.
Book value per share, excluding accumulated other comprehensive income (AOCI), was $57.87, up 15.5 percent for the year
Bank of America
Fairholme also is bullish on Bank of America (NYSE: BAC), holding a concentrated position at an average cost per share of $15. Berkowitz sees many reasons for owning BAC shares:
- Trades at less than half book value
- Core businesses generating 1% return on assets and 10% return on equity
- Improved balance sheet
- Largest US retail deposit market share and serves one in every two US households
- Essential to global economic security
- Trends improving in BAC's favor: a strengthening job market, a stabilizing housing sector, and improving fundamentals in the financial sector.
Bank of America trades at just 0.7x TBV and its core businesses are improving its Return on Equity (similar situation with AIG). Considering that 40% of Bank of America's balance sheet is exposed to the housing sector, economic trends are going in the company’s favor. The company is also prudently accumulating capital well above regulatory minimums. In fact, CEO Brian Moynihan told investors in August 2011 that the bank’s capital levels are among the highest they have ever been in Bank of America’s history.
In a presentation Berkowitz made in April 2012, Berkowitz explained that BAC should trade near $20 considering the company's normal earnings power. Berkowitz is convinced that in the long term companies consistently revert to reasonable assessments of value. He compared the current situation with the problems that Wells Fargo experienced at the start of the 1990s when its earnings were held back by its strong loss provisionings, but the stock recovered sharply as earnings went back to normal levels.
Despite BAC could be a great pick for the long run, investors should be prepared for near-term volatility.
FBR Capital recently raised their BAC estimates to $12 from $11.50 on what FBR now view as achievable cost cuts, lower reps/warranties expenses, sustainable margins, and relatively flat asset balances. Considering that management projects a stable NIM of 2.35% and relatively flat earning asset balances over the near term, quarterly net interest income of $10.5 billion seems achievable for FBR. In order to earn its cost of capital by 2015 (which will fuel the stock to $20), BAC has to effectively eliminate $2 billion of costs per quarter without sacrificing revenues in the process, a task that will likely be difficult to achieve and could create significant volatility in the stock price.
Oppenheimer is also hesitant on BAC's future cost strategy. Oppenheimer primary issue with BAC's stock continues to be the uncertainty around the ultimate costs of private label mortgage put-backs which should be resolved around mid-year. In addition, this sell-side firm agrees with FBR that BAC should reduce costs in a considerable way to improve earnings.
Leucadia: ideal for value investors
Leucadia (NYSE: LUK) is a company that Berkowitz has placed his confidence in for many years. Leucadia National is a diversified holding company that was founded over 150 years ago. Leucadia's expertise is deep value investing, operating like a mutual fund, looking for companies that have executed their vision with great success and operate in industries that make things people frequently use.
The stock is trading in the low range of its historical P/BV showing a disconnect to the improving fundamentals of its holdings. There is nothing fundamentally wrong in this company to justify this level of undervaluation. I think that the market awaited some clarification into succession plans considering that both Cummings and Steinberg are old. I think that clarification appeared in 2012 when the company announced that Jefferies(NYSE: JEF) will merge with Leucadia and Mr. Handler (JEF CEO) will become the Chief Executive Officer of Leucadia, as well as one of its Directors, and also remain Jefferies' Chief Executive Officer and Chairman. I am bullish on LUK from a long term perspective.
laurapaur2013 has no position in any stocks mentioned. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and Bank of America and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!