Fairholme Fund Undervalued Picks
Federico 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. This year 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.
I mentioned many times in my blog the importance to study what top hedge fund holds in their portfolios. Let’s review Fairholme's current holdings:
AIG: big conviction here!
The fund’s most important position is AIG (NYSE: AIG). There are two main reasons that support AIG’s investment thesis.
First, the company trades at 0.5x its Tangible Book Value and has a fortress balance sheet which has been strengthened in recent years as AIG has reduced its derivative exposures and its CDS portfolio by 89% and 95%, respectively. Second, the intrinsic value of AIG is still strong as Chartis and SunAmerica (AIG’s most important segments) are intact and making great returns. Berkowitz thinks that the fair value for AIG is in the $70s or $80s as the company can trade at 1x or more its book value considering that AIG is on the path to achieve a 10% return on equity and its EPS should keep uptrending in the coming years.
AIG’s management is shareholder friendly, which also drove other powerful hedge fund managers to invest in the stock (David Tepper, Daniel Loeb, Leon Cooperman, Fir Tree Partners, among others). This month marks a significant period in the history of AIG as the company sold its stake from AIA as well as got rid of the US government bailout loan of $182.3 billion and its ownership in the company,. The sooner-than-expected wipe-off of Treasury’s stake accelerates the capital flexibility of the company and helps retain investors’ confidence.
Bank of America: the best financial pick for 2013?
Fairholme’s third largest holding is Bank of America (NYSE: BAC). I think that BAC has a very simple investment thesis: its earnings power has been hurt by the intense provisioning for loan losses and the weak US credit environment. But when provisioning gets back to normal levels (which is starting to happen) and the US credit markets recover (also started to happen in 2012), Bank of America could experience strong earnings power and an enhanced bottom line. In fact, my partner in the blog invested 150k in this stock some weeks ago.
Bank of America trades at just 0.7x TBV and its core businesses are generating 1% ROA and a good 10% ROE. 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: a strengthening job market, an improving housing sector and a recovery in the US credit market. The company is 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, he 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.
Leucadia: the essence of value investing
Leucadia (NYSE: LUK) is a company that Berkowitz has placed his confidence in for many years. Leucadia is managed by gifted investors Ian Cumming and Joseph Steinberg. Leucadia National is a diversified holding company that was founded over 150 years ago. Its investment portfolio includes wineries, copper mines and boutique investment banks. 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.
Leucadia has been reducing its leverage by calling $511.3 million of long-term debt in 2012 and retiring other debt during the last three years in market transactions. With those steps, management have cut Leucadia's leverage by over 40%. In addition, Leucadia’s top holdings (Jefferies, Mueller Industries, National Beef, etc) generated strong results in 2012.
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 last month 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 think this catalyst could unlock value.
martinzaldua has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group and Bank of America and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend 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!