Here is the transcript Consuelo Mack WealthTrack interview with Bruce Berkowitz - August 27, 2010
CONSUELO MACK: This week on WealthTrackās Great Investor series, Morningstarās Fund Manager of the Decade Bruce Berkowitz is always diving for hidden investment treasures, but could his recent deep dive into financial stocks blow up in his face? A rare interview with Fairholme Fundās Bruce Berkowitz is next on Consuelo Mack WealthTrack.
Hello and welcome to this Great Investor edition of WealthTrack. Iām Consuelo Mack. This week we have a rare TV interview with one of the hottest mutual fund managers around. He is Bruce Berkowitz, portfolio manager of the Fairholme Fund which he founded in 1999, and whose assets are now climbing toward $20 billion. The five star Fairholme Fund is ranked in the top one percent of all large blend funds by Morningstar for the past three, five and ten year periods. Over the past ten years, it has delivered average annualized returns of over 12%. Thatās 13 percentage points a year better than the S&P 500.
But market and peer beating performance are not the only reason that Morningstar named Berkowitz Domestic Stock Fund Manager of the Year in 2009 and its first Domestic Equity Fund Manager of the Decade. It also considered his ability to minimize the risks he took to achieve those results. And itās that risk avoidance quality that some say he has now lost with his most recent investment choices. As money has poured into Fairholme, Berkowitz has been making a huge bet on some of the most battered financial companies. Just under 60% of his stock holdings are in companies such as AIG, Citigroup, Bank of America, Goldman Sachs, CIT Group and bond insurer, MBIA.
Now the recent history of the group is certainly dramatic. Before the financial crisis, the S&P financial sector accounted for over 22% of the S&P 500 index. By August 2010, its position had shrunk to just over 16%. From peak to trough- October 9, 2007 to March 9, 2009- the financial sector fell about 83% versus a nearly 57% decline for the S&P 500 overall. The recovery that followed was even more spectacular. From the low of March 2009 to the 2010 high on April 23rd, the S&P financials soared 170% versus 80% for the overall market.
But despite that huge recovery, from the 2007 market peak to the April 2010 high, financials were still down about 53% versus some 22% for the market. Is this flight from financials warranted or are there overlooked treasures in these pariahs? In a recent interview, I asked Bruce Berkowitz why he has invested so heavily in what even he calls āmostly hatedā financials.
BRUCE BERKOWITZ: There are two parts to the investment equation. There's sort of what you give and what you get. So we'll start out with what you get. We've had this most extreme period in the financial history of the United States. Some say we came very close to another Depression. And the U.S. government and its agencies just did a great job of pulling us away from that cliff. And, for the last couple of years, companies have gone through tremendous stress, the financials. But today, their balance sheets are stronger than ever, their earnings power, their pre-tax, pre-provisioning power is stronger than ever. And, you have to think about loans and the life of loans. You know, most loans go for between two and five years, whether it's an individual loan, commercial. So there's been this two-year stress period of burning through all these bad loans. And at the same time, they've had these two years of good loans, because they're in very stressful periods. That's normally when they put on their best loans.
So, the financial system came to the brink. U.S. Treasury, New York Fed, Congress did amazing job. I mean, with hindsight, you know, you could criticize a little here and there. But they did an amazing job. Now it's up to private enterprise to take it over from here. And traditionally, that's going to be our banks and our brokers leading the way on this nascent recovery. And there are going to be fits, and there are going to be starts. But again, their balance sheets are strong; the potential earnings power is huge. They've battled hard, and it's a trite saying, but whatever doesn't kill you makes you stronger is quite true. And for those financial institutions still standing, and the ones we've invested in, will get through this period and move on to a more normal earnings period.
CONSUELO MACK: So, what's the biggest risk that you're taking, in having this sort of a concentration in these companies that have been through the grinder?
BRUCE BERKOWITZ: Well, the biggest risk would be the correlation risk, that they all don't do well. Which would mean, you know, a severe double dip in the entire financial system of the United States, totally melts down, malfunctions, no longer exists. So, it's hard to see that.
But, on the other hand, when you take a look at our fund today, one-sixth of the fund now is cash equivalent. Another one-sixth of the fund is in fixed income securities. So, we're only two-thirds invested. So we have billions of dollars of cash ready to take advantage of whatever further stresses may come our way. And then, as I was mentioning to you, the other part of the equation is what you give. And by "most hated," I meant that the financial institutions are not very popular today, given what's happened in the past couple of years, and their price reflects it. So, we're paying a pessimistic price for institutions that are essential to the country, and that will lead us, as they usually do, out of the recession.
CONSUELO MACK: Some of your competitors, including Don Yachtman, of the Yachtman Funds, who has a terrific track record as well, you know, recently told me that he doesn't understand what you're doing because he feels that financials are black boxes. That, in fact, you can't possibly know what Citigroup's loan portfolio really looks like. And that, he feels that you're taking a tremendous amount of risk that is kind of contrary to what your prior practices have been. You don't think they're black boxes? I mean, you actually think that you know what Citigroup owns and what its debts are?
BRUCE BERKOWITZ: It's our belief that enough time has gone by now, as I've said, that you've had the vintages, the various loans for a given year. You start to see, you know, the bad parts, the delinquent loans. You get to see the cash yields on the bad debt. You know, one thing that's nice about getting older is that you start to see certain cycles before, and this is very reminiscent of '91, '92, when people thought Wells Fargo was going to go under because of commercial real estate. Citigroup, again. And, it's perverse psychology. You've had so much strain in the system, so many balance sheets; individuals have been hurt, that it's just very hard to look at them in a positive way.
But, with time, you start to see the patterns and the recovery, and you also have to give credit to the regulators, to the auditors, to the executives, to the oversight committees of the Congress. I mean, these institutions have been studied in the last two years. They're under a microscope. Every element has been studied. And when you're in stress mode, and when your institutions are shrinking, it's very difficult to hide bad news. Everything comes out in shrink mode. But the good news is, when you're shrinking, cash flows build up. You're able to pay off the bad debts, and you're able to fight another day. And, you see it now with the institutions.
CONSUELO MACK: Bruce Berkowitz and the Fairholme Fund's rule number one is don't lose money. And then, rule number two and number three is pay attention to rule number one. So, given the current strategy that you're following, in the Fairholme Fund, are you still adhering to the rule number one and two and three, of don't lose money?
BRUCE BERKOWITZ: We believe we are. At the prices that we're paying for securities, we just don't see the downside. We don't see death, we don't see bankruptcy, we don't see significant losses. In the case of the banks, we've been buying below book values. We've been buying single-digit earnings yields. I mean, at some point, the banks will start to have a more normal earnings period.
It's amazing, when you think of a Bank of America and all of the organizations they have merged with over time, including Merrill Lynch and MBNA, it's tremendous. The amount of value and wealth is just tremendous in a Bank of America and in fact, it's essential to the rebuilding of the country's balance sheet. And so is Morgan Stanley and Goldman Sachs, and Citigroup and Regions Financial and CIT. All the companies that we purchased during their stressful periods.
CONSUELO MACK: So, Bruce, what would convince you to sell? I mean, is it going to be a price decision with some of these companies?
BRUCE BERKOWITZ: It's going to be a price decision.
CONSUELO MACK: It is a price decision.
BRUCE BERKOWITZ: It's going to. It's just so cheap, relative to what you're getting. And eventually, if we're right in our understanding and we don't have that dreaded double dip, going back into the Great Depression, then there'll be a more normalized earning period. And then, that'll be a tough part to determine, at what point our investments start to equate to T-bill type returns.
CONSUELO MACK: And so, when you look at, you know, a Citigroup, for instance. Let's just take them one at a time. I mean, it's value now. Do you think that there's still a lot of value left?
BRUCE BERKOWITZ: Yes. Citigroup has the ability to earn a dollar a share, which would put it at $10, let's just say. And you compare it to where it's trading today, four. Under four.
CONSUELO MACK: And Bank of America, again, same?
BRUCE BERKOWITZ: All the same.
CONSUELO MACK: Same equation.
BRUCE BERKOWITZ: With Merrill Lynch, with all the operations they've purchased. Citigroup, with its International Banking Franchise.
CONSUELO MACK: Bruce, AIG.
BRUCE BERKOWITZ: A great company that stumbled, for various reasons, that still has intact franchises, that still has the ability to repay taxpayers, New York Fed, the U.S. Treasury, and will hopefully emerge a smaller, yet streamlined organization, with Chartis and the old Sun America. And, we're, you know, sad, but some very valuable divisions will be sold. AIA, Alico. But we see the company having the ability to pay back taxpayers over time.
CONSUELO MACK: The other, you know, company that I'm really intrigued with, for two reasons, MBIA, which a cousin of mine actually co-founded and left many years ago. I'm not a shareholder. But MBIA has now been split up into two companies. It's in litigation over that decision to have two different companies. I mean, why MBIA? You know, what's the attraction? What's the value there, first of all?
BRUCE BERKOWITZ: Well, the value, if you ask the individuals and institutions who have probably received between four and five billion dollars of proceeds from MBIA, for guaranteeing the bonds--
CONSUELO MACK: Municipal bonds, right.
BRUCE BERKOWITZ: --they'll tell you that MBIA's had tremendous value, and they have kept their word to all of their insureds. They continue to keep their word. And, unlike a rating agency, what I like about MBIA is, besides giving the investor the good housekeeping seal, they're also putting their money where their mouth is. And as they continue to pay, and I believe be the advocate for individual investors, how can an individual investor claim, if they have to follow or they're unhappy about something, they just don't have the scale to talk with counterparties, where MBIA is going to be their advocate. So when all is said and done, we expect MBIA to regain their franchise value.
CONSUELO MACK: In the municipal bond insurance business?
BRUCE BERKOWITZ: In the municipal bond area, and in other areas also, where it makes sense for them to do business. Granted, all the financial institutions made the mistake of starting out with a very good idea and slowly changing it to the point where you've reached an illogical extreme.
Now, with hindsight, you can actually say, well, how could the banks and insurers, how could they have gone from A to B to C to D? It makes no sense now. But, there were slow changes. So I think everyone realizes mistakes of the past, and they're going to get back down to their basic business. And, with a little bit of luck, they'll be able to get the right price for the product, the insurance. And they've clearly shown that the insurance is worthwhile, and they've clearly kept their word about paying the insureds. So, it's now just a question of working through it. And even if they don't write another bit of business, which I believe they will, the runoff value alone of the institution is such that I don't see how our shareholders lose money.
CONSUELO MACK: Let me ask you about a recent Wall Street Journal article about you. It talked about how you were breaking Wall Street's rules and making other mutual fund managers look bad, by doing all the things they say can't be done. And this is your style. Can't time the market- do you time the market?
BRUCE BERKOWITZ: No. We don't predict. We price. So if timing the market means we buy stressed securities when their prices are way down, then yes. Guilty as charged. But, again, we're trying to compare what we're paying for something, versus what we think, over time, we're going to get for the cash we're paying. And, we try not to have too many predetermined notions about what it's going to be. And then we go, once we come up with a thesis about an idea, we then try and find as many knowledgeable professionals in that industry, and pay them to destroy our idea, and tell us--
CONSUELO MACK: You try to kill your investments before you invest in them.
BRUCE BERKOWITZ: Right. We're not interested in talking to anyone whoāll tell us why we're right. We want to talk to people to tell us why we're wrong, and we're always interested to hear why we're wrong. Because one day someone's going to do our shareholders a big favor and tell us why we're wrong, and we're going to be wrong. We want our ideas to be disproven.
CONSUELO MACK: Another Wall Street kind of conventional wisdom that, again, this Wall Street Journal article said that you are breaking this conventional wisdom, is that you shouldn't hold a lot of cash in equity funds. Well, the Fairholme Fund has a history of holding a lot of cash. And I remember you telling me that cash is your financial valium.
BRUCE BERKOWITZ: Yes. Well, the worst situation is if you're backed into a corner and you can't get out of it, whether for illiquidity reasons, shareholders may need money, or you have an investment that, as usual, you're a little too early, and you don't have the money to buy more, or you don't have the flexibility. That's a nightmare scenario. And this is nothing new. I mean, the great investors never run out of cash. It's just as simple as that. And we've learned this is nothing new. We haven't re-created the wheel here, but we always want to have a lot of cash, because cash can become awfully valuable when no one else has it.
CONSUELO MACK: The third thing that you're doing that supposedly is making other mutual fund managers mad, Bruce, is that they're saying you shouldn't put too much money into a few stocks. And, you know, your top 10 holdings or something represent two-thirds of your fund, currently?
BRUCE BERKOWITZ: Yes. Almost all of the equities. Probably all of the equities, which would be about two-thirds. A little under two-thirds of the fund.
CONSUELO MACK: So, is this going to be something that shareholders of the Fairholme Fund, they'd just better get used to the idea that you're going to, heavily focus the portfolio?
BRUCE BERKOWITZ: I think we always have focused. And we're very aware of correlations. And, look what we faced in the last two years. When times get tough, everything's correlated. So, we're wary. But we've always had the focus. Our top four, five positions have always been the major part of our equity holdings, and that will continue.
CONSUELO MACK: Thereās a saying on Wall Street as well, is that size is the enemy of performance. Investors have been flocking to the Fairholme Fund because of your stellar performance, at a time when most other equity funds are losing investors. So what can you tell, especially the newer owners of the Fairholme Fund, about the way you're going to run their portfolio?
BRUCE BERKOWITZ: Everything that we do for our funds, we do with the shareholders in mind. We try and put ourselves into the shoes of our shareholders. And we do that by being large shareholders of the funds. And what I could tell our shareholders is, we think about this every day. And, the important point is that, as the economy still is at the beginning of a recovery, and there's still much to do, and continued stresses, we can put the money to work. The danger's going to be when times get better, and there's nothing to do, and the money keeps flocking in. That obviously is going to be a point we're going to have to close down the fund. But, close down everything.
But of course, it's more than that. Because if we continue to perform, which I hope we do, 16 billion's going to become 32, and 32's going to become 64. And then it's not really an issue about closing down the fund. It's just the size. But I have no idea where we'll all be investing five or 10 years from now. It's a high-class problem which we're focused on, and I hope that we will take the right actions before our shareholders tell us what the right action is. And a lot of our shareholders are concerned about it. It's a question that comes up all the time.
CONSUELO MACK: About size.
BRUCE BERKOWITZ: Of size. Right. But right now size matters.
CONSUELO MACK: And right now, has the size, you know, as you approached 20 billion under management, has the size affected the way you can do business yet?
BRUCE BERKOWITZ: Yes. It's made a real contribution. How else could we have committed almost $3 billion to GGP, or to have done an American Credit securitization on our own, or help on a transformation transaction with Hertz, or offer other companies to be of help in their capital structure, or invest in CIT, or be able to go in with reasonable size? It's helped, and we think it will continue to help, and we hope it will be noticeable to most people over time.
CONSUELO MACK: You're going to be a target. The more successful you are, the more of a target you are for the naysayers. So, the comparisons now are being made that they look at other super investors, like, you know, Bill Miller or Bill Nygren, or Ken Heebner. And they say, these people had, you know, multi-year, spectacular runs, and then had a couple, two or three years of disastrous results. Do those comparisons worry you? Do you feel like, you know, gee, you know, my time's coming too? Is that a concern?
BRUCE BERKOWITZ: What worries me is knowing that it's usually a person's last investment idea that kills them.
CONSUELO MACK: Explain.
BRUCE BERKOWITZ: Well, as you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you've made over decades. So I'm more concerned for our shareholders than I am for myself. That is why, if you look at the fund today, to me, it looks more conservatively positioned than it's ever been. We're two-thirds invested in equities today. That is not exactly what I would call a kamikaze strategy. And when you look at the prices that we're paying for securities and look at the prices where they were five or 10 years ago- granted, they may not be exactly the same companies- it looks like we're getting some bargains.
But we have too much respect for our shareholders. And we say to ourselves every day, we don't mind if our shareholders fire us for underperforming on the up side. But it would be tremendously disappointing if we made some kind of bonehead maneuver which cost our shareholders a lot of money. That would be tough to live with. And that's more important than the money.
CONSUELO MACK: Now, you know one thing that will happen is that a lot of the people that are coming in after you've had this, you know, string of 13% annualized returns over the last 10 years is that they're going to expecting that kind of performance. So if they don't get that kind of performance, you're going to see a lot of that money leave, correct? Or is there some way that you think that you can avoid that from happening to you, what seems to happen to just about every successful investor out there
BRUCE BERKOWITZ: I'm hoping- I mean, famous last words, but I'm hoping we can come close to that performance. I mean, I just don't want my mother to fire me again. That's all.
CONSUELO MACK: When did your mother fire you?
BRUCE BERKOWITZ: Oh, about 2008, when times were tough.
CONSUELO MACK: So Bruce, it's time for me to ask you the question about the one investment that everyone should have in a long-term diversified portfolio, and I know the one investment that you would choose is your own fund, the Fairholme Fund, because that's what you invest in. But you can't recommend your own fund. So what would you have us own some of in a long-term diversified portfolio?
BRUCE BERKOWITZ: I think the one very interesting investment we have today is MBIA. If you believe the numbers and the auditors, the company has a value significantly above where it's trading today, even if it just runs off and doesn't write another dollar of business. The company has some tremendous arbitrage possibilities, and they're really taking the right business actions. But, small. Small part of the fund, because it's a small company. And by law, the Fairholme Fund, we can only own 9.9% of an insurance company. So it's not a relatively large position for the fund. But it is a most intriguing, controversial investment which we believe is going to do quite well. And we have a lot of faith in Jay Brown and his team.
CONSUELO MACK: Controversial it is. And for a risk-averse guy, a lot of people are looking at your portfolio at the Fairholme Fund and saying, what is he doing? But I think you've just given us the best answers that you possibly can on why you think that you're following your traditional, risk less, or less risk type of approach. So Bruce Berkowitz, great to have you here on Wealth Track again. Thanks so much for joining us.
BRUCE BERKOWITZ: Thank you. It's been great.
CONSUELO MACK: As Berkowitz told us as he was leaving the interview, the really interesting conversation will be next year when we find out how the financials have done!
And that concludes this edition of WealthTrack. I hope you can join us next week when I sit down with T. Rowe Price chairman and fund manager Brian Rogers, a āGreat Investorā with an excellent track record and a philosophy of old-time American values. Until then to watch this program again, go to our website, wealthtrack.com to see it as a podcast or streaming video. Thank you so much for visiting with us and make the week ahead a profitable and a productive one.
