Bruce Berkowitz: From Morningstar Manager of the Decade to 15 Years of Underperformance

(Note: a lot of the idea threads and conclusions in this blog are my own speculations, I can’t know what was actually going on inside Berkowitz’ mind)

Bruce Berkowitz is an investor who had incredibly good results for 20+ years (~1988-2010). His track record before Fairholme Funds (Inception of 12/29/1999) is unaudited but was likely very strong. 


Pre Fairholme, he is known for investing in Freddie Mac in the late 80s and for the infamous interview with Outstanding Investor Digest (Nov 1992) where he disclosed he had 33% of his net worth in Wells Fargo. 


Freddie Mac was demutualized in 1988-1989 to shore up the capital shortfalls of the savings and loans companies that went bust at that time. It was a “special situation” -- the demutualized company was trading on a when-issued basis and would go public a year later. Most institutions at that time were precluded from buying when-issued securities due to internal rules so Freddie traded at only 8x trailing earnings with a 20%+ ROE and double digit earnings growth. Buffett and Berkowitz were aggressive in scooping up as many Freddie shares as they could. Freddie was a 4.5x bagger in about 2 years post demutualization (111% CAGR). 


Interview with Buffett in Fortune in 1989 talking about Freddie: https://archive.fortune.com/magazines/fortune/fortune_archive/1988/12/19/71414/index.htm


(As a side note, if you don’t think the stock market has gotten more competitive, consider this: Buffett was able to scoop up a large, nationally well known business at a very cheap valuation because of trading dynamics. In the recent spin off from Constellation Software, multi billion $ AUM managers in far flung financial capitals around the world were buying an illiquid Topicus in the gray market on the tiny Canadian Venture exchange) 


In 1992, Berkowitz mimicked Buffett’s publicly disclosed purchases yet again, this time into Wells Fargo. It was primarily a California focused depository bank at that time. After a building boom in commercial office real estate in the 80s, vacancies spiked and values of buildings crashed hard in the early 90s. On top of that, California had a pretty bad recession. WFC was a large CRE lender doing business primarily in California. Berkowitz, in the OID interview, cites a short report, in essence, by academic researchers stating that WFC was effectively bankrupt. This is still in the fresh aftermath of the S&L crisis so investors were freaked out.


A much simpler explanation was in the financials of WFC. Their accounting was extremely conservative. The bank generated about $33 per share in pre-tax, pre-provision profits.  In the depths of the recession in 1991, WFC took a charge of $27 for loan losses and so barely reported a profit that year. But actual write-offs in the year were only $11, and 50% of loans declared non-performing were current on interest and principal. After normalizing loan losses (at ~$6/share), Bruce thought WFC was trading at a multiple 2X PTPP profits ($65-$70 stock price) and 4X after tax, after provision normal profitability. This for a franchise in an oligopolistic position in sunny California with 2 other banks, a 5% net interest margin (those were the days) and a 40% return on tangible equity. 


Wells was a 6 bagger in ~6 years from that November 1992 interview with Berkowitz (44% CAGR).


So a pretty solid start!


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Fairholme went live on Dec 29, 1999, still about 3-4 months away from the peak of the tech boom.


The record over the first 11 years is sensational:


  • Year End 2002: FAIRX +55.5% vs. -33.2% for S&P 500 (15.5% p.a. Vs. -13% p.a.)

  • Year End 2005: FAIRX +175% vs. -6.2% for S&P 500 (18.4% p.a. Vs. -1.1% p.a.)

  • Year End 2008: FAIRX +154% vs. -28% for S&P 500 (11% p.a. Vs. -3.5% p.a.)


  • Year End 2010: FAIRX +343% vs. 5% for S&P 500 (14.5% p.a. Vs. 0.5% p.a.)


Since then obviously there has been massive underperformance, even including the huge positive black swan that 2020 was for St. Joe, the Florida lank bank that is FAIRX’s biggest holding. 


In the last 15 years, FAIRX is up 200% (7.7% p.a.) vs. 311% vs the S&P (10% p.a.). 2020 was very weird. St. Joe was up about 50% because everyone in coastal America is moving to either Florida or Texas right? I don’t know, maybe it’s real. 


FAIRX’s 5 yr CAGR went from 1.2% in 2019 to 12% in 2020 because of the St Joe move. As of YE 2019, FAIRX was lagging the S&P by 10%/yr over 5 years, 8.5%/yr over 10 years and 3%/yr over 15 years. Let’s see what happens going forward. 


So, what went wrong?


I’ll break it down into two buckets: analytical/stylistic and psychological/ego.


I will emphasize again, these are just my opinions. 


Analytical / Stylistic:


Going through all of Berkowitz’ investments pre and post Fairholme in the successful first 20 years is very informative. He was a very thematic investor, his investments centered very tightly around 1-2 themes.


BB is basically a financials investor, and the late 90s-early 2000s was a great time to be that. Anything non-tech and non megacap, growth/quality (i.e. like a Cisco or a Coca-Cola) was pretty much left for dead. The more boring and “old economy” the business, the cheaper it was: home builders, paint makers, defense, insurers, banks and thrifts, tobacco stocks, industrials etc.


The early Fairholme portfolio was basically a collection of Berkshire and mini BRK insurers (Markel, Allegheny, White Mountains) and Leucadia. The “BRK basket” was well run, had good underwriting, very strong capital levels, and was itself collectively holding a basket of relatively undervalued old economy stocks. Furthermore, insurance had been in a soft market (premiums rising slower than claims) which was reversed by 9/11 - after which insurance entered a very hard market (premiums rising faster than claims). The BRK basket, with their high capital levels, took advantage. 


To sum up: FAIRX was investing in insurers in 1999-2001 that were cheap based on historical prices to book value and on weak underwriting profits in the past few years. After 2001, the prudently run “BRK basket” took advantage of a hard market and the BRK basket’s own boring old economy stocks also did very well. Double win.


It was fantastic timing.


Following the relationship between FAIRX and Leucadia is also interesting. Post tech boom, in and around 2002-2003, a lot of the telco/fiber overbuilders were bankrupt. Leucadia started buying their debt and in certain cases equity, at very cheap prices. FAIRX cloned Leucadia’s position and bought some bonds of a bankrupt fiber company called WilTel, which were converted eventually to equity. Leucadia ended up taking over WilTel shortly thereafter and FAIRX kept the Leucadia equity it received from the deal, making Leucadia an even larger position, second only to Berkshire.


The only things FAIRX did for the first 5-6 years was to hold a massive percentage of the portfolio in a contrarian basket of BRK and BRK lites, own Leucadia directly and follow Leucadia into a few busted telco distressed deals with a smaller % of capital.


It’s pretty clear what Berkowitz liked. He is comfortable investing in great capital allocators and/or cloning their ideas (cloning Buffett - Freddie/WFC pre Fairholme, the “BRK Basket” of great capital allocating insurers, Leucadia + Leucadia busted telcos deals) and he is most comfortable in financial businesses. His investments fall out of that pattern only very briefly and with small amounts of capital.


Financial businesses are interesting in the sense that you don’t really need to be a great business analyst to understand or value banks and insurers. The product is undifferentiated, unaffected by competitive obsolescence or innovation, and the valuation is not reliant on intangible factors like IP or “flywheel effects” or network effects or “unit economics”.  


Investing in financials often just comes down to 3 questions: what’s the health and level of equity capital, what can the company earn on that equity capital over a cycle and is management relatively prudent. Buying trustworthy BRK + BRK lites at sub 1x book in a turning soft to hard market was a layup. (hindsight 2020 obviously - not implying it wasn’t contrarian at the time!) 


The 1999-2005 period was a period where you could just run your Geiger counter and make a fortune buying cheap and boring. Read some interviews with value managers from those days. All some of them did was buy banks, insurers and homebuilders at 4X-5X earnings and just tell the companies to buy back stock to get 20%-25% EPS growth. No one was writing 15 pagers on the flywheel dynamics of their favourite “compounder”.


I think that period’s successful returns (extremely favourable for cheap “old economy” stocks) hid some pretty weak underlying business analysis skills. It was ideal for natural contrarians who ignored tech and could just focus on simple to value financial businesses. Like, a market in which a Walter Schloss does 20% a year is not a market in which you need to be a good business analyst.


(Case in point, Consuelo Mack Wealth Track interview in 2012 - Berkowitz said BAC was trading at “less than the cash they own in the bank”) ???? There are Depositors?? Liabilities??


But you already start to see it ending by 06, when FAIRX invests in Eddie Lampert through Sears, essentially ignoring the future of the retail business. 


2006 mid-year Letter: Sears Holdings, which is 4.53% of the Fund’s net assets, has also become significant because of Eddie Lampert, an unusual investment talent with a fabulous paper trail. While Fairholme is agnostic about the future of Sears’ retailing success, we believe Lampert will continue to redeploy the company’s extensive assets to our benefit.


It’s insane! Why not just replicate the diverse holdings in Lampert’s 13F if you think that highly of him? Why single out Sears as the crown jewel? When you’re agnostic about retail?


The Sears mistake seems like classic FAIRX catnip. First, FAIRX/Berkowitz has been an aggressive cloner of other great investors and Lampert is a historically great one (up to that point!). Two, you can even see from how he continues to talk about Sears 3-5-10 years after the Sears investment that he is fundamentally a financials investor. He talks to appraisers, gets tax valuation documents of Sears’ properties, and does comps of Sears’ real estate values compared to Simon Property or other mall owners. He is hunting for identifiable asset value, ignoring competition, online retail, industry trends, Sears’ higher costs and lower quality, falling foot traffic etc. etc. 


I believe the 1999-2005 period allowed a lot of investors lacking in business analysis skills to do quite well but there was less room to hide after that period.


Going back to the original thesis of Lampert reallocating retail cash flows a la Berkshire textiles into more promising endeavours, just a few years later, FAIRX letters talk up how much stock Lampert has bought back. If the capital allocator is going to double down and buy back stock, you can’t afford to be agnostic about the retail business. That is clear thesis creep. 


2006 end of year letter:


Last year’s success resulted mostly from investors’ belated recognition of Berkshire Hathaway’s large and growing earnings potential, and... Sears’ redeployment of capital, including stock repurchases. How is that redeployment of capital?? 


Here’s a snippet from the 2014 letter, 8 years later, in Sears’ dying days, where FAIRX says Sears is basically Amazon:



How did we get from, we are backing a great capital allocator who will redeploy cash away from retail to → check out the buybacks to → the real estate is cheap to → have you heard of FBA by Sears and Shop Your Way??


This is where you get into some of the interesting psychological considerations.


Contrarianism:


There’s a great scene in The Big Short where Mark Baum’s analyst tells him forthrightly, “You’re happy when you’re unhappy” to which Baum/Eisman replies “I am happy when I’m unhappy.”


There are a lot of people like that. 


Different regimes can reward different skills and personalities. 


There is a certain stereotype of the curmudgeonly, reflexively contrarian “value” investor who thinks everything consensus is a scam and his 0.5X book value timber company is the safest thing. Again, that period of 1999-2005 rewarded reflexive contrarianism. Just zig when the market/consensus zagged and you did great. 


Success slowly becomes culture and then it becomes policy.


From FAIRX’s 2006 letter: Fairholme Capital Management, the Fund’s adviser, has applied for, and been granted in certain jurisdictions, a service mark for the phrase “Ignore the crowd.” 


Years of successful behaviour becomes codified - we ignored the societal delusion that was the .com bubble, we bought cheap boring insurers no one wanted (remember people calling Buffett a has been?), we bought Wells Fargo when California was in recession, we bought the carcasses of the tech boom...and we outperformed like crazy...consensus is idiotic and contrarianism is the way to go


The unwind probably started around 2006. Few people now remember FAIRX got burned early on housing.


From the 06 letter :


Because bargains are usually found among securities out of favor, stressed industries attract us like children to a locked cabinet. Accordingly, we have pried open the residential housing industry. While not drawn to most homebuilders, whose business models we find unattractive, we have identified two related businesses that seem overly depressed by current conditions, Mohawk Industries and USG. 


FAIRX also invested in oil stocks that year (“the era of cheap energy is over”)


Reflexive contrarianism. 


Just because tech didn’t work from 1999 to pre GFC and insurers did, doesn’t mean buying 4% ROE insurers at half of book (AIG) and ignoring suddenly very profitable, high ROIC tech companies will work post GFC.


FAIRX always struck me as extremely stubborn. They just will not get off positions. He still holds Freddie/Fannie after years of suing the government. He still thinks St Joe will turn from swampland into Singapore. He rode Sears all the way to bankruptcy insisting there was $100s per share of underlying real estate value because they checked the property tax records.


Independence, contrarianism and ignoring the crowd becomes extreme stubbornness if you can’t get off your bad positions. Stubbornness (for years) is what allows thesis creep, value destruction and bad analysis.  


To go back to FAIRX being basically a single industry investor (in financials). In 09/post GFC, the US debt clock, worries about sovereign defaults and hyperinflation were constantly all over the news. For a very brief moment, so brief you missed it if you blinked, FAIRX actually put together a pretty clever portfolio of pharma and defence companies because people literally were expecting huge budget cuts post GFC (defence spending shrank only -0.2% in real terms during the GFC!). These were high ROIC companies that FAIRX bought for about a 12% FCF yield. Pretty neat, and logical.


But very very quickly that portfolio was liquidated in order to concentrate on cheap financials, esp AIG (which got all the way up to a 50% weight). 


This is another common thing. Doing one thing for decades that generates really good results tends to strongly imprint that thing into habitual behaviour. And moving outside that “style” is extremely uncomfortable for most people after many years of implementation. 


It doesn’t just happen to contrarians or financials investors. It’s true for growth/tech investors too. Very skilled and smart people made some great investments in the late 90s boom in great growth companies and were aware they were sitting on some stocks at 40x, 50x, 60x+ FCF. I think in many instances, if the runway of growth is long enough, it’s not irrational or crazy cowboy behaviour to hang on to those. 


But you flip some boring, quality “old economy” idea at a 9%-10% FCF yield to such investors for incremental allocation of funds. They’d do the math, they’d check the quality. Everything comes back affirmative. “I get it, it seems good” but they’d turn around and buy another 50x growth company like Home Depot or Coca Cola or Cisco.


(Read for historical context: https://money.cnn.com/magazines/moneymag/moneymag_archive/1999/03/01/256215/index.htm)  


It feels good to read an earnings release with revenues up 25%, earnings up 25% and guidance for the same next year and beyond. That releases that good good serotonin, those good good endorphins. Look man, it’s just kinda boring to read: our volumes were up 1.5% and sales grew 3%, for the next fiscal year we forecast a 5% increase in EPS. YAWN. 


50 told me go ‘head switch the style up...but it is really really hard to do. It’s just amazing to me. He bought pharma and defence for about a quarter and went right back to his NAV/financials focus. 


The problem with fishing where the fish are is that those waters are often uncharted.


Psychology / Ego:


(This is more speculative)


I recently had a great discussion with a close friend who said to me that one of the sharpest people he knew seemed to be getting less thoughtful. Probably because a certain amount of fame was getting to his head and starting to impact his judgement.


I feel that the amount of signal a person generates right after they nail a big win is actually lower than it was before, though most people tend to increase their confidence in that person’s takes and analysis.


Most of us twitter randos can’t relate to killing the indices for two decades, running $20B in AUM, being the Morningstar Manager of the Decade etc. But public adulation (and public chest thumping) can be very very bad for most mortals trying to remain rational.


50%+ of fund assets in AIG stock/warrants

25%+ in Sears

40%+ in St. Joe

15% in Freddie / Fannie (post GFC / gov’t recap)


These are some current and past position weights for FAIRX. Not one of these companies earned even a 7%-8% return on equity while owned or produced any kind of significant distributable FCF. None of them do even today. 


I’m not religiously against high concentration. If someone had 40% of their portfolio in BRK or MSFT or Danaher or something, I don’t think that’s insane survival-threatening risk taking.


But the FAIRX approach is extremely risky, very contrarian/stubborn and probably caused by overconfidence. 


I think for most, operating in the public sphere is fraught with risk. It would be very difficult for most investor nerds not to not get a bloated sense of self after years of winning when people are tracking your 13Fs religiously, watching your interviews and reading your letters religiously. 


Public declarations entrench commitment bias and anchoring bias.


2017 FAIRX letter (writing about Sears):


Disruptive technologies; near-zero cost of capital; and few, if any, legacy obligations provide young competitors with great advantages over old-line operators. Today, Airbnb is the largest lodging company in the world without owning a single hotel room. Uber is the world’s largest taxi company without owning a car (and perhaps soon without utilizing a single driver). Intuit’s Rocket Mortgage lends only via the net. Amazon crushes competition without a physical retail footprint. Megatech companies are now trusted in all aspects of personal and corporate life. I’m reminded of this every day by my Fairholme team, our clients, fellow directors at Sears, and friends.


The subsequent paragraph talks about how Sears is transforming itself through a partnership with Uber. ?? !!!


DUDE! You know what’s going on. You have a grasp of reality. JUST SELL! It’s not a defeat. 


I just believe it is a lot harder to do once you’ve proclaimed loudly that you are right and that others don’t get it, that you will be vindicated, especially if you’ve been vindicated before and your self identity is all about being a contrarian and ignoring the crowd. 

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Buffett:


Buffett has received more public adulation and worship than any investor ever. He’s publicly talked about his investments and positions for decades. He’s been publicly criticized on his decision making or called a has been (eg. Wells Fargo in 1992, not doing tech in 1997-2000). (Many years of public criticism followed by eventual vindication might be worse for future rationality than adulation after years of success - just look at FAIRX of Fairfax) 


Yet, in a moment, he’ll decide, ya I was wrong, and poof, in the next 13F, some 15B position isn’t there anymore. And he’ll say forthrightly I was wrong.


Then, he’ll get back in the saddle, make his biggest equity investment ever in the same industry and make almost one hundred billion dollars. 


This guy did something like high 20s% a year for his first 50 years and low 20s% over a lifetime and he still has his analytical rigour. He doesn’t showboat or have a shoe button complex. There’s dudes that take one SPAC public and think their shit doesn’t stink. That’s not a criticism. That’s human nature! (🔗


He invested in net nets, merger arb, dominant great franchise businesses, distressed debt, high yield, silver, currencies, set up a structure to attract family owned companies for 100% ownership.


He invested in banks, insurance, consumer brands, manufacturing, railroads, media. He said it would be unlikely he would understand tech but then did understand enough to make $100B at 90. How many 70 year olds do you know who did something new? Do the new kids on the block even know any 90 year olds??


This is the guy who said capitalists should’ve shot down the Wright Brothers and said he had a 1800 help number for everytime he thought about investing in airlines. Then he did it again. I don’t care if it didn’t work because of a pandemic. Dawg, I can’t even look at a pharma company without puking (thanks Valeant).


People really underestimate the behavioural spikes in the road of doing this for decades in public. People really underestimate how hard it is to learn and adapt for as long as he has.


Most people don’t even understand how good this guy is.

Comments

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  2. Love your write ups. Have you ever studied Munger’s investment in Tenneco? Munger 10x’ed his money and described it as a very low risk investment, despite the debt trading at ~30%+ yields. Would love to get your thoughts on it.

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  3. Thanks for the humble reminder. Process over result.

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