Q&A: Did Bruce Berkowitz allow his asset base to grow too large?

The following is excerpted from a Q&A that appears in the March issue of No-Load Fund Analyst, published by Litman Gregory. In this Q&A with Melissa Wedel, a research analyst at Litman Gregory, an assessment is given on Berkowitz and Fairholme Capital Management, following the firm’s miserable performance in 2011. For more information on accessing the full issue of No-Fund Analyst, and to see the full version of this Q&A, click here.

Conviction versus overconfidence: Is Berkowitz being irrational and stubborn by holding onto financial stocks even after they have declined so much?

We have talked to Berkowitz about his willing¬ness to replace some of the portfolio’s financial stocks if he found new ideas that were sufficiently cheap, and we believe that he would do so. In other words, he does not seem to be stubbornly sticking with the financials until he is proven right; rather, his decisions are driven by his value-focused investment discipline. In the past, Berkowitz has demonstrated that he is willing to move on from even his largest holdings before their value is fully recognized (e.g., Pfizer in 2009), if more attractive opportunities present themselves. Currently, he thinks that it is unlikely other companies will become as cheap as the financials he owns, so it is unlikely he will move away from these holdings before they appreciate. This seems to be reflective of his analysis of the opportunity set, and his confidence in his assessment of the value of the companies he owns, rather than stubbornness. We will continue to assess this in our ongoing discussions with Berkowitz and his team, as we have seen other successful managers cross the line between conviction resulting from superior research insight, and stubbornness due to overconfidence or the inability to admit mistakes.

Isn’t the magnitude of underperformance in 2011 sufficient reason to sell the fund?

We will not sell a fund solely because of poor performance, as performance itself is not predictive. Our process dictates that we dig in to understand the reasons for underperformance. We sell if we determine that we were wrong in identifying a manager’s edge to begin with or if some positive we originally identified is no longer there. In Fairholme’s case, the primary tenets of our original thesis are still intact, and we continue to be impressed with the quality of Berkowitz’s analysis of the holdings in the portfolio.

Some of the fund’s top holdings traded down massively during the year; most notably the stock price of AIG—the fund’s largest weighting at 25%—lost 52% last year. We believe it is important to bear in mind that a stock’s underperformance in a particular year is not necessarily evidence of a mistake. What today appears to be a mistake could be a case of the cheap becoming cheaper—the eventual success of an investment can only be determined over the full investment period. Incidentally, the same financial stocks that so meaningfully underperformed in 2011 have driven Fairholme’s outperformance thus far in 2012. Of course, this may not persist in the short or even long term. Since we can’t know this, we instead have to evaluate Berkowitz’s analysis to assess whether or not he has critically misjudged the companies in the portfolio. The key is to deter¬mine whether the decreased stock prices reflect flaws in the manager’s original thesis or whether they reflect the market’s temporary failure to recognize value that is in fact present.

In Berkowitz’s case, we have repeatedly discussed his analysis of the companies in the portfolio and have come away confident that his original thesis on these companies was sound. While there appear to have been mistakes in some of his assumptions—particularly about AIG where he thought the government would begin to sell part of its stake in the company at higher prices—his broader case for the under¬lying fundamentals seems sound. Therefore, we believe it would be a mistake to sell the fund based on recent performance.

Did Berkowitz let Fairholme’s asset base grow too large and did that contribute to the fund’s under¬performance?

Fairholme is a prime example of investors chasing performance. Even in the wake of the credit crisis as nearly every other equity fund was facing shareholder redemptions, Fairholme had record inflows.

Admittedly, it is difficult to determine exactly how much is too much when it comes to analyzing a fund’s assets under management—we know the number is influenced by factors related to the fund’s investment universe and investment approach.

We do not believe Fairholme’s asset base had anything to do with the fund’s poor performance in 2011. Rather, it was the financial companies that Berkowitz invested in that caused the poor performance and we don’t believe those investments or their position sizes were driven by (or necessitated by) the growth in his asset base.

Berkowitz has always talked about cash as being a strategic asset. He proved his point by having nearly a third of the portfolio in Treasuries or other “dry powder” assets to put to work when opportunities arose several years ago. Also, Berkowitz has always been aware that the cash could leave just as quickly as it came in. It was a good thing he was prepared, because he was right about that, too. He used the large cash position to meet shareholder redemptions that occurred as a result of the fund’s underperformance. (It seems he also had to sell some equity positions to meet redemptions.) It is possible he could let assets grow too much in the future and this is something we will continue to assess going forward. Generally speaking, we are attracted to the increased flexibility and broader opportunity set afforded by a smaller asset base.