The following is excerpted from the July issue of “No-Load Fund Analyst” newsletter published by Litman Gregory.
Manager Bruce Berkowitz has not made many changes to the Fairholme Fund in the last year. It continues to be heavily concentrated in several large positions, including American International Group (AIG) and Sears Holdings, which account for 38% and 11% of the fund, respectively (as of 6/30/12). Bank of America and General Growth Properties account for another 9% and 7%, respectively. Most of these stocks suffered severe declines in 2011, causing the fund to significantly underperform the market and its peers. But those same companies have also caused the fund's significant outperformance so far in 2012. Fairholme has gained 30.1% versus 13.5% for the S&P 500 through August. We recently spoke with Berkowitz to get an update on the fund's large bets on certain financial companies and real estate. (The real estate bet covers multiple holdings, including General Growth Properties, Sears, and The St. Joe Company.)
Referring generally to the broad portfolio, “We've had two years of improving businesses,” Berkowitz tells us, “with most companies improving book values.” Despite the fund's impressive performance this year, he believes the holdings are still selling at very attractive discounts to their respective liquidation values and so he is “waiting right now for others to agree.” While he says that his companies' share prices had a horrible year in 2011, “If you look at the fundamental business statistics of our companies, they improved dramatically,” he tells us.
AIG, the fund's largest holding, is a good example of this. In 2011, AIG was a major detractor from the fund's performance, as the stock declined nearly 60%. However, for this year through August, this stock has gained nearly 50%. Despite the massive stock price volatility, the company's tangible book value grew more than 30% year-over-year (as of 6/30/12) and Berkowitz notes that all of AIG's businesses are making money.
He believes that management—Peter Hancock and Bob Benmosche, specifically—have done a good job running the company, allocating capital, understanding where they can improve, and which businesses they can cut out. He believes AIG is “just scratching the surface” of what they can do to improve profits and reduce expenses. As Berkowitz puts it, management at AIG is “making the right moves.” He expects that the company will repurchase more stock in the coming months, which could reduce the government's ownership position to less than 50%.
Berkowitz estimates that AIG is going to generate $5 or $6 per share in cash on a forward basis and that an additional $15 billion to $20 billion more of assets could be sold. The stock is trading in the low- to mid-30s, which is approximately half of book value, so a large portion of the proceeds from asset sales could be used to buy back stock at 50 cents on the dollar. With some continued reason¬able capital allocation, Berkowitz sees AIG as potentially having a book value in excess of $70 a share in 2013. Given the current buy-back process, Berkowitz says, “AIG could be done with the government by the end of first quarter of next year, which is three years ahead of schedule.” Berkowitz believes investors won't return to the stock until the Treasury's remaining ownership is at least close to zero, at which point he believes the stock price should appreciate and converge with book value. This doesn't include any expectation of the stock returning to a mid-single-digit multiple of book value, a level at which the company has traded at in the past. As for figuring out whether investors will return to the company after the government is completely out or before that, Berkowitz says, “I don't know, I've never been good at that . . . All I know is that we've got something that's worth over $60 today, and it's going to be worth over $70 sometime next year, in my opinion, and I can't see how price doesn't eventually meet book value.”
We also discussed the fund's large real estate bet, including Berkowitz's meaningful stake in Sears Holdings. (Berkowitz owns about 15% of the company's outstanding shares and is the second-largest shareholder behind Sears chairman Eddie Lampert, who owns 65% of the company's shares.) The stock is up nearly 90% for the year through August after declining 57% in 2011. Through the properties it owns, Sears is one of the largest corporate real estate organizations in the world with over 250 million square feet of retail space. While he has always thought there was a decent chance that Lampert would be able to turn around the struggling retailer, Berkowitz continues to emphasize his liquidation value analysis (or the value if the retailer was shut¬tered and the assets were sold off) of the company. “Any way you slice and dice it,” Berkowitz explains, “the real estate is worth multiples of the stock price.” He adds that recent sales transactions out of the Sears real estate portfolio support his numbers, after the company liquidated some of its stores for a significant profit. “Whoever heard of that?” he asked, “Liquidating stores for a significant profit?”
Sears has over $20 billion of assets on its balance sheet, but according to Berkowitz, the fair values of those assets are not reflected due to generally accepted accounting principles. In other words, he believes Sears's real estate portfolio is being significantly understated because accounting rules require that real estate be carried on the books at the lower of cost or market value. To illustrate the flaw of the approach, Berkowitz says, “If the Dutch still owned Manhattan, GAAP would mandate the $27 or $28 price to value the entire island.”
Part of the significant value of the properties is derived from Sears having established anchor locations in many areas across the country. The benefit of this is that Sears paid little to nothing for the land and received many freebies, such as rights of first refusal to buy more property in some cases as well as ownership of mall parking lots, among other things. To highlight the company's advantaged position, Berkowitz notes some cases where Sears is paying $2–$6 per square foot in locations that get $50–$70 per square foot. “Everyone is vying for the space,” he says. Berkowitz ac-knowledges that some people complain that Sears stores are rundown, but he explains, “Sears does just enough, so they're not breaking the terms of their very long lease.”
Even while Berkowitz feels that Sears's real estate is worth multiples of the stock price, he also believes the inventory is worth the price of the stock. He asserts there is still value in the brands owned by Sears, explaining, “there are 100 million households that have a Kenmore appliance.” Sears also has the largest home delivery and appliance repair service, conducting somewhere between 8 million and 10 million homes visits per year. The company also owns other brands, like Kmart, Lands End, Craftsman, DieHard, and Sears Canada, in addition to Sears auto centers and others. The under¬lying value of these brands and their inventory is Berkowitz's “margin of safety,” although he notes that Lampert is making a dramatic effort to turn around the retail operations. In just the last few quarters, he has brought in new management from companies like Brookstone, Amazon, Juicy Couture, and Apple, among others. “The last quarter, [the company] shocked everyone and made money,” Berkowitz quips. “[Lampert] is going to try to make a go of it and if he doesn't make a go of it, he's going to slowly sell the real estate. So, I just don't see how we lose there.”
Another holding in the fund that was a topic of discussion was The St. Joe Company. We have previously written about Berkowitz's activist role in this company, and he remains the company's largest shareholder, owning almost 30% of the company, and continues to serve as board chairman. Year-to-date St. Joe's stock is up about 30%. Berkowitz says that St. Joe's recent quarterly report speaks for itself. The company's balance sheet has been shored up, with real estate assets being marked down to reflect management's flexibility to make decisions about whether or not (and how) to develop some of the properties. Berkowitz further adds that the company's cost structure has been drastically reduced to a minimal sustainable level. As the property market continues to improve (particularly in Florida, where the company's properties are located), Berkowitz says that St. Joe has options. For example, he reiterates that the company has lots of land that could be developed to meet the demands of an aging baby-boomer demographic that would find Florida appealing (for climate and tax reasons). With the company's now-strong balance sheet, he says that the firm can maintain its much lower current cost structure without having to sell assets at distressed prices, which enables the new management team and board of directors to be patient and “smart” about executing on any future development plans.