January 30, 2006

Fund in Focus: Fairholme Fund

S&P Rank: 5 StarsLarry Pitkowsky, co-manager since December 1999Dining at Buffett's Table

As far as concentrated mutual funds go, the Fairholme Fund (FAIRX) stands apart. The $1.7-billion portfolio invests in three areas: undervalued stocks of any size, "special situations," and cash and cash equivalents, including U.S. Treasuries. The fund will usually keep at least 75% of its assets in common stocks. Special situations will not exceed 25% of assets.

Regardless of the underlying security, managers Bruce Berkowitz, Larry Pitkowsky and Keith Trauner seek "high potential return investments with minimal risk of permanent loss." For the bulk of the portfolio, they avoid 'trendy' sectors or corporations with questionable management, or aggressive accounting practices.

The fund typically holds between 15 and 25 stocks deemed "undervalued, misunderstood, or under-appreciated by marketplace," that possess a strong competitive position, high returns on invested capital, low price-to-tangible asset value, low price-to-earnings ratios, and generate substantial free cash flow. The stock pickers are also drawn to managements that exhibit a track record of success, talent and integrity. In essence, Fairholme adheres to the classic value investing principles of Warren Buffett and Benjamin Graham.

Fairholme fund rose 13.7% in calendar 2005, versus a gain of 6.6% for the average all-cap value fund. For the three-year period, the fund has returned 20.8% annualized, versus 18.4% for the peer group. Over five years, it was up 13.0% annualized, compared to 6.8% for its peers. Even with those outsized returns, the fund has low volatility, with an average P/E ratio of 6.15, just about one-third of the peer group average. It also features an expense ratio of 1.00%, lower than the peer group average of 1.45%.

Berkowitz, Pitkowsky and Trauner -- all principals of the Short Hills, N.J.-based investment adviser, Fairholme Capital Management LLC -- have co-managed the fund since inception in December 1999. The offering is the sole mutual fund product of Fairholme Capital, which runs more than $3 billion in assets. Reflecting their wish to invest in companies with heavy insider ownership, the Fairholme managers themselves own about $5 million in shares of their own fund, with almost all their other liquid personal funds invested in Fairholme's other investment vehicles and products.

The portfolio is currently dominated by a few holdings, including Buffett's insurance and investment company, Berkshire Hathaway (BRK.A), a core position since inception. Pitkowsky explained that the fund managers are not afraid to make heavy bets on individual securities because good ideas are rare. "When we find something we really like with an attractive business we understand, we want to own a lot of it to make it count," he says.

Berkshire Hathaway represents about 19% of the fund's assets. The company is 38% owned by Buffett, who is renowned for his integrity and spectacular track record. Fairholme believes the stock -- currently priced at nearly $90,000 per share -- is undervalued. "Despite its notoriety and decades of success and extreme profitability, Berkshire is still not fully appreciated by the market," Pitkowsky said. "We think it's trading at the low end of its fair value."

Pitkowksy cites the company's "Fort Knox balance sheet," and huge hoard of cash of more than $40 billion. "We feel Berkshire will have a chance to make acquisitions with that money," he said. "In fact, they have a pending $5.1-billion acquisition of electric utility PacifiCorp. Buffett is finding attractive companies to buy. Plus, with the repeal of the Public Utility Holding Company Act, Berkshire should be able to make some more acquisitions in the utility area and thereby add to shareholder value."

Within the special situations portion of the portfolio, the managers are willing to bend the rules a bit. Here, they will invest in companies that may have a blemished corporate track record, but whose depressed stock price provides an attractive risk-reward scenario. Within this category, the fund may also invest in distressed debt, liquidations, reorganizations, recapitalizations or mergers.

As an example of a special situation, in mid-2003, in the aftermath of Worldcom's fraud and bankruptcy, Fairholme began acquiring the defaulted debt of that bankrupt telecommunications company, which metamorphosed into the fund's equity stake in MCI through the conversion of bonds during a Chapter 11 reorganization.

"We became interested in WorldCom just after the announcement of fraudulent accounting and the Chapter 11 proceedings," Pitkowsky said. "We ended up buying most of our position at a per share price that was less than the cash they had in the bank. Moreover, the management that caused all the problems was gone; we felt comfortable with the game plan set forth by new management led by Michael D. Capellas. We also liked the company's earnings growth potential and asset base." In addition, Fairholme felt the industry price declines that had beset MCI and AT&T (T) in the enterprise business were starting to abate.

Pitkowsky says the managers typically start out with a small purchase of a new investment, and hope the price goes down further so they can buy more.

That was what happened with WorldCom. "We bought the bulk of our senior bonds of WorldCom knowing there was a plan of reorganization in place, and that they would convert into shares of the new common stock upon emergence from bankruptcy," he said. "The company exited Chapter 11, the stock price dropped, and we continued buying common shares, eventually becoming one of MCI's largest shareholders." When the company emerged from Chapter 11 in 2004, it had about $5.7 billion in debt, and $6 billion in cash.

Through most of 2005, Verizon Communications Inc. (VZ) and Qwest Communications International Inc. (Q) engaged in a bidding war to acquire MCI. As significant MCI stockholders, the Fairholme managers urged the rival parties to offer a fair price for the company. Eventually, MCI was acquired by Verizon in early January 2006 in a deal valued at about $8.6 billion.

Pitkowsky views purchasing defaulted bonds as a "creative way of investing in troubled companies."

A similar case involved the security that became part of another of the fund's premier core holdings, diversified conglomerate Leucadia National Corp. (LUK). "Before our investment in WorldCom, in 2002 we bought the senior defaulted debt of telecom firm WilTel Communications Group, which was then called Williams Communications," Pitkowsky explained. "We knew the bonds would be converted into common stock of the newly reorganized company. When the new entity came out of Chapter 11, the debt was converted to common, and we bought more shares. In 2003, WilTel was taken over by Leucadia, which the fund already had a significant stake in."

Leucadia has surged in price from the low $30s in early 2005 to nearly $50 at present. The company is similar to Berkshire-Hathaway in that it is engaged in various businesses, including banking, real estate, property and casualty insurance, telecommunications and healthcare.

With its long-term investment horizon, Fairholme keeps a portfolio turnover at about 20% annually, a modest level. The fund's current cash position is 30%, but it has historically kept cash at around 20%. While cash can rise when the managers are not finding suitable opportunities, it has helped to dampen volatility.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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