Fund in Focus: Fairholme Fund

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.