Fairholme’s 2011 Results Show the Risk of Concentrated Positions in Hard to Value Businesses

The performance of the Fairholme Fund (FAIRX) and manager Bruce Berkowitz and his comments in his annual letter have been the subject of numerous commentaries. The fund lost 32.42% in 2011.

The commentary seems to fall in to one of two camps. His staunch supporters, including many “value investing guys”, rush to defend Morningstar’s Fund Manager of the Decade and believe his big bets on financials will eventually be vindicated. The other group seems to portray him as an idiot whose contrarian streak got him in trouble and led to a permanent loss of his investor’s capital.

My critique goes a bit deeper. I have no idea whether he will ultimately be vindicated on his bets or not and I don’t particularly fault him for a bit of underperformance (even if it is severe). Everyone makes bad bets and underperforms, it happens to all fund managers. Instead my issue lies with the investment process that led him to make the large, concentrated bets on financials in the first place.

I have no qualms with concentration per se. After all, it has worked out spectacularly well for some investors.

Tom Russo runs a concentrated portfolio with almost 37% of the portfolio in his top four holdings: Nestle, Philip Morris International, Berkshire Hathaway, and Heineken Holdings. Berkshire Hathaway itself runs a concentrated portfolio with 74% of the portfolio in only five stocks: Coca Cola, IBM, Wells Fargo, American Express, and Proctor & Gamble.

For reference the Fairholme Fund has 70% of its portfolio in only six holdings: AIG, AIA Group, Sears Holdings, Berkshire Hathaway, CIT Group, and Bank of America. The allocation is even more concentrated and includes even more financials like MBIA, Emigrant Bancorp, Wells Fargo, and JPMorgan among others.

Russo and Buffett run concentrated portfolio but they have large holdings in simple, easy to understand businesses. You can be fairly certain nothing evil lurks on the balance sheet of Nestle, Coke, or Philip Morris (regulatory risk aside). In addition those companies operate in sectors that are well known for their historic records of high profitability. You could pick tobacco companies by throwing darts and make out pretty well.

Financial firms are a different animal altogether. First of all the financial sector is not known for its historic track record of profitability. Instead it is known for a boom and bust cycle that makes investing in financials for the long term a dangerous proposition. On top of that, rather than choosing small, easy, and simple to evaluate banks Berkowitz piled in to some of the most confusing businesses in the financial sector. Bank of America is a behemoth of cobbled together parts.

I question whether anyone, including regulators and even the management themselves, truly knows the value of everything on BAC’s books. What is even more alarming is I’m not sure Berkowitz went through BAC himself (if that is even humanly possible). I have seen numerous interviews where he states his thesis for BAC and his justification that all is fine on the balance sheet was that federal regulators have been through the books during the crisis and are continuing to monitor the bank so things must be OK (perhaps given the short nature of my interview segments he didn’t have time to elaborate on work FAIRX did themselves?).

I would question the wisdom of relying on third party verification especially in light of the fact that these were the same regulatory bodies that looked the other way during the buildup of the crisis. How much “regulating” versus rubber stamping and “sweeping under the rug” they are doing is something I have serious questions about. The policy of most federal regulators was much more akin to Sgt. Schultz’s approach to guarding the prisoners at Stalag 13, “I see NOTHING! I know NOTHING!” than it was to actual regulation.

Concentration is fine when it is in simple, easy to understand businesses that operate in attractive sectors of the economy. When you start concentrating a portfolio in the financial equivalent of your high school or college cafeterias “mystery meat” bad things are much more likely to happen.

Disclosure: Long Nestle, Philip Morris International, Berkshire Hathaway, Wells Fargo