Street Capitalist: Event Driven Value Investments

Eleanor Laise, at the Wall Street Journal, has a good article about the recent troubles at the Fairholme Fund a couple of days ago. I’m not invested in the Fairholme Fund, but I really like the work that they do. For much of the year, they managed to dodge the credit crisis by refusing to invest in complex financials and sold their energy holdings around the top. Both of these moves would be a recipe for market beating returns, but eventually as Mr. Market’s depression spread to the entire market, funds that were concentrated in equities like Fairholme were hurt as well.

After outperforming a badly listing market by losing just a few percentage points in each of the first three quarters of 2008, the $6.7 billion mutual fund dropped 24% in the last three months of the year, lagging behind the Standard & Poor’s 500-stock index by two percentage points.

Mr. Berkowitz used his cash hoard to snatch up beaten-down shares, but new holdings like defense companies Northrop Grumman Corp. and Boeing Co. have fallen. Longer-term stakes like investment company Leucadia National Corp. and retailer Sears Holdings Corp. also were hit.

Some Fairholme investors are losing faith. In November, Fairholme experienced its first monthly outflow in more than three years, with investors pulling about $7 million from the fund, according to fund tracker Lipper Inc.

Mutual Fund Fought Off Bears but Now Is Clawed (WSJ)

Laise’s article is actually pretty balanced. Sometimes I think that journalists and the public are quick to cast a stone at managers who hit small bumps like this, but she devotes a good amount of the article to Bruce Berkowitz’ views on the fund.

One thing I’ve noticed is that value investors can have a hard time when managing the money of others. Inherently, value investors are going after areas of the market that no one else is touching. The problem with this is that such decisions can make their investors question their ability. When the markets are panicked, investors can panic too. This is particularly bad for a fund like Fairholme, where the level of concentration increases volatility.

If investors get really panicked, they’ll force withdrawals from funds and sometimes force selling. There are a few ways to get around this (borrowing, cash cushion) but often, it always looks bad when investors are pulling out of an investment vehicle. It’s times like those when fund managers should be vigilant and keep their investors calm.

Laise’s article only touches on it, but Berkowitz responded to the withdrawals by holding a great conference call. For much of the year, during the credit crisis, we’ve seen companies get on and hold these emergency conference calls to calm the fears of their investors. And almost every time, these conference calls are utter wastes of time. They end up trying to place the blame for their current woes on parties besides themselves — be it the government and their market intervention, or demonic short sellers.

Berkowitz didn’t do that. Instead, he spent most of his time on the call going back and forth with people who’ve invested in the Fairholme Fund. What investors received was great – frank discussions about the companies that were invested in and his perspectives on what went wrong this quarter. Rather than play the blame game, he said that Fairholme’s performance was due to a couple mistakes.

1. Misreading the management of a couple companies.
2. Buying too early.

Even Warren Buffett sometimes finds himself in situations like that (staying in Coca-Cola too long, buying to early during this most recent financial crisis). I don’t think that the occasional misread of a company’s management will end up killing a portfolio. Most investors are sufficiently diversified to protect against that. I don’t believe that the fund’s short term performance will be any indication of how it will perform in the longer term. Value investors aren’t trading daily and as a result, should probably be judged with a longer time period.

Throughout the call, Berkowitz was incredibly reassuring to investors. He spent a lot of time talking about specific holdings with the fund’s investors.

I liked the questions about Sears Holdings (NYSE:SHLD). Sears has taken a lot of hits in the press lately about the poor performance of its stock and the continuously turning turnaround. But now, if you look at what Eddie Lampert has done, maybe his decisions weren’t too bad. While most retailers were spending cash on upgrading their stores, Lampert was more focused on allocating cash to generate high returns. With cash and spending tight, a company like Sears might be better positioned than others. The fund’s investment thesis in Sears was really based around the company’s liquidation valuation, not because other value investors flocked to it, or Eddie Lampert’s successful hedge fund career.

He also discussed Pfizer (NYSE:PFE) a company that the fund selected because of its free cash flow yield, new CEO, cost-cutting, and distribution network. Berkowitz envisions Pfizer as a pharmaceutical merchant bank. With Pfizer generating what looks like $14 billion in FCF TTM, that kind of capital could be deployed quite well to acquire other companies with more developed drugs. That would be incredibly useful to offset the loss of Lipitor.

If you read through the Fairholme Fund’s letters, you’ll see that they mainly look for factors like high FCF yields, a good moat, and a good balance sheet. These companies might be hurting right now because of Mr. Market’s depression, but it seems hard to argue that their long term prospects are bad. The wont need government intervention and should be able to thrive by engaging in cheap acquisitions right now.

Besides specific investments, Berkowitz mentioned on the call that he would be pushing 100% of his net worth into the Fairholme Fund. I don’t know of a more reassuring move that a fund manager could make, especially in a time when investors are particularly frenzied and the economic situation remains a bit bleak.