Street Capitalist: Event Driven Value Investments

Bruce Berkowitz of the Fairholme Fund (FAIRX) is featured in a great interview with Advisor Perspectives. Here’s a few quotes, but be sure to read the whole thing:

Leucadia National has minimal disclosure, no Wall Street coverage, and no conference calls. Further, their free cash flow is irregular. How can you meet Ben Graham’s requirement of thorough analysis or determine the margin of safety?

We can’t do that analysis in this case, because we are dealing with more of a Berkshire Hathaway issue. We place a significant amount of weight on the past record of management, along with analyzing holdings on a quarterly and annual basis. Mostly, this represents the style of investing where we respect the people running the company. We have studied Leucadia and their management over a 20 year period. There are no surprises.

Their management is honest, decent, and does not have an oversized ego. They have a better track record than Berkshire Hathaway and they take their fiduciary roles very seriously. Moreover, whereas Berkshire Hathaway is built to last for a very long time horizon, Leucadia has value even over shorter time periods. When the CEO, Ian Cumming, and the president, Joseph Steinberg, retire, they’ll probably give all the money to their shareholders and call it a day.

Leucadia (NYSE:LUK) has always been a favorite of value investors, but they’ve hit a bit of a rough patch lately, stemming from their acquisition of Fortescue. I particularly like this bit about investing in the underlying debt of some of Fairholme’s companies-

You have paired some of your stock positions with senior subordinated debt. Can you explain the investment thesis behind this?

The bond market is more dysfunctional than the equities market. When we see that we can get excess return on the higher end of the credit structure, we know we are on to something good.

We look for certain covenants on the bonds we buy. For example, we want “cross default” provisions, so that if any of the company’s bonds default, then principal payment is accelerated on all the bonds. Similarly, we want change-of-control or “poison pill” provisions, which accelerate principal payments in the event of a takeover. This way, even in an unfriendly or hostile situation, we still get our “box of chocolates” from the bond markets.

And the Fairholme investing process:

Are your positions in health care predicated on the Congress and the new administration enacting some form of national health care plan? What happens if the funds to move forward with such a plan are not available?

To answer this question I must explain our investment process. First, we look at a company’s free cash flow relative to its price. Ideally, we look for a free cash flow yield of 10% or better. [In a recent conference call with investors, Berkowitz said that he is now seeing opportunities with companies trading at two or three times cash flow.] Then we ask what management will do with that cash. If management has a record of investing wisely, that’s great. But we also worry about what can go wrong – what I referred to earlier as “killing the company.” If there are signs that value will be destroyed by actions such as over-leveraging the balance sheet or other stupid management decisions, or if there are certain questions we cannot answer, then we move on to the next investment candidate.

We did not invest in these sectors because we saw nationalized health care coming. We invested because of the value of these companies, in terms of free cash flow, relative to their prices in the market.

The Baby Boomer generation is entering retirement, and they are interested in life, liberty, and the pursuit of happiness. I know, because I am 50-and-a-half and at the edge of this generation. This is a gigantic demographic segment starting to retire and they want to be in good shape and to stay young – and it will take a lot to achieve that.

We have a great health care system, but the unintended consequences include rising costs. For example, nobody says you are too old for a hip replacement. Health care is expensive and HMOs insure the greatest number of people. The two HMOs we own handle 25% of the insured population in the US.

Obama wants everyone insured with the same degree of coverage as the members of Congress. If HMOs like UnitedHealth, WellPoint, WellCare, and others cannot provide these services, then who will? The only thing government can do is to cut a check. Those that are providing these services now will be the ones providing it in the future.

These businesses are very much like our insurance businesses. They can make a mistake in pricing a policy, but in six months they will have the opportunity to adjust those policies. They may lose some members but overall retention rates will be quite high.

Be sure to read the rest, Berkowitz discusses Sears Holdings (NASDAQ:SHLD) and what his thoughts are on 2009. Here’s the full interview in PDF format.