Street Capitalist: Event Driven Value Investments

The people over at Advisor Perspectives have a great interview with Bruce Berkowitz of the Fairholme Fund which touches on his thoughts regarding Sears Holdings (NASDAQ:SHLD), Leucadia (NYSE:LUK), and Berkshire Hathaway (NYSE:BRK-A). These are three investor favorites all which ran into pessimism by the investor community over the last two years or so.

I thought I would excerpt some of the interview (full interview PDF)

Is deflation – particularly with respect to asset prices – eroding the margin of safety at Sears Holdings?

Deflation eroded the margin of safety, in that real estate values came down as the housing market was destroyed. There is a significant correlation between the housing market and Sears. The answer is yes.

On the other hand, Eddie Lampert was quite astute in the way he handled capital allocation in the last couple of years. In hindsight, you can say it was a mistake for him to buy stock at $150 to $170 – it was a different environment. But by creating a company such that there is significant free cash flow being generated, the company has a huge number of degrees of freedom. If deflation was causing a decline in value and Sears’ shareholders overreacted or very smart people start shorting the stock, then the company has more than enough cash to buy all the shares that Lampert and I don’t own – and together we own over 60% of the company.

It was a real win-win situation, in that I believe it was a temporary condition, but he configured the company for adversity. If you count how much cash he generated in the last few years you will see it. Sometimes it is a little hidden, for example because he had to fill a gap in a pension fund liability because the market turned south and the rules required him to put more money in. He’s also paid off a nice chunk of debt. The company does not have a lot of debt. He has bought back a ton of shares.
If you add up all the money used to do that, it’s a significant amount of free cash.

Berkowitz goes on to talk about Leucadia, which is in some circles described as a mini-Berkshire.

Is the value in Leucadia National affected by the tightness in the credit market? Do they have access to capital at attractive rates, and if so why have they not been more active?

Yes, they have been affected by tightness in the credit markets, but they have access to lots of money. With the right idea they have no issues with access to capital. We would loan money to Leucadia. In this environment, it may not be a lack of ideas; it may be an unwillingness to share. Clearly this environment killed cheap money. Could they still get money on reasonable terms? Absolutely.

You have to have a little blind faith with Leucadia, like with Berkshire Hathaway. You can’t predict what they will do. You measure what they have versus what you have to pay for it, and make a determination as to whether you will get the future for free. Of course, you have to assume the future is going to be good.

Leucadia is difficult for me to peg right now. I think with the way the company is structured now, the investment attractiveness depend on your view of the macro and the timing of it all. I do think though that the company will at least be able to preserve its wealth because of its capable managers, whereas other companies may stumble.

Finally, there is a great bit about the Burlington Northern acquisition and whether it was a good deal for Berkshire Hathaway:

We interviewed Bruce Greenwald, the Director of the Heilbrunn Center for Graham & Dodd Investing at Columbia University in November. He was less than impressed with Berkshire Hathaway’s decision to buy the balance of Burlington Northern they do not already own. You own a good deal of Berkshire Hathaway, what is the value investor’s case for using Berkshire Hathaway stock to buy this company?

Last year I sold all my Berkshire and then I bought back what we now own. Last year I said that you have to take Warren Buffett at his word that he will do a couple of points better than the S&P going forward. And he did. That’s not bad at all. But I believe that we are still of the size where we could do a bit better. But that is absent some type of cataclysmic event – and then we faced this cataclysmic event, which allowed Berkshire to put tens of billions of money that was earning less than 1% to work, to earn 10%.

I can’t see how Burlington Northern was a great deal. The greatness of Berkshire is its deployment of float and profit. They are deploying other people’s money in terms of float – premiums on insurance policies that don’t have to be paid out for years and years. If you are going to use part of that float to pay for an investment, you have to make sure the investment is going to make good money. With Burlington Northern, if you adjust for a buyer with cash and don’t think much more about it, then it was not a great deal. But if you bought it using cheap debt and good chunk of other people’s money and you were highly confident that the company would give you a cost-plus return over a decade, then it’s a good investment.

Borrowing money is a sure way to die. But if you are buying toll booths and roads and regulated industries – pipelines or railroads or electric utilities, where you know you are going to end up with some type of cost-plus pricing – you are going to do very well, given that the actual equity you have in it is low.

It’s like buying a house with a low down payment. If you judge the return after expenses, after taxes, and on the profits on shareholder equity, the return can be two to three times what it looks like to an all-cash buyer.

Be sure to read the entire interview (click here to read more) it is well worth your time and delves into the car rental business and Fairholme’s view on healthcare stocks.

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.

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.