I recently returned from a trip to Miami, Florida, where I visited with the Fairholme fund’s investment team. Periodically meeting with management and/or analysts allows us to gain a better understanding of the investment process and provides an opportunity to ask more detailed questions about the fund holdings.
For the five years ending 6/30/15, the Fairholme fund has averaged 8.36% per year (this is roughly the length of time we have used the fund). While acceptable in absolute terms, Fairholme has trailed the S&P 500 by a significant margin over that time (5-yr average of 17.34% as of 6/30/15). One of our main goals in visiting Fairholme was to determine the status of their various ideas playing out.
AIG & Bank of America
As the largest holdings of the fund, these two are showing the signs of progress that Fairholme originally anticipated. AIG is buying back stock, increasing its dividend and refocusing on underwriting profitability. Bank of America is largely done with the litigation costs associated with the financial crisis and should see the benefits of a major cost-cutting campaign. Both are still trading at a discount to book value, though Fairholme expects them to trade at a multiple of book in the future. Rising interest rates would help.
Though the company is often characterized as a failed retailer, Fairholme estimates that the total value of its owned and leased real estate, net of debt, is more than five times the current stock price. In arriving at this conclusion, Fairholme has compiled a database of all of the properties through their examination of company filings and public records. They have valued the properties using three different methods and have an analyst solely dedicated to working with independent real estate experts and even visiting the store locations himself. During my visit, the Fairholme team walked me through their analysis of some of the properties. One interesting example: Kmart leases almost 300,000 square feet in two New York City locations. There is about 20 years left on the leases, and Kmart pays $28 per square foot. Comparable market rates are conservatively several hundred dollars per-square-foot, putting the value of subletting opportunities at roughly $400 million (almost 20% of the entire market capitalization of Sears).
Fannie Mae and Freddie Mac
These companies are mired in a legal battle over whether the Government can seize all of their profits in perpetuity. Fairholme believes that they, as plaintiff, have the momentum in the court cases. For one, discovery materials in the Court of Claims have now been released to the DC District Court, creating the possibility of the original dismissal to be overturned. Several high profile figures, including a former Chief Justice of the Delaware Supreme Court, have filed “friends of the court” briefs in support of shareholders. And the recent deposition of a former Fannie Mae CFO purportedly shows the government’s submissions as “incomplete and misleading, if not outright false.” Fairholme believes that the companies are indispensable to the US mortgage market and shareholders will ultimately receive their due.
Bruce Berkowitz, as portfolio manager, is the face of Fairholme. However, the team supporting him is quite capable, as I observed from my time with them. The trip served to strengthen my belief that there is a reasonable basis and appropriate research supporting their ideas. The gap between price and value for the underlying holdings suggests potential outperformance for the fund going forward.
Aaron Pettersen, CFA, CFP®