Wednesday, May 25, 2011

Will Fairholme Become A Mini-Berkshire?

Fairholme (FAIRX) now has roughly 75% of its assets in financials.

Previous post: Fairholme's 1Q 2011 Portfolio: Still Dominated by Financials

So far that concentration in financials has performed poorly but Fairholme certainly has made a lot of money for its investors over the years.

Time will tell how that all works out but below is an article on Fairholme that is well worth reading. The article is from Institutional Investor Magazine and explores how Fairholme may use its control of St. Joe (JOE) as a way to buy assets that a regulated mutual fund normally cannot.

If so, Fairholme just might become an investment vehicle that is more similar to Berkshire Hathaway (BRKa) over time.

A Mini-Berkshire?
...they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett's Berkshire Hathaway.

"We're trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders," Berkowitz says.

Buying Banks
"There are plenty of people out there who think we're crazy for being in banks and brokers and AIG," Berkowitz says.

Then later in the article...

"We're only in the third inning," he says. "The last time I was heavily involved with the banks, it was a five-to-ten-year period. And I'm always early, which in a way is a good thing because if you were right on day one, you'd have a much smaller position."

The last comment is something that's been covered several times in the past on this blog (most recently here).

Value investing sometimes requires living with an asset in the red for an extended period of time to make sure a large enough position is accumulated. In other words, you sometimes need to be temporarily willing to be in the red to avoid the quantity of "an eyedropper" when a full glass is wanted problem.

Something cheap generally ends up getting even cheaper and it's impossible to pick the bottom. So, inevitably, being in the red while accumulating shares is going to happen. I know of no perfect solution to this.

The fact is many cannot stomach to see the temporary paper losses that are usually part of this process.

Being "too early" is a situation that goes with the territory but it only works if an investor can consistently get the approximate value a business right and buys it with the appropriate margin of safety. Some assets, like most tech stocks need the gap of price versus value to be large enough to drive a truck through while the Coca-Cola's (KO) and Pepsi's (PEP) of the world need much less.

An entirely different situation is when you judge the value of an asset wrong then hold on while losses mount in an attempt to get back to even.

The impact to a portfolio for this kind of behavior can be hugely negative.

Comparing the two:

1) An investor misjudges what an asset is worth yet holds on. The end result will frequently be, other than pure chance working in the investor's favor, an unnecessarily large permanent loss of capital.

2) An investor buys "too early" at a discount having correctly assessed intrinsic value and the potential for growth in that value. In contrast, returns are likely to work out just fine with enough patience and discipline over the long haul (even if it looks ugly on paper for a while).

"The first principle is that you must not fool yourself -- and you are the easiest person to fool." - Richard Feynman

To be successful, making a candid assessment whether the situation is more 1) than 2) is crucial.

In any case, what happens with Fairholme and St. Joe will be interesting to watch.

Adam

Long BRKb, KO, and PEP

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