Mutual Funds

A Bargain Hunter Stands Tall

Bruce Berkowitz survived the carnage better than nearly all his peers. Now he sees plenty of good values.

By Manuel Schiffres, Executive Editor

From Kiplinger's Personal Finance magazine, January 2009

As a wretched 2008 draws to a close, Bruce Berkowitz displays mixed emotions. On the one hand, Fairholme fund, which he's run since its late-1999 launch, is again beating the stock market (by eight percentage points in early November). On the other hand, the fund is on track for its worst year ever (down 28%). And yet the swoon in share prices that is responsible for Fairholme's losses also brings a smile to Berkowitz's face. The candy store is wide open, and the bargain-hunting Berkowitz, 50, feels like a kid again.

Despite the 2008 loss, Fairholme's long-term record remains solid. From its inception through November 7, the fund returned 11% annualized. During the same period, Standard & Poor's 500-stock index lost 3% a year. Fairholme, which typically owns only about 25 stocks, has trailed the index in only one calendar year.

What really stands out about Berkowitz's performance, though, is how he escaped the ignominious fate of so many other value managers over the past year. He applied strict value criteria when he assessed stocks, and he adhered to the simple (but wise) rule of not investing in anything he couldn't understand. So Berkowitz was never tempted by the likes of AIG, Bear Stearns or Lehman Brothers, no matter how cheap their stocks had seemingly become.

To learn more about how Berkowitz operates, we visited him in his Miami office, located the length of a football field from Biscayne Bay.

KIPLINGER'S: What were you doing as the markets gyrated so dramatically in the fall?

BERKOWITZ: Although the fall in stock prices hurt our performance, it has been a blessing. We've been buying companies at prices that even when I was in my most pessimistic mood, I didn't think we would see so quickly. These are 1974-type valuations, and what's fascinating is that stocks fell to these levels not because of earnings issues but because of the sheer magnitude of the forced liquidations. So this is still a bargain hunter's dream.

We are selling that which is cheap to buy that which is cheaper, in order to make more money in the future and to help manage taxes for our shareholders. And we're pairing our stock positions with senior subordinated debt.

So you're buying the bonds of companies whose stock you own?

Yes. Some of the stocks we hold are so cheap that we fear the companies will be taken over at too cheap a price. So we're buying discounted bonds that have anti-takeover triggers, meaning the price of the bonds will immediately rise to 100 cents on the dollar on a change of control. And if we like the stock, we don't mind owning bonds that are yielding 15%, 16%, 17%.

A lot of well-known value investors fell on their faces the past year or two. Why did Fairholme hold up as well as it did?

Maybe it's because I don't invest in things I can't understand. Eighteen years ago, after the financial stocks got killed, I was a big buyer of Wells Fargo, Freddie Mac and MBIA. They were simpler businesses then -- and they were cheap and understandable. You could read an annual report or a 10-K and you knew what you were getting.

Or take American International Group. If you looked at an AIG annual report six or seven years ago, you saw one paragraph on derivatives. You look at an AIG annual report today and you see 15 pages on derivatives. I don't think company insiders fully understand what's going on, let alone outsiders. So if I don't understand something, I've learned to walk away.

Do you try to anticipate which sectors will do best?

We tend to react rather than to predict. We look at companies, count the cash, and then try to kill the company.

Kill?

We spend a lot of time thinking about what could go wrong with a company -- whether it's a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can't kill it, maybe we're on to something. If you go with companies that are prepared for difficult times, especially if they're linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness.

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