Where the Bargains Are

Value-oriented fund managers have had to navigate a minefield over the past year. Financial stocks, which are typically important holdings in a value portfolio, are sucking wind. Meanwhile, energy stocks, which look awfully overvalued to many bargain hunters, have been the only sure way to make a buck.

Amid the carnage, Bruce Berkowitz and Susan Byrne are hanging tough. Berkowitz's Fairholme fund (symbol FAIRX) has lost 6.47% year-to-date through June 26, beating Standard & Poor's 500-stock index by nearly five percentage points. Byrne's Gamco Westwood Equity AAA (WESWX) has lost 8.14%, beating the index by 3.2 points.

Both managers say they are finding compelling investments. Berkowitz likes sectors that everybody else hates, and today that's leading him to health care. Ten years ago, he says, "people were rushing to buy pharmaceutical companies with price-earnings ratios of 40 and 50, and today they're at ten." But baby boomers will only spend more on health care and drugs as they age, he says.

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As of the fund's last shareholder report, dated February 29, Fairholme had more than 3% of its assets in the shares of Bristol-Myers Squibb (BMY). The fund may have more in health care now.

Berkowitz is also looking at misunderstood retailers. He's still bullish on Sears Holdings Corp. (SHLD), which accounts for 9% of Fairholme assets. He says there's hidden value in the company's real estate and in its brand names, such as Kenmore appliances and Craftsman tools.

You won't find either Berkowitz or Byrne snooping around many financials. "It's impossible to know what the banks and brokers really have" on their balance sheets, Berkowitz says. "I don't know if their managements really know what they have."

One exception is MasterCard, which Byrne recently sold after watching it soar from $50 to $300 a share. "There were perceptions that because MasterCard is involved in credit cards that they're exposed to credit risk, but they're not," she says. Instead, the company collects fees off transactions.

Berkowitz says that all the uncertainty over banks' balance sheets underscores the importance of cold, hard cash. He says his three most important considerations when picking stocks are as follows: how much free cash flow per share a company is generating, how management puts that cash to work for shareholders, and whether the company has a strong enough balance sheet to sustain any disruptions. At Fairholme, says Berkowitz, "we try to focus on those companies that are genetically engineered for hard times."

Byrne, too, looks for stocks that other investors misunderstand. She says she's been purchasing Nike (NKE), whose shares have been weak because of concerns about the health of U.S. consumers. But the two-thirds of Nike's sales that come from outside the U.S. are growing at a yearly pace of 20% to 30%, she says, so the company's doing just fine with or without the help of Americans. "But if everyone understood that, we couldn't buy it at a favorable price," Byrne says.

Neither Byrne nor Berkowitz claim to know where energy prices are going. But Berkowitz says the sector's overwhelming popularity is starting to drive him away: "The euphoria is driving me crazy -- it's like the Internet bubble."