The Trouble at Fairholme
The once highflying mutual fund is down sharply this year, and one of its top executives has abruptly left the firm. Is there a connection?
Bruce R. Berkowitz had plenty of admirers while his Fairholme Fund was tripling investors' money over the past decade. Financial publications like this one encouraged readers to put their savings into the hands of the now 53-year-old value investor who affects the plain-spoken ways of Warren Buffett and beat the market by an average of 14% in each of the past 10 years. But this year, the mutual fund (ticker: FAIRX) is down 27%, while the broad market has been roughly flat.
Suddenly, Berkowitz has plenty of doubters. Redemptions and negative returns have cut Fairholme's assets in half since last year, to about $9 billion.
Folks with firsthand knowledge of Berkowitz wonder if the brilliant investor—whom Morningstar last year dubbed Manager of the Decade for his U.S. stockpicking–has lost his way. Says a Wall Streeter familiar with Berkowitz: "The way he's making money—and who he's doing it with—is not how the 10-year track record was created."
As for "who," that would be Charles M. Fernandez, whom Berkowitz abruptly made director, president and co-manager of Fairholme in 2008. Fairholme's long-time team of portfolio professionals were effectively displaced by the now 49-year-old Fernandez, who had no apparent experience in investment management. Berkowitz even installed Fernandez in the mansion next door to his own, in the tony Tahiti Beach Island enclave of Coral Gables, Fla., and then forgave Fernandez's $9 million mortgage. But something seems to have changed in their relationship.
A DAY AFTER Barron's asked Fairholme about him, Fernandez resigned "for personal reasons," according to a curt filing made Tuesday with the Securities and Exchange Commission. "References to Mr. Fernandez in the prospectus," said the notice, "are hereby deleted."
Whether Fernandez's co-management of Fairholme contributed to its current predicament isn't clear. But mutual-fund veterans do say that the concentration of Fairholme's stock holdings has been unprecedented, even in comparison with other "focused" funds, such as Bill Miller's Legg Mason Value Trust (LMVTX) or Ken Heebner's CGM Focus Fund (CGMFX). As Fairholme doubled down on its bets on unpopular shares like American International Group (AIG) and St. Joe (JOE), its most recent SEC filings (from May and June) showed cash levels near historical lows and some two-thirds of its holdings piled high in stocks including Sears Holdings (SHLD) and Brookfield Asset Management (BAM). To handle any redemptions, SEC rules discourage mutual funds from putting more than 15% of their assets in "illiquid" securities—those that would take over a week to sell.
Fairholme's portfolio has surely changed since its latest holdings report to the SEC on June 30—the September holdings report, due this week, may show cash raised from its recent sale of shares in Regions Financial (RF)—but the June snapshot revealed positions that would take months to unwind without overwhelming the stocks' daily volume and crushing the share prices. One expert on large trades' price impact, the Santa Fe Institute economist Doyne Farmer, says that traders who don't want to drastically move a stock's price try to keep their own trading below 20% of a day's volume. The table below shows the hypothetical number of days required to exit Fairholme's least liquid positions at that rate.
Fairholme's "Long" Squeeze
If Fairholme had to sell its big holdings, but wanted to keep the sales under 20% of the stocks' usual daily volume, some of its positions could take months to unwind.
| Company/Ticker | Recent Price | 52-Week Range ($) | June 30 Holdings (mil shares) | Value at Recent Prices (mil) | % of Equity Holdings | Days Needed to Sell** |
| St Joe Co/JOE | $14.51 | 14.52-30.34 | 27 | $386 | 4.2% | 227.5 |
| Sears Hldgs /SHLD | 73.44 | 51.14-94.79 | 16 | 1,203 | 9.1 | 148.7 |
| Brookfield Asset /BAM | 27.43 | 24.42-34.23 | 27 | 748 | 7.0 | 109.2 |
| Leucadia Natl Gp/LUK | 25.69 | 20.81-39.14 | 19 | 481 | 4.9 | 88.1 |
| MBIA/MBI | 8.15 | 5.99-14.96 | 47 | 382 | 3.2 | 76.8 |
| American Intl Group /AIG | 22.91 | 19.18-52.67 | 103 | 2,363 | 23.4 | 66.9 |
| China Pacific Ins/2601 HK* | 2.77 | 2.59-4.55 | 148 | 410 | 4.1 | 50.8 |
| CIT Group/CIT | 34.13 | 27.68-49.57 | 19 | 663 | 6.7 | 47.1 |
| Winthrop Realty/FUR | 8.46 | 8.05-13.84 | 1 | 11 | 0.1 | 40.0 |
| AIA Group Limited/1299 HK* | 2.98 | 2.54-3.79 | 302 | 901 | 7.1 | 37.2 |
| *Hong Kong stock holdings, as of May 31, 2011 **Based on 20% of daily volume | ||||||
IN RESPONSE TO QUERIES from Barron's, all Berkowitz would say about Fernandez, who also resigned as vice chairman of the St. Joe board chaired by Berkowitz, was that Fairholme wishes him the best. We were unable to reach Fernandez. But he seems to have been an unlikely choice to replace Fairholme's veteran investment pros. A biography in Fairholme's prospectus told of Fernandez's 23 years of management experience at companies like Big City Radio and IVAX (IVD), the generic drug maker founded by billionaire Phillip Frost. But the bio doesn't mention a scandal that sent a Florida Assembly speaker to jail for taking secret payments from a political-action committee Fernandez headed. Or that two public companies, Continucare and Big City Radio, lost a combined $150 million with Fernandez as their chief executive.
By many accounts, Berkowitz and Fernandez have been inseparable the past few years. Fernandez is married to Berkowitz's cousin, and the Coral Gables neighbors have summered together in Bridgehampton, N.Y. In a June interview, Berkowitz described Fernandez as an alter ego, like Buffett's famous associate, Charlie Munger. "I did learn from Warren Buffett," quipped Berkowitz, "that everybody needs a Charlie."
The story of Bruce Berkowitz and Fairholme is legendary.Berkowitz has said that in high school, he ran his father's small-time bookmaking operation for a couple of months, while his dad recovered from a heart attack. He went on to become a successful stockbroker at Salomon and then Lehman Brothers, doing his own research and betting on companies, like Berkshire Hathaway (BRKA) and Leucadia National (LUK), that were run by great investors. His clients made a sevenfold return on Wells Fargo (WFC) in the early 1990s, when other people were wrongly betting that the California bank was going bust. Then as the dot.com frenzy peaked in 1999, Berkowitz launched the Fairholme mutual fund with the out-of-favor strategy of value investing.
Before long, Fairholme was handily beating the market with big bets on insurers like Markel (MKL) and White Mountains Insurance (WTM), not to mention large investments in Berkshire and Leucadia. Working with Berkowitz at his Short Hills, N.J., office was a small investment team lead by Larry Pitkowsky and Keith Trauner. Outside consultants also supplied industry expertise when Fairholme took contrarian plunges on companies like WilTel Communications and MCI. Although Berkowitz owned the firm that ran Fairholme, Trauner and Pitkowsky joined him on media interviews. All three drafted and signed letters sent to Fairholme investors.
After a couple of years in which the fund gained better than 20%, investors started pouring money into it. Assets under management hit $1.4 billion in 2005, then almost $6.5 billion in 2007. Berkowitz's firm got an advisory fee of 1% of assets, which came to more than $50 million in 2007. Add the gains on Berkowitz's own stake in Fairholme's funds–Fairholme management held over $300 million worth as of March 2011—and that's pretty good money.
In late 2006, Berkowitz moved to Miami to escape Wall Street's groupthink and New Jersey's taxes. Fernandez and Berkowitz met when Fernandez married a cousin of Berkowitz named Lauren Sturges in July 2007. Her father, Robert Sturges, had run the gaming business of cruise-ship operator Carnival (CCL) and owned a piece of the Miami Heat basketball team with Fernandez's uncle. After Fernandez joined Fairholme in November 2007, fractures began developing in what had been a tight-knit group. Neither Trauner nor Pitkowsky will discuss what happened; they eventually left Fairholme and started the GoodHaven Fund (GOODX).
But a civil suit filed last year in a Miami state court by a fired analyst might fill in some blanks. The plaintiff, David Ahl, contends that Fairholme was a hostile working environment. He recounts how he came to Fairholme as a telecom-industry consultant in 2003 and then a full-time analyst in 2006. When Berkowitz told his portfolio team that they needed to join him in Florida, Ahl bought a $3 million condo in Coconut Grove in September 2007. A few months later, says Ahl, Berkowitz installed Fernandez as boss of Fairholme's portfolio management team, overseeing Ahl, Pitkowsky and Trauner. Fernandez also brought in new directors and officers to Fairholme, such as Treasurer Paul R. Thomson, who had worked for Fernandez at the unprofitable Big City Radio. Fairholme has denied Ahl's allegations.
Fernandez is shown with his wife, Lauren, Berkowitz's cousin.
Charlie Fernandez seemed as though he was connected to everyone in Miami—he'd married four times by the age of 45—and his network included South Florida mayors, police chiefs and pension-fund trustees. Acquaintances note that, at the time, Berkowitz had just lost a key mentor with the death of Fairholme director Joel Uchenick. Fernandez and Berkowitz hit it off. Berkowitz lent Fernandez the money to buy the mansion next door, and then forgave the mortgage. They visited Fernandez's favorite after-hours spots, in ponytails and guayabera shirts.
In his lawsuit, David Ahl complains that Fernandez had no experience in securities analysis or portfolio management. Public records show that Fernandez had plenty of experience in business and politics, however. At hearings of New Jersey's Casino Control Commission in 1999, Bally Entertainment magnate Arthur Goldberg had to explain why his firm shouldn't lose its Atlantic City license after funneling secret payments to Florida Assembly Speaker Bolley "Bo" Johnson through a political action committee.
The PAC was headed by Fernandez, who was running Bally's unsuccessful campaign to legalize casinos in Florida. Goldberg and Fernandez testified to the casino commission about Atlantic City junkets and payments they arranged for Florida politicos. State prosecutors concluded that the payments didn't constitute bribery under Florida law. Fernandez and his Bally associates weren't charged with any offense. But a federal prosecution sent Johnson and his wife to prison for failing to report the Bally payments on their tax return.
Fernandez got his start in business working for his uncle Amancio Suarez, a real-estate developer who owned two Spanish-language radio stations in South Florida. They sold out to a broadcasting chain called Heftel in 1995 for about $20 million.
Fernandez next started the health-care company Continucare, with the backing of Miami entrepreneur Phil Frost and George Soros' brother Robert. Continucare spent $45 million acquiring South Florida medical practices, but as the roll-up failed to generate cash profits, its stock fell from 13 bucks to 19 cents. Fernandez stepped down as CEO in 1999.
He soon was CEO of Big City Radio, a radio chain that he converted to a Spanish-language format. Over the next three years, it lost $90 million and its stock slid from five bucks to 10 cents. After Big City sold its radio stations for the benefit of creditors in 2003, Fernandez spent the next few years running an addiction-treatment hospital and serving as a director of Phil Frost's IVAX.
After arriving at Fairholme, says Ahl's complaint, Fernandez urged Berkowitz to invest in health-care outfits like WellCare (WCG). He also became a key player in Fairholme's fight to control St. Joe, the owner of 600,000 acres of Florida panhandle property whose value has been the subject of a fierce debate between Berkowitz (who thinks it's high) and hedge-fund manager David Einhorn (who doesn't). Since January 2011, St. Joe shares have fallen from about $30 to $15. Until last week, Fernandez was co-manager of all three Fairholme funds, including Fairholme Focused (FOCIX) and Fairholme Allocation (FAAFX), which are also down substantially this year.
Berkowitz, of course, is Fairholme's ultimate decision maker. In the past, he has extolled Fernandez's business savvy. And he has praised Fernandez for bringing in last year's $2 billion gain on bond investments in AmeriCredit and General Growth Properties (GGP). In fact, Berkowitz has said, Fernandez made more money for Fairholme investors than had all previous employees, combined.
Fernandez probably did fine for himself, too. Barely a year after his arrival, Pitkowsky and Trauner departed from Fairholme. Fernandez seems to have been the only investment employee remaining to claim what David Ahl's lawsuit says was a bonus pool of 15% of the advisory firm's profits—probably more than $10 million in 2008.
Pitkowsky and Trauner declined to discuss Fairholme. And Barron's was unable to obtain comment from Ahl or his attorney.
Will Berkowitz's big bets work out? Maybe. Or maybe not. But one thing is clear: His travels with Charlie have ended.
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