Corrected on 03/03/08: An earlier version of this article incorrectly reported that the Fairholme fund was launched in 1997. While its parent company was founded in 1997, the fund was launched in 1999.
As manager of the $6.8 billion Fairholme fund, which he launched in 1999, Bruce Berkowitz is on the hunt for undervalued companies with strong managers and plenty of free cash. Rather than building a traditional, diversified portfolio, Miami-based Fairholme—named after a street Berkowitz once lived on—concentrates its resources on a limited number of positions, a strategy that has led to impressive returns. Fairholme boasts annualized returns of more than 20 percent over the past five years and has returned nearly 2 percent so far in 2008—despite the nasty market.
Berkowitz recently spoke with U.S. News about why diversification is overrated, how volatility is opportunity, and whether Sears Holdings can be the next Berkshire Hathaway. Excerpts:
What kind of fund is Fairholme?
It's a focused fund, nondiversified. That means when we find something we like, we buy a lot. Our top positions plus the cash—and we've averaged about 20 percent cash since we started—is between two thirds and three quarters of the fund. How does this investment approach differ from others?
In business school, you're taught that diversification is very important. But really, when you think about it, diversification has to do more with ignorance. If you are highly confident in your top five positions, why should you put more in your 10th position if you could put more in your best idea? Secondly, business schools teach that risk is volatility. We think volatility is opportunity. For example, if you follow the business school formula, when something goes down 50 percent in price, it's considered riskier. Personally, I would say it's considered safer—you're paying half. What opportunities has the recent market upheaval created?
The current turmoil is affecting, of course, the home builders, the suppliers to the home builders, the roofers, the wallboarders, the carpeting companies—and now it's affecting the purveyors of entertainment in one's home, from cable to satellite. So it's reverberating out. What moves have you made to capitalize on this turmoil?
For example, a company like [satellite television provider] EchoStar Communications (now known as Dish Network). In the last couple of years, there was a perception that the satellite distributors of entertainment wouldn't be able to compete with the cable companies because the cable companies were offering the triple play—you've got the entertainment, you've got the fast cable broadband, you've got the telephone, all on one bill. But that was never true. People want the best service possible, and it doesn't all have to be on one bill. So EchoStar got down to a very low price. But the company is run by a great guy who owns 50 percent of the company and against the odds built up 12½ million subscribers. And the company was at that point where it was starting to generate significant amounts of free cash, and it was being given away on the basis that there is no way they are going to be able to compete in the future. Now, it's come back down again, the idea being that if so many people are so stressed with their homes—facing the possibility that they are eventually going to be kicked out of their homes—well, obviously, how can they pay their satellite TV bill? [As such, Fairholme recently added to its position in the company.]
Why haven't you jumped into the foundering banking sector?
Our attention naturally goes to stressed areas, and we try and understand it. Now, today you have the banks and the insurers—very stressed. The problem, though, is we can't figure it out. We don't know the true assets and liabilities of these companies. I think some of the companies don't even know. I have a real problem getting hurt on an investment, and my only answer would be, "Well, it was impossible to know, so I had to guess." What's another position you took amid turmoil?