Investment managers with over $100 million under their control must report their holdings on a quarterly basis to the Securities and Exchange Commission on form 13F within 45 days of the end of the quarter. For committed investors, this information can provide insight into the decisions of some of the world's successful money managers -- along with potential stock ideas.
Today, we're looking at some of the third-quarter activity at Bruce Berkowitz's Fairholme Capital Management, with the addition of significant new positions in Citigroup (C -0.78%) and International Business Machines(IBM 1.56%) and a reduction in their massive position in Bank of America (BAC 0.63%).
First, a few words -- and numbers -- to explain why it might be worth tracking Fairholme Capital Management:
- Fairholme's founder and chief investment officer, Bruce Berkowitz, is a highly respected value investor who was named Morningstar's Domestic Equity Fund Manager of the Decade for 2000-2009.
- Since inception (Dec. 29, 1999) through the end of the third quarter, Berkowitz has achieved an annualized return of 11% for his flagship Fairholme Fund against just 3.7% for the S&P 500. That's enough to turn $10 into $51.99 (against $17.73 for the index).
- Fairholme runs highly concentrated funds. For example, the top 10 positions of the Fairholme Fund represented 53.9% of fund assets at the end of the third quarter. Each position is the product of painstaking research and is, therefore, indicative of genuine conviction; conversely, sell decisions are not taken lightly, either.
1. International Business Machines: New position (4.3% of reported holdings)
Berkowitz's interest in IBM is corroborated by some fellow in Omaha: At $11.7 billion, IBM was Berkshire Hathaway's (BRK.A 0.07%) (BRK.B 0.18%) third largest equity position at the end of the third quarter. Furthermore, we know that Warren Buffett added to the position in the quarter, while Berkowitz was initiating his.
Berkshire's third-quarter report states:
Unrealized losses at September 30, 2015 included approximately $2.0 billion related to our investment in IBM common stock, which represented 15% of our cost. IBM continues to be profitable and generate significant cash flows. We currently have no intention of disposing of our investment in IBM common stock. We expect that the fair value of our investment in IBM common stock will recover and ultimately exceed our cost.
Based on the value of the position and the unrealized loss, we can estimate Berkshire's cost basis: $169.65 (which is consistent with the "roughly $170" estimate Buffett gave on Aug. 10, when a CNBC host asked him for that figure).
The volume-weighted average price (VWAP) of IBM in the third quarter was $154.65, according to data from Bloomberg. On Tuesday, the shares closed 8.6% below the VWAP, at $9.36.
2. Citigroup: New position (3.2%); Bank of America: Reduced position (to 14.7%, from 26.1% at the end of the second quarter)
The combination of these two actions suggests that Berkowitz wanted to swap some of his exposure to Bank of America for exposure to Citigroup. That's a bit surprising, given how he has qualified the opportunity in B of A's stock in the recent past -- and we know he's not afraid to carry very concentrated positions.
On a conference call at the beginning of February, Berkowitz told his investors:
From the beginning, I've believed that a 10% return on equity that is distributable to owners by dividends or buybacks would very clearly show the power of Bank of America's franchises. This is a very possible outcome. In fact, Wells Fargo achieves a much greater return at 15% return on equity. And I believe that as Bank of America moves toward Wells Fargo, we shall see those types of returns.
[...] Everyone's worried about where interest rates are how the banks are going to perform at current interest rates, and then with rising interest rates. It's quite possible -- and it's quite probable -- that Bank of America will do well in this interest rate environment.
[...] Bank of America is able to achieve a reasonable return in the current structure. But higher rates will allow much higher returns on equity, and I think that will be a big boost to the financial sector over a two- to three-year period when we start to see rates increasing.
(If you'd like to review Berkowitz's detailed pitch on B of A, you'll find an entire 28-page presentation by Fairholme here.)
The next day, in an interview on Bloomberg Television, Berkowitz was more explicit in terms of the returns that Bank of America shareholders might expect [emphasis mine]:
The thesis that we have on these financials [AIG and B of A], whose prices were so decimated in 2011, is that we were able to buy them at half their liquidation value and that, as they recover, they're going to make money. A more normal environment's going to come back and they will earn a nice, reasonable profit.
So, over the next five, seven years, their equity [book] values will double and the [stock] prices will more than just meet those equity values, they'll increase it. And I expect we'll see four times the price on these financials over a five- to seven-year period. [...] That is why we're "all in" with the Bank of America.
He even went on to point out that the shares contain some optionality with regard to a huge shift in the housing finance market:
[T]here may be some significant growth potential in these companies [Bank of America and AIG]. For example, with banking, as the government-sponsored enterprises [Fannie Mae and Freddie Mac] run off and wind down, who's going to take the role of the government-sponsored enterprises? Could it be the banks that traditionally did their loans and held parts of those loans, rather than just securitize them? [...] It's a huge market where there could be significant growth.
When the interviewer asked Berkowitz to justify his preference for B of A over Citi and Wells Fargo, he responded:
I think Brian Moynihan is going to make Bank of America more like Wells Fargo than Wells Fargo. [...] It is America's bank.
[...] Citi doesn't have that retail element that [B of A] has -- definitely in the United States, which I know the best. And Wells Fargo is a fine institution, but investing is all about what you give versus what you get and Bank of America gave you the chance to get an awful lot for very little.
It's not clear why Berkowitz's preference might have shifted away from B of A toward Citi since then (if that is indeed what happened), but it doesn't appear to have anything to do with the "what you give/ what you get" trade-off. In the third quarter, Citigroup shares traded at an average discount of 20% with regard to their book value during the third quarter. By contrast, the average discount on B of A's shares was 23%, and both of those figures fell by just 1 percentage point relative to the previous quarter. (Meanwhile, Wells Fargo traded at an average premium of 68% in the third quarter.)
There is one thing, though: Citi reminds this columnist of AIG, which is Fairholme's largest holding.