Bruce Berkowitz's Fairholme Fund (FAIRX) has gotten a lot of media attention and investor inflows in recent years. According to Morningstar data, the fund has outranked 99% of all large-cap value funds over the past decade. In that 10-year time frame, Fairholme has put up an annualized 11.2% return, compared to a mere 2.8% showing for the S&P 500 Index. But as I have repeatedly warned the investors piling into the fund, results won't always look this good -- as recent months have unfortunately proved.
All good things…
Despite Fairholme's fine long-term track record, the fund has stumbled lately. It currently lands in the bottom 1% of its peer group in the past year, earning just 1.9% versus the S&P 500's far more impressive 17.2% showing. And apparently, investors are beginning to lose patience. Morningstar data shows that Fairholme saw outflows of roughly $300 million in March, the first significant such movement in two years.
This change of fortune hinges upon Berkowitz's current positioning. Right now, the fund has allocated nearly 80% of fund assets to the financial and real estate sectors. Berkowitz is betting big on a rebound here, but with such a heavy concentration in just one area, there's a lot of risk for fundholders. In fact, the underperformance of many of these holdings accounts for the fund's lagging recent performance.
At last glance, the largest fund holding was AIG (NYSE: AIG), accounting for a whopping 16% of assets as of the end of 2010. AIG has fallen roughly 4% in the past year. Likewise, top 10 holdings Goldman Sachs (NYSE: GS) and Citigroup (NYSE: C),as well as Warren Buffett's Berkshire Hathaway (NYSE: BRK-A), have gained ground in the past year, but only in the single digits. Former top holding General Growth Properties (NYSE: GGP) made quite a bit of money for the fund after its bankruptcy in 2009, but it hasn't seen much improvement since. And Bank of America (NYSE: BAC) has lost roughly 30% of its value in the past year.
Short-term focus, short-term losses
While some folks are already speculating that Berkowitz, a former Morningstar Domestic Stock Fund Manager of the Decade, has lost his fabled touch, there are more important considerations here. First of all, investors should use Fairholme's travails as a lesson on what usually happens to top-performing funds at some point in time. Funds at the very top of their game are more likely to fall back down the rankings in the short run than they are to remain No. 1 for extended periods of time.
All good managers, even the esteemed Bruce Berkowitz, will encounter periods of underperformance -- sometimes lasting for a year, or two, or even three. Investors who jump ship now follow the classic pattern of chasing performance, moving into funds after they have done well, and abandoning their post at the first sign of difficulty. That's a sure-fire way to lose money. Fund investing should be done for the long run. If you're going to trust your fund manager in good times, you've got to be willing to trust him or her in bad times, too.
Second, it helps to remember that outsized returns usually don't come without outsized risk. Berkowitz's big sector concentration in financials is undoubtedly risky, and investors who aren't comfortable with such an approach should probably look elsewhere for a more diversified offering. Berkowitz may yet hit it big with his bet on financials, but investors have to realize that in the meantime, they may have to ensure some bottom-of-the-charts returns.
Staying the course
So what's in store for Fairholme? Well, right now, barring a meaningful change in positioning, that all depends on how the financial sector fares. Given how badly the sector was battered in 2007 and 2008, I think it's a reasonable assumption that financials will rebound more strongly as the economy strengthens. While the sector has gained some ground in 2009 and 2010, financials remained in the bottom half of ranked sector returns for those two years. And given how slowly the economic recovery is playing out, and the tremendous uncertainty still surrounding aspects of our financial system, there are solid reasons why the sector hasn't dazzled. But that's not to say there's not more powder in the keg once the recovery firms up. Berkowitz may not be wrong -- just early.
Ultimately, Berkowitz still has the same skills and talent that made his fund a top performer in the past decade. I don't think that he's suddenly lost his touch, nor do I believe that investors should dump the fund now. His financial bet may or may not work out, but if you're going to invest here, you need to invest for the long run. There may be some more bumps in the road ahead, but I believe that Fairholme remains a fine long-term investment option for risk-tolerant investors.
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