Monday, November 23, 2009

Bruce Berkowitz: WealthTrack Interview Transcript

CONSUELO MACK: This week on WealthTrack, the golden rules of investing from Fairholme Fund’s Bruce Berkowitz. He’ll explain how avoiding losses, focusing on cash and trying to kill a business added up to big runs for this five-star fund. “Great Investor” Bruce Berkowitz is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. The naysayers are licking their wounds. The zippy recovery that recent guest Jim Grant referred to could not be more apparent in the financial markets. Much was made of the fact that the Dow snapped its six-day winning streak on Thursday, but give the market a break. The blue chip average hit a series of 13-month highs last week and is still 57% higher than its March lows. Gold ended its eight-day run on the same day but is still trading in record territory, having advanced 25% this year. And oil has gained 73% year to date.
Meanwhile, despite a relatively lukewarm auction of 30-year Treasury bonds late in the week, the government successfully sold $81 billion of new debt, even though the Federal Reserve had wrapped up its $300 billion Treasury purchase program last month. Well, macro events such as these are not of particular interest to this week’s Great Investor guest. Bruce Berkowitz is a bottom-up value investor in the Graham and Dodd tradition. As a matter of fact, he was one of the handful of leading value investors chosen to introduce a chapter of the latest edition of Benjamin Graham’s classic, Security Analysis.
Berkowitz’s now $10 billion Fairholme Fund, a five-star Morningstar favorite, will celebrate its tenth anniversary at the end of the year, but its approach, which has delivered market and peer-beating annualized returns of more than 12%, remains the same. He and his team run a tightly focused portfolio of about 15 to 20 stocks and hefty cash positions averaging around 17%. And despite the increasing lure of overseas markets, Fairholme is sticking to what Berkowitz calls his “home team advantage,” investing in the U.S.-based companies. As if his job were not changing enough, the former bond manager is going back to his roots and will be launching a Fairholme bond fund in the New Year. A man of many memorable lines- one of his slogans is “the right time to invest is always”- I asked him, what about now?

BRUCE BERKOWITZ: Probably as good a time as any time, because after all investing is just an equation of what you pay and what you get. And there are more than enough situations today where you get so much more for what you’re paying today.

CONSUELO MACK: Let me ask you about the Fairholme Fund, some of your mantras. One is never to lose money. What do you mean by “you never want the lose money?”

BRUCE BERKOWITZ: Well, we make the assumption that people worked very hard for their money and that we have all of their long-term investment money, and that money is going to be very important to them in their retirement in the future. So our number-one goal is, don’t lose it. Because you lose it, you can’t start over again if you don’t have anything to start with, and no one likes to go back to go. So the number-one rule, don’t lose the money. Number-two rule: follow number-one rule. Number-three rule, try and make as much as possible at a reasonable risk basis.

CONSUELO MACK: What are some of the lessons that you learned from the last 18 months or so from the market meltdown? Did you learn anything?

BRUCE BERKOWITZ: Well, it reinforced a lot of the old lessons that people forget during very bullish times. Leverage is a two-edged sword. At the end of the day you have to count cash because after all, that’s all you can spend. Many people come up with reasons why an investment is going to do well. We’d like the turn that upside down and think about why an investment can kill you, so we try and kill the business, and if you can’t kill the business, then maybe something good will happen.

CONSUELO MACK: What do you mean by the exercise of trying to kill a business?

BRUCE BERKOWITZ: It gets to the point about the balance sheet. When you have a very leveraged organization, such as a bank or a credit card company, you’re really dependent upon the kindness of strangers, your bankers. If they decide one day they no longer like you, your business is over, so the balance sheet is very important. We want businesses that have a fortress-like balance sheet. If they don’t have a fortress-like balance sheet, we have to be absolutely convinced that the management has the ability to generate the cash necessary for the business to survive, even without the acceptance of their financial community supporting them and their credit structure.
Another lesson learned, getting back to that, is that when times are really tough, everything is correlated. When people need money, they sell that which is easy to sell no matter what the price is because so much can’t be sold. So people do not prepare for those one in every 10, 15-year events where you have this extreme moment that can take you out of the game because it is just too hard to sit on all that cash for such a long period of time or to be too conservative because there are new rules, but eventually we find out there are no new rules, just the old rules that work.

CONSUELO MACK: If you look at the events of the last two years, a lot of people were shocked at what happened, the market meltdown, the credit freeze-over, and a very popular book over the last couple years has been The Black Swan, by Nassim Taleb. He’s been on WealthTrack, and the fact that people look at what these “black swan” events and say this is a once-in-a-lifetime, a once in a generation, a once in a 100-year perfect storm. But you’re saying not so, and you have to figure they’ll happen more often.


BRUCE BERKOWITZ: That’s right. Hurricane predictions, you say this is a storm that will happen every one in 300 years or one in 100 years, but we seem to have these 1 in 100-year storms every seven to 15 years. We don’t get it right. There’s a problem with the modeling. There’s a lack of common sense, and also with statistical theory that it’s only going to happen once in 100 years- what happens if it happens in the first year rather than the 70th year? Your statistics is all about the spinning of a roulette wheel in the Monte Carlo simulations. But you can’t apply that, for example, to Russian roulette. If you have a gun with 1,000 chambers and one bullet, does it pay to put it to your head and pull the trigger? The answer is no because if that bullet is in the first chamber, you can’t pull again. You’re dead.
So a lot of statistics assume that you can keep spinning and spinning and take chances and chances when, if you play Russian roulette, you can’t continue. And this probability theory that people apply to investing takes you down a very treacherous path.

CONSUELO MACK: So what is your substitute for it then? I mean, how do you protect yourself against these events that you think are going to happen much more frequently than we are willing to admit?

BRUCE BERKOWITZ: I don’t know if it was Warren Buffett or Charlie Munger who once quoted an old country western song. I think they quoted it backwards and it went something like, “tell me where I’m going to die so I don’t go there.” The trick to investing is not to die and not the play Russian roulette. Frankly, if there is a low, low probability of death, you pass. You don’t say to yourself, it’s only 1 in 100, 1 in 1,000. It’s unacceptable. Death is death.

CONSUELO MACK: Cash flow, free cash flow is another emphasis that Fairholme Fund has when you’re looking at companies. Number one, describe what you mean by free cash flow and also why free cash flow is so important to you.

BRUCE BERKOWITZ: Well, the best example I can give on free cash flow is my first job in a corner grocery store behind the counter. People will come in and buy what they needed for the day. Money would go into that single cash register. From that cash register you would pay the bills. You would restock the shelves. You would keep the place clean, paint it every once in a while, and then in the end what was left in that cash register was for the owner of the business to pay employees. And the remainder was for that owner to keep. And that’s the free cash. And then the owner had to think about capital allocations. Do I spend the money? Some of it, do I spend on my family? Do I spend the money to try to grow the business? Do I use the money to grow another business? And that’s how I think about it. Free cash flow is that amount of cash left in the cash register at the end of the business day, and we try and use that analogy on all of the complex businesses that exist today.

CONSUELO MACK: So give me an example, Bruce, of a company that is throwing off a lot of free cash flow that you’re invested in now and why that is so important to that company, especially given, again, this very difficult environment we’ve just been through.

BRUCE BERKOWITZ: Today you have the health insurers, where the fear is so great they’re going to be put out of business by the government, so their prices, their stock market prices have fallen off the proverbial cliff. So when you look at the prices today of a Humana or a Well Point compared to the amount of free cash that they generate, it’s a very high free cash flow yield. And it’s not because they’re making egregious profits, which they’re not. They make about a 4% profit margin which isn’t that much and is very sensible and competitive, but it’s because of the fear of their failure based upon what the current administration is going to do, allowed Fairholme to buy at a very cheap price in relationship to those existing cash flows, which have done quite well. And then, of course, we try to kill the business, and we ask ourselves, well, if the current health insurers aren’t going to do it, who is going to do it for the country?
The answer is there isn’t anyone else to do it for the country. Government is very good at printing checks, sending them out to people, but there’s no hidden department with hundreds of thousands of people ready to help with health care.

CONSUELO MACK: This is a long-term investment for you essentially. What’s your average holding at the Fairholme Fund?

BRUCE BERKOWITZ: It’s in the years. It’s many years. Investing is sort of like marriage. It’s like the longer we can hold an investment, the better we feel that all the time and effort we put into studying a company- it’s kind of when we sell a position, I feel as if it’s divorce. We’d like to ride a nice, long wave.

CONSUELO MACK: But you in the recent past have sold Berkshire-Hathaway; was one of your largest holdings. You sold it. Then it’s become one of your largest holdings once again. What happened? Why did you sell? Why have you bought back?

BRUCE BERKOWITZ: I wish I had a good answer as to why we sold. It probably was a stupid move on my part, but Warren talked about how we’re big, we’re large, we’re slow, we’re going to be cautious. We’re going to still do well, a couple points better than the S&P 500. Nothing wrong with that. It’s fabulous performance. I thought, given our size, we could do a bit better absent some type of cataclysmic event which would allow Berkshire Hathaway to put the tens upon tens of billions of dollars of cash they have, and that event happened. Warren Buffett has been able to put a tremendous amount of money to work that was yielding maybe 1% that’s now yielding 10, 12%. And the businesses that he’s put together just complement the insurance businesses so well, the volatility of insurance business versus the stability of the electric utility, and now the railroad business. These are big-scale businesses that will allow Berkshire to put much more money to work over time.

CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it said Warren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer the nimble investment firm that it was once. What’s your view of what Warren is doing in buying these big industrial companies?

BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments: electric utilities cost plus or a railroad business which has the stability unlike many businesses. So here he’s taking money that’s actually got a zero cost to it and then investing it at a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost is zero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’s married another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime.

CONSUELO MACK: You think this might be the golden age of Warren Buffett, is that right, what he’s doing with Berkshire-Hathaway right now?

BRUCE BERKOWITZ: I think in the past two years, given prices and where he’s been able to buy and how much money he’s put to work and given how so many of his competitors have been weakened from this environment that this may prove to be his best period of all time.

CONSUELO MACK: Are there parallels to what Warren Buffett is doing with Berkshire Hathaway and what you’re doing in building a portfolio with the Fairholme Fund?

BRUCE BERKOWITZ: There are huge parallels. I mean, nothing we do is original. We’ll take our ideas from any successful person to help our investors. We have no ego when it comes to the origination of ideas. Warren Buffett and Benjamin Graham before him and others have taught some extremely valuable lessons. So, yes, and we’re constantly looking at the risks. We’re constantly looking at how the fund can get hurt, how our shareholders can get hurt. So we’re balancing. We want to be focused because after all how much can one person do? We want to focus on our best 10, 20 ideas so that we have the time to protect our shareholders, but at the same time if the positions do well, it will make a meaningful difference to the performance of the portfolio. But then we have to balance the different sectors that we’re involved in so we don’t get too heavily weighted in one.
We always want to have cash. I find cash to be a form of financial valium, that you can keep your cool during very difficult times. Of course cash is extremely valuable when no one else has it. When that situation occurs, the phone starts to ring and there are interesting propositions. We’ve been able to do securitized bonds at 18% yield to maturity, again, 25 plus percent bonds. We’ve been able to buy large positions in companies whose management we respect, where the prices were being decimated for no good reason at all. So it’s wonderful to have that flexibility, to have the heft of that balance sheet is the safety of having that cash.

CONSUELO MACK: Let’s talk about some of your top holdings. If an outsider were to look at the Fairholme Fund portfolio, there would be some quizzical looks and some people would say, what, is he nuts to be investing in these companies? You know, your two largest holdings, Pfizer for one and Sears. Why Pfizer?

BRUCE BERKOWITZ: Investing is all about what you pay and what you get. And for the prices we pay, we think the amount of cash that owners will eventually get will show a nice return in a company with a very solid triple-A like balance sheet run by a fairly new management team that’s heading in the right direction: very defensive, recession-proof, everyone’s again with the new administration coming down hard on anything that’s health-related. It’s caused the price the really ratchet down and the stock price. So that was the advantage. It was really a cheap price relative to the cash flows.

CONSUELO MACK: So what’s your excuse for Sears?

BRUCE BERKOWITZ: It’s not just a retail company. It’s four, five different companies, and I know Eddie Lampert deeply wants Sears and K-Mart to work, and I hope they do, but he’s also an economic person. He’s going to give it the good old college try, but he’s not going to keep throwing money down a sinkhole in terms of losing stores that may have a higher and better use for the property or for the parking lots or for whatever the zoning may allow. It’s very, very analogous to Berkshire Hathaway. When Warren Buffett bought the Berkshire Hathaway textile spinning mills, it turned out to be quite a losing operation. He had a tremendous respect for the employees there. He spent years trying to make a go of it with equipment, and in the end he realized that he had to take the cash, the free cash that the operation was generating and reallocate it for higher and better uses. And that’s the way Sears is going to go.

CONSUELO MACK: I don’t usually delve into our guest’s distant past, but you grew up at one point being a bookie.

BRUCE BERKOWITZ: Oh, who told you that? That’s good. Statute of limitations are over so I’m okay. I was a minor. I did drop out of high school, but don’t tell anybody.

CONSUELO MACK: I didn’t know that. Did you drop out of high school?

BRUCE BERKOWITZ: For about a year to be a bookmaker.

CONSUELO MACK: So what did you learn from being a bookmaker that you’re applying to your investing strategy?

BRUCE BERKOWITZ: Perverse psychology of the human condition: how people behave, how they judge winning versus losing, the need for hope. Most people do not understand the nature of odds, how some things are multiplicative in nature as an additive. I mean, for example, if you had to decide on a company and that company had, there were 15 different aspects of that company that you had to think about and you could be 95% correct on every one of those aspects, you still have about a 50/50 chance of, probably less than 50, probably 45% chance. So I learned about odds. I learned about people and their hopes and dreams and drudgery of work and the perverse psychology that makes people make stupid decisions. I was lucky in that I learned at a young age, but it’s time the move on; when I went back the high school, it was sad because it took about 15 years for me to get back to what I was making when I was about 15 years old.

CONSUELO MACK: I think you’ve made up for that since. Bruce, are you expecting a highly inflationary environment the next couple of years?

BRUCE BERKOWITZ: Well, when I think about the fixed income markets, I think of safety first. Given that the printing presses have been going 24/7, something’s going to give. That’s one of the reason we have a very large investment in St. Joe, a very large real estate company in Florida. So I think people, there are a lot of people reaching for yield now because interest rates are so low, there’s a tendency to go out very long to get that extra 1%, 2% per annum. Reaching for that extra one and two I believe will cause a lot of pain down the road. So we’re going to try and do what we think is right.

CONSUELO MACK: So are we going to see you… at the Fairholme Fund, you mentioned St. Joe, one of your largest hold, which is a major real estate holder in Florida. Are you looking more to the asset side of the economy?

BRUCE BERKOWITZ: We’ve always looked at the balance sheet, and St. Joe was developed from the DuPont family at the time of the Depression. The company has remaining maybe about 700,000 acres of land, 80% of which is within 15 miles of the Gulf of Mexico. If you’ve never been to that part, the panhandle, people call it the Redneck Riviera, or L.A., they call it the lower Alabama. It’s a tough place to get to, but it has some of the most gorgeous beaches, land that I’ve ever seen. The beaches are 95% quartz. They’re so white you need sunglasses to look at the beach. They’re wide. The company has 140 miles of land that touches the gulf, another 70 miles of land that goes to the intercoastal waterways. From one end of the other, about 145 miles of driving, and what most people don’t know about, I hope they don’t find out about, is that right in the middle of St. Joe’s land, a brand-new international airport is opening up next May, the first probably since 1995.

CONSUELO MACK: Wow.

BRUCE BERKOWITZ: But no one knows it and most people think it’s just a mosquito infested swamp land. That’s the price we paid for St. Joe. We basically paid swamp land prices.

CONSUELO MACK: Given again what we’ve just been through in the last couple years, what is the one piece of investment advice you would give individual investors?

BRUCE BERKOWITZ: The advice I give to most investors is that there’s just… investing is not your profession. That at the end of the day, you’re going to have to trust someone. So there are four, five simple rules that we use, that Fairholme uses when evaluating companies’ managements I think investors should use. You have to study the paper trail. So if you were looking at a mutual fund, you want to study the paper trail of the fund, especially during stressful periods. Don’t read what the fund is talking about now. Go back to before 1990, go back to 2006, ‘07, read what the fund had to say before a difficult period. See how the fund behaved during a very stressful period.
Now, talk is cheap. But when times get very tough, you see the true person. You see. It all comes out in tough times. And also you want to make sure that whoever is managing your money has most of their family net worth in the same investments because if it’s going to be good enough for you, it better be good enough for them. Of course you want honest, integrity, a smart crook is going to get you every time. The last is you have to have a layman’s understanding of the strategy. You have to have a basic grasp of what the manager is trying to do, because if you don’t, you will be shaken out at the worst possible time. If you’re a doctor, a lawyer, whatever profession you may be in, you have to get those five or six dynamics, then eventually you just have to trust someone. And that’s the advice that I give to individuals, and those are the rules we try and use when we look at companies.

CONSUELO MACK: Bruce Berkowitz from the Fairholme Fund, thank you very much for joining us.

BRUCE BERKOWITZ: It’s always a pleasure. Thank you, Consuelo.

CONSUELO MACK: The Fairholme Fund is extremely focused. It has around 40% of its portfolio in health care stocks right now. I asked Berkowitz if there is one holding that stands out. There is. Bruce Berkowitz’s One Investment for a long-term diversified portfolio is health insurer, Humana. Berkowitz likes its management, its business, it is a large Medicare Advantage provider, its free cash flow and, of course, its price, which he says has been battered by fears that health insurers will be driven out of business by the government- a prospect he feels is highly unlikely.
Well, needless to say, others disagree, so in that contrary note, let me tell you about the Great Investor we’re talking to next week. He is another true blue contrarian- Robert Kleinschmidt runs the Tocqueville Fund and one of his favorite pastimes is reading the new low list for investment ideas. Before we leave you, we want to welcome another state to our television family. WealthTrack will now be seen on public broadcasting in Atlanta in the state of Georgia, extending our reach to 77% of the country. Thanks for joining us. Have a great weekend and make the week ahead a profitable and a productive one.


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