Fairholme's Girth Doesn't Have to Spell Doom
This fund will eventually stumble, but the culprit won't necessarily be its size.
Fairholme Fund (FAIRX) has gathered $4.1 billion in net inflows so far in 2010, more than any other domestic-equity fund and an amount equal to 41% of its total assets under management just 11 months back. Managed by Morningstar's Domestic Equity Fund Manager of the Decade, Bruce Berkowitz, the fund now has $17 billion in assets, and is the 19th-largest actively managed domestic-stock fund.
That's a lot of scratch to put to work, and it's got some longtime Fairholme shareholders nervous. Many have contacted me to say they worry that Berkowitz will drown in a sea of cash and will have to ditch the flexible, eclectic approach he's used to build the fund's stellar record. That's a valid concern. Plenty of funds have raked in hot money during long winning streaks only to disappoint for a stretch thereafter. They've then had to manage big outflows that hamper their ability to execute their strategy. Bill Miller's Legg Mason Capital Management Value (LMVTX) is a famous example of this, but far from the only one.
Big Is Not Always Bad
But it doesn't have to end in tears when assets pour into a fund. I looked at the 40 actively managed domestic-equity funds with more than $10 billion in assets and was surprised to see a steady group of performers showing few signs of losing a step. About 70% are beating their category average over the past three years and 82% are besting it over the past five. So, a bulging asset base is a big hurdle, but one that can be cleared.
Berkowitz Not Yet Handcuffed
The most common way for massive inflows to derail a fund is by forcing the manager to alter his approach. The good news for Fairholme shareholders is that, in this case, the influx of assets hasn't forced Berkowitz to change his stripes.
The fund's cash stake is now 24% of assets, but that's nothing new. From day one Berkowitz has kept a pile of dry powder on hand. In fact, about a fourth of the fund's assets were in cash its first three years--a time when it had less than $50 million under management. The only time the portfolio's cash hoard dipped below double digits was in late 2008, when Berkowitz was among a tiny group of investors loading up on bargains at the tail end of the bear market. The cash cushion would also provide plenty of wiggle room if the fund is ever hit with mass redemptions.
The portfolio hasn't become bloated, either. Many fast-growing funds boost the number of names they hold to spread their new cash around, diluting their best picks. But Fairholme continues to own 20-25 stocks. The percent of assets in its top 10 holdings is a tad lower than its historic range but that's a function of it owning 6% stakes in two separate tranches of General Growth Properties debt. Combine these, and the portfolio is as concentrated as ever.
And Berkowitz hasn't had to change the type of firms he buys. Many managers who once profited by finding lesser-known small or mid-sized stocks are forced up the market-cap ladder as assets climb, fundamentally altering their strategy. But at $16.4 billion, Fairholme's average market cap matches its 2002 level and is in line with its historic range. The fund's sector weightings are also in flashback mode. Berkowitz has stashed 74% of his equity assets in financials, in line with the oversized bet on that sector he made from 2000-04.
Fairholme's size has even created some opportunities lately. In 2010, Fairholme committed $2.7 billion to partner with Bill Ackman's Pershing Square Capital and Brookfield Asset Management (BAM) in a deal to successfully recapitalize General Growth Properties. Without Fairholme's bulk, the deal--already starting to benefit Fairholme's shareholders--probably wouldn't have closed.
One Red Flag
All is not rosy, though. Fairholme is taking much bigger stakes in the names it holds, which boosts the degree of difficulty in establishing and exiting positions. The fund owns more than 10 days of the average trading volume for several of its stocks, including Sears Holdings , St. Joe (JOE), and Leucadia (LUK). If big problems hit any of these firms, Fairholme would be unable to quickly exit its positions without pushing prices down further. Funds as varied as Vanguard PRIMECAP (VPMCX) and Longleaf Partners (LLPFX) have successfully managed such liquidity risk, so it can be done. But Berkowitz typically makes quicker and bigger shifts than most managers, so he faces an extra degree of difficulty. This is a risk Berkowitz must actively manage now.
Trust, But Verify
Berkowitz says Fairholme's asset growth isn't limiting his options, and the data bears him out. Fairholme will stumble. Berkowitz commonly takes on risky plays and he's most often been right, but eventually he'll miss with one or more of his big picks, damaging this concentrated portfolio. And even if Fairholme doesn't stumble, it could easily lag by a mile in a growth-happy rally that doesn't favor Berkowitz's holdings. And the inflows merit a watchful eye. But, so far, a careful review shows that, despite the remarkable pace of investment into what was once an obscure fund, the approach that made it so successful has not been altered.
Michael Breen has a position in the following securities mentioned above: JEF. Find out about Morningstar’s editorial policies.