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Fund Spy

This Fund Is One of 2017's Biggest Disappointments

Fairholme Fund hasn't lived up to expectations.

From its Dec. 29, 1999, inception through November 2017,  Fairholme (FAIRX) doubled the S&P 500's return. But really it is a story of two halves. The record from 2000 to the end of 2010 was absolutely remarkable, and the record from 2011 to today is remarkably dismal.  

We recommended the fund for most of that time, so your opinion of the fund has a lot to do with when you owned it. I wrote earlier about funds we upgraded in 2017, so I thought I'd write here about a fund that has declined in my view. We downgraded the fund's Morningstar Analyst Rating to Neutral in September 2016. We first made the fund an Analyst Pick in March 2005.

When we rolled out our Analyst Ratings in November 2011, Fairholme was one of the few picks that did not receive a Gold rating. It was a Silver--still a high recommendation--from 2011 until 2016, when we cut it to Neutral. We had assigned it a Silver in 2011 rather than Gold because of its big bets on relatively risky stocks. 

Looking back at our past analyses, I am pleased we flagged the fund's risks quickly, but I wish we had lowered it from Silver sooner than we did. We pointed out the threat of a huge and growing asset base, large weightings in higher-risk holdings than before, and the effects of mass redemptions. 

As the fund was growing rapidly, manager Bruce Berkowitz argued that the larger asset base would enable him to take part in bigger deals and have greater leverage on companies he wanted to influence. Thus, he argued that this would compensate for the fact that small- and mid-cap investments would have less of an impact on returns.  

But he didn't appreciate that rapid inflows signal hot money that could go out just as quickly as it went in, and the fund's big loss in 2011 proved to be just the thing to send all that hot money flying out. The outflows have meant the fund was ever more focused. It's not a good sign when flows alter a portfolio in a significant way.

Berkowitz made some smart opportunistic investments out of the bear market, such as the controversial  American International Group (AIG). But he stuck to his guns on two deep-value investments that were essentially land plays: St. Joe (JOE) and Sears Holdings (SHLD). It's disappointing that he didn't recognize the change in market fundamentals. Real estate values swooned in the crisis, and the rise of  Amazon.com (AMZN) made Sears' already-dated land holdings even less valuable. Perhaps another flaw is in Berkowitz's mantra, "First we want to see how we can kill a business." His point is he wants to understand how a company might go bankrupt if things go against it so that he can properly assess the risks. But a company doesn't have to go bankrupt to still be a value trap, and that's what Sears and St. Joe have looked like so far, with both costing the fund quite a bit. By now, bankruptcy might be a possibility for Sears, even if it wasn't for much of the time the fund owned it. Sears looked like a value trap even when Berkowitz first bought it, but he liked the land value and CEO and top shareholder Eddie Lampert. In recent months, Berkowitz stepped down from the Sears board, and I wouldn't be surprised if he began selling the fund's shares in the retailer, though there are few buyers for Sears these days.

Were these red flags of asset growth and big bets on distressed companies also departures from Berkowitz's strategy? He said they were not if you looked back to his record before the mutual fund. With flexible focused funds like this one, it's hard to say whether something is truly style drift. But of equal importance when evaluating issues like this is whether the fund is departing from your expectations and whether it is no longer fulfilling the role that you wanted it to play in your portfolio.

 

Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.