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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. Â 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. Â 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? Â 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 ***, 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 *** 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 ***.
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. Â 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.