He Does It His Way

07/21/2010 1:30 pm EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, director of mutual fund research for Morningstar, and analyst Michael Breen say Fairholme Fund’s Bruce Berkowitz acts with the freedom of a hedge fund manager while charging the fees of a mutual fund.

Few mutual funds look or behave like Fairholme (FAIRX). Manager Bruce Berkowitz focuses on what could go wrong, not right, with potential investments. Berkowitz simply looks for firms with loads of cash on their balance sheets and double-digit free cash-flow yields where the coupon appears to be rising or stable.

Like Warren Buffett, Berkowitz prefers to be approximately right, rather than precisely wrong. Berkowitz rarely meets with management, preferring a deep dive on the data to see if they’ve delivered on past promises. A few years back Berkowitz broadened the fund’s charter, giving him flexibility to invest in a wide range of securities. The portfolio has two-thirds of its assets in equities, with the remainder split between cash and a mix of short-term fixed-income securities that includes floating-rate loans, commercial paper, high-yield corporates, and convertible bonds.

Fairholme has partnered with real estate firm Brookfield Properties (NYSE: BPO) and hedge fund Pershing Square to provide a $3.9 billion financing plan and capital backstop to help the struggling REIT General Growth Properties (NYSE: GGP) emerge from bankruptcy. If General Growth continues shoring itself up, the fund’s convertible bonds will pay off in spades. It’s the sort of creative and advantageous deal Warren Buffett regularly does, but few mutual funds would dream of making.

Berkowitz is dodging the herd elsewhere. Save for Berkshire Hathaway (NYSE: BRK.A), he wouldn’t touch banks or insurers in 2007 because of a lack of clarity on their liabilities. That was a big reason the fund lost less than nearly all its rivals when financials went off the rails in 2008’s downdraft. But now the fund has half its assets in financials. Berkowitz says government scrub jobs and Treasury audits have better illuminated the landscape, giving him a comfort level in the firms’ balance sheets.

A couple of other factors keep things on an even keel. First, Berkowitz loves cash. The fund nearly always has 20% of its assets in cash, so Berkowitz can quickly take advantage of unexpected opportunities without liquidating existing holdings. As Berkowitz is fond of saying, “Cash is worth an awful lot of money when others don’t have it.”

An area of small concern is the fund’s structure as a 1940 Act mutual fund. Berkowitz is increasingly doing hedge-fund-type deals, such as the recent General Growth Properties transaction, that require patience and can be illiquid. If a rough patch leads to redemptions, Berkowitz might lose some ability to do the creative deals that are becoming his hallmark. It’s a minor quibble, and it would take a landslide of redemptions to eat into the fund’s gargantuan cash reserves, but it’s worth monitoring.

Only time separates luck from skill, and this fund’s risk/reward profile since its 1999 inception is no fluke. Berkowitz will stub his toe at some point. It is matter of when, not if. But expect him to remain adept at carving his own path over time.

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