A Winning Fund Run by a Maverick

11/23/2009 10:33 am EST

Focus: FUNDS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, says the Fairholme fund has lots of cash and is investing in health care, despite the fears over health care reform.

One critical question in the mutual fund world is whether managers should have broad leeway to go to cash as needed. The debate is raging particularly hard amid a bear market, and it isn’t likely to be settled any time soon.

The main argument made by the anti-cash crowd makes perfect sense: You don’t pay your fund manager to sit on the sidelines. But you do pay him or her to use their best judgment, and, ultimately, to not lose your money.

One thing we look for, particularly with regard to equity funds, is a broad mandate that allows managers to go to cash when, in their best judgment, there just aren’t enough compelling opportunities in the market place. We also look for cases when managers have actually exercised this type of discretion.

Bruce Berkowitz of Fairholme (FAIRX) is an excellent example of a manager who has no qualms about seeking a safe haven when the markets get choppy. An avowed value investor with a slight contrarian streak, Berkowitz seeks out companies generating strong, totally unencumbered free cash flows with solid growth prospects.

He distills the fund’s portfolio down to his 20 or so best ideas, and when he can’t find enough opportunities, he has no problem sitting on risk-free Treasury bills until some come around. Berkowitz, who’s guided Fairholme into the top one percent of the large core fund category on trailing three- and five-year bases, has established an enviable track record following that strategy during his and his team’s first decade together.

And in the process of generating consistent index-beating returns, he’s held as much of a third of his portfolio assets in cash from time to time. Even now, while he’s winning accolades as an “all-star” manager, more than 17% of Fairholme’s assets are in cash.

Berkowitz seeks out companies generating substantial free cash flow. Pfizer (NYSE: PFE), the fund’s top holding, won the approval of both the US and Canadian governments to consummate its $68-billion acquisition of Wyeth (NYSE: WYE).

The combination will help Pfizer stem the massive revenue loss that will occur when its top-selling cholesterol drug Lipitor loses its patent protection in 2011. Another major benefit for Pfizer will be the addition of Wyeth’s huge veterinary pharmaceutical business. Pfizer had to agree to sell half the business to satisfy antitrust concerns, but the unit is still expected to add more than $500 million in annual revenue.

The fund also holds large positions in health insurers Humana (NYSE: HUM), WellCare Health Plans (NYSE: WCG), and UnitedHealth Group (NYSE: UNH). Although insurers are perhaps the most at-risk segment of the industry [from any health care reform plans,] WellCare and Humana have a leg up in the potentially changing business environment: Their largest single customer is the federal government.

Even if insurers have less leeway to deny coverage, the inclusion [in the final bill] of an individual mandate requiring most Americans to carry coverage should offset higher medical losses.

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