Bruce Berkowitz’s Loss Aversion, And The Remarkable Portfolio Concentration Of The Fairholme Fund

The “FLNG” function of Bloomberg is one of my many favourites – you can quickly view hedge fund’s 13-F filings and sort by new purchases, sales, etc.  This morning I was looking at Berkowitz’s Fairholme Fund (FAIRX) and was taken aback by the concentration in the portfolio.

Almost 55% of the Fairholme Fund is made up by $AIG, $SHLD, $BAC, and $C.  I could be entirely wrong, but I believe this type of extreme concentration could be a result of loss aversion by Bruce and team.  After destroying peers ala Bill Miller and being named Morningstar’s “Manager of the Decade”, Fairholme has struggled to say the least.  FAIRX is down 27% YTD largely due to large bets made on banks.  Loss aversion is generally characterised as taking increased amounts of risk in an effort to avoid losses.  Given how much FAIRX is down, it *could* be possible that Bruce is going “all in” into these financial positions in an effort to make up prior losses.  

Looking at chart of $BAC and $C might cause someone to consider whether the sell-off is overdone.  My answer is that nobody knows – for now.  IMO, Berkowtiz’s error’s on the financials have stemmed from the following:

  • Overconfidence-  I believe he and his team suffered from overconfidence in their analysis of the banks.  Fairholme, among others, incorrectly believed that by placing haircuts on loans and assuming certain level of liabilities, that they could arrive at a margin of safety.  Wrong.
  • Analysis – This is largely a continuation of the last point, but many investors gained a false sense of security with valuation metrics such as Book Value.  As someone with industry knowledge, it is challenging enough to decipher financials of a $5-$10bil bank.  To think you have a reasonable gauge of $BAC or $C’s books is just crazy.
  • Interest Rate Sensitivity- Berkowitz’s go to line was always “there is a certain earnings stream in these banks”.  What he and many others failed to account for was longer term interest rates falling.  Assets continued to reprice lower (be it securities or loans) and liabilities were already priced so low that any incremental benefit was negligible.  Outcome?  NIM contraction and an earnings stream that was suddenly much lower than he and others thought.

Opportunity: While I really do admire the desire to buy a beaten down sector like financials, many don’t have the first clue where to look for value.  There will come a time when having a large and sticky deposit base will generate value.  Wells Fargo’s CEO John Stumpf is right on the money with this sentiment.  

You can find small & mid sized banks that are void of many entanglements that TBTF banks have had to be deal including mortgage liabilities and structured products.

Part II:  In part two, I will highlight a few of these banks which have gone through the financial crisis unscathed (i.e. NCO’s under 1% and low NPA’s).  I will highlight the valuations in which they are trading (and where they could trade), and how their earnings stream would react to an improving economy.  Plenty of funds have found these type of banks – they just aren’t the Paulson’s & Tepper’s of the world.