MIAMI--(BUSINESS WIRE)--The Fairholme Fund, The Fairholme Focused Income Fund, and The Fairholme Allocation Fund filed their Annual Reports with the United States Securities and Exchange Commission (“SEC”). The filings contain information on the respective portfolio holdings of The Fairholme Fund (NASDAQ: FAIRX), The Fairholme Focused Income Fund (NASDAQ: FOCIX), and The Fairholme Allocation Fund (NASDAQ: FAAFX) as of November 30, 2014.
The Portfolio Manager’s Reports for each series of the Fairholme Funds and their respective 2014 Annual Reports will be available online to the public on the SEC’s EDGAR database and are currently available at www.fairholmefunds.com. The following is the Portfolio Manager’s Report for The Fairholme Fund:
FAIRHOLME CAPITAL MANAGEMENT, L.L.C.
PORTFOLIO MANAGER’S REPORT
For the Year Ended December 31, 2014
Mutual fund investing involves risks, including loss of principal. The chart below covers the period from inception of The Fairholme Fund (December 29, 1999) to December 31, 2014. Past performance information quoted below does not guarantee future results. The investment return and principal value of an investment in The Fairholme Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance information quoted below. Performance figures are after expenses and assume reinvestment of dividends and capital gains but do not reflect a 2.00% redemption fee on shares redeemed within 60 days of purchase. Most recent month-end performance and answers to any questions you may have can be obtained by calling Shareholder Services at 1.866.202.2263. The S&P 500 Index is a broad-based measurement of changes in the stock market, is used for comparative purposes only, and is not meant to be indicative of The Fairholme Fund’s performance, asset composition, or volatility. The Fairholme Fund maintains a focused portfolio of investments in a limited number of issuers and does not seek to diversify its investments. This exposes The Fairholme Fund to the risk of unanticipated industry conditions and risks particular to a single company or the securities of a single company. The Fairholme Fund’s performance may differ markedly from the performance of the S&P 500 Index in either up or down market trends. The performance of the S&P 500 Index is shown with all dividends reinvested and does not reflect any reduction in performance for the effects of transaction costs or management fees. Investors cannot invest directly in an index. The Fairholme Fund’s total expense ratio reflected in its prospectus dated March 28, 2014, was 1.02%, which included acquired fund fees and expenses that are incurred indirectly by The Fairholme Fund as a result of investments in securities issued by one or more investment companies.
January 28, 2015
To the Shareholders and the Directors of The Fairholme Fund:
The Fairholme Fund (the “Fund” or “FAIRX”) decreased 2.72% versus an increase of 13.69% for the S&P 500 Index (the “S&P 500”) in 2014. The following table compares the Fund’s unaudited performance (after expenses) with that of the S&P 500, with dividends and distributions reinvested, for various periods ending December 31, 2014.
At December 31, 2014, the value of a $10.00 investment in the Fund at its inception was worth $53.60 (calculated by assuming reinvestment of distributions into additional fund shares) compared to $18.72 for the S&P 500. Of the $53.60, the market price (net asset value per share) was $35.08 and the value of distributions reinvested was $18.52.
The potential advantages of the Fund’s long-term focused investment approach are most evident when evaluating performance over any consecutive 5-year period since the inception of FAIRX. The Fund has achieved 117 positive 5-year return periods and only 4 negative 5-year return periods, compared with 94 positive 5-year return periods and 27 negative 5-year return periods for the S&P 500. The Fund’s average rolling 5-year return was 72.30% versus 31.48% for the S&P 500. The Fund has outperformed the S&P 500 in 96 of 121 5-year periods, calculated after each month’s end. The Fund’s worst 5-year-period return was (6.89)% versus (29.05)% for the S&P 500. In its best 5-year period, the Fund’s return was 185.26% versus the S&P 500’s best return of 181.57%.
AIG and Bank of America – the Fund’s two largest positions – produced returns that were in line with the market during 2014. But, unlike the overall market, both financials still trade at large discounts to book value, a conservative measure of worth. To close the gap, these two systemically important financial institutions must prove that core operations are capable of earning an average 10% return on equity and demonstrate that such profits are distributable to shareholders. We anticipate growing profits, dividends, and buybacks from both in the future, particularly when interest rates normalize.
AIG common (41.0%) and warrants (8.1%) remain the Fund’s locomotive. Last year, AIG increased its quarterly dividend by 25% and bought back over $3.4 billion of stock. Efficient capital management allowed the company’s reported book value to grow by about 15% year-over-year to $77.35 per share as of Q3 2014. Going forward, we expect that AIG’s property and casualty business will be the main driver of further increases in value. If management is able to deliver underwriting margins and expense efficiencies consistent with its peer group, then the company’s book value and stock price will meaningfully increase. We shall soon see.
Bank of America (22.3%) has executed its business plan admirably to date. By refocusing on core customer relationships across multiple platforms (i.e., checking, credit card, mortgage, and small business), the company is positioning itself for long-term profitability. Effective cross-fertilization of these services will make parallels with best-in-class Wells Fargo more pronounced, and help Bank of America’s still- depressed market price to at least reach book value, reflecting the higher values of existing business. The company recently surpassed its 2011 cost-cutting goal of $8 billion per annum, ahead of schedule. Litigation expenses – a major weight on the company in recent years – have largely dissipated. Heeding lessons learned from the financial crisis, the company prudently disposed of a profitable (at the time) wholesale mortgage business. Intermediaries might seem like ideal clients, but history shows that they are more adversary than friend. Investors should not be surprised to see Bank of America continue to shrink no-longer-core activities. However, the company’s balance sheet is poised for a growing business economy and a rising interest rate environment, with every increase of 100 basis points potentially boosting revenue by $3.7 billion. Sometimes you must take two steps back in order to go ten steps forward.
When we initiated the Fund’s investments in Fannie Mae (4.5%) and Freddie Mac (3.5%), conventional wisdom was that the companies would be liquidated. We disagreed. Our investment was predicated on a simple thesis: there are no substitutes. Fannie and Freddie provide services that are absolutely essential to the American way of life. They help make the popular 30-year fixed-rate mortgage available and affordable. They provide liquidity and stability to the nation’s housing finance system – during good and, especially, in bad times. No one does it better.
Time is proving our thesis true. Fannie and Freddie have already benefited from post-crisis reform and are returning to simpler, safer business models. Under a range of scenarios, the companies are collectively expected to earn at least $21 billion per year. The United States Treasury has already recouped $36 billion more than it disbursed to Fannie and Freddie during the crisis, rendering this our nation’s most successful equity investment ever. In fact, Treasury’s current profit from Fannie and Freddie is almost three times more than it made from all of its other financial rescue programs combined. These figures do not even account for Treasury’s warrants to acquire 79.9% of each company’s common stock.
Today, Washington bureaucrats are unlawfully holding these profitable companies captive in a perpetual conservatorship. Congress never authorized Treasury to become Fannie and Freddie’s “overlord” – forcing the companies to spend all their capital on executive branch prerogatives and circumventing the legislature’s appropriations process. Indeed, the power of the purse remains vested in Congress under the Constitution. The Housing and Economic Recovery Act of 2008 does not authorize any federal agency to use these two publicly traded, shareholder-owned companies as a piggy bank. Yet, in an unprecedented abuse of executive power, the bureaucrats have illegally expropriated and de facto nationalized two of the most valuable companies in the world with apparent impunity. Worse still, their actions are now endangering our housing market, making it more difficult for lower- and middle-income Americans to access mortgage credit.
By preventing Fannie and Freddie from accumulating any cushion against potential future losses, Treasury is obstructing the ability of the Federal Housing Finance Agency (“FHFA”) to perform its duties as safety and soundness regulator of both companies. Treasury’s actions are also directly impeding the statutory obligations of the FHFA, as conservator, to “preserve and conserve [their] assets and property.” Even Fannie and Freddie’s political foes admit that this situation is untenable.
Given the dim prospects for comprehensive housing finance reform legislation in the foreseeable future, we believe that FHFA will ultimately heed the pragmatic advice offered by Senate Banking Chairman Tim Johnson on November 19 at a congressional hearing and “engage the Treasury Department in talks to end the conservatorship.” Johnson is not alone in his call for such action.
The Leadership Conference on Civil and Human Rights recently voiced concerns about the housing market’s growing inequities: “Any successful policy to promote affordable homeownership must involve strong leadership by Fannie Mae and Freddie Mac… eliminat[ing] the GSEs would be counterproductive; it would negatively impact communities of color and young people, and it would impede our ability to grow our nation’s middle class… in order to ensure the best path forward to increasing homeownership in the communities we represent, we believe it is vital to initiate serious discussions about unwinding the conservatorship and allowing Fannie and Freddie to begin rebuilding their capital… Fannie and Freddie can be fixed; discarding them in entirety would be a colossal mistake.”
In the interim, the Fund continues to pursue litigation against FHFA and Treasury to defend its rights as an owner of the companies. To date, the Fund’s lawyers have received approximately 387,000 pages of documents – most of which have come from Fannie Mae, Freddie Mac, and their respective auditors. Not only has the government insisted on shrouding all documents in a veil of secrecy known as a “protective order,” but FHFA and Treasury have further shielded responsive documents from disclosure by broadly asserting executive privilege. Examples from the recently released Privilege Log are indicative.
One of the documents cited above is a news summary containing public information prepared by a third-party aggregator after the Net Worth Sweep was announced in August 2012 that is being withheld from discovery due to “Presidential Privilege.” Why are FHFA and, particularly, Treasury resisting discovery so fiercely? Is it because the document trail directly implicates some of the President’s most senior advisors in the White House?
FHFA and Treasury have argued that courts have no jurisdiction to review their administrative actions in this matter. However, recent comments by several Supreme Court justices in Mach Mining v. EEOC challenge the government’s similar attempt to evade judicial scrutiny in a separate case. The government’s claim – “We think this is a matter that is entrusted to the agency that is not for court review”– was met with skepticism by the highest court in the land. Chief Justice Roberts swiftly responded: “Trust you? Just trust you? I am very troubled by the idea that the government can do something and we can’t even look at whether they’ve complied with the law.” Justice Scalia echoed those concerns, noting how he found it “extraordinary” that the government wanted to be exempted from litigation. Justice Breyer weighed in: “In my mind, of course, there should be judicial review.” Sunlight is indeed the best disinfectant.
More than just patience, this investment requires persistence. Every major financial institution relied upon federal government assistance during the 2008 crisis. Each institution repaid the Treasury in full, plus interest. The same is true of Fannie and Freddie, yet only they remain under the day-to-day control of a federal agency. Government cannot pick private market winners and losers. We forge ahead with the facts squarely on our side, and the assurance that no one is above the law.
Market participants have often failed to ascribe appropriate intrinsic value to conglomerates, and Sears Holdings Corporation (“SHC”, 7.1%) is no exception. For years, SHC has remained a misunderstood sum-of-parts story. Few have the inclination to examine all of the company’s pieces, which equate to a net asset value that we estimate to be multiples of current market prices.
SHC’s substantial portfolio of real estate is its most valuable component. The company’s 977 Kmart and 714 Sears properties total 195 million square feet of commercial retail space – more than Simon Property Group, the largest mall REIT with an enterprise value of $100 billion. The possibilities for SHC’s owned and leased properties are endless. Redevelopment is one feasible option that the company is actively pursuing, including: the transformation of its 162,000 square foot store at Janss Marketplace (Thousand Oaks, CA) into a mini-mall; the reorganization of a 14-acre site in St. Paul, Minnesota, with 111,000 square feet in adjacent structures including 130 units of housing; and the redevelopment of a 12.3-acre property at top-performing Aventura Mall in Florida into 251,250 square feet of high- end open-air retail and restaurant space, 43,802 square feet of office space, 128,737 square feet for a luxury hotel with 120 rooms, and 476,297 square feet of parking. At this proposed “Esplanade at Aventura,” Sears would retain a 20,000 square foot presence, effectively reducing its footprint by 90%. Subleasing to single and multiple tenants is another option: millions of square feet have already been subleased to tenants such as Ansar Gallery International, Dick’s Sporting Goods, Kroger, Nordstrom Rack, Primark, and Whole Foods. Finally, some stores will remain as-is: for example, “cash cow” locations throughout the Northeast corridor, Puerto Rico, and the U.S. Virgin Islands do not require any reconfiguration.
We believe that the company’s non-real estate assets have significant value as well. SHC’s $5.6 billion in cash, receivables, and net inventory (or $44 per diluted SHC common share), leading brands (e.g., Kenmore, Craftsman, and DieHard), and Shop Your Way loyalty program (which has helped the company generate $4 billion in online sales) are important components.2 SHC also operates 750+ pharmacies with $1.75 billion in annual sales. Sears Home Services is the largest national delivery and home repair service with over $2.5 billion in sales. Annual service repair calls exceed nine million, in addition to 4 million deliveries and 1 million installations. Sears Commerce Services provides e-commerce and logistics solutions for third-party businesses, akin to Amazon Services. Sears Logistics has 49 distribution and fulfillment facilities across the U.S. (46.5 million square feet) providing end-to-end supply chain solutions for SHC and competitors. Sears Protection Company has over 15 million products under protection agreement contracts. Sears Reinsurance Company provides management of all insurance risks. And there is more.
We believe that SHC’s liabilities are easily offset by its non-real estate assets. Proceeds from recent and anticipated corporate actions as well as further inventory reductions would re-pay the: (i) $400 million in short-term debt due February 2015; (ii) $1.6 billion from the domestic credit facility expiring April 2016; (iii) $1.0 billion term loan due June 2018; and (iv) remaining pension plan obligations forecasted to be $1.1 billion through 2019 at prevailing low rates.
SHC’s management acknowledges that operating performance must improve, and we remain confident that the company has the ability to effectively address its cash burn by reducing: (i) investments in integrated retail and Shop Your Way; (ii) the dual marketing program spend; (iii) rent and associated costs; (iv) corporate overhead; and (v) the pension deficit. The company indicated that it is “currently carrying costs of two promotional programs: [Shop Your Way] Points and Promotional Markdowns (‘PMDs’)” and intends to expedite the transition from PMDs to Points for a “more efficient promotional model.” SHC is also accelerating unprofitable store closings, and can terminate approximately 80% of existing leases without penalty over the next four years by not exercising its extension options. Retail analysts predictably focus on “revenue per square foot” and “same store sales.” We prefer to ignore the crowd by assessing all the parts. Consider this: at one point last year, the market cap of newly independent Lands’ End almost rivaled the market cap of its former parent, SHC.
The St. Joe Company (6.5%) continues to make steady progress. Since our involvement in late 2010, the company has: (i) streamlined real estate and forestry operations by 50%; (ii) reduced corporate expenses by 35%; (iii) increased liquidity by 260%; (iv) cut debt as a percentage of assets to 4.6%; and (v) focused on entitling core assets surrounding one of America’s newest airports and the Gulf of Mexico. St. Joe’s sale of 380,000 acres of non-strategic timberland and rural land for $562 million last year was an important milestone in positioning the company for long-term success. The company’s search for a new CEO is well underway. And Port St. Joe was recently issued a permit by the Florida Department of Environmental Protection to allow for the dredging of the port’s navigational channel, which will help reinvigorate this deep-water seaport for bulk and cargo shipments.
Leucadia (3.6%) remains the Fund’s longest held position. Our estimate of intrinsic value remains above today’s market price. The company’s historical track record of compounding book value significantly faster than most S&P 500 constituents is partly the result of its willingness to initiate opportunistic investments during market panics, as evidenced by its recent rescue financing of Forex Capital Markets (FXCM) following the surprise Swiss franc surge.
Today, we believe FAIRX is poised for above-average performance with look-through asset values estimated to be far above the Fund’s market price. Cash currently exceeds 8% and we believe overall liquidity is ample to stay the course.
Thank you for your confidence and support over the last 15 years. Please join us for a public conference call on February 3, 2015, at 11:00 AM ET, during which I will discuss the Fund’s investments and address your questions. Participants can use the following dial-in information:
U.S. Toll-Free Dial-In: (855) 477-7449
U.S. and International Dial-In: (636) 692-6489
Conference ID: 72458059
A transcript of the call edited for clarity will be made available at www.fairholmefunds.com.
Onward and upward,
Bruce R. Berkowitz
Fairholme Capital Management
1Represents the cumulative percentage total returns over a five-year rolling period (calculated after each month’s end) since inception through December 31, 2014. Monthly rolling 5-year performance is a period of 60 consecutive months determined on a rolling basis, with a new 60-month period beginning on the first day of each calendar month since the inception of the Fund.
2Pro forma calculations are based on 128,000,000 shares outstanding.
The Portfolio Manager’s Report is not part of The Fairholme Fund’s Annual Report due to forward-looking statements that, by their nature, cannot be attested to, as required by regulation. The Portfolio Manager’s Report is based on calendar-year performance. A more formal Management Discussion and Analysis is included in the Annual Report. Opinions of the Portfolio Manager are intended as such, and not as statements of fact requiring attestation.
Investors should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. The Fund’s prospectus contains this and other information about the Fund. To obtain a copy of the Fund’s prospectus, please visit www.fairholmefunds.com or call 1-866-202-2263. Please read the prospectus carefully before investing.
For a copy of the top holdings for The Fairholme Fund, please click here. Portfolio holdings are subject to risk and may change at any time.
Fairholme Distributors, LLC (01/15)