In the January 3rd 2009 article “Mutual Fund Fought Off Bears but Now Is Clawed” The Wall Street Journal reporter Eleanor Laise attempts to find an explanation of the Fairholme fund’s subpar performance in the last quarter of 2008. She interviews fund manager Bruce Berkowitz as well as industry experts, analyses fund holdings, and looks […]
In the January 3rd 2009 article “Mutual Fund Fought Off Bears but Now Is Clawed” The Wall Street Journal reporter Eleanor Laise attempts to find an explanation of the Fairholme fund’s subpar performance in the last quarter of 2008. She interviews fund manager Bruce Berkowitz as well as industry experts, analyses fund holdings, and looks at the most recent stock picks. Her conclusion: the fund made all the right sector moves (e.g., got rid of energy and financials) and its otherwise exceptional performance in 2008 has been marred by just a series of poor stock bets. The article concludes with assurances from the fund manager that the strategy is sound and that all the bets will pay off. We also learn that Mr. Berkowitz now has almost 100% of his net worth invested with his fund. The latter is indeed a good sign but we believe that a sophisticated investor deserves better insight on what the future might hold for this outstanding fund.
By performing an analysis of the Fairholme return record using MPI Stylus we tried to connect the dots to understand the sources of the fund’s past performance and provide some guidance in what to expect in the nearest future.
“Ignore the Crowd”
Fairholme fund indeed has an exceptional track record. It outperformed the S&P 500 index every single year since its launch at the end of 1999 except for 2003. Even last year, which was the focus of the WSJ article, the fund outperformed the index by 7.3%.
Fairholme is a no-load mutual fund with an expense ratio of 1%. Its manager is true to its motto “Ignore the Crowd” as prominently featured on the fund’s website. The fund makes focused sector and securities bets. It’s concentrated, holding about 22 stocks. The top ten holdings account for 64% of its assets (according to August 31, 2008 data.) We consider this degree of concentration to be especially high given the fund’s size of $7.2B. Annual turnover is only 14%.
Fairholme is classified as Large Blend by Morningstar and Mid-Cap Growth by Lipper. This seems a little odd, though it’s not surprising for fund research firms to disagree on such a concentrated portfolio. We performed a returns-based style analysis of the fund to better understand its style exposure. Then we undertook a second analysis with its focus on sector exposure to get at its underlying strategy and to determine the sources of its past and recent successes.This put us in a position to either confirm or refute conclusions presented in the reporter’s story.
In the chart below we show the fund’s cumulative performance since inception vs. the S&P 500 Index. A chart similar to this is prominently positioned in Fairholme’s semi-annual 2008 and annual 2007 reports. Note the accentuated 2008 loss’ that’s how performance appeared to long-term Fariholme investors.
The depiction of the drop in 2008 seems a bit confusing given that Fairholme outperformed the index by 7.3% that year. For this very reason we find such “growth” charts to be very misleading because the compounding of a single-period return outlier gets multiplied and creates a distorted view of a fund’s performance. A simple cure for this problem is to employ a logarithmic scale on the y-axis as in the chart below. Doing so shows that most of the gains are attributed to years 2000-2002 while over the past several years the fund’s performance was more or less in sync with the S&P 500 index.
Fairholme could help itself either by replacing their growth chart in the 2008 annual report with this alternative form or by showing the fund’s annualized performance next to it. Such a chart will give the fund deserved credit for its outstanding track record despite recent losses.
Getting Under the Hood
In order to determine the drivers of the fund’s performance we needed to perform a returns-based style analysis (RBSA) of the fund. As a reminder, RBSA attempts to create a dynamic portfolio of generic asset indices that replicates the analyzed fund’s performance. For our analysis we use the nine years of Fairholme monthly returns ((Fund returns are provided by Morningstar)) through the end of 2008, the six Russell style indices, and the MSCI Canada equity index to represent Fairholme’s significant exposure to Canadian stocks. The results of the analysis are presented in chart below. ((The analysis is performed using MPI Stylus software in DSA mode. For interpretation of this and following charts please refer to the “Style Primer” and other white papers in the Research section of MPI’s website.)) Note that we didn’t use any holdings information to produce these results. All we needed was a stream of monthly return figures.
The fund behaved as if it held a significant amount of cash that it unloaded entirely in recent months. This could mean that the fund indeed held treasuries, but it is also possible that it included some financial or other interest rate sensitive stocks. SEC filings by Fairholme confirmed that the fund held 25% or more in treasuries, money market funds and bonds during this period. The rest of the cash exposure could be explained by the relative defensiveness or interest rate sensitivity of the specific stocks in the Fairholme portfolio vs. the generic style indices. In any event, this definitely contributed to the fund’s outstanding performance during 2000-2002. Note also defensive style of the fund – its lack of exposure to growth stocks. An exposure to Canadian equities built up during 2005-2007 diminished significantly by the end of 2008.No doubt long-time investors in the fund were expecting the fund manager to make a bold move out of the market to weather the financial storm the way it did back in 2000-2002. But let’s not forget that the size of the fund at that time was a mere $50M vs. $7B+ today!
The quality of the analysis is good with the R-squared equal to 79%, which is relatively high for such concentrated portfolio. It is worth noting that RBSA is especially valuable for studying concentrated portfolios such as Fairholme whereas an analysis based solely on holdings could sometimes produce a distorted view. For instance, an industry sector could be represented by a single stock, the performance of which may have little relationship to its sector’s performance, so provide misleading information about sector representation to an investor. ((It’s a known fact that there are stocks in each economic sector that have higher correlation with sectors other than the ones they belong to.)) Rather than using accounting information and what is sometimes a subjective industry classification, RBSA looks to the effect of a stock or, more properly, all of the stocks on portfolio behavior as viewed and valued by a consensus of market participants.
Another reason why RBSA is particularly helpful in the analysis of concentrated portfolios is that managers of funds with few holdings sometimes engage in “window dressing” to present their portfolio in an appealing way right before the reporting time. An analysis of the return record of a fund uncovers the real drivers (exposures) of its performance, so is not affected by such holdings manipulation.
From the Style Map below we can conclude that Fairholme’s US equity position has been generating performance consistent with Russell Midcap Value Index and that its capitalization size has decreased in the recent years. This is quite different from both Morningstar’s and Lipper’s classifications placing the fund in Large Cap Blend and Mid Cap Growth categories, respectively, based on its portfolio information. As mentioned above, our mapping is not derived from holdings but is based on the fund’s performance relative to Russell style indices and depends on the Russell style classification, so we could expect some differences between both. But this difference between holdings-based and returns-based style is quite significant and should be noted as it puts us in a better position to assess the fund’s near-term risks and exposures.
Though an analysis based on monthly frequency return data is sufficient for a reasonable assessment of the fund’s long-term results, we need to resort to the use of daily frequency return data to get a better understanding of the fund’s recent behavior. By having more data points to enrich the same or a shorter return history, we are able to use more indices (explanatory variables), such as economic sectors and sub-sectors, to get a more detailed analysis. For the daily frequency analysis of the fund’s performance in the 4th quarter of 2008, we used Fairholme’s daily return record as provided by Lipper/Reuters, along with daily returns of MSCI Canada and the S&P 1500 GICS sector indices for the same time period. Given the results of our monthly analysis, we thought that a broad equity index such as the S&P 1500 Index would better represent the fund’s positions than the large cap S&P 500. The results of daily RBSA covering the last quarter of 2008 are presented in chart below.
Although our results do not aim to represent the fund’s holdings, they could be defined as “implied holdings”, i.e., a sector combination that best explains the fund recent performance. In many cases such implied information agrees with the holdings report, especially for highly diversified funds holding hundreds of stocks. Here, the diminishing cash and foreign exposure is consistent both with the WSJ article and the monthly frequency analysis presented above. Negligible Energy and Financials exposures are also consistent with the reported data. One immediate observation from the chart is that the fund manager is making fairly concentrated sector bets and the fund’s performance is dominated by the two sectors: Health Care and Consumer Discretionary. While the significant Healthcare component was noted in the article, the sizable exposure to the Consumer Discretionary segment is rather surprising. Companies in this segment tend to be much riskier and more susceptible to market downturns than in the Consumer Staples segment. This could have contributed to the fund’s poor results in the 4th quarter. The differences in sector exposures vs. the market index are better seen in the chart below where positive values indicate over-exposure while negative ones (below X-axis) suggest under-exposure. Note that the fund seems to be consistently over-exposed to the two above mentioned sectors and is under-exposed to the rest of the sectors.
Fairholme underperformed the S&P 1500 broad equity index by 1.64% in the last quarter of 2008. Instead of trying to guess which of the sectors affected the fund’s results in the last quarter of 2008, we performed an attribution analysis to quantify the impact of each bet. We present results of this analysis in the “Excess Attribution” chart, which represents a breakdown of the 1.64% loss vs. the index. Each bar in this chart shows the impact of over/under weighting a sector in the portfolio vs. an “index-neutral” bet, i.e., passively investing in the index proportional to its weight within a broader index.
In a quarter when all sectors experienced losses, the most significant positive contribution came from the fund’s small cash position. Other notable positive bets were the over-weighting of Health Care stocks and being out of Financials. The most important observation is that the “Selection” component accounted for a loss in the quarter of well over 5%. Selection return represents the difference between the fund’s performance and the performance of the dynamic portfolio of sector indices (shown in the Asset Loadings chart above) and is usually attributed to the manager’s within-sector security selection ability. In this particular quarter the portfolio suffered the most from specific stock picks within sectors rather than from exposure to any particular sector. So, in this regard our findings echo the WSJ article, which targeted specific stock under-performance.
In summary, fund investors should take away from our analysis the following: (a) sector bets overall proved positive during the quarter (although they should keep in mind the exposure to Consumer Discretionary stocks as we’re moving deeper into a recession) and (b) negative Selection bets in a single quarter may prove positive down the road as the fund manager is usually making long-term bets.