Bruce Berkowitz is the manager of the Fairholme Fund. He took the post in 1999 and has since grown it to a multi-billion dollar mutual fund, even earning the distinction of Morningstar’s “Stock Manager of the Decade” for the 12.9% average annual return he generated in the ten years from 2000 to 2009.
Last year was rough for Berkowitz’s Fairholme. It lost over 32 percent in 2011. The loss is significant but it has a few primary contributors. American International Group (AIG), which was Fairholme’s largest stake, lost over 50 percent last year, and that was after adjusting for dividends and splits. Berkowitz also took major hits on his position in Sears Holding Corp (SHLD), which was the funds third largest position, losing 57 percent in 2011. Fairholme’s positions in Bank of America (BAC) and Citigroup (C) performed just as poorly, losing 58 percent and 45 percent respectively.
But, Bruce Berkowitz isn’t daunted. He thinks that these companies will rebound nicely. In an interview with Bloomberg on February 13, Berkowitz explained his viewpoint. “Our thesis on financials, it’s pretty simple,” he said. “We expect that over a cycle, systemically important financial institutions, that are too-big-to-fail, that already have been recapitalized, will have the ability to earn a 10 percent return on equity.” Berkowitz sees the financial companies that weathered the storm as survivors, and is bullish on them. “Investors are going to do well with all of the survivors,” said Berkowitz. “If you go back to the late ‘80s, the early ‘90s, the last time we went through this extreme cycle, to survive is to win. And, you’re looking at the survivors today.”
The only question is, should a do-it-yourself investor be just as encouraged? The risks are huge.
Take AIG for instance. The company has a beta of 3.78. It was trading at $26.71 when the markets opened on February 14 and it has a mean one-year target estimate of just $27.42 (range $23 to $32). If the number is accurate, investors buying in now would barely be able to recoup their transaction costs, let alone gain from the investment – and, it’s not like AIG offers a dividend to offset any of that risk. It is priced at 10.79 times its forward earnings. Analysts estimate its earnings will grow by 10% per annum over the next five years, narrowly outpacing its industry expectations of 9.44% and falling short of sector estimates of 10.11%. AIG is a hold position at best, but only because it isn’t really doing much of anything. William Blair and Stifel Nicolaus agree. The firms initiated opinions market perform and hold, respectively, in January.
Compared to ING Group (ING), the outlook for AIG is even more bleak. ING opened trading on February 14 at $8.58 a share and has a mean one-year target estimate of $13.00 a share. In addition to a stronger outlook, ING also has a lower beta at 2.98 and an earnings growth estimate of 16.60% per annum over the next five years. ING is also priced lower, at just 5.79 times its forward earnings. Sure AIG could recover and turn into a great long term position, but, for our money, we would sell a stake in AIG to buy ING any day with numbers like that. It’s just better.
Next, take Sears. Bruce Berkowitz may be bullish on the company, seeing the company’s real estate, position as an anchor store, service business and leasing agreements as major positives, but we see better places to put our money.
Sears opened trading on February 14 at $47.00 a share. It has a mean one-year target estimate of less than half that, at $19.50 a share (range $6 to $27). The company has a high 2.12 beta and doesn’t offer a dividend to make up for that. Analysts say the company’s earnings could grow at a rate of 32.30% per annum over the next five years, but we just don’t see it. With the advent of the Internet, the lure of the department store where shoppers can buy appliances, suits, tools and shoes in the one place just isn’t there.
JC Penney is also an anchor store, but it keeps its scope of business much more narrow than Sears. Sure, shoppers can buy towels and some small appliances at the same place they buy their shoes and office wear, but there are no power tools or refrigerators there. The numbers are also better. JC Penney opened trading on February 14 at $42.11 a share. It has a mean one-year target estimate of $39.71 but the range is $29 to $50. The company has a lower beta than Sears at 1.95, and it pays a dividend of 80 cents (1.90% yield), which makes up for some of that risk. JC Penney is priced at 20.55 times its forward earnings, which is a little high, but we think it may be worth it. Its share price has gone up 16.80% over the last 52 weeks, plus it has the involvement of activist hedge fund manager Bill Ackman. JC Penney seems to be a better bet than Sears but we wouldn’t invest in either of these stocks.
We believe Berkowitz’s best stock picks are Bank of America (BAC) and Citigroup (C). Financial stocks may seem risky in the short-term but we believe they have the potential to double over the next three years. Citigroup has a 2012 forward PE ratio of 8.1 and is expected to grow its earnings by 9% annually. We think these are very pessimistic estimates. That’s why we have a position in Citigroup and plan to add more.
