An Interview with Bruce Berkowitz – Part 1

by on January 20, 2013  •  In Bruce Berkowitz

Bruce Berkowitz of Fairholme Funds manages $7Bn+ of assets (this figure is based on fund prospectus disclosures, may not be inclusive of separately managed accounts) and was once named Morningstar’s Manager of the Decade.

As you are probably aware, since 2010, it’s been a trying couple of years for Berkowitz. His fund was down 32% in 2011, then rallied ~37% in 2012 — such volatility is not for the faint of heart!

However, we believe that trying times often reveal wonderful insights into an investor’s investment philosophy (his thoughts on cash are especially interesting). Accordingly, below are portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (which, by the way, is an absolute treasure trove of investment wisdom). For more on Berkowitz, there’s also a thorough Fortune Magazine article from December 2010.

Cash, Liquidity, Redemptions, Expected Return

MACK: Another Wall Street kind of conventional wisdom is that…you shouldn’t hold a lot of cash in equity funds. Well, the Fairholme Fund has a history of holding a lot of cash. And I remember you telling me that cash is your financial valium.

BERKOWITZ: Yes. Well, the worst situation is if you’re backed into a corner and you can’t get out of it, whether for illiquidity reasons, shareholders may need money, or you have an investment that, as usual, you’re a little too early, and you don’t have the money to buy more, or you don’t have the flexibility. That’s a nightmare scenario. And this is nothing new. I mean, the great investors never run out of cash. It’s just as simple as that…We haven’t re-created the wheel here, but we always want to have a lot of cash, because cash can become awfully valuable when no one else has it.”

I have written in the past about the parallels between operating businesses and the investment management business (i.e., capital reinvestment and compounding).

Cash management is yet another relevant parallel – both should monitor future liquidity obligations, whether it’s client redemptions, debt maturity, potential future asset purchases or expansion opportunities.

Operating businesses have the advantage of term financing that’s permanent for a specified period of time. Most public market investors don’t have this luxury (private equity and real estate investors are more fortunate in this respect), which should compel them to keep even more rainy day cash.

However, as Mack describes, conventional Wall Street wisdom dictates the exact opposite — that investors should not hold excess cash on the sidelines!

Also, Berkowitz’s last sentence about cash becoming “awfully valuable when no one else has it” implies that the value of cash changes in different market environments. This is in essence a calculation of the future expected return of cash – crazy I know, but similar to an idea echoed by another very smart investor named Jim Leitner, who said:

“The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.”

For those of you who have not read the pieces on Jim Leitner, a former member of Yale Endowment’s Investment Committee, I highly recommend doing so.

When To Buy, Intrinsic Value, Cash, Expected Return, Hurdle Rate, Opportunity Cost

We don’t predict. We price. So if timing the market means we buy stressed securities when their prices are way down, then yes. Guilty as charged. But, again, we’re trying to compare what we’re paying for something, versus what we think, over time, we’re going to get for the cash we’re paying. And, we try not to have too many predetermined notions about what it’s going to be.”

The first part is self-explanatory.

In the second portion, when Berkowitz refers to comparing “what we’re paying for something, versus what we think, over time, we’re going to get for the cash we’re paying,” he’s inherently talking about a hurdle rate and opportunity cost calculation that’s going to determine whether it’s worthwhile to purchase a particular asset.

The purchase decision is not solely driven by price vs. intrinsic value. There’s an additional factor that’s slightly more intangible, because its calculation involves predicting both the future expected return of cash (see above), as well as the future expected return of XYZ under evaluation.


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