The Peril of Being Different

January was a tough month for value stocks, as the S&P 500 Value index fell by -4.57 percent compared to the S&P 500 index, which lost -3.00 percent.

When stocks have a tough month, it’s axiomatic that mutual fund managers who invest in stocks also had a hard time. That was particularly true for one well-known value investor, Bruce Berkowitz, manager of the Fairholme Fund (FAIRX), which lost -9.83 percent last month – the worst performer in the Morningstar category of large cap value mutual funds.

Berkowitz is an interesting manager, one that I follow closely. Even though his results have been poor over the last five years, I respect what he’s doing. That said, I’m also really glad that we’re not investors in his fund – nor would we ever be, based on his style.

He’s a classic value investor and we definitely pursue value strategies. Although there are a number of small differences in our approach, the really meaningful difference is that he prefers to concentrate his holdings into his best ideas, where we like to spread our bets in a highly diversified way.

For example, the Fairholme fund, as of August 31st (the most recently available data), only has 10 stock holdings. He has 15 bond holdings (or more specifically, preferred stock holdings), that account for more than 90 percent of the total assets.

His largest holding, insurer AIG, is slightly more than 40 percent of the fund. That doesn’t include another 6.5 percent position in AIG warrants, which are like stock options in that they give you the right to buy stock at a specific price at a specific date, but differ because they are issued by the company and new stock is created if the investor exercises their rights.

By comparison, the large cap value fund that we primarily use has 270 holdings, a little more than 31 percent of the assets are in the top 10 holdings and the largest position is just 3.59 percent of the holdings.

Over the last 15-years, the total return for the Fairholme Fund is outstanding, earning 8.73 percent per year while the S&P 500 only gained 4.40 percent over the same time frame. His early performance was so good that in 2010, Morningstar named him the Mutual Fund Manager of the Decade.

When Morningstar made their announcement, the fund had somewhere between $5-7 billion in assets under management. One year after the announcement, the assets ballooned up to $18.8 billion.

As it turns out, the next year, 2011, would prove quite difficult. The S&P 500 was essentially flat earning just 2.11 percent (basically, the dividend yield), but the Fairholme Fund lost -32.42 percent, thanks in large part to AIG’s decline of -52.94 percent.

Investors were understandably nervous and bailed out of the fund. By the end of 2011, assets had declined to $7 billion, which is about $5 billion more than what would have been lost just in performance alone.

In interviews, I’ve seen Berkowitz essentially shrug off the performance, saying that he’s a value investor and he’s confident that his picks will work out in the long run.

That may be true, but we take the view that you don’t want such idiosyncratic performance because investors simply can’t stomach that kind of deviation from the benchmark.

A cynic will say that we’re just worried about our assets under management. There’s some truth to that, but we take the view that if investors can’t stick with a strategy when the going gets tough, then an investor shouldn’t pursue the strategy.

You can see that investors in the Fairholme Fund fared poorly by looking at ‘Investor Returns’ that Morningstar calculates by incorporating flows in and out of the fund. While the fund earned 7.47 percent, just below the S&P 500 at 7.61 percent, the investors timed their buys and sells poorly and only earned 3.87 percent.

If you want to beat the market, you have to do something different than the market and, importantly, you have to live through the inevitable periods where you underperform. After all, no reasonable person would expect a strategy to outperform all of the time.

As always, it’s a matter of degree and balance. Maybe Berkowitz’s strategies will pay off in the future, just like they did in the early days of his fund. Although we respect his willingness to take a stand, we would never take the kind of bets that he is taking and, for better or for worse, we won’t deviate so much from the index. ┬áBeing different is hard to stick with.