Bruce Berkowitz 2014 Letter To Investors: Fannie, Freddie, BAC, AIGVW Staff
Bruce Berkowitz’s Fairholme Fund 2014 annual report (lots on Fannie Mae for those interested)
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 stilldepressed 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.
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 highend 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.
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