Bruce Berkowitz Fairholme Focused Income Fund Annual LetterVW Staff
Bruce Berkowitz Fairholme Focused Income Fund annual letter for the year ended December 31, 2014.
To the Shareholders and Directors of The Fairholme Focused Income Fund:
The Fairholme Focused Income Fund (the “Fund” or “FOCIX”) decreased 3.39%, versus an increase of 5.97% for the Barclays Capital U.S. Aggregate Bond Index (the “Barclays Bond Index”), in 2014. Since inception, the Fund increased 45.70% versus 24.31% for the Barclays Bond Index. The following table compares the Fund’s unaudited performance (after expenses) with that of the Barclays Bond Index, with dividends and distributions reinvested, for the period that ended December 31, 2014.
At December 31, 2014, the value of a $10.00 investment in the Fund at its inception was worth $14.57 (calculated by assuming reinvestment of distributions into additional Fund shares) compared to $12.43 for the Barclays Bond Index. FOCIX returned 1.9 times more than the Barclays Bond Index on a $10.00 investment over five years. Of the $14.57, the share price (net asset value per share) was $10.41 and the value of distributions reinvested was $4.16. This difference, more than anything, demonstrates how the Fund has outperformed the market (as represented by the Barclays Bond Index) over the period shown.
Bruce Berkowitz Fairholme Focused Income Fund: Fannie Mae and Freddie Mac preferred stock value decline
The fifth anniversary of the Fund was unceremoniously marked by a weak Q4 2014 performance, largely due to the early October decline in the value of Fannie Mae and Freddie Mac preferred stock following an unfavorable ruling by a federal district court judge. Despite posting a 3.39% decline for 2014, the Fund’s performance over the last five years was almost double that of the Barclays Bond Index. The fact that such outperformance was achieved while holding an average of 35% in cash and equivalents since inception validates our barbell strategy for the Fund. Maintaining ample liquidity allows us to take advantage of unexpected opportunities and helps balance a focused portfolio of higher-yielding securities from companies that we understand well. At December 31, 2014, the Fund is composed of securities from eight issuers (71.1%) along with U.S. Treasury Bills and money market funds (28.1%).
Intermediate-term corporate bonds from Sears Holdings due 2018 (30.0%) and Imperial Metals due 2019 (22.1%) both yield roughly 9% to maturity and are attractive coupons to clip because, in our opinion, their actual “issuer default risk” is simply not commensurate with their purported “issuer default rating” (both CCC). The ongoing transformation at Sears accelerated in 2014, with various corporate actions (including the spin-off of Lands’ End and Sears Canada) generating over $2.4 billion in proceeds to the parent. Our analysis of the company’s vast asset base (including, but not limited to, its real estate portfolio) provides us with ample confi dence that these bonds are covered. While we did not participate in the initial offering by Imperial Metals of attractive 7% senior unsecured notes in March, the Fund was able to take advantage of late summer stress and subsequently buy the notes at a 9% yield to maturity following the unexpected breach at the Mount Polley tailings pond, which caused operations to cease at that site and consequently delayed the eagerly awaited start of the massive Red Chris mine. Investigations to date reveal no injuries, no signifi cant differences in the ecosystem, and no definitive reasons for the accident. We expect that Imperial will overcome this delay of game and resume normal operations.
Bruce Berkowitz Fairholme Focused Income Fund: Fannie Mae and Freddie Mac dividend payment
The preferred stock of Fannie Mae (4.5%) and Freddie Mac (4.9%) do not currently pay dividends due to the terms of the federal conservatorship. Yet, we believe there is potential for significant appreciation in principal over time (and perhaps the recoupment of accrued interest) as the indispensability of these two publicly traded, shareholder-owned companies to affordable homeownership eventually overpowers the taboo imposed upon them by the Washington establishment. Following the substantial price decline at the beginning of the fourth quarter, the Fund purchased more preferred stock – and we continue to believe that these securities have an unusually attractive risk/reward dynamic. On October 10, Fairholme Funds, Inc. (“Fairholme”) fi led a notice of appeal in the U.S. Court of Appeals for the District of Columbia of the ruling by District Court Judge Royce Lamberth that dismissed one of Fairholme’s suits against the Federal Housing Finance Agency and U.S. Department of the Treasury. Fairholme’s statement at the time is worth reiterating:
“Fairholme believes strongly that the Net Worth Sweep – imposed four years after the fi nancial crisis – was not authorized by the Housing and Economic Recovery Act of 2008 (“HERA”) and must be unwound. Fairholme also believes strongly that the Federal Housing Finance Agency (“FHFA”) has contractual and fiduciary duties to the preferred shareholders of Fannie Mae and Freddie Mac, and that these duties can and will be enforced.”
“The resolution provisions of HERA are virtually identical to those that apply to U.S. banks. We are confi dent that Congress did not authorize the conservator – a Federal agency – to operate a profi table fi nancial institution perpetually, to strip away all of its capital, to pay all its future profi ts to another Federal agency, to violate the order of priorities of corporate law, to transfer its assets without determining fair price, to replace the organized claims process of receivership with the self-dealing expropriation of private property, or to make corporate governance decisions without a standard of care. And yet, if the D.C. District Court’s opinion stands, FHFA is authorized to do all of this with impunity, previously and forever. In fact, the District Court opined that it lacks the authority even to review the conservator’s actions – a fundamentally fl awed interpretation of the statute. After all, why would Congress write a 260-page HERA statute specifying and limiting the conservator’s powers if no court has jurisdiction to enforce it? Where there is no remedy, there is no law.”
More recently, the November 19 statement by Senate Banking Chairman Tim Johnson at a congressional hearing revealed uncommon pragmatism on Capitol Hill, as he noted: “There is only so much that can be accomplished while [Fannie Mae and Freddie Mac] are in limbo. Everyone agrees that the conservatorship cannot continue forever, so I hope my colleagues will keep working toward a more certain future for the market. However, if Congress cannot agree on a smooth, more certain path forward, I urge you [FHFA Director] Watt to engage the Treasury Department in talks to end the conservatorship.” Progress in Washington requires patience, but we continue to believe that common sense will ultimately prevail and lead to a viable solution that benefits all stakeholders.
Preferred stocks of Ally Financial (4.4%), Chesapeake Energy (2.7%), Goldman Sachs (1.4%), and Bank of America (1.2%) have current yields exceeding 5% and, on the whole, we believe are well positioned to perform favorably in a rising interest rate environment.
The Fund’s signifi cant cash position will be opportunistically deployed as we look to take advantage of select market dislocations in 2015.
Fairholme Capital Management