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Bruce Berkowitz on the Keys to Success for the Fairholme Fund

January 12, 2010

by Robert Huebscher

Is deflation – particularly with respect to asset prices – eroding the margin of safety at Sears Holdings?

Deflation eroded the margin of safety, in that real estate values came down as the housing market was destroyed.  There is a significant correlation between the housing market and Sears. The answer is yes.

On the other hand, Eddie Lampert was quite astute in the way he handled capital allocation in the last couple of years.  In hindsight, you can say it was a mistake for him to buy stock at $150 to $170 – it was a different environment.  But by creating a company such that there is significant free cash flow being generated, the company has a huge number of degrees of freedom.  If deflation was causing a decline in value and Sears’ shareholders overreacted or very smart people start shorting the stock, then the company has more than enough cash to buy all the shares that Lampert and I don’t own – and together we own over 60% of the company.   

It was a real win-win situation, in that I believe it was a temporary condition, but he configured the company for adversity. If you count how much cash he generated in the last few years you will see it.  Sometimes it is a little hidden, for example because he had to fill a gap in a pension fund liability because the market turned south and the rules required him to put more money in. He’s also paid off a nice chunk of debt. The company does not have a lot of debt.  He has bought back a ton of shares.

If you add up all the money used to do that, it’s a significant amount of free cash.

Now, some people have argued that he is starving the company.  If you look at the revenue of the company, however, it doesn’t look like the company is starving.

Is the value in Leucadia National affected by the tightness in the credit market? Do they have access to capital at attractive rates, and if so why have they not been more active?

Yes, they have been affected by tightness in the credit markets, but they have access to lots of money.  With the right idea they have no issues with access to capital.  We would loan money to Leucadia.  In this environment, it may not be a lack of ideas; it may be an unwillingness to share.  Clearly this environment killed cheap money.  Could they still get money on reasonable terms?  Absolutely.

You have to have a little blind faith with Leucadia, like with Berkshire Hathaway. You can’t predict what they will do.  You measure what they have versus what you have to pay for it, and make a determination as to whether you will get the future for free.  Of course, you have to assume the future is going to be good.

Fairholme owns a little less than a quarter of AmeriCredit common stock a sizable amount of their debt. You have done quite well with it, congratulations. Now that the stock trades close to book value, where is the margin of safety?

The margin of safety is that the company is just coming out of a horrendous environment and there still remains a lack of liquidity for people with less-than-stellar credit to buy cars.  Because of how badly the environment has been decimated, they have a couple of really bright years ahead of them. When during a difficult period you have to lower your business by 80% or 90%, bad loans run off and new loans are fabulous.

It’s what I call the pig in the python.  You are digesting a large amount of bad loans while starting to ingest very good loans.  Now this company faces a period of growth, and they are very good at what they do.

It was the closing of the securitization markets that killed them – a low probability, high severity event.  The one negative is that they are subject to the kindness of strangers – bankers.  That’s where we came in.  We helped them out, and our shareholders received a very good return, in terms of the securitization we did, the corporate bonds we bought, the stock we bought, all of which gave AmeriCredit the ability to stay the course of restructuring in this very tough environment. 

Now they are coming out the other side – lean and mean.  Good business is coming in.  All they need now is to make sure they have enough capital to grow the business. It’s a very cyclical business, but they just came out of at least two very difficult years.  Now, given how few organizations remain and how few want to be in the industry, they are in a good place.

It’s a tough business, in that you have to know when to grow and when to stop growing.  It’s not easy to know when to stop growing.  It’s usually when you have the highest level of testosterone.  You have to look in the mirror and say “stop.”  They are good managers. I was on the Board for a while and now I am not.  They made a lot of money for our shareholders. I like them a lot and our ride is not over.

We interviewed Bruce Greenwald, the Director of the Heilbrunn Center for Graham & Dodd Investing at Columbia University in November. He was less than impressed with Berkshire Hathaway’s decision to buy the balance of Burlington Northern they do not already own. You own a good deal of Berkshire Hathaway, what is the value investor’s case for using Berkshire Hathaway stock to buy this company?

Last year I sold all my Berkshire and then I bought back what we now own.  Last year I said that you have to take Warren Buffett at his word that he will do a couple of points better than the S&P going forward.  And he did.  That’s not bad at all.  But I believe that we are still of the size where we could do a bit better.  But that is absent some type of cataclysmic event – and then we faced this cataclysmic event, which allowed Berkshire to put tens of billions of money that was earning less than 1% to work, to earn 10%. 

I can’t see how Burlington Northern was a great deal.  The greatness of Berkshire is its deployment of float and profit. They are deploying other people’s money in terms of float - premiums on insurance policies that don’t have to be paid out for years and years.  If you are going to use part of that float to pay for an investment, you have to make sure the investment is going to make good money.  With Burlington Northern, if you adjust for a buyer with cash and don’t think much more about it, then it was not a great deal.  But if you bought it using cheap debt and good chunk of other people’s money and you were highly confident that the company would give you a cost-plus return over a decade, then it’s a good investment.

Borrowing money is a sure way to die.  But if you are buying toll booths and roads and regulated industries – pipelines or railroads or electric utilities, where you know you are going to end up with some type of cost-plus pricing – you are going to do very well, given that the actual equity you have in it is low.  It’s like buying a house with a low down payment.  If you judge the return after expenses, after taxes, and on the profits on shareholder equity, the return can be two to three times what it looks like to an all-cash buyer.