Fairholme Funds (FAIRX) semi-annual letter Aug 01 2018
Full letter (FAIRX2018SemiAnnualLetter)
To the Shareholders and Directors of The Fairholme Fund (Trades, Portfolio):
Fund performance was disappointing in the first half of the year mostly due to the decline in the preferred shares of Fannie Mae and Freddie Mac even though the enterprises’ businesses are stronger than ever. Consistent with our value-oriented criteria, we initiated new investments in cash generative businesses at discounted prices. Since year end, I have substantially added to my family’s holdings of the Fund, reflecting a view on the attractiveness of the Fund’s holdings and future.
The Fairholme Fund (Trades, Portfolio) decreased 8.49% versus a 2.65% gain for the S&P 500 for the six-month period that ended June 30, 2018. The above graph and performance table compare The Fairholme Fund (Trades, Portfolio)’s unaudited performance (after expenses) with that of the S&P 500, with dividends and distributions reinvested, for various periods ending June 30, 2018. The value of a $10,000 investment in The Fairholme Fund (Trades, Portfolio) at its inception was worth $51,313 (assumes reinvestment of distributions into additional Fairholme Fund (Trades, Portfolio) shares) compared to $26,576 for the S&P 500 at June 30, 2018. Of the $51,313, the value of reinvested distributions was $32,883.
The St. Joe Company
St. Joe’s (NYSE:JOE) entitled land, resort assets, commercial properties, and ample cash pile are presently priced below a reasonable estimate of intrinsic value. As important, St. Joe is more focused than ever on increasing shareholder value in the coming years through expanding its portfolio of income producing assets. Currently, the market values all of St. Joe at $6,800 per acre of owned land or about $5,100 per acre net of the company’s cash and short-term liquidity portfolio. We are hard pressed to find cheaper comparables considering:
St. Joe’s increasing growth initiatives, including Latitude Margaritaville, a joint venture with Minto Communities and Margaritaville Holdings to create a 55-and-better community located about six miles off the coast and just north on the Inter Coastal Waterway, with the first phase of 3,000 homes projected to open in early 2020.
St. Joe’s leasable commercial property has grown over 44% to 813,000 square feet over the past few years, with occupancy now up to 87% leased.
Airport capacity at Northwest Florida Beaches International Airport has increased from one airline carrier in 2009 to four, with passenger traffic up 300% as the airport soon approaches the one million annual passenger mark.
For these reasons and others, you can begin to understand why St. Joe has repurchased nearly one-third of its outstanding shares over the past few years and why St. Joe is the largest position in The Fairholme Fund (Trades, Portfolio).
Fannie Mae and Freddie Mac
We remain confident in our preferred equity ownership. For evidence, look no further than the latest developments.
Last month, the White House released a paper advocating for a series of government reforms, including ending the conservatorship of Fannie and Freddie, with the goal for these mission critical institutions to remain shareholder-owned. Secretary Mnuchin believes 2019 is the year to resolve remaining issues.
This month, the Fifth Circuit Court of Appeals ruled that the Federal Housing Finance Agency (FHFA), Fannie and Freddie’s conservator, is unconstitutionally structured, as the court concluded that a variety of factors unlawfully sheltered the FHFA from presidential oversight. Although the Net Worth Sweep was not vacated, this is a positive development for shareholders, as it increases the odds of further review by the en banc Fifth Circuit, the Supreme Court, or both. However, by a two-to-one vote, the Fifth Circuit rejected the plaintiffs’ argument that the FHFA exceeded its statutory authority under HERA and that the Net Worth Sweep agreement violated the Administrative Procedure Act. Judge Don Willett, the lone dissenter, provided a powerful and highly persuasive dissent concluding that “the net worth sweep strips the GSEs of their capital reserves, and it is thus antithetical to the FHFA’s statutory command that it ‘preserve and conserve the assets and property’ of the GSEs”. When acting as conservator, HERA does not authorize the FHFA “to bleed the GSEs profits in perpetuity.” We agree and the Eighth Circuit, which has yet to rule on Saxton v. FHFA, was notified of Judge Willett’s sound analysis.
Meanwhile, Fannie (FNMA) and Freddie continue to report strong quarterly profits, highlighting the strength of the core operating franchises. Had the Net Worth Sweep never been implemented, Fannie and Freddie would have retained earnings well over $100 billion, which highlights how quickly capital can be restored. Trading at approximately one-quarter of their intrinsic value, we continue to view the preferred shares as an excellent investment.
Imperial Metals Corporation (TSX:III)
The securities of Imperial are backed by substantial asset value, notably the copper and gold deposits at the Red Chris mine in northern British Columbia. Imperial is only a few years into operating Red Chris, which has the resource depth to be a multi-generational asset. Continuous operational improvements and improving copper fundamentals provide tailwinds. Given current prices, Imperial bonds provide double digit yields with near term maturities, and we also expect a favorable return on the company’s equity over the next few years.
Sears Holdings Corporation
Sears (NASDAQ:SHLD) continues to reduce its operating footprint. Its pension liability has been greatly diminished and the maturity date of most debt obligations have been extended beyond our senior bonds, which mature December 2019. Over the past few quarters, liquidity has been enhanced from a new credit card agreement with Citigroup and further monetizations of real estate assets. Sears securities are priced for doom, but we continue to expect additional asset sales and continued cost cutting will fuel outperformance in our remaining Sears investments.
International Wire Group Debt
The secured notes of International Wire Group are backed by a low-cost manufacturer of copper wire and wire-related products with a diverse set of customers across industrial, energy, telecom, defense, and medical segments. The company has a long history with many of its customers, and the largest customer accounts for less than 9% of total revenue. The bonds, which mature April 2021, offer an attractive equity-like return.
New Investments
The Fund has initiated several new investments during the year.
Vista Outdoors Inc.
Vista Outdoors (NYSE:VSTO), originally owned by Honeywell until the early 1990s, is a dominant producer of ammunition that is purchased by military, police, and governments around the world, in addition to U.S. consumers. Vista’s product portfolio spans 50+ brands. We believe that Vista’s bottom-cycle profitability has largely been clouded by the temporary oversupply of the U.S. consumer ammunitions market. We expect a return to equilibrium this year and that the company will further recover to past profit levels by selling non-core brands and reducing debt outstanding.
Spectrum Brands Holdings
Spectrum Brands Holdings (NYSE:SPB) is a global consumer products company with leading brands, including Armor All, Kwikset, and Nature’s Miracle to name a few. The company just completed an all-stock merger with its controlling shareholder, HRG. We expect that the combined company will generate much higher levels of cash, sell non-core assets, and apply proceeds to reduce debt and repurchase common shares.
Vistra Energy Corp.
Vistra Energy (NYSE:VST), the merger of a reorganized Energy Future Holdings and Dynegy, is a uniquely positioned generator and retailer of electricity. The combination of its diversified portfolio of power plants, well-regarded TXU Energy consumer brand, focus on the growing Texas market, and a strong balance sheet results in an attractive business profile with significant free cash flow generation. Shares were purchased at a double-digit free cash flow yield.
AT&T Inc.
AT&T (NYSE:T) offers substantial free cash flow providing ample coverage for a large dividend. This is an attractive proposition for a firm endowed with historical advantages and diversified wireless, wired, and media business lines.
Citigroup Inc.
Citigroup (NYSE:C) was purchased at approximately ten times earnings and a discount to book value, a modest valuation for an essential, global financial institution. Recently approved by the Federal Reserve, Citigroup’s capital allocation plan calls for substantially all earnings to be used for share repurchases, which should drive per share earnings growth.
Sold Investments
Seritage Growth Properties
The Fund exited its position in Seritage Growth Properties (NYSE:SRG) as we became concerned that the cash flows from developed properties no longer covered a below-industry average dividend in a raising rate environment.
General Outlook
It has been nearly ten years since the financial crisis. The U.S. economy has prospered with the help of low interest rates and low inflation. The result has been new highs in the stock market with low volatility. As we monitor our portfolio and research new opportunities, we are keenly aware that these conditions can quickly turn, providing opportunities to those with liquidity.
Respectfully submitted,
Bruce R. Berkowitz
Chief Investment Officer
The Portfolio Manager’s Report is not part of The Fairholme Fund (Trades, Portfolio)s, Inc. Semi-Annual Report due to forward-looking statements that, by their nature, cannot be attested to, as required by regulation. The Portfolio Manager’s Report is based on calendar-year performance. A more formal Management Discussion and Analysis is included in the Semi-Annual Report. Opinions of the Portfolio Manager are intended as such, and not as statements of fact requiring attestation.
