The Fairholme Fund - Annual Report and Letter to Shareholders

We have always been attracted to sectors showing large declining market values. Usually, stock prices of businesses within these industries drop faster than underlying values, tainted by the collapse of speculative securities. Such conditions create a Darwinian process of the strong getting stronger and the weak disappearing. The winners are usually run by battle-hardened owner/managers who know that the seeds of greatness are planted during the worst of times and reaped after the storms pass. To the victor belong the spoils…

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Berkshire Hathaway remains the Fund’s largest business investment. The implosion of credit markets, overextension of financial guarantors, weakened competitors, and the struggles of housing-related industries have allowed Berkshire to start a municipal bond insurer, acquire a super-majority of the Pritzker’s building-related Marmon Group, and increase float. With a war chest of roughly $40 billion of cash and $100 billion of other liquid investments, Berkshire is a logical senior lender or last-resort acquirer for the financially wounded.

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Energy continues to be a substantial component of the Fund with Canadian Natural Resources the second largest Fund investment. Notwithstanding the province of Alberta’s proposed royalty increases, the company has a unique ability to materially increase production without acquisition in today’s high price/high cost environment. Canadian Natural remains undervalued in a world where most reserves are subject to significant political risk and long term-demand threatens to outrun supply.

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Sears Holdings is a relatively new, core position that continues to cost the Fund. Store traffic has been weak given stressed consumers and the company’s greater exposure to depressed housing markets than most. Many despair that Sears seems unable to regain past retail glory, despite a conservative balance sheet and many valuable assets. In searching for instant gratification, most are missing key points. As with Warren Buffett in the late 1990s, many believe Eddie Lampert’s investment skills have faded — but it is just as unlikely that this leopard has lost his spots.

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Leucadia National knocked the ball out of the park last year with its investment in Australian, iron-ore miner Fortescue. Although Leucadia does not seem inexpensive, its roster of lottery tickets, liquidity, and history of success in difficult times allow us the luxury of patience.

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The unexpected happens more frequently and with more severity than most expect. Accordingly, cash remains a sizeable chunk of the portfolio. As demonstrated this year, cash helped the Fund to weather portfolio headwinds and allowed the Fund to buy without the need to sell already inexpensive securities on the cheap. Shareholders should not fear a temporary decline in the Fund’s NAV, as lower prices for sound investments usually indicate better bargains and higher future returns — particularly with cash hoarded for such chances. As a cagey old veteran of Wall Street once said, “You make your best money in a bear market; you just don’t know it at the time….”