A Portfolio Warren Buffett Would Love

As manager of the $6.8 billion Fairholme fund, which he launched in 1997, Bruce Berkowitz is on the hunt for undervalued companies with strong managers and plenty of free cash. Rather than building a traditional, diversified portfolio, Miami-based Fairholme—named after a street Berkowitz once lived on—concentrates its resources on a limited number of positions, a strategy that has led to impressive returns. Fairholme boasts annualized returns of more than 20 percent over the past five years and has returned nearly 2 percent so far in 2008—despite the nasty market.

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Berkowitz recently spoke with U.S. News about why diversification is overrated, how volatility is opportunity, and whether Sears Holdings can be the next Berkshire Hathaway. Excerpts:

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What kind of fund is Fairholme?

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It's a focused fund, nondiversified. That means when we find something we like, we buy a lot. Our top positions plus the cash—and we've averaged about 20 percent cash since we started—is between two thirds and three quarters of the fund.

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How does this investment approach differ from others?

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In business school, you're taught that diversification is very important. But really, when you think about it, diversification has to do more with ignorance. If you are highly confident in your top five positions, why should you put more in your 10th position if you could put more in your best idea? Secondly, business schools teach that risk is volatility. We think volatility is opportunity. For example, if you follow the business school formula, when something goes down 50 percent in price, it's considered riskier. Personally, I would say it's considered safer—you're paying half.