June 5, 2008  Notes from AAII NYC discussion with Bruce Berkowitz of Fairlholme Fund

S&P500    1,377
DJIA       12,391

Bruce is a well known value investor with concentrated portfolios.  He labeled his fund as "Focused and Value Based."  The following are my notes to this wonderful meeting.  John O'Shaughnessy and I were very appreciative of the discussion.

1.    "Doesn't make sense to have greater than 10 or 20 positions.  Diversification is insurance against ignorance."

2.    Risk is the chance of permanent loss.  There are two concepts of risk.

        A.    Business dies.

        B.    Pay too much. He expanded and said that "the greatest company in the world at a high price is a speculative investment."

3.    Various investment rules.

        A.    Rule 1 - don't lose

        B.    Always figure out how you can "die" in the investment. He mentioned an old country song, "tell me where I am going to die, and I won't go there."    Always invert.  Try to die in your investment and if you find a good way to die, try to avoid the investment.

        C.    Crowd is comfortable, but you will pay a high price for being with the consensus.

        D.    Institutions have a disadvantage in investing because they have an institutional imperative.

        E.    Don't have a herd mentality.

        F.    Emphasis on Free Cash Flow and not Fee Cash Flow.  Free Cash Flow means "owner's earnings."  Free Cash Flow is likened to the old corner grocery store.  At the end of the period, how much is left in the register after all payments are made.  That is Free Cash Flow.

4.    Invests with the Benjamin Graham's dividend payers.  Shareholder buy-backs are a means of giving shareholders money.

5.    Read annual reports backwards.  After reading 60 pages you will be exhausted.  Hence you will miss all the good and important footnotes.

6.    Sears Holding (SHLD) ($85.26) -

        A.    Lampert has cards up his sleeve. He is a smart guy.  The price of SHLD means you get Eddie Lampert for nothing.

        B.    Obvious investment is real estate for Sears.

        C.    Claims lots of Free Cash Flow.

        D.    Bought back stock at high price.

        E.    Think about a young Berkshire Hathaway.  Buffett struggled with the ailing textile mill for over 7 years before he pulled the plug.  Look what Berkshire turned into.      

        F.    Claims that K-Mart and Sears could disappear as retailers and all is still good.  If they happen to hit, merely a bonus.  "What if they become a Wal-Mart?"  Don't count on it, but could happen.

        G.    You can't kill Sears.  If you can't kill it you should own it.

7.    "I buy when I can get double digit Free Cash Flow.  This has potential to grow with time."  Look at Free Cash Flow in comparison to a risk free rate.  This gives a margin of safety.    "I like buying $1.00 for $0.50.

8.    Will sell based on liquidity of positions.  "Respect based on the liquidity of positions."  (Side note, this is where I failed.  I accumulated a position that was not liquid, and could not exit even if I wanted to.  I went to the Charlie Munger school of inevitable hard knocks.  Hopefully I learn by my past errors.)

9.    He likes long holding periods.  The longer you own the company, the more you know it.  You will get a feel for the company's cycles, both good and bad.

10.    In reference to Pharmaceutical companies he discussed that 10 years ago you couldn't buy them for under 30 - 40 Price Earnings ratios.  Now you can't touch them at single digit Price Earnings ratios.  "The mighty shall fall and the fallen shall rise from the ashes."

11.    Make sure you don't do anything stupid.  Inevitably all of us will do stupid things. "Everyone is a bonehead at some point.  Eddie Lampert is a bonehead right now.  He was up 20X investors money for the last decade, now that is down to 8X."  He emphasized that he has all the confidence in the world with Eddie.  He certainly was not thinking Mr. Lampert is a "bonehead."  He was merely stating that his short term performance does not appear to be living up to what Berkowitz expects will be Lampert's long term successes.  A similar situation to Warren Buffett in the early days of his Berkshire holdings.   "You have to make sure that person really isn't a bonehead."  "Do not underestimate the stupidity of people."  This accounts for bubbles and bursts.

12.    Try to keep lots of cash.  This enables deployment when opportunity knocks.

13.    "I assume my shareholders have worked hard for their money invested with us.  I assume they have all of their invested money with us, and that they will need it in the future."

14.    "There are 2 hedges I know of.  One is cash, the other is knowledge.  Carol Loomis once wrote, "The perfect hedge is a Japanese garden."

15.    Study the winners over the centuries.

16.    He indicated he gets his buy ideas by seeing who is throwing up and where.

17.    When you invest think of the worst things that could happen.  What if a natural disaster, an attack, a dirty bomb, what if financing dries up, etc.

18.    I asked about St. Joe Co.(38.02).  "Has anything changed since your Barron's article a few weeks back?"  He mentioned, "I really don't want to answer that."  I told him, "no problem, I understand."  He said, "No, I should discuss it."  He claims JOE owns over 750,000 acres in the Florida Panhandle, there will be an international airport and from there things will grow. "That is why I own it."

19.    Insider ownership is a good factor.  It creates more of a level playing field.  Yet if the CEO is delusional, he is delusional.  Make sure the insiders have paid for their shares as opposed to acquiring via options and so forth.  He talked about being in a meeting with a major company and the CEO.  Bruce said, "With all due respect Mr. CEO and your advisors.  It seems as though I am the only one in this meeting that has actually paid for his investment.  I could see the steam coming out of the angry CEO of the major company's head.  When they don't pay for their shares, they are robbers."

20.    Warren Buffett is genetically engineered to perform well in bad times.

21.    "Cash is worth an awful lot of money when others don't have it."

22.    Things get trendy and come back in style.  He referred to energy plays today.  He likened it to "Blue Suede Clogs."  They seem to always come back and go out of style.

23.    "Nothing worse than a market going up."

24.    An attendee asked about asset allocation advice.  Bruce responded , "Asset Allocation?  What's that?  It's a bad word.  If you mention it in my office you get fired.  Next week will you ask me about efficient market theory and beta?"

25.    He was asked if he speaks with management and if so, how far down the ladder does he go.  Bruce mentioned, "I have been bamboozled by CEO's.  They take me on their cool plane, and serve me NYC Ray's Pizza.  They show me their shiny and new factories.  I should have known a shiny factory is bad.  What would I know about a factory being good or not.  There is plenty of material on the internet to learn about the companies and their officers past.  Read the transcripts and learn to see how they delivered on their statements.  They never change.  You have years and years of data.  There is no need to meet management and you can do all your research in the privacy of your own home."  In relation to how far down the ladder he mentioned something similar to the following.  "I don't talk to the lower level employees.  I send people in to work for the companies. I get the real story.  I'm only kidding.  I've never done that, yet I have thought about it.

26.    He was asked about the tax efficiency of his fund. Bruce's response was that his fund is tax efficient. He added that he would not opt for tax efficiency if he was going to lose money on something.

Respectfully submitted,