MPI Blog

Berkshire Hathaway’s sector classification suddenly became important to many investors after BRK.B (Berkshire’s B Share Class) was added to the S&P 500 on February 12, 2010. Because BRK.B was classified as a Financial, XLF, the most popular Financial Sector ETF, now has a significant weight in BRK.B. Other popular financial sector ETFs, like VFH, have smaller, though still significant, allocations to BRK.B. Since these ETFs are liquid, inexpensive and relatively precise, they’re widely used to make and hedge financial sector bets. However, if a large holding in a Financial Sector ETF doesn’t behave like other Financials, the ETF risks losing considerable precision.

The question many investors are now asking is: Does BRK.B actually belong in the Financial sector? If BRK.B behaves like a Financial, for all practical purposes (including portfolio construction and risk management) it should be treated as a Financial. However, our analysis of BRK.B’s historical returns shows it behaves more like a Consumer Staple stock than a Financial.

BRK.B’s sector classification is of particular importance to both long-only and long-short portfolio managers attempting to manage sector exposure. For example, consider a long-short portfolio manager attempting to construct a sector neutral portfolio. If the portfolio manager is long BRK.B and it behaves like a Consumer Staple and not a Financial, this portfolio will have unintended, potentially large sector tilts towards Consumer Staples and away from Financials.

Based on monthly return correlations, it appears that, in recent years, BRK.B behaves more like a Consumer Staple than a Financial.

As the chart below clearly shows, not only are BRK.B’s returns more closely correlated with Consumer Staples, but the magnitudes of its returns are more similar to Consumer Staples than Financials.

The results from this simple correlation analysis were further supported by more rigorous, quantitative analysis done using MPI’s proprietary Dynamic Style Analysis (DSA) model. When using a multi-factor model comprising of the S&P 500 sectors, Consumer Staples is the dominating factor driving BRK.B’s returns. Since 2001, the exposure of BRK.B’s returns to Consumer Staples is much larger than its exposure to Industrials and Financials combined.

Why does the market treat BRK.B as a Consumer Staple instead of a Financial when, according to Berkshire itself, their primary business is in the insurance and reinsurance sector? We posit that three different considerations, when viewed together, provide a plausible explanation. First, a large chunk of Berkshire’s insurance businesses are viewed as Consumer Staples not Financials. Second, Berkshire’s reinsurance businesses impact BRK.B’s idiosyncratic returns, but do not have a significant impact on its systematic returns. Finally, and most obviously, Berkshire has large public holdings in companies like Coca-Cola and P&G.

Interestingly, looking at the exposure chart above, prior to 2001, BRK.B traded more like a Financial than a Consumer Staple. What explains this apparent shift in how the market perceives Berkshire Hathaway? We will continue our investigation into BRK.B and Berkshire Hathaway in future blog posts.

Kushal Kshirsagar Main, Research

The class action lawsuit involving the Oppenheimer Core Bond Fund (OPIGX) alleges that the firm understated the fund’s risks as reported in a Read more…

Michael Markov Main, Mutual Funds, Research

Back in 2007, we published a research report “The Law of Large Numbers“ with an analysis of the Renaissance Technologies RIEF fund and showed how a similar strategy would have performed during previous recessions and major market downturns. Thus, it shouldn’t come as a surprise that the RIEF has lost about 17% through April and 8-9% in April alone as it was reported by The Wall Street Journal and various blogs. Read more…

Michael Markov Hedge Funds, Main, Research

I thought the chart below may be of interest. We compared performance results of Stanford’s investors taken from the SEC complaint¹ with one of the largest stable value funds (name withheld). Stanford results in the complaint go only through 2006 and that’s why the line stops there while the stable value fund continues its upward trend through 2008.

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1. Please see my previous blog post [↩]

Michael Markov Hedge Funds, Main, Research

Recent cases of alleged fraud involved investors placing billions of dollars in unregistered products attracted by smooth positive returns. Hedge funds and other unregistered investment vehicles do not have a monopoly on “stable” positive returns. In fact, there exists a class of products known as stable value funds that share similar stable return characteristics and can be found in many retirement plans. Read more…

Michael Markov Main, Mutual Funds, Research

In the January 3^rd 2009 article “Mutual Fund Fought Off Bears but Now Is Clawed” The Wall Street Journal reporter Eleanor Laise attempts to find an explanation of the Fairholme fund’s subpar performance in the last quarter of 2008. She interviews fund manager Bruce Berkowitz as well as industry experts, analyses fund holdings, and looks at the most recent stock picks. Her conclusion: the fund made all the right sector moves (e.g., got rid of energy and financials) and its otherwise exceptional performance in 2008 has been marred by just a series of poor stock bets. The article concludes with assurances from the fund manager that the strategy is sound and that all the bets will pay off. We also learn that Mr. Berkowitz now has almost 100% of his net worth invested with his fund. The latter is indeed a good sign but we believe that a sophisticated investor deserves better insight on what the future might hold for this outstanding fund.

By performing an analysis of the Fairholme return record using MPI Stylus we tried to connect the dots to understand the sources of the fund’s past performance and provide some guidance in what to expect in the nearest future.

“Ignore the Crowd”

Fairholme fund indeed has an exceptional track record. It outperformed the S&P 500 index every single year since its launch at the end of 1999 except for 2003. Even last year, which was the focus of the WSJ article, the fund outperformed the index by 7.3%.

Fairholme is a no-load mutual fund with an expense ratio of 1%. Its manager is true to its motto “Ignore the Crowd” as prominently featured on the fund’s website. The fund makes focused sector and securities bets. It’s concentrated, holding about 22 stocks. The top ten holdings account for 64% of its assets (according to August 31, 2008 data.) We consider this degree of concentration to be especially high given the fund’s size of $7.2B. Annual turnover is only 14%.

Fairholme is classified as Large Blend by Morningstar and Mid-Cap Growth by Lipper. This seems a little odd, though it’s not surprising for fund research firms to disagree on such a concentrated portfolio. We performed a returns-based style analysis of the fund to better understand its style exposure. Then we undertook a second analysis with its focus on sector exposure to get at its underlying strategy and to determine the sources of its past and recent successes. This put us in a position to either confirm or refute conclusions presented in the reporter’s story.

In the chart below we show the fund’s cumulative performance since inception vs. the S&P 500 Index. A chart similar to this is prominently positioned in Fairholme’s semi-annual 2008 and annual 2007 reports. Note the accentuated 2008 loss—that’s how performance appeared to long-term Fariholme investors.

The depiction of the drop in 2008 seems a bit confusing given that Fairholme outperformed the index by 7.3% that year. For this very reason we find such “growth” charts to be very misleading because the compounding of a single-period return outlier gets multiplied and creates a distorted view of a fund’s performance. A simple cure for this problem is to employ a logarithmic scale on the y-axis as in the chart below. Doing so shows that most of the gains are attributed to years 2000-2002 while over the past several years the fund’s performance was more or less in sync with the S&P 500 index.

Fairholme could help itself either by replacing their growth chart in the 2008 annual report with this alternative form or by showing the fund’s annualized performance next to it. Such a chart will give the fund deserved credit for its outstanding track record despite recent losses.

Getting Under the Hood

In order to determine the drivers of the fund’s performance we needed to perform a returns-based style analysis (RBSA) of the fund. As a reminder, RBSA attempts to create a dynamic portfolio of generic asset indices that replicates the analyzed fund’s performance. For our analysis we use the nine years of Fairholme monthly returns¹ through the end of 2008, the six Russell style indices, and the MSCI Canada equity index to represent Fairholme’s significant exposure to Canadian stocks. The results of the analysis are presented in chart below.² Note that we didn’t use any holdings information to produce these results. All we needed was a stream of monthly return figures.

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1. Fund returns are provided by Morningstar [↩]
2. The analysis is performed using MPI Stylus software in DSA mode. For interpretation of this and following charts please refer to the “Style Primer” and other white papers in the Research section of MPI’s website. [↩]

Michael Markov Main, Mutual Funds, Research