FAIRHOLME CAPITAL MANAGEMENT LLC

December 1999
“Graham and Dodd [value] investors are people who place a very high value on having the last laugh. In exchange for the privilege, they have missed out on a lot of laughs in between.”
Michael Lewis, author of The New New Thing, a chronicle of the start up of new technology companies associated with Jim Clark, one of the founders of Netscape Communications

The last 18 months have not been fun. We have watched our Companies perform as businesses and languish as stocks. During the same time, extreme popularity has been conferred on technology companies, many with short or mediocre operating histories. We empathize with any frustration you have over the short-term price behavior of our Companies (as owners of the same securities, we should), but want to remind you why we are excited about the future:
♦ ♦ ♦ ♦ Our Companies are quality businesses with proven histories. Our Companies are selling at bargain prices. Our Companies are run by successful managers who are significant shareowners. Our Companies and their managers respect their fellow shareowners. Our Companies use conservative accounting.

The recent price performance of our Companies does not reflect their business performance. Stock price declines are “mark-to-market” declines, not permanent losses. It is critical for you to understand that we believe the intrinsic value of our companies has increased, not decreased, over the last year. The longer it takes value to be recognized, the larger our future profits will be. Furthermore, if Mr. Market continues to place low prices on our Companies, we will buy more. This is how we have made lots of money in the past. Nevertheless, watching the high-tech fireworks unfold has caused us to miss a lot of laughs in the last two years. Dreams have temporarily displaced conservative analysis. Eventually, numeracy will return. The high tech gold rush is a dangerous game which we have been unwilling to play. We own terrific Companies at bargain prices. We expect to laugh again.

We bought more. Fund American. we made many purchases. In the past. there were times when performance lagged badly. Page 2 of 11 . and MBIA. In 1991. However. During this period.P. It would have been easy to become discouraged. However. Wells Fargo. Household International. look at the chart below of the longterm price of Wells Fargo through the Norwest merger in late 1998. Margin of safety is defined as the discount from intrinsic value at which we can purchase a part of a company for you. Here’s what Wells Fargo looked like during our primary period of purchasing shares: Wells Fargo Common Stock 1991-1992 Source: Bloomberg L. We define intrinsic value as the present value of free cash generated by a corporation over time or the value that would be received should the company liquidate its assets and distribute the cash to shareholders.FAIRHOLME CAPITAL MANAGEMENT LLC OUR HISTORY The entire history of Fairholme and its investment managers is intertwined with the concepts of intrinsic value and margin of safety. Freddie Mac. holding tightly to these concepts has allowed us to make large profits without assuming large risks in such securities as Berkshire Hathaway. we began buying Wells Fargo at prices between $52 and $78 per share and watched the stock trade down or sideways for nearly two years.

When the Company merged with Norwest the last sale was $374. more patience. we find a huge gulf between the valuation of the companies providing Page 3 of 11 . we make extensive use of technology. In many examples our initial purchases showed losses and we averaged down. We are committed to this strategy and will not stray from our circle of competence because many are profiting from other strategies which we think have high risk. In virtually every case where we have had wonderful investment success. THE CURRENT ENVIRONMENT We are not strangers to new technologies and their potential impact on the world. This is not an easy strategy to employ. and sometimes even more than that.FAIRHOLME CAPITAL MANAGEMENT LLC Wells Fargo Common Stock 1991-1998 Area of Previous Chart Source: Bloomberg L. It requires patience. we ended up with large positions that rose to multiples of our purchase price. Eventually. we bought quality businesses during times of distress and low valuations. In our business. It requires a commitment to dig deep into the business and to understand the business as well as the managers running the company. Yet. (Wells split 10 for 1 after the Norwest merger in 1998 and the merged company has since traded as high as the equivalent of $498 per share.P.) We want to be greedy when most are fearful and fearful when most are greedy. whenever we have looked at some of these companies as potential investments.

these valuations cannot be sustained. and we see no reason why our existing investments should not prove as rewarding. We question whether they will ever generate the significant profits needed to justify their current market prices. the well-known and deep pocket semiconductor and cellular telephone manufacturer. In prior investments. leaving shareholders with nothing. the future looks bright. Its major backer was Motorola. Our investment criteria have not changed. In prior letters. In addition to the untested ventures. and the right backers. Don’t think that this has only happened in the past. uranium in the 1960s. Page 4 of 11 . and combined losses of more than $3 billion. We recently sent you an article describing the experience that followed the purchase of speculative securities during prior technological boom periods involving automobiles and aviation. may not persist. biotech in the 1980s. there have been other stock market excesses in specific market sectors such as radio in the 1920s. However. there are good businesses in the technology sector run by honest and talented managers. where poor companies fall by the wayside and long-term competitive advantages become clear. There will be a shakeout in this area. How could it lose? Not long ago. Our Companies have proven their worth through many competitive challenges and varied economic conditions. Our goal in managing money for you is simple: to create and increase your wealth and ours while avoiding permanent losses. Of the internet companies that went public this year. there is no margin of safety. That we felt this way a year ago makes us even more unwilling to take these risks with your money or ours. A company called Irridium was formed a few years ago to provide satellite telephone service worldwide. the only thing that seems to matter is what these companies do rather than how much money they make or whether or not there is serious competition. Presently. and now technology in the 1990s. many of the new companies failed completely. It had excellent technology. It is illogical for us to compare our Companies to ventures whose competitive advantages. we may well own a great technology company at the right price. A group of 133 recently public Internet companies has a combined market value of nearly $500 billion.FAIRHOLME CAPITAL MANAGEMENT LLC these new technologies and the value of their products and services. Most of the popular newcomers have yet to experience a single downturn in the economy. about one-third paid more in investment banking fees than they booked in revenue in the last twelve months. the company filed for bankruptcy and the Bloomberg news service recently reported that common stockholders are expected to receive zero for their shares. written off research and development expenses. We own the same investments you own. these criteria have earned us high returns. no direct competition. These are extraordinary figures. oil in the late 1970s. or more than 30 times revenues. Despite participating in rapidly growing industries that changed society in major ways. and undertaken extensive restructuring charges. In our opinion. we have discussed our concerns about the poor quality of earnings where companies have issued large numbers of stock options. In our view. Over the years. if any. One day.

and Mercury General. the quarterly earnings of Berkshire Hathaway have always been volatile for several reasons.e.FAIRHOLME CAPITAL MANAGEMENT LLC OUR COMPANIES Currently we hold major positions in Berkshire Hathaway. ♦ GenRe appears to be reducing costs substantially. we see little evidence to suggest that recent results represent any serious threat to the long-run economics of this business. In addition. However. GenRe has recorded the worst underwriting results in the company’s recent history. And they are currently bargain-priced. It is tolerating lower shortPage 5 of 11 . They generate real cash earnings to benefit owners. immediately expensing these efforts rather than capitalizing them or reporting the often-used “restructuring charge”. Berkshire Hathaway Through its history. The nature of insurance. Household International. particularly reinsurance. Mercury in particular now appears to be an extraordinary bargain. Berkshire has chosen to have certain of its businesses grow rapidly. We have also provided a brief note on Leucadia National. These companies are excellent businesses with fabulous histories of shareholder returns. we think the overall results were affected by some one-time factors. is to have poor quarters followed by great quarters (i. They use conservative accounting that typically understates income and balance sheet strength. profits are lumpy. which is paying an additional distribution at year-end. Given GenRe’s long history of profitable operations and sizeable float generation. Among these are variability in short-term insurance profits. and the costs of growth that Berkshire will tolerate for future benefit. and that GenRe is refusing marginal business.) We have seen signs that reinsurance rates are starting to rise. reporting results as honestly as accounting allows without any attempts to smooth quarterly results. They are run by talented and honest managers. ♦ Under Berkshire. the company treats shareholders as co-owners. GenRe appears to have adopted more conservative policies regarding the recognition of profit. the uncertainty of realizing capital gains. Berkshire’s reported earnings for the third quarter of 1999 were below our expectations due to continued underwriting losses at GenRe. ♦ Stock option plans were converted to cash incentives at significant cost. much as Berkshire’s other reinsurance units have behaved over the years. So far this year. There is another very important factor currently affecting Berkshire’s short-term earnings.

Below is a chart representing our current valuation of Berkshire. Consequently. Berkshire’s valuation could suddenly increase by $15 billion or $10. $1 billion of new business can cost $300 million in foregone profit while $4 billion of old business earns $400 million for a net profit of $100 million. Note that the low end of our range includes a value for Berkshire’s stock holdings that is more than $8 billion below current market value. We estimate their current value to exceed $12 billion (with the recent purchases). along with investments made in the other operating companies are rarely considered when people look at Berkshire. At its current premium level of roughly $5 billion. float grew by close to $2 billion. In five years. We know that the cost to acquire new business in the auto insurance sector can amount to 25 to 30 cents in losses for every dollar of premium in the first year. we have priced in a decline of close to 40% from current market prices for the major holdings of Berkshire. Remember that Berkshire has chosen to invest in GEICO’s growth by foregoing the higher profits generated by a mature business. GEICO is foregoing roughly $250 -$300 million of reported profits to grow at its current rate. Lowell. the same customer will be generating a profit of close to 10 cents for every dollar of premiums. In effect. These pending acquisitions. The Company continues to have close to $20. Flight Safety. In the latest quarter. the Company committed to invest approximately $2. which holds large cash and bond positions and which consistently generates large amounts of free cash. The current decision to grow despite reporting hundreds of millions less in profits is quite possibly reducing Berkshire’s market value by $5 billion. Brown.5 billion by announcing the acquisition of a well-known regional furniture retailer in New England and a large electric utility holding company. On the day growth slows. We have tried to be conservative in our presentation. this worst-case view should remove investor concern about the effect of a stock market decline on Berkshire’s intrinsic value.H. and Dexter).000 per share in cash and bonds and continues to generate sizeable amounts of cash. Among the subsidiaries in this position are GEICO. and Executive Jet.FAIRHOLME CAPITAL MANAGEMENT LLC term earnings for significantly higher future profits. During the quarter. by placing a lower than market value on the look-through earnings of the largest investments. Page 6 of 11 . These characteristics make Berkshire’s current reported profits considerably less than its economic profits.000 per share attributable just to GEICO’s more visible earnings. In our opinion. The major equity holdings have increased in value since the end of September by close to $3000 per Class A equivalent share. reported profits will start to skyrocket. The company would not be investing in growth without the expectation of considerably higher future profits. which must be invested. However. With the exception of the shoe segment (H. Keep in mind that a significant stock market decline would provide enormous opportunities for Berkshire. or about $8000 per share. the rest of the businesses owned by Berkshire are performing well. in the second or third year of the policy renewal.

as well as the growth of its book value and stock price over the last 15 years compared to the S&P 500 Index. Below is a chart of the growth of Berkshire. Page 7 of 11 .FAIRHOLME CAPITAL MANAGEMENT LLC It is worth reviewing some of the history of Berkshire. clearly one of the most unusual and rewarding businesses created in the last 50 years.

000 1984=100 BRK Book Value 3. Berkshire is an extraordinary company selling at a very ordinary price. we will earn high returns from current prices. and credit quality remains high. Household International Household continues to generate stellar quarterly results. Its revenues are growing.FAIRHOLME CAPITAL MANAGEMENT LLC From the chart below. BERKSHIRE HATHAWAY GROWTH IN BOOK VALUE AND STOCK PRICE VS GROWTH OF S&P 500 WITH DIVIDENDS 6. Through the generation of low cost float. Should the Company’s future be half as attractive as its past. we will do very well with this investment. we have explained in some detail how we believe the business model of Berkshire functions. its profits growing faster. It has tremendous resources and exceptional management. you can see that the dynamics of Berkshire’s business strategy has produced incredible rewards for shareholders. If the Company continues to create low-cost float and generate modest after-tax returns of 10% on its investments over time as we expect (far below its historical experience).000 2.000 BRK Stock Price 1. The Company has delivered on virtually every promise it has made over the last four years.000 S&P 500 (w/Div) 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 YEAR ENDED In previous letters.000 4.000 Berkshire Hathaway 1984=100 Stock Price andStock Price Berkshire Book Value Compared to the S&P 500 1984=100 5. Berkshire creates funds available for investment that leverage its returns on shareholders’ equity. Management (as well as ourselves) is highly Page 8 of 11 .

4 billion. We know that part of the decline in the stock price has nothing to do with corporate fundamentals. from $. Expenses as a percentage of revenues reached record lows. This is a business with staying power and the proven ability to grow. We now believe that Household is in a similar position. We expect these repurchases to continue at current prices. As more stress has surfaced in the auto insurance business.55. Our research tells us that the industry-wide price cutting of the last three years is over.72 per share for the third quarter of 1998. The current stock price is a bargain. Norwest acquired Wells. we said “If Wells does not succeed [after the acquisition of First Interstate]. with the strongest growth in home equity loans. we wrote to you about Wells Fargo and the fact that the stock price had been stagnant.90 per share. In April of 1998. We are excited about this Company. Last quarter. Fee income rose 9. quarter. However. but significantly profitable. core receivables grew $2. Mercury General is shaping up as an extraordinary bargain. Net interest margin percentage widened to 8. Cash basis EPS for the quarter rose 25 percent to $. It serves a segment of the population for which borrowing is a necessity. Household has a long history as a profitable lender to the asset-poor consumer.5 times estimated 2000 earnings. but with investor tax strategies. Mercury’s stock price has declined substantially since we began purchasing shares nearly six months ago.3 percent for the quarter and 22. improving to 32 percent. Quarterly branch originated growth was the best in the company's history. then another institution may buy them. We have been adding to our position. Page 9 of 11 . In that letter. Household continues to repurchase shares in significant amounts. compared to 37 percent a year ago. and has done so since the 1880s. we believe Mercury’s strengths far overshadow one mildly weak. Every indication we have says that Household’s business is continuing to perform to expectations. Previously. These are not the results of a company whose stock price you would expect to be languishing. We continue to see signs that the automobile insurance industry is on the verge of raising prices. We have seen significant earnings disappointments. When a terrific insurance company is knocked down because of competitor losses and tax strategies. We know there has been tax loss selling pressure. bad news for Mercury’s competition has been a signal that Mercury’s growth is about to accelerate. the Company acquired nearly nine million shares at an average price of $40.” Several months later. Wall Street has cast a pall over the industry.2 percent year-to-date. not a choice. In the latest quarter. All product lines grew in the quarter. it is the time to buy. The Company is now trading at approximately 8 times 1999 earnings and possibly as low as 6.5 percent in the quarter. Return on equity reached 25.FAIRHOLME CAPITAL MANAGEMENT LLC disappointed at the price performance of the Company’s stock. Mercury’s results last quarter were slightly below our expectations. Mercury General At its current price of $22 per share.4 percent.

3 $96. Mercury has increased its earned premiums by about 11% annually.2 $799. including its recent efforts in Florida and Texas. Mercury remains the best underwriter among its peers. we expect a significant portion of this capital to be used to repurchase shares and expand the business of Mercury to other geographic locations.2 $66.7 $1. Over the last decade.000.2 $353. $1.020.5 $474.4 $1.3 $90.3 $105.5 $148. and Net Earnings of Mercury for the last 10 years.5 $83. it reinforces our view that the Company is well run. Mercury should succeed in becoming a nationally known insurer over the next decade. mirroring its success in California.400.4 $477.0 $600.0 $Earned Premiums Net Worth Net Earnings 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999E $472. and able to capitalize on opportunities in its markets. positioned properly. George Joseph is operating Mercury with at least $300 million in excess capital on his balance sheet. Below is a chart of the Earned Premiums.300.031.0 $1.3 $616.121. Over the next two years.0 $1. consistent underwriting profits are the hallmark of a well-run insurance company.5 $219.3 $457.FAIRHOLME CAPITAL MANAGEMENT LLC Several companies (among them Safeco and Progressive) have announced an intention to file for rate increases or have already sought higher prices. and its net profits by roughly 16% annually. Return on equity has averaged close to 20%. Net worth has grown close to 20% per year over the same period.8 $51.0 $200. $33.8 $156.4 $277.200. Net Worth.5 $65.7 $450.3 $754.5 $455. In our view. $176.6 $917. Page 10 of 11 .0 The 1994 decline occurred as a result of the Northridge earthquake in California and the decline in 1999 as rate cuts put into place 18 months ago flowed through the income statement. In other words.0 $800.3 $473. it has consistently earned profits selling insurance before adding earnings on investments created by the insurance sales.2 $565.3 $177.1 $529. where its market share has increased every year for the last ten years.2 $641. Every time we learn a new piece of information about Mercury. $1.0 $400. $1.

Statements of fact have been obtained from or based upon sources considered reliable but no representation is made by this Firm or any of its affiliates as to their completeness or accuracy. or investment. We encourage you to call us with any questions you may have about these securities or any of our other holdings. Mercury conservatively appears to be selling for under 8 times 2000 earnings despite significant growth prospects. The investing environment of the last couple of years has been quite unfriendly to Leucadia’s historical strategy of purchasing businesses with temporary problems or large contingent liabilities.L. From all of us at Fairholme. P. but will positively impact future returns. we remain confident about the future of our investments. We do keep duplicate copies of all customer records off-site from our offices and take all necessary measures to ensure the integrity of our client records. healthy. We still believe that Joe Steinberg and Ian Cumming will create additional value for us. industry. Fairholme has examined all its in house technology to ensure that it is indeed Y2K compliant. It sells at a modest premium to book value. should be construed as an offer to sell or a solicitation of an offer to acquire any securities or other investments mentioned herein. sell or buy such securities or investments. These distributions have sharply reduced our total dollar investment in Leucadia. the Company elected to distribute a sizeable portion of its huge cash position.C. It currently pays a dividend yield of about 4% and we believe the dividend will be increased next year. We have examined our Companies in detail and cannot possibly give justice to our knowledge in a few brief pages. which resulted from the sale of Colonial Penn Insurance to General Electric. Consequently. The company continues to repurchase shares around the $21 per share level (equating to $33 before the extraordinary distribution) and has announced that it will pay another partial liquidating payment at year-end of $1. Page 11 of 11 . Leucadia National Leucadia appears to have stepped up its level of business activity in recent months as it purchased a sub-prime automobile lender and increased its interest in MK Gold. While we cannot guarantee the absence of any short-term issues. As fellow owners. is available at your request. Mercury common stock traded above $70 per share. we do not believe that Y2K will give us any significant problems. security.S. Leucadia still has one of the best records in American business for creating wealth. from time to time. which positions may change at any time. Nevertheless. Neither this study. We have also contacted all of our outside vendors and have been assured that all our critical vendors have also achieved compliance. a diversified mining company. and may. Please be advised that the latest copy of Fairholme’s Form ADV Part II filed with the Securities and Exchange Commission. The comments contained herein are not a complete analysis of every material fact respecting any company.FAIRHOLME CAPITAL MANAGEMENT LLC About eighteen months ago. We continue to buy with the expectation that we will see its share price above $70 per share within a reasonable time. we wish you a happy. Despite our recent frustration. and prosperous New Year. nor any opinion expressed herein. which we think is conservatively stated.58 per share. including Schedule H as required by the Investment Advisors Act of 1940. This Firm or persons associated with it may own or have a position in any securities or investments mentioned in this study. we want you to understand why we are comfortable owning our Companies and why we feel excited about their future performance. At its current price of less than $22. © 1999 Fairholme Capital Management L. We have had several clients ask us about the Year 2000 (Y2K) issue.