N-CSR 1 d451566dncsr.htm FAIRHOLME FUNDS, INC. Fairholme Funds, Inc.

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT

INVESTMENT COMPANIES

Investment Company Act file number             811-09607                

                                   Fairholme Funds, Inc.                                  

(Exact name of registrant as specified in charter)

4400 Biscayne Blvd., 9th Floor

                           Miami, FL 33137                          

(Address of principal executive offices) (Zip code)

Bruce R. Berkowitz

4400 Biscayne Blvd., 9th Floor

                           Miami, FL 33137                          

(Name and address of agent for service)

registrant’s telephone number, including area code:   1-866-202-2263

Date of fiscal year end:   November 30

Date of reporting period:   November 30, 2012

Form N-CSR is to be used by management investment companies to file reports with the Commission not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under Rule 30e-1 under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may use the information provided on Form N-CSR in its regulatory, disclosure review, inspection, and policymaking roles.

A registrant is required to disclose the information specified by Form N-CSR, and the Commission will make this information public. A registrant is not required to respond to the collection of information contained in Form N-CSR unless the Form displays a currently valid Office of Management and Budget (“OMB”) control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. § 3507.


Item 1. Reports to Stockholders.

The Report to Shareholders is attached herewith.


FAIRHOLME

Ignore the crowd.

 

 

The Fairholme Fund (FAIRX)

Seeking long-term growth of capital

ANNUAL REPORT 2012

 

MANAGED BY FAIRHOLME CAPITAL MANAGEMENT

 

1.866.202.2263 • fairholmefunds.com


THE FAIRHOLME FUND

 

 

TABLE OF CONTENTS

November 30, 2012

 

 

     Page

FUND PERFORMANCE

   3

MANAGEMENT DISCUSSION & ANALYSIS REPORT

   4

EXPENSE EXAMPLE

   7

SCHEDULE OF INVESTMENTS

   8

STATEMENT OF ASSETS & LIABILITIES

   10

STATEMENT OF OPERATIONS

   11

STATEMENTS OF CHANGES IN NET ASSETS

   12

FINANCIAL HIGHLIGHTS

   13

NOTES TO FINANCIAL STATEMENTS

   14

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

   21

ADDITIONAL INFORMATION

   22

 

2


THE FAIRHOLME FUND

 

 

FUND PERFORMANCE (Unaudited)

November 30, 2002 — November 30, 2012

 

 

THE FAIRHOLME FUND VS. THE S&P 500 INDEX

INITIAL INVESTMENT OF $10,000

 

LOGO

The Fairholme Fund (the “Fund”) commenced operations on December 29, 1999. The chart above presents the performance of a $10,000 investment for up to ten years to the latest fiscal year ended November 30, 2012.

The following notes pertain to the chart above as well as to the performance table included in the Management Discussion & Analysis Report. Performance information in this report represents past performance and is not a guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate, so that an investor’s shares when redeemed may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted within. The performance information does not reflect the taxes an investor would pay on Fund distributions or upon redemption of Fund shares. Any questions you have regarding the performance data current to the most recent month-end can be obtained by calling Shareholder Services at 1-866-202-2263.

Data for both the S&P 500 Index and the Fund are presented assuming all dividends and distributions have been reinvested and do not reflect any taxes that might have been incurred by a shareholder as a result of the Fund distributions. The S&P 500 Index is a widely recognized, unmanaged index of 500 of the largest companies in the United States as measured by market capitalization and does not reflect any investment management fees or transaction expenses, nor the effects of taxes, fees or other charges.

 

3


THE FAIRHOLME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS

For the Fiscal Year Ended November 30, 2012

 

 

The Fairholme Fund (the “Fund”) shares outstanding and audited net asset value per share (“NAV”) at November 30, 2012, the end of the Fund’s fiscal year, and NAVs at other pertinent dates, were as follows:

 

     11/30/2012
Shares
Outstanding
   11/30/2012
NAV
(audited)
   05/31/2012
NAV
(unaudited)
   11/30/2011
NAV

(audited)

Fund

   233,953,597    $29.89    $26.70    $25.10

At December 31, 2012, the unaudited NAV of the Fund was $31.44. Performance figures below are shown for the Fund’s fiscal year ended November 30, 2012, and do not match calendar year figures for the period ended December 31, 2012, cited in the Portfolio Manager’s report.

 

     Six
Months
    One
Year
    Five
Years
    Ten
Years
    Since
Inception
12/29/1999
 

Cumulative:

          

Fund

     11.95     23.69     7.90     148.56     286.45%   

S&P 500

     9.32     16.13     6.87     85.23     23.27%   

Annualized:

          

Fund

       23.69     1.53     9.53     11.02%   

S&P 500

       16.13     1.34     6.36     1.63%   

For the six months ended November 30, 2012, the Fund outperformed the S&P 500 Index (“S&P 500”) by 2.63 percentage points while over the last year the Fund outperformed the S&P 500 by 7.56 percentage points. From inception, the Fund outperformed the S&P 500 by 9.39 percentage points per annum or, on a cumulative basis, 263.18 percentage points over twelve years and eleven months.

Fairholme Capital Management, L.L.C. (the “Manager”) believes continuing economic recovery contributed to overall performance. However, the fact that securities increase or decline in value does not always indicate that the Manager believes these securities to be more or less or attractive — in fact, the Manager believes that some price increases present selling opportunities and some price declines present buying opportunities. Shareholders are also cautioned that it is possible that some securities mentioned in this discussion may no longer be held by the Fund subsequent to the end of the fiscal period and that the Fund may have made significant new purchases that are not yet required to be disclosed. It is the Fund’s general policy not to disclose portfolio holdings other than when required by relevant law or regulation. Portfolio holdings are subject to change without notice.

Not all Fund portfolio dispositions or additions are material, and, while the Fund and the Manager have long-term objectives, it is possible that a security sold or purchased in one period will be purchased or sold in a subsequent period. Generally, the Manager determines to buy and sell based on its estimates of the absolute and relative intrinsic values and fundamental dynamics of a particular security and its underlying corporation and its industry. However, certain strategies of the Manager in carrying out Fund policies may result in shorter holding periods.

In the opinion of the Manager, performance over short intervals is likely to be less meaningful than performance over longer periods. Investors are cautioned not to rely on short-term results. Further, shareholders should note that the S&P 500 is an unmanaged index incurring no fees, expenses, or tax effects and is shown solely to compare Fund performance to that of an unmanaged and diversified index.

The Manager invests Fund assets in securities to the extent it finds reasonable investment opportunities in accordance with its Prospectus and may invest a significant portion of Fund assets in liquid, low-risk securities or cash. The Manager views liquidity as a strategic advantage. At November 30, 2012, cash and cash equivalents (consisting of cash, commercial paper, deposit accounts, U.S. Treasury Bills, and money-market funds) represented

 

4


THE FAIRHOLME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

11.2% of total assets. Since inception, the Fund has held liquid, low-risk securities or cash for periods without, in the Manager’s view, negatively influencing performance, although there is no guarantee that future performance will not be negatively affected by Fund liquidity.

The Fund is considered to be “non-diversified” under the Investment Company Act of 1940. The Fund can invest a greater percentage of assets in fewer securities than a diversified fund and may invest a significant portion of cash and liquid assets in one or more risky securities at any time, particularly in situations where markets are weak or a particular security declines sharply. The Fund may also have a greater percentage of assets invested in a particular industry than a diversified fund, exposing the Fund to the risk of an unanticipated industry condition as well as risks specific to a single company or security. The following charts show the top ten holdings by issuer and sector in descending order of net assets as of November 30, 2012.

 

 

The Fairholme Fund

       

 

The Fairholme Fund

  

Top Ten Holdings by Issuer*       Top Ten Sectors   
(% of Net Assets)       (% of Net Assets)   
     

American International Group, Inc.

     42.3%               Multi-Line Insurance      42.3%   

Bank of America Corp.

     11.5%               Diversified Banks      11.5%   

Sears Holdings Corp.

     8.5%               Cash and Cash Equivalents**      11.2%   

General Growth Properties, Inc.

     7.2%               Retail Department Stores      9.5%   

The St. Joe Co.

     6.9%               Real Estate Management & Development      7.8%   

Leucadia National Corp.

     3.9%               Real Estate Investment Trust      7.2%   

CIT Group Inc.

     3.2%               Diversified Holding Companies      3.9%   

MBIA, Inc.

     3.1%               Commercial Finance      3.2%   

Sears Canada, Inc.

     1.0%               Surety Insurance      3.1%   

Howard Hughes Corp.

     0.9%               Specialty Retail – Home Improvement      0.1%   
    

 

 

               

 

 

 
       88.5%                    99.8%   
    

 

 

               

 

 

 

    

                                
*

Excludes cash, U.S. Treasury Bills, and money market funds.

**

Includes cash, U.S. Treasury Bills, and money market funds.

The Manager views the ability to focus on fewer investments than a diversified fund as a strategic advantage. However, since inception, such a strategy has negatively influenced short-term performance and there is no guarantee that future performance will not be negatively affected.

The Fund may invest in non-U.S. securities and securities of corporations domiciled outside of the United States which may expose the Fund to adverse changes resulting from foreign currency fluctuations or other potential risks as described in the Fund’s Statement of Additional Information.

The Fund’s Officers, the Board of Directors (the “Board” or the “Directors”), and Manager are aware that large cash inflows or outflows may adversely affect Fund performance. Such flows are monitored and appropriate actions are contemplated for when such flows could negatively impact performance.

Since inception, the Fund has been advised by the Manager. Mr. Berkowitz, both the Managing Member of the Manager and Chairman of the Fund’s Board, continues to have a significant personal stake in the Fund, holding an aggregate 10,487,264 shares at November 30, 2012. While there is no requirement that the Manager own shares of the Fund, such holdings are believed to help align shareholder interests.

Independent Fund Directors continue to believe that it is in the best interests of the Fund to have Mr. Berkowitz serve as Chairman of the Board given: his long-term relative performance; his experience, commitment, and

 

5


THE FAIRHOLME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

significant personal investment in the Fund; the present constitution of Directors and policies; and current rules and regulations. Certain Directors and Officers of the Fund are also Officers of the Manager. Nevertheless, at November 30, 2012, a majority of Directors were independent of the Manager, no stock option or restricted stock plans exist, Officers received no direct compensation from the Fund, and Directors affiliated with the Manager received no compensation for being Directors.

For more complete information about the Fund, or to obtain a current Prospectus, please visit www.fairholmefunds.com or call Shareholder Services at 1-866-202-2263.

 

6


THE FAIRHOLME FUND

 

 

EXPENSE EXAMPLE

For the Six Month Period from June 1, 2012

through November 30, 2012 (unaudited)

 

 

As a Fund shareholder, you incur direct and indirect costs. Direct costs include, but are not limited to, transaction fees at some broker-dealers, custodial fees for retirement accounts, redemption fees on Fund shares redeemed within 60 days of purchase, and wire transfer fees. You also incur indirect, ongoing costs that include, but are not limited to, management fees paid to the Manager.

The following example is intended to help you understand your indirect costs (also referred to as “ongoing costs” and measured in dollars) when investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds. This example is based on an investment of $1,000 invested in the Fund, at June 1, 2012, and held for the entire six month period ending November 30, 2012.

Actual Expenses

The first line of the table below provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you had invested at the beginning of the period, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During the Period” to estimate the expenses you paid on your Fund holdings during this period.

Hypothetical Example for Comparison Purposes

The second line of the table provides information about hypothetical account values and hypothetical expenses based on the Fund’s actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund’s actual return for the period presented. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses that you paid for the period presented. However, you may use this information to compare ongoing costs of investing in the Fund with the ongoing costs of investing in other funds. To do so, compare this 5% hypothetical example with the 5% examples that appear in the shareholder reports of other funds.

Please note that the column titled “Expenses Paid During the Period” in the table below is meant to highlight your ongoing costs only and do not reflect any transactional costs, such as redemption fees (if any), or other direct costs. Therefore, the second line of the table is useful in comparing ongoing costs only, and will not help you determine the relative total costs of owning different funds. In addition, if these direct costs were included, your total costs would be higher.

 

     Beginning
Account Value
June 1, 2012
   Ending
Account Value
November 30, 2012
   Annualized
Expense
Ratio
  Expenses Paid
During the Period
June 1, 2012
Through
November 30, 2012*

Fund

          

Actual

   $1,000.00    $1,119.50    1.00%   $5.30

Hypothetical
(5% return before expenses)

   $1,000.00    $1,020.00    1.00%   $5.05

 

 

*

Expenses are equal to the Fund’s annualized expense ratio, multiplied by the average account value over the period, multiplied by 183 days/366 days (to reflect the one-half year period).

 

7


THE FAIRHOLME FUND

 

 

SCHEDULE OF INVESTMENTS

November 30, 2012

 

 

Shares

       Value  
 

DOMESTIC EQUITY
SECURITIES — 74.7%

  
 

COMMERCIAL FINANCE — 3.2%

  
6,068,829  

CIT Group Inc. (a)

   $ 224,850,114   
    

 

 

 
 

DIVERSIFIED BANKS — 11.5%

  
81,607,015  

Bank of America Corp.

     804,645,168   
    

 

 

 
 

DIVERSIFIED HOLDING
COMPANIES — 3.9%

  
12,229,050  

Leucadia National Corp.

     270,873,457   
    

 

 

 
 

MULTI-LINE INSURANCE — 38.0%

  
80,280,825  

American International
Group, Inc. (a)

     2,659,703,732   
    

 

 

 
 

REAL ESTATE MANAGEMENT & DEVELOPMENT — 6.9%

  
23,136,502  

The St. Joe Co. (a)(b)(c)(d)

     479,818,660   
    

 

 

 
 

RETAIL DEPARTMENT
STORES — 8.5%

  
14,212,673  

Sears Holdings Corp. (d)

     597,074,393   
    

 

 

 
 

SPECIALTY RETAIL-HOME IMPROVEMENT — 0.1%

  
592,993  

Orchard Supply Hardware Stores Corp., Class A (a)(d)

     4,595,696   
    

 

 

 
 

SURETY INSURANCE — 2.6%

  

20,501,100

 

MBIA, Inc. (a)(d)

     183,279,834   
    

 

 

 

TOTAL DOMESTIC EQUITY SECURITIES
(COST $5,813,054,777)

     5,224,841,054   
    

 

 

 
 

FOREIGN EQUITY
SECURITIES — 1.0%

  
 

CANADA — 1.0%

  
 

RETAIL DEPARTMENT
STORES — 1.0%

  
6,087,327  

Sears Canada, Inc. (a)

     68,328,078   
    

 

 

 

TOTAL FOREIGN EQUITY SECURITIES
(COST $65,108,224)

     68,328,078   
    

 

 

 

Shares

       Value  
 

DOMESTIC PREFERRED EQUITY SECURITIES — 0.0%

  
 

SPECIALTY RETAIL-HOME IMPROVEMENT — 0.0%

  
420,052  

Orchard Supply Hardware Stores Corp., Preferred, Zero Coupon,
Series A (a)(d)

   $ 756,094   
    

 

 

 

TOTAL DOMESTIC PREFERRED EQUITY SECURITIES
(COST $708,317)

     756,094   
    

 

 

 
 

WARRANTS — 12.4%

  
 

MULTI-LINE INSURANCE — 4.3%

  
21,588,480  

American International Group, Inc.,

  
 

Vested, Strike Price $45.00,
Expire 01/19/2021 (a)(e)

     300,079,872   
    

 

 

 
 

REAL ESTATE INVESTMENT
TRUSTS — 7.2%

  
40,634,357  

General Growth Properties, Inc.,

  
 

Vested, Strike Price $9.412,
Expire 11/09/2017 (a)(b)(c)(e)

     501,216,667   
    

 

 

 
 

REAL ESTATE MANAGEMENT & DEVELOPMENT — 0.9%

  
1,896,270  

Howard Hughes Corp.,

  
 

Vested, Strike Price $50.00,
Expire 11/09/2017 (a)(b)(c)(e)

     62,518,505   
    

 

 

 

TOTAL WARRANTS
(COST $351,676,339)

     863,815,044   
    

 

 

 

Principal

          
 

DOMESTIC CORPORATE
BONDS — 0.5%

  
 

SURETY INSURANCE — 0.5%

  
 

MBIA, Inc.

  
$17,932,000  

7.000%, 12/15/2025 (d)

     14,166,280   
13,859,000  

7.150%, 07/15/2027 (d)

     11,017,905   
11,580,000  

5.700%, 12/01/2034 (d)

     9,206,100   
    

 

 

 
       34,390,285   
    

 

 

 

TOTAL DOMESTIC CORPORATE BONDS
(COST $33,624,144)

     34,390,285   
    

 

 

 
 

 

The accompanying notes are an integral part of the financial statements.

 

8


THE FAIRHOLME FUND

 

 

SCHEDULE OF INVESTMENTS (continued)

November 30, 2012

 

 

Principal

       Value  
 

U.S. GOVERNMENT
OBLIGATIONS — 9.3%

  
$100,000,000  

U.S. Treasury Bills 0.143%,
12/13/2012 (f)

   $ 99,995,250   
100,000,000  

U.S. Treasury Bills 0.096%,
01/24/2013 (f)

     99,985,675   
100,000,000  

U.S. Treasury Bills 0.119%,
03/14/2013 (f)

     99,976,200   
100,000,000  

U.S. Treasury Bills 0.181%,
05/30/2013 (f)

     99,935,800   
100,000,000  

U.S. Treasury Bills 0.203%,
06/27/2013 (f)

     99,922,800   
50,000,000  

U.S. Treasury Bills 0.169%,
10/17/2013 (f)

     49,930,550   
100,000,000  

U.S. Treasury Bills 0.163%,
11/14/2013 (f)

     99,841,700   
    

 

 

 

TOTAL U.S. GOVERNMENT OBLIGATIONS
(COST $649,506,922)

     649,587,975   
    

 

 

 

 

Shares

         Value  
  

MONEY MARKET FUNDS — 1.9%

  

136,597,492

  

Fidelity Institutional Money Market Funds - Money
Market Portfolio, 0.180% (g)

   $ 136,597,492   
     

 

 

 

TOTAL MONEY MARKET FUNDS
(COST $136,597,492)

     136,597,492   
     

 

 

 
  

MISCELLANEOUS
INVESTMENTS — 0.2%
(h)

  

(COST $16,488,299)

     16,697,504   
     

 

 

 

TOTAL INVESTMENTS — 100.0%
(COST $7,066,764,514)

     6,995,013,526   
  

LIABILITIES IN EXCESS OF OTHER ASSETS — 0.0%

     (2,935,597
     

 

 

 

NET ASSETS — 100.0%

   $ 6,992,077,929   
     

 

 

 

 

 

 

(a) 

Non-income producing security.

(b) 

Security is deemed an illiquid security under procedures approved by the Directors.

(c) 

Restricted or controlled security under procedures approved by the Directors. The value of these securities totals $1,043,553,832, which represents 14.92% of the Fund’s net assets. Information related to these securities is as follows:

 

Acquisition
Shares

    

Issuer

   Acquisition
Date(s)
   Acquisition
Cost
     11/30/2012
Carrying Value
Per Unit
  23,136,502      

The St. Joe Co.

   12/12/2007-10/13/2010    $ 607,609,975       $20.7386
  40,634,357      

General Growth Properties, Inc., Warrants, Vested, Strike Price $9.412,
Expire 11/09/2017

   05/10/2010            12.3348
  1,896,270      

Howard Hughes Corp., Warrants, Vested, Strike Price $50.00, Expire 11/09/2017

   11/05/2010            32.9692

 

(d) 

Affiliated Company. See Note 8.

(e) 

Warrants have terms and conditions based on dividends paid and other events that may lower the strike price and raise the shares per warrant conversion ratio. Reported strike prices and conversion ratios are as of the date of this report. All share-to-warrant conversion ratios are currently 1:1, excluding the General Growth Properties, Inc. warrants, which on November 30, 2012 had a conversion ratio of 1:1.1157.

(f) 

Rates shown are the effective yields based on the purchase price. The calculation assumes the security is held to maturity.

(g) 

Annualized based on the 1-day yield as of November 30, 2012.

(h) 

Represents previously undisclosed unrestricted securities, which the Fund has held for less than one year.

The accompanying notes are an integral part of the financial statements.

 

9


THE FAIRHOLME FUND

 

 

STATEMENT OF ASSETS & LIABILITIES

November 30, 2012

 

 

 

Assets

  

Investments, at Fair Value:

  

Unaffiliated Issuers (Cost — $5,121,832,841)

   $ 5,695,098,564   

Affiliated Issuers (Cost — $1,944,931,673)

     1,299,914,962   
  

 

 

 

Total Investments, at Fair Value
(Cost — $7,066,764,514)

     6,995,013,526   

Receivable for Investments Sold

     15,347,228   

Receivable for Capital Shares Sold

     1,524,314   

Dividends and Interest Receivable

     1,305,109   
  

 

 

 

Total Assets

     7,013,190,177   
  

 

 

 

Liabilities

  

Payable for Capital Shares Redeemed

     6,413,829   

Payable for Investments Purchased

     8,844,035   

Accrued Management Fees

     5,854,384   
  

 

 

 

Total Liabilities

     21,112,248   
  

 

 

 

NET ASSETS

   $ 6,992,077,929   
  

 

 

 

Net Assets Consist of:

  

Paid-In-Capital

   $ 7,250,541,308   

Net Accumulated Realized Loss on Investments and Foreign Currency Related Transactions

     (186,712,391

Net Unrealized Depreciation on Investments and Foreign Currency Related Translations

     (71,750,988
  

 

 

 

NET ASSETS

   $ 6,992,077,929   
  

 

 

 

Shares of Common Stock Outstanding* ($0.0001 par value)

     233,953,597   
  

 

 

 

Net Asset Value, Offering and Redemption Price Per Share ($6,992,077,929 / 233,953,597 shares)

   $ 29.89   
  

 

 

 

 

*

700,000,000 shares authorized in total.

The accompanying notes are an integral part of the financial statements.

 

10


THE FAIRHOLME FUND

 

 

STATEMENT OF OPERATIONS

 

 

     For the
Fiscal Year Ended
November 30, 2012
 

Investment Income

  

Interest — Unaffiliated Issuers

   $ 2,273,455   

Interest — Affiliated Issuers

     3,168,333   

Dividends — Unaffiliated Issuers

     14,492,822   

Dividends — Affiliated Issuers

     95,239,107   
  

 

 

 

Total Investment Income

     115,173,717   
  

 

 

 

Expenses

  

Management Fees

     75,477,154   

Other Expenses

     292,458   
  

 

 

 

Total Expenses

     75,769,612   
  

 

 

 

Net Investment Income

     39,404,105   
  

 

 

 

Realized and Unrealized Gain (Loss) on Investments and Foreign Currency Related Transactions

  

Net Realized Gain (Loss) on Investments

  

Unaffiliated Issuers

     226,284,484   

Affiliated Issuers

     (34,322,124

Net Realized Loss on Foreign Currency Related Transactions

     (662

Net Change in Unrealized Appreciation on Investments and Foreign Currency Related Translations

     1,362,297,154   
  

 

 

 

Net Realized and Unrealized Gain on Investments and Foreign Currency Related Transactions

     1,554,258,852   
  

 

 

 

NET INCREASE IN NET ASSETS FROM OPERATIONS

   $ 1,593,662,957   
  

 

 

 

The accompanying notes are an integral part of the financial statements.

 

11


THE FAIRHOLME FUND

 

 

STATEMENTS OF CHANGES IN NET ASSETS

 

 

     For the
Fiscal Year Ended
November 30, 2012
    For the
Fiscal Year Ended
November 30, 2011
 

CHANGES IN NET ASSETS

    

From Operations

    

Net Investment Income (Loss)

   $ 39,404,105      $ (33,469,437

Net Realized Gain (Loss) on Investments and Foreign Currency Related Transactions

     191,961,698        (366,929,655

Net Change in Unrealized Appreciation (Depreciation) on Investments and Foreign Currency Related Translations

     1,362,297,154        (2,604,264,053
  

 

 

   

 

 

 

Net Increase (Decrease) in Net Assets from Operations

     1,593,662,957        (3,004,663,145
  

 

 

   

 

 

 

From Dividends and Distributions to Shareholders

    

Net Investment Income

     (213,247,996     (195,136,284

Net Realized Capital Gains from Investment Transactions

            (838,210,865

Return of Capital

     (63,552,375       
  

 

 

   

 

 

 

Net Decrease in Net Assets from Dividends and Distributions

     (276,800,371     (1,033,347,149
  

 

 

   

 

 

 

From Capital Share Transactions

    

Proceeds from Sale of Shares

     723,122,041        4,326,090,664   

Shares Issued in Reinvestment of Dividends and Distributions

     250,020,401        939,524,411   

Redemption Fees

     555,316        2,714,993   

Cost of Shares Redeemed

     (3,313,776,781     (10,062,106,880
  

 

 

   

 

 

 

Net Decrease in Net Assets from Shareholder Activity

     (2,340,079,023     (4,793,776,812
  

 

 

   

 

 

 

NET ASSETS

    

Net Decrease in Net Assets

     (1,023,216,437     (8,831,787,106

Net Assets at Beginning of Year

     8,015,294,366        16,847,081,472   
  

 

 

   

 

 

 

Net Assets at End of Year

   $ 6,992,077,929      $ 8,015,294,366   
  

 

 

   

 

 

 

Distributions in Excess of Net Investment Income at End of Year

   $      $ (17,009,472
  

 

 

   

 

 

 

SHARES TRANSACTIONS

    

Issued

     25,564,197        127,523,200   

Reinvested

     10,652,155        27,554,666   

Redeemed

     (121,560,995     (328,478,267
  

 

 

   

 

 

 

Net Decrease in Shares

     (85,344,643     (173,400,401

Shares Outstanding at Beginning of Year

     319,298,240        492,698,641   
  

 

 

   

 

 

 

Shares Outstanding at End of Year

     233,953,597        319,298,240   
  

 

 

   

 

 

 

The accompanying notes are an integral part of the financial statements.

 

12


THE FAIRHOLME FUND

 

 

FINANCIAL HIGHLIGHTS

 

 

     For the Fiscal Year Ended November 30,  
    

2012

   

2011

   

2010

   

2009

   

2008

 

PER SHARE OPERATING PERFORMANCE

NET ASSET VALUE, BEGINNING OF YEAR

     $25.10        $34.19        $28.90        $20.95        $32.30   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Investment Operations

          

Net Investment Income (Loss)(1)

     0.15        (0.07     0.33        0.28        0.13   

Net Realized and Unrealized Gain (Loss) on Investments

     5.55        (6.95     5.22        8.20        (10.79 )(2) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total from Investment Operations

     5.70        (7.02     5.55        8.48        (10.66
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Dividends and Distributions

          

From Net Investment Income

     (0.70     (0.39     (0.27     (0.11     (0.22

From Realized Capital Gains

            (1.69            (0.43     (0.48

From Return of Capital

     (0.21                            
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Dividends and Distributions

     (0.91     (2.08     (0.27     (0.54     (0.70
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Redemption Fees(1)

     0.00 (3)      0.01        0.01        0.01        0.01 (2) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET ASSET VALUE, END OF YEAR

     $29.89        $25.10        $34.19        $28.90        $20.95   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL RETURN

     23.69     (22.10 )%      19.37     41.48     (33.69 )% 

Ratio/Supplemental Data

          

Net Assets, End of Year (in 000’s)

     $6,992,078        $8,015,294        $16,847,081        $10,558,010        $6,696,139   

Ratio of Expenses to Average Net Assets

     1.00     1.01 %(4)      1.00     1.00     1.01 %(5) 

Ratio of Net Investment Income (Loss) to Average Net Assets

     0.52     (0.22 )%      1.02     1.14     0.44

Portfolio Turnover Rate

     1.57     43.95     88.74     71.09     81.35

 

(1) 

Based on average shares outstanding.

(2) 

Redemption fees per share, which were initially reported as a component of net realized and unrealized gain (loss) on investments per share, were reclassified to conform to the current presentation and are separately reported.

(3) 

Redemption fees represent less than $0.01.

(4) 

0.01% is attributable to legal expenses borne by the Fund outside of the 1.00% management fee.

(5) 

0.01% is attributable to shareholder meeting expenses borne by the Fund outside of the 1.00% management fee.

The accompanying notes are an integral part of the financial statements.

 

13


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS

November 30, 2012

 

 

Note 1. Organization

Fairholme Funds, Inc. (the “Company”), a Maryland corporation, is registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as an open-end management investment company. The Company’s Articles of Incorporation permit the Board of Directors of the Company (the “Board” or the “Directors”) to issue 1,100,000,000 shares of common stock at $.0001 par value. 700,000,000 shares have been allocated to The Fairholme Fund (the “Fund”). The Fund is a non-diversified fund. The Fund may have a greater percentage of its assets invested in particular securities than a diversified fund, exposing the Fund to the risk of unanticipated industry conditions as well as risks specific to a single company or the securities of a single company. The Board has the power to designate one or more separate and distinct series and/or classes of shares of common stock and to classify or reclassify any unissued shares with respect to such series.

The Fund’s investment objective is to provide long-term growth of capital. Under normal circumstances, the Fund seeks to achieve its investment objective by investing in a focused portfolio of equity and fixed-income securities. The proportion of the Fund’s assets invested in each type of asset class will vary from time to time based upon Fairholme Capital Management, L.L.C.’s (the “Manager”) assessment of general market and economic conditions. The Fund may invest in, and may shift frequently among, the asset classes and market sectors. The equity securities in which the Fund may invest include common and preferred stock (including convertible preferred stock), partnership interests, business trust shares, interests in real estate investment trusts (“REITs”), rights and warrants to subscribe for the purchase of equity securities, and depository receipts. The Fund may invest in equity securities without regard to the jurisdictions in which the issuers of the securities are organized or situated and without regard to the market capitalizations or sectors of such issuers. The fixed-income securities in which the Fund may invest include U.S. corporate debt securities, non-U.S. corporate debt securities, bank debt (including bank loans and participations), U.S. government and agency debt securities, short-term debt obligations of foreign governments, and foreign money market instruments. Except for its investments in short-term debt obligations of foreign governments, the Fund may invest in fixed-income securities regardless of maturity or the rating of the issuer of the security. The Fund may also invest in “special situations” to achieve its objective. “Special situation” investments may include equity securities or fixed-income securities, such as corporate debt, which may be in a distressed position as a result of economic or company specific developments. Although the Fund normally holds a focused portfolio of equity and fixed-income securities, the Fund is not required to be fully invested in such securities and may maintain a significant portion of its total assets in cash and securities generally considered to be cash equivalents. The Manager serves as investment adviser to the Fund.

There is no guarantee that the Fund will meet its objective.

Note 2. Significant Accounting Policies

The Fund’s investments are reported at fair value as defined by Accounting Principles Generally Accepted in the United States of America (“U.S. GAAP”). The Fund generally determines its net asset value as of approximately 4:00 p.m. Eastern Time each day the New York Stock Exchange is open.

A description of the valuation techniques applied to the Fund’s securities measured at fair value on a recurring basis follows:

Security Valuation:

Equity securities (common and preferred stocks): Securities traded on a national securities exchange or reported on the NASDAQ national market are generally valued at the official closing price, or at the last reported sale price on the exchange or market on which the securities are traded, as of the close of business on the day the securities are being valued or, lacking any sales, at the last available bid price. To the extent these securities are actively traded and valuation adjustments are not applied, they are classified in Level 1 of the fair value hierarchy. The Manager may also employ other valuation methods which the Manager believes would provide a more accurate indication of fair value. In these situations, if the inputs are observable, the valuation will be classified in Level 2 of the fair value hierarchy, otherwise they would be classified in Level 3. As of November 30, 2012, equity investments of The St. Joe Co. valued at $479,818,660 (6.86% of net assets) in the Fund

 

14


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

are fair valued by the Manager due to a trading restriction. The value is calculated by applying a discount to the official closing price on the day of valuation.

Fixed-income securities (U.S. government obligations, corporate bonds, convertible bonds, and asset backed securities): The fair value of fixed-income securities is estimated using market quotations when readily available, but may also be estimated by various methods when no such market quotations exist and when the Manager believes these other methods reflect the fair value of such securities. These methods may consider recently executed transactions in securities of the issuer or comparable issuers and market price valuations from independent pricing services and/or brokers (where observable). Where the Manager deems it appropriate to do so (such as when independent prices are unavailable or not deemed to be representative of fair value) fixed income securities will be fair valued in good faith. As of November 30, 2012, fixed income securities are valued by the Manager utilizing the average bid of independent broker/dealer quotes and/or the average of valuations from independent pricing services. Although fixed-income securities are classified in Level 2 of the fair value hierarchy at November 30, 2012, in instances where lower relative weight is placed on transaction prices, quotations, or similar observable inputs, they would be classified in Level 3.

Open-end mutual funds: Investments in open-end mutual funds including money market funds are valued at their closing net asset value each business day and are classified in Level 1 of the fair value hierarchy.

Short-term securities: Investments in securities with maturities of less than sixty days when acquired or long-term securities, which are within sixty days of maturity are estimated by using the amortized cost method of valuation, which the Manager and the Board have determined will approximate fair value. To the extent the inputs are observable and timely, the values would be classified in Level 2 of the fair value hierarchy.

Restricted securities: Depending on the relative significance of valuation inputs, these instruments may be classified in either Level 2 or Level 3 of the fair value hierarchy.

Warrants: The Fund may invest in warrants, which may be acquired either through a direct purchase, included as part of a private placement, or pursuant to corporate actions. Warrants entitle, but do not obligate, the holder to buy equity securities at a specific price for a specific period of time. Warrants may be considered more speculative than certain other types of investments in that they do not entitle a holder to dividends or voting rights with respect to the underlying securities that may be purchased nor do they represent any rights in the assets of the issuing company. Also, the value of a warrant does not necessarily change with the value of the underlying securities and a warrant ceases to have value if it is not exercised prior to its expiration date. Warrants traded on a security exchange are valued at the official closing price on the valuation date and are classified as Level 1 of the fair value hierarchy. Over the counter (OTC) warrants are valued using simulation models utilizing market value of the underlying security, expiration date of the warrants, volatility of the underlying security, strike price of the warrants, risk-free interest rate at the valuation date, and are classified as Level 2 or Level 3 of the fair value hierarchy depending on the observability of the inputs used.

The Fund uses several recognized industry third-party pricing services (TPPS) - approved by the Board and unaffiliated with the Manager - to value some of its securities. It also uses other independent market trade data sources (such as TRACE, the FINRA-developed mandatory reporting of over-the-counter secondary market transactions), as well as broker quotes provided by market makers of securities not valued by these and other TPPS. The data within these feeds is ultimately sourced from major stock exchanges and trading systems where these securities trade. If a price obtained from the pricing source is deemed unreliable, prices will be sought from another pricing service or from a broker/dealer that trades that security or similar securities.

The Manager may determine the fair valuation of a security when market quotations are insufficient or not readily available, when securities are determined to be illiquid or restricted, or when in the judgment of the Manager the prices or values available do not represent the fair value of the instrument. Factors which may cause the Manager to make such a judgment include the following: (a) only a bid price or an asked price is available; (b) the spread between bid and asked prices is

 

15


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

substantial; (c) the liquidity of the securities; (d) the frequency of sales; (e) the thinness of the market; (f) the size of reported trades; (g) actions of the securities markets, such as the suspension or limitation of trading; and (h) bona fide bids or offers made to the Manager by independent third parties. Among the factors to be considered to fair value a security are recent prices of comparable securities that are publicly traded, reliable prices of securities not publicly traded, the use of valuation models, current analyst reports, valuing the income or cash flow of the issuer, or cost if the preceding factors do not apply. The circumstances of Level 3 securities are frequently monitored to determine if fair valuation measures continue to apply.

The Manager reports quarterly to the Board the results of the application of fair valuation policies and procedures.

The inputs and valuation techniques used to measure fair value of the Fund’s investments are summarized into three levels as described in the hierarchy below:

 

   

Level 1 — quoted prices in active markets for identical securities;

 

   

Level 2 — other significant observable inputs (including quoted prices for similar securities, quoted prices in inactive

   markets for identical securities, interest rates, prepayment speeds, credit risk, etc.); and

 

   

Level 3 — significant unobservable inputs (including the Manager’s determination as to the fair value of investments).

The inputs or methodology used for valuing investments are not necessarily an indication of the risk associated with investing in those investments. The summary of the Fund’s investments by inputs used to value the Fund’s investments as of November 30, 2012 is as follows:

 

     Valuation Inputs              
     Level 1 –
Quoted Prices
          Level 2 – Other
Significant
Observable Inputs
          Total
Fair Value
at 11/30/2012
 

ASSETS:

              

INVESTMENTS (Fair Value):

              

Domestic Equity Securities

              

Real Estate Management & Development

   $          $ 479,818,660          $ 479,818,660   

Other*

     4,745,022,394                       4,745,022,394   

Foreign Equity Securities*

     68,328,078                       68,328,078   

Domestic Preferred Equity Securities*

     756,094                       756,094   

Warrants

              

Multi-Line Insurance

     300,079,872                       300,079,872   

Real Estate Investment Trusts

                501,216,667            501,216,667   

Real Estate Management &

              

Development

                62,518,505            62,518,505   

Domestic Corporate Bonds

                34,390,285            34,390,285   

U.S. Government Obligations

                649,587,975            649,587,975   

Money Market Funds

     136,597,492                       136,597,492   

Miscellaneous Investments

     16,697,504                       16,697,504   
  

 

 

       

 

 

       

 

 

 

TOTAL INVESTMENTS

   $ 5,267,481,434          $ 1,727,532,092          $ 6,995,013,526   
  

 

 

       

 

 

       

 

 

 

 

*

Industry classifications for these categories are detailed in the Schedule of Investments.

The Fund had no transfers between Level 1 and Level 2 during the fiscal year ended November 30, 2012.

 

16


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

The following is a reconciliation of Level 3 investments for which significant unobservable inputs were used to determine fair value:

 

     Assets:
Investments (Fair Value)
     Warrants                 
     Real Estate
Investment
Trusts
   Real Estate
Management
& Development
   Total Level 3
Investments

Balance as of 11/30/2011

      $ 339,268,437             $ 35,943,608             $ 375,212,045      

Change in unrealized appreciation

                                         

Purchases

                                         

Sales

                                         

Transfers into Level 3 (1)

                                         

Transfers out of Level 3 (1)

        (339,268,437)               (35,943,608)               (375,212,045)      
     

 

 

          

 

 

          

 

 

    

Balance as of 11/30/2012

      $             $             $      
     

 

 

          

 

 

          

 

 

    

 

(1) 

The Fund’s policy is to recognize transfers into and transfers out of Level 3 as of the beginning of the reporting period. As of November 30, 2011, the Fund used certain significant unobservable inputs in determining the value of these investments. As of November 30, 2012, the Fund used observable inputs in determining the value of the same investments. As a result, the investments transferred from Level 3 to Level 2 in the disclosure hierarchy.

Recent Accounting Standards: In December 2011, FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities”. ASU 2011-11 requires disclosures to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under International Financial Reporting Standards. The new disclosure requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of assets and liabilities as well as instruments and transactions subject to an agreement similar to a master netting arrangement. In addition, ASU 2011-11 requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. New disclosures are required for annual reporting periods beginning on or after January 1, 2013 and interim periods within those annual periods. Management is evaluating the impact of ASU 2011-11 on the financial statements and disclosures.

Warrants: The Fund’s investments in warrants as of November 30, 2012, are presented within the Schedule of Investments.

The Fund’s warrant positions during the fiscal year ended November 30, 2012 had an average monthly market value of approximately $732,952,141.

As of November 30, 2012, the value of warrants with equity risk exposure of $863,815,044 is included with Investments at Fair Value on the Statement of Assets and Liabilities. For the fiscal year ended November 30, 2012, the effect of the net change in unrealized appreciation of warrants with equity risk exposure held of $356,481,502 is included with the Net Change in Unrealized Appreciation on Investments and Foreign Currency Related Translations on the Statement of Operations.

Dividends and Distributions: The Fund records dividends and distributions to shareholders on the ex-dividend date. The Fund intends to distribute substantially all of its net investment income (if any) as dividends to its shareholders on an annual basis in December. The Fund intends to distribute any net long-term capital gains and any net short-term capital gains at least once a year. If the total dividends and distributions made in any tax year exceeds net investment income and accumulated realized capital gains, a portion of the total distribution may be treated as a tax return of capital.

Foreign Currency Translation: The books and records of the Fund are maintained in U.S. dollars. Foreign currency amounts are translated into U.S. dollars on the following basis: (i) fair value of investment securities, assets, and liabilities at the current rate of exchange; and (ii) purchases and sales of investment securities, income, and expenses at the relevant rates of exchange prevailing on the respective dates of such transactions. The Fund does not isolate that portion of gains and losses on investment securities which is due to changes in the foreign exchange rates from that which is due to changes in the market prices of such securities.

 

17


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

Estimates: The preparation of financial statements in conformity with U.S. GAAP requires the Fund to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of both contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.

Redemption Fee: The Fund assesses a 2% fee on the proceeds of the Fund shares that are redeemed within 60 days of their purchase. The redemption fee is paid to the Fund as applicable, for the benefit of remaining shareholders and is recorded as paid-in capital. The redemption fees retained by the Fund during the fiscal years ended November 30, 2012 and November 30, 2011 amounted to $555,316 and $2,714,993, respectively.

Other: The Fund accounts for security transactions on the trade date for financial statement purposes. The specific identification method is used for determining gains or losses for financial statements and income tax purposes. Dividend income is recorded on the ex-dividend date net of foreign taxes withheld where recovery is uncertain and interest income is recorded on an accrual basis. Discounts and premiums on securities purchased are amortized over the life of the respective securities using the effective yield method. Securities denominated in currencies other than U.S. dollars are subject to changes in value due to fluctuation in exchange rates. The Fund may invest in countries that require governmental approval for the repatriation of investment income, capital, or the proceeds of sales of securities by foreign investors. In addition, if there is deterioration in a country’s balance of payments or for other reasons, a country may impose temporary restrictions on foreign capital remittances abroad.

The Fund paid commissions, other brokerage fees, and security registration expenses during the period.

Note 3. Related Party Transactions

The Manager is a Delaware limited liability company and is registered with the Securities and Exchange Commission as an investment adviser. The Manager’s principal business and occupation is to provide investment management and advisory services to individuals, corporations, and other institutions throughout the world. Pursuant to an Investment Management Agreement, the Fund pays a management fee to the Manager for its provision of investment advisory and operating services to the Fund. Subject to applicable waivers or limitations, the management fee is paid at an annual rate equal to 1.00% of the daily average net assets of the Fund. Under the Investment Management Agreement, the Manager is responsible for paying all of the Fund’s expenses, including expenses for the following services: transfer agency, fund accounting, fund administration, custody, legal, audit, compliance, directors’ fees, call center, fulfillment, travel, insurance, rent, printing, postage, and other office supplies, except for commissions, brokerage fees, and other transaction costs, taxes, interest, litigation expenses, and related expenses, and other extraordinary expenses.

The Manager earned $75,477,154 from the Fund for its services during the fiscal year ended November 30, 2012.

Certain Directors and Officers of the Fund are also Members and Officers of the Manager.

Note 4. Investments

For the fiscal year ended November 30, 2012, aggregated purchases and sales of investment securities other than short-term investments were as follows:

 

Purchases

       Sales

$107,055,590

     $2,798,946,656

Note 5. Tax Matters

Federal Income Taxes: The Fund intends to qualify each year as a “Regulated Investment Company” under Subchapter M of the Internal Revenue Code of 1986, as amended. By so qualifying, the Fund will not be subject to federal income taxes to the extent that it distributes all of its net investment income and any realized capital gains.

 

18


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

For U.S. federal income tax purposes, the cost of securities owned, gross unrealized appreciation, gross unrealized depreciation, and net unrealized depreciation of investments at November 30, 2012 were as follows:

 

Cost

      

Gross Unrealized

Appreciation

       

Gross Unrealized
Depreciation

       

Net Unrealized

Appreciation

(Depreciation)

$7,071,524,474

     $1,042,545,373       $(1,119,056,321)       $(76,510,948)

The difference between book basis and tax basis net unrealized depreciation, if any, is primarily attributable to the tax deferral of losses on wash sales.

The Fund’s tax basis capital gains are determined at the end of each fiscal year. As of November 30, 2012, the components of distributable earnings on a tax basis were as follows:

 

Accumulated Capital Loss Carryforwards

   $ (181,952,431)   

Net Unrealized Depreciation on Investments and Foreign Currency Related Transactions

     (76,510,948)   
  

 

 

 

Total

   $ (258,463,379)   
  

 

 

 

At November 30, 2012, the Fund utilized capital loss carryforwards of $176,062,509. The Fund has $181,952,431 of net capital loss carryforwards available to reduce future required distributions of net capital gains to shareholders through 2019.

The Manager has analyzed the Fund’s tax positions taken on federal income tax returns for all open tax years (current and prior three tax years) and has concluded that there are no uncertain tax positions that require recognition of a tax liability. The Fund’s federal and state income and federal excise tax returns for tax years for which the applicable statutes of limitations have not expired (the current year and the prior year) are subject to examination by the Internal Revenue Service and state departments of revenue.

Note 6. Dividends and Distributions to Shareholders

Ordinary income and capital gain distributions are determined in accordance with federal income tax regulations, which may differ from U.S. GAAP.

The tax character of dividends and distributions paid by the Fund was as follows:

 

     For the
Fiscal Year Ended
November 30, 2012
   For the
Fiscal Year Ended
November 30, 2011

Dividends and Distributions paid from:

         

Ordinary Income*

     $ 213,247,996        $ 199,071,043  

Long-Term Capital Gain

                834,276,106  

Return of Capital

       63,552,375           
    

 

 

      

 

 

 
     $ 276,800,371        $ 1,033,347,149  
    

 

 

      

 

 

 

 

*

Inclusive of short-term capital gains

 

19


THE FAIRHOLME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

Note 7. Reclassification in the Capital Accounts

In accordance with U.S. GAAP, the Fund has recorded reclassifications in their capital accounts. These reclassifications have no impact on the net asset value of the Fund and are designed generally to present undistributed income and realized gains on a tax basis which is considered to be more informative to the shareholder. Permanent differences were primarily due to the tax treatment of currency gains and losses for the Fund and recharacterization of distributions for the Fund reclass of capital gains and losses for passive foreign investment companies for the Fund. As of November 30, 2012, the Fund recorded the following reclassifications to increase (decrease) the accounts listed below:

 

Accumulated Undistributed Net Investment Income

   $ 254,405,738   

Net Accumulated Realized Gain

     (14,790,854)   

Paid-in-Capital

     (239,614,884)   

Note 8. Transactions in Shares of Affiliates

Portfolio companies in which the Fund owns 5% or more of the outstanding voting securities of the issuer are considered affiliates of the Fund. The aggregate fair value of all securities of affiliates held in the Fund as of November 30, 2012 amounted to $1,299,914,962, representing 18.59% of the Fund’s net assets.

Transactions in the Fund during the fiscal year ended November 30, 2012 in which the issuer was an affiliate are as follows:

 

     November 30, 2011    Gross Additions      Gross Deductions      November 30, 2012                
     Shares/
Par Value
   Shares/
Par Value
     Shares/
Par Value
     Shares/
Par Value
     Fair Value      Realized
Gain (Loss)
     Investment
Income
 

CIT Group Inc.(a)

   16,358,129              —         10,289,300               $       $ (30,554,901)       $   

MBIA, Inc.

   20,501,100              —                      —         20,501,100         183,279,834         -           

Orchard Supply Hardware Stores Corp., Class A(b)

                —      641,893               48,900         592,993         4,595,696         (3,627,929)           

Sears Holdings Corp.

   14,212,673              —                      —         14,212,673         597,074,393                 95,239,107   

The St. Joe Co.

   23,136,502              —                      —         23,136,502         479,818,660                   

Orchard Supply Hardware Stores Corp., Preferred, Zero Coupon, Series A(b)

                —      641,893             221,841         420,052         756,094         (139,294)           

MBIA, Inc.
7.000%, 12/15/2025

   $17,932,000      $ —             $ —             $ 17,932,000         14,166,280                 1,396,153   

MBIA, Inc.
7.150%, 07/15/2027

   $13,859,000      $ —             $ —             $ 13,859,000         11,017,905                 1,060,492   

MBIA, Inc.
5.700%, 12/01/2034

   $11,580,000      $ —             $ —             $ 11,580,000         9,206,100                 711,688   
              

 

 

    

 

 

    

 

 

 

Total

               $ 1,299,914,962       $ (34,322,124)       $ 98,407,440   
              

 

 

    

 

 

    

 

 

 

 

(a) 

Company is not an “affiliated company” as of November 30, 2012, but remains an investment in the Fund’s portfolio. Affiliated realized loss is shown for transactions that occurred through the date the Fund no longer owned 5% or more of the outstanding voting securities of the issuer.

(b) 

Security received in spin-off from Sears Holdings Corp. and was not held in the portfolio at November 30, 2011.

Note 9. Indemnifications

Under the Company’s organizational documents, its Officers and Directors are indemnified against certain liabilities arising out of the performance of their duties to the Fund. In the normal course of business the Company or the Fund enters into contracts that contain a variety of representations and customary indemnifications. The Fund’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Fund that have not yet occurred. However, based on its experience to date, the Fund expects the risk of loss to be remote.

 

20


 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the Board of Directors of Fairholme Funds, Inc. and

the shareholders of The Fairholme Fund:

We have audited the accompanying statement of assets and liabilities, including the schedule of investments, of The Fairholme Fund (the “Fund”), as of November 30, 2012, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the periods presented. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. The Fund is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of November 30, 2012, by correspondence with the custodian and brokers; where replies were not received from brokers, we performed other auditing procedures. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of The Fairholme Fund as of November 30, 2012, the results of its operations, the changes in its net assets, and the financial highlights for each of the periods presented, in conformity with accounting principles generally accepted in the United States of America.

DELOITTE & TOUCHE LLP

Philadelphia, Pennsylvania

January 29, 2013

 

21


THE FAIRHOLME FUND

 

 

ADDITIONAL INFORMATION

November 30, 2012

 

 

Board of Directors (unaudited)

The Board of Directors has overall responsibility for conduct of the Company’s affairs. The day-to-day operations of the Fund are managed by the Manager, subject to the By-Laws of the Company and review by the Company’s Board. The Directors and Officers of the Company, including those Directors who are also officers, are listed below.

 

Name, Age

& Address†

       

Position(s)

Held

with the
Company

       

Term of Office

& Length of

Time Served**

            

Principal
Occupation(s)

During Past

5 Years§

       

Number

of

Portfolios

in Fund

Complex

Overseen

by

Director

       

Other Current
Directorships

Held by

Director

Interested Directors and Officers

 

Bruce R. Berkowitz*

Age 54

      

 

Director,

President

      

 

Mr. Berkowitz has served as a Director of the Company since December 15, 1999.

          

 

Managing Member, Fairholme Capital Management, LLC since October 1997.

      

 

3

      

 

Director and Chairman of the Board of Directors, The St. Joe Co.

 

Cesar L. Alvarez, Esq.*

Age 65

      

 

Director

      

 

Mr. Alvarez has served as a Director of the Company since May 19, 2008.

          

 

Executive Chairman of Greenberg Traurig, LLP since 2010; Chief Executive Officer of Greenberg Traurig, LLP from October 1997 to 2010.

      

 

3

      

 

Chairman, Board of Directors, Mednax, Inc.; Co-Leading Director, Watsco, Inc.; Vice Chairman, Knight Foundation; Director,
The St. Joe Co.

Independent Directors^

 

Terry L. Baxter

Age 67

      

 

Director

      

 

Mr. Baxter has served as a Director of the Company since May 19, 2008.

          

 

Chairman of the Board, CEO, Source One (retired); President of White Mountain Holdings (retired).

      

 

3

      

 

Director, Main Street America Group

 

Howard S. Frank

Age 71

      

 

Director

      

 

Mr. Frank has served as a Director of the Company since May 7, 2007.

          

 

Vice Chairman, Chief Operating Officer and Director, Carnival Corporation & plc.

      

 

3

      

 

Director, Steamship Mutual Trust; Director, New World Symphony; Director,
The St. Joe Co.

 

Avivith Oppenheim, Esq.

Age 62

      

 

Director

      

 

Ms. Oppenheim has served as a Director of the Company since December 15, 1999.

          

 

Attorney-at-Law.

      

 

3

      

 

None.

 

Leigh Walters, Esq.

Age 66

       Director       

 

Mr. Walters has served as a Director of the Company since December 15, 1999.

          

 

Vice-President and Director, Valcor Engineering Corporation.
Attorney-at-Law.

      

 

3

      

 

Director, Valcor Engineering Corporation

 

  †

Unless otherwise indicated, the address of each Director of the Company is c/o Fairholme Capital Management, LLC, 4400 Biscayne Blvd., 9th Floor, Miami, FL 33137.

 

  ^

Directors who are not “interested persons” of the Company as defined under the 1940 Act.

 

  *

Mr. Berkowitz and Mr. Alvarez are each an interested person, as defined in the 1940 Act, of the Company because of their affiliation with the Manager.

 

**

Each Director serves for an indefinite term. Each officer serves for an annual term and until his or her successor is elected and qualified.

 

  §

The information reported includes the principal occupation during the last five years for each Director and other information relating to the professional experiences, attributes and skills relevant to each Director’s qualifications to serve as Director.

 

22


THE FAIRHOLME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

 

Officers (unaudited)

 

Name, Age & Address†         

Position(s) Held with

the Company

              

Term of Office &

Length of Time Served*

              

Principal Occupation(s)

During Past 5 Years

Fred Fraenkel

Age 63^

        Vice President              Mr. Fraenkel has served as Vice President of the Company since January 2013.              Chief Research Officer, Fairholme Capital Management, L.L.C. since October 2011; Vice Chairman Beacon Trust Company from 2008 to 2011; Chairman of Milennium 3 Capital from 2000 to 2008.

Wayne Kellner

Age 43

        Treasurer              Mr. Kellner has served as Treasurer of the Company since March 2012.              Chief Financial Officer, Fairholme Capital Management, L.L.C. since January 2012; Treasurer, Fairholme Capital Management, L.L.C. from January 2011 to December 2011; Tax Principal, Rothstein Kass from 2006 to 2010.

Paul R. Thomson

Age 56

       

Chief Compliance

Officer and Secretary

             Mr. Thomson has served as Chief Compliance Officer of the Company since April 2010 and has served as Secretary since June 2011. Mr. Thomson previously served as Chief Compliance Officer from November 2008 to January 2009.              Chief Compliance Officer, Fairholme Capital Management LLC since April 2010; Chief Financial Officer, Fairholme Capital Management LLC from January 2008 to January 2012; Managing Director and former Chief Financial Officer of Colliers- Seeley, Inc. from 2004 to February 2007.

 

Unless otherwise indicated, the address of each Officer of the Company is c/o Fairholme Capital Management, LLC, 4400 Biscayne Blvd., 9th Floor, Miami, FL 33137.

 

*

Each officer serves for an annual term and until his or her successor is elected and qualified.

 

^

Fred Fraenkel was elected Vice President in January 2013 and thus did not serve as an officer of the Company during the period covered by this report.

 

23


THE FAIRHOLME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

Approval of Investment Management Agreement (unaudited)

At its meeting on October 18, 2012, the Board of Directors of Fairholme Funds, Inc. (the “Company”) approved the renewal of the investment management agreement between the Company, on behalf of The Fairholme Fund (the “Fund”), and Fairholme Capital Management, L.L.C. (the “Manager”). In considering whether to approve the renewal of the agreement, the Directors considered the factors discussed below, and information made available to them at the meeting relating to such factors, and other information they deemed relevant. The renewal of the agreement was not, however, based on any single factor, but on an evaluation of the totality of factors and information reviewed and evaluated by the Directors.

A. Nature, Extent and Quality of Services

The Directors considered information provided to them concerning the nature, extent and quality of investment advisory and operational services provided or overseen by the Manager. The Directors reviewed information concerning the personnel responsible for the day-to-day portfolio and administrative management of the Fund, the overall reputation of the Manager, and the Manager’s current and planned staffing levels. The Directors considered information concerning the Manager’s commitment to the Fund as evidenced by the current share ownership in the Fund by management/owners of the Manager. The Directors considered information describing the Manager’s compliance policies and procedures, including policies designed to address the Fund’s compliance with its investment objective, policies and restrictions and applicable regulatory requirements and to address the Manager’s conflicts of interest in providing services to the Fund and to other advisory clients.

The Directors did not compare the services provided by the Manager to the Fund with the services provided by the Manager to certain of its other advisory accounts, as such accounts are not subject to the same regulatory requirements as the Fund, may have different investment restrictions, holdings and goals than the Fund, and require different levels of client and back-office servicing than the Fund.

The Directors concluded that the nature, extent and quality of services provided by the Manager to the Fund was appropriate and sufficient to support renewal of the agreement.

B. Investment Performance

The Directors considered information regarding the Fund’s performance, the Manager’s views on performance and the holdings of the Fund that contributed negatively and positively to the Fund’s performance. The Directors also considered a third party report comparing the Fund’s investment performance with the investment performance of similarly situated mutual funds. The report for the Fund reflected the performance of the Fund and the similarly situated mutual funds for the 1-year, 3-year, 5-year, 10-year and since Fund inception periods ended August 31, 2012.

C. Management Fee and Expense Ratio

The Directors considered information concerning the Fund’s management fee and expense ratio, including a third party report comparing the Fund’s management fee and most recent expense ratio to the advisory fees and expense ratios of other similarly situated mutual funds. The Directors noted that the Fund’s management fee covers many of the operating and other expenses of the Fund. The Directors noted that the Fund’s expense ratio for its latest full fiscal year was lower than the median expense ratios of its peer group funds included in the third party report.

In evaluating the management fee and expense ratio information, the Directors took into account the demands and complexity of portfolio management for the Fund in light of its investment objective and strategies and asset size. They also considered information regarding the Manager’s payment (in some cases from its resources) of certain expenses for the benefit of the Fund, including distribution expenses and account-level expenses associated with certain omnibus accounts. The Directors also reviewed information concerning the fees paid to the Manager by its other advisory accounts.

After reviewing information presented to them concerning fees, expenses, performance and other matters, the Directors concluded that the Fund’s management fee and expense ratio were reasonable in light of the services provided by or through the Manager.

 

24


THE FAIRHOLME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

D. Profitability

The Directors considered information regarding the estimated profitability of the Fund to the Manager. They considered such profitability in light of the Fund’s asset level, overall expense ratio, performance and the services provided by or through the Manager. The Directors concluded that the Manager’s estimated profitability was not such as to prevent them from approving the renewal of the agreement.

E. Economies of Scale

The Directors considered information concerning economies of scale for the Fund, including the Fund’s current assets. The Directors concluded that no modification to the Fund’s existing arrangements was warranted based on economies of scale.

Proxy Voting Policies, Procedures and Records (unaudited)

The Company has adopted policies and procedures that provide guidance and set forth parameters for the voting of proxies relating to securities held in the Fund’s portfolio. A description of these policies and procedures, and records of how the Fund voted proxies relating to their portfolio securities during the most recent twelve month period ended June 30, 2012, are available to you upon request and free of charge by writing to the Fairholme Funds, Inc., c/o BNY Mellon Investment Servicing (US) Inc., P.O. Box 9692, Providence, RI, 02940 or by calling Shareholder Services at 1-866-202-2263 or visiting our website at fairholmefunds.com. They may also be obtained by visiting the Securities and Exchange Commission (“SEC”) website at www.sec.gov. The Company shall respond to all shareholder requests for records within three business days of its receipt of such request by first-class mail or other means designed to ensure prompt delivery.

N-Q Filing (unaudited)

The Company files a complete schedule of the Fund’s portfolio holdings on Form N-Q for the fiscal quarters ending February 28 (February 29 during leap year) and August 31. The Form N-Q filing must be made within 60 days of the end of the quarter. The Forms N-Q relating to the Fund’s portfolio investments are available on the SEC’s website at www.sec.gov, or may be reviewed and copied at the SEC’s Public Reference Room in Washington, DC (call 1-800-732-0330 for information on the operation of the Public Reference Room).

Shareholder Tax Information (unaudited)

The Fund reported $213,247,996 of total distributions paid during the fiscal year ended November 30, 2012, as ordinary income distributions.

The information below is reported from the Fund’s fiscal year and not calendar year, therefore, shareholders should refer to their Form 1099-DIV or other tax information which will be mailed in 2013 to determine the calendar year amounts to be included on their 2012 tax returns. Shareholders should consult their own tax advisors.

Please note that, for the fiscal year ended November 30, 2012, the respective percentages of ordinary income distributions paid by the Fund were reported as follows:

 

Distribution Period November 30, 2012

      

Qualified Dividend Income for Individuals

     33.11%   

Dividends Qualifying for the Dividends
Received Deduction for Corporations

     33.11%   

Qualifying Interest Income

     5.32%   

Qualifying Short-term Gain

       

U.S. Treasury Securities

     0.09%   

 

25


THE FAIRHOLME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

The law varies in each state as to whether and what percentage of dividend income attributable to U.S. Treasury securities is exempt from state and local income tax. It is recommended that you consult your tax advisor to determine if any portion of the dividends you received is exempt from income taxes.

 

 

All information presented is based on financial information available as of the date of this annual report and, accordingly, are subject to change. For each item, it is the intention of the Fund to report the maximum amount permitted under the Internal Revenue Code and the regulations thereunder.

 

26


LOGO

OFFICERS OF FAIRHOLME FUNDS, INC.

Bruce R. Berkowitz

PRESIDENT

Fred Fraenkel

VICE PRESIDENT

Wayne Kellner

TREASURER

Paul R. Thomson

CHIEF COMPLIANCE OFFICER & SECRETARY

BOARD OF DIRECTORS OF FAIRHOLME FUNDS, INC.

Cesar L. Alvarez, Esq.

Terry L. Baxter

Bruce R. Berkowitz

Howard S. Frank

Avivith Oppenheim, Esq.

Leigh Walters, Esq.

Investment Manager

FAIRHOLME CAPITAL MANAGEMENT, L.L.C.

4400 Biscayne Boulevard

Miami, FL 33137

Transfer Agent, Fund Accountant and Administrator

BNY MELLON INVESTMENT SERVICING (US) INC.

760 Moore Road

King of Prussia, PA 19406

Custodian

THE BANK OF NEW YORK MELLON

1 Wall Street

New York, NY 10286

Independent Registered Public Accounting Firm

DELOITTE & TOUCHE LLP

1700 Market Street

Philadelphia, PA 19103

Legal Counsel

SEWARD & KISSEL LLP

901 K Street NW

Washington, DC 20001

THIS REPORT IS PROVIDED FOR THE GENERAL INFORMATION OF THE SHAREHOLDERS OF FAIRHOLME FUNDS, INC. IT IS NOT INTENDED FOR DISTRIBUTION TO PROSPECTIVE INVESTORS IN THE FUNDS UNLESS PRECEDED OR ACCOMPANIED BY AN EFFECTIVE PROSPECTUS, WHICH CONTAINS MORE INFORMATION ON FEES, CHARGES AND OTHER EXPENSES AND SHOULD BE READ CAREFULLY BEFORE INVESTING OR SENDING MONEY. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. SHARES OF THE FUNDS ARE DISTRIBUTED BY FAIRHOLME DISTRIBUTORS, LLC.


FAIRHOLME

Ignore the crowd.

 

 

 

The Fairholme Focused Income Fund (FOCIX)

Seeking current income

ANNUAL REPORT 2012

 

MANAGED BY FAIRHOLME CAPITAL MANAGEMENT

 

1.866.202.2263 • fairholmefunds.com


THE FAIRHOLME FOCUSED INCOME FUND

 

 

TABLE OF CONTENTS

November 30, 2012

 

 

     Page

FUND PERFORMANCE

       3  

MANAGEMENT DISCUSSION & ANALYSIS REPORT

       4  

EXPENSE EXAMPLE

       7  

SCHEDULE OF INVESTMENTS

       8  

STATEMENT OF ASSETS & LIABILITIES

       10  

STATEMENT OF OPERATIONS

       11  

STATEMENTS OF CHANGES IN NET ASSETS

       12  

FINANCIAL HIGHLIGHTS

       13  

NOTES TO FINANCIAL STATEMENTS

       14  

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

       21  

ADDITIONAL INFORMATION

       22  

 

2


THE FAIRHOLME FOCUSED INCOME FUND

 

 

FUND PERFORMANCE (Unaudited)

Inception through November 30, 2012

 

 

THE FAIRHOLME FOCUSED INCOME FUND VS.

The BARCLAYS CAPITAL U.S. AGGREGATE BOND INDEX

INITIAL MINIMUM INVESTMENT OF $25,000

 

LOGO

The Fairholme Focused Income Fund (the “Fund”) commenced operations on December 31, 2009. The chart above presents the performance of a $25,000 investment from inception to the latest fiscal year ended November 30, 2012.

The following notes pertain to the chart above as well as to the performance table included in the Management Discussion & Analysis Report. Performance information in this report represents past performance and is not a guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate, so that an investor’s shares when redeemed may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted within. The performance information does not reflect the taxes an investor would pay on Fund distributions or upon redemption of Fund shares. Any questions you have regarding the performance data current to the most recent month-end can be obtained by calling Shareholder Services at 1-866-202-2263.

Data for both the Barclays Capital U.S. Aggregate Bond Index and the Fund are presented assuming all dividends and distributions have been reinvested and do not reflect any taxes that might have been incurred by a shareholder as a result of the Fund distributions. The Barclays Capital U.S. Aggregate Bond Index is an unmanaged market weighted index comprised of investment grade corporate bonds (rated BBB or better), mortgages, and U.S. Treasury and government agency issues with at least one year to maturity and does not reflect any investment management fees or transaction expenses, nor the effects of taxes, fees, or other charges.

 

3


THE FAIRHOLME FOCUSED INCOME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS

For the Fiscal Year Ended November 30, 2012

 

 

The Fairholme Focused Income Fund (the “Fund”) shares outstanding and audited net asset value per share (“NAV”) at November 30, 2012, the end of the Fund’s fiscal year, and NAVs at other pertinent dates, were as follows:

 

       11/30/2012
Shares
Outstanding
     11/30/2012
NAV
(audited)
     05/31/2012
NAV
(unaudited)
     11/30/2011
NAV
(audited)

Fund

     25,693,434      $10.02      $9.98      $9.71

At December 31, 2012, the unaudited NAV of the Fund was $9.47. Performance figures below are shown for the Fund’s fiscal year ended November 30, 2012, and do not match calendar year figures for the period ended December 31, 2012, cited in the Portfolio Manager’s report.

 

       Six
Months
     One
Year
     Since
Inception
12/31/2009
 

Cumulative:

          

Fund

       5.33      13.45      19.71

Barclays Bond Index

       1.99      5.51      19.91

Annualized:

          

Fund

          13.45      6.36

Barclays Bond Index

          5.51      6.42

For the six months ended November 30, 2012, the Fund outperformed the Barclays Capital U.S. Aggregate Bond Index (“Barclays Bond Index”) by 3.34 percentage points while over the last year the Fund outperformed the Barclays Bond Index by 7.94 percentage points. From inception, the Barclays Bond Index outperformed the Fund by 0.06 percentage points per annum or on a cumulative basis 0.20 percentage points over two years and eleven months.

Fairholme Capital Management, L.L.C. (the “Manager”) believes continuing economic recovery contributed to overall performance. However, the fact that securities increase or decline in value does not always indicate that the Manager believes these securities to be more or less or attractive — in fact, the Manager believes that some price increases present selling opportunities and some price declines present buying opportunities. Shareholders are also cautioned that it is possible that some securities mentioned in this discussion may no longer be held by the Fund subsequent to the end of the fiscal period and that the Fund may have made significant new purchases that are not yet required to be disclosed. It is the Fund’s general policy not to disclose portfolio holdings other than when required by relevant law or regulation. Portfolio holdings are subject to change without notice.

Not all Fund portfolio dispositions or additions are material, and, while the Fund and the Manager have long-term objectives, it is possible that a security sold or purchased in one period will be purchased or sold in a subsequent period. Generally, the Manager determines to buy and sell based on its estimates of the absolute and relative intrinsic values and fundamental dynamics of a particular security and its underlying corporation and its industry. However, certain strategies of the Manager in carrying out Fund policies may result in shorter holding periods.

In the opinion of the Manager, performance over shorter periods is likely to be less meaningful than over longer periods. Investors are cautioned not to rely on short-term results. Further, shareholders should note that the Barclays Bond Index is an unmanaged index incurring no fees, expenses, or tax effects and is shown solely to compare Fund performance to that of an unmanaged and diversified index.

The Manager invests Fund assets in securities to the extent it finds reasonable investment opportunities in accordance with its Prospectus and may invest a significant portion of Fund assets in liquid, low-risk securities or cash. The Manager views liquidity as a strategic advantage. At November 30, 2012, cash and cash equivalents

 

4


THE FAIRHOLME FOCUSED INCOME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

(consisting of cash, commercial paper, deposit accounts, U.S. Treasury Bills, and money-market funds) represented 40.1% of total assets. Since inception, the Fund has held liquid, low-risk securities or cash for periods without, in the Manager’s view, negatively influencing performance, although there is no guarantee that future performance will not be negatively affected by Fund liquidity.

The Fund is considered to be “non-diversified” under the Investment Company Act of 1940. The Fund can invest a greater percentage of assets in fewer securities than a diversified fund and may invest a significant portion of cash and liquid assets in one or more risky securities at any time, particularly in situations where markets are weak or a particular security declines sharply. The Fund may also have a greater percentage of assets invested in a particular industry than a diversified fund, exposing the Fund to the risk of an unanticipated industry condition as well as risks specific to a single company or security. The following charts show the top holdings by issuer and sector in descending order of net assets as of November 30, 2012.

 

    

 

The Fairholme Focused Income Fund

Top Holdings by Issuer*

(% of Net Assets)

                   

 

The Fairholme Focused Income Fund

Top Sectors

(% of Net Assets)

          
     
   

MBIA, Inc.

   39.6%           Cash and Cash Equivalents**    40.1%    
   

Sears Holdings Corp.

   15.7%           Surety Insurance    39.6%    
   

General Growth Properties, Inc.

   2.1%           Retail Department Stores    15.7%    
   

Howard Hughes Corp.

   0.3%           Real Estate Investment Trust    2.1%    
   

American International Group, Inc.

   0.1%           Real Estate Management & Development    0.3%    
      

 

                
       57.8%           Multi-Line Insurance    0.1%    
      

 

            

 

   
                    97.9%    
                   

 

   
   

    

                           
  *

Excludes cash, U.S. Treasury Bills, and money market funds.

**

Includes cash, U.S. Treasury Bills, and money market funds.

The Manager views the ability to focus on fewer investments than a diversified fund as a strategic advantage. However, since inception, such a strategy has negatively influenced short-term performance and there is no guarantee that future performance will not be negatively affected.

The Fund may invest in non-U.S. securities and securities of corporations domiciled outside of the United States which may expose the Fund to adverse changes resulting from foreign currency fluctuations or other potential risks as described in the Fund’s Statement of Additional Information.

The Fund’s Officers, the Board of Directors (the “Board” or the “Directors”), and Manager are aware that large cash inflows or outflows may adversely affect Fund performance. Such flows are monitored and appropriate actions are contemplated for when such flows could negatively impact performance.

Since inception, the Fund has been advised by the Manager. Mr. Berkowitz, both the Managing Member of the Manager and Chairman of the Fund’s Board, continues to have a significant personal stake in the Fund, holding an aggregate 3,117,216 shares at November 30, 2012. While there is no requirement that the Manager own shares of the Fund, such holdings are believed to help align shareholder interests.

Independent Fund Directors continue to believe that it is in the best interests of the Fund to have Mr. Berkowitz serve as Chairman of the Board given: his long-term relative performance; his experience, commitment, and significant personal investment in the Fund; the present constitution of Directors and policies; and current rules and regulations. Certain Directors and Officers of the Fund are also Officers of the Manager. Nevertheless, at

 

5


THE FAIRHOLME FOCUSED INCOME FUND

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

November 30, 2012, a majority of Directors were independent of the Manager, no stock option or restricted stock plans exist, Officers received no direct compensation from the Fund, and Directors affiliated with the Manager received no compensation for being Directors.

For more complete information about the Fund, or to obtain a current Prospectus, please visit www.fairholmefunds.com or call Shareholder Services at 1-866-202-2263.

 

6


THE FAIRHOLME FOCUSED INCOME FUND

 

 

EXPENSE EXAMPLE

For the Six Month Period from June 1, 2012

through November 30, 2012 (unaudited)

 

 

As a Fund shareholder, you incur direct and indirect costs. Direct costs include, but are not limited to, transaction fees at some broker-dealers, custodial fees for retirement accounts and wire transfer fees. You also incur indirect, ongoing costs that include, but are not limited to, management fees paid to the Manager.

The following example is intended to help you understand your indirect costs (also referred to as “ongoing costs” and measured in dollars) when investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds. This example is based on an investment of $1,000 invested in the Fund at June 1, 2012, and held for the entire six month period ending November 30, 2012.

Actual Expenses

The first line of the table below provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you had invested at the beginning of the period, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During the Period” to estimate the expenses you paid on your Fund holdings during this period.

Hypothetical Example for Comparison Purposes

The second line of the table provides information about hypothetical account values and hypothetical expenses based on the Fund’s actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund’s actual return for the period presented. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses that you paid for the period presented. However, you may use this information to compare ongoing costs of investing in the Fund with the ongoing costs of investing in other funds. To do so, compare this 5% hypothetical example with the 5% examples that appear in the shareholder reports of other funds.

Please note that the column titled “Expenses Paid During the Period” in the table below is meant to highlight your ongoing costs only and do not reflect any transactional costs, such as redemption fees (if any), or other direct costs. Therefore, the second line of the table is useful in comparing ongoing costs only, and will not help you determine the relative total costs of owning different funds. In addition, if these direct costs were included, your total costs would be higher.

     Beginning
Account Value
June 1, 2012
   Ending
Account Value
November 30, 2012
   Annualized
Expense
Ratio
  Expenses Paid
During the  Period

June 1, 2012
Through
November 30, 2012*

Fund

          

Actual

   $1,000.00    $1,053.30    1.00%   $5.13

Hypothetical (5% return before expenses)

   $1,000.00    $1,020.00    1.00%   $5.05

 

*

Expenses are equal to the Fund’s annualized expense ratio, multiplied by the average account value over the period, multiplied by 183 days/366 days (to reflect the one-half year period).

 

7


THE FAIRHOLME FOCUSED INCOME FUND

 

 

SCHEDULE OF INVESTMENTS

November 30, 2012

 

 

 

  Shares   

        Value  
  

WARRANTS — 2.5%

  
  

MULTI-LINE INSURANCE — 0.1%

  

23,212

  

American International Group, Inc.,

  
  

Vested, Strike Price $45.00,
Expire 01/19/2021 (a)(b)

   $ 322,647   
     

 

 

 
  

REAL ESTATE INVESTMENT
TRUSTS — 2.1%

  

437,072

  

General Growth Properties, Inc.,

  
  

Vested, Strike Price $9.412,
Expire 11/09/2017 (a)(b)(c)(d)

     5,391,196   
     

 

 

 
  

REAL ESTATE MANAGEMENT & DEVELOPMENT — 0.3%

  

20,397

  

Howard Hughes Corp.,

  
  

Vested, Strike Price $50.00,
Expire 11/09/2017 (a)(b)(c)(d)

     672,473   
     

 

 

 

TOTAL WARRANTS
(COST $378,123)

     6,386,316   
     

 

 

 

Principal

           
  

DOMESTIC CORPORATE
BONDS — 55.3%

  
  

RETAIL DEPARTMENT
STORES — 15.7%

  

$44,000,000

  

Sears Holdings Corp.
6.625%, 10/15/2018

     40,480,000   
     

 

 

 
  

SURETY INSURANCE — 39.6%

  

60,600,000

  

MBIA Insurance Corp., Subordinate Debenture
14.000%, 01/15/2033 (e)

     13,968,300   
  

MBIA, Inc.

  

8,486,000

  

6.400%, 08/15/2022

     6,760,796   

7,105,000

  

7.000%, 12/15/2025

     5,612,950   

49,716,000

  

7.150%, 07/15/2027

     39,524,220   

47,500,000

  

6.625%, 10/01/2028

     35,943,250   
     

 

 

 
        101,809,516   
     

 

 

 

TOTAL DOMESTIC CORPORATE BONDS
(COST $165,293,434)

     142,289,516   
     

 

 

 

Principal

        Value  
  

U.S. GOVERNMENT
OBLIGATIONS — 27.2%

  

$10,000,000

  

U.S. Treasury Bills
0.096%, 01/24/2013 (f)

   $ 9,998,567   

10,000,000

  

U.S. Treasury Bills
0.156%, 04/04/2013 (f)

     9,996,360   

30,000,000

  

U.S. Treasury Bills
0.170%, 10/17/2013 (f)

     29,958,330   

20,000,000

  

U.S. Treasury Bills
0.163%, 11/14/2013 (f)

     19,968,340   
     

 

 

 

TOTAL U.S. GOVERNMENT OBLIGATIONS
(COST $69,916,365)

     69,921,597   
     

 

 

 

  Shares   

           
  

MONEY MARKET FUNDS — 12.9%

  

33,326,724

  

Fidelity Institutional Money Market
Funds - Money Market Portfolio,
0.180% (g)

     33,326,724   
     

 

 

 

TOTAL MONEY MARKET FUNDS
(COST $33,326,724)

     33,326,724   
     

 

 

 

TOTAL INVESTMENTS — 97.9%
(COST $268,914,646)

     251,924,153   
  

OTHER ASSETS IN EXCESS OF LIABILITIES — 2.1%

     5,505,772   
     

 

 

 

NET ASSETS — 100.0%

   $ 257,429,925   
     

 

 

 
 

 

(a) 

Warrants have terms and conditions based on dividends paid and other events that may lower the strike price and raise the shares per warrant conversion ratio. Reported strike prices and conversion ratios are as of the date of this report. All share-to-warrant conversion ratios are currently 1:1, excluding the General Growth Properties, Inc. warrants, which on November 30, 2012 had a conversion ratio of 1:1.1157.

(b)

Non-income producing security.

 

The accompanying notes are an integral part of the financial statements.

 

8


THE FAIRHOLME FOCUSED INCOME FUND

 

 

SCHEDULE OF INVESTMENTS (continued)

November 30, 2012

 

 

 

(c)

Restricted or controlled security under procedures approved by the Directors. The value of these securities totals $6,063,669, which represents 2.36% of the Fund’s net assets. Information related to these securities is as follows:

 

Acquisition
Shares

  

Issuer

         Acquisition      
Date
   Acquisition
Cost
   11/30/2012
Carrying Value

Per Unit
    437,072      

General Growth Properties, Inc., Warrants, Vested, Strike Price $9.412, Expire 11/09/2017

   05/10/2010    $-    $12.3348
    20,397      

Howard Hughes Corp., Warrants, Vested, Strike Price $50.00,
Expire 11/09/2017

   11/05/2010      -      32.9692

 

(d)

Security is deemed an illiquid security under procedures approved by the Directors.

(e)

Variable rate security. The rate shown is as of November 30, 2012.

(f)

Rates shown are the effective yields based on the purchase price. The calculation assumes the security is held to maturity.

(g)

Annualized based on the 1-day yield as of November 30, 2012.

 

The accompanying notes are an integral part of the financial statements.

 

9


THE FAIRHOLME FOCUSED INCOME FUND

 

 

STATEMENT OF ASSETS & LIABILITIES

November 30, 2012

 

 

Assets

  

Investments, at Fair Value (Cost — $268,914,646)

     $251,924,153   

Dividends and Interest Receivable

     5,711,900   

Receivable for Capital Shares Sold

     32,016   
  

 

 

 

Total Assets

     257,668,069   
  

 

 

 

Liabilities

  

Payable for Capital Shares Redeemed

     26,766   

Accrued Management Fees

     211,378   
  

 

 

 

Total Liabilities

     238,144   
  

 

 

 

NET ASSETS

     $257,429,925   
  

 

 

 

Net Assets Consist of:

  

Paid-In-Capital

     $278,952,750   

Accumulated Undistributed Net Investment Income

     4,666,003   

Net Accumulated Realized Loss on Investments and Foreign Currency Related Transactions

     (9,198,335

Net Unrealized Depreciation on Investments and Foreign Currency Related Translations

     (16,990,493
  

 

 

 

NET ASSETS

     $257,429,925   
  

 

 

 

Shares of Common Stock Outstanding* ($0.0001 par value)

     25,693,434   
  

 

 

 

Net Asset Value, Offering and Redemption Price Per Share

($257,429,925 / 25,693,434 shares)

     $           10.02   
  

 

 

 

 

*

  200,000,000 shares authorized in total.

 

The accompanying notes are an integral part of the financial statements.

10


THE FAIRHOLME FOCUSED INCOME FUND

 

 

STATEMENT OF OPERATIONS

 

 

     For the
Fiscal Year Ended
November 30, 2012
 

Investment Income

  

Interest

     $28,293,916   

Dividends

     117,094   

Other Income

     1,128,070   
  

 

 

 

Total Investment Income

     29,539,080   
  

 

 

 

Expenses

  

Management Fees

     2,827,600   
  

 

 

 

Less: Management Fee Waiver

     (249,582
  

 

 

 

Net Expenses

     2,578,018   
  

 

 

 

Net Investment Income

     26,961,062   
  

 

 

 

Realized and Unrealized Gain (Loss) on Investments and Foreign Currency Related Transactions

  

Net Realized Loss on Investments

     (8,916,060

Net Change in Unrealized Appreciation on Investments and Foreign Currency Related Translations

     19,334,005   
  

 

 

 

Net Realized and Unrealized Gain on Investments and Foreign Currency Related Transactions

     10,417,945   
  

 

 

 

NET INCREASE IN NET ASSETS FROM OPERATIONS

     $37,379,007   
  

 

 

 

 

The accompanying notes are an integral part of the financial statements.

 

11


THE FAIRHOLME FOCUSED INCOME FUND

 

 

STATEMENTS OF CHANGES IN NET ASSETS

 

 

     For the
Fiscal Year Ended
November 30, 2012
    For the
Fiscal Year Ended
November 30, 2011
 

CHANGES IN NET ASSETS

    

From Operations

    

Net Investment Income

   $ 26,961,062      $ 25,394,044   

Net Realized Loss on Investments and Foreign Currency Related Transactions

     (8,916,060     (202,229

Net Change in Unrealized Appreciation (Depreciation) on Investments and Foreign Currency Related Translations

     19,334,005        (44,625,687
  

 

 

   

 

 

 

Net Increase (Decrease) in Net Assets from Operations

     37,379,007        (19,433,872
  

 

 

   

 

 

 

From Dividends and Distributions to Shareholders

    

Net Investment Income

     (26,792,196     (24,764,705

Net Realized Capital Gains from Investment Transactions

            (1,303,780
  

 

 

   

 

 

 

Net Decrease in Net Assets from Dividends and Distributions

     (26,792,196     (26,068,485
  

 

 

   

 

 

 

From Capital Share Transactions

    

Proceeds from Sale of Shares

     55,945,236        314,120,403   

Shares Issued in Reinvestment of Dividends and Distributions

     23,226,833        23,479,746   

Cost of Shares Redeemed

     (131,553,019     (357,108,236
  

 

 

   

 

 

 

Net Decrease in Net Assets from Shareholder Activity

     (52,380,950     (19,508,087
  

 

 

   

 

 

 

NET ASSETS

    

Net Decrease in Net Assets

     (41,794,139     (65,010,444

Net Assets at Beginning of Year

     299,224,064        364,234,508   
  

 

 

   

 

 

 

Net Assets at End of Year

   $ 257,429,925      $ 299,224,064   
  

 

 

   

 

 

 

Accumulated Undistributed Net Investment Income at End of Year

   $ 4,666,003      $ 4,497,137   
  

 

 

   

 

 

 

SHARES TRANSACTIONS

    

Issued

     5,506,711        28,561,964   

Reinvested

     2,300,007        2,237,086   

Redeemed

     (12,916,946     (34,047,999
  

 

 

   

 

 

 

Net Decrease in Shares

     (5,110,228     (3,248,949

Shares Outstanding at Beginning of Year

     30,803,662        34,052,611   
  

 

 

   

 

 

 

Shares Outstanding at End of Year

     25,693,434        30,803,662   
  

 

 

   

 

 

 

 

The accompanying notes are an integral part of the financial statements.

 

12


THE FAIRHOLME FOCUSED INCOME FUND

 

 

FINANCIAL HIGHLIGHTS

 

 

     For the
Fiscal Year Ended
November 30, 2012
    For the
Fiscal Year Ended
November 30, 2011
    For the
Period Ended
November 30, 2010(1)
 

PER SHARE OPERATING PERFORMANCE NET ASSET VALUE, BEGINNING OF PERIOD

     $9.71        $10.70        $10.00   
  

 

 

   

 

 

   

 

 

 

Investment Operations

      

Net Investment Income(2)

     0.97        0.64        0.45   

Net Realized and Unrealized Gain (Loss)on Investments

     0.31        (0.95     0.45   
  

 

 

   

 

 

   

 

 

 

Total from Investment Operations

     1.28        (0.31     0.90   
  

 

 

   

 

 

   

 

 

 

Dividends and Distributions

      

From Net Investment Income

     (0.97     (0.64     (0.20

From Realized Capital Gains

            (0.04       
  

 

 

   

 

 

   

 

 

 

Total Dividends and Distributions

     (0.97     (0.68     (0.20
  

 

 

   

 

 

   

 

 

 

NET ASSET VALUE, END OF PERIOD

     $10.02        $9.71        $10.70   
  

 

 

   

 

 

   

 

 

 

TOTAL RETURN

     13.45 %      (3.24 )%      9.05 %(3) 

Ratio/Supplemental Data

      

Net Assets, End of Period (in 000’s)

     $257,430        $299,224        $364,235   

Ratio of Expenses to Average Net Assets:

      

Before Expenses Waived

     1.00     1.00     1.00 %(4) 

After Expenses Waived

     0.91     0.67     0.50 %(4) 

Ratio of Net Investment Income to Average Net Assets

     9.53     5.96     4.69 %(4) 

Portfolio Turnover Rate

     8.27     91.67     77.03 %(3) 

 

(1) 

The Fund commenced operations on December 31, 2009.

(2) 

Based on average shares outstanding.

(3) 

Not Annualized.

(4)

Annualized.

 

The accompanying notes are an integral part of the financial statements.

 

13


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS

November 30, 2012

 

 

Note 1. Organization

Fairholme Funds, Inc. (the “Company”), a Maryland corporation, is registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as an open-end management investment company. The Company’s Articles of Incorporation permit the Board of Directors of the Company (the “Board” or the “Directors”) to issue 1,100,000,000 shares of common stock at $.0001 par value. 200,000,000 shares have been allocated to The Fairholme Focused Income Fund (the “Fund”). The Fund is a non-diversified fund. The Fund may have a greater percentage of its assets invested in particular securities than a diversified fund, exposing the Fund to the risk of unanticipated industry conditions as well as risks specific to a single company or the securities of a single company. The Board has the power to designate one or more separate and distinct series and/or classes of shares of common stock and to classify or reclassify any unissued shares with respect to such series.

The Fund’s investment objective is to seek current income. Under normal circumstances, the Fund seeks to achieve its investment objective by investing in a focused portfolio of cash distributing securities. To maintain maximum flexibility, the securities in which the Fund may invest include corporate debt securities of issuers in the U.S. and foreign countries, bank debt (including bank loans and loan participations), government and agency debt securities of the U.S. and foreign countries, convertible bonds and other convertible securities and equity securities, including preferred and common stock and interests in real estate investment trusts (“REITs”). Although the Fund normally holds a focused portfolio of securities, the Fund is not required to be fully invested in such securities and may maintain a significant portion of its total assets in cash and securities generally considered to be cash equivalents. Fairholme Capital Management, L.L.C. (the “Manager”) serves as investment adviser to the Fund.

There is no guarantee that the Fund will meet its objectives.

Note 2. Significant Accounting Policies

The Fund’s investments are reported at fair value as defined by Accounting Principles Generally Accepted in the United States of America (“U.S. GAAP”). The Fund generally determines its net asset value as of approximately 4:00 p.m. Eastern Time each day the New York Stock Exchange is open.

A description of the valuation techniques applied to the Fund’s securities measured at fair value on a recurring basis follows:

Security Valuation:

Equity securities (common and preferred stocks): Securities traded on a national securities exchange or reported on the NASDAQ national market are generally valued at the official closing price, or at the last reported sale price on the exchange or market on which the securities are traded, as of the close of business on the day the securities are being valued or, lacking any sales, at the last available bid price. To the extent these securities are actively traded and valuation adjustments are not applied, they are classified in Level 1 of the fair value hierarchy. If these securities are not actively traded, they are classified in Level 2. The Manager may also employ other valuation methods which the Manager believes would provide a more accurate indication of fair value. In these situations, if the inputs are observable, the valuation will be classified in Level 2 of the fair value hierarchy, otherwise they would be classified in Level 3.

Fixed-income securities (U.S. government obligations, corporate bonds, convertible bonds, and asset backed securities): The fair value of fixed-income securities is estimated using market quotations when readily available, but may also be estimated by various methods when no such market quotations exist and when the Manager believes these other methods reflect the fair value of such securities. These methods may consider recently executed transactions in securities of the issuer or comparable issuers and market price valuations from independent pricing services and/or brokers (where observable). Where the Manager deems it appropriate to do so (such as when independent prices are unavailable or not deemed to be representative of fair value) fixed-income securities will be fair valued in good faith. As of November 30, 2012, fixed-income securities are valued by the Manager utilizing observable market prices on the day of valuation or the average bid of independent broker/dealer quotes and/or the average of valuations from independent pricing services. Although fixed-income securities are classified in

 

14


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

Level 2 of the fair value hierarchy at November 30, 2012, in instances where lower relative weight is placed on transaction prices, quotations, or similar observable inputs, they would be classified in Level 3.

Open-end mutual funds: Investments in open-end mutual funds including money market funds are valued at their closing net asset value each business day and are classified in Level 1 of the fair value hierarchy.

Short-term securities: Investments in securities with maturities of less than sixty days when acquired or long-term securities, which are within sixty days of maturity are estimated by using the amortized cost method of valuation, which the Manager and the Board have determined will approximate fair value. To the extent the inputs are observable and timely, the values would be classified in Level 2 of the fair value hierarchy.

Restricted securities: Depending on the relative significance of valuation inputs, these instruments may be classified in either Level 2 or Level 3 of the fair value hierarchy.

Warrants: The Fund may invest in warrants, which may be acquired either through a direct purchase, included as part of a private placement, or pursuant to corporate actions. Warrants entitle, but do not obligate, the holder to buy equity securities at a specific price for a specific period of time. Warrants may be considered more speculative than certain other types of investments in that they do not entitle a holder to dividends or voting rights with respect to the underlying securities that may be purchased nor do they represent any rights in the assets of the issuing company. Also, the value of a warrant does not necessarily change with the value of the underlying securities and a warrant ceases to have value if it is not exercised prior to its expiration date. Warrants traded on a security exchange are valued at the official closing price on the valuation date and are classified as Level 1 of the fair value hierarchy. Over the counter (OTC) warrants are valued using simulation models utilizing market value of the underlying security, expiration date of the warrants, volatility of the underlying security, strike price of the warrants, risk-free interest rate at the valuation date, and are classified as Level 2 or Level 3 of the fair value hierarchy depending on the observability of the inputs used.

The Fund uses several recognized industry third-party pricing services (TPPS) - approved by the Board and unaffiliated with the Manager - to value some of its securities. It also uses other independent market trade data sources (such as TRACE, the FINRA-developed mandatory reporting of over-the-counter secondary market transactions), as well as broker quotes provided by market makers of securities not valued by these and other TPPS. The data within these feeds is ultimately sourced from major stock exchanges and trading systems where these securities trade. If a price obtained from the pricing source is deemed unreliable, prices will be sought from another pricing service or from a broker/dealer that trades that security or similar securities.

The Manager may determine the fair valuation of a security when market quotations are insufficient or not readily available, when securities are determined to be illiquid or restricted, or when in the judgment of the Manager the prices or values available do not represent the fair value of the instrument. Factors which may cause the Manager to make such a judgment include the following: (a) only a bid price or an asked price is available; (b) the spread between bid and asked prices is substantial; (c) the liquidity of the securities; (d) the frequency of sales; (e) the thinness of the market; (f) the size of reported trades; (g) actions of the securities markets, such as the suspension or limitation of trading; and (h) bona fide bids or offers made to the Manager by independent third parties. Among the factors to be considered to fair value a security are recent prices of comparable securities that are publicly traded, reliable prices of securities not publicly traded, the use of valuation models, current analyst reports, valuing the income or cash flow of the issuer, or cost if the preceding factors do not apply. The circumstances of Level 3 securities are frequently monitored to determine if fair valuation measures continue to apply.

The Manager reports quarterly to the Board the results of the application of fair valuation policies and procedures.

The inputs and valuation techniques used to measure fair value of the Fund’s investments are summarized into three levels as described in the hierarchy below:

 

   

Level 1 — quoted prices in active markets for identical securities;

 

15


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

   

Level 2 — other significant observable inputs (including quoted prices for similar securities, quoted prices in

inactive markets for identical securities, interest rates, prepayment speeds, credit risk, etc.); and

 

   

Level 3 — significant unobservable inputs (including the Manager’s determination as to the fair value of investments).

The inputs or methodology used for valuing investments are not necessarily an indication of the risk associated with investing in those investments. The summary of the Fund’s investments by inputs used to value the Fund’s investments as of November 30, 2012 is as follows:

 

       Valuation Inputs           
       Level 1 –
Quoted Prices
       Level 2 – Other
Significant
Observable Inputs
       Total
Fair Value
at 11/30/2012
 

ASSETS:

              

INVESTMENTS (Fair Value):

              

Warrants

              

Multi-Line Insurance

     $ 322,647         $         $ 322,647   

Real Estate Investment Trusts

                 5,391,196           5,391,196   

Real Estate Management & Development

                 672,473           672,473   

Domestic Corporate Bonds

                 142,289,516           142,289,516   

U.S. Government Obligations

                 69,921,597           69,921,597   

Money Market Funds

       33,326,724                     33,326,724   
    

 

 

      

 

 

      

 

 

 

TOTAL INVESTMENTS

     $ 33,649,371         $ 218,274,782         $ 251,924,153   
    

 

 

      

 

 

      

 

 

 

The Fund had no transfers between Level 1 and Level 2 during the fiscal year ended November 30, 2012.

The following is a reconciliation of Level 3 investments for which significant unobservable inputs were used to determine fair value:

 

       Assets:
Investments (Fair Value)
 
       Warrants           
       Real  Estate
Investment
Trusts
       Real Estate
Management
& Development
       Total Level  3
Investments
 

Balance as of 11/30/2011

     $ 3,649,245         $ 386,623         $ 4,035,868   

Change in unrealized appreciation

                             

Purchases

                             

Sales

                             

Transfers into Level 3 (1)

                             

Transfers out of Level 3 (1)

       (3,649,245        (386,623        (4,035,868
    

 

 

      

 

 

      

 

 

 

Balance as of 11/30/2012

     $         $         $   
    

 

 

      

 

 

      

 

 

 

 

(1)

The Fund’s policy is to recognize transfers into and transfers out of Level 3 as of the beginning of the reporting period. As of November 30, 2011, the Fund used certain significant unobservable inputs in determining the value of these investments. As of November 30, 2012, the Fund used observable inputs in determining the value of the same investments. As a result, the investments transferred from Level 3 to Level 2 in the disclosure hierarchy.

Recent Accounting Standards: In December 2011, FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities”. ASU 2011-11 requires disclosures to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under International Financial Reporting Standards. The new disclosure requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of assets and liabilities as well as instruments and transactions subject to an agreement similar to a master netting arrangement. In addition,

 

16


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

ASU 2011-11 requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. New disclosures are required for annual reporting periods beginning on or after January 1, 2013 and interim periods within those annual periods. Management is evaluating the impact of ASU 2011-11 on the financial statements and disclosures.

Warrants: The Fund’s investments in warrants as of November 30, 2012, are presented within the Schedule of Investments.

The Fund’s warrant positions during the fiscal year ended November 30, 2012 had an average monthly market value of approximately $5,709,253.

As of November 30, 2012, the value of warrants with equity risk exposure of $6,386,316 is included with Investments at Fair Value on the Statement of Assets and Liabilities. For the fiscal year ended November 30, 2012, the effect of the net change in unrealized appreciation of warrants with equity risk exposure held of $2,208,391 is included with the Net Change in Unrealized Appreciation on Investments and Foreign Currency Related Translations on the Statement of Operations.

Dividends and Distributions: The Fund records dividends and distributions to shareholders on the ex-dividend date. The Fund intends to declare and pay net investment income distributions, if any, quarterly in March, June, September, and December. The Fund intends to distribute any net long-term capital gains and any net short-term capital gains at least once a year. If the total dividends and distributions made in any tax year exceeds net investment income and accumulated realized capital gains, a portion of the total distribution may be treated as a tax return of capital.

Foreign Currency Translation: The books and records of the Fund are maintained in U.S. dollars. Foreign currency amounts are translated into U.S. dollars on the following basis: (i) fair value of investment securities, assets, and liabilities at the current rate of exchange; and (ii) purchases and sales of investment securities, income, and expenses at the relevant rates of exchange prevailing on the respective dates of such transactions. The Fund does not isolate that portion of gains and losses on investment securities which is due to changes in the foreign exchange rates from that which is due to changes in the market prices of such securities.

Estimates: The preparation of financial statements in conformity with U.S. GAAP requires the Fund to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of both contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.

Other: The Fund accounts for security transactions on the trade date for financial statement purposes. The specific identification method is used for determining gains or losses for financial statements and income tax purposes. Dividend income is recorded on the ex-dividend date net of foreign taxes withheld where recovery is uncertain and interest income is recorded on an accrual basis. Discounts and premiums on securities purchased are amortized over the life of the respective securities using the effective yield method. Securities denominated in currencies other than U.S. dollars are subject to changes in value due to fluctuation in exchange rates. The Fund may invest in countries that require governmental approval for the repatriation of investment income, capital, or the proceeds of sales of securities by foreign investors. In addition, if there is deterioration in a country’s balance of payments or for other reasons, a country may impose temporary restrictions on foreign capital remittances abroad.

The Fund paid commissions and other brokerage fees.

Note 3. Related Party Transactions

The Manager is a Delaware limited liability company and is registered with the Securities and Exchange Commission as an investment adviser. The Manager’s principal business and occupation is to provide investment management and advisory services to individuals, corporations, and other institutions throughout the world. Pursuant to an Investment Management Agreement, the Fund pays a management fee to the Manager for its provision of investment advisory and operating services to the Fund. Subject to applicable waivers or limitations, the management fee is paid at an annual rate equal to 1.00% of the

 

17


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

daily average net assets of the Fund. Under the Investment Management Agreement, the Manager is responsible for paying all of the Fund’s expenses, including expenses for the following services: transfer agency, fund accounting, fund administration, custody, legal, audit, compliance, directors’ fees, call center, fulfillment, travel, insurance, rent, printing, postage, and other office supplies, except for commissions, brokerage fees, and other transaction costs, taxes, interest, litigation expenses, and related expenses, and other extraordinary expenses.

Effective March 29, 2012, the Manager’s contractual management fee waiver/expense reimbursement for the Fund expired. Prior to March 29, 2012, the Manager had contractually agreed to waive a portion of its management fee and/or limit the Fund’s operating expenses (excluding taxes, interest, brokerage commissions, acquired fund fees and expenses, expenses incurred in connections with any merger or reorganization and extraordinary expenses such as litigation) so that the Fund’s operating expenses, after such waiver or limitation payment, would not exceed an annual rate of 0.75% of the Fund’s daily average net assets for the period March 30, 2011 to March 29, 2012. For the period December 31, 2009 to March 30, 2011, the Manager had contractually agreed to waive a portion of its management fee and/or limit the Fund’s operating expenses (excluding those expenses noted above) so that the Fund’s operating expenses, after such waiver or limitation payment, would not exceed an annual rate of 0.50% of the Fund’s daily average net assets. The Manager may be reimbursed for fee waivers and/or expense limitation payments made in any fiscal year of the Fund over the following three fiscal years. Any reimbursement is subject to the Board’s review and approval. A reimbursement may be requested by the Manager if the aggregate amount paid by the Fund for operating expenses for such fiscal year, taking into account any reimbursement, does not exceed the fee waiver/expense limitation in place at the time of the initial waiver or reimbursement of the amount by the Manager. For the fiscal year ended November 30, 2012, the Manager may request reimbursement of up to the following:

 

For the period ended November 30, 2010, expiring November 30, 2013:

   $ 1,033,925   

For the period ended November 30, 2011, expiring November 30, 2014:

     1,399,457   

For the period ended November 30, 2012, expiring November 30, 2015:

     249,582   
  

 

 

 
   $ 2,682,964   
  

 

 

 

The Manager earned $2,827,600 from the Fund for its services during the fiscal year ended November 30, 2012. The Manager waived $249,582 of the amount of the management fees earned from the Fund.

Certain Directors and Officers of the Fund are also Members and Officers of the Manager or its affiliates.

Note 4. Investments

For the fiscal year ended November 30, 2012, aggregated purchases and sales of investment securities other than short-term investments were as follows:

 

  Purchases  

       Sales
$19,904,952      $163,007,821

Note 5. Tax Matters

Federal Income Taxes: The Fund intends to qualify each year as a “Regulated Investment Company” under Subchapter M of the Internal Revenue Code of 1986, as amended. By so qualifying, the Fund will not be subject to federal income taxes to the extent that it distributes all of its net investment income and any realized capital gains.

 

18


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

For U.S. federal income tax purposes, the cost of securities owned, gross unrealized appreciation, gross unrealized depreciation, and net unrealized depreciation of investments at November 30, 2012 were as follows:

 

        Cost        

  

Gross Unrealized

  Appreciation  

    

Gross Unrealized

  Depreciation  

    

Net Unrealized

  Depreciation  

$268,914,646

   $7,534,818      $(24,525,311)      $(16,990,493)

There were no differences between book basis and tax basis.

The Fund’s tax basis capital gains are determined at the end of each fiscal year. As of November 30, 2012, the components of distributable earnings on a tax basis were as follows:

 

Accumulated Capital Loss Carryforwards

   $ (9,198,335)   

Undistributed Ordinary Income*

     4,666,003   

Net Unrealized Depreciation on Investments and Foreign Currency Related Transactions

     (16,990,493)   
  

 

 

 

Total

   $ (21,522,825)   
  

 

 

 

*  Inclusive of short-term capital gain

  

At November 30, 2012, the Fund had net capital loss carryforwards for federal income tax purposes of $282,275 which are available to reduce future required distributions of net capital gains to shareholders through 2019. The Fund has $8,916,060 of short-term capital losses to carryforward indefinitely.

Under the Regulated Investment Company Modernization Act of 2010, capital losses originating in taxable years beginning after December 22, 2010 (“post-enactment capital losses”) are carried forward indefinitely. In addition, these losses must be utilized prior to the losses incurred in pre-enactment taxable years. Furthermore, post-enactment capital losses will retain their character as either short-term or long-term capital losses rather than being considered all short-term capital losses as under previous law.

The Manager has analyzed the Fund’s tax positions taken on federal income tax returns for all open tax years (current and prior three tax years) and has concluded that there are no uncertain tax positions that require recognition of a tax liability. The Fund’s federal and state income and federal excise tax returns for tax years for which the applicable statutes of limitations have not expired (the current year and the prior year) are subject to examination by the Internal Revenue Service and state departments of revenue.

Note 6. Dividends and Distributions to Shareholders

Ordinary income and capital gain distributions are determined in accordance with federal income tax regulations, which may differ from U.S. GAAP.

The tax character of dividends and distributions paid by the Fund were as follows:

 

     For the
Fiscal Year Ended
November 30, 2012
        For the
Fiscal Year Ended
November 30, 2011

Dividends and Distributions paid from:

        

Ordinary Income*

   $26,792,196       $26,068,485
  

 

     

 

 

*

  Inclusive of short-term capital gains

 

19


THE FAIRHOLME FOCUSED INCOME FUND

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

The Fund declared and made payable the following distribution on December 28, 2012.

 

Dividends and Distributions paid from:

  

Ordinary Income

   $ 6,178,709   

Note 7. Indemnifications

Under the Company’s organizational documents, its Officers and Directors are indemnified against certain liabilities arising out of the performance of their duties to the Fund. In the normal course of business the Company or the Fund enter into contracts that contain a variety of representations and customary indemnifications. The Fund’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Fund that have not yet occurred. However, based on its experience to date, the Fund expects the risk of loss to be remote.

 

20


 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the Board of Directors of Fairholme Funds, Inc. and

the shareholders of The Fairholme Focused Income Fund:

We have audited the accompanying statement of assets and liabilities, including the schedule of investments, of The Fairholme Focused Income Fund (the “Fund”), as of November 30, 2012, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the periods presented. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. The Fund is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of November 30, 2012, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of The Fairholme Focused Income Fund as of November 30, 2012, the results of its operations, the changes in its net assets, and the financial highlights for each of the periods presented, in conformity with accounting principles generally accepted in the United States of America.

DELOITTE & TOUCHE LLP

Philadelphia, Pennsylvania

January 29, 2013

 

21


THE FAIRHOLME FOCUSED INCOME FUND

 

 

ADDITIONAL INFORMATION

November 30, 2012

 

 

Board of Directors (unaudited)

The Board of Directors has overall responsibility for conduct of the Company’s affairs. The day-to-day operations of the Fund are managed by the Manager, subject to the By-Laws of the Company and review by the Company’s Board. The Directors and Officers of the Company, including those Directors who are also officers, are listed below.

 

Name, Age

& Address†

  

Position(s)

Held

with the

Company

       

Term of Office

& Length of

Time Served**

            

Principal

Occupation(s)

During Past

5 Years§

       

Number

of

Portfolios

in Fund

Complex

Overseen

by

Director

       

Other Current

Directorships

Held by

Director

Interested Directors and Officers

Bruce R. Berkowitz*

Age 54

  

Director,

President

       Mr. Berkowitz has served as a Director of the Company since December 15, 1999.            Managing Member, Fairholme Capital Management, LLC since October 1997.        3        Director and Chairman of the Board of Directors, The St. Joe Co.

Cesar L. Alvarez, Esq.*

Age 65

   Director        Mr. Alvarez has served as a Director of the Company since May 19, 2008.            Executive Chairman of Greenberg Traurig, LLP since 2010; Chief Executive Officer of Greenberg Traurig, LLP from October 1997 to 2010.        3        Chairman, Board of Directors, Mednax, Inc.; Co-Leading Director, Watsco, Inc.; Vice Chairman, Knight Foundation; Director, The St. Joe Co.

Independent Directors^

Terry L. Baxter

Age 67

   Director        Mr. Baxter has served as a Director of the Company since May 19, 2008.            Chairman of the Board, CEO, Source One (retired); President of White Mountain Holdings (retired).        3        Director, Main Street America Group

Howard S. Frank

Age 71

   Director        Mr. Frank has served as a Director of the Company since May 7, 2007.            Vice Chairman, Chief Operating Officer and Director, Carnival Corporation & plc.        3        Director, Steamship Mutual Trust; Director, New World Symphony; Director, The St. Joe Co.

Avivith Oppenheim, Esq.

Age 62

   Director        Ms. Oppenheim has served as a Director of the Company since December 15, 1999.            Attorney-at-Law.        3        None.

Leigh Walters, Esq.

Age 66

   Director        Mr. Walters has served as a Director of the Company since December 15, 1999.            Vice-President and Director, Valcor Engineering Corporation. Attorney-at-Law.        3        Director, Valcor Engineering Corporation

 

  †

Unless otherwise indicated, the address of each Director of the Company is c/o Fairholme Capital Management, LLC, 4400 Biscayne Blvd., 9th Floor, Miami, FL 33137.

 

  ^

Directors who are not “interested persons” of the Company as defined under the 1940 Act.

 

  *

Mr. Berkowitz and Mr. Alvarez are each an interested person, as defined in the 1940 Act, of the Company because of their affiliation with the Manager.

 

**

Each Director serves for an indefinite term. Each officer serves for an annual term and until his or her successor is elected and qualified.

 

  §

The information reported includes the principal occupation during the last five years for each Director and other information relating to the professional experiences, attributes and skills relevant to each Director’s qualifications to serve as Director.

 

22


THE FAIRHOLME FOCUSED INCOME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

Officers (unaudited)

 

Name, Age & Address†                       

Position(s) Held with

the Company

                      

Term of Office &

Length of Time Served*

                      

Principal Occupation(s)

During Past 5 Years

    

Fred Fraenkel

Age 63^

                   Vice President                    Mr. Fraenkel has served as Vice President of the Company since January 2013.                    Chief Research Officer, Fairholme Capital Management, L.L.C. since October 2011; Vice Chairman Beacon Trust Company from 2008 to 2011; Chairman of Milennium 3 Capital from 2000 to 2008.    

Wayne Kellner

Age 43

                   Treasurer                    Mr. Kellner has served as Treasurer of the Company since March 2012.                    Chief Financial Officer, Fairholme Capital Management, L.L.C. since January 2012; Treasurer, Fairholme Capital Management, L.L.C. from January 2011 to December 2011; Tax Principal, Rothstein Kass from 2006 to 2010.    

Paul R. Thomson

Age 56

                   Chief Compliance Officer and Secretary                    Mr. Thomson has served as Chief Compliance Officer of the Company since April 2010 and has served as Secretary since June 2011. Mr. Thomson previously served as Chief Compliance Officer from November 2008 to January 2009.                    Chief Compliance Officer, Fairholme Capital Management LLC since April 2010; Chief Financial Officer, Fairholme Capital Management LLC from January 2008 to January 2012; Managing Director and former Chief Financial Officer of Colliers- Seeley, Inc. from 2004 to February 2007.    

 

Unless otherwise indicated, the address of each Officer of the Company is c/o Fairholme Capital Management, LLC, 4400 Biscayne Blvd., 9th Floor, Miami, FL 33137.

 

*

Each officer serves for an annual term and until his or her successor is elected and qualified.

 

^

Fred Fraenkel was elected Vice President in January 2013 and thus did not serve as an officer of the Company during the period covered by this report.

 

23


THE FAIRHOLME FOCUSED INCOME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

Approval of Investment Management Agreement (unaudited)

At its meeting on October 18, 2012, the Board of Directors of Fairholme Funds, Inc. (the “Company”) approved the renewal of the investment management agreement between the Company, on behalf of The Fairholme Focused Income Fund (the “Fund”), and Fairholme Capital Management, L.L.C. (the “Manager”). In considering whether to approve the renewal of the agreement, the Directors considered the factors discussed below, and information made available to them at the meeting relating to such factors, and other information they deemed relevant. The renewal of the agreement was not, however, based on any single factor, but on an evaluation of the totality of factors and information reviewed and evaluated by the Directors.

A. Nature, Extent and Quality of Services

The Directors considered information provided to them concerning the nature, extent and quality of investment advisory and operational services provided or overseen by the Manager. The Directors reviewed information concerning the personnel responsible for the day-to-day portfolio and administrative management of the Fund, the overall reputation of the Manager, and the Manager’s current and planned staffing levels. The Directors considered information concerning the Manager’s commitment to the Fund as evidenced by the current share ownership in the Fund by management/owners of the Manager. The Directors considered information describing the Manager’s compliance policies and procedures, including policies designed to address the Fund’s compliance with its investment objective, policies and restrictions and applicable regulatory requirements and to address the Manager’s conflicts of interest in providing services to the Fund and to other advisory clients.

The Directors did not compare the services provided by the Manager to the Fund with the services provided by the Manager to certain of its other advisory accounts, as such accounts are not subject to the same regulatory requirements as the Fund, may have different investment restrictions, holdings and goals than the Fund, and require different levels of client and back-office servicing than the Fund.

The Directors concluded that the nature, extent and quality of services provided by the Manager to the Fund was appropriate and sufficient to support renewal of the agreement.

B. Investment Performance

The Directors considered information regarding the Fund’s performance, the Manager’s views on performance and the holdings of the Fund that contributed negatively and positively to the Fund’s performance. The Directors also considered a third party report comparing the Fund’s investment performance with the investment performance of similarly situated mutual funds. The report for the Fund reflected the performance of the Fund and the similarly situated mutual funds for the six-month, 1-year and since Fund inception periods ended August 31, 2012.

C. Management Fee and Expense Ratio

The Directors considered information concerning the Fund’s management fee and expense ratio, including a third party report comparing the Fund’s management fee and most recent expense ratio to the advisory fees and expense ratios of other similarly situated mutual funds. The Directors noted that the Fund’s management fee covers many of the operating and other expenses of the Fund. The Directors noted that the expense ratio of the Fund, with and without fee waivers that existed through the end of March 2012, was lower than the median expense ratio of the peer group funds included in the third party report.

In evaluating the management fee and expense ratio information, the Directors took into account the demands and complexity of portfolio management for the Fund in light of its investment objective and strategies and asset size. They also considered information regarding the Manager’s payment (in some cases from its resources) of certain expenses for the benefit of the Fund, including distribution expenses and account-level expenses associated with certain omnibus accounts. The Directors also reviewed information concerning the fees paid to the Manager by its other advisory accounts.

After reviewing information presented to them concerning fees, expenses, performance and other matters, the Directors concluded that the Fund’s management fee and expense ratio were reasonable in light of the services provided by or through the Manager.

 

24


THE FAIRHOLME FOCUSED INCOME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

D. Profitability

The Directors considered information regarding the estimated profitability of the Fund to the Manager. They considered such profitability in light of the Fund’s asset level, overall expense ratio, performance and the services provided by or through the Manager. The Directors concluded that the Manager’s estimated profitability was not such as to prevent them from approving the renewal of the agreement.

E. Economies of Scale

The Directors considered information concerning economies of scale for the Fund, including the Fund’s current assets. The Directors concluded Fund that no modification to the Fund’s existing arrangements was warranted based on economies of scale.

Proxy Voting Policies, Procedures and Records (unaudited)

The Company has adopted policies and procedures that provide guidance and set forth parameters for the voting of proxies relating to securities held in the Fund’s portfolio. A description of these policies and procedures, and records of how the Fund voted proxies relating to their portfolio securities during the most recent twelve month period ended June 30, 2012, are available to you upon request and free of charge by writing to the Fairholme Funds, Inc., c/o BNY Mellon Investment Servicing (US) Inc., P.O. Box 9692, Providence, RI, 02940 or by calling Shareholder Services at 1-866-202-2263 or by visiting our website at www.fairholmefunds.com. They may also be obtained by visiting the Securities and Exchange Commission (“SEC”) website at www.sec.gov. The Company shall respond to all shareholder requests for records within three business days of its receipt of such request by first-class mail or other means designed to ensure prompt delivery.

N-Q Filing (unaudited)

The Company files a complete schedule of the Fund’s portfolio holdings on Form N-Q for the fiscal quarters ending February 28 (February 29 during leap year) and August 31. The Form N-Q filing must be made within 60 days of the end of the quarter. The Forms N-Q relating to the Fund’s portfolio investments are available on the SEC’s website at www.sec.gov, or may be reviewed and copied at the SEC’s Public Reference Room in Washington, DC (call 1-800-732-0330 for information on the operation of the Public Reference Room).

 

25


THE FAIRHOLME FOCUSED INCOME FUND

 

 

ADDITIONAL INFORMATION (continued)

November 30, 2012

 

 

Shareholder Tax Information (unaudited)

The Fund reported $26,792,196 of total distributions paid during the fiscal year ended November 30, 2012, as ordinary income distributions.

The information below is reported for the Fund’s fiscal year and not calendar year. Therefore, shareholders should refer to their Form 1099-DIV or other tax information which will be mailed in 2013 to determine the calendar year amounts to be included on their 2012 tax returns. Shareholders should consult their own tax advisors.

Please note that, for the fiscal year ended November 30, 2012, the respective percentages of ordinary income distributions paid by the Fund were reported as follows:

 

Distribution Period November 30, 2012

   The Fund

Qualified Dividend Income for Individuals

       3.26 %

Dividends Qualifying for the Dividends Received Deduction for Corporations

       1.83 %

Qualifying Interest Income

       91.00 %

U.S. Treasury Securities

       0.05 %*

* The law varies in each state as to whether and what percentage of dividend income attributable to U.S. Treasury securities is exempt from state and local income tax. It is recommended that you consult your tax advisor to determine if any portion of the dividends you received is exempt from income taxes.

 

 

All information reported is based on financial information available as of the date of this annual report and, accordingly, are subject to change. For each item, it is the intention of the Fund to report the maximum amount permitted under the Internal Revenue Code and the regulations thereunder.

 

26


LOGO

OFFICERS OF FAIRHOLME FUNDS, INC.

Bruce R. Berkowitz

PRESIDENT

Fred Fraenkel

VICE PRESIDENT

Wayne Kellner

TREASURER

Paul R. Thomson

CHIEF COMPLIANCE OFFICER & SECRETARY

BOARD OF DIRECTORS OF FAIRHOLME FUNDS, INC.

Cesar L. Alvarez, Esq.

Terry L. Baxter

Bruce R. Berkowitz

Howard S. Frank

Avivith Oppenheim, Esq.

Leigh Walters, Esq.

Investment Manager

FAIRHOLME CAPITAL MANAGEMENT, L.L.C.

4400 Biscayne Boulevard

Miami, FL 33137

Transfer Agent, Fund Accountant and Administrator

BNY MELLON INVESTMENT SERVICING (US) INC.

760 Moore Road

King of Prussia, PA 19406

Custodian

THE BANK OF NEW YORK MELLON

1 Wall Street

New York, NY 10286

Independent Registered Public Accounting Firm

DELOITTE & TOUCHE LLP

1700 Market Street

Philadelphia, PA 19103

Legal Counsel

SEWARD & KISSEL LLP

901 K Street NW

Washington, DC 20001

THIS REPORT IS PROVIDED FOR THE GENERAL INFORMATION OF THE SHAREHOLDERS OF FAIRHOLME FUNDS, INC. IT IS NOT INTENDED FOR DISTRIBUTION TO PROSPECTIVE INVESTORS IN THE FUNDS UNLESS PRECEDED OR ACCOMPANIED BY AN EFFECTIVE PROSPECTUS, WHICH CONTAINS MORE INFORMATION ON FEES, CHARGES AND OTHER EXPENSES AND SHOULD BE READ CAREFULLY BEFORE INVESTING OR SENDING MONEY. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. SHARES OF THE FUNDS ARE DISTRIBUTED BY FAIRHOLME DISTRIBUTORS, LLC.


FAIRHOLME

Ignore the crowd.

 

 

 

The Fairholme Allocation Fund (FAAFX)

Seeking long-term total return

ANNUAL REPORT 2012

MANAGED BY FAIRHOLME CAPITAL MANAGEMENT

1.866.202.2263  fairholmefunds.com


THE FAIRHOLME ALLOCATION FUND

 

 

 

TABLE OF CONTENTS

November 30, 2012

 

 

 

     Page  

FUND PERFORMANCE

     3     

MANAGEMENT DISCUSSION & ANALYSIS REPORT

     4     

EXPENSE EXAMPLE

     7     

SCHEDULE OF INVESTMENTS

     8     

STATEMENT OF ASSETS & LIABILITIES

     10     

STATEMENT OF OPERATIONS

     11     

STATEMENTS OF CHANGES IN NET ASSETS

     12     

FINANCIAL HIGHLIGHTS

     13     

NOTES TO FINANCIAL STATEMENTS

     14     

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

     20     

ADDITIONAL INFORMATION

     21     

 

2


THE FAIRHOLME ALLOCATION FUND

 

 

 

FUND PERFORMANCE (Unaudited)

Inception through November 30, 2012

 

 

THE FAIRHOLME ALLOCATION FUND VS. THE BARCLAYS CAPITAL U.S.

AGGREGATE BOND INDEX AND THE S&P 500 INDEX

INITIAL MINIMUM INVESTMENT OF $25,000

 

LOGO

The Fairholme Allocation Fund (the “Fund”) commenced operations on December 31, 2010. The chart above presents the performance of a $25,000 investment from inception to the latest fiscal year end ended November 30, 2012.

The following notes pertain to the chart above as well as to the performance table included in the Management Discussion & Analysis Report. Performance information in this report represents past performance and is not a guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate, so that an investor’s shares when redeemed may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted within. The performance information does not reflect the taxes an investor would pay on Fund distributions or upon redemption of the Fund shares. Any questions you have regarding the data current to the most recent month-end performance can be obtained by calling Shareholder Services at 1-866-202-2263.

Data for the Barclays Capital U.S. Aggregate Bond Index, the S&P 500 Index and the Fund are presented assuming all dividends and distributions have been reinvested and do not reflect any taxes that might have been incurred by a shareholder as a result of the Fund distributions. The Barclays Capital U.S. Aggregate Bond Index is an unmanaged market-weighted index comprised of investment grade corporate bonds (rated BBB or better), mortgages, and U.S. Treasury and government agency issues with at least one year to maturity. The S&P 500 Index is a widely recognized, unmanaged index of 500 of the largest companies in the United States as measured by market capitalization and does not reflect any investment management fees or transaction expenses, nor the effects of taxes, fees, or other charges.

 

3


THE FAIRHOLME ALLOCATION FUND

 

 

 

MANAGEMENT DISCUSSION & ANALYSIS

For the Fiscal Year Ended November 30, 2012

 

 

The Fairholme Allocation Fund (the “Fund”) shares outstanding and audited net asset value per share (“NAV”) at November 30, 2012, the end of the Fund’s fiscal year, and NAVs at other pertinent dates, were as follows:

 

     11/30/2012
Shares
Outstanding
   11/30/2012
NAV
(audited)
   05/31/2012
NAV
(unaudited)
   11/30/2011
NAV
(audited)

Fund

   27,375,754    $9.33    $8.74    $8.29

At December 31, 2012, the unaudited NAV of the Fund was $9.36. Performance figures below are shown for the Fund’s fiscal year ended November 30, 2012, and do not match calendar year figures for the period ended December 31, 2012, cited in the Portfolio Manager’s report.

 

     Six
Months
    One
Year
    Since
Inception
12/31/2010
 

Cumulative:

      

Fund

     6.75     12.55     (6.70 )% 

S&P 500

     9.32     16.13     17.38

Barclays Bond Index

     1.99     5.51     12.55

Annualized:

      

Fund

       12.55     (3.55 )% 

S&P 500

       16.13     8.72

Barclays Bond Index

       5.51     6.36

For the six months ended November 30, 2012, the Fund outperformed the Barclays Capital U.S. Aggregate Bond Index (“Barclays Bond Index”) by 4.76 percentage points and was outperformed by the S&P 500 Index (“S&P 500”) by 2.57 percentage points while over the last year the Fund outperformed the Barclays Bond Index by 7.04 percentage points and was outperformed by the S&P 500 by 3.58 percentage points. From inception, the Barclays Bond Index and S&P 500 outperformed the Fund by 9.91 and 12.27 percentage points per annum, respectively, or on a cumulative basis 19.25 and 24.08 percentage points over one year and eleven months, respectively.

Fairholme Capital Management, L.L.C. (the “Manager”) believes continuing economic recovery contributed to overall performance. However, the fact that securities increase or decline in value does not always indicate that the Manager believes these securities to be more or less or attractive — in fact, the Manager believes that some price increases present selling opportunities and some price declines present buying opportunities. Shareholders are also cautioned that it is possible that some securities mentioned in this discussion may no longer be held by the Fund subsequent to the end of the fiscal period and that the Fund may have made significant new purchases that are not yet required to be disclosed. It is the Fund’s general policy not to disclose portfolio holdings other than when required by relevant law or regulation. Portfolio holdings are subject to change without notice.

Not all Fund portfolio dispositions or additions are material, and, while the Fund and the Manager have long-term objectives, it is possible that a security sold or purchased in one period will be purchased or sold in a subsequent period. Generally, the Manager determines to buy and sell based on its estimates of the absolute and relative intrinsic values and fundamental dynamics of a particular security and its underlying corporation and its industry. However, certain strategies of the Manager in carrying out Fund policies may result in shorter holding periods.

In the opinion of the Manager, performance over shorter periods is likely to be less meaningful than over longer periods. Investors are cautioned not to rely on short-term results. Further, shareholders should note that the S&P 500 and the Barclays Bond Index are unmanaged indices incurring no fees, expenses, or tax effects and are shown solely to compare Fund performance to that of an unmanaged and diversified index.

 

4


THE FAIRHOLME ALLOCATION FUND

 

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

 

The Manager invests Fund assets in securities to the extent it finds reasonable investment opportunities in accordance with its Prospectus and may invest a significant portion of Fund assets in liquid, low-risk securities or cash. The Manager views liquidity as a strategic advantage. At November 30, 2012, cash and cash equivalents (consisting of cash, commercial paper, deposit accounts, U.S. Treasury Bills, and money-market funds) represented 18.0% of total assets. Since inception, the Fund has held liquid, low-risk securities or cash for periods without, in the Manager’s view, negatively influencing performance, although there is no guarantee that future performance will not be negatively affected by Fund liquidity.

The Fund is considered to be “non-diversified” under the Investment Company Act of 1940. The Fund can invest a greater percentage of assets in fewer securities than a diversified fund and may invest a significant portion of cash and liquid assets in one or more risky securities at any time, particularly in situations where markets are weak or a particular security declines sharply. The Fund may also have a greater percentage of assets invested in a particular industry than a diversified fund, exposing the Fund to the risk of an unanticipated industry condition as well as risks specific to a single company or security. The following charts show the top holdings by issuer and sector in descending order of net assets as of November 30, 2012.

 

The Fairholme Allocation Fund

Top Ten Holdings by Issuer*

(% of Net Assets)

          

 

The Fairholme Allocation Fund

Top Sectors

(% of Net Assets)

       
     

MBIA, Inc.

     26.0%           Surety Insurance      26.0%   

American International Group, Inc.

     12.8%           Cash and Cash Equivalents**      18.0%   

Bank of America Corp.

     9.1%           Diversified Banks      17.2%   

Sears Holdings Corp.

     7.8%           Multi-Line Insurance      15.4%   

Imperial Metals Corp.

     7.6%           Retail Department Stores      8.7%   

Leucadia National Corp.

     5.6%           Metals & Mining      7.6%   

Wells Fargo & Co.

     4.9%           Diversified Holding Companies      5.6%   

JPMorgan Chase & Co.

     3.1%           

The Hartford Financial Services Group, Inc.

     2.6%           

Sears Canada, Inc.

     0.9%           
    

 

 

       

 

 

 
       80.4%            98.5%   
    

 

 

       

 

 

 
     
                        

  * Excludes cash, U.S. Treasury Bills, and money market funds.

** Includes cash, U.S. Treasury Bills, and money market funds.

The Manager views the ability to focus on fewer investments than a diversified fund as a strategic advantage. However, since inception, such a strategy has negatively influenced short-term performance and there is no guarantee that future performance will not be negatively affected.

The Fund may invest in non-U.S. securities and securities of corporations domiciled outside of the United States which may expose the Fund to adverse changes resulting from foreign currency fluctuations or other potential risks as described in the Fund’s Statement of Additional Information.

The Fund’s Officers, the Board of Directors (the “Board” or the “Directors”) and Manager are aware that large cash inflows or outflows may adversely affect Fund performance. Such flows are monitored and appropriate actions are contemplated for when such flows could negatively impact performance.

Since inception, the Fund has been advised by the Manager. Mr. Berkowitz, both the Managing Member of the Manager and Chairman of the Fund’s Board, continues to have a significant personal stake in the Fund, holding an aggregate 9,202,191 shares at November 30, 2012. While there is no requirement that the Manager own shares of the Fund, such holdings are believed to help align shareholder interests.

 

5


THE FAIRHOLME ALLOCATION FUND

 

 

 

MANAGEMENT DISCUSSION & ANALYSIS (continued)

For the Fiscal Year Ended November 30, 2012

 

 

 

Independent Fund Directors continue to believe that it is in the best interests of the Fund to have Mr. Berkowitz serve as Chairman of the Board given: his long-term relative performance; his experience, commitment, and significant personal investment in the Fund; the present constitution of Directors and policies; and current rules and regulations. Certain Directors and Officers of the Fund are also Officers of the Manager. Nevertheless, at November 30, 2012, a majority of Directors were independent of the Manager, no stock option or restricted stock plans exist, Officers received no direct compensation from the Fund, and Directors affiliated with the Manager received no compensation for being Directors.

For more complete information about the Fund, or to obtain a current Prospectus, please visit www.fairholmefunds.com or call Shareholder Services at 1-866-202-2263.

 

6


THE FAIRHOLME ALLOCATION FUND

 

 

 

EXPENSE EXAMPLE

For the Six Month Period from June 1, 2012

through November 30, 2012 (unaudited)

 

 

As a Fund shareholder, you incur direct and indirect costs. Direct costs include, but are not limited to, transaction fees at some broker-dealers, custodial fees for retirement accounts, redemption fees on Fund shares redeemed within 60 days of purchase, and wire transfer fees. You also incur indirect, ongoing costs that include, but are not limited to, management fees paid to the Manager.

The following example is intended to help you understand your indirect costs (also referred to as “ongoing costs” and measured in dollars) when investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds. This example is based on an investment of $1,000 invested in the Fund at June 1, 2012, and held for the entire six month period ending November 30, 2012.

Actual Expenses

The first line of the table below provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you had invested at the beginning of the period, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During the Period” to estimate the expenses you paid on your Fund holdings during this period.

Hypothetical Example for Comparison Purposes

The second line of the table provides information about hypothetical account values and hypothetical expenses based on the Fund’s actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund’s actual return for the period presented. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses that you paid for the period presented. However, you may use this information to compare ongoing costs of investing in the Fund with the ongoing costs of investing in other funds. To do so, compare this 5% hypothetical example with the 5% examples that appear in the shareholder reports of other funds.

Please note that the column titled “Expenses Paid During the Period” in the table below is meant to highlight your ongoing costs only and do not reflect any transactional costs, such as redemption fees (if any), or other direct costs. Therefore, the second line of the table is useful in comparing ongoing costs only, and will not help you determine the relative total costs of owning different funds. In addition, if these direct costs were included, your total costs would be higher.

 

     Beginning
Account Value
June 1, 2012
   Ending
Account Value
November 30, 2012
   Annualized
Expense
Ratio
   Expenses Paid
During the Period
June 1, 2012
Through
November 30, 2012*

Fund

           

Actual

   $1,000.00    $1,067.50    1.00%    $5.17

Hypothetical

           

(5% return before expenses)

   $1,000.00    $1,020.00    1.00%    $5.05
                     

 

*

Expenses are equal to the Fund’s annualized expense ratio, multiplied by the average account value over the period, multiplied by 183 days/366 days (to reflect the one-half year period).

 

7


THE FAIRHOLME ALLOCATION FUND

 

 

 

SCHEDULE OF INVESTMENTS

November 30, 2012

 

 

 

Shares

          Value  
  

DOMESTIC EQUITY SECURITIES — 49.4%

  
  

DIVERSIFIED HOLDING COMPANIES — 5.6%

  
  642,100      

    Leucadia National Corp.

   $     14,222,515   
     

 

 

 
  

MULTI-LINE INSURANCE — 10.0%

  
  772,900      

    American International Group, Inc. (a)

     25,606,177   
     

 

 

 
  

RETAIL DEPARTMENT STORES — 7.8%

  
  472,100      

    Sears Holdings Corp.

     19,832,921   
     

 

 

 
  

SPECIALTY RETAIL-HOME IMPROVEMENT — 0.0%

  
  8,070      

    Orchard Supply Hardware Stores Corp., Class A (a)

     62,546   
     

 

 

 
  

SURETY INSURANCE — 26.0%

  
  7,437,900      

    MBIA, Inc. (a)

     66,494,826   
     

 

 

 

 
 

TOTAL DOMESTIC EQUITY SECURITIES
(COST $131,263,684)

       126,218,985   
     

 

 

 
  

FOREIGN EQUITY SECURITIES — 8.5%

  
  

CANADA — 8.5%

  
  

METALS & MINING — 7.6%

  
  1,536,500      

    Imperial Metals Corp. (a)

     19,520,441   
     

 

 

 
  

RETAIL DEPARTMENT STORES — 0.9%

  
  202,201      

    Sears Canada, Inc. (a)

     2,269,634   
     

 

 

 

 
 

TOTAL FOREIGN EQUITY SECURITIES
(COST $22,381,449)

     21,790,075   
     

 

 

 
  

WARRANTS — 22.6%

  
  

DIVERSIFIED BANKS — 17.2%

  
  5,570,428      

    Bank of America Corp.,

        Vested, Strike Price $13.30,

            Expire 01/16/2019 (a)(b)

     23,340,093   
  718,000      

    JPMorgan Chase & Co.,

        Vested, Strike Price $42.42,

            Expire 10/28/2018 (a)(b)

     8,005,700   

Shares

          Value  
  1,349,565      

    Wells Fargo & Co.,

        Vested, Strike Price $34.01,

            Expire 10/28/2018 (a)(b)

   $   12,456,485   
     

 

 

 
        43,802,278   
     

 

 

 
  

MULTI-LINE INSURANCE — 5.4%

  
  507,515      

    American International Group, Inc.,

        Vested, Strike Price $45.00,

            Expire 01/19/2021  (a)(b)

     7,054,459   
  524,400      

    Hartford Financial Services Group, Inc.,

        Vested, Strike Price $9.622,

            Expire 06/26/2019 (a)(b)

     6,722,808   
     

 

 

 
        13,777,267   
     

 

 

 

 
 

TOTAL WARRANTS
(COST $47,197,197)

     57,579,545   
     

 

 

 
  Principal         
  

U.S. GOVERNMENT OBLIGATIONS — 3.9%

  
  $10,000,000      

    U.S. Treasury Bills 0.176%,

        05/30/2013 (c)

     9,993,580   
     

 

 

 

 
 
 

TOTAL U.S. GOVERNMENT
OBLIGATIONS

(COST $9,991,200)

     9,993,580   
     

 

 

 
  Shares         
  

MONEY MARKET FUNDS — 14.1%

  
  36,068,221      

    Fidelity Institutional Money

        Market Funds—Money

            Market Portfolio, 0.180% (d)

     36,068,221   
     

 

 

 

 
 

TOTAL MONEY MARKET FUNDS
(COST $36,068,221)

     36,068,221   
     

 

 

 
     
  

MISCELLANEOUS INVESTMENTS — 1.6%(e)

  

 

    (COST $3,533, 481)

     3,957,836   
     

 

 

 
 

 

The accompanying notes are an integral part of the financial statements.

 

8


THE FAIRHOLME ALLOCATION FUND

 

 

 

SCHEDULE OF INVESTMENTS (continued)

November 30, 2012

 

 

 

          Value  

TOTAL INVESTMENTS — 100.1%
(COST $250,435,232)

   $ 255,608,242   
  

LIABILITIES IN EXCESS OF OTHER ASSETS — (0.1)%

     (178,150
     

 

 

 

NET ASSETS — 100.0%

   $ 255,430,092   
     

 

 

 
 

 

(a) 

Non-income producing security.

(b) 

Warrants have terms and conditions based on dividends paid and other events that may lower the strike price and raise the shares per warrant conversion ratio. Reported strike prices and conversion ratios are as of the date of this report. All share-to-warrant conversion ratios are currently 1:1.

(c) 

Rates shown are the effective yields based on the purchase price. The calculation assumes the security is held to maturity.

(d) 

Annualized based on the 1-day yield as of November 30, 2012.

(e) 

Represents previously undisclosed unrestricted securities, which the Fund has held for less than one year.

The accompanying notes are an integral part of the financial statements.

 

9


THE FAIRHOLME ALLOCATION FUND

 

 

 

STATEMENT OF ASSETS & LIABILITIES

November 30, 2012

 

 

 

Assets

  

Investments, at Fair Value (Cost — $250,435,232)

   $ 255,608,242   

Receivable for Capital Shares Sold

     26,258   

Dividends and Interest Receivable

     4,206   
  

 

 

 

Total Assets

     255,638,706   
  

 

 

 

Liabilities

  

Accrued Management Fees

     208,614   
  

 

 

 

Total Liabilities

     208,614   
  

 

 

 

NET ASSETS

   $ 255,430,092   
  

 

 

 

Net Assets Consist of:

  

Paid-In-Capital

   $ 264,321,723   

Accumulated Net Investment Income

     1,507,246   

Net Accumulated Realized Loss on Investments and

Foreign Currency Related Transactions

     (15,571,887

Net Unrealized Appreciation on Investments and

Foreign Currency Related Translations

     5,173,010   
  

 

 

 

NET ASSETS

   $ 255,430,092   
  

 

 

 

Shares of Common Stock Outstanding* ($0.0001 par value)

     27,375,754   
  

 

 

 

Net Asset Value, Offering and Redemption Price Per Share

($255,430,092 / 27,375,754 shares)

   $ 9.33   
  

 

 

 

 

*

200,000,000 shares authorized in total.

 

 

 

The accompanying notes are an integral part of the financial statements.

 

10


THE FAIRHOLME ALLOCATION FUND

 

 

 

STATEMENT OF OPERATIONS

 

 

 

     For the
Fiscal Year Ended
November 30, 2012
 

Investment Income

  

Interest

     $  1,044,027   

Dividends

     3,476,606   
  

 

 

 

Total Investment Income

     4,520,633   
  

 

 

 

Expenses

  

Management Fees

     2,727,767   
  

 

 

 

Less: Management Fees Waiver

     (225,673
  

 

 

 

Net Expenses

     2,502,094   
  

 

 

 

Net Investment Income

     2,018,539   
  

 

 

 

Realized and Unrealized Gain on Investments and

Foreign Currency Related Transactions

  

Net Realized Gain on Investments

     13,442   

Net Change in Unrealized Appreciation on Investments and

Foreign Currency Related Translations

     28,126,159   
  

 

 

 

Net Realized and Unrealized Gain on Investments and

Foreign Currency Related Transactions

     28,139,601   
  

 

 

 

NET INCREASE IN NET ASSETS FROM OPERATIONS

     $30,158,140   
  

 

 

 

 

 

 

 

The accompanying notes are an integral part of the financial statements.

 

11


THE FAIRHOLME ALLOCATION FUND

 

 

 

STATEMENTS OF CHANGES IN NET ASSETS

 

 

 

     For the
Fiscal Year Ended
November 30, 2012
    For the
Period Ended
November 30, 2011(1)
 

CHANGES IN NET ASSETS

    

From Operations

    

Net Investment Income (Loss)

   $ 2,018,539      $ (511,267

Net Realized Gain (Loss) on Investments and

Foreign Currency Related Transactions

     13,442        (15,585,355

Net Change in Unrealized Appreciation (Depreciation) on Investments and Foreign Currency Related Translations

     28,126,159        (22,953,149
  

 

 

   

 

 

 

Net Increase (Decrease) in Net Assets from Operations

     30,158,140        (39,049,771
  

 

 

   

 

 

 

From Capital Share Transactions

    

Proceeds from Sale of Shares

     112,096,144        308,704,162   

Redemption Fees

     18,631        71,160   

Cost of Shares Redeemed

     (98,964,733     (57,603,641
  

 

 

   

 

 

 

Net Increase in Net Assets from Shareholder Activity

     13,150,042        251,171,681   
  

 

 

   

 

 

 

NET ASSETS

    

Net Increase in Net Assets

     43,308,182        212,121,910   

Net Assets at Beginning of Period

     212,121,910          
  

 

 

   

 

 

 

Net Assets at End of Period

   $ 255,430,092      $ 212,121,910   
  

 

 

   

 

 

 

Accumulated Net Investment Income (Loss) at End of Period

   $ 1,507,246      $ (511,293
  

 

 

   

 

 

 

SHARES TRANSACTIONS

    

Issued

     12,081,277        32,332,438   

Redeemed

     (10,289,046     (6,748,915
  

 

 

   

 

 

 

Net Increase in Shares

     1,792,231        25,583,523   

Shares Outstanding at Beginning of Period

     25,583,523          
  

 

 

   

 

 

 

Shares Outstanding at End of Period

     27,375,754        25,583,523   
  

 

 

   

 

 

 

 

(1) 

The Fund commenced operations on December 31, 2010.

 

 

 

The accompanying notes are an integral part of the financial statements.

 

12


THE FAIRHOLME ALLOCATION FUND

 

 

 

FINANCIAL HIGHLIGHTS

 

 

 

     For the
Fiscal Year Ended
November 30, 2012
    For the Period
Ended
November 30, 2011(1)
 

PER SHARE OPERATING PERFORMANCE

    

NET ASSET VALUE, BEGINNING OF PERIOD

     $8.29        $10.00   
  

 

 

   

 

 

 

Investment Operations

    

Net Investment Income (Loss)(2)

     0.07        (0.02

Net Realized and Unrealized Gain (Loss)on Investments

     0.97        (1.69
  

 

 

   

 

 

 

Total from Investment Operations

     1.04        (1.71
  

 

 

   

 

 

 

Redemption Fees(2)

     0.00 (3)      0.00 (3) 
  

 

 

   

 

 

 

NET ASSET VALUE, END OF PERIOD

     $9.33        $8.29   
  

 

 

   

 

 

 

TOTAL RETURN

     12.55     (17.10 )%(4) 

Ratio/Supplemental Data

    

Net Assets, End of Period (in 000’s)

     $255,430        $212,122   

Ratio of Expenses to Average Net Assets:

    

Before Expenses Waived

     1.00     1.00 %(5) 

After Expenses Waived

     0.92     0.75 %(5) 

Ratio of Net Investment Income (Loss) to Average Net Assets

     0.74     (0.30 )%(5) 

Portfolio Turnover Rate

     26.96     41.60 %(4) 

 

(1) 

The Fund commenced operations on December 31, 2010.

(2) 

Based on average shares outstanding.

(3) 

Redemption fees represent less than $0.01.

(4) 

Not Annualized.

(5) 

Annualized.

The accompanying notes are an integral part of the financial statements.

 

13


THE FAIRHOLME ALLOCATION FUND

 

 

 

NOTES TO FINANCIAL STATEMENTS

November 30, 2012

 

 

Note 1. Organization

Fairholme Funds, Inc. (the “Company”), a Maryland corporation, is registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as an open-end management investment company. The Company’s Articles of Incorporation permit the Board of Directors of the Company (the “Board” or the “Directors”) to issue 1,100,000,000 shares of common stock at $.0001 par value. 200,000,000 shares have been allocated to The Fairholme Allocation Fund (the “Fund”). The Fund is a non-diversified fund. The Fund may have a greater percentage of its assets invested in particular securities than a diversified fund, exposing the Fund to the risk of unanticipated industry conditions as well as risks specific to a single company or the securities of a single company. The Board has the power to designate one or more separate and distinct series and/or classes of shares of common stock and to classify or reclassify any unissued shares with respect to such series.

The Fund’s investment objective is to seek long-term total return. Under normal circumstances, the Fund seeks to achieve its investment objective by investing opportunistically in a focused portfolio of investments in the equity, fixed-income and cash, and cash-equivalent asset classes. The proportion of the Fund’s portfolio invested in each asset class will vary from time to time based on Fairholme Capital Management, L.L.C.’s (the “Manager”) assessment of relative fundamental values of securities and other investments in the asset class, the attractiveness of investment opportunities within each asset class, general market and economic conditions, and expected future returns of other investment opportunities. The Fund seeks to capitalize on anticipated fluctuations in the financial markets by changing the mix of its holdings in the targeted asset classes. The Fund may maintain a significant portion of its total assets in cash and securities generally considered to be cash equivalents. The Manager serves as investment adviser to the Fund.

There is no guarantee that the Fund will meet its objective.

Note 2. Significant Accounting Policies

The Fund’s investments are reported at fair value as defined by Accounting Principles Generally Accepted in the United States of America (“U.S. GAAP”). The Fund generally determines its net asset value as of approximately 4:00 p.m. Eastern Time each day the New York Stock Exchange is open.

A description of the valuation techniques applied to the Fund’s securities measured at fair value on a recurring basis follows:

Security Valuation:

Equity securities (common and preferred stocks): Securities traded on a national securities exchange or reported on the NASDAQ national market are generally valued at the official closing price, or at the last reported sale price on the exchange or market on which the securities are traded, as of the close of business on the day the securities are being valued or, lacking any sales, at the last available bid price. To the extent these securities are actively traded and valuation adjustments are not applied, they are classified in Level 1 of the fair value hierarchy. If these securities are not actively traded, they are classified in Level 2. The Manager may also employ other valuation methods which the Manager believes would provide a more accurate indication of fair value. In these situations, if the inputs are observable, the valuation will be classified in Level 2 of the fair value hierarchy, otherwise they would be classified in Level 3.

Fixed-income securities (U.S. government obligations, corporate bonds, convertible bonds, and asset backed securities): The fair value of fixed-income securities is estimated using market quotations when readily available, but may also be estimated by various methods when no such market quotations exist and when the Manager believes these other methods reflect the fair value of such securities. These methods may consider recently executed transactions in securities of the issuer or comparable issuers and market price valuations from independent pricing services and/or brokers (where observable). Where the Manager deems it appropriate to do so (such as when independent prices are unavailable or not deemed to be representative of fair value) fixed-income securities will be fair valued in good faith. As of November 30, 2012, fixed-income securities are valued by the Manager utilizing valuations from independent pricing services. Although fixed-income securities are classified in Level 2 of the fair value hierarchy at November 30, 2012, in instances where lower relative weight is placed on transaction prices, quotations, or similar observable inputs, they would be classified in Level 3.

 

14


THE FAIRHOLME ALLOCATION FUND

 

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

 

Open-end mutual funds: Investments in open-end mutual funds including money market funds are valued at their closing net asset value each business day and are classified in Level 1 of the fair value hierarchy.

Short-term securities: Investments in securities with maturities of less than sixty days when acquired or long-term securities, which are within sixty days of maturity are estimated by using the amortized cost method of valuation, which the Manager and the Board have determined will approximate fair value. To the extent the inputs are observable and timely, the values would be classified in Level 2 of the fair value hierarchy.

Restricted securities: Depending on the relative significance of valuation inputs, these instruments may be classified in either Level 2 or Level 3 of the fair value hierarchy.

Warrants: The Fund may invest in warrants, which may be acquired either through a direct purchase, included as part of a private placement, or pursuant to corporate actions. Warrants entitle, but do not obligate, the holder to buy equity securities at a specific price for a specific period of time. Warrants may be considered more speculative than certain other types of investments in that they do not entitle a holder to dividends or voting rights with respect to the underlying securities that may be purchased nor do they represent any rights in the assets of the issuing company. Also, the value of a warrant does not necessarily change with the value of the underlying securities and a warrant ceases to have value if it is not exercised prior to its expiration date. Warrants traded on a security exchange are valued at the official closing price on the valuation date and are classified as Level 1 of the fair value hierarchy. Over the counter (OTC) warrants are valued using simulation models utilizing market value of the underlying security, expiration date of the warrants, volatility of the underlying security, strike price of the warrants, risk-free interest rate at the valuation date, and are classified as Level 2 or Level 3 of the fair value hierarchy depending on the observability of the inputs used.

The Fund uses several recognized industry third-party pricing services (TPPS) - approved by the Board and unaffiliated with the Manager - to value some of its securities. It also uses other independent market trade data sources (such as TRACE, the FINRA-developed mandatory reporting of over-the-counter secondary market transactions), as well as broker quotes provided by market makers of securities not valued by these and other TPPS. The data within these feeds is ultimately sourced from major stock exchanges and trading systems where these securities trade. If a price obtained from the pricing source is deemed unreliable, prices will be sought from another pricing service or from a broker/dealer that trades that security or similar securities.

The Manager may determine the fair valuation of a security when market quotations are insufficient or not readily available, when securities are determined to be illiquid or restricted, or when in the judgment of the Manager the prices or values available do not represent the fair value of the instrument. Factors which may cause the Manager to make such a judgment include the following: (a) only a bid price or an asked price is available; (b) the spread between bid and asked prices is substantial; (c) the liquidity of the securities; (d) the frequency of sales; (e) the thinness of the market; (f) the size of reported trades; (g) actions of the securities markets, such as the suspension or limitation of trading; and (h) bona fide bids or offers made to the Manager by independent third parties. Among the factors to be considered to fair value a security are recent prices of comparable securities that are publicly traded, reliable prices of securities not publicly traded, the use of valuation models, current analyst reports, valuing the income or cash flow of the issuer, or cost if the preceding factors do not apply. The circumstances of Level 3 securities are frequently monitored to determine if fair valuation measures continue to apply.

The Manager reports quarterly to the Board the results of the application of fair valuation policies and procedures.

The inputs and valuation techniques used to measure fair value of the Fund’s investments are summarized into three levels as described in the hierarchy below:

 

  Level 1     quoted prices in active markets for identical securities;
  Level 2     other significant observable inputs (including quoted prices for similar securities, quoted prices in inactive markets for identical securities, interest rates, prepayment speeds, credit risk, etc.); and

 

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THE FAIRHOLME ALLOCATION FUND

 

 

 

NOTES TO FINANCIAL STATEMENTS (continued)

November 30, 2012

 

 

 

  Level 3     significant unobservable inputs (including the Manager’s determination as to the fair value of investments).

The inputs or methodology used for valuing investments are not necessarily an indication of the risk associated with investing in those investments. The summary of the Fund’s investments by inputs used to value the Fund’s investments as of November 30, 2012 is as follows:

 

     Valuation Inputs              
     Level 1 –
Quoted Prices
          Level 2 – Other
Significant
Observable Inputs
          Total
Fair Value
at 11/30/2012
 

ASSETS:

              

INVESTMENTS (Fair Value):

              

Domestic Equity Securities*

   $ 126,218,985          $          $ 126,218,985   

Foreign Equity Securities*

     21,790,075                       21,790,075   

Warrants*

     57,579,545