Citigroup shares: No longer toxic?

NEW YORK (Fortune) -- Yes, Citigroup lost billions in the financial crisis. And yes, it's still swimming in toxic assets. But Bruce Berkowitz argues the worst is over.

Berkowitz, who manages the $11 billion Fairholme fund and was recently named Morningstar's U.S. stock manager of the past decade, recently bought more than $700 million worth of Citi (C, Fortune 500) shares.

In an interview with Fortune, Berkowitz said Citi's balance sheet is slowly improving. He calculates that even its bad assets now return more than 5%."People are so focused on the liabilities," he says, "that they've potentially forgotten about some of the assets."

Citi also has some of its highest capital ratios in years after the U.S. Treasury and other regulators thoroughly examined its balance sheet. Citi's widely followed Tier 1 capital ratio, an important measure of the bank's ability to absorb losses, was 11.7% at the end of 2009. That's up from about 7% in 2007, before the economic crisis.

Yet, as Berkowitz argues, shares remain cheap.

The stock trades at 0.8 times tangible book value, which doesn't include goodwill or other intangibles like intellectual property. That's almost half the ratio of its peers. "The price is right," Berkowitz says. "It's just a question of when it becomes obvious to everyone that the worst is over."

Other smart money has recently been speculating on the stock. Hedge fund legend George Soros bought nearly 100 million shares in the fourth quarter of 2009; John Paulson of Paulson & Co. added more than 200 million shares; and Daniel Loeb's Third Point bought shares worth $83 million.

For the short term, it's difficult to argue that Citi's problems are gone. The bank lost $7.6 billion in the last quarter and announced that it's still working to sell off $547 billion in bad assets.

But Berkowitz says investors can't ignore the Treasury's move to allow Citi to repay its Troubled Asset Relief Program (TARP) funds. "The only way the government was going to allow repayment was if they thought the bank was recapitalized," he says.

With what he calls the "government's Good Housekeeping seal," Berkowitz thinks Citi shareholders no longer face large losses from hidden toxic assets. It also decreases the odds that Citi will need more capital from large stock offerings that dilute existing shares. (Citigroup is now the most widely held U.S. stock, with 28 billion shares outstanding.)

Berkowitz has had a stellar stock-picking record in the past ten years. His Fairholme fund has posted gains of 13.2% a year on average for the past decade. The value-oriented manager made bets on energy up until oil's fall in 2008. He also presciently avoided financials for several years before the meltdown because many of their holdings didn't make sense to him.

If his call is correct, it wouldn't be the first time Berkowitz has profited from a bank crisis. In the late 1980s, he bought Wells Fargo after the bank had made bad bets on risky real estate loans in California. The stock gained more than 400% from 1990 to 1997.

Berkowitz says it took him longer to buy bank stocks after the most recent crisis because Citi and others held so many opaque derivatives. Now he feels comfortable that regulators and Citi have at least identified the bad assets, and the bank is working to sell them.

"It's unclear to me how much our shareholders are going to make," says Berkowitz, "but it's becoming quite clear to me they're not going to lose."