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John Burbank of Passport Capital – Explanation for His Gold Investments

September 12, 2010 | About:

I’ve been following Burbank and Passport Capital for a few years since first learning of him being one of the few investors to earn huge returns from the housing market collapse.

Burbank came to investing a little differently than most hedge fund managers. He didn’t start investing until the age of 30 and his start was financed by $50,000 in credit card debt. Of that $50,000 he quickly almost lost all of it through an investment in a fad biotech stock. That experience quickly taught him that serious investing takes a lot of homework and patience.

After managing to scrounge together $800,000 from friends and getting office space from a former boss Burbank started Passport Capital in August 2000. Incredibly, that $800,000 of assets under management is now closer to $4 billion.

I think Burbank is an independent thinker who one should follow closely. Not to mimic his investment moves necessarily but to understand his reasoning behind making those decisions. Passport runs a fairly concentrated portfolio, so anything Burbank commits to is done with a lot of thinking behind it.

Here is his thinking on Physical Gold that he outlined in January of this year:

Our Rationale for Investing in Physical Gold

• We remain constructive on gold as a long-term investment. There are several trends in place that we believe are supportive of a higher gold price.

• The demand outlook for gold is favorable in our opinion. The long-term risk of inflation is widely appreciated, and we believe this will support strong investment demand for the foreseeable future. We believe jewelry demand in India will return, perhaps at lower volumes, when price volatility subsides. China will continue to gain strength as a market for jewelry for years to come.

• We believe the supply outlook for gold is also supportive of higher prices. We believe that mined supply, which peaked in 2001, is in a long-term downward trend. We feel that the ability of above-ground gold stocks to satisfy demand is undergoing structural change, and markets may be overestimating their ability to satisfy an increase in demand at current gold prices.

• We believe 2009 will mark an important shift in central banks’ behavior in the gold market, as they emerge as a net source of demand – not supply – for the first time in over two decades. An attempt by central banks collectively to affect even a slight shift in their gold holdings as a percentage of their overall reserves could have a powerful impact on prices. The potential impact of such a change on the gold market should not be underestimated.

• We believe the paper-based process that discovers the price of gold may understate its true value. If the price of gold is being understated, rational behavior for investors would be to buy and hoard the metal. We believe this is happening, as investors increasingly purchase physical gold and take it off the market.

• A situation potentially unfolding in the gold market is similar to a short squeeze on a stock. As short sellers depress the price of the stock by shorting the stock naked, buyers may take advantage of the mispricing and start accumulating the stock. Eventually, enough stock will have gravitated to a few hands so that the remaining free float is not sufficient to cover the borrowing needs of short sellers setting the stage for a price spike. We believe that gold is susceptible to a similar squeeze as the metal gravitates to investors who have little intention of lending or selling it at current prices, and central banks step back from the market as a provider of liquidity.

• Holders of paper-based instruments that derive value from gold may not realize expected gains in the event of such a squeeze. To profit from such an event we believe investors must be positioned to deliver physical gold into the market. The Hunt brothers’ squeeze on the silver market three decades ago is an interesting parallel in history that suggests a physical squeeze on a precious metals market is possible, and that exchanges may change rules to protect the stability of markets in ways that do not necessarily benefit those holding futures positions.

• Given our bullish view on gold, combined with the possibility that the price discovery process for gold understates the metal’s value and leaves it susceptible to a short squeeze, Passport Capital is an owner of allocated, physical gold.

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