I finally got a copy of Passport Capital’s Q3 investor letter. Burbank is a hedge fund manager that I find extremely interesting. He has gone from virtually nothing 10 years ago to managing a multi-billion dollar fund (about $5 billion I think) thanks to his great vision on the credit crisis.
And his record is terrific. Up 23% annualized since August 2000 vs basically no positive return for the overall stock market. The funny thing about investing though, is you have to wonder if his great call on the mortgage bubble was a one-off and whether he can outperform going forward.
As you would expect Burbank still has some very interesting thoughts. Here is what I found to be interesting in his latest communication to shareholders:
- He has the fund positioned 95% long and 39% short with the largest long exposures in basic materials (13%) and consumer (12%).
- He holds 12 private equity investments that make up about 5% of the two funds.
- The funds are not concentrated with 129 long positions and 78 short positions
The top ten long positions were as follows:
RANK COMPANY TICKER % NAV
1 Riversdale Mining Ltd. RIV AU 10%
2 Microsoft Corp. MSFT US 4%
3 Exxon Mobil Corp. XOM US 4%
4 Las Vegas Sands Corp. LVS US 3%
5 Financial Technologies Ltd. FTECH IS 2%
6 Tarpon Investimentos TRPN3 BZ 2%
7 CF Industries Holdings Inc. CF US 2%
8 Wendy's / Arby's Group WEN US 2%
9 Labrador Iron Mines LIM CN 2%
10 Jordan Phosphate Mines JOPH JR 2%
And some commentary on the larger positions:
Riversdale continues to be our largest holding and represents approximately 10% of Fund NAV. Riversdale was unchanged for the quarter at $10.45 AUD per share. The company has a market capitalization of $2.5 billion AUD and holds about $560 million AUD in cash.
As reported last quarter, Riversdale signed a Memorandum of Understanding with Wuhan Iron and Steel, a Chinese steelmaker, valuing their 100%-owned Zambeze project, with coal resources of 9 billion tonnes, at $2 billion USD.
Together with the company’s cash, this equates to a per-share valuation of approximately $10.85 AUD. Importantly, this ascribes no value to the Benga project (65% owned by Riversdale with resources of 4 billion tonnes and reserves of 500 million tonnes) or the potential for other licenses in the region. We expect the Wuhan Iron and Steel deal should close during the fourth quarter.
In advance of the anticipated closing of the Wuhan deal, the company completed a $337 million AUD equity raise in July. This was done to accelerate production for the Benga project, which in production is anticipated to deliver 6 million tonnes of hard coking coal and 4 million tonnes of thermal coal. Such production would make Benga one of the largest coking coal mines in the world.
Physical gold comprised 8% of Fund NAV at quarter end. The Fund holds 100,000 ounces in Zurich. Gold began the quarter at $1,242 per ounce and finished up +5% at $1,308. The third quarter began with gold in a bit of a free fall as speculative buyers began liquidating; strong physical demand out of India, however, helped to stabilize the price.
During the quarter, central banks remained active with their purchasing: Russia 57 tonnes, Thailand 15 tonnes, Philippines 11 tonnes, and Bangladesh 10 tonnes. The International Monetary Fund sold 60 tonnes during this past quarter and now owns fewer than 100 tonnes of gold available for sale, down from just over 400 tonnes as of September of last year.
A potential distorting force in the quarter came from AngloGold, a major South African gold producer, covering their hedge positions. AngloGold announced on September 14th that it would raise nearly $1.4 billion to combine with cash on hand and available credit facilities to buy over 2 million ounces in the market. We had been wary of the potential impact of AngloGold’s hedging activities, and delta hedged our entire gold position shortly after the announcement.
We believe that the bigger picture now is that another gold mining company has capitulated, choosing to no longer protect itself from possible future declines in the price of gold. We believe the recent correction in gold will be relatively shallow due to the significant buying interest on the sidelines. We remain bullish on gold longer term.
Recently, we have begun adding certain large-cap, multinational stocks to our portfolio. These are the same stocks that we largely avoided for the last ten years. What has changed? For one, many such companies have dividend yields of greater than 3% and “earnings yields” of 6–9%. Compared to “riskfree” 10-year Treasuries (yielding 2.5% at quarter end), these are quite appealing. While these companies’ future earnings and dividends are uncertain, we think they are very likely to rise over time given strong franchises (predictable pricing and market share) and meaningful exposures to faster growing emerging markets.
We have sought out companies we believe are characterized by strong management teams, powerful competitive moats, healthy balance sheets, predictable cash flows, and healthy growth prospects.
Two such companies in our top ten holdings are Exxon (4% of Fund NAV) and Microsoft (4%). Exxon yields 2.8% and Microsoft yields 2.6%, and, after paying these dividends, both companies have plenty of retained earnings to repurchase shares and acquire assets. The U.S. 10-year Treasury yield has fallen from 2.9% to 2.5% during the quarter, making the case for high-yielding equities ever stronger.
Exxon traded close to $90 in April and May of 2008; it fell to the mid-$50s this past June, largely as a result of the Gulf oil disaster. During the quarter, Microsoft increased its dividend and set a record for corporate bond yields, issuing 5-year debt at 1.6%. We feel that with Microsoft’s stock delivering a 9% earnings yield, the market is offering an attractive arbitrage.
In a year where fixed income has been the big winner, we are on the lookout for a meaningful equity rally that pushes well beyond the recent range and beyond most investors’ expectations. We could imagine Exxon and Microsoft’s gaining 20% to 25% and remaining comfortable longs at those higher levels.
Fertilizers (4% of Fund NAV) sold off significantly in May along with other commodities after China’s tightening and the financial tumult in Europe. At that point, most fertilizer stocks were trading at historically low P/E ratios, and we believed that “risk-off” liquidations of equities, especially commodity equities, played too great a role. We focused on the coincidence of lower corn prices and the expected end of the inventory cycle to identify a compelling point at which to increase positions in Mosaic and CF Industries. BHP’s surprise bid for PotashCorp was a helpful event, and, more recently, the idea of quantitative easing has driven the dollar down and commodity stocks up. We exited Mosaic with gains of approximately $10 million for the quarter, while CF Industries provided profits of more than $20 million over the same period.
QE2: Getting There Is Half the Fun
Our analysis of markets has prompted fears that we may be suffering from a split personality disorder: we find ourselves agonizing over deflation in the Western world even as we fret over inflationary fears in emerging markets. On the deflationary side, yields on U.S. Treasuries are flirting with the lowest levels in history. Bank lending has been flat for two years, while consumer credit has collapsed. Jobs continue to be scarce, with unemployment levels threatening double digits. The U.S. economy remains weak, despite massive stimulus and a ballooning balance sheet, and similar problems exist in Japan and Europe.
In the emerging markets, however, a different story surfaces. In countries like China, Brazil,and India, debt levels are moderate, demographics are attractive, and economic growth remains strong.
In China, for example, GDP growth will approach 10% this year despite recent policy tightening. Rising investment and consumption spending, along with inflation of food, energy, commodity, and labor prices, dominate the headlines in China. This global dichotomy has led to extreme uncertainty, and we have responded with a more tactical approach to managing the portfolio. Recently, markets have begun to anticipate the Federal Reserve’s potential purchase of its first (and maybe second) trillion worth of Treasuries, and have once again started to discount the effects of inflation.
A second round of quantitative easing, or “QE2,” as it has become known, has gone from a distinct possibility to a near certainty in our view. As many of you are aware, the Federal Reserve has a dual mandate: to maintain both maximum employment and price stability (i.e., control inflation).
But the ability of the Federal Reserve to influence the real economy is fundamentally limited. The Fed’s ultimate power lies in its authority to set interest rates and to create money. With the fed funds rate in a target range of 0.0% to 0.25%, the Fed can only loosen by creating money and using it to buy financial assets.
These purchases put money into the banking system which can theoretically be lent to prospective borrowers, and that reinvestment should stimulate the economy. When the Fed next meets on Nov. 2nd and 3rd, we expect the continuing streams of weak economic data to compel it to begin QE2 after midterm elections.
Markets seem largely to agree: in recent weeks, Treasuries, stocks, gold, and commodities have rallied while the dollar has fallen somewhat. The yield on the 10-year U.S. Treasury has dropped from 3% at the beginning of the third quarter to 2.5% in recent weeks. For widely discussed reasons, we believe that current yields do not make logical sense on a long-term basis. Low yields will likely cause investors seeking higher returns to shift their portfolios into riskier, less-liquid assets like gold, commodities, global equities, and emerging market currencies.
The Fed would watch this process with hopes of “reflexivity” in the real economy.
Already, foreign flows into Brazil’s real led its Finance Minister Mantega, in October, to declare an “international currency war” and raise taxes on foreign capital inflows to prevent the real’s appreciation. Mantega said he thinks the USD is the world's biggest distortion in the FX market, even more than China. We would not be surprised to see more capital controls announced unilaterally given the vulnerability of exports and sensitivity of local inflation to foreign capital flows. Ironically, the Fed’s actions may lead to what should have happened some time ago: emerging world currencies rising against their Western world counterparts. This has yet to happen—primarily due to liquidity, risk aversion, and the U.S. dollar’s waning reserve-currency status—yet we view it as inevitable over the longer term.