Oxstones Investment Club™By Edward Robinson, Bloomberg,
As a hedge-fund manager who thrives on turbulence in the commodities markets, John Burbank couldn’t have done better than the first week of May.
The prices of oil, metals and other raw materials nose- dived the most in two years as investors retreated from emerging markets amid surging inflation in China and India and political upheaval sweeping through the Middle East and North Africa. For Burbank, the founder and chief investment officer of San Francisco-based Passport Capital LLC, the sell-off is an opportunity. He’s looking to add to the heavy bets he’s made in the frontier market of Saudi Arabia, Bloomberg Markets magazine reports in its July issue.
The Saudi monarchy’s decision to roll tanks into neighboring Bahrain to help quell an uprising — as well as the rebellions in Libya and Syria — may give some investors pause. Not Burbank, a hedge-fund manager who made his name by earning a 220 percent net return in 2007 after shorting subprime mortgages.
He sees little chance that the Saudi regime will be overthrown or that crude prices will collapse. As the insular kingdom opens up to foreign investors — it didn’t permit outsiders to buy Saudi stocks until 2008 — Burbank says now is the time to plow into the country’s petroleum-rich economy.
He’s acquiring stakes in publicly traded petrochemical companies, banks, construction firms and even health-care providers. The Saudi investments made up about 11 percent of Passport’s $2.1 billion flagship fund, Global Strategy, as of May.
Unorthodox Methods
“The crisis isn’t affecting the long-term reality that this is where the oil is,” says Burbank, 47, a beefy man with a full beard who looks more like a longshoreman than an elite money manager. “We want exposure to the Saudi economy because the prices are very cheap and there’s going to be a lot of growth and higher returns on capital, and that’s something that’s likely to play out over a number of years.”
Burbank’s Saudi trade is right in character for a money manager with a knack for using unorthodox methods to exploit the globe’s scarcity of raw materials. While the commodities market’s two-year rally skidded in the second quarter — crude dropped almost 15 percent and silver shed 28 percent from April 28 to May 9 — Burbank says the ongoing development of emerging economies will convert little-known raw material producers into money machines for years to come.
Prospecting Skills
Burbank has little interest in trading commodities themselves, which are subject to price distortions as speculators move in and out of markets. Instead, he wants to make a 10-fold return on his investments by purchasing equity in undervalued companies such as oil tanker operators that are poised to grow as long as demand for raw materials steadily rises.
That often involves unearthing small firms that discover mother lodes of highly sought resources, ranging from potash in Kazakhstan to coking coal in Mozambique.
Passport’s investors have profited from Burbank’s prospecting skills. The Global Strategy fund has delivered an annualized 23.6 percent net return since its inception in August 2000, according to data obtained from Passport investors. The HFRX Global Hedge Fund Index gained 4.3 percent in that span, and the Standard & Poor’s 500 Index rose 0.6 percent.
Burbank is racing to beat multinational companies in Australia, China and India that are hunting for new sources of ore, metals and minerals. Passport reaps big dividends when these large players purchase the output of one of the hedge fund’s companies or, even better, the entire enterprise itself.
138 Percent Return
In 2007, Passport started buying shares in Riversdale Mining Ltd. (RIV), an Australian firm developing deposits in Mozambique of coking coal to be used in making steel. Last year, Riversdale was Passport’s No. 1 holding, even though it had yet to mine any coal from the find in Mozambique and lost $799 million.
Burbank’s gamble paid off when Melbourne-based Rio Tinto Ltd. (RIO) made a $3.4 billion bid for Riversdale on Dec. 6 and later increased it to $4 billion. Riversdale shares soared 138 percent in 2010 and helped lift Global Strategy to an 18.2 percent performance after fees. Passport sold most of its shares to Rio Tinto in the first quarter. In early May, Rio Tinto held 73 percent of Riversdale and planned to delist the company.
Burbank, a somewhat rumpled man who shuns neckties and suits in favor of fleece vests and chinos, has long contended our era will be defined by the acute shortage of resources and the decline of debt-strapped economies in the U.S. and Europe.
Underestimated Damage
“I believe the West is bankrupt and failing and it’s just a question of when,” he intoned in his baritone voice to more than 1,700 attendees at the SkyBridge Alternatives Conference for hedge-fund investors in Las Vegas on May 12.
Burbank’s investment record and outspokenness have won him respect from peers who see him emerging as an elite name in hedge funds.
“He’s an original thinker, and he’s got guts,” says Kyle Bass, founder of Hayman Capital Management LP in Dallas, who was at the conference.
Even so, Passport investors have been whipsawed at times during the past decade. In 2008, Burbank almost lost his firm after he underestimated how much damage the global credit crunch would inflict on emerging-market stocks. Confident his long-term bullishness on commodities producers would be rewarded, he added shares of raw materials companies even as investors exited such positions in August and September.
Hybrid Approach
“Had we been even more imaginative about the economic crisis that the financial crisis would beget, we would have sold more broadly,” Burbank wrote to his clients in February 2009. “We were too eager to buy companies at levels we thought were attractive.” His fund plunged 51 percent in 2008, more than twice as bad as the HFRX Index’s 23 percent swoon.
“Most funds down that much don’t survive,” says Don Steinbrugge, a managing partner at Agecroft Partners LLC, a Richmond, Virginia-based consulting firm that advises investors in hedge funds. “Passport does take very big bets, and when you invest with them you have to understand that their performance is going to be volatile.”
Passport, which has $4.6 billion in total assets under management, follows a hybrid approach that weds Burbank’s macroeconomic analysis with old-fashioned, value-driven stock picking. While the firm invests in an array of industries and markets — Apple Inc. (AAPL) and brewer Anheuser-Busch InBev NV (ABI) have been top 10 holdings in the six months ended on May 9 — more than 40 percent of Global Strategy’s exposure was in commodities producers and energy as of March 31.
“Never Happened Before”
Passport dispatches its 41 managers and analysts around the world for weeks at a time to size up investments. Burbank himself led a team to Mongolia in March to scrutinize opportunities in the resource-rich country. Passport’s trading floor, located in a loftlike space near San Francisco’s Chinatown district, resembles a high school science lab. Lumps of coal, nickel and other metals and minerals are strewn on desks, and posters depicting the geology of Africa and Australia are tacked to the walls.
By analyzing supply and demand data for raw materials, Passport tries to anticipate which natural resources will experience price swings once considered unthinkable, from oil going to $140 per barrel in 2008 to the sky-high prices this year for coking coal.
“We’re looking for things that have never happened before,” Burbank says. “That’s my strategy for producing high compounded returns. You’d rather have something that goes up 10 times than just doubles.”
Enormous Risk
Burbank’s strategy faces a crucial test this year. After pouring capital into China, Brazil and other developing economies in 2009 and 2010, investors reversed course this year and pulled more than $7.7 billion from emerging-market equity funds through June 7, according to Emerging Portfolio Fund Research Inc. in Cambridge, Massachusetts.
Prices of food, energy and other consumer goods jumped 5.4 percent in China in March, exceeding Beijing’s full-year target for the third consecutive month. Central bankers there and in India are ratcheting up interest rates to curb inflation, which may dampen economic growth in two of the world’s biggest buyers of natural resources.
If the Bank of China revalues the renminbi to fight inflation as well, the commodities markets could suffer a major correction and hurt investors holding large illiquid positions in raw materials producers.
“There is enormous risk in that posture,” says Peter Rup, chief investment officer of New York-based Artemis Wealth Advisors LLC. “I have taken all of my clients out of China, India and Brazil.”
Fleeing Commodities
Passport’s Global Strategy fund is up a net 0.8 percent this year through April 30 compared with a 9 percent return by the S&P 500, according to a report sent to investors. Burbank says the end of the Federal Reserve’s program for purchasing $600 billion in Treasuries, known as quantitative easing, or QE2, could spur more investors to flee commodities- related securities this year. The fund manager says the program, which expires on June 30, weakened the dollar and prompted investors to pile into commodities to hedge greenback-linked inflation.
Nouriel Roubini, the chairman of Roubini Global Economics who gained fame by predicting the global credit crisis, disagrees with Burbank’s analysis. Roubini says near-zero interest rates in the U.S. will continue to undermine the dollar and spur investors to buy commodities and other hedges.
“I don’t think the end of QE2 is going to have a major impact on the financial markets,” Roubini says.
Liquidity Shock
Since May, Burbank has been trimming and hedging his raw materials-linked holdings, allocating 10 to 20 percent of Global Strategy’s net asset value to cash, according to Passport investors. “You don’t want to be overinvested in commodities during a liquidity shock,” Burbank says. He plans to swoop in and buy his favorite stocks at distressed prices once the market bottoms out.
“John’s an outlier,” says Jamie Knall, a managing director at Stifel, Nicolaus & Co. in Indianapolis, a money management firm that has invested $100 million with Passport on behalf of wealthy clients. “When his own fundamental analysis is telling him one thing but the mainstream is saying another, that’s when he sniffs an opportunity.”
Burbank grew up in New Haven, Connecticut, surrounded by books. His father, John, is a retired Russian and Slavic literature scholar who translated Pushkin and taught at Shady Side Academy in Pittsburgh and other prestigious private secondary schools. Burbank studied English literature at Duke University in North Carolina and worked his way through college by running a house-painting business during the summers.
Backpacking Through Africa
After graduating in 1987, he set off for Ningbo, a port city south of Shanghai. China’s statist economy was just beginning to open to capitalism, and Burbank was in awe of the country’s scale and potential. “It put in context how much I didn’t know about the world,” Burbank says.
He flirted with film school before seeking an MBA at Stanford University near Palo Alto. There, he met Jim Cunningham, an American born in Mexico City who’d already earned degrees in economics and food research. Following Burbank’s graduation in 1992, the two friends spent the summer backpacking through Egypt, Kenya and Tanzania. Back in San Francisco, Burbank took a job in 1996 as research director at a tiny hedge fund called ValueVest Management LLC that concentrated on emerging markets. His pay: $1,000 a month.
First Big Score
Burbank found it strange to be combing the developing world for undervalued industrial stocks when all around him the dot- com boom was minting unprecedented wealth. In 1998, he came up with his own tech trade: Softbank Corp., a Tokyo-based investment firm that held stakes in Yahoo! Inc. and its Japanese unit and other Internet companies.
He calculated that Softbank was valued at the same level as its equity in Yahoo and U.S. website provider GeoCities, which meant its stock was trading at a deep discount just as the Internet frenzy was hitting Japan.
While ValueVest chose not to put on the trade, Burbank told everyone he knew to pile into Softbank shares. He invested $5,000, all the cash he had, in November 1998. During the next 15 months, his stake multiplied more than 30 times as Softbank’s stock skyrocketed, according to Bloomberg data.
That was Burbank’s first big score, and it taught him that markets can utterly fail to efficiently price assets poised to make a historic move. The key, as Burbank puts it, is to discern when a market’s “structural reality” is about to shift and then find undervalued equities to ride the move.
“Aha Moment”
With that strategy in mind, Burbank set up Passport in a one-room office in a San Francisco high-rise in early 2000. He had $800,000 in capital and one analyst, a chatty former ValueVest intern named Walther Lovato. Burbank concentrated on an industry that had been moribund for 14 years: energy. With the exception of a spike after Iraq invaded Kuwait in 1990, West Texas crude had languished at an average $21.22 a barrel from 1983 to 2000.
Burbank figured that if demand were to suddenly jump, oil- related equities had nowhere to go but up, especially because the global industry had slowed the addition of new refineries or major fields in that period.
“Just because there is a higher price, they can’t easily produce more,” Burbank says. “Understanding the real nature of this led me to the aha moment.”
By the second quarter of 2002, Burbank and Lovato, 44, had converted that view into investments in oil tanker stocks. Plagued by the fixed costs of operating massive vessels, tanker companies were ignored by most investors, Lovato says.
“Absolute Killing”
He found some trading at only a third of the liquidation value of their ships. Yet he and Burbank bet that tanker stocks would rise if refiners were forced to order more supply from the Middle Eastern oil fields to meet an uptick in demand; shutting down a plant wasn’t an option.
“You can make an absolute killing because your customer needs what you have and will pay any price for it,” Lovato says.
In 2003, China’s increased thirst for oil and the U.S. invasion of Iraq spurred a bull market for crude. Rates for tankers spiked to $250,000 a day in 2004 from as low as $7,000 a day in 2002. Shares of Bermuda-based Frontline Ltd., a tanker operator that Passport had invested in, quadrupled in value from Jan. 1, 2002, to Dec. 31, 2004. The tanker trade helped the Global Strategy fund gain 59 percent cumulatively in 2003 and 2004.
Weak Link
Burbank’s old traveling companion Cunningham quit a job managing money at Renberg Capital Management Inc. in Beverly Hills, California, and joined Passport in 2003 to oversee its metals investing and set up an agriculture strategy.
The two friends believed that growth in China and India would stimulate demand for copper, iron ore and other metals to build power plants, airports and highways. Many positions in basic materials were in relatively illiquid private and public companies that would be hard to sell if the commodities markets took a hit.
In November 2005, Burbank put a hedge in place to cushion such a blow. Mortgage debt in the U.S. had ballooned about eightfold to $1.4 trillion in 2005 from $181 billion in 1995, according to the Federal Reserve. If a global credit crunch struck, Burbank was sure investors would cease buying subprime mortgages, bringing America’s housing party to an abrupt end.
“This huge liquidity coming into the U.S. would be curtailed, and it would show up in the weak link in U.S. financials, which was mortgages,” he says.
$370 Million Payday
To profit from that possibility, Burbank invested in a funky instrument known as a subprime-mortgage credit-default swap — a CDS that insured the holder against a loss in a pool of high-risk mortgage bonds. The trade was cheap: Passport paid only a one to two percentage point annual premium on the notional amount of the bonds in 2005 and 2006, which it was entitled to collect should the debt holders default.
In 2007, Passport’s swaps paid off when foreclosures on subprime mortgages soared. And its long positions in raw materials producers delivered too, as China’s insatiable demand drove up commodities prices. Burbank personally pocketed $370 million that year.
Emboldened, Burbank dug even deeper into the obscure precincts of the commodities markets. He and Cunningham focused on coking coal, which steelmakers use to smelt iron ore in blast furnaces. Global steel production had increased more than 50 percent from 2002 to 2007 even as fresh reserves of coking coal, which is less abundant than the thermal variety used to fire power plants, failed to keep pace.
World-Class Find
Cunningham, 48, was searching for a way to take advantage of that imbalance when he met Michael O’Keeffe, Riversdale’s chief executive officer, at a mining conference in Cape Town in February 2007. Busting out his roadshow Power-Point presentation, O’Keeffe showed Cunningham and Passport geologist Neil Adshead how drilling results indicated that a site in Mozambique might be a world-class find.
Cunningham was impressed that O’Keeffe had given up a plum job as managing director of the Australian unit of Glencore International AG, the Swiss commodities trading giant, to join Riversdale.
“It was important that this astute operator took this kind of personal risk,” Cunningham says. “That was a positive for me.” Glencore raised $10 billion in an initial public offering on May 19.
Passport bought a small number of Riversdale shares on the Australian Securities Exchange. Then, in February 2008, Cunningham and Adshead journeyed to the highlands of western Mozambique and inspected Riversdale’s Benga project by helicopter and by foot.
Considerable Risks
Cunningham saw coal come out of the ground when workers drilled wells and dug holes for latrines at a mining camp, and seams of the black rock were visible throughout the area. Riversdale says its Mozambique projects possess 13 billion tons of coal reserves, much of it the highly sought coking variety.
Cunningham returned to San Francisco bearing a piece of Benga coal for Burbank and told him that the mine had huge potential and considerable risks. Riversdale had to secure numerous operating rights and permits from the Mozambique government and build railroad lines and port facilities to export the coal.
Even so, by December 2010 Passport was Riversdale’s No. 2 investor, with a 16 percent stake worth more than $535 million, according to Bloomberg data. Burbank, Cunningham and O’Keeffe sealed their deal by buying a racehorse together.
“Take the Volatility”
“Not many managers are willing to run a fund with that kind of exposure on a single name, but if they’ve got the geology right the value will be recognized,” says Paolo Alimonti, co- founder and managing director of Adair Capital LLC, a New York- based fund-of-funds firm and longtime Passport investor.
“Would I rather have them concentrate on the best idea, which was Riversdale, or go around the world and buy a basket of coal miners? I’d rather take the volatility.”
Even as Passport was amassing its position in Riversdale, raw materials producers were sucked into the panic that engulfed global financial markets in September 2008. In the fourth quarter that year, Riversdale shares plunged 71 percent to A$1.78 from their 12-month high. “We were all sweating, but John stuck with us,” O’Keeffe says.
Compounding the damage, Burbank had shorted the stocks of U.S. banks in the third quarter. On Oct. 3, the U.S. Congress passed the $700 billion bailout to save the financial industry, and banking shares arrested their slide and staged a short-lived rally. Passport covered its shorts by Nov. 1 at steep losses; Global Strategy plummeted 38 percent in October alone.
“Gone to Zero”
Burbank could only watch with regret as banks sank to 12- year lows over the next five months and rewarded bears who’d maintained their short positions.
Burbank is still irked that the government’s rescue undermined his trade. “There should have been major penalties for those who were wrong,” Burbank says. “Equity holders should have gone to zero, but they didn’t.”
In January 2009, Passport unveiled a risk management system designed to protect Global Strategy from market shocks. Every morning, Chief Risk Officer Tim Garry sends an e-mail to Burbank and his team reporting about the peril that each investment contributes to the fund. He also executes stress tests to see how the portfolio would fare in a crash like the one in September and October 2008.
Sell-Off in Gold
Garry, a quant who managed money at Boston-based State Street Corp. (STT) from 2005 to 2007, also runs simulations to measure the impact of a global equities market sell-off and a commodities bust. And Global Strategy, which aims to commit no more than 25 percent of its assets to thinly traded stocks, hasn’t made investments in closely held companies since September 2008.
Burbank’s $500 million Special Opportunities fund remains unfettered by the new risk controls. In 2010, it produced a 73 percent net return, according to a performance report obtained from Passport investors.
This year, in the run-up to the expiration of QE2 and a possible correction in the commodities markets, Burbank has been more cautious. Wary of a sell-off in gold, Burbank in January liquidated his position in the metal, which had amounted to 7 percent of Global Strategy in December, according to investment reports. Gold hit an all-time high of $1,577. 57 on May 2, an 18 percent gain since Jan. 31.
Burbank’s big idea this year is Saudi Arabia. Mindful that the world’s No. 1 oil producer might put its massive cash surpluses to work domestically, Burbank and his team started visiting the country and meeting with officials and local investors in 2007.
Opening to Foreigners
He’s betting that the Saudi ruling class will invest its petrowealth inside the kingdom with more wisdom than government leaders and investors did in neighboring Dubai and Abu Dhabi, where runaway real-estate markets crashed in 2008 and 2009.
“Saudi is not Dubai,” Burbank says.
As the Saudi monarchy pursues a massive infrastructure program, Burbank sees the country opening to foreign investors in much the same way that other emerging markets such as India did over the past decade. Less than 1 percent of equities traded on the Saudi Arabian Stock Exchange are controlled by outsiders. This year, King Abdullah Bin Abdulaziz has directed more than $80 billion to be spent on home building, and his advisers approved changes to mortgage laws to permit private investment in housing loans.
Hypervolatile Market
Burbank says the regional outcry for greater economic opportunities is likely to drive Saudi Arabia to spend even more domestically. While the U.S. government’s killing of Osama bin Laden may prompt followers to strike at targets in the Gulf state and spur oil prices higher, his death will have little long-term impact on the politics or economy in Saudi Arabi, Burbank says. If more capital flows into the country, valuations of Saudi equities should rise. “It’s a fantastic, idiosyncratic risk,” Burbank says.
While Adair Capital’s Alimonti endorses Burbank’s strategy, the longtime Passport investor does see peril should street protests erupt again in Bahrain. The island nation’s Shia majority has long chafed at the Sunni monarchy’s rule, and Alimonti worries the conflict could become a flash point between Sunni-dominated Saudi Arabia and its regional rival, Shiite- controlled Iran, which lies across the Persian Gulf.
“Does Iran do something? That’s the real risk here,” Alimonti says.
So far, Burbank has demonstrated a deft touch in wringing profits out of trades that other investors might overlook or avoid. He believes that if he and his team dig deeply enough into arcane markets such as Saudi Arabia or coking coal, the rewards can prove well worth the risks.
As Passport’s near-death experience in 2008 shows, today’s hypervolatile global market can upset the most thorough analysis and turn worthy bets into serious losses in a matter of weeks.
To contact the reporter on this story: Edward Robinson in San Francisco at edrobinson@bloomberg.net
Tags: Africa, Australia, commodities, global small caps, hedge fund, hunting for value, investment guru, john burbank, Middle East, minerals, oil, passport capital, saudi arabia