Passport Capital Details Curve Steepener Play (Investor Letter) ~ market folly

Wednesday, July 29, 2009

Passport Capital Details Curve Steepener Play (Investor Letter)

John Burbank's hedge fund Passport Capital has released their latest investor letter and there are quite a few interesting bits of information included. Most notably, we see that Passport likes basic materials, curve steepeners, the Japanese yield spread, and healthcare stocks. We'll get into specifics about each below, but let's first dive into their most recent performance numbers.

Year to date for 2009, Passport Capital is up 25.4% compared to the S&P500 being up only 3.2% over the same timeframe. Passport was up 18.1% for the 2nd quarter of 2009 and now has seen a 26.4% compounded net return since inception. This phenomenal number comes against a -3.1% return for the S&P500 over the same period. Overall, Passport's main fund now has $1.3 billion under management and their firm as a whole manages $2.1 billion. You can view numerous other hedge fund performance numbers in our June hedge fund update.

Portfolio Specifics

We're going to work backwards here and are first going to start with the specific portfolio positions Passport mentions. Because let's be honest, that's what everyone is really curious about anyways. They have increased their short exposure and at the same time have reduced their net exposure. They were basically taking profits from the massive gain they saw in May and decided to hedge their portfolio.

Curve Steepeners

Firstly, we must point out that Passport took profits in their yield curve steepener recently (specifically, the 2-10 year curve). However, they still hold some of the position and are looking to add to it should the curve flatten or if volatility decreases. Currently, they see short-term deflationary pressures that will steepen the curve going forward. Passport purchased 2-10 year curve steepeners in the first half of 2008 for $80.3 million that had a notional value of $24.3 billion. At the most recent quarter end, these positions had a notional value of $11.4 billion. As mentioned earlier, they have taken profits on the position and still remains bullish on the curve steepener as a play. As of June 30th, 2009, Passport had $100 million invested in these vehicles. We point all of this out because previously here on Market Folly we focused on hedge fund legend Julian Robertson's steepener swap play. Although the plays are slightly different, we'd highly recommend everyone check out the article for a better understanding as to what these hedge funds are betting on.

Japanese Yield Spread

John Burbank's hedge fund also focused on another interest rate trade, but this time in Japan. Passport has purchased 5-year CMS caps (calls) on the Japanese yield spread of the 5-10 year. Their position will become profitable should 10-year rates rise over the upcoming five years. They have risked $40 million to gain anywhere from $88 million to $240 million should things go as planned. Their rationale behind such a play is as follows: "Given these ratios and Japan's witches' brew of cyclical downturn, secular stagnation, the effects of aging on productivity and risk tolerance, the 1.36% yield on a 10-year Japanese Government Bond may surprise the uninitiated. For over fifteen years Japan's citizens and corporations have retreated from risk while easily financing their government's fiscal largesse with their significant savings and trade surpluses. Given the absence of inflation, currency risk, and compelling alternatives for most JGB investors, very low yields made sense. Looking forward, however, we assign a high probability to the prospect of persistent deterioration of fiscal and trade balances. With deteriorating finances come an even higher debt/GDP ratio, yen weakness, and rising dependence upon foreigners. Mounting financial stress means political pressure on fiscal policy and GDP. Each of these forces should place upward pressure on JGB yields and volatility, and their confluence could produce a step-function change." Whew, everyone got that?

Healthcare Stocks

Although their fund has only 11% of their NAV dedicated to healthcare, it is the highest weighting in their fund's history. And, that should say something. They like this sector due to the uncorrelated market returns and the fact that there is a bullish case for both the short-term and long-term. They also cite demographics, political realities, and profitable business models as compelling reasons to own healthcare names.

Basic Materials

Passport has been bullish on natural resources/basic materials for a little while now and it has been a large part of their long portfolio. When we last covered Passport's portfolio, we noted that they had a lot of exposure to base metals, fertilizer, and gold. And, specifically, we saw them add massively to their gold stake. For a current look at gold's situation, check out this technical analysis video that says we could see the metal rally up to $980 before cooling off. We have covered gold a lot on the blog recently solely because we've seen a ton of hedge funds in it. David Einhorn's Greenlight Capital recently moved to storing physical gold. John Paulson's hedge fund firm Paulson & Co owns a ton of gold via GLD, and there are many other prominent hedge fund managers that own the metal. Additionally, hedge fund firm Sprott Asset Management recently harped on the 'real assets' theme in their July market commentary.


Lastly, we also wanted to highlight the fact that Passport sees the technology sector as ripe for the picking. Specifically, they like internet business models around the world on the long side.

Short Positions

Passport is short companies within the financial and consumer sectors. They say they are short companies that have deteriorating fundamentals and highly indebted capital structures/customers. They have also bought put options on indexes which could be classified either as a hedge or a short position, depending on how you look at it. As volatility has come down, these options have become priced very cheap and David Einhorn of Greenlight Capital also pointed this out in his latest investor letter. Additionally, Passport has also hedged some of their basic material and technology exposure. They were net short the consumer to the tune of -13%. In the technology sector, Passport likes short opportunities in companies that relate to product cycle technology since they are more susceptible to economic downturns.

Portfolio: General Information

Okay, so let's dive right into the other good stuff. Passport has 94 long positions, 122 short positions, and 12 private investments. They were 88% long, -59% short for a gross exposure of 147% and a net exposure of 28%. Their top 10 long positions were 34% of their exposure. They are long basic materials, India, healthcare, energy, and emerging market financials. Their longs were +34.5% for the quarter while their shorts lost -15.7% gross. Passport was net long basic materials to the tune of 25% and India to the tune of 13%. Those two long sector bets were their largest wager. On the short side of the portfolio, they were net short the consumer and 'other' as previously mentioned (where 'other' constitutes index puts among additional positions).


Passport also goes on to say that the "legacy of the financial crisis is asset-price deflation. The credit bubble drove overproduction of goods and services that the downturn has exposed as overcapacity. Now the world is eliminating capacity while relying upon fiscal stimulation of demand. This process will take time." They continue believe that inflation will be the long-term outcome of all of this. However, they are actively managing positions and are being nimble for the time being, as there is no telling how long this could take to play out. They believe inflation will prevail due to "the political appeal of inflation in the context of daunting unfunded liabilities, the political and practical difficulty of tightening historically loose fiscal and monetary policies, and global understanding of the problematic position of the US dollar." They go on to note that the market will overreact to both deflationary and inflationary signals and that focusing on the long-term strategy here is essential.

Passport again harps on their desire to be long the economies of China, India, and the emerging world, preferring those to that of the Western world. Among many reasons, they like the fact that there is a growing demand for natural resources; resources that there are a finite supply of. As such, they are obviously bullish on commodities as well. They go on to point out that, "market economics eliminate excess capacity while government subsidies maintain it. The Darwinian existence of commodity producers means that their pricing power is improving while their industries' ability to satisfy longer-term, normalized levels of commodity consumption is deteriorating."

Additionally, John Burbank's hedge fund sees negative consequences for the US dollar going forward. They point out that the rise in the dollar through the crisis was due to high demand during a period of extreme deleveraging. Passport instead likes currencies such as the Australian and Canadian dollars, the Chinese renminbi, Norwegian krone and some Middle Eastern currencies. They favor these because of trade surpluses and higher returns.

Turning now to specific fund matters, we see that Dipak Patel has resigned from Passport after the trading scandal involving their India Fund. John Burbank will continue to manage the fund. In terms of redemptions, Passport saw 7% of fund assets go out the door in the second quarter ($105 million). However, the second quarter also marked the first significant inflows in capital since 2008. Due to their poor performance in 2008, they still have a high-water mark and current investors looking to add to their stake in the fund will be charged no performance fee until the carry forward losses have been recouped.

For more information on John Burbank and Passport, make sure to check out our background information and portfolio update on the fund. Additionally, for more in-depth performance metrics, check out their June 2009 performance attribution sheet. Their top 10 public long positions as of the end of June were Riversdale Mining (RIV.AU), Financial Technologies (FTECH.IS), Jordan Phosphate Mines (JPH.JR), Mosaic (MOS), Potash (POT), EFG-Hermes Holding (HRHO.EY), China Lotsynergy (8161 HK), Shuaa Capital (SHUAA.UH), London Mining (LOND.NO), and AK Steel (AKS).

Those of you interested in reading Passport's latest investor letter can try to download the .pdf here as long as the link works.

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