China: Bubble or Bonanza? Xerion Fund's Dan Arbess Versus Kynikos' Jim Chanos

Continuing our coverage of the Delivering Alpha conference today, we turn to the panel on China: Bubble or Bonanza? In the bull corner sits Perella Weinberg Partners' Dan Arbess, who runs the highly successful Xerion Fund. Opposite him in the bear corner is renowned short-seller, Kynikos Associates' Jim Chanos.

While the respective fund managers disagree on whether to be bullish or bearish on China, they do agree that there are 3 key issues in Chinese investing:

1. Real estate
2. Financial system
3. Dependency on fixed assets

Dan Arbess has long said to play the 'shake hands with China' trade by buying multinationals that are seeing high revenue growth from China. This is something we've touched on in a past Xerion Fund letter and you can also read up on Xerion's 2011 investment strategy.

Arbess says that, "to short China in general is to short the march of history. The single most important development of our lives is the devolution of communism and the entry into the global consumer economy of the 3.5 billion people." He clearly feels there's a monumental shift taking place in the global economy.

Chanos, on the other hand, says that GDP in China has declined over the last few years and net exports have fallen too. He feels that the country is structurally imbalanced.

In the past, Jim Chanos has fixated on China's 'ghost towns' as reasons to short China property. Chanos today said that, "these buildings may not be standing in five or 10 years. You're talking about an economic system where profits are not maximized for the largest economic actors. You're talking about a history of horrible lending. You're talking about a system in which the export-driven model hasn't been changed by Western demand."

Arbess counters that Chinese ghost cities are a red herring. He argues that everyday people are moving to the cities and plugging the supply of developments. While he admits that there is speculation in the property market, policy makers are dealing with it by clamping down credit and curtailing the ownership of multiple homes.

The Xerion Fund manager went on to say that, "I think there are misallocations of capital. But those misallocations of capital can be managed by various levers of policy that Chinese policy makers have to keep the urbanization, industrialization of their economy on track."

Earlier today, we highlighted how Chanos is long corruption and short property in China. He likes being long the Macau casinos but short property developers and short some banks (he noted he is not short US banks).

On Ackman's Long Hong Kong Dollar Trade

Both men came on after the speech from Pershing Square's Bill Ackman where he unveiled his new long Hong Kong dollar trade. Given the China bull/bear debate that Arbess and Chanos had, it was also interesting to get their takes on Ackman's latest investment.

Arbess said Ackman's play was plausible while Chanos said he would prefer to be long the Singapore dollar if he was choosing an Asian currency. Earlier we detailed how Tiger Management's Julian Robertson likes the Singapore dollar as well.

Dan Arbess' Xerion Fund Likes Chemical Stocks

Per Bloomberg's Hedge Fund Brief, Dan Arbess' Xerion Fund (part of Perella Weinberg Partners) is betting on chemical stocks. In particular, he likes those companies that utilize lower-cost natural gas in production, such as LyondellBasell (LYB).

Chemical maker LYB emerged from bankruptcy last year and has been a big favorite amongst investment managers. In fact, LyondellBasell was a consensus buy in the fourth quarter amongst hedge funds we track in our Hedge Fund Wisdom newsletter. In addition to Xerion, Dan Loeb's Third Point LLC holds a large stake in LYB as it is their fifth largest position.

Arbess said that, "There are a lot of companies that can just take higher feedstock costs and pass them right on to their customers. They are being sold off very aggressively right now and can be picked up. We liked them 10-15% higher before the sell-off; we love them down here." In addition to LYB, Arbess fancies Solutia (SOA) and Rockwood Holdings (ROC).

Arbess also reiterated his positions in exploration and production oil companies in Brazil and West Africa. We've posted about these investments in a previous investor letter that detailed Xerion's 2011 investment strategy & outlook.

Dan Arbess' Xerion Fund: 2011 Investment Strategy & Outlook

Daniel Arbess' Xerion Fund is out with its investment strategy and outlook for 2011. The hedge fund, part of Perella Weinberg Partners, manages $2.3 billion and has annualized returns of 18.97% net since inception in 2003. For 2010, Xerion finished up 12.66% net. Our previous coverage focused on how Xerion likes commodities.

2011 Market Outlook

Taken directly from Xerion's year-end letter to investors, here is a breakdown of their outlook for the new year,

" - Global economy and markets remain unbalanced, dependent on government support and highly vulnerable to policy changes and conflicting national agendas. Government-stimulated market momentum will recede in 2011, in favor of either gradual normalization or renewed crisis.

- Expect continued moderate economic recovery, however frequently punctuated by episodes of macro instability. Key risks include potential over-heating and reversal in China, persistently high domestic unemployment and acceleration of sovereign debt crises in Europe and other developed economies.

- Receding tailwinds from government intervention imply security selection and idiosyncratic opportunity will be most important in 2011. Select U.S. credit opportunities as rising yields signal higher re-financing costs. “Shake Hands With China” with exposure to commodities and equities, industrials and Asian consumer- facing industries. Selective sector opportunities in U.S. Equities. Commodity bias captures both fundamental demand in EM and fiscal crisis hedge in DM."

Portfolio Positioning

Given the above themes, Xerion is positioned cautiously long and they expect U.S. credit opportunities to be limited given the large wave of restructurings over the past two years. In developed markets, they see a few equity opportunities but they still favor emerging market equity plays and continue to play their 'shake hands with China' theme.

Of Xerion's positioning, Arbess writes, "Our portfolio structure and positioning going into 2011 is quite consistent with where it was one year ago - slightly longer and more skewed toward equity strategies versus credit, but also more hedged (which is to be expected given the higher beta and volatility of equities)."

Credit: In this asset class, they're focused on event-driven corporate plays and an opportunistic tilt toward distressed credit. Arbess writes, "we also see M&A as an evolving high yield catalyst for 2011, given that sponsors have cash to use and limited organic growth opportunities, while high yield companies are in the mode of bolstering liquidity and shedding assets to fund creditor friendly actions."

Equities: Xerion is generally cautious on domestic equities and favors high growth plays in emerging markets. Specifically, they are focusing on the rise of China's consumer and how to play that. The hedge fund is concerned with the liquidity of Asian equities in general but is intrigued by the state-owned segment of China's economy. Overall, they continue to favor their 'shake hands with China' portfolio theme.

Commodities: Arbess and his team believe that industrial commodity demand has been in a 'supercycle' since 2004. They like commodities for a couple of reasons, citing that they "benefit from robust and growing fundamental demand from industrializing emerging markets, and also attract financial investors looking for monetary debasement hedge."

In particular, Xerion prefers industrial commodities to even gold, claiming that the latter is less supported by demand and more-so driven by a financial crisis hedge. The hedge fund also likes various equity plays for this theme, specifically the junior resource companies (such as Fortescue Metals Group, Ivanhoe Mines, OGX and HRT).

Concerns In The Coming Year

Xerion rounds out its commentary and outlook by commenting on reasons to be cautious this year:

"For the past two years, markets have rallied in response to government stimulus and the anticipation of an economic recovery. We are cautiously optimistic that strong growth in the developing economies will continue to anchor the global economy in 2011, while improving sentiment in the developed world could potentially unlock cash-laden corporate balance sheets, supporting an investment-led recovery. However, bullish sentiment is already largely priced in. We expect the tailwinds of QE-inspirited rising markets to subside in 2011, further highlighting the importance of security selection, idiosyncratic opportunity and events, and, above all, hedging ever-present macro risks."

In the end, Arbess' hedge fund identifies the following as the key to continued economic recovery:

"The sustainability of global growth in 2011 will be highly dependent on G-20 policy makers’ successfully reining in short-term national interests in favor of longer-term globally coordinated efforts to shore up consumption growth in the EM."

For more on Dan Arbess' hedge fund, head to our past post on Xerion's 'shake hands with China' play.

Dan Arbess' Xerion Fund Prefers Commodities Over Equities

Daniel Arbess' hedge fund Xerion is out with its latest letter to investors. The fund, a part of Perella Weinberg Partners, has returned 18.68% annualized net since inception in January 2003 and currently manages around $2.3 billion. Maybe the most impressive aspect about Arbess' numbers is the fact that he's done so with a correlation to the S&P 500 of only 0.34%.

The hedge fund "seeks to draw on fundamental valuation skills to identify opportunities that offer the potential for asymmetric returns--downside protection with upside potential." Xerion is named for an alchemy tool whose legend says it can turn base metals into gold. Apparently, it is also supposed to be an elixir of enlightenment. When markets crumbled in 2008, Xerion returned 0.31%, beating out numerous hedge funds that suffered. In 2009, the hedge fund was up 35.33%. Through October in 2010, Xerion is up 7.34% net.

Arbess has been positioned around 61.6% net long with equity strategies around 43.7% net long, credit strategies 35.6% net long and macro strategies -17.7% net. At the end of the month, their top 10 longs comprised 34.8% of equity. Some of the hedge fund's top performers included positions in HRT Participações em Petróleo (HRT), Abitibi (process driven distressed credit), LCORA (credit special situation), Solutia (SOA - thematic Asian growth equity), and Ivanhoe Energy (IVAN - special situation equity).

"Quantitative Easing May be Counter-Productive"

Arbess dedicates a decent portion of his commentary to the Federal Reserve, quantitative easing, and his belief that while QE may spur equity price advances, it will do little to make a real difference in the economy.

He writes, "The unintended consequences of QE are eroding confidence in the Dollar and the entire monetary system. We generally prefer commodities over equities as a medium term play on the 'Fed Put'. Equities may not keep going up if QE doesn't work, but it seems to us that commodity-related investments will have legs whether QE works and economies improve, or QE doesn't work and more Dollars are left chasing the same commodities."

This viewpoint is generally aligned with that of John Burbank's hedge fund Passport Capital as Burbank favors hard assets. However, their shared thinking contrasts with that of David Tepper and Appaloosa Management. Tepper doesn't want to 'fight the Fed' and thinks equities will continue to rally.

"Shake Hands With China"

One of Arbess' ongoing themes has been to own what China's government and consumers desire. He argues that China is transforming itself from the world's factory into the world's consumer. As such, the Xerion fund is investing in hard assets that China and developing nations need to build infrastructure and fuel urban growth. The hedge fund has also been researching cheap producers in southeast Asia and retail distributors that will serve this rising consumer.

HRT Participações em Petróleo (HRT)

Arbess' letter also singles out their investment in newly IPO'd HRT. Xerion made an initial $20 million private investment back in November 2009 at a $360 million capitalization. HRT went public raising $1.5 billion at a pre-money valuation of $1.8 billion. It is a Brazilian exploration and development company formed by Petrobras seismic experts who provided consulting advice to large oil companies.

Of the company Arbess writes, "We think this Company is just getting started, with the IPO implying a reasonable valuation for HRT's known onshore oil assets, but discounting its substantial gas potential in the Amazon and offshore hydrocarbon blocks in Namibia. We like this investment at its current valuation and are looking forward to favorable news as the Company's drilling program ramps up over the next several months."

Xerion Portfolio Exposures

Interestingly enough, Arbess writes that, "Our net long corporate exposures are still weighted nearly 2:1 credit to equity. About three quarters of our equity exposures (and hedges) are leveraged to the global industrialization theme, mostly through what we intend to be asymmetric commodity plays like HRT. About a quarter of our equity exposures are more domestically-focused, playing for either idiosyncratic events or high operating leverage, strong free cash flow or secular strength in a weak economic environment (hotels, transportation, technology, etc.)."

Currently, the fund has 21.4% of assets under management dedicated to special situations equities (mainly hard asset-focused). Arbess makes a footnote that the Xerion fund has been looking at stressed credit situations in the arenas of food service, lodging, and technology. Lastly before everyone asks, unfortunately we can't post a copy of the actual letter due to revealing watermarks.

We'll continue to provide updates on Arbess' hedge fund, but in the mean time you can view a previous Xerion presentation: Investing as the foundation shifts.

Dan Arbess Ira Sohn Presentation: Investing As The Foundation Shifts

Today again courtesy of Dealbreaker we wanted to highlight Dan Arbess' recent presentation from the Ira Sohn Investment Conference entitled, 'Investing As The Foundation Shifts'. We had previously summarized the Ira Sohn Conference and have detailed numerous presentations from the event. This time around, we're taking a deeper look at the slideshow from Dan Arbess, the Xerion Fund manager at Perella Weinberg Partners. Just yesterday, we looked at Dan Arbess' portfolio commentary and identified that he is seeing opportunity in stressed credit and owning what China wants to buy. And now, we'll focus on some of his additional investment ideas.

When we summarized the Ira Sohn Investment Conference, we noted that Arbess was bullish on China exposure and in particular, Yum Brands (YUM) given their prolific expansion into the country. He isn't alone in his conviction here as we've seen a slew of hedge funds add positions in Yum Brands in recent quarters. In particular, we made note of Bill Ackman's YUM stake.

If you hadn't already guessed from the title, the theme of Arbess' presentation centered around a shift in the global economy. He wants to 'shake hands' with China and overall sees less borrowing in the Western world coupled with more consumption in the Eastern world. He says you can play this theme by shorting overleveraged Western producers, shorting weak currencies, and hedging monetary debasement with precious metals and miners. Arbess is also bullish on Ivanhoe (IVN) due to its solid assets and position in the metallurgical coal space.

This echoes what many hedge funds have already practiced. Hedgies have been quite short the euro (currently a weak currency) but they have been covering as of late. Additionally, tons of prominent investment managers have boosted gold exposure in their portfolios either by adding the physical metal or gold mining companies. Arbess doubts this is a top in gold and is using exposure there to hedge against inflation.

Sticking with the Asian growth theme, the Xerion Fund manager also likes Solutia (SOA) and Celanese (CE) as they both are seeing solid growth overseas. Arbess also seemingly pokes fun at a previous presentation we've posted up from Vitaliy Katsenelson entitled, China: The Mother of All Black Swans by including a picture of the lead slide from that slideshow with a giant "NOT" stamped across it. (How about a nice little Borat impersonation here for our comedic readers: "China is the mother of all black swans..... ... .....NOT.")

Ahem, anyways. Embedded below is Daniel Arbess' presentation from the Ira Sohn Conference, "Investing As The Foundation Shifts":



You can download a .pdf copy here.

For more from Arbess, head to his Xerion Fund portfolio commentary. We also recommend viewing the other presentations from the Ira Sohn Conference including David Einhorn's speech, as well as Bill Ackman's presentation and last but not least, Steve Eisman's latest investment thesis. You can also view a summary of the conference here.

Perella Weinberg Partners: Xerion Fund Portfolio Review & Commentary From Dan Arbess

Thanks to Dealbreaker who posted up this gem: Perella Weinberg Partners recent May 2010 portfolio review and commentary regarding their Xerion Fund managed by Dan Arbess. If you're unfamiliar with them, here's what you need to know: Xerion is named after a legendary alchemical tool that is supposedly capable of turning base metals into gold and is also believed to be an elixir of life or enlightenment. The hedge fund "seeks to draw on fundamental valuation skills to identify opportunities that offer the potential for asymmetric returns--downside protection with upside potential." Xerion returned 0.31% in 2008, a year in which many other hedge funds suffered greatly. In 2009, Xerion returned 35.33% versus 26.46% for the S&P 500.

Thus far this year, Perella Weinberg's Xerion has had a decent outing, sitting up 3.37% for the year. The month of May was brutal for hedge funds, and the same applied to Xerion which ended the month down 4.23%. In their portfolio, Xerion's top performers were an alpha macro short on the Euro, beta hedges on the S&P 500, as well as a -6.3% short in the Australian dollar (a hedge to their mining and materials exposure). The first position of course ties in with the fact that many hedge funds have been drastically short the euro this year. However, as you'll see in a forthcoming article this morning, many hedgies have been covering their euro shorts as of late.

Arbess' portfolio commentary took somewhat of a concerning turn when he proclaimed that, "The twilight of the debt supercycle may be less dramatic yet more chronic and possibly more difficult to position around than the '08 financial crisis." He focuses on the fact that addressing the issues at hand will require fundamental changes. As the world re-balances, he feels that outbursts of asset classes and markets trading in correlation will become more frequent.

Shifting next to investment opportunities, Arbess identifies the following as areas ripe with potential:

- Owning what China's government and consumers want to buy
- Stressed credit opportunities
- Process-driven credit opportunities
- Hedging monetary instability with metals, bonds and currencies

His last point is intriguing as throughout his commentary you'll notice he is very fixated on hedging. As we've detailed countless times before, many prominent hedge funds have exposure to gold in some form. Some argue that gold is good, but gold mining is better, while others prefer to own the physical metal. John Paulson has a hedge fund dedicated to investing in gold related entities. While he primarily takes stakes in gold miners, he also owns derivatives on the precious metal. So, it seems the Xerion Fund is interested in these tools as well, but mainly for hedging purposes.

Arbess points out that May was an 'anomaly' month because there was essentially nowhere to hide on the long-side as asset classes correlated to the downside. Xerion's top losers included an equity stake in a post-emergence chemicals company, a large cap agricultural sector position, and an energy special situation. Despite the rough month, Arbess viewed May as a buying opportunity for their highest conviction ideas. Xerion has essentially been running "lean and mean" by reducing other positions in favor of their highest conviction plays.

Arbess notes that, "quality credit is just where we want to be in an uncertain environment, because it has a built-in catalyst called maturity, which delineates our return based on our conservative assessment of company performance even against a weak economic backdrop." These comments echo that of investment guru Seth Klarman who prefers bonds and recently reiterated his preference.

In overall portfolio exposure, Xerion has been 86.5% gross long and -30.7% gross short, leaving them 55.8% net long. Given that Xerion's main focus is on distressed credit, it should come as no surprise that their largest exposure levels can be found in that arena. To see how Xerion compares to other managers, check out our recent look at hedge fund exposure levels.

Embedded below is the portfolio commentary from Dan Arbess' Xerion Fund of Perella Weinberg Partners:



You can download a .pdf copy here.

For more insightful commentary and analysis from prominent investment managers, head to the latest thoughts from Dan Loeb's hedge fund Third Point, global macro fund Prologue Capital's commentary, and the latest portfolio positioning from John Burbank's Passport Capital.