What Concerns Passport Capital

Last week, I received Passport Capital's quarterly letter. I have remarked in the past, that I believe Passport Capital's John Burbank is one of the most creative thinkers and investors in the hedge fund world. While macro is definitely not my specialty, Passport brings a level of expertise to various regions of the world that are simply unparalleled. The results speak for themselves: Since inception in August 2000, the fund is up ~22% net on an annualized basis.

While I will not post the entire letter, I found Passport's thoughts on the risk factors currently in the market very relevant to the current environment:

Dan Loeb in his recent investor letter commented the difficulty of the macro environment is having on investors:
"Generally, we are "bottom-up investors." However we are living in a climate where these economic and political considerations are at least as - if not more - important than underlying fundamentals in forecasting investment outcomes. Given the great uncertainty described above and sentiment levels that reflect it, I can foresee scenarios where securities could trade much higher - or much lower. Happily, as Warren Buffett has pointed out, we operate in a "no strike" game, which is to say that we can let many pitches pass us by before swinging at the ball that comes right to our sweet spot."
Last week, every single investment bank had conference calls and numerous pieces on the debt ceiling legislation and a US downgrade. While interesting water cooler talk, the big takeaways were a lot of uncertainty, with the assumption a deal would get done. The CDS leveles reflects the sentiment last week:

This is the chart of the 1 year CDS spread of the U.S. Government. You can see the collapse today as a debt limit deal was reached. The run up was spectacular to watch.

While I will not pontificate on macro environments, I will say this: The range of outcomes has increased dramatically. And the tails are getting fatter. Seth Klarman has always advocated putting on cheap hedges to hedge against tail risks (he once spoke about sovereign CDS which has to be a home-run trade at this point). While this is getting more and more difficult as investors across the board are looking for cheap hedges (volatility, whether it be interest rates or equity risk, has increased dramatically) a prudent investor should understand that to win the race, you must actually finish the race. Overlaying the portfolio with well out of the money puts or buying protection on senior tranches of high grade and high yield credit indices (a post coming will discuss these in detail), may marginally detract from performance, but will allow you to survive if one of those tails comes to fruition.

In the meantime, you wait for the fat pitches and bet when the betting is good. Like any good poker player, you wait until the odds are significantly stacked in your favor, and then you bet when you have the best of it. You can only have an edge on so many investments - the human capital required to know more about every company out there is impracticable and uneconomical. Stick to those areas where you have an edge, hedge against tail risks, and in my opinion, you should make out just fine.


jeremy 8/26/2011  

Great piece. Looking forward to the follow-up piece on tail-risk hedging. Key is of course not paying an excessive premium for downside protection in this climate of fear...


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.