– December 2002 –

Confessions III: Commodity Speculator Paradise

Hi, guys, this is Hugh Hendry.

And this is the third instalment of my Confessions podcast where I take you back in time, I take you back to the bottom of the great bear market immediately following the Tech-Media-Telecom crash, which started in late 1999 and ended with some of the most popular stocks of the time falling 80%.

For the month of December 2002, I’m pleased to say that I staged something of a comeback in true eclectica style. For the entirety of the Fund’s life we had a profile which was long volatility which is to say we typically made money when others lost it briefly and for the most part of the time we clambered to minimize potential losses, as volatility simply ground lower. I like to say that we offered an annual positive carry of c.8% whilst providing enormous protection should general stock market conditions deteriorate rapidly and/or substantially. December was one of those months. The stock market fell the best part of 7%, hurrah!

Because as we approached the end of calendar year 2002, and my first quarter as a hedge fund manager, I really wasn’t inspiring confidence. My new restaurant, if you will, wasn’t exactly turning away hungry or inquisitive diners. Like our culinary risk cousins, most hedge funds never make it past those first 12 months…was I really destined to go the same way? Was I the guy down the chip shop who swore he was Elvis? Or was I going to be the real deal?

I mean, it’s not like I was going to be judged at the end of 2002, but if I didn’t get my ass off the floor soon and start producing a decent return, especially as we had launched coming off the bottom of one of the greatest bear markets in history, then for sure I was going to be TOAST. This is what keeps you up at night…if I hadn’t had December would I really be recording this podcast today?

December was a mirror image of that first catastrophic month if my memory serves me right because normally I’m guilty of making a lot of this up; Crispin Odey was another who was notorious for this! but with these returns in December I was going to close my first quarter down just 3%…hmm…boring but not fatal, with the equity markets up 1.5% and running an idiosyncratic macro portfolio vs. a diversified equity index; crazy, no? This is why when you see these comments like Hendry was so mediocre; maybe? I would be the first to concede. But mediocre at what? Because just citing fund returns is almost a redundant useless endeavour in my opinion.

The discovery that you can produce positive numbers as equity markets got slammed was very invigorating. Making money is the financial equivalent of Viagra…making it whilst at the same time everyone else is getting slaughtered is just even more uplifting; my pecker was very definitely up allowing me to even imagine a Commodity Speculator’s Paradise. Now that’s the kind of territory where we would eventually head to but back then it was still a very provocative term back then at the end of 2002.

At the end of 2002 the economy in America was beginning to recover slowly and tentatively, but you gotta remember that this was the beginning, the first steps, on the road to monetary radicalisation. We had gone from Fed funds rates of 6.5% to just 1.25%. I mean, that was a big WoW factor. So monetary policy is very much in its ascendancy whereas fiscal policy whilst stimulatory was only committing to spend just 1% of GDP; modest vs what we have come to expect today. Nothing versus what we’ve come to expect today. The year drew to its close with speculation that the US might spend another 1% of GDP; yawn…but supportive of a commodity based portfolio.

The dollar, given that big tsunami-like cut in rates, had weakened and fallen the best part of 10%. There was a lot of liquidity in the system but liquidity is very unfair…the monetary system is wonky, because money never really flows to where it’s most required, which would be to say, distress businesses and distressed households but instead all this liquidity that’s being discharged from the government’s plumbing system, the liquidity is going to sharks like me – it’s going to things which are inflating, that are in asset price uptrends – soft commodities, the fx of commodity producing nations like Australia. The euro vs the dollar; this is well before Draghi vowed to do whatever it takes…

My mental health was on the mend, I was definitely beginning to feel a little bit more confident in myself and began to layer more risk on the portfolio. We were running 120% gross, with 80% of nav being dedicated to the longs and just under 40% to the shorts. When I look at the short names, I really can’t make no rhyme or reason, to why we had selected those names? I guess we were running an RV trade. We were long a group of eccentric high-risk commodity cyclicals and short large cap dependable secure/safe staples. Curiously that isn’t too far from what I would propose today except without the shorts – for whilst everyone bangs on about gold today, riskless equities have been the best defence against today’s disinflationary world. That because their profits are less vulnerable, that they have been isolated from the rise in equity risk premiums and soared as analysts have lowered their DCF rates to almost zero. Other equity sectors such as transport or industrials can only look on in awe. Today’s markets have deemed everything else bar the FANGS as riskier.

But the big change from December is the arrival of the gold boys. Gold shares have entered the eclectica fund. We’ve got the blue-chip names of course: 5% of nav in Newmont, 5% in Goldfields, Ashanti and 6.5% position in the CRB commodity futures index and topped up with a  5% of nav in Durban Deep – talking of risk appetite being up!

I never studied the Classics but I worked with plenty smart kids who did and they told me that a nomen is an omen, which is to say that the name or title always reveals something. That to the attentive and curious there’s always a giveaway hinting at how things are going to go. So, what was Durban’s name telling us? That it was a profoundly deep South African mine. I don’t think I ever met management. All I heard was that they operated a very deep gold mine in South Africa.

It was consistently, almost reliably, unprofitable owing to its high cost base. But if you were to imagine a commodity paradise, and multiply the gold price by two or three times the present, then the marginal shift in profitability was astonishing – this business had enormous operating leverage to the gold price. To the uninitiated trapped in the blindness of the matrix this was a mediocre company at best but double the gold price and you would discover that you had something offering a 50% plus earnings yield, i.e., it was on 1x or 2x earnings. Welcome to a world of hyper-reality; to the power of imagining a different world!

But I want to say this, from the kid who was schooled by a very Edinburgh based, very, diligent, very professional, very analytical house that controlled risk by investing in superior companies!, and here I was seeking superior returns from the dustbin of very poor businesses?

I was pursuing a train of thought picked up from one of the Soros books, the idea that once you’ve found a convincing narrative, that you bar-bell and own the very best companies – in the most likely eventuality that you’re wrong – and the very worst companies just in case your fantastical crazy idea is proved correct! And that was something that always stuck with me as a hedge fund manager who pursued contentious narratives.

So, 120% gross equity. But remember, people always think that they’re going to make money from their short positions; that they have a robust / stable, diversified, or market neutral portfolio that will allow them to stand valiantly in the face of whatever the markets can throw at them and their belief systems. Oh Boy! Big mistake.

In my experience, there are too many moments where you lose money on both sides!! And so really, I believe it is better to look at your risk book as simply being 1.2x NAV long risk; i.e., assume auto-correlation and that in extreme moments you could lose money across the broad spectrum of your risk book. That’s a very pessimistic way of thinking. But for someone like me seeking tenure, for someone that wanted to outlast everyone else, that lusted at the prospect of being allowed to do this over and over again every day…I found it helpful.

So, 1.2x in long-short equities and then another 60% in currencies which largely reinforced the dominant risk of the equity positions. We were long commodity producing nations like Australia and shorting countries such as Japan, a very large global importer of commodities, whose terms of trade were endangered by higher commodity prices.

60% sounds like a large risk position, it was half of our gross equity balance sheet allocation, but adjusted for volatility currency? Less so. The daily price volatility for major country fx pairs is typically very low in comparison with equities, especially in relation to gold equities to which we had a large allocation at the time. This 60% allocation on a risk adjusted basis would have been no more than c. 20% of NAV. To put it in some context, a 5% position in Durban Deep, the goldmining equity, would be of a similar magnitude to our total fx risk exposure; it takes a lot of swagger or naivety to invest successfully at the bottom of the market.

Stock insight? I don’t want to spend too much time on this.  Barry Callebut was very similar to Amsterdam Commodities which we explored at length last time. It’s another very solid, almost boring, cyclical business, with an uneven progression in earnings that stock markets never care for greatly and re-rate them lower. These guys are the largest producers of cocoa and so tonight if you’re raiding your fridge looking for chocolate then most likely the cocoa came from these guys out of West Africa. The growth story has been consumer choice. Next time you go to the supermarket try notice just how many different brands and offerings proliferate the shelves; diversity of customers has been a boon to profitability.

I have to CONFESS, that I am a little ashamed because with my game plan of looking for 9x or 9 baggers; for stocks that could rise 9-fold, typically required that I was buying new highs; price highs in the context of recent years but small change versus where the same business had traded a generation ago. But in this instance, I was doing the opposite.

I don’t know why; but I do know that I got lucky. Normally it was the voices in my head insisting that I take a small opening trade position but my voices were unusually quiet in this instance and so it was more, I think, the intelligence contribution from my analytical department that was saying, Hey, look, you want commodities?  You want exposure to soft commodities? This Barry Callebut is a very, very sound very, very cheap company which will deliver under the circumstances that you describe.

Chart wise, the only defence for my purchase, was that the price chart had broken its down-trend. But this was not the strongest validation from a technical perspective for me to typically launch an investment.

And so, maybe if I am to be self-critical, last time I presented Amsterdam Commodities and it was a 20x; a 20 bagger. This time we are discussing a nine bagger and yet the Fund only made 8% p.a. after fees compound over 15 years. So, what went wrong? Is this just selective cherry picking of good ideas? More likely I think that I compromised and favoured a strategy that delivered longevity over profit maximisation; I’m undecided but it’s most likely on some due diligence rap sheet.

My good friend, Steve Drobny, christened me the plasticine macro trader in his book URL AMAZON?. I would have my central thesis – a commodity super up-cycle – and then I would deconstruct it into hundreds of little positions, like a centipede. So, I always had FEET in the game but I could also expand or contract my positions at will; they were malleable, allowing me the opportunity to change my mind. I always reserved the right to completely reject everything that I had believed the day before!

I could chop, slice and dice these positions in and out of the portfolio; nothing was going to take me hostage. Me, I was going to live forever. But the smallness of each stock position almost certainly diluted the great work of my research team and was ultimately to the detriment of the fund’s returns – hey, you make your choices…

And finally, when I think about this speculator’s paradise, and how we seem to be entering what I believe is the third act in this long drawn out narrative, I want to leave you with a little anecdote from back then. It wasn’t 2002, probably 2006/7, and I had been asked to present at a Russian investors forum which followed on in the slipstream of Davos but in Moscow. In typical fashion, I had made a name for myself, probably by being super rude and disparaging on a smaller stage at this enormous investor event, and so I had been invited onto a bigger stage with the true finance rock stars and subsequently invited to a VIP closing party overlooking Red Square.

And there, would you believe, was Marc Faber of Doom Boom and Gloom fame, Jimmie Rodgers and Nassim Taleb and his black swans. I mean, it was just an astonishing evening and I was bumping off them all night. I had earlier in the day shared a panel discussion with Taleb and he was most surely not interested in my friendly overtures at the time. In fact, he was an ass! Jimmie Rodgers? We’ve always had a love hate relationship. He’s that kind of guy…and Mark Faber, the most over sexed financial brain in the universe.

Nassim warmed to me after the panel debate. All is forgiven in love and war. At the party he kept approaching me for my name. Again, and again, “What is your name?” I would repeat, Hugh Hendry, and he would struggle until we settled on Hugues Hendrix, and then, of course, he would walk away with me in mid-sentence. Only for him to return once more, a mouth full of food, and he would repeat, “what is your name?” Funny guy…

Later, I found myself sitting on a sofa beside Jimmy who was constantly surrounded by kids and others seeking out his wise council. Jimmy’s a God and that attracts its own force-field and he was riding the commodity bull market for all its worth.

He would open his jacket and produce a silver coin to his mesmerized audience. You should buy silver! He would shout at the top of his voice. From his trouser pocket would appear a sachet of sugar. Sugar is going to the moon! From another pocket, a gold coin. It was fascinating to watch – he really loves an audience – I remonstrated with him; I asked him, “Jimmy? what are you doing? What, dare I ask, are you carrying in your shoes? That was a funny old night.

And Marc? Marc was just being himself which is to say this enormous, larger than life character, that looks straight from the James Bond evil villain department; all that’s missing is the white pussycat sitting attentively on his lap. He left shortly afterwards to pursue other endeavours; I never inquired as to his intentions.

Funny times…the bull market was fast approaching, and my losses were quickly recovering relative to the equity markets. And so, I hope you will join me next time, when we move into the new calendar year of 2003 which ultimately, despite some hiccups along the way, ends in being a great personal triumph, perhaps securing my tenure for a little while longer. So, thank you for listening and goodbye from St Barts.