– January 2003 –

Confessions IV: How many times can you say sorry?

Hello, everyone, this is Hugh Hendry, and I ran the Eclectica Macro Hedge Fund, a rather idiosyncratic fund, between the years 2002 and 2017. Spoiler alert! Yes, it did come to an end. But before we set off once more on another story, I’d like just to remind you of what I am trying to achieve with these podcasts: this is a study of risk – an exploration of uncertainty. So, I would contend that it doesn’t matter that today’s edition is from January 2003. We’re going to be reviewing gold and today many years later the parallels seem eerily like what was going on back then. You have the benefit of hindsight – you know what happens next whereas I was caught up in the moment and, so, I hope that adds an element of entertainment to this exercise. You can shout NO! Don’t touch the red button! Me? I didn’t have that advantage – back then I just had a sense of foreboding or a sense of change. And so I welcome you to sit back and let the drama unfold.

So here we are and it’s January and I’ve just made 4% and equity indices as measured by the FTSE All Share are down 8% and so the pressure is just starting to ease off a little. I’ve kind of laboured the point before that most new hedge funds fail, and on the back of my first month, I’d been very much beset with anxiety that the same fate would befall me except here we are now and the Fund is up 0.75%. So, you know, let’s not pop the champagne yet but the stock market since I launched is now down over 2.5%. So, I’m kind of getting a little breathing space to find my own pace and approach to investment.

Here is a question for you is 4% a good month? Yes! An 8% decline in the stock market tells you that there has just been a big explosion at the short end of the volatility curve – that other investors have just woken-up and discovered that they are on risk – and me? I’ve profited from that. But to answer my question more fully you must examine and explore the nature of the risk taking that i had been adopting. It was clearly a different risk given how the correlations played out. But from the scant evidence available in this little document, the newsletter, all that can be said is that, in terms of the scale of my bets, I was committing to larger and larger position sizes: our long positions were 1.7x the Fund’s value. And we had short positions the equivalent size of a further 35% of the Fund value.

The convention is to net one against the other – and so I had a net investment of 1.4x the Fund’s asset value. I’ve never been a great believer in that convention: if everything auto-correlates and moves in the same direction such that your shorts appreciate at the same time as your longs decline – and shit like that happens, I’ve seen it too many times to call it an aberration – its perilous and you end up in deep trouble. I’ve always liked being a drama queen and have always therefore tended to exaggerate my risk, at least in my head.

I also had a further 28% of the Fund’s nav invested in EuroBund futures…but first, that’s a really, really, pathetically small holding in German Government bond futures… too put it in context, we had just over 12% of the Fund’s assets in just 2 junior gold mining stocks, and with their volatility being 4 or 5x greater than the bonds, I want to say that the gold share position would have been at least of equal risk weighting, if not more risky, than the bond futures position.

So, clearly, I had a lot of cumulative risk. My risk was pointing in different directions, and I presume, or rather I would have hoped at the time and with my naivety, that this diversity would have enabled the portfolio to overcome some adversity. But yeah, the quantum of risk taking was high and commensurate with the 4% return for the month – so no free lunch – I took some big bets and they came good this month, but the Fund’s robustness would soon be tested

And so despite making 4% there was no. And I think that’s a function of the fact that I typically would have written these things towards the end of the following month. And I suspect that three to four weeks after the end of January 2003, we probably had seen quite a vicious reversal in the fortunes of those gold positions.

Chris Cole, of Artemis Capital, in one of his recent commentaries,  noted that the right hand side of the volatility curve in gold stocks, i.e., upside volatility, is beginning to look very similar to what we saw in the tech bubble at the end of the 1990s and what I was about to encounter for gold stocks back in 2003. Which is to say that the shares would appreciate in a Tesla manner; that they would rise 250% and then half in price suddenly and without warning. That kind of sawtooth bull market is very dynamic to the upside. But try underwriting a 50% drawdown? Not easy folks. As I recently proclaimed on my IG account, markets use volatility to separate profits from the majority.

At the end of May this year, 2020, and having hid under a rock for the best part of two years, I invested some cash balances back into gold and junior gold miners. I obeyed my quality hierarchy of gold which is to say I purchased bullion futures – but I also some silver futures – followed by the safer royalty companies, and then some major gold production companies, for example Newmont, and then finally I bought a handful of junior gold miners. I’m not seeking to manage this PA portfolio actively. But that is my take at a precious metals model portfolio. If I was actively managing, I imagine that I would have chosen instead just the silver futures and the junior gold mines…I do like things that go BUMP! In the night.  Why? Because those junior miners are trading on not much more than 1x asset value, and I can assure you, bull markets in gold do not come to an end when those guys are trading on one time!! 3x for sure but not 1x.

So, the insight this month is gold. “Gold gold, you’re making me old?” Why are you making me old, gold, because this journey that you’re insisting that I take…that this journey is so…I shouldn’t say erratic, it’s not erratic, it’s explosive! Why is it explosive? It’s explosive because there’s a huge amount of convexity, or optionality embedded into these mining assets. Let me explain.

You have the gold price as the principal determinant clearly, but the shares are like an investment trust: you’ve got a price-to-nav consideration, and then you’ve got the interaction between the two. So, what’s happening is that investors can see gold moving higher or lower, and they form expectations on such trends – such expectations are being shaped and formed by the rate of change in the gold price. And these expectations impact on the discounted cash flow rates that the analytical community use to bring forward future sales of gold to the present in order to calculate and make calibrations to the asset valuations of the shares. And the daily gyrations of stocks – the inhaling exhaling of a speculative mood is creating bigger and bigger premiums to asset values. Gold shares are a volatility time bomb.

So, the principal variable is the rate of change in the gold price. Followed, or shaped by the normative / intellectual macro posturing of inflation expectations and central banking policies. It serves to create a fervent background. I take somewhat exception today to the notion that central banks have printed money, but these expansions in central bank reserves that we have seen this year are very, very large. Will they help the economy? Maybe? Will they help the stock market? They have. What will they do for gold? That’s the least uncertain part of the equation. Gold is deemed to be a riskless asset and in these rabid times the price of gold can become priceless…

So an intense macro dialogue about the economy and policy making decisions combines to shape and form the rate of change in the price of gold and this prompts stock analysts to fade and adjust their DCF rates constantly lowering them as the gold price inches higher and higher and all of this creates massive price leverage to the upside or indeed to the downside when periodic windows of self-doubt perpetuate. What can I say? Gold stocks are a wild ride!

Probably at the end of February 2003 my gold component had overshot and was beginning to anticipate an average gold price of $400 when the cash price was $300;  we went on to experience a price pullback but that’s for another time – And that’s why my tone in this month’s newsletter had not been victorious. I wasn’t high-fiving back then.

Actually, at the beginning of the manager’s report I did want to reflect on this notion of how is one to explain my simultaneous ownership of gold shares, commodity futures -well, that speaks for itself – but government bonds!? Some of you would know that between 2005 and the ensuing crash in US house prices nationwide, an unprecedented event, that I had been anticipating a deflationary event of this magnitude, and I had been arguing provocatively that if you thought the future was inflationary then you had to buy government bonds, which is to say, inflation would only be unleashed by yet more deflationary events which in turn would create heroic or even more adventurous interventionist monetary policy which itself would ferment another huge ride to the upside for gold.

But that’s not what I meant to say back in early 2003. It owed more to the price observation – a pattern that had emerged – that I called TORSCHLUSSPANIC.  Following the waterfall decline in tech stocks during the fallout from the TMT crash, most of the German stock market lost 80% of its value in those three years 2000, 2001 & 2002. I had been overseeing a unit trust, which is a British mutual fund, and I had done everything to preserve and add to its value. Indeed I had become “notorious” for not losing money – much easier for other managers to blame the impossible investing background to explain their losses but what if one guy was making money!? That got them nervous.

So, there I was avoiding as much equities as possible in my all stock unit trust (!) and investing in the least risky a.k.a bond-like equities. I retained a lot of cash and used my trust mandate to the max to justify buying government bonds – I really did not like losing money! So, no surprise that I would have had these German bunds at the beginning of my hedge fund career.

Torschlusspanik is a wonderfully graphic German word describing the harrowing situation of a fire in a cinema and the unfortunate audience rushing and fighting to escape through the exit. It had come to mind after the observation from Switzerland where the regulator had mandated a 3% guaranteed return on the country’s pension schemes. And it was implemented just as the 10-year yield had started to break the crucial 3%. That was the metaphorical cinema exit.

If you could secure a 3% yield, then you were risk free in terms of being the provider of these pension liabilities with this guaranteed rate. But what to do if the yield dipped to 2.99%? Overnight the pension providers would be signing their own death warrants. And yet buy they did and with great gusto. For sure they were destined to go bankrupt but the closer you could buy the bonds at yields near 3% the slower you went bankrupt – torchlusspanic. And, of course, that’s what drove yields down to 2.99 to 98 to 96 to 97. Today they are negative 70 or 80 basis points. And so that was the rationale for owning German bund futures whilst buying commodities at the turn of an up cycle – they just don’t teach you these type of eventualities in class.

Despite this being a gold bonanza episode, I just can’t stop myself from raining on the party to point out that as businesses gold miners SUCK. If you look at Newmont, again, the gilded Newmont that in the eyes of many can do no wrong. Well, the 10 years from 2002 to 2012 when the price rose from 310 to almost 1700, the EBIT margins for sure exploded but cash costs got out of hand – it’s so darn expensive to get those last ounces of gold out of the ground.

Cash costs more than doubled from $190 per ounce to something like 700$ an ounce. You still had operational leverage as demonstrated by the expanding profit margins, but net cash had gone from 5 billion positive to net debt! And they had had to issue shares. So, you as an equity holder, you’ve been diluted. And then gold production was down a third as well. So, unless you kept up with your rights, you own a third less and the mine has been permanently depleted by one third also, and that’s in the best of times…do you really want to buy gold mining stocks?

And the other thing that I observed is that there’s a huge volatility illusion at work between the returns cited owning just the mining shares versus the metal; that the price of gold shares typically vibrate two to three times more than the price of the gold futures. And so to truly compare how well the gold stocks perform relative to the metal, the opportunity cost of owning one set versus the other, you need to consider what your return would have been if you had invested instead 2x or 3x more in the gold futures. So, if you had 10% in gold miners in your Fund you had to think of that as the equivalent of holding 30% of the Fund in gold futures. Typically, you discover that, volatility adjusted, there’s no great rationale for exposing your Fund to the very specific risks of accidents, flooding, confiscation, taxes and rising marginal cash costs of extraction.

I mentioned royalty companies, Franco Nevada comes to mind. They’re like a kind of a smart venture capitalist whose Mastermind special subject is where is the gold? And they buy a percentage of production, they don’t pick up any liability associated with the cost of extraction, which as I explained above can prove quite ruinous. But that’s not a problem shared by the royalty companies – when the gold price goes up it’s their partners that have the pressing desire to get the gold out of the ground as quickly as possible, and it’s them who take on the extravagant cost of doing so. The royalty companies having written their initial prospecting cheque simply sit back and count as their royalties come rolling in off the back of a rally in the gold price. Good luck if you’re trying to do a valuation model. Been there tried that without success.

Ultimately I put my faith in the gold matrix: if you’re really risk hungry go buy the junior gold miners just now, especially because their valuation is compelling as they trade not far from 1x nav; if you’re trying to lay off risk, you could buy into the larger cap stocks; if you’re trying to lay off more risks and starting to get worried that gold has really had its big run then you should be in the permanent camp of the royalty stocks. Or you have a staging post strategy with a representation in each category of risk, changing your weights over the course of the rather extravagant nature of a gold bull market. Certainly that was what I witnessed in the year of 2003 and onwards, and it’s something that we’re probably experiencing now in the here and now of 2020

David Yarrow was a hedge fund manager; a British hedge fund manager from Glasgow like me, but David came from a very different part of Glasgow, his family owned the eponymous Yarrow shipyards, a big deal in Glasgow at the time. So DY was very socially connected but very entertaining. I’d met David at various speaking engagements and he always had that that WoW factor and he always made me laugh.

What comes to mind is that I recall having to attend one of these best of – tell me your best idea – sort of conferences and David was due to speak before me and he was such…like I said, very…entertaining but he was such a sucker for name dropping. So, he stood up and I chuckled to myself and I said this is going to be interesting. Me? I had yet to conceive of my best idea.

David immediately named dropped that one of his biggest investors in his hedge fund, his Fund was called Pegasus and had performed well, but shame on him because at the end of 1999, he was boasting that one of the biggest UK retailers of mobile phone contracts, Carphone Warehouse, was making him privy to all sorts of exciting developments in telephony that the wider market and other hedge fund managers were not wise to; that he had an edge…

As an aside, I had never understood why operators such as Carphone Warehouse should capture a lot of economic value in a mobile phone contract transaction. To my mind, they were like the butler offering you, the consumer, the phone on a silver platter but very much the business was being conducted within the grand mansion of the telephone operators. Who overpays their butler?

Regardless, I digress, because David continued that he was so lucky to have such friends in such exalted, high places and that he had just spent the weekend in an igloo with the chief executive of Nokia! And he proclaimed that from such a VIP vantage point – this cosy nook with the CEO of the most valuable company in the world – both looking misty eyed at the Northern Lights, that they had both concluded that the future just seemed so bright not only for the present, with Nokia’s huge 30% global market share (2x its nearest competitor), its big fat profit margins, and the fact that everyone loved its phones (?), but that the future promised to be even brighter.

I think it was the shameless name dropping that annoyed me most. I had found my best idea – short Nokia! And so, I countered that David and I shared more than a common ancestry, not our take on the future, but that we had some common investors. It’s just that I didn’t hang on their every word nor had I been invited to hang out on the ice. That I kept myself to myself. I don’t think I had any rage against Nokia in particular. I will pass on offering you a fundamental argument for why Nokia peaked at the end of 1999. I think that fundamentals as a reason are redundant in the kind of exponential terminal stage that we were then experiencing. My point was rather that we were towards the end of a price-bubble and that sooner rather than later it would come crashing down and Nokia as one of the darlings of the movement would come crashing down with it.

That I was correct is not the point of this story. But rather as I got back to the office, I discovered, much to my horror, that someone had ratted on me. That Carphone Warehouse was on the phone to my boss and they were seriously unhappy, “how dare you say such bad things about us in public”? Crispin Odey at times like this was just such a great boss. And he made light of the matter and despite insisting that I had to to call and apologize he wanted to wager on how many times a cocky ass like myself could say sorry! I remember beginning the conversation in front of our team by saying how I really was sorry, sorry, sorry, sorry, sorry, sorry. Sorry, I should never have said that…sorry.

I bought some Nokia just recently and I am way too early in buying it; indeed, I am feeling such a wave of revulsion that I may reverse the trade. Remember I seek confirmation for my crazy ideas: I needed Durbin Deep, the gold mining stock, to triple before I bought it at 10 in May this year before it subsequently traded to 18 just two months later.

But I purchased Nokia for the worst of reasons. Yes, it’s had a devastating bear market – who knew, David, back then sitting in that igloo? –  but even so these stocks can remain profoundly volatile at the bottom their historic price ranges and they can thrash around endlessly awaiting a future more gilded, less uncertain. This volatility can be enough to bankrupt you if you get your positioning wrong.

But the hook for me is the narrative surrounding fifth generation telecom infrastructure spend allied with the fact that Nokia seems durable enough to survive on its own as it is. However, there is optionality from the politically ordained demise of Huawei; its more successful Chinese competitor. There are some other Asian competitors, but I understand that their technology is inferior which just leaves Nokia and Ericsson.

I can’t fully understand why, with the US waging this political war against China, that it doesn’t have its own American national champion to pick up the pieces from the demise of Huawei. But then remember that embedded within Nokia is Alcatel Lucent. Lucent had been a big US telecom infrastructure play back during the TMT bubble in the 90s. It was acquired by the French after the demise of the huge order cycle and then the new entity was subsequently passed onto Nokia as the equipment suppliers continued their frantic game of survival and they shuffled assets back and forward between themselves after the huge bounty of 4G orders and investor sentiment had long since vanished.

But as I see it, why doesn’t Cisco, a giant US telecoms player, come in and offer to buy Nokia, and so create a national champion for the U.S to rally its flag around and ensure that the crucial 5G network is installed with no compromise on security, why not? I don’t know the answer to that. But the set up of a long bear market, no new lows and just such a paucity of other players to play this theme encouraged me to take a small modest position.

But really at this stage it feels way too early and risky for me. It’s as though the chief disciple of the Faith, me, were breaking the basic tenants of his creed…it trades around €4 in Europe but really I should be buying at prices greater than €6…I guess I think the gap risk from a take-over is just too great to wait for the comfort of the trend confirmation? Otherwise my hedge fund rule would have ordained that Nokia sit on the bench – like an inventory system of ripe ideas just awaiting their moment to shine for the team. But there is a discipline in awaiting the right time, that narrative without the correct price triggers can deny you the opportunity to participate in the explosive upside.

Reassuringly, Ericsson, the only other substantial player in the sector, has a similar but more developed price chart where the “voices” are most certainly beginning to chirp more positive vibes about the future. Again, buy the best and buy the worst in the sector when you are prospecting for a cyclical upswing; so I want to claim that I am just inside my framework for risk taking. Just…

And then finally, David Yarrow has been recurring theme in this podcast. I mention him again because I took a month out of the office back in November 2004 and I spent it in Mustique, very much the VIP Island in the Caribbean. Eclectic by name, eclectic by nature perhaps but cheap by name, cheap by nature, almost certainly.

I managed to reserve the cheapest house on the island. It was right on the beach, but it didn’t have AC. However, it did have these beautiful wooden shutters and you could open them and enjoy the cooling effect from the island breeze…except there was no island breeze that unfortunate month. And my son broke his ankle, he was four-years old four years old, and the medication made him grumpy and he couldn’t use the pool and couldn’t understand why, and did I mention that we took my mother in law?

Truth be told it was not a great time.  So much so that despite being offered the opportunity to buy the property for a million and a half dollars we declined. I was like, hmm, neighbours with Mick Jagger, Bryan Adams, Tommy Hilfiger; that sounds sexy – David would love it!  But having suffered such a miserable time, my wife said, we’re never coming back and that was that.

Anyway, on the way back to London, after a month marked by the very close American election between Bush and Gore and the drama in Florida, on the way back I was connecting via Barbados, and who do I see? But David Yarrow and he’s in business class and looking resplendently wonderful. And me? I just looked like something that cat has dragged in or as though I’m Robinson Crusoe and I’ve been rescued from a stranded island; a pretty sight I was not. And so, I put my head down and I sped past him to my cheap economy seats. But sitting back there, I promised myself that I was going to start my own asset management business. And so, I thank David. I thank him for helping me to break the status quo and to create Eclectica. It’s very hard to break away from an existing partnership, a super different, super energized, partnership which was Odey back then. But to see David sitting there in the expensive business class cabin was all the encouragement I needed. Pity about the house in Mustique which I’m sure today would be worth more than $10m. Jagger bought it.

And what you need is now for me to sign off. I promised you these podcasts were going to become more regular and yet I continue to fail with timeliness – I’m working on it. But yes, the Eclectica monthly for January 2003 is at an end, it was a good month: the boy has staged a comeback and the Fund is now modestly up since inception. So, tune in next time to find out what happens next. I think we already know – things get tough again. But anyway, thank you very much.

Thank you.