Towards the end of last year we felt there was an interesting opportunity to be long equities hedged with a short position in the Euro. Our thinking was that equities were attractively priced as long as a crisis was averted, and most of the bad things we could imagine would either begin in Europe (i.e. Euro collapse) or affect it more than the U.S. (such as an Israeli strike on Iran given the EU’s greater reliance of Middle East imports than the U.S.). We employed this bias in Fixed Income where long positions in bank debt were combined with short Euro positions.

That trade is no longer interesting, because a short Euro is a less effective hedge now that it’s weakened. But a similar concept exists with gold miners and equities.

Gold and Silver miners have for many months been trading at a healthy discount to the NAV of their reserves. Although the optionality provided by a long position in a miner should be worth something (since a rising gold price ought to create a disproportionate increase in the stock through operating leverage while if gold falls to unprofitable levels they can simply stop digging) the market continues to price the sector at a discount. One obvious move is to buy the Gold Miners ETF (GDX) and short gold itself (GLD). However, this means simply betting on a reversion to the mean of the relationship, and there’s no knowing when that might happen.

Instead, long GDX and short S&P 500 is an interesting trade. Gold is out of favor and a short position isn’t likely to provide much protection from here. If gold does sink, along with GDX, it’s likely to be in response to slower growth so the short equity hedge should provide some protection. But in that scenario the odds of QE increase, so reflation ought to provide some support for the yellow metal. Conversely, if the world avoids all the various disasters that may afflict it, rising markets are likely to lift commodities with them, and the weaker US$ that would result in that scenario would also provide support for GDX.

The correct hedge ratio is less than 1:1 – we prefer something closer to $1 of GDX versus short $0.75 of SPY. And the correlation between GDX and SPY is not as strong at with GLD, but we think this combinaton of exposures makes more sense. In the long run (i.e. years) we don’t think gold will perform as well as equities. Warren Buffett and others have articulated most eloquently the problems with an asset that does nothing, pays no dividend and costs money to store. But we’re entering a period where developed world central banks will be redoubling their efforts at reflating, with the ECB likely to adopt their own form of QE in the next several weeks. Long GDX allows one to invest in mining stocks at a current discount to their reserves without direct exposure to the relationship continuing to deteriorate. This is why we are currently invested in GDX in our Deep Value Equity Strategy, since we think it offers an attractive risk/return profile compared with the broader equity markets.

The chart below shows the last two years of a position long GDX/short 75% SPY, and also the S&P500 itself, both rebased to 100 on August 2, 2010.

Disclosure: Author is Long GDX

Interesting piece from NY Fed on negative interest rates and the possible behavioral changes they would cause. If banks were charged for leaving deposits with the Fed, they would in turn charge customers for holding balances. It could cause all kinds of odd outcomes; naturally individuals would hold much more cash, but for corporations and institutions that wouldn’t be feasible. It could cause bills to be paid early, or where the recipient is highly creditworthy paid in advance. Many more certified checks could wind up being issued – you could issue one to yourself to avoid bank charges on the deposited cash. And special purpose banks might spring up who would hold deposits in the form of cash in a vault (as opposed  to make loans).

It all illustrates the difficulties presented by deflation, which is why we can expect the Fed to use all means available to avoid such a situation.

I hadn’t got involved in the recent flotation of Manchester United (MANU), perhaps Britain’s best-known brand of (English) football club. Not just because I’m an Arsenal fan either, but because investments in sports franchises can often be a case of heart ruling head and the Glazers (current owners) were unlikely to be selling cheap.

But this morning I came across this wonderful article that shows MANU’s IPO foisted on hapless retail investors was “Facebookian” in its cavalier attitude towards earning a return for new owners. IPO buyers have virtually no voting control, little prospect of a near-term dividend and proudly possess shares trading at 106 times earnings, a level Mark Zuckerberg even failed to emulate. And MANU describes itself as an “emerging growth company” (in order to qualify for more lenient disclosure requirements), a scarcely credible notion for anyone who grew up watching them in the 70s or earlier.

As long as deals like MANU’s IPO can get done it shows that not everybody’s hunkered down waiting for one of the many looming disasters (Euro/Fiscal Cliff/Israel-Iran/China Crash) to hit.

A few weeks ago the London-based Alternative Investment Management Association (AIMA) issued a “comprehensive rebuttal” of my book, The Hedge Fund Mirage. AIMA’s mission is to promote the hedge fund industry, so one might anticipate a breathless endorsement of their paymasters, and in this they did not disappoint.

 
I didn’t bother commenting on their report because it didn’t receive any mainstream financial press coverage. Few serious journalists took them seriously. And in any case, AIMA’s clients (i.e. hedge funds) have (unfortunately for their clients) been helpfully providing further empirical support for my assertion that $2 trillion in AUM is more than they can usefully manage by generating consistently mediocre results at great expense.

 
But Jonathan Ford in today’s FT rightly questions whether the hedge fund industry as a whole is over capitalized. Mr. Ford is providing a far more useful perspective for consideration by those pension funds cramming ever more assets into hedge funds than the industry’s increasingly ineffective and far from impartial lobbyists.

A little known element of the Greek bond restructuring of several months back was the granting of warrants whose coupons were linked to Greece’s GDP. Maybe this was inspired by Professor Shiller’s suggestion (most recently in his book, “Finance and the Good Society”) in which he proposed that the U.S. issue “Trills”, securities whose coupons would pay one trillionth of GDP annually. Such an approach is pro-cyclical, in that it links a government’s cost of financing to economic growth. While there’s no chance of the U.S. adopting anything so radical, the problem facing southern European Euro members is that slow GDP growth impedes their ability to finance their existing debt, perversely driving up its cost as the risk of default overwhelms the subdued inflation expectations that would normally drive rates down.

The Greek warrants were an attempt to share some of that risk with their creditors, and as noted in the FT today these originally unloved instruments have performed quite well of late.

It illustrates the many unconventional tools and limitless ingenuity of the Europeans to maintain the Euro and keep the European project alive.

We have been invested in gold miners through GDX for some time. Gold has been a mediocre performer but a form of quantitative easing is looking increasingly likely in Europe. The London Daily Telegraph today also believes that Germany will endorse “capping” the spreads between the bonds of weaker Euro members and Germany. If implemented, this really would represent the a blank check for the ECB to finance Italy and Spain and thus prevent high borrowing costs from offsetting their budget discipline. While controversial in Germany, it makes financial assets (such as bonds) marginally less attractive and we think improves the case for investments in real assets including gold. We are invested in GDX in our Deep Value Equity Strategy.

Barron’s ran a piece on MLPs (Master Limited Partnerships) over the weekend. Regular readers of our research will know that we have long liked the sector and of course run an MLP strategy. Finding sources of investment income while avoiding the tyranny of conventional bonds manipulated by government intervention is what we do, and MLPs fit with that approach.

The article was positive but nonetheless balanced (at least in my opinion). We’ve avoided MLP funds (such as closed end funds, ETFs etc.) for many reasons, including tax-inefficiency and leverage (investing with leverage is something we avoid). The article made the case for MLP funds in retirement accounts and for smaller retail accounts, and while there’s no reason to contradict what they wrote it remains true that direct investments in MLPs are the most tax-efficient way for high net worth clients with, say, $500K and up to access the strategy. It’s worth reading the article.

Greece is seeking a two year extension of its latest austerity program, arguing that the additional time would improve its chances of ultimately bringing its debt down to a sustainable level. This is hardly news. Many observers had already concluded that the latest plan was as unworkable as prior ones. But it does illustrate that the inconclusive, status quo can persist indefinitely. As with the penalties envisaged in the Maastricht Treaty that ushered in the Euro, fiscal penalties on sovereign states are a nuclear option and as such are only valuable until they’re used.

While many analysts have forecast that Greece will either be dumped out of the Euro or will leave voluntarily, regardless of who initiates such a move the consequences are huge and unpredictable. As long as neither side miscalculates, it’s quite plausible for this seemingly perpetual round of renegotiations in which the Greeks seek forms of debt forbearance but stop short of provoking the EU to kick them out and the Germans keep squeezing but stop short of driving them out. As unsatisfying as this may seem to an outsider, why would it ever end?

By reducing the odds of an imminent Euro disaster it makes equity markets somewhat less risky, and bonds less attractive. Of course we still have to contend with the looming fiscal cliff in the U.S., a potentially far more damaging event for the U.S. economy and one whose resolution has been pushed off to a post-election lame-duck Congress with highly unpredictable results. Whatever your political leanings, virtually everyone must agree that this is an abrogation of responsibility by America’s leaders.

Volatility (as defined by the VIX) has been trending lower, as the many sources of bad news fail to get any worse and confiscatory interest rates relentlessly push investors into the water. Investors are searching for ways to bet on it rising again – a tricky concept to get right. As investors climb the wall of worry through buying stocks they push down levels of implied volatility in the process.

Bonds are without doubt guaranteed both to return your money and to reduce its purchasing power. It’s a Faustian bargain readily accepted by many, and yet the pessimist would say you can lose money quickly (in stocks) or slowly (in Bonds). Without dismissing such fears, I’d simply say that figuring out how much of the bad news in the the overall level of the market isn’t something that we spend an inordinate amount of time on. Better to focus on companies that can survive the bad things that may come and can prosper if everything turns out not quite so awful.

In our Deep Value Equity Strategy we’ve made a few modest changes over the past couple of weeks. We have net raised a bit of cash, mostly through trimming positions that had grown too big rather than through any darkening top-down view of the world. We reduced our position modestly in Comstock Resources (CRK). We still like the natural gas theme and CRK is making the right moves, repaying their revolver with $300MM of long term debt maturing in 2020 (incurred following their purchase of properties in west Texas) and continuing to shift their capex to oil while natural gas prices remain weak. They also announced a partnership with KKR sharing their development risk in their Eagle Ford shale. About a year ago BHP Billiton acquired Petrohawk (HK), in whom we were invested, at a 60% premium but more recently had to take a writedown on the shale gas assets then acquired. Floyd Wilson, then Petrohawk’s CEO, always said he wanted to sell the company and showed timing of a similar order to Steve Case (AOL to Time Warner) or brother Dan Case (H&Q to JPMorgan) with that move.

But it’ll be a while before CRK realizes the value in its portfolio through being acquired, and daily volatility of 5 times or more the equity market caused us to trim this back somewhat. We maintained our energy exposure with an investment in Kinder Morgan Inc., (KMI), which owns most of the GP for Kinder Morgan Partners (KMP).

We invested in Leukadia (LUK), a holding company with a fairly eclectic portfolio of businesses that has been trading at a discount to book value for some time and recently dipped when Knight Trading (KCG) almost bankrupted themselves through a poorly debugged trading program. LUK owns a portion of Jefferies (JEF), and no doubt traded down in sympathy at that time.

We’ve also invested in Burger King (BKW), which recently started trading in the U.S. following an investment by a UK SPAC called Justice Holdings and controlled by Bill Ackman. BKW is in the midst of a turnaround, and generates about $1.1MM per year from its restaurants, far less than its peers in the Quick Serve Restaurant (QSR) industry such as Wendy’s (WEN) at $1.4MM or McDonalds (MCD) at 2.4MM! We also own MCD in our Hedged Dividend Capture strategy.

Finally, we sold some of our position in Kraft (KFT) as it broke through $40. Kraft will split into two in October and we still think it’s a good investment but no longer worthy of a maximum position at current prices.

We watched the JCPenney earnings webcast with interest last week. We have around a 4% position in JCP – although we began accumulating the position over a year ago (after CEO Ron Johnson had joined the company but before he assumed his high profile CEO role). In a spectacularly wrongheaded move earlier this year we neglected to take profits when it reached $40, so convincing was the smooth yet inspiring Ron Johnson in his investor presentation. It was a missed opportunity as the stock proceeded to lose half its value through collapsing sales as the transformation of JCP proceeded not altogether smoothly. We’ve neither bought or sold JCP for several months, and will likely do nothing for quite a long while. If they can truly pull off the change they’re projecting then the company will be worth substantially more, and in the meantime they have enough cash and cash generating capability to provide time. We’re going to wait this one out.

From Felix Salmon’s examination of AIMA’s latest attempt to counter the criticisms of the hedge fund industry in my book. Felix is far more eloquent than I ever could be in assessing AIMA’s report. It’s well worth reading his analysis.

The title isn’t my creation, but is rather the work of Michael Edesess, PhD, CIO of Fair Advisors (an investment firm) and author of The Big Investment Lie (which I am currently reading). Michael just posted a review of my book, and he does an excellent job of summarizing the highlights and adding his own commentary. I had a most interesting chat with him a couple of weeks ago when he was writing the review from his office in Hong Kong.