Burbank Bets on Global Recession With Subprime Conviction

Passport Management CIO John Burbank
Passport Management LLC Chief Investment Officer John Burbank. Photographer: Jacob Kepler/Bloomberg

In the dozen years that John Burbank has run his $3.4 billion Passport Capital hedge fund, he’s never been as negative on global stocks as he is now.

Burbank, 48, expects that the U.S. and much of the rest of the world will slide into a recession, and he’s setting up for that event with a big wager that global stocks will fall. Most of his peers are still betting that stocks, especially those in the U.S., are more likely to rise than decline.

“You have a great contrarian outcome here that will be obvious in hindsight, just like subprime was,” Burbank said in a May 31 interview. “I have a lot of conviction about something that others don’t seem to see clearly.”

For Burbank, it’s reminiscent of 2006, when he bet big on a tumble in subprime mortgages, a wager that earned his fund 220 percent the following year. Unlike most equity-heavy hedge-fund managers, Burbank is comfortable making big bets based on macroeconomic themes, an investing style that has tripped up some peers as of late.

John Paulson, who made $15 billion betting against subprime, lost 51 percent last year in one of his largest funds with a wrong-way bet on a U.S. economic recovery, then missed out on the market rebound after scaling back risk.

Burbank also has a lot to prove. His main fund has climbed about 20 percent this year through the end of May, yet he’s still below his previous peak level after losing 50 percent in 2008, according to two investors, who asked not to be named because the information is private. After returning almost 20 percent in each of the following two years, his fund tumbled 18 percent in 2011. He lost money in the fourth quarter on emerging-market stocks and commodity equities with smaller market capitalizations, and when he started to switch his portfolio to a more bearish stance at the end of November, he missed the late-year rally.

Client Redemptions

Some clients have lost patience, pulling about $500 million from the main fund in the first quarter, according to a letter sent to investors. Redemptions from that fund, which now has $1.5 billion in assets, have since stopped. The firm had net deposits in the second quarter, said a person familiar with the fund who asked not to be named because the information is private.

“In 2006 we had a lot of redemptions before our strategy paid off,” said Burbank, adding that the fund lost about 20 percent from the subprime bet that year. “Redemptions are a lagging indicator not a leading one.”

Passport’s year-to-date gains, most of which were earned in the last two months, trounced other hedge funds and the stock market. Stock hedge funds have returned less than 1 percent this year through May 31, according to a daily index published by Chicago-based Hedge Fund Research Inc. The Standard & Poor’s 500 Index returned 5.2 percent in the same period.

Governments Broke

Burbank said that governments in the U.S., Europe and China can no longer afford to inject cash into their respective economies and that will cause global growth to slow.

“What was government stimulus is giving way to austerity because balance sheets are now swollen with debt,” he said. “We have reached the end of what governments can do.”

In 2008, the U.S. government provided a $700 billion bailout to save the banks, their management and shareholders. China that year introduced a 4 trillion yuan ($628 billion) fiscal package. Since December of last year, the European Central Bank’s longer-term refinancing operations have pumped more than $1 trillion euros ($1.25 trillion) into the financial system.

“They ran up so much in deficits with so little to show from it,” said Burbank. “It won’t be repeated. What happens the next three years is highly deflationary, we are stuck with even more debt, a bigger slowdown and we didn’t fix anything.”

Gains Erased

The Dow Jones Industrial Average last week erased its 2012 advance as economic reports showed the American jobs engine sputtered in May. Payrolls climbed less than economists had expected and unemployment rose to 8.2 percent from 8.1 percent. Manufacturing shrank in Europe and slowed in China, the world’s second-largest economy.

To benefit from the expected global slowdown, Burbank has 120 percent of his portfolio betting that stocks will tumble, and only 80 percent on wagers they will rise. In hedge fund parlance, he’s 40 percent net short. Most stock hedge funds, which can use borrowed money, or leverage, to buy more assets and amplify returns, were 46 percent net long as of last week, according to Morgan Stanley’s prime brokerage unit.

Copper and Gold

About 100 percent of assets in Burbank’s fund are bets against individual stocks he expects will plummet, and another 20 percent went to buy out-of-the-money put options on the S&P 500, which will gain in value if the benchmark falls. A put option is a contract that gives the owner the right to sell an underlying asset for a fixed price at a future date. The contract is out of the money if the strike price is lower than that of the underlying security.

Burbank says he’s focused on shares of copper and gold miners as well as gas exploration and production companies, which will all be hurt by a global slowdown. He’s bearish on financials and industrial companies as well. Financial stocks were among the main contributors to Paulson’s losses last year.

Since February, about 20 percent of Passport’s short book is in France, Spain and Italy, primarily in telecommunications companies, banks, consumer products and industrial companies. Burbank declined to disclose specific shorts.

Some companies in those industries have struggled amid the region’s debt crisis. Telefonica SA, Spain’s biggest phone company, is considering merging its German unit with Royal KPN NV’s German business as it seeks to cut its debt. The stock has lost 30 percent this year through May, including dividends.

Short Book

Bankia, the country’s third-biggest bank, was nationalized by Prime Minister Mariano Rajoy’s government on May 9, leading the lender with the biggest Spanish asset base to request 19 billion euros of state backing to clean up bad loans. The shares plunged 71 percent this year through last month.

Burbank said he’s also bearish on emerging market stocks because European banks don’t have the capital to lend to companies there. Emerging markets, as measured by the MSCI Emerging Markets Index, are down about 2.5 percent this year, with dividends reinvested, after having risen about 18 percent in the first two months of the year.

His biggest wager on a rising market, accounting for about 16 percent, is in Saudi stocks, which he likes because it’s an insulated market where foreigners only own about 2 percent of the shares. The currency is pegged to the dollar, and the companies there are growing fast and pay high dividends, he said.

Buying Apple

Burbank is also long innovative companies like Apple Inc., his sixth-largest U.S. holding at the end of the first quarter, as well as health care and consumer staples, industries that are considered defensive during an economic slowdown.

Another 11 percent is in mortgages, and about 9 percent in gold, as governments in India and China look to buy more of the precious metal. A separate mortgage fund, with about $200 million in assets, is up 6 percent this year, according to an investor.

Burbank, who graduated from Duke University with an English degree in 1987, never imagined he’d be a trader. He put himself through college running a house-painting business during the summers. After earning $35,000 one year, he figured he’d be an entrepreneur and got an MBA from Stanford University in 1992. Two years later, at the age of 30, he borrowed $50,000 from his credit cards and tried his hand at trading.

‘I Was Curious’

“I was curious,” Burbank said in the interview. “After reading and studying it, I decided to start trading. I had never done it before so I had to do it to understand it.”

The experience led to a two-year job as research director for ValueVest Management, and a one-year stint as a consultant for hedge fund JMG Capital Partners LP. In 2000, he founded Passport with $800,000.

Burbank isn’t fazed that other hedge-fund managers are still at least modestly bullish on the U.S. No one wants to miss a run up in stocks, he says, and even with May’s 6 percent tumble, the S&P 500 is still up 2.6 percent for the year. Most managers say it’s too risky to stay out of the market or to go short, he says, especially because over the last few years, governments have provided liquidity.

Burbank sees things differently.

“My whole approach is betting on things being different than they were in the past.”

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