For John Burbank’s Passport Capital LLC, shorting individual stocks has just become too hard.
The $3.9 billion hedge-fund firm, which rose 220 percent in 2007 by wagering on a bust in subprime mortgages, reached the conclusion after losing money in June on some of its bets, it said in a second-quarter letter to clients, a copy of which was obtained by Bloomberg News. Passport, which didn’t anticipate markets rising so strongly, listed a decline in liquidity, or the ease of buying and selling securities, as one of the reasons, along with Federal Reserve Chair Janet Yellen bolstering markets and an increase in merger activity.
“There is no shame in acknowledging that this is an especially difficult market to make money on shorts even if you feel you have strong skill,” the San Francisco-based firm wrote.
For Passport, a contrarian investor, the answer isn’t giving up on betting against market declines. Instead, it expects to make fewer concentrated short bets, focusing on easy to trade securities and put options. Short sellers borrow shares to bet on a decline; put options represent the right to sell a set amount of stock at a set price in the future, offering another way to make a bearish bet.
Steve Bruce, a spokesman for Passport at ASC Advisors LLC, declined to comment on the letter.
Passport cited a Goldman Sachs Group Inc. basket of the most wagered-against stocks rising 8.1 percent in June and the bank’s index of companies with weak balance sheets climbing 14 percent this year, the best-performing group.
One reason for the dramatic increase is diminishing market liquidity. Starting in May, Standard & Poor’s 500 Index trading is down more than 20 percent relative to the year-to-date average, Passport wrote. Volume in the U.S. stock market has dropped to a daily average of 6.3 billion shares this year from 9.8 billion shares in 2009, according to data compiled by Bloomberg.
“Equity liquidity was quite poor in June,” Passport wrote. “Recognizing that low quality was outperforming and that liquidity would likely only worsen as we approached August, we chose to selectively reduce shorts with high short interest.”
Pacific Investment Management Co.’s Bill Gross, has also complained of deteriorating trading conditions. He said in a Bloomberg Radio interview earlier this month that global asset markets are showing signs of a “liquidity shortage” and “walking a tight line.”
Passport started to cut its holdings in Chinese Internet companies, although it’s still bullish on Qihoo 360 Technology Co., the owner of the country’s second-biggest search engine, and SouFun Holdings Ltd., which runs its biggest real-estate website, according to the letter.
During the second quarter the firm reduced its positions in Saudi Arabia by more than 50 percent because of factors including geopolitical risk, it said in the letter. In July, the firm rebuilt the holdings to 22 percent of the Passport Global Fund. That was before the kingdom’s regulator said it will publish rules allowing the first purchases by qualified foreign financial institutions starting next year, according to a person briefed on the matter, who asked not to be identified because the information is private.
The firm also touted its investments in Detour Gold Corp., CF Industries Holdings Inc. and Solazyme Inc. In the case of Detour, Passport sees the company showing “significant improvement in operations” in the second half of this year as its Detour Lake mine ramps up to capacity.
“We find DGC to be the most attractive takeout candidate in the gold space,” Passport wrote. The firm has bet against several gold miners “in an attempt to have near neutral exposure” to the sector.
The Passport Global Fund rose 1.8 percent in 2014 through July, the person said. Passport Long Short climbed 0.9 percent and Passport Special Opportunities advanced 15 percent this year.
Even with an expected reduction in its long wagers, the potential for equities to “melt up into year-end” can’t be ruled out, the firm said. Buying by sovereign wealth funds may support assets, Burbank, 50, said last week in an interview on Bloomberg Television.
A market decline could mean an opportunity for aggressive buying, according to the letter.
“I’m very bullish about U.S. companies, many different sectors, but I’m very bearish about liquidity,” Burbank said in the TV interview. “It’s a strange environment.”