Note the full document is embedded below in scribd for easier reading (and contains charts).
October 31st, 2011
Dear Passsport Global Investor:
For the thhird quarter, Passport Gloobal Fund Class A was down -8.1% neet versus -17..3% for the MMSCI
AC World Index andd -13.9% for the S&P 5500. Since inception in August 200, the Fund has compounded at +20.55% net on ann annualized basis. Over the same perriod, the MSSCI AC World has compounded at +1.0%% and the S&P 500 at -0.22%.
Q3 in Review
As has been the case for most of the prior four years, macro events were a key driver of liquidity and
prices in Q3. A quick review of the quarter’s major events:
Hang
DAX Seng Brent 10 Yr.
Date Event S&P (EUR) (HKD) Crude UST Gold DXY
30-Jun-11 Fed ends QE2 1321 7376 22398 113 52.7 1500 74.3
2-Aug-11 Debt ceiling debate deadline 1254 6797 22421 116 59.3 1661 74.5
4-Aug-11 China hard-landing fear 1200 6415 21885 107 60.9 1647 75.1
5-Aug-11 S&P U.S. debt downgrade 1199 6236 20946 109 59.0 1664 74.6
8-Aug-11 S&P August Bottom 1119 5923 20491 104 61.4 1720 74.8
26-Aug-11 Jackson Hole Fed Symposium 1177 5537 19583 111 63.3 1828 73.8
12-Sep-11 French bank solvency fears 1162 5072 19031 109 65.0 1815 77.6
20-Sep-11 FOMC Meeting 1202 5572 19014 109 65.1 1804 77.0
21-Sep-11 Operation Twist announced 1167 5434 18824 109 65.3 1782 77.3
30-Sep-11 End of Q3 1131 5502 17592 101 64.5 1624 78.6
Change from FOMC Meeting -6% -1% -7% -7% -1% -10% 2%
Q3 Performance -14% -25% -21% -9% 22% 8% 6%
In aggregate, action (and inaction) by central banks and governments had a negative impact on risk
assets. As the table above depicts, equity indices around the world and commodities like oil declined
while safe havens including U.S. Treasuries, gold, and the U.S. dollar rose. Notably, the Fed’s
announcement of “Operation Twist” did not provide a lift to risk assets and in our view was far too
modest to meaningfully impact a struggling U.S. economy, stubbornly high unemployment, and
collapsing consumer confidence.
As a result, the quarter proved quite challenging for the Fund’s commodity equity and emerging markets
exposure. Many of the sectors and regions in which the Fund invests sold off much more than the major
indices:
Q3
Sector (Fund Exposure) Relevant Index/ETF Performance
Basic Materials (20%) XME (Metals & Mining) -35%
XLB (Materials SPDR) -25%
Emerging Markets (17%) EEM (MSCI Emerging Markets) -26%
BOVESPA (Brazil) -19%
Tadawal (Saudi) -7%
Energy (11%) XLE (Energy Select SPDR) -22%
OIH (Oil Service Holders Trust) -32%
Internet/Tech (9%) NASDAQ -13%
Europe (6%) FTSE (London) -16%
CAC (France) -25%
DAX (Germany) -25%
Many of the Fund’s holdings suffered even greater markdowns. On average, the Fund’s top ten holdings
at quarter-end had been marked down nearly 25% during the quarter as shown below:
Top Ten Holdings
2011 Performance
(dividends
reinvested)
Company Q3 YTD
1. Walter Energy -48.1% -52.9%
2. Thoratec -0.5% 15.3%
3. Marathon Petroleum -34.3% -30.2%
4. Cytec Industries -38.4% -33.3%
5. Tarpon Investimentos 6.4% 20.4%
6. Crew Energy -38.1% -51.4%
7. Liberty Media -12.0% -6.4%
8. Labrador Iron Mines -52.7% -50.2%
9. Cie Financiere Richemont -24.9% -24.8%
10. Yanbu National Petroleum -4.4% -5.0%
Average -24.7% -21.9%
In our view, these markdowns do not reflect meaningful change in the underlying fundamentals of these
companies; more on this later. Rather, they represent investors’ flight from risk assets in the face of rising
global uncertainty.
Risk Commentary
For the last twelve months, the Fund had a daily annualized standard deviation of 10.2%. The MSCI
AC World Index had a daily annualized standard deviation of 17.9% and the S&P 500 had a daily
annualized standard deviation of 19.9%.
While the S&P 500 Index declined 13.9% in the third quarter, this beta source fails to capture our heavy
allocation to resource equities, which declined much more sharply. As described earlier, XME (SPDR
Metals & Mining ETF) declined 35% in the quarter and OIH (Oil Service HOLDRS Trust) declined
32% in the quarter—with the bulk of these declines coming in September.
As we discussed on our Q2 Global conference call, there were many risks we believed the market was
mispricing. We proactively positioned ourselves in June and July for a fall dislocation while maintaining
our core holdings. August was the easier dislocation to hedge as optionality was cheap, and during the
dislocation we rolled our puts down several times. Between August 9th and 11th we monetized the bulk
of the puts, allowing our net beta to rise while leaving puts in the tail to lean on. After a significant
bounce in mid-August we reinitiated many of our hedges—this time coming back primarily through
short ETFs, short currencies, and short physical commodities on swap. After the bounce, skew appeared
too expensive and it was not the appropriate time to add back equity optionality. Each environment may
suggest a different, proactive portfolio construction in order to hedge optimally.
September’s dislocation was far more difficult. The first half of September progressed generally as we
expected, but during the second half of the month, with volatility still expensive, we saw rather stunning
liquidations of idiosyncratic long positions. We only had one CVaR day in the month, suggesting that it
was a slow bleed of alpha rather than a binary event. While thematic hedges performed well, many of
our company-specific equities, particularly those in Basic Materials and Energy, declined sharply—even
more so than our commodity equity hedges and physical commodities we were short on swap. XME was
down 23.3% in September and OIH was down 22.9%. From our perspective the last two weeks of
September were the culmination of several events: 1) China growth scare speculation which coincided
with a large quantitative factor rotation away from growth securities; 2) de-risking and cash raising by
hedge fund and mutual fund managers in an increasingly illiquid period for company-specific securities;
and 3) the continual basis risk and crowding between being long idiosyncratic risks (alpha) and short
indices (beta).
Given the carnage in commodity equities, we believe we have likely taken the bulk of the basis risk pain
in our resource theme. We viewed this as an opportunity to continue to add to some very attractively
priced resource, consumer and technology names that we believe now have very attractively priced
expected returns on a 1–2 year basis. Given extremely high correlations, it is imperative to recognize that
short term price movements are more a function of macro variables than bottom up fundamentals. We
are using dislocations to think long duration and acquire companies with strong fundamentals. As the
average investment period of a hedge fund shortens, longer term opportunities become more attractively
priced. Liquid, short-duration hedges may be utilized in an effort to bridge the gap between long-
duration fundamentals and short-term beta and volatility management.
While it may sound counterintuitive, from a risk management perspective we are now as concerned
about the upside tail as we are about the downside tail. Institutional investors are broadly and presently
greatly concerned with risk. While there are some serious known risks, it is the unknown risks that
concern us most. Investing is a two-tailed distribution with risks to both sides. For several months, one
of the biggest risk factors has been the correlation between equities. We saw a substantive increase again
in equity correlations this past quarter such that the top 50 names in the S&P are exhibiting a realized
correlation above 90%, and the top 500 are exhibiting a realized correlation above 75%. This suggests
equity diversification is nearly impossible and beta is the driver of risk. Add to this the fact that many
managers are buying company-specific names and hedging them with short indices (rational behavior
with correlations this high) and you have a recipe for trouble. Our present concern is that in any rally
indices may greatly outperform stock-specific equities, as was the case last week. Recognizing this risk,
we utilized the early October decline to reposition out of our delta one hedges and back into front-
month tail risk optionality—this time for a different purpose. In this environment of high correlation
and volatility, we want to bet on the tails: we want to open up upside beta to ensure we capture a portion
of any rally, given how cheap our idiosyncratic names are, and at the same time we want to have high-
gamma front-month protection such that we are protected in a sharp move down; it is the convexity of
beta that matters. Much as the last week of Q3 exhibited, it is our view that in this environment being
directionally net long 30–40% with index shorts will make it difficult to keep pace with beta in a rally
because correlations will stay stubbornly high until we get some resolution on macro events or central
bank intervention.
We will be discussing these topics in much greater detail at our November conference.
What’s Your View?
While the extreme volatility of the third quarter is a very unhealthy signal from markets, it has provided a
welcome opportunity to communicate frequently with many of you. The following are recurring and
important questions:
Q.
Do the events of Q3 invalidate any of Passport’s key themes?
A.
No. While inaction by Western leaders and tightening in China have deflationary implications
near-term, the secular drivers of our themes (listed below) are intact:
1.
Debt and imbalances continue to make unprecedented the role of governments in
economies and markets
2.
Persistent resource scarcity—be long what China is short
3.
Demographics, productivity trends, and financial strength support long-term expansion
of consumption in leading emerging markets
4.
Debt and deficits in the U.S. and G7 mean poor economic growth and range-bound
financial markets for years to come
Q.
How do crises in the EU, gridlock in Washington, D.C., and the threat of recession not
overwhelm global growth? Why would liquidity seek out risk assets with this backdrop?
A.
We believe that the political unacceptability of deflation means that Western policy makers will
be forced by market prices to reflate. Meanwhile, reduced emerging market inflation (especially
commodity prices) will allow China and other emerging markets to begin monetary easing (as
Brazil has). These are the seeds of the next “risk on” period.
Q.
How will you know when it is time to take more risk?
A.
In our assessment, the primary influencers of liquidity are (in descending order of importance):
1. The U.S. Federal Reserve
2. China
3. The U.S. Congress
4. President Obama
5. The E.C.B.
6. E.U. politicians
7. U.S. investors
8. Japan
9. Collectively, the other emerging markets
In formulating our near term strategy, we have considered the actions of each of these players in
response to the unfolding crises, and what each can do from here. The “star” player, the Fed, has
also been the most accommodating, constantly redefining “easing” while keeping rates low in an
effort to stimulate the U.S. economy and markets. Recently, though, the Fed has backed off.
Operation Twist was a much milder tonic than the two prior rounds of quantitative easing, and
it appears to us that a third round of quantitative easing will require strong evidence of recession
given the politically charged environment in which Chairman Bernanke finds himself. China,
the most overlooked player in this context, is focused on inflation and the turnover of power in
Fall 2012. It is our view that China, because of its economic confidence, is unlikely to ease until
inflation is well in check. Taming Chinese inflation may take more time. Obama and Congress
have largely rendered each other impotent. Similarly, the ECB and EU officials appear incapable
of solving their political/economic crisis until forced to by the markets. The other players—U.S.
investors, Japan, and the rest of the emerging markets—have largely followed and not led, and
we expect this to be the case for the foreseeable future.
It would appear to us that the players to watch are Western and Chinese politicians and central
bankers. For now, all appear to be essentially inactive. Given the underlying deleveraging
pressures, this inaction is deflationary. In the next several quarters we’ll be watching for signs of
easing; worsening U.S. economic and unemployment data for the Fed and a slowing of
commodity inflation in China seem to be the likeliest catalysts for now.
Q.
Is China finally on course for a hard landing?
A.
No. China is misunderstood. We’ve evaluated the arguments of many China bears and offer
our thoughts below:
CChina’s Credit-to-GDP unnbalancedChina’s Credit-to-GDP unnbalanced: CChina’s creditt-to-GDP levvel, even including off-ballanceshheet
items, is approximatelly 180%, muuch lower thann developed ccountries likee the U.S. or Japan
att more than 3300%.
l
MMuch focus h as been placeed on the abssolute level off credit to GDDP. Howeveer, it is the chhange
thhat counts. WWhile Chinesee loan growthh is beginningg a digestion period, we seee no evidencce that
CChina, whose fast growth enables it too “de-lever naaturally” wheen needed, iss collectively overleeveraged.
Foor context, Eastern Europpe experienceed a fast-risinng credit-to-GGDP ratio off over
80% in 2003 to nearly 1000% in 2007––08 prior to iits trouble. DDuring the saame period, CChina
wwas actually unndergoing deeleveraging (ccredit-to-GDPP dropped froom 160% inn 2003 to 1400% in
2008) before iit released a ccredit and stiimulus packaage in responsse to the globbal financial crisis.
CChina initiatedd preemptive tightening inn early 2010, and leveragee appears to bbe stable in sppite of
sttrong GDP ggrowth, simil ar to what itt experiencedd from 2003 to 2008. AAdditionally, bank
looan-to-deposiit ratios are al so stable and household saavings rates reemain high.
Innfrastructure or “Fixed Asset Investtment” (FAII) decline caannot be offfset by dommestic
coonsumption: Compare d with othher developinng nations, China’s FAAI and dommestic
coonsumption appear healthhy relative too its stage off developmennt. China exxperienced a 13%
decline in connsumption as a percentagee of GDP froom 2000 to 2010; Japann and South KKorea
exxperienced 144% and 21%% declines inn consumptioon during thheir respectivve periods off high
caapital intensiive growth (Japan: 195 5–70; Southh Korea: 1978–88). TThe U.S. simmilarly
exxperienced a 25% fall in consumptionn early in thhe twentieth ccentury. Immportantly, China’s
abbsolute and pper capita levvels of consuumption havee been grow wing strongly: we estimatte per
caapita consummption growthh accelerated to 10% annuually in the laate 2000’s froom 7% annuaally in
thhe late 1990’ss. For Chinaa’s consumptiion to rise as a percentagee of GDP froom its currentt level
off 34% to the developed wworld average range of betwween 46% annd 54% over the next ten years,
7
and assuming 8% GDP growth, consumption would need to rise between 11% and 13% per
annum, an acceleration of about 2% per year. In terms of infrastructure investment, China’s
FAI appears reasonable compared to the industrialization of the U.S. and Japan. China’s
estimated 2010 capital stock per capita (at constant 2005 prices) is $9,000, 6 to 7% of the U.S.’s
2009 level and less than 25% of the U.S.’s level during the Great Depression in 1930. China’s
estimated 2009 capital stock per capital (in constant 2000 prices) is 7% of Japan’s, or similar to
Japan’s level in 1970.
Economic slowdown in the West will adversely impact China’s export-dependent economy:
Exports are becoming less relevant to Chinese growth, especially since the 2008 global financial
crisis. Net exports as a percentage of GDP fell from a peak of 11% in 2007 to 6.4% in 2010.
Net exports’ contribution to GDP growth fell from peak levels in 2005 of 23% to 9.2% in 2010
and -0.7% in 2011 (a year when expected GDP growth will exceed 9%!). Infrastructure
investment and consumption should continue to offset China’s slowing export sector.
Underground lending will trigger systemic risk: Although limited data is available on China’s
underground lending, we believe it to be of limited scale. An estimate by Credit Suisse puts
China’s total underground, or informal, lending is about RMB 4 trillion, approximately 8% of
the formal lending market or 5% of China’s total RMB deposit base. Despite reports of
widespread underground lending in China, a national survey conducted by CLSA’s China
Reality Research for Q2 2011 indicates that underground lending funded only 6% of SME
capital expenditures, down from 13% a year ago.
Underground lending is not a new phenomenon in China. Inevitably, the underground market
becomes more active as Chinese monetary policy contracts, as it serves as an alternative financing
channel for smaller borrowers. Underground lending was rampant during China’s previous
tightening cycle (2007 through mid-2008) but did not cause any shock to China’s financial
system.
Oversupply of housing will lead to property sector collapse: Sales of homes in China actually
exceed completions, indicating inventory destocking (not oversupply). While housing starts have
exceeded both completions and sales by a wide margin, our research suggests that this number is
inflated by local government and developers’ seeking to promote their own growth. China’s
housing shortage was estimated by Dragonomics to be 86 million units in 2009, falling to 70
million units by 2015. Despite greater than 80% home ownership, much of China’s housing
stock is older, poor-quality state-constructed housing sold very cheaply or nearly free during the
1990s’ Housing Reform. We believe the demand for higher-quality homes and living standards
is high. According to a national survey conducted by CLSA’s China Reality Research, over 75%
of housing demand is from first-time or upgrade buyers and not investment buyers.
Q. Are fundamentals for risk assets better or worse than in 2008?
A. Better. Commodities provide an interesting illustration.
At the outset we note that commodity prices are deceiving. We compared a basket of exchange
traded commodities to a basket of non-exchange traded commodities.
–
Note: The Non-Exchange Traded Commodities basket consists of the following indexes: China import Iron Ore Fines 62
[TSIPIO62], Qinhuangdao 6000 kc GAD fob St [CLSPCHQUI], Metal Bulletin Ferrous scrap [MBSF8309]. The
Exchange Traded Commodities basket consists of the following indexes, ETF’s, and equities: LME COPPER 3MO ($)
[LMCADS03], LME ALUMINUM 3MO ($) [LMAHDS03], LME NICKEL 3MO ($) [LMNIDS03]
Exchange traded commodities have capitulated, falling nearly 23% YTD, while non-exchange
commodities remain nearly flat on the year. This resembles what occurred in 2008, and suggests that
price declines in exchange traded commodities may not fully reflect underlying commodity demand.
One example can be seen in the price of oil. According to the U.S. EIA (Energy Information
Administration) statistics, world oil production is up just +0.9% on June 2008 levels; world oil output
has been virtually flat for the last three years. Offshore decline rates are greater. Statoil (the largest
Norwegian operator) has seen total production declines of 6% annually, even with continued investment
in new wells. It largest producing fields, Gullflaks and Kristin have experienced annual production
declines of -23% and -31% respectively.
Meanwhile, the emerging market’s demand for oil grew unabated. In China, for example, comparing
June 2011 with June 2008, monthly car sales were up 89%, highway miles traveled were up 32%, rail
passenger miles were up 27%, air passenger miles were up 68% and total passenger miles for all
categories were up 34%. It is hard to imagine that total passenger miles will stop growing, regardless of
oil production.
Another example where supply does not appear to be keeping up with demand can be found in iron ore,
a key input of steel:
.
Global steel production collapsed in the Q4 2008 and on an annual basis troughed in
2009. 2009 production was 1.2 billion tons, down 8% vs. 2008 which itself was down
1% from 2007. In 2011, it is expected to be 1.5bn tons: up 26% vs. 2009.
.
Chinese steel production also collapsed in Q4 2008. The trough for China was 2008
where production was 498mt. In 2011, we project that they will produce 705mt, up
42% since 2008.
.
Expressed in iron ore tons, the global increase from 1.2bn tons to 1.5bn tons is
equivalent to 360mt of incremental iron ore demand. (This assumes 70% of the steel
increase is from blast furnaces that use iron ore, and assumes 1.6t of iron ore per ton of
steel.) For China, the increase in iron ore demand was 282mt.
But supplies of iron ore have not kept up:
.
The seaborne iron ore supply has increased from 848mt in 2008 to 1,021mt in 2011 —a
20% increase in supply. Compare this to China’s 37% increase in demand (given that
most of the seaborne demand comes from China). Even if you compare that to the
global demand increase (up 26%), we still come up short.
.
Measured from trough to peak and expressed in tons, China needed 282mt more iron
ore but we added only 173mt to the seaborne supply.
.
Where did the incremental iron ore come from? Australia, Brazil, and India, the three
largest exporters, did not meet demand; Australian exports are up only 33%, Brazilian
exports are up only 20%, and Indian exports are down 24%.
.
The tons that are missing seemingly came from marginal production sources including
China and the rest of the emerging world. In China, run-of-mine (i.e., raw) iron ore
production increased from 785mt in 2008 to 1214mt in 2011 (YTD annualized).
That’s a 55% increase; however, the grades have decreased from 23% Fe to
approximately 17% Fe. So on an Fe unit basis, the Chinese have had to increase mining
production by 55% to get 15% more iron ore units. On this basis, it is not surprising
iron ore prices have stayed high.
Top Holdings
On September 30, the top ten equity positions in the Fund accounted for approximately 26% of AUM:
RANK COMPANY TICKER % NAV
1 Walter Energy WLT US 5%
2 Thoratec THOR US 3%
3 Marathon Petroleum MPC US 3%
4 Cytec Industries CYT US 3%
5 Tarpon Investimentos TRPN3 BZ 3%
6 Crew Energy CR CN 2%
7 Liberty Media LINTA US 2%
8 Labrador Iron Mines LIM CN 2%
9 Cie Financiere Richemont CFR VX 2%
10 Yanbu National Petroleum YANSAB AB 1%
An update on some of these positions follows:
Walter Energy Inc. (5% NAV): Walter is a new position in the Global Fund and represented
approximately 5% of Fund NAV at quarter end. Walter is the largest pure play metallurgical coal
producer in the world and is the sixth largest seaborne met coal supplier worldwide.
We believe met coal fundamentals are underpinned by very solid demand growth driven by rising steel
production in emerging markets (especially China, India, and Brazil) and by chronic supply shortages.
The met coal market was in deficit in 2011 as demand grew close to 8% while weather-related supply
disruptions in Australia caused global met coal production to remain virtually flat. Even as supply
conditions normalize, we still expect the met coal market to remain in deficit for the foreseeable future.
It is simply too hard to bring new supply on line: premium hard coking coal, which is the kind of met
coal that Walter produces, is geologically very scarce, and infrastructure constraints, especially in
Australia where there’s a shortage of port and rail capacity, limit current availability.
On the demand side, we expect growth from China, India, Brazil, and other emerging markets as they
grow their steel production. China has recently become a net importer of met coal over the last two years
and should remain so for the foreseeable future as its ability to expand production is hitting many
hurdles with mine consolidation, safety and environmental issues, high labor costs, low mechanization,
and rail bottlenecks. We believe China is increasingly looking to preserve domestic coal resources, and
new policies are being discussed to encourage imports.
Met coal prices have remained elevated in 2011, increasing from $225 in Q1 to $330 in Q2 and settling
at $285 in Q3. For 2012, we are assuming that met coal prices will average around $250, which is the
price at which China favors imports over domestic production. With low-cost producers such as Walter
able to produce met coal for about $120 per ton, a price of $250 means that margins should be very
healthy.
In our view, Walter has the best met coal assets in the world outside of the major mining companies. Its
mines Four and Seven in Alabama produce among the highest-quality premium hard coking coal and
have well-established markets in Europe and Brazil. The company also operates three mines out of
Northeast British Columbia that sell hard coking coal and ultra-low volatile pulverized coal injection (an
auxiliary fuel for blast furnaces) to Asian steel mills. Because of the high quality of its coals and because
its mines are globally significant, we believe Walter is a strategic asset, one that may be a logical takeover
target for several of the large diversified mining companies that have insufficient met coal exposure.
Walter has an attractive growth profile at its Canadian operations and the ability to increase production
at its U.S. mines. The company believes it can increase met coal sales volume by 50% by the end of
2013.
The company’s shares fell from approximately $116 to $60 during the quarter. The market cap was $3.8
billion at quarter end, down from $7.2 billion a few months ago. We believe the valuation already
reflects a global recession and assumes no growth in production and, as a result, we think the risk/reward
ratio is highly compelling. Based on our model, which assumes $250 met coal, the company is trading at
5.1x 2012 P/E and 4.3x 2012 EV/EBITDA. These low multiples are even more appealing in light of the
recently announced $4bn acquisition of Macarthur Coal by Peabody and ArcelorMittal which valued
Macarthur at 10.5x 2012 EV/EBITDA. We judge Walter’s assets to be superior to Macarthur’s.
Marathon Petroleum Corp. (3% NAV): Marathon is a U.S. energy refiner with diversified and
profitable assets in the US midcontinent. The company is one angle that we are playing to capitalize on
the wide WTI/Brent crude spread trade. We believe that the current market conditions will create an
environment that could produce outsized profits for this company. At quarter end MPC had a market
cap of $9.6 billion and an enterprise value of $11.3 billion, and has well-diversified assets in the U.S.
mid-continent. In addition to a profitable mix of assets, Marathon has what we feel is a superior
management team that has demonstrated great operational performance for over the last 30 years. Since
1998, the company has been profitable, which we think is an impressive statistic.
Our model employed in evaluating MPC uses a WTI/Brent crude spread of $13. Under the parameters
of this model, we believe the company will generate, in a base case, EBITDA of $4.7 billion in 2012 and
2013, resulting in an EV/EBITDA ratio of 2.1x. Traditionally the refinery group trades at 5 to 7 times
EBITDA. If the mark to market for the WTI/Brent spread remains elevated in the vicinity of $16 for
2012, this would add approximately an incremental $400 million to EBITDA. We’ve stress tested the
company under the parameters of a recession similar to 2009 and our model suggests that MPC would,
according to our assumptions, still be generating EBITDA of $3 billion. We expect the company should
have strong free cash flow yields of approximately 20% for 2012 and 2013; even if there is a recession in
2012 in the U.S. similar to 2009 we project it will generate low double-digit free cash flow yields. With
this potential ability to generate free cash flow, we believe MPC has significant room to add shareholder
value.
Cytec Industries (3% NAV): Cytec is one of only a handful of companies with the technology to
produce aerospace-quality grade carbon fiber, which is rapidly replacing aluminum as the primary
material of construction for commercial aircraft. There is a large upswing in both legacy aircraft builds,
which traditionally have been about 10% carbon fiber by weight, as well as new design builds such as the
Boeing 787 Dreamliner and Airbus A350, which are greater than 50% carbon fiber. We believe Cytec’s
carbon fiber sales will grow at over 20% annually for the next few years as a result.
In many respects, the situation for Cytec today is much better than it was in 2008 heading into the
financial crisis. In 2008, customer inventories for many of Cytec’s products were running at very high
levels. Today, buyers have more moderate inventory levels. Inventories of carbon fiber and other
composites at all the suppliers and aircraft manufacturers are difficult to measure, but Cytec’s total
company inventories are down approximately 30% since the third quarter of 2008. Heading into 2009,
carbon fiber demand grew 2% year-over-year, while 2012 demand appears to be up 28% year-overyear.
We believe the aerospace cycle is largely insulated from the potential economic crisis for at least the
next two years. In 2008, Cytec’s net debt-to-equity ratio was 38%; today it is 8%. This reflects the
company’s efforts to massively delever its balance sheet and reduce risk. We estimate that the company
could be debt free by the end of 2012, assuming it doesn’t increase its share buyback program, and either
case is a positive for shareholders. In late 2008, Cytec’s EV/EBITDA multiple hit 3.4x for a very short
period; historically, the company’s EV/EBITDA multiple has averaged 6.1x. We believe the company is
heading into a strong aerospace cycle and has shed its lower multiple commodity chemical
business. Thus we expect the company to be valued at least at between 6–7x EBITDA to reflect
significant improvements to its business mix, cost structure, and balance sheet.
As of quarter end we were hopeful of either an improvement or an outright sale of its low margin coating
resin business which had been a drag on earnings, hoping that this would lead to significant value
realized over a 12–15 month period. We expect the quarter end valuation discount to narrow as its
carbon fiber unit grows as a percentage of EBIT through 2013. The company traded at 4.3x 2011
EV/EBITDA and 4.6x 2012 at quarter end. Hexcel (HXL US), a pure-play carbon fiber maker, traded
at 9.4x 2011 and 9.8x 2012. Using a sum of the parts and applying HXL’s multiple to Cytec’s carbon
fiber business, the market is ascribing zero value to the rest of the company at this multiple.
In late October it was announced that Cytec was looking to sell its underperforming coating resin
business as we had been hoping and Cytec’s equity price reacted favorably upon this announcement.
CIE Financiere Richemont (2% NAV): Compagnie Financiere Richemont manufactures and retails
luxury goods. The company produces jewelry, watches, leather goods, writing instruments, and apparel.
We estimate that more than 55% of Richemont’s sales this year will be to emerging market consumers.
At quarter end, the company had a market cap of $21.4 billion and net cash per share of approximately
EUR 5, or 2% of the company’s equity market capitalization.
One of our core investing strategies has been to make long-term investments in companies like
Richemont that are selling highly differentiated products to emerging market consumers. We
understand that luxury goods businesses (and their stock prices) can be volatile, but view their growth
and profits as predictable over time. In many emerging markets, and especially China, we observe
intensely favorable cultural preference for Western luxury brands, rapidly rising discretionary income
(locally and especially in EUR and USD), and upside to per capita consumption levels. For example, in
2010, Chinese per capita consumption of Swiss watches, adjusted both for mainlanders’ purchases in
Hong Kong and for the rural population, was USD 4. This compares to USD 5.8 in Japan, USD 8.7 in
Saudi Arabia, USD 12.2 in Taiwan, USD 14.3 in Italy, USD 16.8 in France, and USD 201 in Hong
Kong (excluding est. mainland Chinese tourists).
Within luxury, Richemont’s categories—watches, jewelry and accessories—show the highest growth and
greatest profitability. Richemont has enhanced its prospects through many years of thoughtful yet
aggressive expansion of its Cartier, Van Cleef, Piaget, and Mont Blanc brands through company-owned
retail and third-party (wholesale) distribution. Richemont’s investments are steadily improving the
structural profit margin and growth rate of the business. Notably, Wall Street estimates assume less
growth over the next 3 years than has occurred over similar periods in the past.
Over the next three years, we expect annual sales growth of 17% and EPS growth of 23%. At quarter-
end, Richemont’s EV/net operating profit after tax was nearly 12x for the year ending March 2012.
While we believe this low multiple is a function of skepticism of those estimates given global
uncertainties, we judge global demand, and especially emerging market demand, for luxury goods to be
strong. While the market tends to value luxury goods companies based on backward looking p/e
multiples, we note that Richemont is experiencing steady structural improvement as its cash pile grow
and the emerging consumer increases as a percent of sales by approximately 4% per year
Yanbu NNational Petroochemical Company (1%% NAV): Yaanbu is the llargest positi on in our MMiddle
East/Nortth Africa (“MMENA”) portfolio. The coompany had a market capp of $6.5bn aat quarter en d and
traded at 8x 2011 earnnings. Yanbu declined onlyy -4.4% for thhe quarter whhile global peetrochemical sstocks
sold off much more: Dow Cheemicals declinned 37.6%, Lyondell Baasell declinedd 36.6%, DuuPont
declined 226.1%, and HHuntsman de clined 48.7%%.
anbu NNational Petroochemical Company (1%% NAV): Yaanbu is the llargest positi on in our MMiddle
East/Nortth Africa (“MMENA”) portfolio. The coompany had a market capp of $6.5bn aat quarter en d and
traded at 8x 2011 earnnings. Yanbu declined onlyy -4.4% for thhe quarter whhile global peetrochemical sstocks
sold off much more: Dow Cheemicals declinned 37.6%, Lyondell Baasell declinedd 36.6%, DuuPont
declined 226.1%, and HHuntsman de clined 48.7%%.
Passport Global – Q3 2011 – Investor Letter Download Disabled for Legal Reasons
