Seth Klarman's Inflation hedge

People far and near have wondered what Seth Klarman's inflation hedge is! In a Columbia Business School conference he said (along with other nibbles n bits), "We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges."

Only a part of his portfolio is disclosed publicly, a lot of his portfolio consists of distressed debt and derivatives which do not have to be disclosed. But from what he has disclosed I think I might have an answer! The popular view is that there will be some deflation, followed by massive inflation (the printing press is in overdrive). Now to be clear, I have no idea what the macro situation would be tomorrow or in 3-5 years (too many variables!), I am just making a humble attempt - trying to analyze his comment.

Energy MLP's, I think is the answer. He owns Linn Energy (LINE), Breitburn Energy (BBEP) and Atlas Pipeline Partners (APL). Why? I will explain the picks later, but the short answer is this: These MLP's have yields of around 20-50% right now and their oil production is hedged 5 years forward at oil prices of around $80/bbl and gas prices of around $8.50/mcf. This means the yield is 'safe' (if its really safe can only be determined by extensive DD) and that if we have any amount of deflation, the yield will more than make up for it. Now in 3-5 years if we have inflation the USD will probably depreciate and oil - priced in USD (and perhaps gold and other commodities) will appreciate as we saw in the last few years. The MLP's will again be able to lock in high oil prices and might increase in value. Again, this is a cheap inflation hedge, not a core strategy! There is a difference. Cheap inflation hedge means that if things don't work out as you expected you will loose, albeit less - the MLP's have a payback period of around 3-5 years because of the yield.

There is a lot of information on MLP's out there, not a lot with investors thou (they've been busy with the crisis). The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies. However, in recent years, a number of upstream oil and gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market. They are income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor (Canadian energy trusts anyone?). To be sure, these are business and should be analyzed as such, the management, capital structure, finding costs, risks etc. should be thoroughly analyzed. I looked at LINE and BBEP and they looked decent (I have not done extensive DD), Leon Cooperman of Omega Advisors has been pumping the Atlas series of MLPs for a while. During 'normal' times they have yields of around 8-15%.

An interesting factor here (an one that value investors love) is that Lehman Brothers was big in MLPs (As of June, Lehman Brothers Asset Management owned $1.1 billion of MLP equities). So when it went under there was massive selling pressure on these vehicles! To be sure, many small oil and gas MLPs also used Lehman as the counterparty to their oil and natural gas hedges. In addition, Lehman provided lines of credit to some of these companies. But net-net this was a case of broken stocks and not broken companies (LINE terminated the contracts before Lehman bankruptcy) and therefore these MLPs are priced at a discount of around 30% to where Seth Klarman bought. Again, there is a lot of information on MLPs on the internet and if someone thinks they fit their portfolio, please do your due diligence before buying.

What were the signs?

I have read about a few booms and bust, but this is my first bust in real time (and what a bust it is). Now going back to my notes, I see a few things coming back. what were the signs? Now I am not saying that I could see all these signs, but the next time I see something similar brewing, I'll know what will follow!

Exhibit A: Housing
This has been talked about in depth, everyone and their dog know now what exactly took place here. But looking back 2-3 years, some of the signs could be: anyone with a pulse getting a loan, 20 year old realtors, 2-4 shows on TV dedicated to flipping houses, flipping houses a 'sure' thing for making money to name a few. Going back to Charlie Mungers's power of incentives, if one just analyzed the incentives in the housing securitization chain, the fallout becomes really easy to predict. No one, and I mean no one had an incentive to keep the quality of the mortgages sane, everyone was concerned about volume (and that is obviously not good!).

Exhibit B: Private equity
Endowment and Pension funds are funny creatures. They employ the best of the best, manage insane amount of capital and serially fall prey to 'glamour' investments. In the late 1970's they lobbied to change the regulations so that they could hold more gold; this time it was Private Equity that took them down. Endowment and pension funds couldn't get enough of their cash in PE funds. Now consider the recent dumping of PE stakes by investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion. Interests in funds managed by KKR, Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent. Now ain't that smart! In addition, when in any field things get large, the likes of which have never been seen before you know that an access is developing. In PE's case the buyouts became larger and larger. In the late 1980's it was RJR Nabisco deal by KKR that signaled the end in that era, and this time it was BCE - the Canadian telecommunications giant that was to be taken over for $52 billion. Furthermore, they say that when you cant determine who the sucker on the table is, it is usually you. This was the case with the various Private Equity/Hedge Fund IPO's. When Stephen Schwartzman is selling, buying would be a bad idea! This was in my opinion the most obvious sign that the party is coming to an end.

Exhibit C: Risk..What Risk?
Yes, unfortunately that was what the world had come to believe. This was not just true this time, but every time people are feeling joyous. The spread between the treasuries and the junk bonds becomes smaller and smaller, the covenants become looser (pik toggles anyone) and investors just need yield, any yield as long as it higher than the treasuries (and they don't care how much more risk they are taking!).

Exhibit D: Net-Nets
Now method this is proprietary I must say, and is one that roughly works. One just needs to look at the number of net-nets available in the market and its as simple as that. You don't have to buy them, but as a rule when there are a few (or no) net-nets available in the market, you know some excesses have developed and its time to be cautious.

Now I can't (and no one can) tell you exactly when the kindgom will come, or what the catalyst would be, and none of the things mentioned above is precise but I rather be roughly right and be cautious than be precisely wrong and do nothing (or short it all).