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.