| Main |
4. John
Burbank IIIPassport CapitalJohn Burbank III’s investment philosophy might seem more at home in a Silicon Valley start-up than at a hedge fund firm, but a belief in innovation and a focus on the future form the foundation of Passport Capital.
Burbank, 51, chose San Francisco as his home base largely because of its climate of creativity and technological progress. He says that thanks in part to a degree in literature from Duke University, he sees investing as narratives: stories unfolding around the world that together inform his ever-changing macro outlook.
Growing up in New Haven, Connecticut, Burbank never thought he’d one day run a hedge fund firm with $4.1 billion in assets under management. After considering several different careers, he earned an MBA from the Stanford Graduate School of Business in 1992, then invested on his own for a time. In 1996 he became an analyst at ValueVest Management Co., where he was ultimately appointed director of research, and in 1999 he moved to the JMG Triton Offshore Fund as an equity analyst. Burbank founded Passport Capital in 2000.
The firm quickly became known for its multistrategy approach to macro investing, tending to focus more on risk profile than on asset class and combining elements of fundamental and quantitative strategies. In an industry that’s relatively slow to embrace change, especially in a postcrisis world full of squeamish investors, Passport is pushing the envelope. But Burbank believes the firm’s structure allows it to take risks others wouldn’t dare, and they often pay off. The firm’s flagship Passport Global Fund has produced annualized returns of 17.8 percent since inception. Burbank says his firm is uniquely positioned, both geographically and philosophically, to capitalize on the “mind-blowing” changes that various U.S. industries are set to experience.
Institutional Investor’s Alpha: How has your educational background contributed to the way you approach investing?
Burbank: My dad is a teacher and studied Russian, Slavic and Czech language and literature, so that was my model growing up. I studied English literature. I was trained to think there’s narrative, there’s plot, there are characters; there’s a beginning, middle and end. Numbers don’t factor into literary concepts, really. But I actually think that’s very helpful in thinking about markets because what happens in markets or business in general is so complex and so full of complex pieces of information that it’s often very difficult to organize and make sense of. It’s easy to organize it in ways that are factually correct in terms of numbers but then miss the point of what’s really happening. Investing and the financial industry tend to attract numbers-oriented people, for lots of obvious reasons. But intuiting — understanding how to use your time, how to conceptualize, how to describe, how to frame what you see in the realm of words and ideas and imagination — is a different skill set.
“The business of investing is really the business of anticipating or understanding the likelihood of something happening before it happens.” — John Burbank III It’s a funny thing. If you’re going to be very bound by numbers, you also can be very bound by what’s already happened or what has just happened, whereas imagination is the recognition of the possibility that something out-of-bounds may be happening. And I find that a lack of imagination is quite normal. There’s a shortage of imagination — well-founded imagination — among market participants. There are only so many people who have come from a background like mine.
How does psychology factor into what you do?
There is an aspect of psychology as well. In literature it’s about character development and the interaction of one character with another and with the writer to the reader. In finance, psychology — which I guess is called behavioral economics now — is extremely important. And one big concept that I don’t hear other people discussing is the idea that price is the equilibrium of liquidity — meaning that price is nothing more than the point where as many people are buying something as selling it and selling it as buying it. It doesn’t mean the market is accurate about the future. It just means it’s accurate as to what is happening, what people believe right now or where liquidity is right now.
But people want to believe that the market is the perfect forecaster of the future. The Efficient Market Hypothesis was formulated by Ph.D.s, by very math-centric people, and investors have defaulted to that and just believe the market is a perfect instrument to fully value the future. My view is that because most people lack imagination, because investing is so complex, because so much money is run by numbers-oriented, backward-looking people, that the market is not terribly good at discounting the future. It’s better than every other mechanism we have — certainly better than government allocation — but we overrate the market about its predictive abilities.
Do you think this translates into a hesitancy to innovate?
When there’s dynamic change, people look backward and extrapolate forward. They expect the past to repeat. They don’t expect their lives or the market to be meaningfully different because if the price is not telling them that, if the equilibrium of liquidity is not telling them how it’s going to be, they don’t believe it.
The business of investing is really the business of anticipating or understanding the likelihood of something happening before it happens, and there are various ways of doing that, but understanding change in a broad sense is exactly what I try to do. I try to understand change because I think people are very poor at understanding, anticipating and discounting change. I’d say that those who are good at it are often good at it in a very narrow way, meaning they understand just from an industry standpoint but they don’t understand how currencies, commodities and industries can be affected in ways they never were before.
What I have tried to do by investing in all kinds of industries, in all kinds of countries, in all kinds of asset classes over the past 20 years is to understand change, anticipate change, because the future is always going to be different than the past. I believe that’s an unarbitrageable reality, meaning that’s the way it’s always going to be. I’ve looked back through the history of markets, and when you see such big swings in price in various asset classes, you realize that these markets had no idea price was going to change so much in the future. The market — and prices — never fully discount the magnitude and duration of change.
If you have duration and understand how volatile the market can be before you get to that future, it’s often possible to do better than the market. You just have to broaden your understanding of markets and asset classes to understand how to participate in the change correctly.
How did this philosophy inform the creation of Passport?
When I started, in 2000, I’d just been through the emerging-markets crisis, which was a brutal one-year collapse that no one predicted. I had been through the tech bubble here in San Francisco, something else nobody predicted. So when I started, I thought, “Oh my God, markets are overrated in anticipating and understanding change, despite what everyone believes and says.” I had lived through two extraordinary events that no one predicted. So I began with the idea that the U.S. had hit a top. Ten years of being the sole superpower after Russia collapsed, then the ’90s, and the U.S. was primed to top and then fall apart in a lot of respects. And that’s what happened. From 2000 into ’09 the U.S. essentially fell apart. In 2000 you had the election that didn’t get decided for a month, then 9/11, then [former Federal Reserve chairman Alan] Greenspan cut rates early. You had the invasion of Iraq and the housing bubble. You had the Fed and financial regulators presiding over the financial crisis but not fully understanding what was happening. You had delusion. For those ten years, while I was negative on the U.S. and was looking to avoid the bear market, I went into commodities and emerging markets. I anticipated China and rode that up into the crisis, and that was the right thing to do.
But I’ll tell you, things change. And often it takes years for people to recognize it, because significant change happens over a long period of time. Jumping ahead to today, I think America has changed dramatically since the crisis. I actually think that culturally the crisis was profoundly important and valuable to the country, and I’m shocked that I’m saying it, but I see such a difference, such a change in behavior of corporations and of consumers. Even though the government and the Fed want people to spend and invest, people essentially have wised up. It is as if we were in the Matrix from the mid-’90s into the crisis, and now we’re on the mother ship and we realize it was a false world you can’t trust and that you’re going to have to figure things out differently and on your own.
Markets started trading differently in 2011, and I totally changed my view. I believe that now you want to be long the U.S. You want to be long not commodities but actually the opposite. You want to be long the highest-value-added human capital in the world, which is in the U.S. and generally in the developed world. You want to be short things that need GDP growth, and you want to bet on the extraordinary benefits of human capital development.
What do you think that next phase will look like?
One way to look at this is through technology. Until the web browser in ’94, tech was basically a San Jose–to–Palo Alto experience. It was engineering-dominated, and it was essentially about physical goods. It was hardware, it was chips, it was about making things cheaper, faster, better in greater and greater quantities. Then the Internet happens, and suddenly people realize tech is also about consumer, business services, media and all kinds of things. What we consider the tech bubble was really the Internet infrastructure bubble. But since the crisis people have been so concerned with policy actions — what the Fed does and how much stimulus there will be — that they’re looking at the lowest common denominator, GDP, as opposed to the highest value-added, human capital, and what it’s doing, and that’s innovating.
Think of the Internet as a person. The Internet was born, you might say, in 1994. And in 2000 it was only six years old. It’s going to take a long time to fully mature. The incredible thing about children is that they require an 18- to 25-year investment. It takes a long, long time for a child to develop into a productive member of society, and you expect very little revenue from a child during that period. In 2009 the Internet was only 15 years old, and the Internet’s going to turn 21 this year. What you expect from a person from 21 to 30, that’s essentially the end of investment and the beginning of a huge ramp-up of output of revenue, of production. It’s making use of all that previous investment.
The market seems toppy today, but meanwhile what happened to tech is that all the leading companies — the largest tech companies — virtually all of them provide services, apps, software or things that actually aren’t capex-heavy and are just plugging into all that previous investment. And qualitatively they are extraordinarily different. In fact, they don’t really care if GDP is plus three or zero. It doesn’t really matter anymore. The Internet is in a completely different part of its life cycle.
Do investors understand innovation?
I think innovation is fundamentally misunderstood. If you don’t live in San Francisco and if you’re away from this human capital clustering, it’s really hard to perceive if it’s not shown in prices in the stock market. From the second quarter of 2013 to February 2014, growth innovation led the market. And that’s the only period since the crisis that that’s happened.
I would argue that innovation will be understood much better three to five years from now than it is today, but we’re going to see these nonlinear benefits in the next five or ten years. The extraordinary benefit that’s going to accrue to San Francisco, the home of the greatest clustering of human capital and the culture that most understands and embraces and wants change to happen, is going to be mind-blowing. The future output of all that previous investment and where this human Internet thing is, what it’s going to produce, is going to be so surprising because I think people look backward and expect the same thing to happen.
Have you taken any inspiration from the tech gurus of San Francisco and Silicon Valley that you think is applicable to running a firm like Passport or to investing in general?
From my perspective, San Francisco is the most important place to be to understand change, because technology is penetrating old industries that are going to have to change a lot and will derive benefit from that change. But if you’re not here, you don’t see it. You’re not surrounded by it. You don’t bump into it as often.
A good example of a very large, old industry that previously really didn’t have to change would be health care. It’s a huge industry which is extremely dependent on information. Health care had almost no overlap with Silicon Valley before Obamacare; the fee-for-service regime meant that more information wasn’t required. You did things with a protocol that was agreed upon. Obamacare is a huge change, and this value-based care, which is basically getting paid per capita, now means the only way many participants are going to make money is via cost savings as they manage people’s care. And to do that you have to have good information, and to have good information you have to have technology.
A lot of people look at the biotech index and think it’s a bubble. In fact, [Federal Reserve chair] Janet Yellen herself singled it out as being a bubble. I look at it and see human capital, the industry of human capital, writ large. This is innovation heading into the greatest change — positive change — of understanding and of targeted therapies that’s ever happened.
We’re going into a very nonlinear cycle, and my mind-set is I think I can be long the best of those things for the next ten years. That’s my view. I’m not going to sell them soon. My view is that what I call the A students — the best students in the class — are who you want to bet on now. You might as well disregard the rest of the class. And if it’s technology-related, it’s 80 percent of the time going to be in San Francisco.
I’ve been telling my investors for the past six years after the crisis, “If you’re worried about your kids’ future, just send them to San Francisco, and they’ll get that change, that mentality in their head, which will serve them well in the future.” Being here is so much more valuable than being anywhere else, because you get this preview and you can kind of size it up and you can investigate it.
How has Passport evolved and innovated in its operations over the past several years?
We’ve improved a lot of things. Systems and reporting are the obvious things, but they’re not the most important things. I’ve been involved in the hedge fund industry for about 20 years, and it’s changed tremendously in that time. The funny thing about the industry, though, is that investors somehow don’t expect managers or organizations to change that much.
Passport has changed and innovated by doing not just macro and bottom-up but also quant and risk, believing that is necessary now to understand and navigate markets. And yet investors lack this understanding, and they really do not expect or essentially need you to change. In fact, I think they look at change as risk, so they actually shrink from it.
I’ve been struck by how few funds change that much and how investors don’t actually expect you to innovate. Whereas I think we’ve done a tremendous amount of investment in innovation, and I think we’ll get the benefit of it with time as people see it work and others start validating it. I think the industry is not very good, because of risk avoidance, at absorbing innovation at the manager level.
So it is going to take education on the part of both investors and managers to get better at innovating?
Yes, exactly. I think there are three basic disciplines of investing: macro, fundamental and quantitative. People are used to those three things being separate. Even combining two of the three is rare. Doing quant and risk in the way we are is like speaking three languages now, not one. And it’s like we’re at the United Nations, because we’re trying to understand all this different noise. We’re trying to turn noise into signals, and we realize we need to use different ways of looking at things, which is essentially to understand the disciplines of at least these three different ways of investing.
Investors are institutional. They’re risk-averse because of the crisis. They don’t expect you to change. So if you do, it’s actually pretty surprising.
