By Neal Berger, President and Founder, Eagle’s View Capital Management, LLC
January losses in the shipping strategy were entirely unrelated to this. In the category of “when it rains it pours”, the second unforeseen event to hit this Manager was the Vale, SA iron ore mine disaster in Brazil during the last week of January. This disaster made international news. Please see some news stories as follows:
Prior to the disaster at the Vale SA mine (the largest Iron Ore producer in the world), the Fund was short iron ore and long freight in the 2020 contracts utilizing iron ore as a hedge. The Fund has a very strong focus on analyzing iron ore and under normal circumstances, iron ore has a very big impact upon freight rates. They have had iron ore hedges in the past against freight. To be fair, there have been other disasters in iron ore mines, so, this is one possibility that the Fund could have taken into account in their risk management. In 2015, they had a less severe similar situation in Iron Ore. Since that disaster, a check of these mines was instituted every 2 weeks both those who are in charge of safety at this mines. Unfortunately, despite this, we saw this tragedy happen, nonetheless.
When asked if in hindsight the Manager would have done anything different, he said that he should have utilized options instead of an outright position short iron ore. The Fund wanted to retain long freight positions in the 2020 period. However, they started to get concerned about a global slowdown in economic activity and they saw steel prices falling, and other commodity prices falling. They hedged their long 2020 freight positions with short iron ore as well as short 2019 freight. Obviously, the breaking of the dam at the Vale SA mine in Brazil, blindsided them once again causing Iron Ore to skyrocket. As soon as they saw the situation, as quickly as possible, they cut 90% of their iron ore position and increased their 2019 freight hedge. They felt iron ore had been bid up by Chinese speculative trading. Again, they acknowledge that they “should” have been in iron ore through options and not through outright due to the generally small possibility of a disaster at a mine such as what we saw. According to the Manager, had they not acted at all, the Fund would likely be down an additional -10%. Due to their fast reaction in switching out of iron ore into 2019 freight as the hedge, the Fund reduced the potential losses here.
The Manager indicates that part of their “bread and butter” is deep analysis into the Brazilian iron ore market. Brazilian iron ore has a big impact upon freight rates. Vale mine production will likely be taken offline but ultimately will come back online later in the year. The Fund is investigating utilizing satellite imagery to monitor activity at the Vale SA mine as this will cause big swings in iron ore as well as freight according to the Manager.
When I think about how to evaluate a situation like this, and more importantly, what to do about it, I ask myself the following questions: could I as an investor have anticipated this situation happening prior to the fact? Second, could the Manager have anticipated this situation happening? Do I still believe that the reasons I invested in this Manager in the first place are present and that the Manager/strategy has positive expectancy ahead? Although painful, I do not believe neither I, nor the Manager could have predicted this issue with the Baltic. As for the Vale SA mine disaster, nobody could have predicted that this disaster would occur and the timing of it. As mentioned, I do believe the Fund should have used options to protect against disasters in mines as they do happen from time to time. However, this risk is often incorporated into the pricing of the option contracts making them more expensive. Finally, I do believe this Manager/strategy has material positive expectancy ahead.
In sum, when we experience a sudden, surprising and outsized loss in an investment, we have to avoid the initial impulse to react emotionally. If one has been an investor for any material length of time, everyone will be faced with this issue at one point or another. We have to truly examine whether this was unpredictable (an earthquake, terrorist attack, natural disaster, etc.), or, this was something that could or should have been predicted by us or by the experts we’ve hired in the space. Finally, we have to determine if the reasons we invested in the first place are still valid and the opportunity set is robust. In this case, we have come to the conclusion to stay with this position and Manager. Although we suffered these past 4 months, we have to look forward and not behind. As an aside, through Sept. 30, 2018, the Fund had been operating for 8 years with an annualized return of +32% net of all fees and expenses and a Sharpe of 1.30. We do not believe this was an accident and we believe they will be highly additive ahead.