The Billion Dollar Interview:
Cato Brahde, Managing Director of Tufton Oceanic (Isle of Man) Limited
Cato Brahde is the Managing Director of Tufton Oceanic (Isle of Man) Limited. Mr Brahde heads up the Tufton group's equity fund management activities comprising Oceanic Hedge Fund and Oceanic Small Cap Fund.
Eurekahedge: Could you give us a brief rundown of how you joined Tufton and what you were doing prior to running the Oceanic Hedge Fund?
Cato Brahde: I am a naval architect by training. After getting my degree, I spent a couple of years in the Norwegian navy. After the navy, I joined Brown and Root, which was a subsidiary of Haliburton that did offshore oil and gas construction. This was back in the 70s when the North Sea was just opening up. At that point, I met Ted Kalborg and worked with him during the early 80s. Ted subsequently founded Tufton in 1985.
EH: What was Tufton like at the beginning?
Brahde: It was started as a boutique consultancy in shipping and energy. There was a lot of early work helping out of owners of ships and rigs who got into trouble at the time. The Swedish shipyards were going through a crisis in the late 80s because they had a lot of oil rigs being delivered, but because of the oil crisis collapse, some of the owners of those rigs did not survive. So the oil price in 1986 had major repercussions for the energy industry. By 1989, the Tufton shareholders decided to put a fund together to be run like an investment club. Ted knew I had an interest in stocks and shares so he asked me if I wanted to come and run the club. We called the company ISIC (International Shipping Investment Company). Andreas Vergottis, who is our current Head of Shipping Research, had just done a PhD in shipping economics. All our complex modelling, working on ship-by-ship models, was essentially Andreas's work from then.
EH: So the hedge fund was born out of ISIC?
Brahde: Post ISIC, we put together a fund that had a specific theme. In 2000, credit risk in shipping was very high – there was a credit bust so we created a shipping and oil services credit fund and called it 'Shipping Bond Fund''. In 2002, we launched The Oceanic Hedge Fund using the experience we had with the 'Shipping Bond Fund'. We found that the various subsectors had a low correlation with each other, and the whole idea of the hedge fund was to try and stay in the niche where we had an advantage but to try and replicate what a macro fund does. So that's what's always been our thought process behind the fund. We always look at all our sectors from a relative value basis, so we are never long on all our sectors, and we're never short on all our sectors. We've had to differentiate and say "Well, I like this sector better than that sector because…" and then we put length into that one and shorts into that one. So that kind of approach is more of a macro fund type approach. We find that this kind of sector differentiation is actually our biggest generator of performance over time, followed by the stock selection as the second-biggest. So the best way for us to generate money is to really find out what is driving a sector, what is going to push it up and what's going to push it down.
EH: Is there a special reason behind your visit to Singapore?
Brahde: The asset-backed part of Tufton acquired a distressed fleet after the financial crisis, so we have a small office here in Singapore to run it. I take the opportunity – when there are board meetings here – to come and see the Singapore industry, the shipyards and the offshore operators and also some of our investors. However, the primary reason is that the offshore oil and gas in this region is very much focused on Singapore. This is where all the entrepreneurial talent is. Singapore has the best, fastest and most efficient rig building yards I've seen. It's really fascinating to see how quickly they put those things together. Singapore's facilities aren't as spacious as some others. All shipyards are a question of what space you have available when you build them. And yet, Singapore uses that real estate more efficiently than anyone else. They finish one rig, put it out in the middle of the night, and the next morning, they start the next rig. It's just continuous.
EH: Given its impact on the world, we would like your thoughts on the global financial crisis. Firstly, did you see any warning signs before the crisis hit the markets?
Brahde: In 2007, there were two things that really got my attention in showing that the financial world wasn't in very good shape. The first was February 2007, HSBC announced a couple of billion dollars write-off on their sub-prime engagements in the US. I thought "why is it that only HSBC is getting caught up in this?" because none of the American banks had said a word about it. We, therefore, took length off our portfolio in terms of our net exposure – in fact, both net and gross. We just got more cautious. Then, in August 2007, we saw two Bear Stearns hedge funds collapse. Bear Sterns stood behind them and said that they would support them. But this made us look closely at the balance sheets of Bear Stearns and all the other investment banks and saw how they were leveraging each $1 of their equity with $30 of debt. And I thought to myself "how many times in the 10 years have I lost 3%?" I looked it up and I saw that a couple of times in the last 10 years, we had lost 3% of our portfolio. In our case, moments like those just lost us 3% of our equity and that was it. In their case, it would be wiping out all of their equity. So, as a result of that, we put in place limits so that we would only take 5% unsecured risk against anybody, including prime brokers, although we later made an exception for JP Morgan, Credit Suisse and HSBC for whom we put it up to 10%.
EH: You mentioned looking closely at the Bear Stearns balance sheet before they went out of business. We know you had some success in changing the basis of counterparty risk with them. Could you talk us a little through that?
Brahde: We made a bit of legal history with Bear Sterns. One of the problems with Lehmans was that the documentation never envisaged that Lehmans could default on its obligations. As a result, there was no mechanism where the Lehman counterparties could come back in and make a determination on what they were owed. That determination could only be made by Lehman. In our agreement with Bear Stearns, we changed the structure of the documentation to make it more reciprocal so we would not to be left entirely in the hands of a Bear Sterns bankruptcy trustee. We also put in place a second prime broker and limited the amount of rehypothecation of our assets to the net amount that we owed to each of our prime brokers. I think the result of it all was that by the time the real crisis came, we had the legal infrastructure to deal with it and we had the risk controls to deal with it.
EH: What were the immediate impacts of the global financial crisis on the fund?
Brahde: To me, one of the most interesting features of the financial crisis was that it really uncovered who was doing what they said they were doing and who was doing something completely different. If you operate as a long/short hedge fund, you have some long positions, you have some short positions; in the financial crisis, the values all collapsed together. Yes, you lose something on the longs but on the shorts, you will generate a lot of liquidity, so if all your positions go to zero, you're just going to be holding cash, so that's what we saw happening during the financial crisis. At the beginning of September 2008, we had $350 million in cash. Without any substantial changes to the structure of the portfolio, in the middle of November, we had $850 million in cash.
EH: Has the way you follow the shipping industry had to change much because of the financial crisis?
Brahde: We've seen that life has really changed since the crisis. Before the crisis, we found that our sectors were operating very much in a global climate so we could look at a shipping company in Taiwan and how it was priced in comparison to a shipping company in New York. Ships trade worldwide so in practice, if you're a Taiwanese owner who owns a fleet of cargo ships or you're a New York owner who owns a fleet of cargo ships, you will have access to the same revenue stream and have the same prospects. So we could always look at these in the worldwide universe and we were probably the only fund that did that in a systematic structured basis. Looking at every company, we work out, ship by ship, what each of those ships are worth and what they are doing. If a ship has a 5-year charter, then it's got locked in revenue for five years. So we track what that revenue stream is going to be. If it doesn't have a charter, we use the futures market for our forecast. You can trade freight in the futures market and we can use that as our predictor for future earnings. The result of that is that we reforecast every day, based on the stock price and the futures market.
EH: That level of analysis must have been extremely useful during the crisis.
Brahde: Absolutely. We saw freight rates collapse during the crisis. The biggest dry cargo ships in May 2008 were earning typically $230,000 a day. By November, it had gone down to $2,000 a day. So that was a collapse of 99.2%. And as this whole thing imploded, everyday we could make a new forecast about who were likely to be survivors and who were likely to be non-survivors. And we were able to differentiate between the two. It wasn't always obvious because it might be to do with ships that had been ordered for two or three years down the line so we had to keep track of those as well.
EH: Has that level of analysis been affected due to the crisis?
Brahde: Before the crisis, you could look at a Taiwanese company against a US company and put them on some sort of common base in denomination terms. Now that's much more difficult because what's happened since the financial crisis is that country risk has re-emerged. So now, for example, Taiwan, Korea and Singapore – they each have their own characteristics which tend to overshadow the sector characteristics. So we found last year to be exceptionally difficult. In Europe, you can see who are potential default candidates and who are not. Four years ago, you didn't have that kind of differentiation. In 2009 and 2010, the markets were completely preoccupied with "are we going to double dip back into recession?", and when we were preoccupied with that, people tend to look very much at the revenue side of companies. If you're a fundamentals-based manager, you tend to look for profitability rather than orders. That's the been the problem for us over the last two years; the market hasn't focused much on profitability, it has focused on revenues and new orders.
EH: Could you not adjust your models to ease the difficulty?
Brahde: If you adjust too much, you lose something very important and useful, which is historical consistency. We've been using the same models now for over 20 years since 1989, long before we started the hedge fund and it has a lot of value which is consistent over time. By having our individual proprietary models, we see what's priced into the market. You can see what were similar stories in the 1950s, the 1970s, to what we have today so those long-term valuation stories are very useful. Most people have an active investment history of 10, maybe 20 years. There is no one trading today that was trading markets in the 1950s but by having all that data, you can draw parallels from the 1950s, the 1930s and so on. We do make some adjustments of course. During the financial crisis, we had to adjust because Chinese cost of capital was very different to Western cost of capital.
EH: Are the effects of the crisis still lingering?
Brahde: What's happened over the last six months is that things have normalised, although we will live with much higher country correlations. Certain specific risks, many of which have always been there, will remain, such as South Korea will always be affected by the fact that it has North Korea next door. Everybody's affected by China and their relations with China. I think, although the world is not going to go back to the pre-2008 way of looking at things, it is becoming more of a rational place again in terms of looking for growth and looking for profitability in the right places. From our point of view, we're in shipping and energy. We've talked a lot about shipping but more than half our fund is in energy, about 60%.
EH: Moving on to energy, how much of an impact are the various problems in the Middle East having in terms of the long term future of energy?
Brahde: Well, it has made energy an outperformer in the last two months, but it's not clear what is the impact from the Middle East and what's Japan. Japan, in a sense, has a more fundamental effect, as it questions again the whole thesis of nuclear power. The world was tracking along the route that in order to lower carbon emissions, nuclear power was going to be a significant component. Now, of course, everyone's re-evaluating that. Germany is shutting down some of the older, nuclear power stations and everyone is questioning it.
EH: Do you think that it is a political move rather than a scientific one?
Brahde: I think so, yes. Though I do also think that even in politicians' minds, the end game might not be too different in terms of increased nuclear power adoption, but there is going to be a delay with the nuclear power industry. So we have to think about how energy is going to shape up. We know we're going to run short of oil in the next 5 to 10 years so you can't rely on oil to provide more energy, you have to rely less on it. You cannot rely on nuclear power stations coming on stream any time soon. Alternative energy is difficult because it's very expensive and you're starting from a very small base. I would argue that, in a sense, this obsession with bio fuels caused the whole Middle Eastern debacle in the first place because one of the big problems in the Middle East is food prices. And why are food prices so high? Because the US and Europe have taken acreage off producing food and instead, subsidised the production bio fuels – this causes food prices to go up.
EH: That could be a big problem going forward…
Brahde: It is a big problem and the question is: where are the solutions? The obvious near-to-medium term solution is natural gas. Natural gas is half as dirty as oil and it is much cheaper than oil. In the US, natural gas prices are around $4 dollars. It's also got oil that is 10% cheaper than world market prices in oil so it's a big beneficiary of cheap energy right now. Japan obviously buys huge quantities of energy at world market prices so energy is not cheap for the Japanese. Now that the nuclear power stations are offline, obviously they are using more oil to keep everything running. I think the energy strategies around the region will increasingly use natural gas. That's good for Australia, it's good for everyone in the natural gas business. It's a viable stop-gap solution for getting to a lower carbon world. It's not going to last forever but in this coming decade, I think natural gas is the obvious solution to energy problems, in addition to using all the oil we can produce. Developing alternative energies will take many years. The efficiency of solar and wind is improving but it's going to take a long time before they get there. I would say that nuclear power still has a big part to play but it has now been delayed.
Of course, in shipping, we have capacity in the world to build any number of ships. Whenever the world demands ships, the shipyards will build them and three years later, they will be available to meet the demand. In energy, we have a structural shortage, which is not easy to deal with, it's a real challenge for humanity but you've got to try and track through which are the sources in the geological world, which are the technologies available so it's much more of a technological detective game than shipping, where the solution is reasonably simple – provide more ships.
EH: How many investors are familiar with the industry?
Brahde: Relatively few. When we started, it was more friends and family. Investors who have come in recently are typically foundations and endowments, pension funds and a couple of sovereign wealth funds so that has been a change.
EH: Your minimum investment is only a $100,000 which is unusual for such a large fund.
Brahde: People can come in and put in $100,000 but very few do apart from staff. A typical investor would come in with between $5 million to $20 million.
EH: You are currently based on the Isle of Man, which is a little unusual for a hedge fund. Is there a reason for this?
Brahde: I was at a Credit Suisse investor conference in Hong Kong last week and the author Malcom Gladwell who wrote 'The Tipping Point', gave a keynote speech about successful entrepreneurs and one of the things he suggested is that being away from where everyone else is doing things gives you a different perspective. This made me think about myself in the Isle of Man. I originally moved there 20 years ago when Tufton bought a fleet of offshore supply vessels in the North Sea, and have found that running a fund from there works well. Our energy research team is in London and our shipping research team is in Hong Kong. I talk to those guys everyday and we make joint decisions on the sectors each of the analysts look after, but being away from it all in the Isle of Man, I think is quite an advantage. It makes you question things on a more individual basis.
EH: You mentioned your research team just now – how exactly are they setup?
Brahde: In the hedge fund team, we have a senior analyst for each of our sub sectors. Each day, we have a daily call when we get together and talk through a structured agenda and go through all the sectors we follow. Yesterday, we went through refining and shipyards – we typically do one energy sector and one shipping sector each day. We start on Monday and by the time we get to Friday, we've covered all the sectors. That way, the senior analyst and I jointly review every position in the fund on a weekly basis.
EH: Could you give us an idea of what you think about the global economy as a whole? Do you have a positive or negative outlook?
Brahde: It's hard to tell, isn't it? Companies are still making good money, interest rates are zero or negative. That has had the effect of creating bubbles everywhere but I don't think that equities is a bubble at the moment. And you never get a double bubble. You get a bubble and then you get the next cycle. There was a dot com bubble ten years ago but there hasn't been one since. Telecoms had a bubble in 2000, but none since. Energy had a bubble in 1981 and has never had a bubble since. So whoever has had a bubble will not have the next. So in that sense, equities are not going to be part of the next bubble, I think. China real estate might be a bubble, Hong Kong real estate tends to get a bit bubbly, but it's a question about your cost of capital. There is a research house called Gavekal in Hong Kong who gave an interesting presentation this week called ‘The high cost of free money'. Their argument is that, what the central banks in the West are doing now is forcing a massive misallocation…markets are really based on a number of prices, building up from a cost of money. And if you're effectively subsidizing it, all the prices based on the cost of capital become meaningless.
EH: Like house prices…
Brahde: Like house prices. Their argument is that when you have a real cost of money then growth rates actually go much higher because it makes the market act more efficiently. They showed that when Reagan and Thatcher came into power and allowed interest rates to get high enough to beat inflation and pushed the real cost of money higher, the UK and US stock markets and the return on capital in businesses took off from that point on. So when you're forced to allocate scarce money, you make much better allocation decisions. And the other thing is, if governments finance themselves with free money, then there is no incentive to cut the bureaucracy. That's why it's interesting to see what the UK coalition government is doing right now because they aren't cutting government expenditure based on money getting expensive – but rather an argument that they have to get the deficit under control. It'll be interesting to see how they fare. As Jean-Claude Juncker, prime minister of Luxembourg, famously said “We all know what to do - but we don't know how to get re-elected once we have done it!”.