How to Make Money in a World of Risk

Adam Fisher, Co-founder, CommonWealth Opportunity

Capital
By

Leslie P. Norton

Updated May 8, 2010 12:01 a.m. ET

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COMMONWEALTH OPPORTUNITY CAPITAL is a young Los Angeles-based hedge fund

that some other investors watch closely. One of its founders, Adam Fisher, 38, who is also
its chief investment officer, has lots of experience in investing in property and private-equity
deals around the world, including Asia. The other founder, Reagan Silber, 49, is a gaming,
entertainment and telecom entrepreneur and an amateur card player who competes in the
World Series of Poker. A former lawyer, Fisher navigates through the thicket of market
expectations, government policy and corporate strategy, and then decides what it all means
for asset prices. Fisher thinks Europe's problems could spark another crisis -- in fact, he's
been extremely cautious this year -- but believes there are plenty of ways to make money
there.

Says admirer Jeff Greene, the billionaire real-estate investor known for shorting subprime
early: "He's definitely on my list of somebody who could make it big." To learn Fisher's
views, keep reading.

Barron's: What do you do differently from some of your competitors?

Fisher: I didn't sit on a prop[rietary trading] desk my whole life, I don't come from a trader's
background, and Reagan Silber and I have bought and built businesses and invested in
difficult markets. It took a John Paulson, who never traded a credit, to see the forest for the
trees [during the housing bubble]. The most salient issue in the world today is debt. Real
estate is a levered product: You can't get good returns in property without leverage, and
that's a fact. So you have to get comfortable with it. You have basically gone through one of
the biggest margin calls in the history of mankind. What the world is wrestling with is: What
does debt mean for an economy, for margin of error, for asset prices?

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"The probability of dissolution of the euro zone or massive devaluation of the euro is 65%. It is a 30% probability that they sit on their hands
and the European financial system blows up." -- Adam Fisher Thomas Michael Alleman for Barron's

I was in private equity or leveraged buyouts or real estate, and with levered assets, you had
to ask yourself those questions all the time. In Europe now, virtually all policy prescriptions
are devoted to dealing with debt.

Before getting into Europe, let's talk about your overall investment themes.

There is a big variance of opinion. The markets are unhealthy when there is homogeneity.
You have a whole bunch of people who are still very bearish, cynical and skeptical,
particularly in the hedge-fund world. They acknowledge the issue of what happens when the
monetary and fiscal stimulus goes away. You have deflationists, as well as inflationists, who
believe the risk is that the velocity of money will increase too fast and that [the situation] will
end in tears because the Fed will lose control of the monetary base. They believe the tears
will come sooner rather than later, because once the stimulus measures are pulled, debt will
reassert its pull on the market. And by the way, the emerging markets are just a levered bet
on developed markets.

There are three buckets. One holds Japan and Europe, where the debt problems can
overwhelm any good things that can happen. Both have reached the end of their loosening
cycle, and euro-zone Europeans can't even print debt in their own country's currency.

The next bucket holds the guys with debt problems, but improving circumstances: the U.K.
and the U.S. The U.K has worse demographic problems than the U.S. and a potentially
hung parliament, but it has its own currency, can print debt and has longer durations than
anywhere in the world, meaning it has a lot of flexibility. The U.S. has really good
demographics for a developed market. Yes, it has some problems. But it did recapitalize its
financial institutions, has a flexible labor market and a pretty good political system that can
get things done, and if it turns a few dials on its entitlement programs, it can put itself in a
pretty good position, solvency-wise.

The third bucket holds the emerging markets. The fact that the developed markets are
doing so badly helps them, because money is flowing their way very aggressively, and they
don't have the debt or stock problems I refer to.

Let's start with Europe and, of course, Greece.

We're horribly bearish about the options and likely outcomes. We've added further short
positions in the euro, and added U.S. Treasuries and gold. You can't really see how it's
going to work out. We've been bearish on Europe and its periphery since last summer, and
gotten even more bearish on the euro against all cross-currencies. We are buying credit
protection on the European periphery and on European banks. We are short a basket of
European banks and domestic-oriented companies. We're long a basket of northern
European exporters including Siemens [SI], Daimler [DAI], and BMW [BMW.Germany] that
are exposed to overseas markets and would benefit from a big drop in the euro. One
possible trade is on the Eonia/Euribor inter-contract spread, the European version of the
TED Spread, which represents counterparty risk. Another is to short bonds of the European
periphery.

There are two real issues. One: If you're going to spend 110 billion euros [$140 billion] on
Greece, you've fired too many bullets. Their foot-dragging forced them into it. In February,
they could have spent 20% of that amount. When Portugal and Spain come knocking -- and
I think they will -- will there be any left? Two: The problem impacts every other investor's
portfolio, because the scope of infection is very hard to predict. Smart investors will have to
lighten up, hedge out or buy more risk insurance, which means returns will be reduced.

People are having a hard time conceptualizing a few things. The Europeans are
experimenting with deflationary policies in the midst of a depression. Ireland is viewed as a
country doing all the right things, and they just printed a 14% deficit-to-GDP number, bigger
than the 11% to 12% that people expected. Growth rates are coming in demonstrably lower
than expectations. And every quarter, [European Union agency] Eurostat will disclose worse
growth and tax revenues for all these countries. So bond investors will face scary stats
every quarter, and the EU will be faced with the reality that risk aversion in the bond market
will force it to provide a holistic solution. The 2008 experience in the U.S. is perfectly
analogous. The market refused to stop testing U.S. policymakers until they provided a
holistic solution, with the Fed backstopping commercial paper, the FDIC raising the cap on
insured deposits -- many different programs. Here's the bad news: The European Union
doesn't have a political infrastructure for a holistic solution. The one silver bullet is that the
European Central Bank can do what the Fed did: Buy government bonds.

What about easing requirements for European banks to buy these bonds?

The ECB has relaxed collateral requirements, providing easy credit terms to those banks to
buy loans. Those loans last, best case, for a year. If you buy a 10-year piece of paper, you
have to worry that the ECB loan goes away. And if you buy a bond at par and those bonds
trade down to 92, you owe the ECB eight bucks. It's very different. The Fed took actual debt
out of supply. Here's the big problem: The treaties that created the ECB don't allow for
[what the Fed did]. The German Supreme Court views German law as superior to European
Union law. So you have the makings of Germany leaving the EU if the ECB tries to
monetize government debt. That leaves you with an untenable situation: either the
destruction of the European financial system because the banks all use government bonds
as collateral, or the destruction of the euro. And if the European financial system comes
under stress, that will spill into the U.S., because those member banks like Deutsche Bank
and Barclays are counterparties to U.S. banks. What bullets do we have left? We're already
at zero-percent interest rates. There is no one left to bail out the earth -- unless the Martians
come. You could allow the financial market to let prices clear, which would mean a
depression would occur.

How probable is a new financial crisis?

The probability of a significant change -- either dissolution of the euro zone or massive
devaluation of the euro by way of European Central Bank mass easing -- is 65%. It is a 30%
probability that [the Europeans] sit on their hands long enough and the European financial
system blows up.

What about other parts of the world?

The options and likely outcomes in Europe are our biggest theme, of course, but we've cut
our emerging markets and commodity currencies positions substantially, given contagion
risk. The developed markets will remain weak, so you'll have very, very low rates and low
yields in them.

That said, most capital is yield-seeking. Portfolio managers are exporting capital
precipitously to the emerging markets, which creates huge challenges. Currencies have
been going up a lot in Brazil, Korea and so forth, creating real inflationary pressures, which
you see in Chinese property prices and so on. That's also being manifested in the
commodity producers, the oil countries.

The Australian real-estate market may be the most overvalued in the world. You see a
bifurcation between developed and emerging, but they are interrelated. How do you play all
that? You've got to ride the wave because people always underestimate the durability of the
wave. You can buy the currencies of commodity producers that export to the developed
markets.

For example?

Buy the Brazilian real, short the euro. The carry is phenomenal. Be long Aussie dollar, short
euro; long krona, short euro. You could, for example, short the FXE [ CurrencyShares Euro
Trust ] and go long the FXA [ CurrencyShares Australian Dollar Trust ] or FXS [
CurrencyShares Swedish Krona Trust ]. We like some very good commodity companies in
Indonesia, like PT Adaro Energy [ADRO.Indonesia], the coal company. We're long Mechel
OAO [MTL], the Russian coking coal and steel producer.

China will revalue the yuan, and thus get a price discount on dollar-denominated
commodities, which increases the marginal demand for these commodities. Also, what
happened in the Gulf of Mexico [where British Petroleum is trying to stop a huge undersea
oil leak] presents a real opportunity: BP [BP] and Transocean [RIG] got hammered. BP has
a 7% dividend yield; the last time it traded at these prices, oil was at $35. It's compelling on
a value basis. Other great offshore oil-service plays that got caught in the downdraft are
Technip [TEC.France], and Subsea 7 [SUB.Norway]. Because in fairness, oil prices are
going up, not down. What could go wrong? If oil prices go back to $150 a barrel like in July
of 2008, it could suck the oxygen right out of demand.

A more interesting play could be Chinese revaluation. Many offshore Chinese in Hong
Kong, Taiwan and so forth are trying to take advantage of that one-way bet. You put money
in Chinese currency-denominated assets and, a year later, they will be up 5%, and the year
after by 10%, and the year after by 15%. China's revaluation between 2005 and 2007 was
about 20%. China won't do much more than that. And once it gets to 10% to 12%, rich
offshore Chinese will start taking chips off the table, and the capital cycle will abate.

The third thing, which is very interesting for all risk assets globally, is that a hugely steep
yield curve doesn't lend itself to crashes. It is highly accommodative. The crashes in the
real-estate market occurred after the curve inverted. In 1998, in 1990-91, the curve got flat;
in 1981-82 it inverted hugely. The shape of the yield curve might be the best predictor of
risk-asset pricing the world has ever known. Not to say that crack-ups can't happen, as you
can see with the breakdown in Europe. But it's harder for them to happen. A reversal in the
yield curve would take pressure off China to revalue the currency.

What about the U.S.?

We aren't heavily involved in the U.S., although we own some equities in the financial
space, including Citigroup (C) and Goldman Sachs (GS). When the SEC announced its
charges against Goldman, we added to our positions. Legally, I don't even think it's a close
call. Both Reagan and I were lawyers, and we've read through the charges carefully
because we trade in the credit-default-swap market. The charges are very flimsy, and that's
being polite. In a synthetic collateralized debt obligation, by definition, there is somebody on
the short side. It is almost irrelevant who selected the securities that go into it. Quite frankly,
all of these guys were big boys, and if any of them thought they were being misrepresented
to, they would have sued a long time ago.
But, look, that will be a damper on the stock prices of companies like Citi and Goldman in
the near term. That creates opportunity for us, because we think these guys will earn an
incredible amount of money. The economy in the U.S. is improving, so loan losses will go
down dramatically. And these companies now sit in a more monopolistic position than ever.
A final point for Goldman: They are devoting less to employee compensation. So while they
won't pay people as much, they will earn more.

Thanks, Adam.