A hedge fund bets big on a Canadian mega quarry

Date: Thursday, February 16, 2012
Author: Scott Cendrowski, CNNMoney

Superstar investor Seth Klarman's controversial plan to develop a quarry in Ontario could pay off bigtime.

FORTUNE -- Drive an hour northwest from Toronto along Highway 10 and you come across some of the best farmland in Canada. Folks here call it the Garden of Eden. Atop a 15,000-acre plateau sits a layer of dark dirt so perfectly balanced with clay and nutrients that it breaks apart in your hand like potting soil. "The stuff is like butter," says a local potato farmer, David Vander Zaag, who sells his spuds to Frito-Lay. Even better: Below the rich topsoil lies a limestone deposit some 200 feet thick, creating an ideal natural drainage system. It once rained nine inches in a day, says Vander Zaag, and he didn't lose a single potato from his crop.

It's that limestone, though, that has brought the farming town of Melancthon, Ontario, pop. 2,900, the fight of its life. Last spring a Canadian firm called the Highland Cos. submitted an application to turn 2,300 acres of area farmland into one of the top-producing rock quarries in Canada. One of the principal owners of Highland is the Baupost Group, a $24 billion hedge fund based in Boston and run by a secretive investor named Seth Klarman.

Highland's quarry proposal has ignited a firestorm of controversy in Melancthon. Residents have myriad concerns -- from increased truck traffic to the impact on the water supply to the unsightliness of an enormous pit mine in the distance. The farmers feel betrayed by Highland chief John Lowndes, an entrepreneur who grew up in the area. Beginning in 2006, Lowndes spent two years and some $50 million amassing 6,500 acres from some of the area's biggest farming families. Several farmers claim that he approached them by saying that he wanted to build the region's largest potato-farming operation -- which he did -- but never mentioned a quarry. Only after he owned the land, the farmers claim, did Lowndes reveal that Baupost and Highland had other plans. Lowndes declined to speak to Fortune.

The farmers say Lowndes breached their trust. But they have identified a second, bigger target for their frustration: Klarman. Why, they wonder, does an American hedge fund manager they'd never heard of until recently want to spoil their lush land? "Yeah, there's something I'd like to tell him: Come up here," Vander Zaag says, overlooking his 1,000 snow-covered acres in late December. "I want him to see the land. To see what he's doing to it."

Klarman's name may be new to the farmers of Ontario, but in the world of hedge funds he's long been a superstar. In fact, Fortune identified him back in 1989 as an investor with the potential to become the next Warren Buffett. And Klarman, 54, certainly has delivered. "He's one of the most astute investors of our time," says Jeff Scott, chief investment officer of Wurts & Associates, which advises institutional investors on hedge funds. The proof is in his returns: Klarman has earned 19% annual gains after fees since starting at Baupost in 1982, making $10,000 invested then worth $1.55 million today. (The same investment in an S&P 500 index fund earned $216,000.) Baupost's assets have grown sixfold over the past decade; it's now the world's 11th-largest hedge fund, according to Bloomberg. Klarman's record is all the more impressive because he avoids using leverage to boost his gains. Moreover, he typically holds a third of Baupost's assets in cash -- a sign of his strict value standards and patience. (Currently 17% of the fund is in cash.)

Opponents of the quarry project marched from Toronto to the farming town of Melancthon last year.

So what, exactly, is this investing heavyweight doing in a fight with small-town Canadian farmers? The publicity-shy Klarman declined Fortune's requests for an on-the-record interview to discuss his investing approach or his stake in Highland. Instead, a spokesperson provided a statement. "Baupost's investment in the Highland Cos. is consistent with our long-term, value-oriented strategy," the statement reads. "We take our role as a responsible investor seriously." It goes on to say that Baupost is confident that Highland will proceed in a way that respects the community and environment.

Well, sure, but here's the bottom line: The quarry investment could provide an exponential return over time. Based on recent market prices, the volume of limestone in the proposed quarry is worth more than $6 billion. And its value could be on the rise. The Ontario government expects demand for limestone and other rock used in construction to increase by 13% annually over the next two decades, driven by an ongoing population and construction boom in the province.

In a broader sense, Klarman's willingness to put money into a Canadian quarry is reflective of his view that stocks today offer little value. The really big potential gains, he believes, are in more complex investments. Klarman is not bullish on the recovery. "With most of the world's developed economies grappling with structural budget deficits and a grim outlook," he wrote to clients last July, "and because all foreseeable solutions to excessive borrowing and spending will dampen global economic activity, we find it hard to be optimistic about the economy." At Baupost's client meeting this past October, Klarman told investors that stocks were neither cheap nor expensive. It is the Federal Reserve's policy of near 0% interest rates combined with government bailouts, he believes, that have driven asset gains since the financial crisis. "Massive government intervention in the wake of the 2008 financial crisis is now widely considered to have been a good thing," he wrote in July. "We remain unconvinced." He worries that the next crisis could be worse than the one in 2008.

Klarman grew up in Baltimore, where his father was a public health economist at Johns Hopkins University and his mother taught high school English. The family lived four blocks from Pimlico racetrack and Klarman spent a lot of his childhood there. Today he owns a stable of racehorses with names like Bail Out the Banks and Sovereign Crisis. At Harvard Business School, Klarman so impressed his professors with his market acumen that a group of them pooled their money to form Baupost and recruited Klarman to manage the fund. (The name Baupost is an acronym made up of the professors' last names.)

Klarman's basic investing philosophy has changed little since those early days. He's a generalist who waits to buy assets until they trade far below what he thinks they're worth. (Klarman outlined this approach in his 1991 book called Margin of Safety, and it's a testament to his cult status that the out-of-print tome sells today for $1,700 on Amazon.com.) "His strategy is predicated on waiting for the fat pitch," says André Perold, chief investment officer of endowment-management firm HighVista Strategies. "His investor base understands him well enough that he can be 60% in cash and no one's going to whine."

Former employees say that the Baupost office in Boston's Back Bay neighborhood has an academic feel. Klarman is tall -- just over 6 feet -- and a little chubby, and has a trim, graying beard that gives him a professorial look. He sits in an open office at the front end of the main floor, facing the analysts and traders. It's usually dead quiet as Klarman and his 180 employees study investments. "It feels like you're in a university library," says a former analyst.

Klarman's biggest bets right now are actually in the credit markets. About 40% of Baupost's $24 billion portfolio is currently in debt -- such as distressed commercial mortgage-backed securities and other complex structured products like second lien home-equity loans. One of the fund's largest positions is in Lehman Brothers' debt. And Baupost's investment in the bankrupt bank's notes offers a good example of how Klarman applies his value discipline.

A Baupost team, including Klarman, began analyzing Lehman's assets on the Sunday before the bank filed for bankruptcy in September 2008. The team watched as the price of Lehman debt plummeted in trading from 80¢ on the dollar to 20¢ after the filing -- but waited for it to go even lower. Weeks later, the debt of one Lehman subsidiary was trading at 11.5¢ on the dollar when Baupost swooped in and bought one-third of the issue; it now trades for 70¢ and Baupost has a 500% gain on paper. In all, Klarman spent $2 billion buying trade claims on the bankrupt company. Distributions to creditors, including Baupost, are expected to begin this year.

Klarman may not be bullish on equities overall, but he has been strategically boosting his positions in certain names. As of its last filing, Baupost held 22 stocks that trade in the U.S., worth a total of $3 billion. That represented 17% of the portfolio as of October, or almost double the amount from early in 2011. Large purchases included stakes in BP (BP), Hewlett-Packard (HPQ), and News Corp. (NWS) -- all companies whose shares in recent years have been battered by disaster, management turmoil, or scandal.

Though he stresses a bottom-up approach, analyzing individual assets rather than being guided by a big-picture point of view, Klarman has repeatedly expressed to clients his concern about a crisis scenario: sky-high inflation or a collapse of the U.S. dollar if the government's fiscal experiments go awry. He believes the best hedge against that risk remains gold -- but not necessarily bullion. Gold miners are dramatically cheaper than gold itself right now, he told clients in October. Baupost owned shares in miners NovaGold Resources (NG) and Allied Nevada Gold (ANV) as of the firm's most recent filing.

Baupost's own mining venture in Ontario, meanwhile, has gotten bogged down amid rising anger toward Klarman and his partners. Wealthy Toronto residents with weekend homes near the proposed site have taken up the fight, and STOP THE MEGA QUARRY signs have appeared downtown. In September, Ontario's Ministry of the Environment ordered a full environmental assessment, an unusual move that could require two years of studies before the project can proceed. But as Klarman knows well, the payoff on a great investment is always worth the wait.

This article is from the February 27, 2012 issue of Fortune.