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Why Armajaro Holdings' Massive Cocoa Bet Went Bust -- And How to Play It

Justin Rohrlich August 30, 2010 12:20 PM|

       When the world thought the sky was about to fall, it didn't. But cocoa prices did.

On July 16, Anthony Ward’s Armajaro Holdings attempted to corner the world cocoa market by taking delivery of 7% of the world’s physical supply when prices were at a 32-year high of $3,200/tonne.

The 240,100 tonne purchase was the largest in 14 years and spooked end users who were convinced Armajaro’s move would cause a supply squeeze just as confectioners were gearing up for increased holiday season production.

After the news broke, Tim Spencer, a former Armajaro executive, told the New York Times that, “Globally, [Ward] is unmatched in his knowledge of cocoa.”

Eugen Weinberg, an analyst at Commerzbank in Frankfurt, told the paper that “The squeeze was really timed perfectly.”

And Juergen Steinemann CEO of Barry Callebaut, the world's biggest chocolate maker told the Financial Times, "If you consider the fundamentals, I'd tend to say prices won't fall. There's no fundamental reason why cocoa should become cheaper."

But, at the time, Shawn Hackett, president of Hackett Financial Advisors, a money management firm with a focus on agricultural commodities, told Minyanville that he had quite a different outlook.

“Every once in a while someone attempts to do this. It’s always a huge failure and never works,” Hackett said. “I couldn’t be more bearish on cocoa, especially after this news.”

Hackett noted that, “the market will force [Ward] out of that position and cocoa prices will likely fall substantially from here.”

He continued, “I think we’re going straight down in the cocoa market. There are other speculators out there who can short the cocoa market and make a fortune. The hedge fund community doesn’t care about each other, they care about making money. They’re probably thinking, ‘Okay, now this guy is on an island, we can go short, hammer this thing down, and blow him out.’ Then that starts triggering stop losses, there’s a cascading effect, his equity is then falling and falling and falling…I can just see this guy getting totally ruined.”

Turns out, Hackett was right.

Armajaro’s mammoth play didn’t cause the sky to fall, nor did cocoa prices go through the roof. In fact, quite the opposite occurred, as prices have dropped 26% since.

The Wall Street Journal now reports that “Two hedge funds run by Armajaro, including its CC+ Fund, which focuses on cocoa and coffee, lost about 6% of their value during the first two weeks of August, according to investors who have viewed the returns. And since then, prices have continued to decline, suggesting Mr. Ward could be coming under more pressure.”

Hackett explains what investors can learn from the “Great Cocoa Scare of 2010”:

When you see a dramatic purchase like this, it almost always signifies a near-term panic buy that is associated with a major high point in a market. You see it periodically, like with cotton in early ’08. There was a rush of panicked buying right before the market changed direction, and several end users that had been around for years and years went bankrupt. Ford (F) panicked about palladium 10 years ago when it went from $200/oz to $1200/oz and bought up massive quantities for catalytic converters. "Let’s not take any chances -- we need this stuff." Well, it just went straight down to $400 after that.

According to Hackett, the pattern is always the same.

It’s unbelievable. You hear it over and over again -- "This time it’s different, this time it’s bullish," but it never is. It inevitably ends in disaster. It’s always been a clear topping signal, a quintessential contrarian indicator, and when you see this happen, either get out of a long position or go short. Cocoa was at $3200/tonne when the announcement came out, Monday morning it was down to $2950/tonne. There was a brief rebound rally, and now it’s down to $2700/tonne. And it’s all happened literally since that supposedly bullish indicator.

A near-term bottom will likely be established “the minute you hear Armajaro’s out completely,” says Hackett. “When somebody blows a position out like that, the overhang of the market is gone -- it takes all the psychological pressure off, there’s no one there to pick up the slack, and the buyers come rushing in.”

Hackett maintains that “during much of the rally that many thought was fundamentally-based, it was obviously artificial demand. It just wasn’t moving up for the right reasons.”

Companies like Hershey (HSY), Tootsie Roll (TR), Kraft (KFT), and even Archer Daniels Midland (ADM), which processes cocoa for manufacturers globally, could benefit from the move down in cocoa.

“Buying at 20, 30% lower prices should help improve margins going into 2011, at least on the input cost for cocoa,” Hackett says.

“In the Armajaro case, as typically happens, the true investment opportunity was to do exactly the opposite of what seemed logical. It’s very hard to do, it never feels comfortable to do what everyone else isn’t, but if you want to realize a return that’s better than most, you have to do something that’s different than most."

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