Great Readings from John Paulson

Wednesday, February 2, 2011


John Paulson's Year-End Letter: Restructured Equities Will Drive Future Returns

John Paulson is out with his hedge fund firm's year-end letter and in it we learn that his funds have seen impressive compound annual growth rates ranging from 13.81% to 84.85% over their lifespan. Paulson & Co now has $35.9 billion in assets under management (AUM).

The bulk of Paulson's AUM can be found in his event funds (Paulson Advantage, Advantage Plus) as they collectively manage $18.6 billion. His original merger arbitrage funds garner just over $5 billion, his Credit Fund manages $8.6 billion, and his Recovery Fund manages $2.6 billion. Also, Paulson's gold fund (which we've covered in-depth) now manages just under $1 billion.

Focus on Restructuring Equities

Paulson's Recovery Fund, which is obviously betting on an economic recovery, primarily focuses on the financial sector but also takes stakes in industrials, hotels, and real estate. Interestingly enough, Paulson & Co's investment roadmap lays out the case for a focus on restructuring equities. We've detailed before how Dan Loeb's Third Point likes post-reorg equities as well. Paulson writes,

"In the midst of the credit bubble in 2006, we bought protection on our corporate and mortgage credit, which drove our returns in 2007. In 2008, we shifted our focus to shorting the equity of financial firms we thought could fail because of their exposure to credit losses, which was the main contributor to our gains in 2008. In late 2008 and early 2009, as credit markets bottomed, we switched to long distressed credit. From 4Q 2008 through 2Q 2009, we went from having no long exposure in credit to being $25 billion long. Long credit exposure drove our profitability in 2009.

As high yield bonds now trade at par and yields have plummeted, our focus has shifted to restructuring equities as the driver of future returns. While returns in our current-pay portfolio are still decent, we believe going forward the highest returns will be in restructured equities, mergers and acquisitions, and event arbitrage."

Paulson has essentially wagered over $20 billion in 40 different transactions. He feels that since these companies now have solid capital structures that their equity offers large upside potential. Paulson emphasizes that, "This is the part of the cycle where we want to have long event exposure and do not want to be under-invested."

Embedded below courtesy of ZeroHedge is Paulson & Co's year-end letter:

(Email readers need to come to the site to view the letter).

Finally, one other portion of Paulson's letter worth highlighting is his argument that his firm's large size will not be a detriment to finding opportunities and generating performance. So far, he is correct with Paulson's solid 2010 performance. We'll have to see if this holds true going forward as numerous hedge funds have struggled once they become asset gathering behemoths.

Read more: http://www.marketfolly.com/2011/02/john-paulsons-year-end-letter.html#ixzz1CrMsNm74





Monday, November 30, 2009

John Paulson's Gold Fund: Betting Against the US Dollar

By now you are undoubtedly aware that John Paulson's hedge fund firm Paulson & Co is set to launch a gold fund. We wanted to take a minute to investigate things on a deeper level and examine why he is doing so and why now. Simply put, Paulson & Co is betting on the devaluation of the US dollar. They see inflation in the cards for the future and are positioning themselves accordingly. The fund is set to launch in January and John Paulson will personally invest $250 million into the fund.

This is notable not for the wager on inflation, but for the vehicle they have selected to hedge their exposure. Many prominent hedge funds and market gurus have previously warned of inflation and have shorted long-term US treasuries. One of the original hedgies Michael Steinhardt himself has called treasuries foolish. Legendary investor and ex-Quantum fund manager Jim Rogers shares this sentiment and dislikes treasuries. Hedge fund legend Julian Robertson is betting on higher interest rates and is doing so via constant maturity swaps (CMS). We also note that John Paulson's former colleague Paolo Pellegrini has also taken an inflationary stance. Instead of playing gold, Pellegrini's hedge fund PSQR had previously been shorting treasuries and longing oil. We could go on and on but the main point is that there are some prominent and smart minds betting on inflation. While many of them share the same ideas on the topic of inflation, they've used a myriad of investment vehicles to execute their call. John Paulson has taken a slightly different approach to his inflationary bet and here's why.

The Introduction

Paulson's wager on gold is by no means new information. After all, Paulson's current hedge funds hold over $4.3 billion of gold related investments. And as we have pointed out in the past, this exposure is purely to hedge their US dollar exposure as one of their other hedge funds has a share class denominated in gold. Paulson's conviction in gold related investments has undoubtedly risen. After all, why else would he be launching a hedge fund dedicated to investing solely in gold related entities? The creation of Paulson's fund traces an eerily similar pattern to one of his prior hedge fund launches where he crafted an idea, launched a hedge fund based on that idea, and then made billions. (We're talking of course about his large bet against subprime). Paulson has made his next large bet and his new gold fund is the vehicle by which you can join him on the ride. His gold fund's objective "is to outperform gold price in a rising gold price environment." They will pursue this by investing in gold equities that are levered to the price of gold, as well as derivatives on the price of gold. Can Paulson be successful on two big bets back to back? We'll have to wait and see.

The Gold Thesis

According to recent presentations from Paulson & Co, their thesis for gold is threefold. Firstly, they believe that the printing presses of money that have been working overtime in America and other countries will cause depreciation in paper currency. Secondly, they believe that demand for gold will increase, particularly as a reserve currency. In fact, they think gold could become the primary reserve currency again as they have been looking at gold as currency, not a commodity. Thirdly, their belief is that demand for gold in general will be far greater than supply, causing prices to head higher. Overall, they see a very high probability of inflation in America's future and have selected gold related investments to hedge against this.

Ben Bernanke's Printing Presses

Looking further, Paulson & Co highlights that the monetary base has expanded to an absolutely exponential degree. According to the Federal Reserve, typical year over year changes in monetary base were under 20%. When the crisis occurred, that year over year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply. In turn, unit money supply then is also highly correlated to the GDP price index, nearly a 1:1 correlation again. Paulson & Co's main argument here is that the monetary base has expanded dramatically, yet the money supply growth hasn't yet expanded. This is due to the fact that the velocity of money dropped furiously after the collapse of Lehman Brothers. Once money supply expands, look out for inflation.

Bolstering their argument, Paulson has also cited inflationary outlooks issued by the likes of former St. Louis Fed President William Poole, Harvard Professor of Economics and President Emeritus Dr. Martin Feldstein, and many more. Obviously they are not alone in their fears here. While America has taken center stage for their Central Bank balance sheet expansion, other countries' balance sheets have become just as bloated. From late 2008 until Q2 2009, the US Federal Reserve has expanded their balance sheet by 119%, the Bank of England's has expanded by 127%, the Swiss National Bank's has increased by 80%, and the European Central Bank's balance sheet has seen a 39% increase.

In the end, the crux of this part of their argument for inflation centers around money supply. Historically, inflation has lagged money supply growth by 2 to 3 years. So the lesson is that when you have money supply growth, inflation is just around the corner. And, gold has historically held its value and/or appreciated in times of inflation.

Rising Demand

To those pointing toward gold as a crowded trade or bubble, Paulson & Co argue that there has been vast appetite for gold, particularly in the popular exchange traded fund GLD. While the holdings of this ETF were only recently around $57 billion, the total pool of US money market reserves was a massive $3,850 billion. They imply that this leaves a vast amount of room for savers to shift away from paltry money market rates and into gold. Not to mention, Paulson's hedge fund actually expects central banks to turn into net buyers of gold in 2010. We've already seen signs of this as India's appetite for gold has heartily increased lately. It seems that the central banks have concluded they should not sell assets that are appreciating (gold) in order to buy assets that are depreciating (US dollar).

Gold has been on a rampage the past few months, breaking above the $1,000 technical and psychological level and heading even higher. The question now becomes, what's next for gold? Check out this video on gold to see logical pullback areas, price targets for gold's move higher, as well as where to place your stops. One thing's for certain: investors have definitely had more of an appetite for the precious metal as of late.

The Strategy

Curiously enough, it appears that Paulson's gold fund will actually not buy any physical gold. Instead, they will play inflation via gold equities as well as derivatives on the price of gold. The derivatives portion of their book has not been put on yet but they will target it to be slightly over 15% of their portfolio by using long-dated options. So, the vast majority of their gold fund will be comprised of gold equities. Some of Paulson & Co's other hedge funds already have large exposure to specific gold miners such as Anglogold Ashanti. They've selected this strategy for greater potential upside as they think gold equities will actually benefit most should gold prices stay flat or continue to rise.

Risks

As with any trade, there are always risks. Paulson's hedge fund has identified volatility, timing, price, and confiscation as potential risks to this play. In regards to timing, there is seemingly always a lag in when exactly inflation hits. It is usually a domino effect as the monetary base expands, then the money supply expands, and then you see inflation. The risk from their perspective is that it could take three to five years before we see any true signs of inflation. In regards to potential deflation in the price of gold, they identify the risks of a decline in industrial demand (jewelry etc), sales by central banks, and an increase in supply. Lastly, they identify confiscation by central banks as a threat. However, this scenario would essentially require the presence of hyperinflation and at that point the price of gold would be sky high.

A Winning Trade For Paulson

Regardless of gold's potential price appreciation, Paulson has already won on this trade. Why, you ask? Well, nowadays John Paulson is an investment icon and everyone wants to invest with him. He is already in the trade in some of his other hedge funds and soon will be with his gold fund. Not to mention, numerous other prominent hedgies are singing the praises of gold as of late. As others begin to filter into the trade and warm up to its potential, Paulson's play benefits. As our friend on Twitter mojakus puts it, Paulson can "ride the wave of wider recognition of the trade's merits. (It) doesn't really need to work out for him to mint it."

Paulson & Co don't necessarily need the trade to be realized, but rather they just need others to recognize the risk. They don't need gold prices to go higher, they only need others to recognize the potential for prices to head higher. After all, Paulson will charge a 1.5% management fee and a 20% performance fee in his gold fund with a $10 million minimum investment. As we posted on our Twitter, a massive rush of investors into gold funds could signify a top, but Paulson & Co obviously won't turn down receiving a nice set of fees for investing your cash into gold equities and derivatives.

This all comes on the heels of Paulson's huge bet against subprime over the past few years. Wall Street Journal columnist Gregory Zuckerman has detailed Paulson's amazing play in The Greatest Trade Ever, his new book (see our review here). Can Paulson do it again with his wager against the US dollar? It certainly would be quite the feat to nail two major trades in such a short span of time.

Hedgies Like Gold

As we've covered previously, hedge fund colleague David Einhorn of Greenlight Capital is positioning himself to benefit from the printing presses of the US and other governments. Einhorn is bullish on gold as well and has actually shifted from using the exchange traded fund GLD for his position to storing physical gold. So while Einhorn prefers physical gold instead of gold miners ala Paulson, the bottom line is they both have identified quantitative easing as a major inflationary threat going forward. As such, they are positioning themselves to benefit by what they deem to be the most beneficial way.

The Debate Continues

The inflation versus deflation argument rolls on and is shaping up to be quite the investment battlefield. With his gold hedge fund launch, John Paulson has planted himself firmly in the inflation camp. In the other corner, PIMCO's bond vigilante Bill Gross is betting on deflation. While the outcome could still be a few years away, it's interesting to see the wagers and investment vehicles selected by various notable investors. Slowly but surely the prominent names in the industry are placing their bets. Which side are you on?