Exclusive: The Paulson Portfolio Post-Mortem (In Which We Learn That The Maestro Himself Is Advising J.P. On Future Gold Prices)
One of the most fabled funds of recent years, John Paulson's Paulson and Co., has not had a good first half to 2010: not only was Paulson implicated in the biggest Goldman Sachs scandal in recent history (which took the 200 West firm a few hours worth of operating profits to settle with the SEC), but the firm has seen substantial outflows after a subpar performance in the first half of 2010, a time which has seen the firm's flagship Event Arbitrage ($16.6 Billion in AUM) fund lose just under 6% YTD and 6.6% in H2. Yet among the other Q2 losers, which have also included the firm's Merger Arb fund ($4.0 Billion, down 5.21% in Q2), and Credit Fund ($7.7 Billion, down 1.75% in Q2), nowhere was the pain as acute as for investors in the firm's reflation bet, better known as the $2 Billion Recovery Fund, which was down 12.6% in Q2. For the man who had rarely if ever tasted loss before, many are asking if the recent disappointing performance a sign that the multi-billionaire has peaked? And surely with a personal net wealth well in the billions, just how big is Paulson's motivation any more? If the fund is now nothing more than a levered bet on the broader market, surely there are other levered ETFs available that do not charge 2 and 20%, and may be better suited for the needs of the firm's LPs? Or is Paulson right, and once the market realizes the folly of its ways he will make his investors (in addition to himself) truly rich? Just what is the logic behind the investment choices? Read on to find out.
But first, here is a snapshot summary of the firm's various investment strategies, funds, along with strategy AUM and performance.
What is curious is that while the firm has recorded disappointing returns in dollar-denominated terms, its gold-share performance (which is basically the return for those investors who have invested in the fund in a gold-equivalent form - once again gold shows a better relative performance expressed against an infinitely dilutable currency).
Looking at the overarching strategy of the fund, it is in a nutshell: hook, line and sinker uber-bullish. All those who had hoped against hope that the fund manager may have a contrarian bet hidden somewhere deep down, in the form of undisclosed credit and equity shorts, or some humongous CDS book, we are sorry to disappoint you. In fact, recently, the firm's net equity exposure in its reflation and banking megabet, the Recovery Fund, was a whopping 139.7%. In other words, not only was Paulson not hedged at all, but his gross and net leverage were well above normal levels for what is usually considered a hedge fund. Only following the massive drubbing in the Recovery Fund in Q2, did Paulson reduce his exposure from 139.7% to 107.6%. This means that for all those hoping to see an expansion in the firm's financial holdings in Q3 when Paulson files its next 13-F in November, will be in for a big disappointment, as the firm has actually reduced exposure notably (whether by selling off positions or by pressing shorts).
As for where Paulson believes the economy is in the cycle, no surprise there. The graph below summarizes it best:
To be sure, Paulson's market timing track record so far has been nearly impeccable: he top ticked the market perfectly, and subsequently was buying up every form of credit when the market was dumping at the very trough. Here is how the fund summarizes its historical activities:
In 2006 and 2007, the primary focus of our funds was on buying credit protection on mispriced securities. As the credit markets corrected, this portfolio produced large gains for our funds primarily in 2007, but also in 2008... As financial companies realized their losses, their stock prices collapsed and our positions produced large gains for our funds in 2008.
Beginning in the 4Q of 2008 and through mid-2009, as high yield spreads reached all time highs, we shifted our focus to long distressed credit acquiring significant positions in mortgage backed securities, distressed bonds, levered loans, and defaulted securities. As spreads tightened in 2009, the value of our fixed income securities rose, producing high returns.
Indeed, there is nothing one can say about Paulson's past. He has certainly been impeccable in picking the two most crucial market inflection points over the past 5 years. The result is that Paulson & Co. is now the single largest (non quant) hedge fund in America, and has made Paulson a billionaire. The only question that remains now is whether Paulson is correct about the future.
And according to the firm's economic outlook, the future is truly very bright (even if a few dark clouds may be appearing on the horizon). There is nothing in the fund's general outlook that one would not find in a typical letter on any given Sunday from Goldman's Jim O'Neill, as it is merely the prevailing Wall Street consensus. Here it is in a nutshell:
Although greater uncertainty exists, the U.S. economy continues to expand although most economists have lowered growth estimates. While still fragile, the housing market is stabilizing, and certain hard hit regions are coming back. Retail sales have demonstrated resiliency and ISM manufacturing and non-manufacturing indices continue to report positive numbers.
On the positive side, corporate earnings of both European exporters and US companies have exceeded analyst estimates... The S&P 500 now trades at only 13.8x 2010 estimates, well below the 30 year average of 19.5x [TD: oddly enough, this matches precisely the entire period of the great credit moderation, in which bond yields collapsed from 15% to record lows. To say this is indicative of a fair value, absent constant Fed intervention, meddling and manipulation is shockingly naive - cutting to the chase, Paulson is basically betting on the continued and neverending existence of the Fed's yield-reduction scheme]. With 10 year Treasury yields at less than 3%, the earnings yield on equity compared to treasuries is the widest it's been in thrity years. The low relative valuation of the stock market combined with the strong earnings creates the potential for a stronger market which, in turn, could boost GDP growth [oddly enough this tail-wags-dog logic first appeared on the scene when anunciated by none other than the Maestro in a late July Meet The Press interview, when he said that "if the stock market continues higher it will do more to stimulate the economy than any other measure we have discussed here"... for a much more surprising connection between Paulson and the Maestro read on].... Externally, we believe European debt problems are manageable. The cheaper euro will prove to be a boost for European exporters, making Europe more competitive. Accordingly, we believe Europe will perform modestly better than consensus estimates.
Yet not all is rainbows and unicorns:
Despite a challenging second quarter, we believe the economic recovery will continue fueling corporate growth and the Funds' performance for the remained of 2010 and 2011. The Recovery Funds are exposed to general economic risks, such as a significant tightening of monetary policy, a double-dip recession or a sovereign debt crisis. While we are excited about our portfolio, in order to protect the portfolio from these economic risks, we decided to lower our net equity exposure from almost 140% to 107% currently.
Sorry Citi and Bank of America stockholders: soon there will be an announcement that Paulson has offloaded substantial portions of his C/BAC shares.
In terms of immediate products that the fund is currently focusing on, it appears that Paulson's sweet spot is in post-reorg equities. The thesis is that once previously impaired debt reaches par, the only continued upside is in the form of the post-emergency equity tranche. As these firms tend to have a (unfounded) bias against them due to their recent bankruptcy (the bankruptcy completely redoes the balance sheet), the prevailing opinion should provide an attractive entry point for those who are not worried about following a clean cash flow story. Of course, this was the premise behind ESL's investment in K-Mart, which Paulson highlights prominently as a case study, showing that the stock price surged by 13x from its emergence out of bankruptcy, all the way to its all time high in 2007 (that this exit valuation was predicated upon a horribly mangled post-reorg valuation model created by assorted permabullish bankruptcy advisors while the firm was in court apparently is irrelevant... as is the fact that post the peak K-Mart dropped to almost its all time lows at the end of 2008, nearly costing ESL his fund). Yet the point is, that as Paulson notes: "we are now at the point in the economic cycle where further upside in the enterprise is less in the credit but rather in the equities of companies which have or will undergo restructuring, recapitalization abd bankruptcy reorganization." More on the fund's focus on its preferred investment class for 2010-2012:
Historically, investments in restructuring equities have been the highest performing part of event arbitrage in this stag of the economic cycle following a recession [how about entering a Double Dip?]. We believe that over the next two years, they will appreciate more than the markets. This is the fourth distressed cycle since 1980 and each cycle has exhibited similar trends. [ah, our earlier warning that no technical patterns and historical analogies are any longer applicable to the current systemic paradigm goes unheeded... oh well]
Paulson summarizes his post-reorg equity theme with the following chart:
How will this investment theme play out for Paulson's various strategies, and which companies will benefit the most? The following chart summarizes the initial assumptions:
Yet when it comes to his extremely bullish outlook, what happens if Paulson and his echo chamber of sycophant Ph.D.'s (even Bill Gross prefers to surround himself with people who disagree with him) are wrong about the housing double dip? As Paulson admits "Banking represents our largest sector exposure." He continues: "Banks' earnings recovery continues to be driven by a decline in provisioning for bad loans as old loans are written off and new higher quality loans are made... As provision expense falls, we expect a corresponding rebound in earnings." Oddly enough, people seem to have seen right through this, and even Jamie Dimon recently argued that earning boosts based on provision reductions are not real earnings. Well, apparently they are good enough for Paulson. Yet what happens if the double dip (or Great Depression V2.1) is now here, and home prices plunge another 20-30% as many, among them Robert Shiller himself, have argued could happen? Well, kiss the beneficial provisioning trend goodbye for one, as banks will once again be forced to start increasing loan-loss assumptions (as Meredith Whitney has been warning recently), causing major EPS losses and earnings misses, resulting in a step down in stock prices. As we currently stand on the edge between the realization that the double dip has arrived, and the tenuous hope that the lack of any stimulus for at least another 3 months will prevent an economic collapse, the Recovery Fund PM must be chewing his nails, knowing full well that unless the investing public buys into this latest round of reponzification, the fund's $2 Bn in AUM are very much at risk.
On the other hand, if he is proven correct, the fund stands to make huge gains, as will the key stocks that make up the fund's main holdings. As the chart below shows, Paulson has the following massive upside targets for the key banks as of FYE 2011: Citi - $6.10 (~25% upside), Bank of America - $26.59 (~50% upside), JPM - $71.18 (40% upside), and Wells Fargo - $40.52 (~25% upside).
The chart below summarizes the Fund's view on these top 4 bank positions (yet the footnoted Risk factors tell a probably even bigger story...)
Other notable bets for the fund include a massive legacy exposure in Distressed Debt, which accounts for $5.8 billion in AUM for the Advantage Fund ($9.2 billion in notional, which is also 30% of the AUM). "The distressed portfolio is comprised of a broad array of fixed0income securities, including high-yield bonds, levered loans, mortgage-backed securities and defaulted bonds." A comparable breakdown is also responsible for all of the AUM of the firm's Credit Funds, which had invested $7.7 billion, leveraged 126% into $8.982 billion of market value of bonds, equivalent to $12.3 billion in notional value. In other words, between Advantage and Credit, Paulson owned over $21 billion notional (almost $15 billion market, or roughly a 70 cents on the dollar blended price) in distressed names. To say that Paulson is to the distressed market as Pimco is to the UST/MBS market would certainly not be an overstatement.
(on the chart, Advantage credit exposure is on the left, while the Credit Fund's holdings are on the right)
More details on the Credit Fund's holdings:
The Current Pay portfolio is the largest portion of the firm's credit exposure, and amounts to roughly $7.7 billion in notional, or 68% of total. It has a duration of approximately three years.
Also notable is that Paulson bought $440 million of Hilton mezz debt at 73% (15% yield), and the hope is that the issues will be called. Good luck.
Some other curious tidbits: we discover that Paulson's price target on MGM is $60 based on a 12x 2015 EBITDA target. The fund's cost basis is $11.50, so unfortunately for the time being instead of the 39% 5yr IRR, Paulson has to be content with a nearly 20% loss on his $400MM MGM stake (MGM closed at $9.84).
Paulson, also anticipates a surge in Hartford, based on the simplistic catalyst that the P/B ratio should go up from the current 0.6x to the industry average of 1.0x and in line with its historical valuation of 1.5x. We truly hope there is more of a catalyst to this thesis.
Abroad, Paulson has made a material investment in Renault, where he has a €68 price target, about 100% higher than recent closing levels.
Also, Paulson has invested substantial capital in the stock of HeidelbergCement with a €37 cost basis, and the expectation that the stock will hit about €100 in the future, based on a 2012-2013 7X projected EBITDA.
To be sure, Paulson's fund is not purely a levered play on the Fed's attempt to reflate the economy: about $4 billion is invested in straightforward merger arb situations. Of course, as we saw a few days ago, even these "spread closing" strats are not risk free, when Mariner's stock price tumbled after the firm announced its platform fire, despite the ongoing Apache M&A, which is supposed to generate a 5.7% annualized spread when closed. This merely confirms that upside/downside analyses in relatively risk-free M&A can and will easily blow up in one's face (perhaps explaining the fund's -1.07% performance YTD through June). Among the other merger arbs on Paulson's books are Smith/Schlumberger, Qwest/Centurylink, Hewitt Associates/Aon, SSL/Reckitt Benckiser, Allegheny/First, NBTY/Calryle, Americredit/GM, and Psychiatric Solutions/Universal Health. All in all, more pennies before a black swanish rollercoaster. An aggresive swoon in the market could easily blow up the bulk of these pending acquisitions, leading to massive pain for the fund's LPs.
Yet focusing on Paulson's most curious bet, his Recovery Fund, yields the following observations: of the fund's $2 billion in AUM, "banks continue to be the leading long investment (75%), followed by hotels (15%), and insurance (9%).
As noted previously, the key catalyst on the bank side is the expectation that a decline in provisioning will boost EPS. Perhaps the Recovery Fund's LP should have some talks with Jamie Dimon and coordinate stories on just how much of a viable upside catalyst this is rather unremarkable accounting phenomenon is truly supposed to be.
In addition to the holdings mentioned above as making up the Advantage Fund, the Recovery Fund is also targetting such post-reorg situations as Delphi, Dex One, Education Media, Idearc, and Supermedia. In other words, pretty much everything in the space.
The chart below summarizes the Recovery Fund's holdings by investment thesis:
Also, as we suspected months ago, frontrunning the FDIC is now a full blown investment strategy, and works for Paulson the same way as frontrunning the Fed in general works for Pimco.
So up to here the theme is pretty consistent: reflation at all costs. Deflation will promptly lead to an evisceration of the bulk of Paulson's holdings. Indeed, the fate of Paulson & Co., and the Federal Reserve are very, very closely tied...
Which explains why Mr. Paulson has recently retained the services of a most prominent consultant: none other than former Fed Chairman Alan Greenspan.
Fast forwarding to the only fund of Paulson's that is truly outperforming (and oddly enough has the smallest AUM of all), the firm's Gold Fund, which is up 12.5% YTD as of June 30. The investment thesis here should be very clear to our regular readers. Before we get into the abovementioned tidbit, here is how the Gold fund is positioned in terms of the current portfolio:
Some of the notable outperformers in the fund include Osisko and Detour, which have outperformed the price of gold by 142% and 96%, respectively.
All in all, there is nothing negative one can say about the Gold Fund, which if the prevalent thesis about ongoing dislocation between gold as a commodity and as a currency is validated, Paulson should achieve material gains in this fund (which incidentally is open for further investment and currently have just $535 million in AUM: as Paulson observes, "we believe that liquidity in the gold market would allow the Funds to accommodate much higher levels of investment.").
All in all, this is a good barbell hedge to some of the other funds in the Paulson group of investment, as should ongoing currency debasement continue (and it will), while the impact on financials will most definitely be negative due to the inevitable even more dramatic flattening of the Yield Curve following QE2, 3, ... etc., gold should continue to appreciate as the market prices in ever more proximal (hyper)inflation.
Yet, in discussing the gold research expertise that backs up the fund, we read this most curious disclosure:
Lastly, and perhaps most important, from a monetary policy perspective in developing an ability to forecast the timing and future price of gold we believe we have an unparalleled team. Former Federal Reserve Chairman Alan Greenspan has been extremely helpful to us in undestanding the relationship between the monetary base, the money supply, inflation and gold prices.
This is probably the single most important take home message in this entire post. Basically, Paulson confirms implicitly that the Fed itself (via the man who got us to this woeful economic state), is advocating the purchase of gold, as he is confident that the double whammy of the monetary base and supply will lead to a surge in gold. Whether this means inflation or hyperinflation, and the final playout of the "Gold to $36,000 scenario" is uncertain. But when the world's biggest hedge fund, and the world's greatest economic disaster have sat down, and decided that gold is a buy here, we will certainly not step in their way. Basically the Paulson-Greenspan JV have confirmed what everyone tacitly knows: the Fed has no option but to reflate. And it will stop at nothing, even if it means the forced conversion of gold from its legacy commodity status, to a full-accepted currency. Gold bears beware.
Lastly, for all those who are curious as to what the fund has been doing lately (since the most recent 13-F), here is the spoiler:
During the second quarter we had higher net equity exposure and correspondingly higher short-term market correlation. We attempted to reduce that correlation by having short positions against our long positions and by buying CDS protection on vulnerable credits. While spread widening produced gains to offset the losses. Going forward we intent to focus more on short event opportunities to reduce our net long exposure and to consider buying put protection or other forms of protection to reduce the volatility.
Translation: despite all the bluster to the contrary, Paulson is shorting the market (and himself). Cause at the end of the day, the only thing better than a zero hedge is a perfect hedge.
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