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How John Paulson Became a Billionaire in the Stock Market

Holly LaFon

Holly LaFon

258 followers
In a short span of time, John Paulson catapulted to the status of one of the most successful investors in history. He made an unprecedented $3.7 billion in one year in 2007 foreseeing the subprime debacle and earned massive returns on several other bets in recent years. His ability to achieve such success while the majority of the investment world cratered has left many investors asking how he did it and what they could learn from him. In his 2010 investor letter, he broadly explained that his firm made billions by “anticipating market events before they are generally recognized.”

Risk Arbitrage

Before the events that would make him legendary, Paulson was a successful hedge fund manager focusing on risk arbitrage. His arbitrage funds are his oldest, dating back to 1994, and their track record shows that they resisted economic downturns and returned above average rates over the long term (approximately 17% compared to 10% of the S&P 500). His first fund had only one down year since its inception in 1994. By the end of 2004, Paulson & Co. managed $2.9 billion.

In a 2003 interview with Hedge Fund News, he said that in risk arbitrage his method to outperform the merger arbitrage index was to minimize drawdowns from deals that break, by weighting portfolio to deals that could receive higher bids, by focusing on unique deal structures which offer the potential for higher returns and by occasionally shorting the weaker transactions.”

Paulson’s firm still engages in risk arbitrage. His most recent deal involves French drug maker Sonofi-Aventis (SNY), which initiated a hostile takeover of Genzyme Corp. in October of 2010. The deal closed on April 8, 2011, for approximately $20 billion, or $74 per share. In the fourth quarter of 2010, Paulson raised his stake in Genzyme from about to 1.9 million shares to 6.8 million shares. He also bought 9 million shares of CommScope Inc. (CTV) at $29.26 per share in the fourth quarter of 2010. On April 1, BCE Inc. (BELL) completed a $3.2-billion acquisition of CTV.

In October 2010, it profited from Pfizer’s (PFE) acquisition of King Pharmaceuticals Inc. for $3.6 billion, or $14.25 per share, a 40% premium to King’s closing price the day before. Paulson purchased 20 million shares, valued at $284.8 million, before the deal went through.

Another example is his 2009 arbitrage of a deal in which PepsiCo (PEP) reached deals to acquire two of its bottlers— Pepsi Bottling Group and PepsiAmericas – for about $7.8 billion. In his third-quarter 2009 investor letter, Paulson stated that they had confidence the deal would go through due to the “low initial price, strategic importance, and large size of the acquirer relative to the target.”

Subprime

The first banner year for Paulson occurred in 2007. As early as 2005, he began to recognize the trouble with the mortgage industry. Banks were offering mortgages – often at adjustable rates – with few restrictions or credit requirements; when the rates went up and people could no longer pay, they would have to refinance or default. The loans were based on the presumption that housing prices would continue to increase. Paulson told the Financial Crisis Committee in 2010 that when he recognized that home prices ceased going up, he began buying securities against low-graded loans likely to default.

Mortgage dealers told Paulson that the mortgages were safe because home prices had never declined on a national scale since the Great Depression. “Our opinion was [home prices] were overvalued and they were going to correct and that the quality of mortgages was very poor, and the losses would likely be substantial,” Paulson said. By June 2006, he set up a fund for credit default swaps – a form of insurance which would pay him if people could not pay their loans – to capitalize on the fallout.

By February of 2007, before the credit crisis actually hit, his return soared to 66%. By the end of 2007, his firm had made $15 billion.

Shorting Financials (2008)

In early 2008, he even made money as financial institutions related to the mortgage backed securities collapsed. He did it primarily by shorting stocks in some of the world’s largest financial institutions, betting they would fail. He shorted Fannie Mae, Freddie Mac, Barclays (BCS), Royal Bank of Scotland (RBS) and Lloyds TSB (LYG). By November of 2008, his firm had $36 billion assets under management.

Financial Recovery (2009)

As he profited when the financial sector fell apart, so he profited as it began to recover in 2009. In a speech at a hedge-fund seminar in Tokyo, Paulson called distressed assets in the U.S. “the best opportunity in a lifetime.” He formed a new fund called the Paulson Recovery Fund in 2008, making investments, primarily in the financial sector, that would appreciate as the economy improved. He also deemed the consumer staples, pharmaceutical and health industries as attractive options.

In Paulson’s 2009 investor letter, he said the biggest challenge to performance was picking the right security and the right entry point. “Many investors have tried to buy at what they thought was the bottom but to date almost every investor that has bought financial equity securities has lost money,” he wrote.

Paulson & Co. followed approximately 70 banks in 2009, analyzing them based on need for further equity, core earnings forecasts, estimated losses and projected capital deficiency. They then projected earnings per share that would help them forecast future prices. The Paulson Recovery Fund had a return of 25.49% in 2009.

His best returns in 2009 came from his Credit Funds, which were up 28.45% through November, beating the industry average of 13.6%. He made most of the money in that fund through buying an assortment of cheap loans and bonds and selling them for a profit.

Gold (2010)

In 2009, Paulson increased his investment in the gold sector. He created the Paulson Gold Fund in April 2009, and five gold mining stocks comprise 14% of his firm’s portfolio. In the first quarter of 2009, he purchased 31,500,000 shares of SPDR Gold Trust (GLD) at $89.56 per share. As of April 2011, GLD stock has risen 63% to approximately $133 per share.

His second largest gold holding is AngloGold Ashanti (AU) which comprises 7.11% of his portfolio. As of Dec. 31, 2011, he owns 40,949,437 shares. He first purchased shares of AngloGold in the first quarter of 2009 at approximately $30, and the share value has risen 64.5% since then.

He is also buying into gold-related companies. Gabriel Resources (GBU), of which he owns over 19%, is the largest potential gold mine in Europe. Gabriel Resources is an “impaired” gold company in that it has been involved in a lengthy process to obtain environmental permits and expects that it will not be until 2014 that everything will be in place to actually begin mining. But the company’s problems sent its stock price down. Paulson first bought the stock at around $2 per share in the first quarter of 2009. As of April 2011, it has increased 233% to $7.22 per share.

Paulson’s gold funds debuted with an over 35% net return. Paulson & Co. attributed the return to their “exposure to production, development, exploration gold mining shares and the rising value of derivatives.”

Gold prices have risen over 131% in the last five years. In 2010 it leaped almost 30%, and his investment paid off even better than his subprime bet in 2007: He made $5 billion. However, in the first quarter of 2011, his gold funds have lost 1.26%.

Individual Stock Home Run: Citigroup

John Paulson made over $1 billion on a single stock over 18 months beginning in 2009 – Citigroup (C). The largest position in his Advantage Fund, the stock increased 43% in 2010. In a shareholder letter, Paulson said that Citigroup’s performance demonstrated the “upside potential” of his restructuring investments.

Forecast (2011-2012)

Looking forward, Paulson expects that the U.S. economy will continue to grow and recover. He will avoid high yield bonds and focus on restructuring equities for big future returns. As of Dec. 31. 2010, his largest holdings are in SPRD Gold Trust (GLD), Anglogold Ashanti Ltd. (AU), Citigroup Inc. (C), Bank of America Corp. (BAC), and Anadarko Petroeleum Corp (APC).

For John Paulson’s complete portfolio, click here.

Rating: 3.7/5 (30 votes)

Comments

dealraker
Dealraker - 3 years ago
Does anyone other than me question the so-called value investor site worship of the 2 and 20 crowd? Where does 2 and 20 come from? Out of investors pockets. Now I guess those that think this is just dandy think there is no overall loss to stock owners from this structure.

gurufocus
Gurufocus premium member - 3 years ago
2 and 20 is certainly expensive. But one thing for sure is that John Paulson's clients have been happy to pay that than investing in index funds and paying almost no fees.

The goal of this article is to summarize how John Paulson made the billions, and hopefully all of us can learn something from it.
paulwitt
Paulwitt - 3 years ago
It gets worse. I copied and pasted the following from the crimeandfederalism.com website:

Did you know that hedge fund managers pay a lower income-tax rate than you? Hedge fund managers only pay 15% income tax. How?

When you take a draw of your partnership profits, it's treated as income. If you, like many readers, are successful, then you're paying 35% income tax on your profits.

When a hedge fund manager takes a draw from profits, his income is treated as long-term capital gains - 15%.

This is a loophole that has existed for years. Every year there's an editorial about it. Here is the New York Time's latest. Every year the loophole remains.

paulwitt
Paulwitt - 3 years ago
By the way, even though I commented on taxes, I don't begrudge Mr. Paulson his gains. He made a big time contrarian play and scored big. Well done!

paulwitt
Paulwitt - 3 years ago
Another tax problem is inherited wealth. Large amounts of money are allowed to compound without paying taxes on it - and it becomes a societal problem.

How about if inherited wealth is treated as passive income and mark to market accounting is used for tax purposes. For example: someone inherits a $10 billion stock portfolio. Anything over $10 billion is taxed at ordinary tax rates. And if the portfolio goes under $10 billion there are no taxes (except for dividends of course)

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
So how much of Paulson's wealth is from fee alpha vs market alpha?
paulwitt
Paulwitt - 3 years ago
So maybe capital gains treatment should be as follows: If it's management's money at risk they get regular capital gains treatment. If they are using investor money they pay ordinary tax rates.

sww
Sww - 3 years ago
I can think of a problem with mark to market taxes, say you inherit 100K worth of a stock, the stock went up to 300K in a year, you pay taxes on the 200K @ 15% = 30K. Next year the company bankrupt, you lost all the 100K + 30K. Seems hardly fair right?

No income tax and just tax on spending (like 3-5% GST) is a much better solution and you don't need to hire an army of IRS. Every year April, nobody (individual) needs to file a "tax return". Only business need to hand in the tax every month/quarter. You simplified the entire tax system and scale down the government.

Another tax problem is inherited wealth. Large amounts of money are allowed to compound without paying taxes on it - and it becomes a societal problem.

How about if inherited wealth is treated as passive income and mark to market accounting is used for tax purposes. For example: someone inherits a $10 billion stock portfolio. Anything over $10 billion is taxed at ordinary tax rates. And if the portfolio goes under $10 billion there are no taxes (except for dividends of course)

mcwillia
Mcwillia - 3 years ago
Alberta;

The fee alpha question is a very good one. I'm dying to know. I would like to know the same thing about Buffett. Thanks for asking this. Does anybody have an answer?

Please leave your comment:


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