John Paulson's Health Care Stocks Drop Far Below Sector Return

Losses and redemptions mount despite Paulson's strong record

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Oct 06, 2016
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After years of uneven returns following his multi-billion-dollar profits shorting the subprime mortgage market in 2007, Paulson’s pain intensified this year as his outsized bet on the wrong health care stocks scuttled returns and spooked investors.

Returns and outflows

Reports placed Paulson’s Advantage funds down 15% in the first quarter, against the market’s 0.81% rise and a 0.55% for the HFRI Fund Weighted Composite Index, which measures the average return of hedge funds. Year to date, his top five holdings, which make up 44.8% of his portfolio, have each dropped, missing the 5.82% rally in the S&P 500 and 3.53% return of the HFRI Fund Weighted Composite Index.

Poor hedge fund performance has driven redemptions across the industry, including at Paulson’s hedge fund Paulson & Co. The firm manages $18 billion in assets, a shadow of the $36 billion that rolled in by 2008 when returns were soaring. Industry-wide, client redemptions for hedge funds totaled an estimated $25.2 billion in July, bringing the total for the year through July to $55.9 billion, according to Evestment.

“Funds producing losses in 2015 are by far the primary source of outflows throughout the year into July,” a July asset flow report from Evestment said. “Additionally, in both June and July, redemptions have accelerated from within funds producing losses in 2016. Funds reporting the ten largest outflows in July have returned an average of -4.1% YTD, with average losses of -5.3% concentrated in Q1.”

Stock picking correlation

Research suggests that losses indicate both investor skill and client behavior. Performance during down markets reveals more about an investor’s skill “possibly in part due to increasing difficulty for mediocre managers to mimic the skilled ones during down markets,” according to a study from the Federal Reserve Board released in 2016.

“Our results suggest that only winners in down markets repeat, thus focusing on past DownsideReturns could allow investors to better select hedge funds than using unconditional historical returns,” authors of the paper, titled “Only Winners in Touch Times Repeat: Hedge Fund Performance Persistence Over Different Market Conditions,” concluded.

In addition, the paper confirmed existing findings that “hedge fund investors actively chase past performance,” and that they “appear to react more strongly to past performance during down markets.” Hedge fund investors are also more likely to react to news about cash flows in downturns than in upturns because down markets expose the true value of the manager’s projects.

Paulson

In Paulson’s case, he sailed past the market’s stark losses during the financial crisis. These returns would categorize him as a skilled manager able to outperform during down markets. In 2007, he returned 6.28% versus a 37% plunge in the S&P 500, and produced positive results though underperforming the market for the next two years.

But in 2011, a new era began. Paulson lost 51% that year, erasing his 51.7% gain in 2007, and watched the S&P 500 edge forward 2.1%. He would then post losses for the next four out of five years while the market rallied, including a 15% loss year to date.

Paulson also protected client capital through the dot-com bubble, generating returns as the market crashed from 2000 to 2002, suggesting his recent losing streak may amount to a slew of bad luck and missteps.

In confirmation of the study, Paulson’s investors may be more galvanized to remove their money and more susceptible to news about outflows because of uninspiring past returns. Paulson-sized redemptions have occurred among other recognizable funds this year, however, such as Perry Capital and Och-Ziff Capital Management Group, Bloomberg reported.

Losing stocks

In 2016, Paulson went overweight in a sector that has had a mediocre year – health care. The sector has declined 0.09% compared to the S&P 500’s 5.67% rise year to date, according to Fidelity Research. The industry in which three of his five top holdings reside, pharmaceuticals, has even eked out a 0.24% positive return while his picks dwindle.

Mylan NV (MYL, Financial)

Paulson has lost the most on his biggest drug manufacturer stock and second biggest position overall, Mylan NV (MYL, Financial). The generic and branded drug maker was ordered by the Federal Trade Commission in July to drop two of its generic drugs in order to acquire Swedish drug maker Meda to preserve competition. It also came under fire beginning in September for price-gouging customers for its lifesaving EpiPen drug and on Oct. 5, the government accused it of overcharging Medicaid for the drug for years.

Thursday close: $36.84

YTD return: -35.73%

Market value: $19.71 billion

Financial strength: 5/10

P/E ratio: 24.23

Forward P/E ratio: 6.58

PEG ratio: 3.24

Allergan (AGN, Financial)

Paulson’s $912.5 million stake in Allergan represents his third-largest holding. He was just one of several hedge funds, including Andreas Halvorsen (Trades, Portfolio)’s Viking Global Investors, taken by surprise in the second quarter when the government regulators crushed its plan to merge with Pfizer (PFE) to create the world’s biggest drug company and move to Ireland for tax purposes.

Thursday close: $237.41

YTD return: -24.03%

Market value: $93.33 billion

Financial strength: 4/10

P/E ratio: 23.44

Forward P/E ratio: 13.87

Teva Pharmaceutical Industries (TEVA, Financial)

Paulson’s fourth-biggest holding, global generic drug company Teva Pharmaceuticals, has a value of $842.55 million. Teva completed a $40.5 billion takeover of Allergan’s Actavis Generics after awaiting multinational regulatory clearance delayed the transaction. As part of the deal, however, regulators forced Teva to divest a record 79 generic drugs to main competitive pricing for consumers.

In a positive twist, Teva announced on Feb. 9 it plans to gain approval by 2017 or 2018 for a generic version of Myland’s EpiPen, whose price jumped from $100 to $600 from 2007 to now, sparking widespread outrage. Its creation of a competing allergy treatment device would take business from near-monopoly Mylan, which corners 94% of the U.S. market.

Thursday close: $45.40

YTD return: 30.83%

Market value: $45.88 billion

Financial strength: 5/10

P/E ratio: 30.14

Forward P/E ratio: 7.47

PEG ratio: 12.08

Other top 5 holdings

Paulson also holds Shire PLC (SHPG, Financial) as his biggest position, worth $956.6 million. That stock has declined only 479% year to date. Extended Stay America (STAY, Financial), a travel and leisure company, rounds out the top five, and is down 8.1%.

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