John Paulson (Trades, Portfolio) was once a darling of Wall Street, having handsomely profited because of his smart bets on the subprime crisis while many of his counterparts suffered.
Today, though, he’s struggling, after experiencing three successive years of double-digit losses. What was a $36 billion portfolio six years ago now struggles to get over the $10 billion mark.
Paulson is listed as one of the GuruFocus gurus based on his big scores of the previous decade, but can he maintain that status?
To read about other investing gurus, click on any of the following names: David Tepper, Prem Watsa, Bill Ackman, Seth Klarman (by Rupert Hargeaves), Chuck Akre, Vanguard Health Care Fund, Yacktman Focused Fund, Jerome Dodson, Frank Sands, the Eaton Vance Worldwide Health Sciences Fund, PRIMECAP Management, Daniel Loeb, Bill Nygren, Mariko Gordon, David Rolfe and Mairs & Power.
Who is John Paulson?
He graduated from Harvard in 1980 with a Master of Business Administration after completing an undergraduate degree in finance at New York University’s College of Business and Public Administration in 1978.
A few years later, he became a general partner at Gruss Partners and a managing director in mergers and acquisitions at Bear Stearns. In 1994, he launched his own hedge fund firm –Â Paulson & Co. Inc. –Â in New York City.
Paulson became famous (or infamous, in some eyes) with a $15 billion win on the mortgage and financial crisis of 2007 and 2008. The story of his exploits is chronicled in the book, “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History” by Gregory Zuckerman.
That success brought large sums of capital into his fund, which subsequently became a giant in the industry. However, recent years have produced more losses than gains, with poor performance costing him both capital losses and clients. The New York Times reports Paulson now (at the date of publication, May 1) manages less than $10 billion, compared with more than $36 billion in 2011. Last year, 2016, was so bad that he and his fund were included in a Fortune magazine article titled “These Are the 7 Biggest Hedge Fund Disasters of 2016.”
The Times also reports the fund manager is close to the Donald Trump administration, with Paulson having been one of the first Wall Streeters to back Trump, as well as providing economic advice, making a quarter-million-dollar donation to the inaugural committee, and participating in a “CEO Town Hall.”
Measuring up to past greatness can be a curse, even for hedge fund managers who post respectable results. But Paulson failed to bring in even modestly respectable returns in recent years, making it more difficult to keep existing clients and attract new ones.
What is Paulson & Co. Inc.?
This is an investment advisory firm, also known as a hedge fund, based in New York City.
According to its Form ADV filed with the U.S. Securities Commission in April of this year, more than 75% of its business is done with pooled investment companies, or institutional investors (such as mutual funds and pension funds). It also invests on behalf of some high net-worth individuals, banks/thrifts and other entities. Specifically, it reports having 11 to 25 clients in the most recent fiscal year with 60% based outside the U.S.
Regulatory assets under management totaled $12,443,210,000, managed on behalf of 17 clients. But Paulson and key associates may be the biggest holders of that total, according to this statement on the 2A portion of the Form ADV:Â “Paulson employees and partners are currently the largest category of investors in our funds on a firmwide basis.”
The phrase "largest category" is not defined, but Forbes puts Paulson’s personal wealth at $7.9 billion, and no doubt a portion of that is managed by the firm.
The firm manages a lengthy list of funds across several categories, as detailed in Form ADV Part 2A:
Merger Arbitrage
- Paulson Partners L.P.
- Paulson International Ltd.
Merger Arbitrage (1.5x exposure)
- Paulson Partners Premium L.P.
Merger Arbitrage (2x exposure)
- Paulson Enhanced Ltd.
- Paulson Partners Enhanced L.P.
Event Arbitrage
- Paulson Advantage Master Ltd.
Event Arbitrage (1.5x exposure)
- Paulson Advantage Plus Master Ltd.
Credit Fund
- Paulson Credit Opportunities Master Ltd.
Special Situations Fund
- Paulson Special Situations Master Fund Ltd.
Gold Fund
- PFR Gold Master Fund Ltd.
Event Equity
- Paulson European Event Equities Master Fund Ltd.
Long/Short
- Paulson Long/Short Master Fund Ltd.
Pure Spread
- Paulson Pure Spread Fund, L.P.
- Paulson Pure Spread Fund Ltd.
Real Estate
- Paulson Real Estate Recovery Fund, L.P.
- Paulson Real Estate Fund II, L.P.
Separate Accounts: managed on behalf of institutional investors but using the same strategies as the other funds.
Note that the best-known fund, Paulson Advantage, is listed under the Event Arbitrage heading. Also, there are several leveraged funds; these deliver bigger rewards when they’re making money –Â and bigger losses when they don’t.
Although all funds are said to be managed in the same way, the firm manages quite a diverse mix of funds, not to mention the leveraged funds. Interestingly, the firm’s principals may have more skin in this game than arm's-length investors.
Paulson’s investing strategy
The firm describes itself, on its Web site, as an “investment management firm specializing in event-driven arbitrage strategies, including merger arbitrage, bankruptcy reorganizations and distressed credit, structured credit, recapitalizations, restructurings and other corporate events.”
Another way to describe the firm might be as a follower of special situations, which is to say events or disruptions that have a profound and long-lasting effect on companies (unless otherwise noted, information in this section comes from the firm’s Form ADV Part 2A Brochure).
It has three objectives: “Our goals are capital preservation, above average returns over the long term and low correlation to the markets.”
To execute, it uses “bottom-up fundamental research within corporate events and sectors where we have expertise.” In addition, it focuses on compounding gains over the long term.
By way of process, Paulson begins with fundamental (and sometimes legal) analyses of financial and legal documents of candidate companies. In addition, managers and analysts take part in conference calls and monitor external data.
Candidate companies are caught up in situations that might change the corporate structure, or control, and lead to "positive excess returns" for shareholders. That includes situations such as:
- Tender offers.
- Mergers.
- Spinoffs.
- Proxy contests.
- Liquidations.
- Recapitalizations.
- Restructuring.
- Bankruptcy reorganizations.
It aims to buy securities or derivatives of these challenged corporations "at a discount to what it believes will be their value on consummation of the proposed event."
At the same time, Paulson tries to minimize exposure to the general securities markets by dealing in event-specific investments that do not mimic the ups and downs of the market.
While most of its attention goes to the trading of common stock, the firm also trades a wide array of other securities, including other equities, debt vehicles, options, forward and future contracts and credit derivative swaps. Commodities such as gold and real estate investments are also the focus in some funds.
As it notes in the Form 2A Brochure, a derivative contract such as options involves leverage, which can deliver exceptional gains and losses, accounting for the 1.5x exposure and 2.0x exposure funds. They note “an adverse change in the relevant price level can result in a loss of capital that is more exaggerated than would have resulted from an investment that did not involve the use of leverage inherent in the derivative contract.”
Paulson and his company research the fundamentals to find stocks that may be available at a discount because of a restructuring or change of control. And by buying stocks and other securities caught up in these special situations they aim to avoid correlations with the broader markets; a diversification strategy of a different type.
Current holdings
As this GuruFocus chart shows, slightly more than half of the Advantage portfolio is made up of health care stocks:
These are the top 10 holdings in the portfolio:
- Allergan PLC (AGN, Financial) 9.4%.
- Shire PLC (SHPG, Financial) 9.31%.
- Mylan NV (MYL, Financial) 9.01%.
- SPDR Gold Trust (GLD, Financial) 6.92%.
- Teva Pharmaceutical Industries Ltd. (TEVA, Financial) 4.72%.
- Mallinckrodt PLC (MNK, Financial) 4.47%.
- Extended Stay America Inc. (STAY, Financial) 4.26%.Â
- Time Warner Inc. (TWX, Financial) 3.95%.
- American International Group Inc. (AIG, Financial) 3.80%.
- T-Mobile US Inc. (TMUS, Financial) 3.58%.
With five of the top six positions filled with health care stocks –Â and the exception filled with a gold-related stocks –Â volatility seems a given. Although Paulson tries to reduce risk through "event-specific" investments, this profile looks riskier than the profiles of other gurus.
Paulson’s performance
The guru has been an underperformer in the past few years. Bloomberg reports that Paulson lost $3 billion in 2016, the worst performance among the top 20 hedge funds.
The following returns, as listed by GuruFocus, underline the progressive lagging of the Advantage Funds average annual returns:
- Five years: 4.1%.
- Ten years: 7.9%.
- Inception: 11.7%.
The New York Times reported the Advantage Fund suffered double-digit losses in 2014, 2015 and 2016. It adds that the some of merger funds, credit funds and gold funds have managed gains, but they haven’t been enough to pull the overall portfolio above the waterline. The paper also observes, “Health care bets, in particular those on pharmaceutical companies, have proved especially punishing for Mr. Paulson and his investors. Losing wagers on economic recoveries in Greece and Puerto Rico haven’t helped.”
“Together, the five pharmaceutical stocks [Valeant (VRX, Financial), Shire, Allergan, Mylan and Teva] have generated at least $4 billion in losses for Paulson's fund, Fortune estimates. And while some of those stocks got a boost following Trump's victory in the presidential election – partly on the belief that the Trump administration will go lighter on pharmaceutical regulation than Hillary Clinton would have – Paulson, who himself is part of Trump's inner advisory circle, missed out on some of the gains, having sold down his drug company positions just before their rally, according to securities disclosures.” – Fortune Magazine
This information suggests that Paulson’s long-term gains depend on long-past glories, including the right bet on subprime mortgages a decade ago. Health care missteps are erasing the gains that long-time investors might have enjoyed had the Advantage and other funds gone in different directions in 2009 and beyond.
Conclusion
Paulson & Co. has three objectives: to preserve capital, to generate above average returns over the long term and little correlation with the markets.
But clients have failed to see either the first or the second over the past decade. Three years of double-digit losses have destroyed the gains and momentum of earlier years.
Bad health care picks no doubt caused much of this pain, but losses such as these beg the question, “Is the overall strategy wrong for these times?” We might also ask, “Is there a systemic problem underlying these results?”
Special situations can produce above average returns, but they can also produce above average losses. In particular, we might ask about the logic of leveraged funds when the basic strategy appears to be flawed.
Disclosure: I do not own shares in any of the stocks listed in this article, nor do I expect to buy any in the next 72 hours.
