The Paulson Funds 2010 letter (click here)
As backgroud, who is John Paulson? John Paulson is head of The Paulson Funds, which is the combination of several hedge funds focusing on event arbitrage or special situations. This includes merger arbitrage, investing in distressed companies, and restructurings. Funds can be net long or short at any given time, or invested in equities and/or fixed income at any time. Recently, Mr. Paulson made large sums betting against mortgage credit and then banks with large sub-prime exposure.
News coverage of the letter focused primarily on returns for 2010. The performance could be primarily attributed to gold-denominated funds. Shortly after the first round of quantitative easing of the Fed, Paulson reasoned the increased printing of money by the Federal Reserve would devalue the dollar. Thus, he offered investors the option of being invested in gold-denominated funds, versus dollar denominated funds. For example, these gold denominated funds outperformed dollar-denominated funds by up to 46%. According to the letter, only about one-third of investors were invested in these funds.
On page 7 of the report, there is a chart titled "Paulson & Co. Roadmap." This roadmap is the illustration of the implement phases and monetization phases mentioned in the earlier post about Mr. Paulson. This roadmap is important as it illustrates the investment success in Paulson and team to identify market events before the general market does and implement strategies to monetize that mismatch.
Assets under management (AUM)
- Some have questioned the firm size and whether or not the firm was too large to make meaningful investments. Results of 2009 and 2010 indicate the opposite, as several smaller firms did not outpeform the market and are struggling to survive.
- Key is not asset size for investors, but rather firm's management team understands market conditions. The size of the firm has its advantages including: 1) lead investor in several bankruptcies; 2) management teams want Paulson to offer capital at attractive to terms to either repay debt or repair balance sheets
- High yield bonds yields how lessened and are trading at or near par causing companies in the categories of restructurings, merger arbitrage, and event arbitrage to increase in value. (The mechanics: These firms now have a lower cost of capital because bond yields have come down. When discounting the future cash flow of the firm, the cash flow will now be worth more. Thus, the underlying value of the equity in the firm should increase).
- Inflation remains a concern, and the firm has implemented stratgies to preserve capital should inflation become a bigger issue.
- Extending the Bush-era tax cuts, in addition to the other tax benefits in the recent tax compromise should help increase growth. These tax benefits should lead to somewhere around $900 billion addition in the system. According to the letter, the general growth rate consensus has gone up 0.5% as a result.
- Equity-risk premium is at the highest it has been in fifty years. (Equity risk premium = earnings yield - risk free bond yield. Earnings yield is the inverse of the P/E ratio, so earnings per share divided by current price. I used the 10-yr Treasury for the risk free bond yield).
- Make restructuring investments in high-quality assets at deeply distressed prices to take advantage of economic recovery
- As the economy moves towards normalization, companies have repaired balance sheets. Equity, especially in former distressed situations, offers substantial upside versus downside risk.
I calculated the equity-risk premium for each Dow component, excluding Caterpillar. Based on the Paulson formula, several stocks are attractively priced against government bonds. In addition, three of the top five companies on the list are also "Dogs of the Dow," indicating low risk due to high dividend yields and attractive valuations (Dogs of the Dow are highlighted in grey). In fact, JPMorgan is held by Paulson.
| Ticker | Company name | Price | TTM EPS | Earnings yield | Equity risk premium |
| T | AT&T | $27.67 | $3.35 | 12.1% | 8.6% |
| TRV | Traveler's | $56.71 | $6.62 | 11.7% | 8.2% |
| INTC | Intel | $21.56 | $2.05 | 9.5% | 6.0% |
| JPM | JP Morgan | $45.45 | $3.96 | 8.7% | 5.2% |
| CVX | Chevron | $96.48 | $8.37 | 8.7% | 5.2% |
| KFT | Kraft | $30.56 | $2.59 | 8.5% | 5.0% |
| MSFT | Microsoft | $27.94 | $2.34 | 8.4% | 4.9% |
| JNJ | Johnson & Johnson | $60.62 | $4.78 | 7.9% | 4.4% |
| HPQ | Hewlett-Packard | $46.89 | $3.69 | 7.9% | 4.4% |
| AXP | American Express | $43.72 | $3.35 | 7.7% | 4.2% |
| MRK | Merck | $33.82 | $2.59 | 7.7% | 4.2% |
| WMT | Wal-Mart | $55.86 | $4.04 | 7.2% | 3.7% |
| IBM | International Business Machines | $163.30 | $11.52 | 7.1% | 3.6% |
| XOM | Exxon-Mobil | $83.41 | $5.65 | 6.8% | 3.3% |
| MMM | 3M | $87.75 | $5.63 | 6.4% | 2.9% |
| CSCO | Cisco | $21.62 | $1.37 | 6.3% | 2.8% |
| DD | DuPont | $51.85 | $3.28 | 6.3% | 2.8% |
| BA | Boeing | $71.00 | $4.46 | 6.3% | 2.8% |
| MCD | McDonald's | $73.64 | $4.58 | 6.2% | 2.7% |
| PG | Procter & Gamble | $62.79 | $3.67 | 5.8% | 2.4% |
| UTX | United Technologies | $82.16 | $4.74 | 5.8% | 2.3% |
| KO | Coca-Cola | $62.86 | $3.25 | 5.2% | 1.7% |
| GE | General Electric | $20.71 | $1.06 | 5.1% | 1.6% |
| HD | Home Depot | $36.56 | $1.85 | 5.1% | 1.6% |
| DIS | Walt Disney | $40.49 | $2.03 | 5.0% | 1.5% |
| PFE | Pfizer | $18.96 | $0.76 | 4.0% | 0.5% |
| VX | Verizon | $36.16 | $0.90 | 2.5% | -1.0% |
| AA | Alcoa | $17.21 | $0.24 | 1.4% | -2.1% |
| BAC | Bank of America | $14.24 | ($0.37) | -2.6% | -6.1% |
For the chart below, the prices are as of February 2 close. EPS is based on the trailing twelve month EPS. Bond yield is the ten-year Treasury. All information is from Yahoo! Finance.
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