Paulson Takes it on the Chin

John Paulson is probably the most celebrated hedge fund manager in the world. For those of you who have been living under a rock for the past few years, he rose to prominence after one of his funds returned just under 600% in 2007 after taking long positions in CDOs which tracked MBS backed by sub-prime mortgages. This trade has been the inspiration for two books: Gregory Zuckerman's "The Greatest Trade Ever" and Michael Lewis' "The Big Short", and the basis for a record-setting settlement in an SEC case filed against Goldman Sachs.

Although he was not the only one to see through the mess of subprime mortgage securitization, he certainly profited the most handsomely. He followed up this bet with short positions in select financial firms in 2008 and reversed this position in time to catch the epic rally in bank stocks from the March 2009 lows.

Lately however, he has been giving his profits back. His largest fund is down 46% year to date (here), representing approximately $9 billion in losses. In response, Paulson is reportedly scaling back risk, which will make it awfully effectively impossible for him to reclaim his high water. Presumably massive redemption requests are in the mail.

Personally, I have always thought that Paulson was a considerably over-hyped. Before his subprime bet, he was an also-ran in the merger arbitrage space. Yes, he made one fantastic call but if he was a mediocre merger-arb manager, how does one call make him a savant? His bets on a vigorous economic recovery have made it quite clear that he (and his analysts) do not understand what a post credit-bubble economy looks like. The fact that he held somewhere around $1B of Sino-Forest stock speaks volumes to his due diligence practices.

Paulson's investment attributes aside though, he may be suffering from a very common problem in the hedge fund world - size begetting poor performance. FTAlphaville recently posted an article summarizing a comprehensive report of hedge fund returns (here):

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%... The dollar-weighted number is a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number.

It is a common refrain that the best returns are earned when a fund is in its infancy, but it is nice to see someone actually run the numbers to confirm it. Combine that fact with the astronomical growth in Paulson & Co's assets under management (and a manager with dubious global macro credentials), and the -50% annualized return becomes much less of a surprise.

I would not be surprised if Paulson & Co shuts up shop sometime in 2012.

Forecast Fails

As a user of the (excellent) Bloomberg data terminals at work, I am by default a recipient of the (generally crappy) Bloomberg Markets magazine. I usually keep them on hand for when I have been thinking too hard and need to read something inane while my brain reboots.

This month’s edition had an article titled “The World’s Best Financial Stock Pickers” which detailed the sell-side analysts – complete with awkward, contrived photographs – who had the best record calling financial stocks since January 2009.

The best team was Citigroup, who “made 26 accurate calls on the 43 financial stocks they follow”. 60 percent. That was the best of 212 firms - not very impressive. Despite having a section on “How We Crunched the Numbers”, the authors were not clear on what constituted a correct call in their methodology. This is unfortunate because it does not allow us to determine whether flipping a coin is more accurate than all that analysis. That being said, this gem implies that maybe the Citi team was better than the 60% implies: “on average, the 212 firms ... got 1.3 stock recommendations correct out of every 16”. I don’t know if that’s a typo, but it sure makes me sceptical of the next bounce I see off of an analyst upgrade.


Note: As an aside, there a few members of my organization who consider Bloomberg Markets to be more insightful than much higher-quality publications such as The Economist. Such a conviction is generally an excellent indicator of the intellectual capacity of its possessor.

Wisdom from the Gartman Letter

I recently came across a blog which discussed the top 10 rules of trading, according to the Gartman Letter, an excellent daily piece which "addresses political, economic, and technical trends from both long-term and short-term perspectives".  I thought they were worth sharing here:

1. Never, ever, ever add to a losing position: To do so will eventually and absolutely lead to ruin. Remember Long Term Capital Management and its legion of Nobel laureates who broke this rule repeatedly and went into forced liquidation. Learn this lesson well and early!
2. Capital comes in two varieties: Mental capital, and that which is in your account: Of the two, mental capital is the more important. Holding losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
3. The objective is not to buy low and sell high, but to buy high and to sell higher: We can never know what price is “low.” Nor can we know what price is “high.” Always remember that Nortel fell from $85/share to $2 and seemed “cheap” all times along the way.
4. “Markets can remain illogical longer than you or I can remain solvent,” is a brilliant statement from our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are inefficient despite what the academics try to tell us.
5. Sell that which shows the greatest weakness, and buy that which shows the greatest strength: Metaphorically, when bearish, throw rocks into the wettest paper sack, for they break most readily. In bull markets, ride the strongest winds.
6. Think like a fundamentalist; trade like a technician: It is imperative that we understand the fundamentals driving a trade, and that we understand the market’s technicals also. When we do, then, and only then, should we trade.
7. Understanding psychology is usually more important than understanding economics: Markets are driven by human beings making human errors and also making super-human insights.
8. Be patient with winning trades; be enormously impatient with losing trades: Remember, it is quite possible to make large sums trading/investing if we are “right” only 30% of the time, as long as our losses are small and our profits are large.
9. The Hard Trade is the Right Trade: If it is easy to sell, don’t; and if it is easy to buy, don’t. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this 25 years ago and it holds truer now than then.
10. There is never one cockroach: Bad news begets bad news, which begets even worse news.

You Can Lead a Horse to Water...

Okay, so I wrote in the run up to Goldman's earnings that the stock was a good buy on the gut reaction sell/short on the back of news of the SEC's lawsuit.  My basic intuition was twofold: the case seemed quite bunk (a feeling that has been reinforced since); and even if Goldman is found guilty, the approximately $14B hit to their market cap was a large overreaction.  My expectation was that Goldman would surpass earnings expectations by a mile and they did: EPS of $5.59 vs expectations of $4.16 (beating by approx. 40%).  The gross figures were revenues of $12.8B, $7.4B of which was from Fixed Income, Commodities and Currencies (FICC), and profits of $3.29B.  Enormous quarterly numbers, but the stock refused to budge. 

Clearly the trade I recommended was not much good (although had you bought at open Friday and sold at open Tuesday - the day of the earnings report - you would have netted a couple percent).  People who seek to improve themselves look at their decisions, and aided with the benefit of hindsight they isolate where they went wrong in order to avoid such mistakes in the future.  My mistake hereis quite clear.  The overriding negative sentiment from the SEC case (no matter how bunk) made it impossible for this stock to bounce nicely on a very strong earnings report.  The lesson?  In the short term, perceptions (animal spirits) outweigh fundamentals.  I feel very strongly that Goldman will continue to outperform and my ideas will be vindicated in the long run.