3 Recommendations From a Legendary Investor

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John Paulson, the man who made $3.7 billion personally in 2007 by wagering against subprime mortgages, gave out three investing tips last week. Prick up your ears because all three are accessible to the individual investor, in contrast with his earlier bet, which he implemented with credit default swaps. Better yet, these recommendations should do very well under a scenario that the market isn't paying much attention to right now, but that looks increasingly likely to occur.

Tip 1: Buy gold
As I highlighted in April, Paulson has made a big bet on gold; in fact, he seeded a dedicated gold fund with $250 million of his own money at the beginning of the year. At the end of June, his funds had a massive $3.8 billion position in the SPDR Gold Shares ETF (NYSE: GLD  ) . He also owns shares of several gold miners, including NovaGold Resources (AMEX: NG  ) , IAMGOLD (NYSE: IAG  ) , and Barrick Gold (NYSE: ABX  ) .

New price targets: $2,400, then $4,000
All this has been public knowledge for a while, but Paulson got much more specific last week. Speaking in front of a standing-room-only audience at the University Club in New York, he said that gold could rise to $2,400 per ounce based on fundamentals alone, and that momentum could carry it to $4,000. He further revealed that fully 80% of his own assets are denominated in gold.

Fiat money and gold: elastic vs. inelastic supply
Looking at the historical data, Paulson found that the price of gold tracks the monetary base closely. The monetary base is essentially the monetary balance sheet of the Fed and the U.S. Treasury. If the monetary base doubles over the next three years -- it has already more than doubled since the financial crisis began -- then gold should do the same, which would put it at approximately $2,400. How, then, do we get to $4,000? In a bull market, gold prices will outrun their correlation with the monetary base, which can add 100% to the predicted price, as occurred in 1980.

Are these numbers reasonable? The first one is completely plausible, since it is almost exactly equal to the price achieved by gold in 1980, once adjusted for inflation ($2,435). Sure, the 1980 high came on the back of seven years of annual inflation exceeding 8% on average, but Paulson sees the same -- or worse -- coming down the pipe. Reasoning that the Fed's experiment in quantitative easing (i.e., printing money) will spur significant inflation, he thinks it could reach the low double digits by 2012.

Tip 2: Switch out of bonds into high-quality dividend stocks
If that inflation scenario comes to pass, long-dated Treasury bonds will prove to be a disastrous investment. Consider a 10-year Treasury currently yielding 2.5%, which yield becomes an atrocious negative 7.5% real return in a 10% annual inflation environment.

When inflation threatens, investors should own real assets (i.e. stocks, real estate, commodities) over nominal assets (bonds). A fixed income stream is highly vulnerable to increases in the general price level, and with yields near historic lows, bond investors have absolutely no margin of safety (in fact, the margin of safety is negative).

Inflation protection at a good price
Meanwhile, you should expect corporate profits and dividends to rise along with inflation. I have been urging investors to consider high-quality dividend stocks for months. If you won't listen to me, perhaps you will listen to one of the greatest investors of his generation. In this category, Paulson mentioned three stocks he owns:


Dividend yield

Estimated Long-Term EPS Growth

New Paulson & Co. Position

Johnson & Johnson (NYSE: JNJ  ) 3.5% 6.7% Yes
Coca-Cola (NYSE: KO  ) 3.0% 8.5% Yes
Pfizer (NYSE: PFE  ) 4.2% 2.8% No

Source: Capital IQ (a division of Standard & Poor's), SEC.

Tip 3: Don't own long-dated bonds, sell one!
Once you've determined that bonds are overpriced, is there a way to profit from this? In theory, you could sell bonds short, but I promised you tips that an individual investor can easily implement. If you don't want to buy bonds and you can't sell them short, what can you do? You can sell a bond outright by taking out a mortgage: When you borrow cheaply -- mortgage rates hit a record low last week -- you're effectively selling your lender a very expensive 30-year bond.

Furthermore, if, or rather when inflation takes hold, the real value of your fixed mortgage payment will fall and your home value will rise. Last week, Paulson couldn't contain his enthusiasm for this strategy, gushing: "If you don't own a home, buy one. If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home."

Two slam dunks, one good speculative bet
As far as these three recommendations go, I consider gold to be a good bet, but a speculative bet nonetheless. The other two, on the other hand, are as close to investing slam dunks as you are likely to find. To be sure, a home is more than simply a financial asset for most people; however, for anyone wavering on the purchase of property, the current environment provides all the incentive anyone needs.

From 1926 to 2000, dividends contributed 40% of stocks' average annual return. Over the next decade, it could be higher than that! Matt Koppenheffer knows where to find the best dividends.

Coca-Cola and Pfizer are Motley Fool Inside Value recommendations. Johnson & Johnson and Coca-Cola are Motley Fool Income Investor picks. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Coca-Cola and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks in this article. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 06, 2010, at 2:20 PM, jesusfreakinco wrote:

    Good advice by Paulson overall. Interesting asset allocation...


  • Report this Comment On October 06, 2010, at 5:36 PM, nin4086 wrote:

    Above theory: high inflation. It is an assumption not a fact.

    Paulson: Your investment goals may not be the same as Paulson's. Also, above article is not written by him. Alex may have mis-interpreted. Or Paulson could be telling a lie about his bets (or half truth). 1980s has nothing to do with what would happen now if there was excessive inflation. Market could react completely differently.

    Home values: Not likely to rise significantly anytime soon due to the overwhelming backlog of foreclosures. Infact, they may not keep up with inflation making owning a home a bad bet.

  • Report this Comment On October 06, 2010, at 9:57 PM, ikkyu2 wrote:

    I think Paulson is right about homes - I just bought one, based entirely on the same kind of thinking as his thesis.

    What I'm afraid of is that my real wages won't keep pace with any of the other things he's talking about!

  • Report this Comment On October 06, 2010, at 10:34 PM, awallejr wrote:

    Well I can't argue against JNJ or KO, but I just hate the CEO of PFE. Look at the stock's chart over the last 10 years and you can see why. It is ugly. Yet he remains in office.

  • Report this Comment On October 07, 2010, at 12:16 AM, rtichy wrote:

    I think 2 of these ideas are whacked out for the average person. Yeah on a 15 or 30 year mortgage I believe we will see inflation that makes these mortgages look like steals, but do you want to put all your risk into one little piece of geography and a bunch of sticks and clay? You have to pay the mortgage, insure the house, maintain the house including paying for utilities, etc. All the while waiting for the late 70's- early 80's inflation to come along. And if a whole city vacates in the meantime (think Detroit), or goes "Orange County" on you, your particular investment is dead money.

    Gold is a great place to have been recently, but it reverts to a lousy investment in between bouts of popularity. And it's not really scarce or limited; there's tons of gold in the oceans in the saltwater and like tar sands, when the price is high enough it will be extracted. They dig more of it up every day, and it doesn't get used up like oil or coal. And god help you if some chemist/alchemist! figures out how to effectively convert another element into gold (unlikely, of course)....

  • Report this Comment On October 07, 2010, at 1:03 AM, TMFAleph1 wrote:


    I wouldn't worry too much about the tons of gold in the oceans (!?) or someone discovering the philosopher's stone...

    Alex D

  • Report this Comment On October 07, 2010, at 7:56 AM, nickolassc wrote:

    I agree on JNJ, also KMB, LMT, and several others are looking attractive right now. However, gold is a short term play only as the bubble will probably burst by this time next year. Good advice on selling off bonds too.

  • Report this Comment On October 08, 2010, at 8:05 AM, artiecab wrote:

    Who would ever believe Paulson. He was/is as bad as his namesake, "Hank," being involved in the bank thievery and bust. He made billions while 10% of the US citizenry are either living in thier cars or under expressway underpasses. Of course he recommends gold. He owns 3 friggen gold mines! Don't you realize what that will do to his holdings if everyone keeps buying gold? If god ever got to $4,000 an ounce and any one was stupid to buy a Krugerrand for that price, then they will deeply regret it when Paulson has already started shorting the "precious" metal. Remember what happened to gold in 1980 after it reached $800 an ounce? Short memories.

  • Report this Comment On October 11, 2010, at 10:02 AM, thefinancemaster wrote:

    A lot of pushing of gold at the moment!

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