Nobody's Listening to the World's Most Successful Investor

Here's an example of how the financial media get things wrong: Last week, journalists and commentators marveled at a couple of news items regarding hedge fund titan John Paulson, but they completely ignored a much more interesting tidbit from the same man. It's very odd: The topics that got all the attention concern past performance; meanwhile, Paulson's future outlook came out to the sound of crickets.

A $5 billion bonanza!
To recap the "big" news: The Wall Street Journal reported that Paulson earned an astounding $5 billion personally in 2010. That's a big number, but Paulson manages a lot of money, and his performance was impressive (Paulson & Co. funds returned between 11% and 35%). As Paulson pointed out in his year-end investor letter, part of these gains are attributable to the $1 billion in profits he earned on his Citigroup (NYSE: C  ) position since mid-2009. (Interested in Citi? Have a look at my bank basket trade idea.)

In the same letter, Paulson discusses his market outlook, which is what investors should really be interested in. The guarded hedge fund manager takes unusual precautions to keep his investor letters out of the public domain. Most of his investors can't print the letter out more than once or view it on more than one computer. Despite this, a copy did make its way onto the Web.

Bullish on stocks
The upshot of this outlook? Paulson is bullish on stocks:

The Equity Risk Premium is now the highest it has been in over 50 years, indicating to us that equities are due to rise as the current economic environment is by no means the most challenging it has been in 50 years. In fact, corporate earnings and global growth were quite strong in 2010.

If you're wondering what the equity risk premium is, Paulson explains "it essentially shows the difference between the yield on equities and the yield on bonds." (The yield on equities refers here to the earnings yield, a measure of shareholder return equal to earnings-per-share divided by share price -- in other words, it's the inverse of the price-to-earnings ratio.)

4 Paulson & Co. holdings
I compared the earnings yield of all the stocks in the S&P 500 with an estimate of the return investors should require to hold them (I derived the estimates using the Capital Asset Pricing Model). The four stocks in the following table are at the top end of the list in terms of the extra return earned over their required return, which suggests that they are undervalued. They also happen to be Paulson & Co. holdings at the end of the third quarter:

Company

Current Yield (Actual)*

Required Return (Theoretical)

Capital One Financial (NYSE: COF  ) 12.3% 7.4%
Family Dollar (NYSE: FDO  ) 6.4% 3.7%
JPMorgan Chase (NYSE: JPM  ) 8.8% 6.8%
Pfizer (NYSE: PFE  ) 7.5% 5.3%
S&P 500 6.6% --
10-year T-bond 3.4% --

Sources: Capital IQ, a division of Standard & Poor's, and the Federal Reserve. *As of Jan. 28. Earnings yield for stocks, yield-to-maturity for the 10-year T-bond.

The CAPM is far from infallible, and one needs to use judgment with these results. For example, anyone who actually believes investors should be satisfied with less than a 4% return on a no-moat business like Family Dollar ought to have their head examined. Indeed, looking at the earnings yield in isolation already provides some indication of a stock's attractiveness. The following two stocks sport some of the highest earnings yields in the S&P 500; in my opinion, they're very likely to be undervalued:

Company

Earnings Yield

Explanation for Apparent Undervaluation

SUPERVALU (NYSE: SVU  ) 19% Overreaction to missed earnings/ lowered guidance on Jan. 11.
Eli Lilly (NYSE: LLY  ) 11% Concerns regarding patent expirations/ drug pipeline.

Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's.

Equities are due to rise?
While there are certainly individual stocks that remain undervalued in this market, Paulson's notion that equities, in aggregate, "are due to rise" looks flat wrong. Furthermore, I'm not sure why Paulson thinks the equity risk premium is "the most relevant indicator we track in the current environment" -- the same environment in which the Treasury bond market is subject to multiple distorting factors and bond yields are near historic lows. In this debate, I prefer to side with Ben Inker of asset manager GMO, who told Barron's recently:

There are a few things that people tend to get wrong. One of them is an obsession with comparing stocks to bonds. So if you are in a situation like today, where bond yields are very low, people say, "Well, that makes stocks look cheap." It doesn't make stocks cheap. It is possible for stocks and bonds to be simultaneously cheap or simultaneously expensive.

That may not be a problem for Paulson, who is, after all, a value investor focusing on arbitrage situations and specific, undervalued securities. However, it should give pause to investors with broad exposure to the U.S. stock market.

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The COO of Paulson & Co. is a member of The Motley Fool's board of directors. Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Pfizer is a Motley Fool Inside Value recommendation. The Fool owns shares of JPMorgan Chase and SUPERVALU. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (58)

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 February 01, 2011, at 7:50 PM, sagolfer wrote:

    " (hat tip to Zero Hedge)"

    Did you just give a hat tip to someone for publishing copyright protected material that people pay for and agree not to share?

    Maybe Zero Hedge can publish the content of the Fool subscription services for all to view for free. Will we get them a "hat tip"?

    :-)

  • Report this Comment On February 01, 2011, at 8:12 PM, fatdiesel wrote:

    I imagine that Mr. Paulson is using relative valuation. In a period where interest rates are chronically low, P/E ratios will go up in the aggregate. Bernanke has made it clear that rates are going to stay low for a while.

  • Report this Comment On February 01, 2011, at 8:15 PM, Merton123 wrote:

    Valuation comes down to opportunity cost. What are my alternative investment opportunities? If Gold, small cap stocks, and so-forth are priced very high what remains (i.e., large caps stocks, bonds, and cash) for most people. From an opportunity cost perspective Paulson may be correct that USA large cap stocks are the only remaining investment which seems reasonable priced in comparison to what other investment possibilities exist. This is probably a good time to be broadly diversified and dollar cost averaging to minimize to minimize downsize risk.

  • Report this Comment On February 01, 2011, at 8:31 PM, TMFAleph1 wrote:

    @Merton123

    Actually, I think it's a horrible time to be broadly diversified because stocks are -- in aggregate -- overvalued. In that environment, it's smarter to be very selective about the names you own.

    Alex Dumortier

  • Report this Comment On February 01, 2011, at 8:32 PM, TMFAleph1 wrote:

    @sagolfer

    That's the way I roll! ;-)

    Alex Dumortier

  • Report this Comment On February 01, 2011, at 11:35 PM, Merton123 wrote:

    Alex - The Vanguard Total World Index VTWSX invests in Europe which has some very low P/E multiples and also Japan which also has very low P/E multiples. Where do you think the money will go when the Feds start applying the brakes in the United States? The money will flow overseas and the Europe markets and Japanese markets will have a nice rise and the American Markets will deflate. Over the long run (i.e., ten years or more) the VTWSX will outperform the majority of mutual funds as the averages zig zag there way ever higher in my opinion. Admittedly the last decade doesn't support that perspective :)

  • Report this Comment On February 02, 2011, at 12:14 AM, TMFAleph1 wrote:

    @Merton123

    Ah, you meant broadly diversified across world markets -- fair enough.

    "Admittedly the last decade doesn't support that perspective."

    Reversion to the mean is real -- if the last decade doesn't support it, then this one is more likely to!

    Alex Dumortier

  • Report this Comment On February 02, 2011, at 12:24 AM, daveandrae wrote:

    Merton-

    Alex also said that he could not "find anything" worth buying on November 1st 2010, when the s&p 500 was trading at 1189 and GE was trading at 16, yielding 3%, and had 11.13 in net assets behind the stock price.

    The index has sent shot up by 10% and the stock has since shot up by 30%. And I have ignored dividends.

    In full discloser, I've grown my own portfolio by 19.76% since then.

    Don't take my word for it. Put "why I'm not buying anything" in the search.

    Clearly, Alex has not been around the block enough times in this business to know what "overvalued" even smells like. Let alone looks like. At 12.21 times 2011 earnings, the s&p 500 at 1308 is STILL cheap. Thus, we ain't no where near the top.

    I wonder what he's going to say this time next year when the s&p is trading well over 1500, or in 2016, when the index is trading well over 2400.

    Thomas Edmonds

  • Report this Comment On February 02, 2011, at 12:29 AM, daveandrae wrote:

    Correction-

    Right analysis, wrong Alex.

    My apologies.

    Thomas Edmonds

  • Report this Comment On February 02, 2011, at 1:20 AM, TMFAleph1 wrote:

    @daveandrae

    Inherently, there are very few certainties in financial markets; that the S&P 500 will NOT be trading "well above" 2,400 is about as close to certain as you'll get. I'll be happy to take bets on it, in any size.

    Alex Dumortier

  • Report this Comment On February 02, 2011, at 1:22 AM, TMFAleph1 wrote:

    I forgot the forecast date. The previous post should read:

    "...that the S&P 500 will NOT be trading "well above" 2,400 in 2016..."

    Alex Dumortier

  • Report this Comment On February 02, 2011, at 6:05 AM, daveandrae wrote:

    Alex-

    Two points-

    1. I put my money where my mouth is a long time ago. I don't need yours.

    2. Over the short term, the market is a voting machine. Over the long term, the market is a weighing machine.

    nuff said

    Thomas Edmonds.

  • Report this Comment On February 02, 2011, at 6:42 AM, TMFAleph1 wrote:

    Thomas,

    Your second point is true -- in the long run, market prices will reflect intrinsic value. However, it would take a voting machine, not a weighing machine, to push the S&P 500 "well above" 2,400 in 2016, since that level is well above its 2016 intrinsic value.

    Alex Dumortier

  • Report this Comment On February 02, 2011, at 8:44 AM, jargonific wrote:

    People instinctively know that his short trading has robbed average investors of their hard earned dollars. Funny that Marketwatch did not "like" my posts suggesting that hedge funds be regulated, so they censored them.. I can no longer post at all.

    I know that this crew would never do that.

  • Report this Comment On February 02, 2011, at 9:14 AM, TMFAleph1 wrote:

    I don't think people know that instinctively at all, and if they do, their instincts are completely wrong. There is no reasonable argument to support the notion that John Paulson "has robbed average investors of their hard earned dollars".

    Alex Dumortier

  • Report this Comment On February 03, 2011, at 9:00 AM, geohjr wrote:

    Paulson's the billionaire and I'm the small investor, but;

    Couldn't the equity risk premium be so large because the Fed is artifically keeping rates low through unprecedented efforts?

    Another thing I'm pondering; I believe Paulson's gains at this point are largely paper gains. His timing was precise on mortages and he made his money and got out. Now he's riding the gold wave and will be subject to that and several other investments and the near term results.

    Just thinking out loud.

  • Report this Comment On February 03, 2011, at 3:22 PM, TMFAleph1 wrote:

    "Couldn't the equity risk premium be so large because the Fed is artifically keeping rates low through unprecedented efforts?"

    @geohjr,

    Certainly agree with you here. This is what I was getting at when I wrote:

    "I'm not sure why Paulson thinks the equity risk premium is "the most relevant indicator we track in the current environment" -- the same environment in which the Treasury bond market is subject to multiple distorting factors and bond yields are near historic lows."

    As far as his gains being paper gains, that is the case for any money profitably invested in risky assets. Will these gains reverse? Paulson's track record to date is excellent, though it is certainly harder to outperform with $36 billion in assets than it is with $500 million, say.

    Alex Dumortier

  • Report this Comment On February 07, 2011, at 4:13 AM, rmiers wrote:

    Hedge funds or extra large trades DO effect securities price and value. Naked shorting is nothing more than counterfeiting stock. Cramer even bragged he could take a stock down with a few million and some "less than honest" negative news. He claimed it was "easy money". That horrible excuse for a treasury secretary Paulson said "it was good for markets because it created more money. He said this as he gave his friends the first 800bln. Too this day, the financials fiercely resist the reinstatement of Glass Stegall. These bozo's still want your money to take your own stock value. Overstock dot com had more sold short shares then ever issued. Traced to a hedge fund methinks. If a big trade goes bad, they simply don't pay for it. Wouldn't that be nice for an average investor? This is bigger scam than Madoff deal. He was just a straw man leading the public away from the real issues.

    Most of those investors stand to get back a large portion of their "ponzi" money. Goldman traders have moved offshore....some to england

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