He Made the Trade of the Century. Now What?

At a recent visit to the London School of Economics, Queen Elizabeth II asked the faculty and students the following about the financial crisis: "Why did nobody notice it?"

It turns out the queen was misinformed. There are a dozen high-profile economists, strategists, and fund managers who warned about the consequences of the housing bust -- before it happened. But there is only one who profited spectacularly from it: John Paulson of Paulson & Co.

The trade of the century
John Paulson had expertise in merger arbitrage, so betting against the housing bubble was met with extreme skepticism when he tried to raise money for his Credit Opportunities fund in 2005. The original amount raised was only $150 million, mainly from European investors. The fund was invested in cheap -- at the time -- credit-default swaps on mortgage bonds, and later, in outright short positions of the various ABX indexes, which track the performance of different vintages of mortgage securities.

The fund also sold short risky slices of CDOs, which in the end completely evaporated in value. In a CDO structure, profits trickle down from the top, while losses on mortgages are first absorbed by the lower-rated tranches. If there are large losses -- as there were in this case -- the lower-rated tranches completely disappear as the losses are being absorbed.

The end result was that the Credit Opportunities fund earned 590% in 2007 and the Credit Opportunities II fund, started in January 2007, earned 350%. Due to the incentive structure of the hedge fund industry, Mr. Paulson earned $3.7 billion in the process, the largest single-year payout by a hedge fund manager.

With that as background, let's examine the stocks Paulson is buying now.

Billionaire's portfolio
The big bet in John Paulson's portfolio is impossible to miss: gold. According to the most recent SEC filings, here are his top holdings:

Source: SEC Form 13-F, as of March 31, 2009, and SeekingAlpha.

A caveat: Paulson & Co. has various funds with very different strategies. The SEC filings do not allow for an observer to see the segregated portfolios of the different funds, but sizable positions can speak for themselves, as is the case here.

Paulson & Co. owns 31.5 million shares of the SPDR Gold Trust alone, which is close to $3 billion worth of gold bullion. The market capitalization of the entire PHLX gold and silver index is about $180 billion. The SPDR Gold Trust, of course, is not part of the index -- it is a claim on a real asset, not a stock. It is worth noting that this seems to be a sector bet, as the second-largest precious metals position is in the Market Vectors Gold Miners ETF.

Refresher
I've written before about how gold works well as both an inflationary and a deflationary hedge, as well as a hedge against a rout in any currency, not necessarily only the U.S. dollar. I don't see inflation being a problem in 2009, given the collapse in the securitization mechanism. It is worth noting that Mr. Paulson benefited handsomely from this collapse, and now he is trying to position himself for any outcome, be it deflationary or inflationary in nature.

I believe deflationary pressures will persist for a while. The velocity of money is still slowing down, so I don't see anything happening on the inflation front soon. I too am worried about inflation at some point, but at this very moment, I am worried more about deflation.

The non-precious positions
From the non-precious positions, there are situations that try to capture the difference in the merger spread on announced takeovers, as is the case with Rohm and Haas -- whose acquisition by Dow Chemical closed the day after the quarter’s end -- and Wyeth, which is being purchased by Pfizer. Typically, as the deals close, the positions will be closed too.

There seem to be kosher positions in JPMorgan and Philip Morris International, both unrelated to any takeovers. I like both of these stocks very much -- JPMorgan is a well-run bank, and Philip Morris International is the spectacularly profitable, high-growth part that was spun off from Altria.

Foolish final thoughts
Upon careful consideration, it looks like Mr. Paulson has positioned himself extremely defensively. They often say that in most team sports, the offense gets the glory, but the defense wins the game. Mr. Paulson appears to have learned this lesson well, which is why he is likely to keep -- and multiply in coming years -- the profits from the killing he made in shorting mortgage securities.

Investors will be well served to learn the same lesson about defense.

More on Paulson:

• Paulson's Pet Gold Miner Gets a Foolish Thumbs-Sideways
• Paulson Calls a Bottom in the Mortgage Market
• (Hank) Paulson's Plan: A Cheap Mortgage for Every Home