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
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 |
12.3% | 7.4% |
|
Family Dollar |
6.4% | 3.7% |
|
JPMorgan Chase |
8.8% | 6.8% |
|
Pfizer |
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 |
19% | Overreaction to missed earnings/ lowered guidance on Jan. 11. |
|
Eli Lilly |
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.
John Paulson wrote: "We believe the U.S. economy is recovering". Get onboard this train with 3 ETFs Set to Soar During the Recovery.
