1 Huge Lesson From the Blowup of an Investment Giant

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Who is John Paulson? Yes, he's the guy who made billions betting against the real estate mess. Yes, he made nearly $5 billion for himself last year as his assets under management ballooned. And, yes, he's also the media-dubbed ace hedge fund manager who has gotten absolutely clobbered this year.

But who is John Paulson really?

Oh, no, no. I'm not asking about his home life or his hopes and dreams. I'm talking about who is he really as an investor. Since most people hadn't ever heard of John Paulson until after he'd made billions from his housing positions, it may be easy to assume that Paulson is simply a great all-around investor. But, in fact, for most of the history of his fund, he was pretty specialized.

Prior to getting into the hedge fund business, Paulson was an investment banker. He started with Odyssey Partners, then went to Bear Stearns, where he became a managing director in the mergers and acquisitions division. After that, he made the very reasonable jump to Gruss Partners -- a hedge fund that focuses on merger arbitrage. From Gruss, he went on to start his own fund in 1994, continuing his focus on merger-arb.

By 2003, Paulson's funds were managing a cool $700 million and he was excited about the future for his enterprise. In a July 2003 interview, he said:

Our goals are to continue to grow our asset base and remain focused on the merger arbitrage area. We think merger arbitrage is a very attractive long-term alternative investment strategy and can produce good returns, with low volatility and minimal correlation. We want to be one of the top performers in our category.

But then...
It all changed when Paulson realized that there was a massive bubble building in credit markets. In April of 2005 he started betting heavily against the credit markets. He made billions, his investors made a ton of money, blah, blah, blah... you know that part of the story.

Fast-forward to today. After much of the media finished dubbing him the hedge fund manager with the Midas touch, everything that Paulson now invests in seems to turn to lead. According to The New York Times, for the year through the third quarter, Paulson's Advantage and Advantage Plus funds were down 32% and 47%, respectively, while his Recovery Fund was off 31%. The Times also noted that HSBC ranked Paulson's Advantage Plus fund "the fourth-worst-performing fund in its entire universe, and that was before it recorded September's dismal results."

The extent to which Paulson's investments are getting hammered is almost comical it's so extreme. Year to date, the S&P 500 index is down 3.4%. Included among the Paulson funds' largest positions at the end of last year were:

Company

Percentage of Paulson Funds' Holdings on December 31, 2010

Year-to-Date Performance

Citigroup (NYS: C)

6.2%

(36.4%)

Bank of America (NYS: BAC)

5.2%

(51.4%)

Hartford Financial (NYS: HIG)

3.7%

(28.2%)

SunTrust Banks

3.2%

(34.7%)

Sino-Forest

2.6%

79.4%

Popular

0.7%

(43.3%)

Source: S&P Capital IQ and Yahoo! Finance.

This is an absolutely abysmal performance for a guy who had this to say of his philosophy in a 2007 interview:

Watch the downside, the upside will take care of itself. That's been a very important guiding philosophy for me. Our goal is to preserve principal, not to lose money. Our investors will forgive us if our returns don't beat the S&P in a given year, but we are not forgiven if we have significant drawdowns.

What in tarnation happened?
At least from this Fool's vantage point, the answer seems pretty obvious. If we look back to the Paulson funds' holdings at the end of 2004, the top positions were mostly characteristic of a merger-arb operation. A nearly 14% stake in Sprint almost certainly had a lot to do with Sprint's announced cash/stock deal to buy Nextel. There was a new 10% position in International Steel Group which had announced in October that it would be acquired by the forerunner to today's ArcelorMittal. A 9% position in Symantec likely had everything to do with the company's all-stock takeover of Veritas. And the 8.5% chunk of Mandalay Resort Group seems perfectly lined up with MGM Resorts' acquisition of that hotel group. And I could go on.

Scoot the time period to year-end 2006 and we see much the same thing, with major positions in Phelps Dodge (acquired by Freeport-McMoRan), Constellation Energy (wrapped up in an ultimately failed merger with NextEra Energy), and Symbol Technologies (bought out by Motorola).

Finally, look at his major positions at the end of the second quarter of this year. There is, of course, the massive position in SPDR Gold Trust. Then you've got a huge variety of financials including Citigroup, Capital One, Hartford Financial, and Wells Fargo. Past that, there are bets on a variety of other companies from Hewlett-Packard (NYS: HPQ) to Whirlpool (NYS: WHR) and Teva Pharmaceutical (NAS: TEVA) .

Sure, there are still some merger-arb-related positions, such as the funds' stake in Berkshire Hathaway (NYS: BRK.B) target Lubrizol. But to a large extent, it looks to me like there has been a change in the broad investing approach of the Paulson funds. And I can't help but wonder whether this has a lot to do with the funds' terrible year-to-date performance.

What this means to you, dear Fool
You don't see Tim Lincecum clamoring to get more at-bats and play center field. I haven't heard anything about Adrian Peterson ever begging to be moved to linebacker. And last I heard, Mick Jagger isn't trying to write a cookbook.

As an investor, it's important to know what you know and understand what you're good at. While it's great to have big investment successes, it's important not to let that get to your head and convince you that you suddenly know everything about everything and that you can skillfully invest in anything and everything.

With that in mind, if you're interested in further honing in on the companies, industries, and investing strategies that are in your wheelhouse, a watchlist is a great way to do it. You can add any of the stocks above to your watchlist by clicking the "+" next to their ticker or you can start a new watchlist for free by clicking here.

At the time this article was published The Motley Fool owns shares of Bank of America, Citigroup, Berkshire Hathaway, Wells Fargo, Teva Pharmaceutical Industries, and Freeport-McMoRan Copper & Gold. Motley Fool newsletter services have recommended buying shares of Teva Pharmaceutical Industries and Berkshire Hathaway. 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.Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, Bank of America, Hartford Financial Services, Teva Pharmaceutical, and Arcelor Mittal, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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